The Market Risk and the Developments in It - Research Paper Example

Introduction The current situation in international market is indicating towards the drastic changes to be taken place in order to further regulate the market. The spillover effects of the imprudent lending decisions made by the different financial institutions have not only affected banks and other financial institutions, but they are also badly hurting other sectors of the economy. Risk management is considered as a systematic process which involves the selecting and defining the level of risk to be maintained by the various financial institutions.1 Over the period of time, the process of risk management has greatly improved due to new technologies and methodologies which effectively provided many different choices to financial institutions to manage their overall risk. However, despite such innovation, risk management has not been able to prevent the distortions in markets as the use of sophisticated financial engineering methods have only contributed towards covering up the true nature and value of the economies. The traditional tools of risk management group the overall risks run by financial institutions into market risk, credit risk, liquidity risk, operational risk, legal risk, business risk as well as strategic risk. Based on above broader categories different methods have been devised which measure the respective risks which can then be effectively managed through prudent risk management policies. This paper will study the market risk and the developments which are taking place in market risk assessment methods due to changes in the economic conditions besides assessing their adequacy for current economic environment. Market Risk Market risk is the risk that the changes in the prices and rates prevailing in the market can reduce the dollar value of any security or portfolio of assets. Generally speaking, market risk can be broken down into two components i.e. the risk of the overall market that the prices or rates will generally fall or rise and the second element involves the market risk which specific to that particular security or assets i.e. the changes in prices or rates taking place solely due to individual characteristics of that particular asset. (Crouhy et.al, 2006). Effectively, market risk is defined as the risk of incurring losses, which may be incurred from off and on-balance sheet items which arise due to changes in the prices in the market. Market risk is important for banks and other financial institutions because they hold different positions in financial instruments on their balance sheets. Carrying such financial instruments on balance sheet therefore put them under the risk of movements in the market prices. It is because of this unique nature of the market risk that the market risk is further split into sub categories of interest rate risk, equity position risk, foreign exchange risk and commodity position risk. It is however, important to note that all the sub-categories of market risk are not mutually exclusive as changes in one type of risk can potentially create or increase another risk. Steps involved in market risk management Before discussing the market risk assessment and different methods, it is critical that a comprehensive review of how the market risk is managed by the financial institutions. The management of market risk is a very systematic process and involves different steps which needed to be taken so that the risk can effectively be managed. These steps are: 1. Risk Identification: any good risk management system must first have the capability to identify the risks as accurately as possible. Identification of the risks therefore involves accurately what are the different types of risks which are faced by the bank or financial institutions. 2. The next step involves the measurement of risk i.e. the employment of different market risk measurement models which effectively capture and measure the risk with better degree of accuracy and predictability. 3. Based on the risk measurement parameters, banks and financial institutions than set up limits i.e. the level of tolerance to take the risk. Setting up the risk limits allow banks and financial institutions to set up some standards against which the risk is effectively measured. It is also important to note that setting up such limits may be according to the regulatory requirements from supervisors of the bank, or they are internally set by the banks themselves keeping in view their own risk appetite. 4. The next step is the risk monitoring step which is basically monitoring of the different risk i.e. interest rate risk, commodity risk etc. which are measured and then are monitored against limits set up by the institutions. 5. The culmination of market risk monitoring mechanism in banks finally results into setting up the organizational level framework which oversees the whole risk management process within the organization. For the purpose of this paper, we shall be discussing the different market risk measurement methods and models besides discussing their relevance to the current economic environment. Market Risk Assessment BASEL II is the most important regulatory framework which governs the risk management mechanism in banks of its member countries. BASEL II is a document of best practices which outline the different guidelines and methodologies which if followed can provide an effective risk management set up within a financial institution. BASEL II defines the different risks faced by the financial institutions and provides a detailed framework for understanding and measuring all the associated risk. BASEL II defines two basic methodologies for market risk assessment which banks and financial institutions with international presence need to follow. These two market risk assessment methods are based on Standardized approach and internal model approach for assessing the market risk faced by the financial institutions. This paper will initially therefore focus on discussing the different methods of market risk assessment discussed in BASEL II document besides discussing them in great detail. Different Approaches to Market Risk Measurement Since market risk comprises of different sub categories of risks therefore methods outlined under this approach tend to assess the market risk involved in different risk categories. Maturity ladders are one such crude method for assessing the market risk assessment which can be used under the standardized approach. Under maturity ladder approach, a maturity band is created by summing up all the open positions during two respective dates. The number of maturity bands therefore is collectively nominated as a maturity ladder. What is however important to note that mostly widely used models for assessing the market risk are called value at risk models- a VAR is a measure of the likely maximum amount that a bank can loss due to market risk within a given period of time to be measured against an specified confidence level VAR models are based on two methods i.e. parametric and non-parametric methods. (Christoffersen, 2006). The following sections will discuss both the parametric and non-parametric methods of assessing the market risk. Parametric Normal Models Parametric models are widely used methods for assessing the market risk faced by a financial institution. Parametric normal models are based on different approaches which are used for assessing the risk. These approaches are :( Penza & Bansal, 2000). 