Learning Objectives:

• Define market risk and its sub-categories.

• Understand Value at Risk (VaR) and its methodologies.

• Apply stress testing and sensitivity analysis.

• Explain interest rate risk and foreign exchange risk.

3.1 Defining Market Risk

Market risk is the risk of losses from adverse movements in market prices, including interest rates, foreign exchange rates, equity prices, and commodity prices . The University of Leeds module covers “Market risk and value at risk (VaR)” as a core topic . The University of Reading module covers “alternative risk metrics: value-at-risk and expected shortfall,” “market risk modelling,” and “liquidity risk modelling” .

Key Sub-Categories of Market Risk:

• Interest Rate Risk: Risk from changes in interest rates.

• Foreign Exchange Risk: Risk from adverse currency movements.

• Equity Risk: Risk from stock price movements.

• Commodity Risk: Risk from commodity price movements.

3.2 Value at Risk (VaR)

VaR is a statistical measure that estimates the maximum potential loss of a portfolio over a specific time horizon at a given confidence level . The University of Leeds module covers “Market risk and value at risk (VaR)” . The University of Reading module covers “Value-at-Risk (parametric and non-parametric), VaR time horizon, confidence level and expected shortfall” .

VaR Methodologies:

• Parametric Approach (Variance-Covariance): Assumes normal distribution of returns. Uses mean, variance, and covariance to calculate VaR. The University of Reading module covers “mean, variance and covariance (time series and frequency approach), arithmetic and geometric returns, time aggregation” .

• Historical Approach: Uses actual historical returns to simulate possible outcomes.

• Monte Carlo Approach: Generates random scenarios to estimate potential losses.

Expected Shortfall (ES): An alternative risk metric that measures the average loss in the worst-case tail of the distribution, addressing some of the limitations of VaR .

3.3 Back-testing

Back-testing is the process of assessing the accuracy and reliability of VaR estimates . The University of Reading module covers “Back-testing: Likelihood ratio test, Type 1 and 2 errors, Regulatory back-testing” . Back-testing is a regulatory requirement for banks using internal models to calculate capital requirements.

3.4 Interest Rate Risk Management

Interest rate risk arises from changes in interest rates that affect earnings and economic value. The University of Leeds module covers “Interest rate risk management: Gap Analysis and Duration Gap Analysis” and “Interest rate risk management: The use of derivatives” . The University of Bologna module covers “Liquidity and Interest Rate Risk” .

Key Measurement Techniques:

• Gap Analysis: Measures the difference between interest-rate-sensitive assets and liabilities over various time buckets .

• Duration Gap Analysis: Measures the price sensitivity of assets and liabilities to interest rate changes .

• Derivatives: Using instruments such as interest rate swaps, caps, and floors to hedge interest rate exposure.

Key Sources of Interest Rate Risk:

• Gap Risk: Mismatches in asset and liability repricing dates.

• Basis Risk: Changes in relationships between different interest rates.

• Option Risk: Embedded options in assets and liabilities (e.g., prepayment of mortgages, early withdrawal of deposits).

3.5 Foreign Exchange Risk

Foreign exchange risk arises from adverse movements in exchange rates affecting assets, liabilities, and cash flows. The University of Leeds module covers “International risk assessment” as a core topic . The University of Reading module includes “international bank regulation and risk management and measurement techniques that are common in large banks worldwide” .

Types of FX Exposure:

• Transaction Exposure: Risk from future cash flows in foreign currencies.

• Translation Exposure: Risk from balance sheet items denominated in foreign currencies.

• Economic Exposure: Risk to the bank’s competitive position from exchange rate changes.