Market Risk

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Market Risk</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"><p class="word_list"> <a href="#business risk">business risk</a><p class="word_list"> <a href="#market risk">market risk</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table5"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body">Business activities entail a variety of <a href="../articles/risk.htm">risks</a>. For convenience, we distinguish between different categories of risk: market risk, <a href="../articles/credit_risk.htm">credit risk</a>, <a href="../articles/liquidity_risk.htm">liquidity risk</a>, etc. Although such categorization is convenient, it is only informal. Usage and definitions vary. Boundaries between categories are blurred. A loss due to widening credit spreads may reasonably be called a market loss or a credit loss, so market risk and credit risk overlap. Liquidity risk compounds other risks, such as market risk and credit risk. It cannot be divorced from the risks it compounds.</p> <p class="body">An important but somewhat ambiguous distinguish is that between <b><a name="market risk">market risk</a></b> and <b> <a name="business risk">business risk</a></b>. Market risk is exposure to the uncertain <a href="../articles/valuation.htm">market value</a> of a portfolio. A trader holds a portfolio of commodity <a href="../articles/forward.htm">forwards</a>. She knows what its market value is today, but she is uncertain as to its market value a week from today. She faces market risk. Business risk is exposure to uncertainty in economic value that cannot be marked-to-market. The distinction between market risk and business risk parallels the distinction between market-value accounting and book-value accounting. Suppose a New England electricity wholesaler is long a forward contract for on-peak electricity delivered over the next 3 months. There is an active forward market for such electricity, so the contract can be marked to market daily. Daily profits and losses on the contract reflect market risk. Suppose the firm also owns a power plant with an expected useful life of 30 years. Power plants change hands infrequently, and electricity <a href="../articles/forward.htm">forward curves</a> don’t exist out to 30 years. The plant cannot be marked to market on a regular basis. In the absence of market values, market risk is not a meaningful notion. Uncertainty in the economic value of the power plant represents business risk.</p> <p class="body">The distinction between market risk and business risk is ambiguous because there is a vast "gray zone" between the two. There are many instruments for which markets exist, but the markets are illiquid. Mark-to-market values are not usually available, but <a href="../articles/valuation.htm">mark-to-model</a> values provide a more-or-less accurate reflection of fair value. Do these instruments pose business risk or market risk? The decision is important because firms employ fundamentally different techniques for managing the two risks. </p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="left" id="table6"> <tr> <td width="336" height="10"><font size="2"> </font></td> <td width="9" height="10"></td> </tr> <tr> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="body">Business risk is managed with a long-term focus. Techniques include the careful development of business plans and appropriate management oversight. book-value accounting is generally used, so the issue of day-to-day performance is not material. The focus is on achieving a good <a href="../articles/return.htm">return on investment</a> over an extended horizon.</p> <p class="body">Market risk is managed with a short-term focus. Long-term losses are avoided by avoiding losses from one day to the next. On a tactical level, traders and portfolio managers employ a variety of <a href="../articles/risk_metric_and_risk_measure.htm">risk metrics</a> —<a href="../articles/duration_and_convexity.htm">duration and convexity</a>, the <a href="../articles/greeks.htm">Greeks</a>, <a href="../articles/beta.htm">beta</a>, etc.—to assess their exposures. These allow them to identify and reduce any exposures they might consider excessive. On a more strategic level, organizations manage market risk by applying <a href="../articles/risk_limits.htm">risk limits</a> to traders' or portfolio managers' activities. Increasingly, <a href="../articles/value_at_risk.htm">value-at-risk</a> is being used to define and monitor these limits. Some organizations also apply <a href="../articles/stress_testing.htm">stress testing</a> to their portfolios.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table7"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table8"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/beta.htm">beta</a>—a metric of the systematic risk of a portfolio.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/credit_risk.htm">credit risk</a> Risk that a counterparty may be unable to perform on an obligation.<p class="explanatory_text" align="left"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/duration_and_convexity.htm">duration and convexity</a> Factor sensitivities employed in fixed income markets.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/risk_management.htm">financial risk management</a> Practices by which a firm optimizes the manner in which it takes financial risk.<p class="explanatory_text" align="left"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/greeks.htm"><strong style="font-weight: 400">Greeks</strong></a><strong style="font-weight: 400"> A set of factor sensitivities used to measure risk exposures related to options or other derivatives.</strong><p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/interest_rate_risk.htm">Interest rate risk</a> Risk due to uncertain future interest rates.</p> <p class="explanatory_text" align="left"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/legal_risk.htm">legal risk</a> Risk from uncertainty due to legal actions or uncertainty in the applicability or interpretation of contracts, laws or regulations.