Unit 4

Market Risk,
Investment Risk &
Liquidity Risk
Contents

▪ Identification of Market Risk, different types of market risk: volatility risk,

liquidity risk, currency risk, basis risk, Interest rate risk, commodity risk,
equity risk. Market Risk Management: techniques and their application in
managing market risk: hedging, market risk limits diversification. Concepts
used in risk measurement and control: probability, volatility, regression,
correlation coefficients alpha and beta, optimization. Value-at-Risk (VaR)
approach to managing market risk.

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Contents

▪ The Measurement of Investment Returns: basic concepts and measurement of

investment related returns: nominal returns, real returns, total returns, holding period
return. Identification and Measurement of Investment Risk, asset and portfolio
investment risk, significance of alpha, beta and key investor ratios.

▪ Identification of Liquidity Risk: constituents of liquidity risk and how they can arise
within the contexts of credit, market, investment and operational risk. Measurement of
Liquidity Risk: funding liquidity risk analysis: liquidity gap analysis, stress testing,
expected future funding requirement. 3
Market
Risk
4
“ Market Risk is defined
as
“ the risk of loss arising
from changes in the
value of finanical
instrustments”
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Introduction

❖ One of the major aims of many financial instruments is the generation of profits
through investment in global financial markets.

❖ These business, nature is based on price uncertainty – Uncertainty of knowing whether

the market prices will move in a favorable or adverse direction.

❖ Price uncertainty is the mechanism that allows profits or losses to be made and the risk
of loss associated with it is known as market risk.

❖ This risk reflects the uncertainty of an asset’s future price.

❖ The factors affecting market risk are complex. For instance, when investing in a
company’s shares there are direct and indirect market risk factors to consider.
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Direct and Indirect market risk
factors

Direct Market factors Indirect Market risk factors

Factors that directly reflect the factors that indirectly affect the
perofrmance of a company. performance of a company,

Such as the health of its balance Such as interest rate levels,

sheet, its vision and strength of economic events, political,
its management team. sector, sentiment and
environmental effects.

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Financial service
sector & Market risk?

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Financial service sector & Market risk?

Takes advantage Informed Predict the future

of the existence of decision can
market risk to performance of
be made their investments
make a profit.
Aim of On how Financial institutions have
managing this acceptable the invested heavily in research,
risk is and, tools and expertise to try to
risk is not to
hence, predict the future
eradicate it but whether it is a performance of their
to understand worthwhile investments.
and quantify it. investment. 9
Identification Market
Risk
Types of Market Risk

Interest rate Equity price

Volatality Risk Currency Risk risk risk
1 3 5 7

2 4 6

Market Basis risk Commodity

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Liquidity Risk price risk 1
Volatility Risk

▪ Volatility risk is the risk of price movements that are more

uncertain than usual affecting the pricing of products.

▪ All priced instruments suffer from this form of volatility.

▪ This particularly affects options pricing because if the market

is volatile then the pricing of an option is more difficult and
options will become more expensive.
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Market Liquidity Risk

▪ This is the risk of loss through not being able to trade in a

market or obtain a price on a desired product when required.

▪ Market liquidity risk can occur in a market due to either a

lack of supply or demand or a shortage of market makers

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Currency Risk

▪ This is caused by adverse movements in exchange rates. It affects any

portfolio or instrument with cash flows denominated in a currency
other than the firm's base currency.

▪ Currency risk is also inherent when trading cryptoassets.

▪ These are digital currencies in which encryption techniques are used to
regulate the generation of units of currency and verify the transfer of
funds, operating independently of a central bank.
▪ Cryptoassets often display far higher volatility than so-called 'fiat
currencies'. 1
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Basis Risk

▪ This occurs when one risk exposure is hedged with an offsetting

exposure in another instrument that behaves in a similar, but not
identical, manner.

▪ If the two positions were truly ‘equal and opposite’ then there
would be no risk in the combined position.

▪ Basis risk exists to the extent that the two positions do not exactly
mirror each other.
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Interest Rate Risk

▪ This is caused by adverse movements in interest

rates and will directly affect fixed income securities,
futures, options and forwards.

▪ It may also indirectly affect other instruments.

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Commodity Price Risk

▪ This is the risk of an adverse price movement in the value

of a commodity.

