Market risk

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Market risk is the risk of losses in positions arising from movements in market prices.[1]

Types[edit]

Some market risks include:

Risk management[edit]

All businesses take risks based on two factors: the probability an adverse circumstance will come about and the cost of such adverse circumstance. Risk management is the study of how to control risks and balance the possibility of gains.

Measuring the potential loss amount due to market risk[edit]

As with other forms of risk, the potential loss amount due to market risk may be measured in a number of ways or conventions. Traditionally, one convention is to use value at risk (VaR). The conventions of using VaR are well established and accepted in the short-term risk management practice.

However, VaR contains a number of limiting assumptions that constrain its accuracy. The first assumption is that the composition of the portfolio measured remains unchanged over the specified period. Over short time horizons, this limiting assumption is often regarded as reasonable. However, over longer time horizons, many of the positions in the portfolio may have been changed. The VaR of the unchanged portfolio is no longer relevant.

The Variance Covariance and Historical Simulation approach to calculating VaR also assumes that historical correlations are stable and will not change in the future or breakdown under times of market stress.

In addition, care has to be taken regarding the intervening cash flow, embedded options, changes in floating rate interest rates of the financial positions in the portfolio. They cannot be ignored if their impact can be large.

Use in annual reports of U.S. corporations[edit]

In the United States, a section on market risk is mandated by the SEC[2] in all annual reports submitted 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, that the company is in fact also carrying out non-dairy activities such as investing in complex derivatives or foreign exchange futures.

References[edit]

  1. ^ Bank for International Settlements: A glossary of terms used in payments and settlement systems [1]
  2. ^ FAQ on the United States SEC Market Disclosure Rules
  • Dorfman, Mark S. (1997). Introduction to Risk Management and Insurance (6th ed.). Prentice Hall. ISBN 0-13-752106-5. 

See also[edit]

External links[edit]