Market Risks

Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices.

Market Risks are broadly classified as:

1. Crrency Risk
2. Interest Rate Risk
3. Liquidity Risk

Currency Risk:

Banks deal in different currencies both on behalf of their customers as well as themselves to earn trading gains. Currency Risk is the probability of potential loss caused due to changes in market exchange rate of currencies. US Dollar/Euro is the most traded currency pair. Increasing Forex Turnover in the world shows the integrated world feature the flipside of which is increasing the volatility of exchange rate of currencies. Volatile Exchange rates can have a significant impact in the earnings, cash flow and profitability of companies. Effective management of foreign currency risk can help stabilize a company’s performance relative to currency market and is a source of competitive advantage. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.

Interest Rate Risk:

It is the exposure of a bank’s Financial System to adverse movements in Interest Rates. Banks typically borrow for short-term and lend it for long-term and this process attracts repricing risk as interest rates might increase over the period whereas the asset would have been financed at fixed interest rate. The major portions of bank deposits are demand deposits in which depositor has an option to withdraw at any point of time leading to borrowings by banks at higher cost.

Liquidity Risk:

Banks face liquidity risks due to mismatch in asset and liability. Liquidity risk also arises when banks do not have enough funds to provide loans. Also the risk that arises from the difficulty of selling an asset is called as liquidity risk. A security has a good liquidity if it is easy to trade and has low bid-ask spread (difference in bidding price of buyers and ask quotes of sellers). In recent times due to shortage of capital, banks are still facing extreme funding liquidity risk as they cannot fund their loans. In order to induce faith in customers mind Banks had to maintain enough Liquidity by devaluating some of the assets and practicing tighter risk management. This has also been caused due to wide gap between bids and ask price.

Banks like Lehmann Brothers and Bear Stearns have been a true consequence of Liquidity crisis.

After Recession shocks, stimulus provided has included recapitalization of banks. The stress has been on raising new capital for banks to tackle liquidity problems.