▪ The price risk of commodities differs considerably from

other market risk drivers because most commodities are
traded in markets where the concentration of supply in the
hands of a few suppliers can magnify price volatility.

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Commodity Price Risk

▪ Other fundamentals affecting a commodity’s price include

the ease and cost of storage, which varies considerably
across the commodity markets (eg, from gold, to electricity,
to wheat).

▪ As a result of these factors, commodity prices generally

have higher volatilities and larger price discontinuities (ie,
moments when prices leap from one level to another) than
most traded financial securities. 1
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Equity Price Risk

The returns from investing in equities come from:

▪ • capital growth – if a company does well, the price of its

shares should go up

▪ • income – through the distribution by the company of its

profits as dividends.

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Boundary Issues
Boundary issues can arise between different types of market risk due to
the complexities and interconnections within financial markets.

Market risk refers to the potential for financial losses resulting from
adverse market movements.
Different types of market risk include:
▫ Interest Rate Risk
▫ Equity Price Risk/ Stock price risk
▫ Currency Exchange Rate Risk
▫ Commodity Price Risk
▫ Liquidity Risk
▫ Credit Risk/ default risk
▫ Systemic Risk
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Boundary Issues

▪ For example:
▫ liquidity risk could be caused by a lack of supply or demand –
which also causes price level risk
▫ an increase in volatility risk will intensify price level risk for
investors wishing to buy or sell
▫ interest rate risk will indirectly affect the real economy and
therefore the markets.

▪ These boundary issues mean that it is not straightforward to analyse

exactly which factors are causing which movements. 2
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Reasons for Boundary Issues

Correlations

Risk Aggregation

Model Assumptions

Regulatory challenges

Portfolio management 2
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Correlations: Market risks are often interconnected. For instance, a change in interest
rates can impact both equity and bond prices. These interdependencies can make it
challenging to isolate the effects of one specific type of risk.

Risk Aggregation: Financial institutions and investors need to aggregate their various
risks to assess their overall risk exposure accurately. However, different types of market
risk may have nonlinear effects when combined, making accurate risk assessment
complex.

Model Assumptions: Different types of market risks require different models for
measurement and analysis. Assumptions made in these models can influence the way
risks are quantified and managed, leading to potential discrepancies when risks
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intersect. 4
Regulatory Challenges: Regulatory frameworks may classify and regulate different
types of risks separately. However, in reality, these risks can interact and amplify each
other's impact, which can pose challenges for regulatory authorities.

Portfolio Management: Investors and portfolio managers need to diversify their

portfolios to manage various risks effectively. However, diversification may not be as
effective if risks are not clearly delineated and properly understood.

Addressing these boundary issues requires a comprehensive understanding of the

interconnected nature of market risks and the development of robust risk management
strategies that consider these interactions. It also emphasizes the importance of ongoing
monitoring, stress testing, and scenario analysis to account for the complex interplay
between different types of market risk. 2
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Case let

XYZ Corporation is a multinational company operating in the technology sector. The

company is listed on several stock exchanges and generates a significant portion of its
revenue from international markets. XYZ Corporation's management is concerned about
market risk, especially given the volatility in the global economy and financial markets.

Scenario: In recent years, XYZ Corporation has expanded its operations globally, and it
is now exposed to various forms of market risk, including currency risk, interest rate risk,
and equity market risk. The management team is aware of the importance of effective risk
management to protect the company's financial stability and shareholder value. They have
appointed a dedicated risk management team to assess and mitigate market risk. 2
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Questions
1.What is market risk, and why is it important for XYZ Corporation to manage it
effectively?
2. Identify and describe the specific types of market risk that XYZ Corporation is
exposed to.
3.What strategies can XYZ Corporation use to manage its currency risk effectively?
4.How can XYZ Corporation mitigate interest rate risk in its financial operations?
5. What steps can XYZ Corporation take to manage equity market risk in its
investment portfolio?
6.How can XYZ Corporation’s risk management team regularly monitor and assess
market risk exposure? 2
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Market Risk Management
Techniques and their Application
 High
Market risk
Hedging Diversification Frequency
limits
Trading

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Hedging

▪ Hedging is a means of reducing the risk of adverse price movements

by taking an offsetting position in a related product. It is a means of
insuring against market risk.

▪ The decision to hedge is a trade-off between the risk of adverse market

movements and the cost of the hedge – in this case, the purchase
price of the option.

