Market Risk

RMA Journal, The, March, 2001 by Hank Prybyiski

Still a Balancing Act

This month, RMAlert looks at market risk management practices, tile most established of the risk management disciplines, and common industry initiatives.

Market risk management practices provide for the identification, measurement, mitigation, and monitoring of exposures to interest rates, foreign currency, equity, and commodity prices, most typically for trading portfolios.

* Identification processes have focused on characterizing what market events can cause portfolio losses (that is, parameters of risk). The risk parameters can be as simple as a stock price or interest rate to the more complex parameters of a derivative portfolio, such as volatility and time decay.

* Measurement processes have focused on characterizing the level of risk. Risk measures can either describe only one parameter (that is, a specific exposure), or an aggregation of parameters (that is, value-at-risk). Other measurements describe the impact of specific events or scenarios.

* Mitigation processes involve the daily trading or hedging activities in response to changes in market conditions.

* Monitoring processes involve a hierarchy of review and supervision with a strong reliance on independence and reporting.

Market risk management has received the most academic research, has the greatest regulatory reliance placed upon it, and is the catalyst for quantitative aggregation methods in credit risk, operational risk, and risk-adjusted performance measures. However, for all its maturity, fundamental changes in market risk management practices continue to occur:

* Consolidation/Integration--Mergers are requiring firms to measure more diverse and global portfolios. Significant work is occurring on the integration of position and market data, from the position keeping systems to the risk measurement applications.

* Regulatory Optimization--Opportunities to derive regulatory capital savings from the internal modeling of specific risk exposures have created a value proposition for advances in the granularity of risk modeling. The more granular modeling presents significant analytical and infrastructure challenges.

* Activity Expansion--Growth into hybrid risk classes, such as credit derivatives and insurance products, has pressed analytical and infrastructure issues. Synergy between accounting and management reporting processes is also key as market risktaking moves into nontrading activities. Nontrading activities are often not "marked-to-market," yet may share the same underlying risk profiles.

In response to these forces, the industry is undertaking several balancing acts--balanced measurement; balancing exposure-based risk limits and VaR-based limits; balanced solutions; and balancing ex post and ex ante analysis.

Balanced Measurement

The primary objective of any market risk management process is to provide increased transparency to the types and levels of exposure. An increased understanding of complex portfolios cannot be accomplished by relying on a single approach to measuring risk. Accordingly, firms are expanding or balancing the different types of risk measurement techniques utilized and better aligning these techniques to the measured objectives (see Figure 1).

As the need for risk transparency varies across an organization (that is, CEO, risk manager, head trader), risk measures must be tailored to management objectives and exposures / market situations. Far too often, risk management departments have developed their risk measurement toolkits without active direction from the recipients of this information. The result has been costly risk management mechanisms that provide little value to the organization other than regulatory capital calculation.

Balancing Exposure-Based Risk Limits and VaR-Based Limits

Risk limits have been common tools for establishing and communicating clear boundaries around risk tolerances. However, these risk limits are often not developed to produce a relative risk unit consistency. Specific exposure limits such as the notional size of five-year T-bill equivalents, overnight foreign currency positions, vega, (exposure to change in market volatility), and so forth, are frequently developed based on benchmark dollar balances and not adjusted periodically to reflect changes in market volatility. Accordingly, institutions that also use value-at-risk based limits at a higher portfolio level may find that the relative riskiness between an aggregation of their specific exposure limits may exceed or be constrained by their value-at-risk limits. This may result in an inefficient use of economic capital or a misunderstanding of risk exposures. Periodically, firms should reassess the relative balance between the economic capital allocated to a business, the value-at-risk limits, and the specifi c exposure limits.

Balanced Solution

In the initial rush to develop and implement independent risk management systems, organizations prioritized their development and implementation priorities in the following order:

* Analytics--The models to measure risk.