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Market Risk Measurement in Context
by Eben Maré, Associate Professor, Department of Mathematics and Applied Mathematics,
Traditionally, market risk is defined as the risk of losses in on- and off-balance sheet exposures as a result of market movements. The market events surrounding the 2008-credit crisis force us to have a deeper understanding of market risk and its effects on our enterprise. The aim of this short article is to present the market risk process and to present its (frequently misunderstood) measurement metrics.
Risk management process
Figure 1 illustrates the market risk management process.
Firstly, risk identification looks at the sources of market risk in our business. This entails understanding our income statement and balance sheet and the source of any changes to these. As part of this process we need to consider carefully how we value any financial instruments directly or indirectly. Direct valuation would pertain to holdings in shares and physical assets, for example, whereas indirect valuation would pertain to embedded derivatives.
Monitoring and control of exposures ensures that identified and measured risks conform to the stated risk appetite of the organization.
The second step relates to measurement metrics. This entails quantifying our exposure to moves in the market, i.e., what is the monetary effect of a move in the underlying on our business? We provide a detailed discussion of typical metrics, namely, Value-at-Risk and Stress Testing, in the next section.
Monitoring and control of exposures ensures that identified and measured risks conform to the stated risk appetite of the organization. Attaching a metric to identified risks means that we have a sense of the economic damage that could be caused as a result of that risk. We would therefore impose a limit on the risk to ensure adequate control. We would monitor actual exposure against the limit periodically (typically on a daily basis). Exposures above our limits would be reported to senior management and a process would be enacted to ensure the exposures are reduced to within the agreed levels.
The last step of the process is highly important but frequently neglected. How do we test whether our market risk management metrics and controls are working? We need to substantiate our metrics and back-test these to the actual statements of profit and loss on a periodic basis to ensure that we have not overlooked any sources of risk, no matter how small they might seem.