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Market Risk Limits / Stop Loss limit

A type of trade that combines features of stop order with that of a

limit order

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Diversification

○ Exposure to asset classes or securities with inverse or negative relationship

○ Hence, the portfolio risk shall be less than weighted average of the
standard deviation of assets in the portfolio

Ex
The sun cream factory does well when the summers are hot, while the
umbrella business does well on rainy days. Although the earnings of each
individual business can be volatile,

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High Frequency Trading
○A type of algorithmic financial trading characterized by
○high speeds,
○high turnover rates, and
○high order-to-trade ratios
○that leverages high-frequency financial data and electronic trading
tools.
(1) narrower bid–ask spreads;
(2) increased market liquidity in normal times;
(3) improved price discovery; and
(4) significant volume on transparent, traditional exchanges.
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Market Risk Management - Features
▪ ownership of the firm’s market risk management policy
▪ proactive management involvement in market risk issues
▪ defined escalation procedures to deal with rising levels of trading loss, and market risk
limit breaches
▪ independent validation of market pricing and adequacy of VaR models
▪ ensuring that VaR is not used alone, but is combined with stress testing and scenario
analysis
▪ independent daily monitoring of risk utilisation through the daily production of profit
and loss (P&L)
▪ accounts and review of front-office closing prices (independent means a separately
accountable function reporting directly to senior management).e market risk in a
company-wide context. 3
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Concepts used in risk
measurement and control
Measures of Central Tendancy

Measures of Dispersion

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Variance and Standard Deviation

Variance is a measure of dispersion and shows the spread of data

around the mean.

Let us assume we have the following annual returns for an investment: 13%,
11%, 2%, 6%, 5%, 8%, 7%, 9%, 7%, and 6%.

Then the average, or mean can be simply computed as:

(13%+11%+2%+6%+5%+8%+7%+9%+7%+6%) ÷ 10 = 7.4%
Then, the variance calculates the difference between each return from the
mean and then squares it. These are then totalled and their average then
represents the variance. 3
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The standard deviation of a set of data is simply the square root of
the variance and is the most commonly used measure of dispersion.

In effect, by taking the square root of the variance, the standard

deviation represents the average amount by which the values in the
distribution deviate from the mean.

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Understanding the Terminology

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Risk Measurement and Control
Concepts

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Value-at-Risk (VaR)
Approach
▪ Value-at-Risk (VaR) is a widely used measure the maximum loss that can
occur with a specified confidence over a specified period.

▪ Because there is uncertainty about how much could be lost over the
specified time horizon, the VaR measure includes the level of confidence
that the specified loss will not be exceeded.

▪ For example, if a portfolio’s one-week VaR is stated as ￡ 1 million in 95

weeks out of 100, then the portfolio is predicted to lose less than ￡ 1
million at the 95% confidence level.
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VaR Limit Setting and Monitoring

▪ VaR is widely used by banks, securities firms and investment managers to

estimate portfolio market risk. The market risk function will set VaR limits.

▪ It will then monitor them to ensure that traders or fund managers do not
exceed them.

▪ Where they are exceeded, escalation will take place to the head of trading,
the relevant desk head or a risk committee

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Advantages of using VaR
▪ it provides a statistical probability of potential loss
▪ it can be readily understood by non-risk managers
▪ it translates all risks in a portfolio into a common standard, allowing a
comparison of risks between asset classes and, hence, the
quantification of firm-wide, cross-product exposures.

Disadvantage of Using VaR

▪ Its main disadvantage is that it does not specify how bad the
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situation could get. 8
Validation and Back Testing
▪ VaR models can break down if the assumptions that they are based upon are violated
or are simply found to be untrue. It is important with any model to validate its
assumptions and test its output accuracy as far as possible.

▪ Back testing is the practice of comparing the actual daily trading exposure to the
previously predicted VaR figure.

▪ It is a test of reliability of the VaR methodology and ensures that the approach is of
sufficient quality.

▪ It is usually performed on a daily basis by the financial reporting function and if

unsatisfactory differences between reality and estimation are found, the VaR model
must be revised.
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The Three Different Approaches to
VaR
Historical simulation
• this involves looking back at what actually happened in the past and basing our view
of the future on that analysis.

The parametric (or analytical) approach

• this assumes that the distribution of possible returns can be plotted, based on a small
number of factors, so that the required confidence level can be ‘read off’ the graph.

