Credit Derivatives: An Introduction
Credit derivatives are the most important financial innovation in the field of credit risk management. These derivative instruments have been created quite recently. They have only been traded for a couple of decades as compared to other instruments like stocks and bonds which have been around for centuries. Within this short period of time, credit […]
The Future of Public Administration
Future belongs to Flexible Public Sector rather than Machine Bureaucracies As the world around us is changing with concomitant changes in politics, business, economics, and society, the field of public administration cannot be aloof from the need to innovate and change. As the public sector in many developed countries feels the need to move beyond […]
The Burning Cost Approach
In the previous article, we have already seen how reinsurance policies are generally priced and what factors are taken into account while pricing them. There are certain specific methods and approaches which have been used by reinsurance companies across the globe for many years. These methods or approaches have now become a standard that is […]
Assumption Reinsurance Vs. Indemnity Reinsurance
In the previous few articles, we have studied a lot about reinsurance. We are now aware of the various issues related to the field of reinsurance. However, up until now, we have assumed that reinsurance can be of only one type. This is not true. There are several different types of classifications that are possible […]
Identification of Operational Risks
The fundamental principle of operational risk management is to ensure that all operational risks have been considered and decisions have been taken about the best way to mitigate them. This is because experience has shown organizations that the worst outcomes come from risks that they have knowingly or unknowingly ignored. It is therefore important to […]
The global financial system is connected to markets. Markets are where companies go to if they want to raise funds. They are also the place where current investors go when they want to liquidate their existing investments. Hence, it would be fair to say that the financial system of the entire world is closely intertwined with the global market system.
Now, the fundamental principle of an efficient marketplace is that firms are not price makers. Instead, they are price takers. This means that they have very little control over the prices in the market.
The absence of control obviously means that there is a risk attached to it. This risk is called market risk. In this article, we will discuss the concept of market risk in detail.
Market risk is the risk that a change in the market value of an asset or liability held by the firm will lead to financial losses to the firm. This includes the value of the assets and liabilities held on the balance sheet as well as those which are held off the balance sheet.
Market risk is the risk of a negative change in the net worth of a company due to changes in external markets such as stock markets, bond markets, and currency markets. Understanding and mitigating market risk, in a timely manner, is extremely important. The inability to do so has led to the bankruptcy of several firms which were caught off guard during the dot-com crisis, Enron crisis, or even the subprime mortgage crisis.
Measuring market risk is a fairly complicated process. We will explain it in detail in the later parts of this module. However, for now, it is important to understand that market risk is a function of market volatility.
Volatility is defined as the degree of change in the value of an asset on a day-to-day basis. This is the reason why equity investments are said to have more risks as compared to debt investments since their value tends to fluctuate more.
Measures such as standard deviation are used to understand the dispersion in the data. This is because volatility is calculated by finding a mean price and then observing the spread of the distribution of the data.
Hence, the standard deviation is considered to be a valid measure are to estimate market risk. The more sophisticated way to measure market risk is by using a technique called Value At Risk (VaR) which will be explained later in this module.
For a market risk to arise, the company has to be somehow connected to that market either in a direct or an indirect manner. Since equity, commodity, forex, and interbank markets are some of the largest markets in the world, they are also major contributors to market risk.
As a result, a change in the value of these goods and services causes a change in the input price which can cause a huge negative financial impact on the financials of a company. Therefore, some companies are closely linked to the market and seemingly small changes in the market have a huge impact on them.
It is possible for firms to face duration mismatch or interest rate mismatch. Such issues can be significant and can even lead to bankruptcy if the firm is making leveraged bets. Also, the coupon payments of many bonds are linked with the benchmark interest rates. This too causes
Also, many companies raise capital from other markets because the cost of capital is lower. Here too, currency risks are involved. In such cases, the change in the value of one currency relative to the other will cause immense financial loss to some companies.
The fact of the matter is that companies in the modern world have to be linked to the financial markets. Hence, it is impossible to avoid market risks. Therefore, the creation and management of a system to measure and mitigate market risk are of utmost importance to the financial well-being of any corporation.
The market risk management system has to be suitable for the nature and scale of the organization. In many cases, the organization may not be directly exposed to these risks. However, some of their stakeholders might be exposed to them which would change their actions and would therefore impact the organization in an indirect manner.
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