Market Risk

MARKET RISK

AKHIL UCHIL

MARKET RISKOld wisdom dictates that one should avoid putting all eggs in the same basket.

Diversification does not reduce risk below a minimum level.

The minimum level of risk which is attributable to factors which are external to portfolio is MARKET or SYSTEMATIC RISK.

The component of risk which can be reduced by diversification is NON SYSTEMATIC RISK.

What is Market Risk ?The possibility of loss to a Bank caused by changes in market variables.

Risk to the Banks Earnings & Capital due to changes in the market level of Interest rates or prices of Securities, Foreign Exchange, Commodities & Equities as well as volatilities in the prices

MARKET RISK - Types1. Liquidity Risk

2. Interest rate Risk

3. Forex Risk

4. Equity price Risk

5. Commodity price Risk

WHAT IS LIQUIDITY?Ability to fund increases in assets & meet payment obligations on due date efficiently & economically.

WHAT IS LIQUIDITY RISK? Potential inability to meet the Banks liabilities on the due date.Arises due to :1. Inability to generate cash to cope with decline in deposits or increase in assets.

2. Mismatches in maturity pattern of assets & liabilities.

Liquidity Risk Why to Manage?1. Demonstrates safety of Bank & provides confidence.

2. Necessary to nurture relationship.

3. Avoid unprofitable sale of assets.

4. Lowers the default risk premium.

5 Reduces the need to resort to borrowings from the Central Bank.

Liquidity Risk - Dimensions1. Funding Risk

2. Time Risk.

3. Call Risk.

Liquidity Risk how to manage?Have an effective Liquidity management policy.

Should speak out: Funding Strategies, Liquidity planning under alternative scenario, Prudential limits, Liquidity reporting & reviewing.

Tracking of cash flow mismatches. Track the impact of prepayment of loans & pre mature closure of deposits.

Cap on Inter bank borrowings.

Purchased funds vis--vis core assets.

Core deposits vis--vis Core assets.Duration of liabilities & Investment portfolioCumulative mismatches across all time bands. Commitment ratio tracking commitments given

Monitoring high value deposits.

Seasonal pattern of deposits/loans.

Potential liquidity needs for meeting new loan demands, un-availed credit limits, potential deposit losses, investment obligations, statutory obligations etc.

Contingency funding plans.

INTEREST RATE RISKDeregulation of interest rates has exposed the Banks to adverse impact of Interest rate risk.

Risk that value of Assets & Liabilities as also Net Interest Income get affected due to movements in interest rates.

Mismatch in cash flows or re-pricing dates of assets & liabilities expose Banks NII or NIM to variations

INTEREST RATE RISKS- TYPES1. Mismatch or Gap Risk.

2. Embedded Option Risk.

3. Reinvestment Risk.

4. Price Risk.

Rigidities on Interest Rate RiskMost liabilities are on Fixed rate basis while assets are on the floating rate basis.

There is no definite interest rate re-pricing date for floating rate.

Banks have to strengthen the MIS & Computer processing capabilities for accurate measurement of IRR

Interest Rate Risk - Management1. Floating rate Deposits.

2. Fixed rate Lending.

3. Derivative products like FRAs

FOREIGN EXCHANGE RISKRisk that Bank may suffer loss as result of adverse exchange rate movements during the period in which it has open position.

Risk arises whenever business has income/expenditure, asset/liability in a currency other than balance sheet currency.

TYPES OF FOREX RISKOpen or Mismatch positions. Price Risk.4. Credit Risk.5. Country Risk.6. Operating Risk.7. Legal Risk.

FOREX RISK MANAGEMENT1. Set appropriate limit for open position/gaps.

2. Clear cut & well defined division of responsibility between front, middle & back office.

3. Use of hedging tools like forwards, futures & options.

EQUITY PRICE RISKChanges in Equity prices can result losses to the bank holding Equity portfolio.

Banks are not allowed to sell the securities with out holding the same.

Banks are free to acquire Shares/Debs/Units of equity oriented mutual funds subject to ceiling of 5% of the total domestic credit

Equity Price Risk - ManagementBuild up adequate exposure to equity market

2. Formulate transparent policy & procedure for investment in shares.

3. Formation of Investment committee.

4. Review of Investment portfolio on going basis.

5. Fixing prudential exposure limits.

COMMODITY PRICE RISKBanks have very little exposure to commodities in their trading book.

Price rise/movement in commodities is more complex & volatile.

Banks in developed countries use derivatives to hedge commodity price risk.

Banks in India have to acquire the skills to manage as & when they get exposed to commodity price risk.