The term Market risk applies to
- that part of IRR which affects the price of interest rate instruments,
- Pricing risk for all other assets/ portfolio that are held in the trading book of the bank, and
- Foreign Currency Risk.
The risk of adverse deviations of the mark-to-market value of the trading portfolio, due to market movements, during the period required to liquidate the transactions is termed as Market Risk. This risk results from adverse movements in the level or volatility of the market prices of interest rate instruments, equities, commodities, and currencies.
It is also referred to as Price Risk.
Price is a market-driven measure of value. A seller will always want to sell at a higher (or highest) value in the market and a buyer will always want to buy at a lower (or lowest) price in the same market. In trying to achieving so; both the buyers and sellers may sometime delay in buying or selling – in expectation of the price going lower (for a Buyer) or expecting the price to go higher (from a seller’s perspective). This possibility of not realising the expected price may be called the Price risk.
Same situation may pose different risk to different people – depending on which role one is playing.
An onion farmer may be scared that the prices may go down when the final harvest is ready. Whereas a housewife may be thinking if the harvest if not good, the prices may go up. So at any point in time, we always have different sets of people having opposite views, thus helping discover ‘market price’.
Price risk can be classified into the following categories:
- Symmetrical risk – Unsymmetrical
- Absolute risk – Relative risk
- Asset liquidity risk
- Concentration risk
- Credit spread risk
- Volatility risk
Let’s understand each one of the above mentioned Price risk:
- Symmetrical risk – Unsymmetrical risk
Symmetrical risk implies that the movement of a particular contract or an asset in either direction leading to a corresponding impact – be it positive or negative – on the net position value.
In an Unsymmetrical risk; the similar impact is unequal.
Example: If a Mutual Fund is holding 1000 shares of a particular company; say RIL. An increase of decrease in the price of the instrument (shares of RIL in this example) will lead to change in the value of the portfolio in either direction by equal value (value of prince change multiplied by number of shares on both direction: positive or negative)
On the other hand, assuming if the same Mutual Fund has an Option contract – say Put Options to be precise – on the same shares; an increase in the price of the shares of RIL in the cash market beyond the strike price would result in a decline in the value of the option contract held. However any further price movement on the higher side would not result in an equal fall in the value of the option contract. And after certain value of the same shares in the cash market, the value of the Option contract may be worthless (taking strike price and premium into account)
- Absolute risk – Relative risk
Absolute risk maybe arrived at in relation to the initial investment; whereas relative risk is measured in relation to any benchmark index / benchmark reference point. It is always in comparison to some other benchmark or asset.
Example: An investment of INR 100,000 may decline to INR 50,000 as a result of decline in price of the asset. Hence, there is an absolute negative return of 50%.
However if the index or the reference benchmark has fallen by 65% during the same period of time; then the relative return on the asset or the instrument is better compared to the return on the index or that reference benchmark.
- Asset liquidity risk
There may be case when few stocks on a particular stock exchange may not have large volumes of trades. This is not a rare scenario; there are many counters (shares) who have low volumes. If one tries to buy or sell large quantities in these shares, the price change will be quick and may go far in a particular direction depending on what are we trying to do – buy or sell.
Trying to do so may result in a higher cost.
If we are trying to buy large quantities, the rates may rise quickly and our cost of buying may go up – there is also a possibility that we do not get the quantity we desired to buy initially.
If we are trying to sell, the rates may fall rapidly and we are not able to sell at a good rate impacting our total sales proceeds – adding to our losses or driving our profit lower.
- Concentration risk
If one has a large exposure to a particular script, sector, or a commodity, etc.. this results into concentration risk. If the price of that particular stock or commodity changes adversely; it will impact the entire organisation or the entire portfolio.
It won’t be incorrect to say that ‘lack of diversification may lead to concentration risk’
- Credit spread risk
Credit spread risk refers to the yield-difference between the yield of two securities of same asset class but of different credit standing.
Example: Mr. A invests in Government bond at a yield of 8% p.a.
Whereas Ms. B invests in Corporate bond with a yield of 10.75% p.a.
It clearly reflects the extra compensation paid to the Corporate bond holder for having the appetite to take the extra credit risk inherent in Corporate Bond as compared to the Government bond.
- Volatility risk
The probability of the price of a particular asset moving extremely in either direction results into higher volatility risk for that particular asset. It is not arrived at from the change in level of price; but their volatility. Volatility refers to the degree of unpredictable change in the price over a period of time.
Example: Volatility of the underlying asset goes into the pricing of the Options of that underlying asset.
Forex Risk: It is the risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position either spot or forward, or a combination of the two, in an individual foreign currency.
Market Liquidity Risk: This arises when a bank is unable to conclude a large transaction in a particular instrument near the current market price.