Market, Credit, and Interest Rate Risks - Essay Example

Market Risk Faculty This research paper aims to investigate market risk and its techniques for measuring market risk. The discussion topics included in the research paper are; why is duration a better means of measuring interest rate risk? Why is credit risk analysis important to Financial Institution (FI)? There are more risks that FI’s face besides market, credit and interest rate risk that are important. For example OFF-balance-sheet, technology, operational, foreign exchange, sovereign and liquidity risk. The real time risk management of assets, liabilities is difficult to manage, grasp and measure without some error. Even with the Security exchange commission, Federal Reserve still does not grantee immunization from the insecurity that comes with risk. FI’s have faced difficulties over the years for a multitude of reasons; the major cause of serious FI problems remains directly related to lax credit standards. These problems range from borrowers, counter-parties, poor portfolio risk management, or a lack of attention to changes in economic or other circumstances. These lapses in awareness can lead to decline in the credit standing of an FI’s counterparties. This experience is common in both G-10 and non-G-10 countries (Basel 1999). When discussing market risk there are many trading activities that have caught the eyes of regulators by FI managers. For example, in September 1995, a leading Japanese bank, Daiwa Bank was forced into insolvency because of losses trading in Japanese stock futures that took place at a branch in New York City (Saunders & Cornett, pp 258). Market risk can be define as the risk related to the uncertainty of an FI’s earning on its trading portfolio caused by changes in market conditions, such as price of an asset, interest rates, market volatility, and market liquidity (J.P. Morgan). Understanding what is at risk when trading and investing on the market is of great interest to FI managers. There are divergent types of portfolio’s, which can be distinguished on a basis of time, horizon and liquidity. Trading portfolio consists of assets, liabilities, and derivative contracts that can be bought and sold quickly on organized financial markets. The category of asset or liabilities in a trading portfolio could be a long or short position in commodities, foreign exchange, equity securities, interest rate swaps, and options (Saunders & Cornett, pp 258). The investment portfolio has assets and liabilities that are moderately illiquid and held for longer holding periods. The variety of assets and liabilities investment portfolios usually has commercial loans, retail deposits, and branches. In a portfolio regardless of the type assets or liabilities, FI managers who are trading or investing must realize and measure the foundations of risks involved or face the misgivings of insolvency. For example the losses suffered by Allfirst Bank in Baltimore. A single trader allegedly lost $691 million of the bank’s money as he tried to cover up losses by manufacturing scores of false trades, which led to even steeper losses (S.Bill). Risks that can affect a financial market are actively trading assets, liabilities or derivatives rather than holding them for longer-term investments, funding or hedging purposes. The challenges of market risk such as interest rate risk, foreign exchange risk and credit risk must be mitigated, understood and measured, to lesson the chance of collapse and gain the needed results. Since FI are changing from their traditional methods in how income is produced normally from its deposit taking and lending to income from trading activities. The burden of it all may lie in the banking laws and regulators in helping, FI’s understand the difficulties of market risk and the spirit of laws. Market risks have become important in finding out the ability of an FI. That in 1998, U.S. regulators have included market risk in deciding the needed capital an FI must hold and this requisite was also introduced earlier in 1996 in the European Union (EU). A key point about market risk is the dollars exposure of resulting earnings from trading or investment activities. This doubt can be defined in terms as a dollar exposure amount or as a relative amount against some benchmark. What is interest rate risk? Interest rate risk is the risks relative value of a security, especially a bond, will worsen because of an interest rate increase. This risk is commonly measured by the bonds duration (Wikipedia: Bond duration). The volatility of interest rates with the unpredictability of the Federal Reserve and worldwide financial market integration makes interest rate risk a future key issue facing FI. In addition, Banks that handle international settlements are asking lawmakers to create new controls with enforcement to have deposit institution install measurement system that assess interest rate risk changes to earnings and economic value. Why should market risks be measured are reasons that Security exchange commission has a section on market risk in all annual reports put in on form 10-K. The company must detail how its own results may depend directly on financial markets. This is designed to show, for example, an investor who believes he is investing in a normal milk company, which the company is also carrying out non-dairy activities such as investing in complex derivatives or foreign exchange futures. When measuring market risk one has to have management information, setting limits, resource allocation, performance evaluation, and regulations, which are important ingredients when measuring market risk. Market Risk Measurement (MRM) provides senior management with information on the exposure of risk taken by FI traders. Management information must be tangible; therefore, it can be used to compare with the risk exposure to the FI’s capital resources. The trader’s portfolios market risk exposure is considered in MRM, by setting limits it can lead to an establishment of economically logical position limits per trader in each area of trading. Assigning resources by a comparison of returns to market risks in different areas of trading involves MRM. This can identify areas with the greatest potential return per unit of risk into more capital resources. Deciding merit performance or who should receive higher compensation is not always clear. Traders who have higher returns may simply be taking more risk than traders who have lower returns with lower risk exposure. MRM considers the return-risk ratio of traders, which can help determine a more rational bonus compensation system (Saunders & Cornett). The Federal Reserve and Bank for International Settlements (BIS) are regulating market risk through capital condition and private sector benchmarks. As the private industry becomes more reliant