Market risk arises whenever FIs actively trade assets and liabilities (and derivatives)
rather than holding them for longer term investment, funding, or hedging purposes.
Income from trading activities is increasingly replacing income from traditional FI
activities of deposit taking and lending. The resulting earnings uncertainty can be
measured over periods as short as a day or as long as a year. Moreover, market risk
can be defined in absolute terms as a dollarexposure amount or as a relative amount
against some benchmark. The sections that follow concentrate on absolute dollar
measures of market risk. We look at three major approaches that are being used to
measure market risk: RiskMetrics, historic or back simulation, and Monte Carlo
simulation.
So important is market risk in determining the viability of an FI, since 1998 U.S.
regulators have included market risk in determining the required level of capital an
FI must hold.^3 The link between market risk and required capital levels is also dis-
cussed in the chapter.
8.2 MARKET RISK MEASUREMENT. There are at least five reasons why market risk
measurement (MRM) is important:
1.Management information.MRM provides senior management with information
on the risk exposure taken by FI traders. Management can then compare this
risk exposure to the FI’s capital resources. Such an information system appears
to have been lacking in the Barings failure.
2.Setting limits.MRM considers the market risk of traders’ portfolios, which will
lead to the establishment of economically logical position limits per trader in
each area of trading.
3.Resource allocation.MRM involves the comparison of returns to market risks
in different areas of trading, which may allow the identification of areas with
the greatest potential return per unit of risk into which more capital and re-
sources can be directed.
4.Performance evaluation.MRM, relatedly, considers the return-risk ratio of
traders, which may allow a more rational bonus (compensation) system to be
put in place. That is, those traders with the highest returns may simply be the
ones who have taken the largest risks, It is not clear that they should receive
higher compensation than traders with lower returns and lower risk expo-
sures.
5.Regulation.With the Bank for International Settlements (BIS) and Federal Re-
serve currently regulating market risk through capital requirements (discussed
later in this chapter), private sector benchmarks are important since it is possi-
ble that regulators will overprice some risks. MRM conducted by the FI can be
used to point to potential misallocations of resources as a result of prudential
regulation. As a result, in certain cases regulators are allowing banks to use
their own (internal) models to calculate their capital requirements.^48.2 MARKET RISK MEASUREMENT 8 • 3(^3) This requirement was introduced earlier (in 1996) in the EU.
(^4) Since regulators are concerned with the social costs of a failure or insolvency, including contagion
effects and other externalities, regulatory models will normally tend to be more conservative than private
sector models that are concerned only with the private costs of failure.