Monte Carlo simulation

• this involves generating a random set of results based on the actual underlying risk
factors and again ‘reading off’ the graph. 5
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Historical Simulation
This method uses historic analysis of the portfolio’s risk factor values to estimate its risk
exposure in the future.

The historical simulation

approach reconstructs the actual
historical returns, and ranks them
from worst to best.

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The steps are as follows:

1. Identify the risk factors that affect the returns of the portfolio, such as:
• individual stock prices, individual stock volatilities, the correlations between the
stocks (described above).

2. Select a sample of actual historic risk factor changes over a given period of time – say,
the last 500 trading days.

3. Systematically apply each of those daily changes to the current value of each risk
factor, revaluing the current portfolio as many times as the number of days in the
historical sample.

4. List out all the resulting portfolio values, ordered by value and, assuming the required
VaR is at the 95% confidence level, identify the value that represents the fifth percentile
of the distribution in the left-hand tail.
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Advantages and Disadvantages

▪ An advantage of this method is that it is conceptually simple enough to communicate

easily to non-specialists.
▪ There is no need to make any assumption about the distribution of the portfolio’s returns.
▪ There is also no need to estimate the volatilities and correlations between the various
assets in the portfolio.
▪ This is because the distribution, the volatilities and the correlations are implicitly
captured by the actual daily values of the portfolio’s assets over time.

▪ The main disadvantage is that it assumes that history will repeat itself, which is clearly
often not the case.

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Parametric (‘Analytical’) Approach

This approach assumes that portfolio returns are normally distributed, and uses the
standard deviation (volatility) of the returns to ‘plot the graph’ and hence derive the VaR
figure at the required confidence level.

The approach is called ‘parametric

VaR’ because of the assumption that the
returns are normally distributed: the
normal distribution is an example of a
‘parametric’ distribution.
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Advantages and Disadvantages
▪ The parametric approach is the simplest methodology used to compute VaR.
▪ A limited amount of input data is required, and, since there are no simulations
involved, minimal computation time is required.

▪ However, its simplicity is also its main drawback.

▪ Firstly, if the actual returns are not actually normally distributed, as is
assumed, then clearly the results will be inaccurate.
▪ Secondly, it cannot be used with securities such as options, because returns
from these instruments do not follow a normal distribution.

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Monte Carlo Simulation

This process of producing

random numbers in a
controlled fashion and
iteratively using them as
values in an equation is
known as Monte Carlo
simulation.

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Scenario and Stress Testing
▪ Scenario analysis and stress testing should, be conducted on an institution-wide basis,
taking into account the effects of unusual changes in market and non-market risk
factors. Such factors include prices, volatilities, market liquidity, historical correlations
and assumptions in stressed market conditions, and the institution’s vulnerability to
worst-case scenarios such as the default of a large counterparty.
▪ Scenario analysis and stress testing would enable the board and senior management to
better assess the potential impact of various market-related changes on the institution’s
earnings and capital position. The board and senior management should regularly
review the results of scenario analyses and stress testing, including the major
assumptions that underpin them. The results should be considered during the
establishment and review of policies and limits.

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Investment
Risk
▪ The credit and market risks are managed for the benefit of the firm’s owners
and clients.

▪ Many of these clients are investors whose funds are managed by the firm,
and providing the ‘right’ level of return to these investors as ‘investment
risk’.

▪ Investment is the decision to forgo the use of current resources, in the belief
that they can instead be used to create future benefits which are greater than
their current value.
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 Measurement of Investment
Returns
Basic Concepts and the Measurement of Investment Returns
Basic concepts and measurement of investment
related returns

Nominal returns

Real returns

Total returns

Holding period return

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Nominal Returns
▪ The nominal return on an investment is simply the return it gives,
unadjusted for inflation.
▪ Thus, a bank account paying 12% interest annually has a nominal
return of 12%.

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Real Returns

The real return is the return the investment provides an investor after stripping out the
effects of inflation.
If inflation is running at say 8%, then in real terms the value of the cash in a 12% bank
account is actually growing by just 4% a year.

If the nominal rate of return is 12% pa and the annual rate of inflation is 8% pa, the real rate
of return is the return earned after allowing for the return needed just to keep pace with
inflation.
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Total Returns
▪ Total returns mean the returns on an investment both from its income
production, and any capital gains (or losses) it generates.

