Market Risk, Operational Risk & Credit Risk

As with other forms of risk, the potential loss amount due to market risk may be measured in a number of ways or conventions. Traditionally, one convention is to use Value at Risk (VAR). The conventions of using Value at risk is well established and accepted in the short-term risk management practice.

However, it contains a number of limiting assumptions that constrain its accuracy. The first assumption is that the composition of the portfolio measured remains unchanged over the specified period. Over short time horizons, this limiting assumption is often regarded as reasonable.

However, over longer time horizons, many of the positions in the portfolio may have been changed. The Value at Risk of the unchanged portfolio is no longer relevant.

The Variance CoVariance and Historical Simulation approach to calculating Value at Risk also assumes that historical correlations are stable and will not change in the future or breakdown under times of market stress.

In addition, care has to be taken regarding the intervening cash flow, embedded options, changes in floating rate interest rates of the financial positions in the portfolio. They cannot be ignored if their impact can be large.

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. The associated market risks are:
Equity Risk the risk that stock prices and/or the implied volatility will change.Interest Rate Risk the risk that interest rates and/or the implied volatility will change.Currency Risk the risk that foreign exchange rates and/or the implied volatility will change.Commodity Risk the risk that commodity prices (e.g. corn, copper, crude oil) and/or implied volatility will change.

• VaR (Value at Risk) used traditionally to assess the market risk but limited over time as conditions change this is the same flaw found in the Variance Covariance and Historical Stimulation approach to calculating VaR.
• LCR (Liquidity Coverage Ratio) Jan 2013 forms a key plank of Basel lll reform on capital requirements.
• NSFR (Net Stable Funding Ratio) as it stands and it will be essential that the new standard is appropriately calibrated and that its effects are modelled  comprehensively to mitigate the risk of causing unintended consequences  such as pricing and market distortions- is likely to undergo reforms until mid-2017.

A form of risk that summarizes the risks a company or firm undertakes when it attempts to operate within a given field or industry. Operational risk is the risk that is not inherent in financial, systematic or market-wide risk. It is the risk remaining after determining financing and systematic risk, and includes risks resulting from breakdowns in internal procedures, people and systems or external events.

Operational risk can be summarized as human risk; it is the risk of business operations failing due to human error. Operational risk will change from industry to industry, and is an important consideration to make when looking at potential investment decisions. Industries with lower human interaction are likely to have lower operational risk.

• BIA (Basic indicator approach)
• STA (standardised Approach)
• AMA (Advanced Measurement Approach)

The risk of loss of principal or loss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meet a contractual obligation.  Credit Risk arises whenever a borrower is expecting to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation.

Credit risk is closely tied to the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk.

The higher the perceived credit risk, the higher the rate of interest that investors will demand for lending their capital. Credit risks are calculated based on the borrowers' overall ability to repay. This calculation includes the borrowers' collateral assets, revenue-generating ability and taxing authority (such as for government and municipal bonds).

Credit risks are a vital component of fixed-income investing, which is why ratings agencies such as S&P, Moody's and Fitch evaluate the credit risks of thousands of corporate issuers and municipalities on an ongoing basis. Most lenders employ create their own models (credit scorecards) to help them make lending decisions based on risk of default.  Analysts also create models using specialist software packages such as SAS or SPSS or free tools like R.

Acronyms you may be familiar with in Credit Risk from Basel:

• IRB   (Internal Rating-Based Approach) different accepted ways by Basel of calculating Credit Risks.
• LGD   (Loss Given Default)
• PD    (Probability of Default)
• EAD   (Exposure at Default)
• RWA (Risk Weighted Assets)
• ICAAP (Internal Capital Adequacy Assessment Process) agreed framework to deal with various risks

A counterparty risk or default risk is the risk that a counterparty defaults i.e. does not repay their debt to the company on a transaction, trade, contract etc.  The affect such defaults would have on the businesses ability to continue operating have to be assessed and where possible these risks hedged to counteract defaults.  Hedging is using various financial instruments to create a form of insurance against the loss if it occurs.

Basel lll looks at methods to address the risks via terms you may be familiar with the acronyms:

• CCR (Counterparty Credit Risk)
• CVA (Credit Valuation Adjustments)