What is Market Risk? An Intuitive Summary Now
What is market risk? How is it relevant to us? Should I explore a career in market risk management?
If these are some of your questions, read on to understand more about the exciting field of market risk management and figure out if it’s for you!
What is market risk?
Definition
Market risk is the risk of losses from market movements and comprises two key elements: exposure and market moves.
For example, if we hold/invest in Google equity/stock (an exposure), we’d like the equity price to rise (a market move) so our holdings become more valuable. Thus, the risk is when the stock price falls and we sell off our holdings at a loss. The same, universal concept applies to all financial instruments, including more sophisticated ones like derivatives.
Ultimately, it is all about our asset/trade potentially losing money/value. Note that “assets” here generally refer to financial assets that frequently trade in an established market e.g. the US stock market.
Sources of Market Risk
Market risk arises from a variety of sources (also known as “market risk factors”), most commonly:
– Foreign exchange (FX) rates
– Interest rates and bond prices
– Stock (Equity) prices
– Commodity prices
These risk factors fluctuate daily based on supply and demand dynamics driven by the global economy, geopolitics, etc. These fluctuations/market movements then cause our investment/trading portfolio to change in value. For example, the yield curve affects fixed-income instruments like bonds and swaps so understanding its dynamics enables better prediction of its future movements.
If portfolio value rises, it’s a favorable move and we are happy. Otherwise, it’s a risk that we must decide on how to manage i.e. live with it or hedge away.
Measurement & Management
The measurement and management of market risk goes hand-in-hand. As Peter Drucker, the founder of modern management, said: “You cannot manage what you don’t measure”.
There are two main types of market risk metrics:
1) Loss metrics – measures the potential/actual loss of the portfolio e.g. VaR/ES, Stress PnL, Actual PnL
2) Risk metrics – measures the amount of risk in the portfolio e.g., Greeks/Sensitivities, Volatility, Beta
Financial institutions like banks combine loss and risk metrics to measure market risk. The most common ones are VaR/ES at the business unit/desk level and sensitivities across levels and dimensions. They further impose risk limits on these metrics to manage/control the risk taken.
How is market risk relevant to us?
Market risk affects everyone – individual or institution – who invests or trades assets/financial instruments because their values fluctuate based on prevailing market conditions.
Individuals invest in financial assets like stocks and bonds (and possibly some crypto) to grow wealth and protect against inflation. Institutions, similar to individuals, also invest in financial assets for returns. Financial institutions, in particular, also heavily trade derivatives to provide hedging and yield-enhancing solutions for their clients and themselves.
Therefore, if market risk isn’t properly managed, we risk losing all our hard-earned money. For example, individuals investing their life savings into highly volatile crypto or institutions trading in massive sizes bear significant losses when the market moves unfavorably.
Institutions, especially global ones, bear such risks in their daily operations and even individuals do too in their day-to-day lives.
Real-life Examples in Daily Life
Imagine we work in the US earning USD. If we…
– Go for a holiday in Europe, we bear FX risk since the EUR may strengthen vs USD due to newly launched FDI policies to attract investors
– Place a USD fixed deposit, we bear interest rate risk since USD interest rates may rise but we are “locked in” at the lower contractual deposit rate
– Buy Apple equity, we bear equity price risk since its equity price may fall due to poor performance e.g. lower-than-expected iPhone sales
– Drive a petrol car, we bear commodity price risk since petrol prices may rise due to geopolitical uncertainties involving major oil producers
Should I explore a career in market risk management?
Market risk management is an interesting field with a sizeable scope of areas/roles for you to choose from. If you relate to the following attributes, a career in market risk management might be a good fit for you!
Interest in Financial Instruments & Models
Risk first originates from buying/investing/trading financial instruments/products e.g. stocks, bonds, and derivatives, which generate exposures. While securities like stocks and bonds have straightforward mechanics, derivatives like forwards, swaps, and options can be complex. Curiosity and willingness to understand how a product works and its relevant risk factors and valuation/pricing model ensure risks can be appropriately identified and managed.
Interest in Financial Markets
Market moves convert exposures to losses so the risk manager should stay updated with market developments that will impact PnL. An interest in the financial markets e.g. recent market events, who the participants are, how it usually moves and their drivers leads to a natural curiosity and willingness to stay abreast of markets and develop market sense. This then helps to understand traders’ positioning and anticipate future potential risks.
Strong Analytical/Programming Skills
Market risk management involves lots of analysis and data so strong quantitative and programming skills will be invaluable. Risk managers must often investigate the drivers of a spike in risk measures e.g. VaR/ES, sensitivities, or PnL. Hence, strong analytical and programming skills enable swift analysis, underpinned by good data management, to deliver impactful results.
Effective Communication Skills
The ability to communicate effectively is arguably essential in any industry. In market risk management, an effective communicator can clearly and objectively explain risk issues/assessments to stakeholders (e.g. traders, management, technology) and what needs to be done next. It also means being courageous to ask (sometimes hard) questions and to challenge the business constructively and tactfully.
A Collaborative and Balanced Mindset
A general challenge in risk management is balancing competing interests and perspectives of business and risk. Business’s main goal is to make money while Risk’s main goal is to control risk, which can create tension. A collaborative and balanced mindset facilitates understanding of both perspectives and drives one toward win-win and balanced solutions, ultimately benefitting the firm.
In conclusion, market risk management is an interesting and stimulating field blending technical and business work. Post the 2008 Global Financial Crisis, risk management was further cemented into the industry as an essential function for financial institutions – supporting strong demand and stability of related jobs.
if you enjoyed this article or know someone interested in exploring the market risk management field, please share this post with them! For someone already interviewing for a role, these interview tips may help!
Risk Manager by Profession, Mentor and Coach by Passion.
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