<p class="explanatory_text" align="left"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/liquidity_risk.htm">liquidity risk</a> Risk due to uncertain liquidity.<p class="explanatory_text" align="left"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/operational_risk.htm">operational risk</a> Risk due to human error, systems failure or external events.</strong><p class="explanatory_text" align="left"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/risk.htm">risk</a> Comprises two components: uncertainty and exposure.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/risk_limits.htm">risk limit</a></strong><strong style="FONT-WEIGHT: 400"> A limit placed upon risk taking activity for the purpose of avoiding excessive risk.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/risk_management.htm">risk management</a> Practices by which a firm optimizes the manner in which it takes financial risk.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/stress_testing.htm">stress testing</a> A simple form of scenario analysis typically used to assess market risk.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/valuation.htm">valuation</a> <i>Article about book value and market value accounting.</i><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/value_at_risk.htm">value-at-risk</a> A category of market risk measures.</td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_3.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%">  <p class="ad_legend" style="margin-left: 0; margin-bottom:2"> <a target="_top" href="http://www.riskexpertise.com/link/advertising.htm"> <font color="#000000">Ads by Contingency Analysis</font></a></p> <p style="margin-top: 0; margin-bottom: 0"> <iframe src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82436;type=iframe" style="margin: 0px; padding: 0px; border-width: 0px" width="336" height="265" frameborder="0" marginwidth="0" marginheight="0" scrolling="no" name="I1"> <![if lt IE 4]> <script src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82436;type=js" type="text/javascript"> </script> <noscript> <a href="http://servedbyadbutler.com/go2/;ID=147917;size=336x265;setID=82436"> <img src="http://servedbyadbutler.com/adserve.ibs/;ID=147917;size=336x265;setID=82436;type=img" border="0" height="265" width="336" alt=""></a> </noscript><![endif]></iframe>   </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Books</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table9"> <tr> <td width="100%"> <p class="explanatory_text">Allen (<a target="_blank" href="http://www.riskbook.com/link/allen_s_(2003).htm">2003</a>) is an excellent book on market risk management in trading organizations. Butler (<a target="_blank" href="http://www.riskbook.com/link/butler_c_(1999).htm">1999</a>) is an elementary text on value-at-risk, Holton (<a target="_blank" href="http://www.value-at-risk.net">2003)</a> is a sophisticated book on the same topic.</p> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table10"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap615"> <area target="_blank" coords="0, 0, 82, 124" shape="rect" href="http://www.riskbook.com/link/allen_s_(2003).htm"> </map> <img border="0" src="../images/book_allen_s_(2003)_125.gif" usemap="#FPMap615" width="83" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table11"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/allen_s_(2003).htm"> Financial Risk Management</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Steven Allen</b></td> </tr> <tr> <span style="font-family: Times New Roman; letter-spacing: -0.2pt"> <td width="10%"> <span style="font-family: Times New Roman; letter-spacing: -0.2pt"> <map name="FPMap399"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/star_5.gif" usemap="#FPMap399" width="90" height="16"></span></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <span style="font-family: Times New Roman; letter-spacing: -0.2pt"> <map name="FPMap402"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="1, 2, 89, 15"> </map> <img border="0" src="../images/tech_3.gif" usemap="#FPMap402" width="90" height="16"></span></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> 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cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table16"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_bullhorn_narrow.gif" align="left" width="27" height="22"><a target="_top" href="http://www.contingencyanalysis.com/archive/link_thread/04-1/000004c8.htm">BPV for Int Rate Swaps</a> <i>17 Dec 2003</i><br> A look at what it is really like to be a risk manager.<p class="explanatory_text"> <img border="0" src="../images/bullet_bullhorn_narrow.gif" align="left" width="27" height="22"><a target="_top" href="http://www.contingencyanalysis.com/archive/link_thread/03-2/000000b1.htm">Semivariance</a> <i>21 May 2003</i><br> Definition and estimation of semivariance.<p class="explanatory_text"> <img border="0" src="../images/bullet_bullhorn_narrow.gif" align="left" width="27" height="22"><a target="_top" href="http://www.contingencyanalysis.com/archive/link_thread/02-1/000012c0.htm">Addition of 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2000</i><br> Analyzing the market risk of convertible bonds.<p class="explanatory_text"> <img border="0" src="../images/bullet_bullhorn_narrow.gif" align="left" width="27" height="22"><a target="_top" href="http://www.contingencyanalysis.com/archive/link_thread/99-2/0000007c.htm">Risk Correlations</a> <i>06 May 1999</i><br> Measuring the risk of rare events and properties of the joint-normal distribution.<p class="explanatory_text"> <img border="0" src="../images/bullet_bullhorn_narrow.gif" align="left" width="27" height="22"><a target="_top" href="http://www.contingencyanalysis.com/archive/link_thread/99-1/00000267.htm">Alternatives to VaR</a> <i>07 Jan 1999</i><br> Brief exchange about alternatives to value-at-risk.<p class="explanatory_text"> <img border="0" src="../images/bullet_bullhorn_narrow.gif" align="left" width="27" height="22"><a target="_top" href="http://www.contingencyanalysis.com/archive/link_thread/99-1/00000249.htm">Arbitrage rule in VAR</a> <i>20 Dec 1998</i><br> 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