Why is Market Risk Management Important?

The concept of market risk has always been around ever since financial markets have existed. However, the measurement and management of market risk is fairly new and has come up only in the last three to four decades.

The recent past has seen a proliferation of theories and models which have been used to measure and monitor market risks. This has happened because of certain underlying factors in the macro market environment. In this article, we will have a look at some of these underlying factors as well as how they have impacted the evolution of market risk management.

Companies are Trading More Than Ever

The past few decades have seen a rapid upsurge in the investors who invest their money in various financial markets. This can easily be observed if we look at certain statistics.

For instance, the average number of shares traded daily on the New York Stock Exchange was close to 3.5 million. However, over the course of three decades, this number grew by a factor of 30, and the average number of shares traded daily increased to 100 million! The same trend can also be observed in the foreign exchange market. The daily transaction value used to average close to $1 billion in the year 1965. However, by the year 2000, there was almost a thousandfold increase in this daily transaction value.

Bigger institutions such as pension and insurance funds have started allocating significantly higher sums of money to the financial markets. Therefore, there has been a sudden increase in the quantum of market risk which is being undertaken by the investing community in general. This has led to an increased interest in the management and mitigation of market risk.

Trading Across Borders has Become More Common

The era of globalization has also begun after the 1970s. Prior to the 1970s, trading and investing in financial markets was mostly restricted to the geographical boundaries of the investor’s nation. However, with the passage of time, the national boundaries began to blur.

The idea that there should not be any artificial man-made restrictions in the pursuit of profit also started to take root. This is also the period when many emerging nations such as India, China, Russia, Latin America, and Eastern Europe started opening up their economies to foreign investments. Over time, these countries came to be known as emerging economies and became an important segment of the overall financial markets in the world.

Crossing international borders also brought along new types of risks. However, investors did not want to miss out on these opportunities. Hence, instead of avoiding the risks, they started looking for better mechanisms to manage the risks and this is why the field of market risk management grew rapidly during this period.

Complexity Has Introduced Newer Risks

The development of structured finance and derivatives has resulted in the creation of various new types of financial instruments. The majority of these instruments did not exist a couple of decades ago. However, investors see the utility in using them today. However, they also add risk to the overall portfolio of the same investors.

Once again, investors prefer to manage risks by using advanced techniques instead of avoiding making such investments. Hence, it would be fair to say that with the growth of complex financial instruments, the need for effective risk management has also grown!

Markets Have Become Interconnected

Now, since the same financial organizations have different positions in different parts of the globe, the markets have become more interconnected than ever. The nature of this interconnectedness is such that a default by an organization in one part of the world quickly trickles to related defaults in other parts of the world. This is because the defaulting party is often a counterparty to other organizations in different parts of the world. This tends to trigger a wave of defaults commonly known as contagion. Since the chances of an unforeseen event damaging the net worth of a company have increased, there has been an increased emphasis on having the right risk management tools in place in order to meet the growing challenges.

Computation Capabilities Have Grown

Last but not the least, the computational capabilities have grown by leaps and bounds in the last few decades. It would not be wrong to call the last few decades an information revolution. As a result of these advances, the computational power has been continuously increasing whereas the costs have been witnessing a downward trend. The costs have witnessed an annual decline of close to 25% for the past three decades. The end result of this is that computing power is now available to everyone. This has provided encouragement to mathematicians and statisticians who spend can now create calculation-intensive models.

The increased computing ability makes it possible for organizations to have the infrastructure to run these complex calculations in real-time. This helps provide actionable data to the market risk manager as opposed to the back of the envelope calculations which were the norm before the revolution in computing power.

Hence, it would be fair to say that over the past few years, macroeconomic factors have evolved in such a way that they have encouraged mathematicians to develop more advanced models. Since market risk has now become unavoidable, using high-tech tools to manage it seems to be the only way forward.

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Risk Management