on MRM and regulator’s begin to have more confidence in there decision making the possibility of overpricing by regulators lessons. MRM can aid in pinpointing potential misallocations of resources because of prudential regulation. There are three major approaches to measuring market risk exposure that FI’s have used; Risk metric, historic (or back simulation), and the Monte Carlo simulation method. Each MRM methods of approach in simplicity and accuracy finds out the levels of market risk have advantages and weaknesses. RiskMetrics is based on assuming normally distributed returns; the RiskMetrics model ignores the presence of fat tails in the distribution function, which is an important feature of financial data. Nevertheless, it was commonly found that RiskMetrics performs satisfactorily well, and therefore the technique has become widely used in the financial industry (Pafka & Konder). The advantages of the back simulation approach are that it is simple, does not need asset returns to be normally distributed, and it does not require correlations or standard deviation of asset to be calculated. The disadvantage of back simulation approach is the degree of confidence we have in 5 percent value at risk (VAR) number based on 500 observations. Monte Carlo methods are a widely used class of computational algorithms for simulating the behavior of various physical and mathematical systems, and for other calculations (Wikipedia: Monte Carlo method). The Monte Carlo simulation approach use to its advantage what is a disadvantage using the back simulation method. To overcome the problem of limited observations creating more observations is structured, so returns or rates reflect probability with which they have occurred in recent historic periods. Why is duration a better means of measuring interest rate risk sensitivity? In finance and economics duration is the weighted average maturity of a bonds cash flows or of any series of linked cash flows. The duration idea was introduced by Frederick Macaulay as the weighted average maturity of a bond where the weights are the relative discounted cash flows in each period. What Macaulay showed is that an un-weighted average maturity is not useful in predicting interest rate (Wikipedia: Bond duration). What makes the duration model approach to measuring interest rate risk better is that it incorporates timing of cash flows as well as maturity effects into a simple measure of interest rate risk. Some of the advantages of duration models are that it could be used to immunize a particular liability as well as the whole FI balance sheet. There are some errors when using this model in real world scenarios that FI managers might be concern about. Although there is some weakness in handling actual time convolutions, FI’s can find out the model can handle a robust amount of real world complexities such as credit risk, convexity, floating interest rates, and uncertain maturities. Why is credit risk analysis important to FI? Credit risk analysis is important if FI’s are pricing loans valuing bonds correctly and setting suitable limits on the credit extended to any one borrower. Credit risk is most simply defined as the potential that an FI’s borrower or counterparty will fail to meet its debts in accordance with agreed terms. FI need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions. FI should also consider the relationships between credit risk and other risks. The effective management of credit risk is a critical item of a comprehensive approach to risk management and essential to the long-term success of any FI. For most FI, loans are the largest and most obvious source of credit risk. There are other sources of credit risk that exist throughout a bank. Those items comprise of a banking book, trading book, and both on and off the balance sheet financial reports. FI’s are increasingly facing credit risk (or counterparty risk) in various financial mechanisms other than loans, which are acceptances, inter-bank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in extending commitments, guarantees, and settling transactions. A further particular instance of credit risk is the process of settling financial transactions. If one side of a transaction is settled but the other fails, a loss may be incurred that is equal to the principal amount of the transaction. Even if one party is simply late in settling, then the other party may incur a loss about missed investment opportunities. Settlement risk (i.e. the risk of completion or settlement of a financial transaction will fail to take place as expected) thus includes elements of liquidity, market, operational and reputation risk as well as credit risk. The level of risk is determined by the particular arrangements for settlement. Causes in such arrangements that have a bearing on credit risk include the timing of the exchange of value; payment/settlement finality; and the role of intermediaries and clearing houses (Basel 1999). In summary this paper discussed and identified measures that FI managers can use to reduce portfolio market risk exposure. As loans and previously illiquid assets become marketable and as the traditional franchise commercial banks, insurance companies, and investment banks shrink risk is likely to grow. FI’s have used Monte Carlo simulation, RiskMetrics, the historic (or back simulation) methods to measure market risk. In addition, the duration model is effective in measuring the sensitivity of interest rate risk. It was found using the duration model its best advantage is how well it incorporates the timing of cash flows as well as maturity effects into a simple measure of interest rate risk. To achieve the desired results FI’s must analysis credit risk that is inherent of their portfolio and the risk in individual credits or transaction. The importance of measuring market risk now has the attention of regulators from January 1998 banks in the United States have to hold a capital requirement against the risk of their trading positions. References: Market risk, February 8, 2007 retrieved on 16 February 2007 from http://en.wikipedia.org/wiki/Market_risk Basel 1999. Principles for the Management of Credit Risk. Retrieved on 16 February 2007 from http://www.bis.org/publ/bcbs54.htm Pafka, Szilard & Konder, Imre 2001. Evaluating the Risk Metrics Methodology in Measuring Volatility and Value-at-Risk in Financial Markets. Retrieved on 16 February 2007 http://www.colbud.hu/pdf/Kondor/riskm.pdf Monte Carlo method, February 12, 2007 retrieved on 16 February 2007 from http://en.wikipedia.org/wiki/Monte_Carlo_method Bond duration: Macaulay duration, February 7, 2007 retrieved on 16 February 2007 from http://en.wikipedia.org/wiki/Macaulay_Duration Anthony Saunders, Marcia Million Cornett. Financial Institutions Management: A Risk Management Approach Read More