Market Risk & Counterparty Risk: A Quick Intro

Market risk and counterparty risk (sometimes collectively called “traded risk”) are two key risks that financial institutions manage together daily.

As such, aspiring traded risk managers should be familiar with these concepts. Understanding these concepts is helpful even for personal finance! After all, wherever you invest your hard-earned money, you don’t want to lose them by taking too much risk, right?

Here’s a quick and simple intro to the world of traded risk.

Market Risk

What is market risk?

Market risk is the risk of loss from market price movements impacting your trading portfolio.

It arises when you have positions in financial instruments whose market value changes due to movements in market prices/risk factors e.g., foreign exchange rate, interest rate, equity price, etc. For example, if you buy a Google share at $3,000 and its price falls to $2,900, you lose $100 from a fall in equity price.

Financial institutions, just like you as a retail investor, bear market risk when taking positions in a large and diverse collection of financial instruments. Although their portfolio is much larger and way more complex than yours, this does not change the nature of the risk borne.

Why is market risk important?

Market risk is important because it can result in significant financial losses in a very short time period e.g. in days.

The easiest case to imagine is investing in cryptocurrencies, which are all the rage these days. Stories of people getting rich in a short period by buying crypto abound. For example, consider this 25-year-old who became a millionaire after investing early in ether and bitcoin. However, crypto, like leverage, is a double-edged sword; just as it can make you tons of cash overnight, it can also go the other way and bankrupt you.

This same reasoning applies to financial institutions too, where lots of money can be lost overnight if firms are not careful. Since their portfolios are more diverse and larger, managing market risk carefully is all the more important to safeguard firms against losses.

How do we measure market risk?

In the industry, there are two main market risk measures: Value-at-Risk (“VaR”)/Expected Shortfall (“ES”) and Sensitivities a.k.a. Greeks.

VaR and ES measure how much a portfolio can potentially lose over a specific period and confidence level. For example, a 1-day 99% VaR of $1m means the one-day loss should be within $1m, 99 percent on the time. Similarly, a 1-day 99% ES of $1.5m means that if the portfolio loses an amount beyond the 99% confidence VaR ($1m) in a day, the average loss should be $1.5m. See What is VaR (Value-at-Risk)? for more info.

Sensitivities/market risk exposures measure the portfolio value change driven by an increase in the value of a market risk factor. They are also known as Greeks due to the greek letters often used to represent them. The most well-known sensitivity is Delta, commonly meaning a change in portfolio market value per 1% change in the spot price of an asset. For instance, an equity Delta of $500k means a 1% increase in the current share price leads to a $500k increase in portfolio value.

How do we mitigate market risk?

Market risk can be mitigated by lowering portfolio sensitivities to market risk factors.

Sensitivities can be lowered by hedging or exiting the trade. Hedging means entering into some opposite positions on the same risk factor to reduce the overall net sensitivity. For example, if you have a long position on Apple shares, you hedge by entering into a short position on Apple shares and vice versa. Unwinding/squaring a position means to completely exit/close out the position by entering into an identical but opposite position; this means all exposure is gone (not just reduced).

Counterparty Risk

What is counterparty risk?

Counterparty risk a.k.a. Counterparty Credit Risk (“CCR”), is the risk of loss from a counterparty’s default on their obligations.

A counterparty is whom you face on the other side of a financial transaction. If the counterparty is not able or willing to honor its contractual obligations, it could lead to losses. For example, if you loan $10 to a friend and he does not repay you on the agreed repayment date, you simply lose the $10. However, there can be more interesting cases where the amount owed to you is different, depending on the situation.

Imagine you and your friend bet whether it will rain tomorrow (similar to a coin flip). One party bets it will rain and the other bets the opposite; the winner receives $5 from the loser. Here, the counterparty risk you bear depends on the situation. If you win the game, you bear counterparty risk because you lose the $5 receivable if the counterparty decides to walk away. However, if you lose, there is no counterparty risk because you are not owed anything and therefore, don’t care if the counterparty defaults.

Financial institutions essentially face similar counterparty risks. When it gives a loan to its customers/counterparties, that entire amount is subject to counterparty risk. However, when it trades derivatives (like the betting game), the counterparty risk becomes a contingent one that depends on the market value of these contracts. Typically, one refers to the latter when talking about counterparty risk.

Why is counterparty risk important?

Counterparty risk, like market risk, can result in significant financial losses if mismanaged.

The Global Financial Crisis in 2008 is a great example of how not managing counterparty risk can lead to losses. In short, many large financial institutions traded derivatives e.g. Credit Default Swaps (“CDS”) with each other. This resulted in the build-up of significant and interlinked counterparty exposures, creating a domino effect of losses when Lehman Brothers went bankrupt. Hence, after the financial crisis, the BCBS proposed new regulations such as margin requirements for non-centrally cleared derivatives to reduce systemic counterparty risk.

How do we measure counterparty risk?

Counterparty risk is measured by various credit exposure metrics. The two most common ones are Potential Future Exposure (PFE) and Expected Exposure (EE).

PFE is the positive market value of a portfolio at a specific future time point and confidence level (does it sound familiar to VaR?). Further, EE is the average positive market value of a portfolio at a specific future time point. Both metrics represent positive portfolio market values that will constitute credit losses in the event of counterparty default. For example, if EE is $5 a year from now, the credit loss is $5 if the counterparty defaults then.

How do we mitigate counterparty risk?

There are two main ways to mitigate counterparty risk: netting and collateralization.

Netting means you can offset amounts owed to you against amounts you owe, to arrive at a final payment due to either party. For example, if you are owed $5 and you owe $3, the netted amount owed to you would be $5 – $3 = $2. So, instead of you collecting $5 from your counterparty and paying him $3 back, you’ll simply collect the net amount of $2.

Collateralization means to collect something of value i.e. collateral from your counterparty. In case your counterparty defaults on you, you may sell off the collateral and recoup some money. For example, if you are owed $5 and have collateral worth $4, your net credit exposure is $5 – $4 = $1.

A third and relatively less common way to mitigate counterparty risk is by risk transfer. Specifically, it is to enter into a CDS that pays out if the counterparty defaults. For instance, if your credit exposure is $8, you can enter into a CDS that pays out $8 on counterparty default, which will mitigate this exposure.

What is the difference between market risk and counterparty risk?

Market risk and counterparty risk are really not too different, which is why they are managed out of the same risk unit in some financial institutions. In fact, they are akin to two sides of a coin. Aside from the key differences shown below, both risk types share similarities in modeling techniques and financial instruments to which it applies.

Market risk and counterparty risk are really interesting because it requires a unique combination of skills and knowledge across different areas such as finance, economics, mathematics, etc. to be an effective risk manager. If you’re looking to break into these areas and would like to maximise your chances to land the role, let’s have a conversation to see how I can help!

This intro only touches the surface of traded risk and I hope you enjoy and continue exploring this exciting area =)

Ray Yeo

Risk Manager by Profession, Mentor and Coach by Passion.