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Market Risk

This document discusses various types of market risk that banks face, including liquidity risk, interest rate risk, foreign exchange risk, equity price risk, and commodity price risk. It provides definitions and explanations of these risks, as well as strategies that banks can employ to manage each type of risk, such as maintaining adequate liquidity, using hedging tools for foreign exchange, and setting prudent exposure limits for equity investments. Market risk refers broadly to the possibility of losses banks face due to fluctuations in market factors outside of their control.

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Sushil Sharma
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101 views21 pages

Market Risk

This document discusses various types of market risk that banks face, including liquidity risk, interest rate risk, foreign exchange risk, equity price risk, and commodity price risk. It provides definitions and explanations of these risks, as well as strategies that banks can employ to manage each type of risk, such as maintaining adequate liquidity, using hedging tools for foreign exchange, and setting prudent exposure limits for equity investments. Market risk refers broadly to the possibility of losses banks face due to fluctuations in market factors outside of their control.

Uploaded by

Sushil Sharma
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Kachhapi

MARKET RISK
• Old wisdom dictates that one should avoid
putting all eggs in the same basket.

• Diversification does not reduce risk below a


minimum level.

• The minimum level of risk which is


attributable to factors which are external to
portfolio is MARKET or SYSTEMATIC RISK.

• The component of risk which can be reduced


by diversification is NON SYSTEMATIC RISK.
Kachhapi
What is Market Risk ?

• The possibility of loss to a Bank caused by


changes in market variables.

• Risk to the Bank’s Earnings & Capital due to


changes in the market level of Interest rates
or prices of Securities, Foreign Exchange,
Commodities & Equities as well as volatilities
in the prices

Kachhapi
MARKET RISK - Types

1. Liquidity Risk

2. Interest rate Risk

3. Forex Risk

4. Equity price Risk

5. Commodity price Risk

Kachhapi
WHAT IS LIQUIDITY?

• Ability to fund increases in assets & meet


payment obligations on due date efficiently
& economically.

Kachhapi
WHAT IS LIQUIDITY RISK?

• “ Potential inability to meet the Bank’s


liabilities on the due date.”
• Arises due to :
• 1. Inability to generate cash to cope with
decline in deposits or increase in assets.

• 2. Mismatches in maturity pattern of


assets & liabilities.

Kachhapi
Liquidity Risk – Why to Manage?

1. Demonstrates safety of Bank & provides confidence.

2. Necessary to nurture relationship.

3. Avoid unprofitable sale of assets.

4. Lowers the default risk premium.

5 Reduces the need to resort to borrowings from the


Central Bank.

Kachhapi
Liquidity Risk - Dimensions

• 1. Funding Risk

• 2. Time Risk.

• 3. Call Risk.

Kachhapi
Liquidity Risk – how to manage?

• Have an effective Liquidity management policy.

• Should speak out: Funding Strategies, Liquidity


planning under alternative scenario, Prudential
limits, Liquidity reporting & reviewing.

• Tracking of cash flow mismatches. Track the


impact of prepayment of loans & pre mature
closure of deposits.

Kachhapi
 Cap on Inter bank borrowings.

 Purchased funds vis-à-vis core assets.

 Core deposits vis-à-vis Core assets.


 Duration of liabilities & Investment portfolio
 Cumulative mismatches across all time bands.
 Commitment ratio – tracking commitments
given

Kachhapi
 Monitoring high value deposits.

 Seasonal pattern of deposits/loans.

 Potential liquidity needs for meeting new


loan demands, un-availed credit limits,
potential deposit losses, investment
obligations, statutory obligations etc.

 Contingency funding plans.

Kachhapi
INTEREST RATE RISK
• Deregulation of interest rates has exposed the
Banks to adverse impact of Interest rate risk.

• Risk that value of Assets & Liabilities as also Net


Interest Income get affected due to movements in
interest rates.

• Mismatch in cash flows or re-pricing dates of


assets & liabilities expose Bank’s NII or NIM to
variations

Kachhapi
INTEREST RATE RISKS- TYPES

1. Mismatch or Gap Risk.

2. Basis Risk.

3. Embedded Option Risk.

4. Reinvestment Risk.

5. Price Risk.

Kachhapi
Rigidities on Interest Rate Risk
• Most liabilities are on Fixed rate basis while
assets are on the floating rate basis.

• Still there is regulation in place on interest rates.

• There is no definite interest rate re-pricing date


for floating rate.

• Banks have to strengthen the MIS & Computer


processing capabilities for accurate measurement
of IRR

Kachhapi
Interest Rate Risk - Management

1. Floating rate Deposits.

2. Fixed rate Lending.

3. Derivative products like FRA/IRS.

Kachhapi
FOREIGN EXCHANGE RISK

• Risk that Bank may suffer loss as result of


adverse exchange rate movements during
the period in which it has open position.

• Risk arises whenever business has


income/expenditure, asset/liability in a
currency other than balance sheet
currency.

Kachhapi
TYPES OF FOREX RISK

1. Open or Mismatch positions.


2. Gap Risk.
3. Price Risk.
4. Credit Risk.
5. Country Risk.
6. Operating Risk.
7. Legal Risk.

Kachhapi
FOREX RISK MANAGEMENT

1. Set appropriate limit for open


position/gaps.

2. Clear cut & well defined division of


responsibility between front, middle & back
office.

3. Use of hedging tools like forwards, futures


& options.

Kachhapi
EQUITY PRICE RISK

• Changes in Equity prices can result losses


to the bank holding Equity portfolio.

• Banks are not allowed to sell the securities


with out holding the same.

• Banks are free to acquire


Shares/Debs/Units of equity oriented
mutual funds subject to ceiling of 5% of the
total domestic credit
Kachhapi
Equity Price Risk - Management
1. Build up adequate exposure to equity market

2. Formulate transparent policy & procedure for


investment in shares.

3. Formation of Investment committee.

4. Review of Investment portfolio – on going basis.

5. Fixing prudential exposure limits.

Kachhapi
COMMODITY PRICE RISK
 Banks have very little exposure to commodities in
their trading book.

 Price rise/movement in commodities is more


complex & volatile.

 Banks in developed countries use derivatives to


hedge commodity price risk.

 Banks in India have to acquire the skills to manage


as & when they get exposed to commodity price risk.

 Physical product which is or which can be traded on


a secondary market.
Kachhapi

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