Market Risk :

In a sense, the market risk arises on account of the external factors, i.e., market forces of demand and supply factors. Market risk arises from the adverse movements in market price. Market risk can also be defined as the risk of losses on account of on-balance sheet and off balance sheet positions due to the movements in market prices.

The market risk can be broadly recognized as: (i) Interest Rate Risk (ii) Foreign Exchange Rate Risk  (iii) Equity Price Risk (iv) Commodity Price Risk

Interest Rate Risk:

One of the important factors that affect the bottom line of any bank is the volatile movement of. Interest rate. . The interest rates of deposits/loans are basically determined by the market forces (i.e., demand and supply for/ of funds). These are influenced by various factors like: (i) Government Policies (ii) Speculation (iii) Inflow and outflow of funds (iv) present and future commitments (v) Other factors such as opportunities to invest in other markets etc.

The risk that an investment’s value will change is due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. Such changes usually affect securities inversely and can be reduced by diversifying (investing in fixed-income securities with different durations) or hedging (e.g. through an interest rate swap).

Exchange Rate Risk:

The price movement in terms of foreign exchange transactions (deals) is called the exchange rate risk. The exchange rate movement is mainly felt in case of the floating exchange rate system (price/exchange rate is decided by the demand and supply factors). As the markets are wide spread and the exchange rate movement is so quick and moves either way (up and down), it is difficult to assess the market movements when it is very volatile. The volatility in the exchange rates movement are due to various factors such as the Government and Regulators’ policies, speculation, forecasting, markets operating in different time zones almost on 24 x7 basis etc.

The market risk positions necessitate a bank to maintain the capital for calculation of capital adequacy ratio is:

(i) The risks associated with the interest related instruments and equities in the trading book of the banks and

(ii) Foreign exchange risk (including exposures in precious metals) throughout the bank, both in banking and trading book

Banking book:

The banking book comprises assets and liabilities, which are contracted basically on account of relationship or for steady income and statutory obligations and are generally held till maturity.

Trading book:

Investments held for generating profits on the short term differences in prices/yields, Held for trading (HFT) and Available for sale (AFS) category constitute trading book.

Market risk can be assessed/measured by various analysis such as scenario analysis, trend and stress analysis

Scenario Analysis:

Scenario Analysis is a method in which the earnings or value impact is computed for different interest rate scenarios.

It is the process of estimating the expected value of a portfolio after a given period of time, assuming specific changes in the values of the portfolio’s securities or key factors that would affect security values, such as changes in the interest rate.

Stress Analysis (testing):

This is used to evaluate a bank’s potential vulnerability to certain unlikely events or movements in financial variables. The vulnerability is usually measured with reference to the bank’s profitability and /or capital adequacy

Duration Analysis, measures the price volatility of fixed income securities. It is often used in the comparison of interest rate risk between securities with different coupons and different maturities. It is defined as the weighted average time to cash flows of a bond where the weights are nothing but the present value of the cash flows themselves. It is expressed in years. The duration of a fixed income security is always shorter than its term to maturity, except in the case of zero coupon securities where they are the same.

Market Risk – Basel II norms:

Market risk is defined as the risk of loss arising from movements in market prices or rates away from the rates or prices set out in a transaction or agreement. The capital charge for market risk as per the Basel norms can be estimated by two methods viz., Standardized Measurement Method and internal risk management model.

The Standardized Measurement Method:

This method, currently implemented by the Reserve Bank, adopts a ‘building block’ approach for interest-rate related and equity instruments which differentiate capital requirements for ‘specific risk’ from those of ‘general market risk’. The ‘specific risk charge’ is designed to protect against an adverse movement in the price of an individual security due to factors related to the individual issuer. The ‘general market risk charge’ is designed to protect against the interest rate risk in the portfolio. In the Standardized Approach, there are two ways to measure market risk i.e., duration method and maturity method. Under the duration method banks can calculate the interest rate risk, by calculating the price sensitivity, of each position separately. Further the measurement of capital charge for market risks should also include all interest rate derivatives and off-balance sheet instruments in the trading book.

Foreign exchange open positions and gold open positions are also to be considered for capital charge as per Basel norms and the Reserve Bank of India guidelines.

Banks should strictly follow the Reserve Bank of India’s guidelines in classification of securities as Held for Trading, Available for Sale etc., and accordingly assign risk weights. Banks should also assess their trading books and assign risk weights as per the Reserve Bank guidelines

Proper risk management and internal control assist organizations in making informed decisions about the level of risk that they want to take and implement the necessary controls to effectively pursue their objectives.

Risk management and internal control are therefore important aspects of an organization’s governance, management, and operations. Successful organizations integrate effective governance structures and processes with performance focused risk management and internal control at every level of an organization and across all operations.

However, risk management and internal control are not objectives in themselves. They should always be considered when setting and achieving organizational objectives and creating, enhancing, and protecting stakeholder value

Value at Risk:

Market risk can be measured through this tool called “Value –at- Risk” (VaR). .VaR is a method for calculating and controlling exposure to Market Risk. It is a single number (currency amount) which estimates the maximum expected loss of a portfolio over a given time horizon (holding period) and at a given confidence level. It is measured in three variables: the amount of potential loss, the probability of that amount of loss and the time frame.