Market Risk
Market risk arises due to the market price movements of financial instruments. Under market risk another sub category of risk is associated, which is known as interest risk. It arises due to the movement of interest rate. Through this the interest related price is affected, such as bonds, loans, etc. If the interest rate will be increased, then the value of bonds will be decreased. To manage this type of risk, various hedges are available, such as forward rate agreements and interest rate swaps. Hedging concept is introduced to mitigate the risk basically reduce any type of substantial losses, when a combination of assets is selected for investment to offset the movements. When investing in stocks, simultaneously there is a sell option is available to sell out that stock at some point in the future. Like hedging, derivatives are also used to reduce various types of risk. Market risk can be arranged in various classes such as risk exists in interest rate, risk exists in exchange rate, risk exists in equity, risk exists in commodity price and so on (Dowd, 2007).
How to manage the risk before estimating the value at risk is possible by various methods such as analysis of gap, analysis of duration, analysis of scenario, portfolio theory etc. Analysis of Gap will determine a particular time horizon, so that the price of our asset or liabilities can re-price with a better interest rate return, hence the choice of gap of time horizon is a very sensitive issue. The duration analysis is basically applied to the bond (the fixed income investment) to define the weighted average of the bond, where the weights are each class flow’s present value which is related to all class flow’s present value. Scenario analysis is a different approach where a scenario is set to examine whether we can stand to gain or loss under that scenario. Another approach is portfolio theory, where the investors have to choose the portfolio on the basis of their return on investment. Market risk is also called as systematic risk as it depends on various factors that have an impact on entire market such as recessions.
Market risk analysis is basically rising of uncertainty on the return of a portfolio’s price (Alexander, 2009). To determine about the dispersion of the portfolios return from the target value, various portfolio’s risk metrics is introduced such as volatility and correlation, but they are sufficient, when the risk factors return is having a multivariate normal distribution. Another interesting concept is about the premium of market risk, where the expected returns difference basically on a portfolio of market and risk-free rate is considered as a market risk premium. From a survey it is found that 54% of market risk premium used in 2016 is decreased, whereas 38% is increased (Fernandez, Ortiz & Acan, 2017). Alexander Brown et al. analyses over market risk standard formula, where the market risk capital charges is calculated under the standard formula (Braun, Schmeiser & Schreiber, 2017).