Holding Period Returns

▪ Holding period return is the total return on an asset or portfolio over the
period during which it was held. It is one of the simplest measures of
investment performance.
▪ It is calculated as the percentage by which the value of a portfolio (or asset)
has grown for a particular period. It is the sum of income and capital gains
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over the period, divided by the initial period value. 6
Identification, Measurement and
Management of Investment Risk
Main Investment Risks
 Currency risk

Interest rate risk

Issuer risk

Equity risk

Commodity risk

Property risk

Liquidity risk
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 Key Features and Relevance of
Other Asset Classes to Investment
Risk
1. Private Equity
2. Venture Capital
3. Property
4. Responsible investment
a) Environmental concerns
b) Social concerns
c) Corporate governance concerns
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Private Equity

▪ Private equity is an illiquid asset class consisting of equity securities in

operating companies that are not publicly traded on a stock exchange.

▪ Private equity fund managers often take an active role in the management of
the companies they invest in, through having a majority shareholding and/or a
seat on the board.

▪ They look to add value for their investors by transforming the way the
investee company is managed, and may aim to make their money by floating
the company on the market after a few years, once its performance has been
improved. 7
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Venture Capital

▪ Venture capital is a type of private equity capital typically provided to early-

stage, high-potential, growth companies in the hope of generating a return
through an eventual sale of the company once it has become successful.

▪ Venture capital investments are generally made as cash in exchange for

shares in the invested company.

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Venture Capital
▪ Venture capital investments offer three main advantages for a portfolio of
otherwise ‘standard’ investments:

1. Tax advantages – in many countries tax relief is given on the investment.

2. The potential for higher returns than can be achieved by mature

companies.

3. Lack of correlation with more ‘standard’ investments – while mainstream

bond and equity markets may be declining in value, a start-up company
could still be increasing in value.
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Property
▪ As an asset class, property has consistently provided positive real long-term
returns allied to low volatility and a reliable stream of income.
▪ An exposure to property can provide diversification benefits to a portfolio,
owing to its low correlation with both traditional and alternative asset
classes.
▪ However, property can be subject to prolonged downturns and, if invested in
directly, its lack of liquidity and high transaction costs on transfer really
make it suitable only as an investment for the medium to long-term.

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Responsible investment

▫ Environmental concerns
▫ Social concerns
▫ Corporate governance concerns

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Correlation of Performance
between Asset Classes
Asset Allocation

▪ Asset correlations change over time, and the discipline of ‘asset allocation’
is the macro equivalent of diversifying a portfolio to reduce its risk.

▪ Before deciding which stocks to pick, a decision must first have been made
on which asset-mix to choose.

▪ Asset allocation involves considering the big picture first by assessing the
prospects for each of the main asset classes within each of the world’s
major investment regions against the backdrop of the world economic,
political and social environment.
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Tracking Error

▪ Tracking error is a measure of how closely a portfolio follows the index

to which it is benchmarked, and it can be calculated either as a historical
or a predictive indicator. Historical tracking error is ‘realised’ or ‘ex post’,
while predictive tracking error is ‘ex ante’.

▪ Historical tracking error is usually calculated as the standard deviation of

returns relative to the benchmark and is more useful for reporting
performance.

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Methods used to Mitigate
Investment Portfolio Risk
1. Systematic and Non-Systematic Risk
2. Optimisation and Diversification
3. Portfolio Hedging
4. Short Selling
5. Risk Transfer

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Monitoring, Management
& Reporting
There are four main areas where a portfolio will benefit from monitoring, management and
reporting:
1. Peer review with other fund managers in the same firm – this will help to ensure that, for
example, managers are abiding by ‘house view’ rules and not taking ‘unusual’ risks.

2. Risk review with independent risk managers in the firm – this ensures that the investment
process is transparent and duly challenged.

3. Monitoring for mandate compliance – systems are commonly used to perform pre- and post
trade compliance checking, for example, ensuring that forbidden stocks are not invested in.

4. Performance attribution reporting – this enables the fund manager, and the investors, to
better understand which elements within the portfolio are contributing to its returns. Typically,
the contribution to overall performance could come from:
• asset allocation
• stock selection
• currency exchange rate impact.
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LIQUIDITY
RISK
Identification of Liquidity Risk

▪ The Maturity Ladder

▪ Actual and Contractual Cash Receipts
▪ Asset Liquidity Risk
▪ Funding Liquidity Risk

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1. Maturity ladder

▪ A maturity ladder is a useful device for comparing cash

inflows and outflows, both on a daily basis and over a series of
specified time periods.