1. Portfolio Normal. 2. Asset Normal 3. Delta-Normal 4. Delta-Gamma Under the portfolio normal method, VAR- a measure of the market risk is calculated as a multiple of the standard deviation of the portfolio. This approach is largely used when the total number of assets in a portfolio is small and is normally distributed. It is because of this reason that this method is normally considered as simple to use and can provide a quick estimate of the market risk run by a portfolio of assets. From the statistical point of view, this method however ignores the skewness as well as leptokurtosis. Asset normal methods are also one of the basic non-linear methods used by the industry. Asset normal method was the basis behind the development of RiskMetrics, the famous statistical model developed by J.P. Morgan. Asset Normal Method is non-linear in nature therefore lacks the ability to effectively predict market risks involve in portfolios with highly non-linear payoffs. (Manganelli & Engle, 2001). It is also important to note that asset normal method is an extremely difficult method to compute, and it was because of this reason that a better measure of Delta-Normal methods was developed. The delta normal and delta gamma methods attempt to identify the limited sets of risk parameters which are then correlated with the price changes to measure the risks involved in them. Delta Normal methods greatly reduce the computation steps required to calculate the risks and are considered as easier. However, from the statistics point of view, delta normal methods have high estimation error and may include large factor changes. (Frenkel, et.al, 2005). Non-Parametric Methods Non-Parametric methods are considered as one of the easiest methods of assessing the value at risk and hence market risk. Non-parametric methods are mostly based on historical simulation methods which are considered as easy to use and simple. One of the most important characteristics of non-parametric models is the fact that they do not involve mapping of any complex distributions and simply rely on the historical variability of asset prices in order to calculate the market risk. Due to non-parametric nature of such methods, they also capture the whole actual distribution of the asset prices therefore they do not rely on complex statistical assumptions to define the various distributions of the asset prices. Historical simulation methods can be extremely helpful under the conditions even if the asset prices are not normally distributed but are logically consistent and stable over the period of time than historical simulation methods can provide best estimation of the market risk involved. One of the greatest drawbacks of historical simulation methods is the assumption that if the current distribution is greatly deviating from the historical distribution of the asset prices than historical simulation methods can provide extremely distorted results and can result into poor decision making. (Lin et. al. 2005). Monte Carlo Simulation method is another application of non-parametric models which attempt to capture the market risk for the firm. The basic difference between historical simulations and Monte-Carlo simulation method is based on the fact that under Monte-Carlo simulation methods, asset prices or return are not taken from the historical data, but they are generated through a computer application. Its flexible and can produce different risk scenarios which can provide a wider insight to risk managers and subsequently design strategies to deal with different scenarios. Monte-Carlo simulation methods are robust mostly due to the computing power involved in assessing the different risk scenarios. However, due to its reliance on computers and information technology applications, its use is extremely complex and requires a certain degree of statistical and mathematical mastery to perform such a simulation through computers. Adequacy of Models Considering the present economic environment, it can easily be inferred that the current methods and models of assessing market risk may not be totally adequate under the current economic environment because they failed to predict the risk. However, a deeper look at the current crises would suggest that the crises emerged due to bad credit risk management i.e. banks and financial institutions failed to put in place proper credit risk management mechanism due to which they lent to such borrowers which were technically not entitled to get the debt. Failure to predict the default rates is therefore the greatest reason for current economic environment as the current change is largely driven by the credit risk and the factors associated with the market risk i.e. interest rate risk etc. have only changed due to the large scale failure of credit risk models and not the market risk assessment models. As such therefore, it would be premature to state that the market risk models are inadequate with regard to the current financial meltdown. Conclusion Though the latest developments suggest a step forwards towards the use of statistical methods for assessing market risk. However, they may not be entirely blamed for the current financial meltdown as it may be the result of poor credit risk management. References 1. Crouhy, Michel, Galai, Dan , Mark Robert (2006). The Essentials of Risk Management. New York: McGraw Hill. 27. 2. Christoffersen. Peter (2006). Value-at-Risk Models. In: Torben G. Andersen, Richard A. Davis, Jens-Peter Kreiss, and Thomas Mikosch. Handbook of Financial Time Series. New York: Springer-Verlag. 2. 3. Penza, Pietro Bansal, Vipul K. (2000). Measuring Market Risk with Value at Risk. New York: John Wiley and Sons. 255. 4. MANGANELLI, SIMONE &. ENGLE., ROBERT F (2001). VALUE AT RISK MODELS IN FINANCE. European Central Bank Working Paper Series . 01 (0), 1. 5. Lin; Chu-Hsiung , Chang, Chang-Cheng ,Chien; Chen Sunwu Winfred. (2005). A General Revised Historical Simulation Method for Portfolio Value-at-Risk. THE JOURNAL OF ALTERNATIVE INVESTMENTS. 0 (0), 5. Read More