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BACKGROUND
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any of the basic concepts used in risk management have evolved from models and methodologies that were originally developed decades ago. Nowadays, most financial organizations have established sophisticated risk management infrastructures, policies, and processes, which support senior management in the steering and fine-tuning of the risk appetite and risk capacity of institutions. However, crises and accidents have happened in the past and will happen again in the future. Regulators have established rules and methods to measure the risks of individual institutions and to force them to support these risks with capital. Many quantitative models and methodologies have evolved from modern portfolio theory, option pricing theories, and other investment-oriented methodologies. The models have been refined for different instruments and asset types, for short and long investment horizons, etc. But the mapping of regulatory-oriented policies onto academic models and practical everyday applications is not without problems. This chapter analyzes the different models and approaches to market risk, including assumptions and conditions underlying these models and approaches. It also discusses the tolerance and compatibility of both the practical and regulatory approaches to market risk. We will focus on topics such as time horizon, calculation approaches for probability, volatility and correlation, stability of assumptions, and the impact of liquidity. Financial institutions, faced with the need to comply with far-reaching regulations, have a natural incentive to achieve an understanding of the details of risk models and approaches, and to reduce the regulatory re33
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quired capital. The capital saved through understanding academic and regulatory frameworks allows organizations to invest the exempt capital in new and other business opportunities.
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2.2 DEFINITION OF MARKET RISK
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The Bank for International Settlement (BIS) defines market risk as the risk of losses in on- and off-balance-sheet positions arising from movements in market prices. 1 The main factors contributing to market risk are equity, interest rate, foreign exchange, and commodity risk. The total market risk is the aggregation of all risk factors. In addition to market risk, the price of financial instruments may be influenced by the following residual risks: spread risk, basis risk, specific risk, and volatility risk:
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Spread risk is the potential loss due to changes in spreads between two instruments. For example, there is a credit spread risk between corporate and government bonds. Basis risk is the potential loss due to pricing differences between equivalent instruments, such as futures, bonds, and swaps. Specific risk refers to issuer-specific risk e.g., the risk of holding a corporate bond versus a Treasury futures contract. How to best manage specific risk has been extensively researched and is still a topic of debate. According to the capital asset pricing model (CAPM), specific risk is entirely diversifiable. (See Section 2.4.1 for a discussion of the CAPM.) Volatility risk is defined as the potential loss due to fluctuations in (implied) volatilities and is referred to as vega risk.
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To determine the total price risk of financial instruments, market risk and residual risk have to be aggregated. Risk is not additive. Total risk is less than the sum of its parts, because the diversification between different assets and risk components has to be considered (i.e., the correlation would never be 1). This effect is described as diversification effect. High diversification effect between market and residual risk is expected due to the low correlation. Table 2-1 lists the key risk dimensions that give rise to market and credit exposure. Risk can be analyzed in many dimensions. Typically, risk dimensions are quantified as shown in Figure 2-1, which illustrates their interrelationship. Fluctuations in market rates can also give rise to counterparty credit exposure and credit risk, as an increasing interest-rate level makes it more difficult for the issuer to pay the accrued interest rate from the operative cash flow, and as the higher interest rates lower the profit margin.
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