▪ The analysis of net funding requirements involves the

construction of a maturity ladder and the calculation of a
cumulative net excess, or deficit, of funds at selected maturity
dates.

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2. Actual and Contractual Cash
Receipts
▪ It is not possible to estimate with certainty the cash flows from all instruments.
▪ However, some types of financial instruments, such as derivatives, have a very
broad range of possible contractual outcomes.
▪ In these cases, statistical modelling techniques are used to provide ranges of cash
flow likelihoods.
▪ Even when cash flows can be properly estimated, the existence of credit risk
means that the cash may not materialise on the due date – or at all.
▪ The business may not wish to hold the instrument until maturity.
▪ Even without credit issues occurring, the way that the business uses financial
instruments will often result in the actual cash flows being significantly different
from the contractually stated position.
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3. Asset Liquidity Risk

▪ Asset liquidity risk refers to the likelihood of being unable to

transform assets into cash within a preferred time period without
incurring losses; it is closely linked to both credit and market risk.

▫ Potential marketability – how easily they can be sold for cash.

This is linked to market risk.

▫ How easily the assets can be used as collateral against which to

secure increased cash inflows. This is linked to credit risk.
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4. Funding Liquidity Risk

▪ The term ‘funding liquidity’ usually refers to the way in which a firm
obtains liquidity from the liability side of its balance sheet.

▪ Liability liquidity tends to refer to unsecured funding obtained from

depositors, third parties and the wholesale markets.

▪ So the term ‘funding liquidity risk’ refers to the likelihood that the
bank’s funding will not be available when required.

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Measurement of Liquidity Risk
Measurement of Liquidity Risk
Measurement of Liquidity Risk

▪ Liquidity Gap Analysis

▪ Stress Testing
▪ Expected Future Funding Requirement

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Liquidity Gap Analysis

▪ Modern banks rely on a number of sources for their funding. For example,
retail depositors, larger wholesale depositors and the money markets.

▪ Funding is therefore spilt between different areas of the organisation such as

the retail division and capital markets division.

▪ Negative net future cash flows over a given time period represent a major
source of liquidity risk.
▪ Before a liquidity gap analysis can be performed, a technique called cash
matching is used to understand a firm’s or portfolio’s liquidity risk, by 10
examining all net future cash flows. 0
▪ A firm or portfolio is cash matched if:
• every future cash inflow is balanced with an offsetting cash outflow
on the same date, and
• every future cash outflow is balanced with an offsetting cash inflow
on the same date.

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Measurement of Liquidity Risk

▪ Liquidity Gap Analysis

▪ Stress Testing
▪ Expected Future Funding Requirement

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Uses and Limitations of the Key Measures of
Asset Liquidity Risk

• Bid-offer spread – Immediate sale and purchase price

• Market depth – volume to transaction required to move
prices
• Immediacy – time taken to achieve a deal in the market
• Resilience – speed with which the prices return to the
equilibrium following a large trade.

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Managing Liquidity Risk

▪ Liquidity Limits
▪ Counterparty Credit Limits
▪ Scenario Analysis
▪ Liquidity at Risk
▪ Diversification
▪ Behavioural Analysis
▪ Funding Methods

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Market Dislocation

▪ Market are generally held to work in a certain way – if everything was

completely random then no one would invest.
▪ Certain principle are relied upon when making investment decision –
every day
▪ One such principle is the that if the price of something is reduced then
there will be more people interested in buying it.
▪ However, at a certain point – markets occasionally stop clearing at any
price.
▪ Economic experience shows that when liquidity disappears, no one will
lend, regardless of price. This is an example of market dislocation.
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Market Dislocation

The implications of market dislocation are:

▪ companies find it harder to borrow, which means they are more
likely to fail, thus making the economic situation worse and causing
bank profits to fall further

▪ consumers find that they cannot obtain mortgages, thus prolonging

any fall in house prices

▪ central banks lose the use of interest rates as their main economic
lever. Interest rates can only go as low as zero and once this point is 1
reached, the economy risks entering into deflation. 0
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