The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices. Market risk comprises three types of risk: currency risk, interest rate risk, and other price risk.
The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates.
Interest rate risk
The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates.
Other price risk
The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices (other than those arising from interest rate risk or currency risk), whether those changes are caused by factors specific to the individual financial instrument or its issuer, or factors affecting all similar financial instruments traded in the market.
European Banking Authority – EBA
Market risk can be defined as the risk of losses in on and off-balance sheet positions arising from adverse movements in market prices. From a regulatory perspective, market risk stems from all the positions included in banks’ trading book as well as from commodity and foreign exchange risk positions in the whole balance sheet. Traditionally, trading book portfolios consisted of liquid positions easy to trade or hedge. However, developments in banks’ portfolios have led to an increase in the presence of credit risk and illiquid positions not suited to the original market capital framework. To address these flaws, material changes in the market risk framework (generally known as ‘Basel 2.5′) have been introduced by the Capital Requirements Directive (CRD III). The EBA, through the publication of its guidelines intend to foster convergence in the implementation of some of these new capital requirements, namely the stressed value at risk (stressed VaR) and the incremental risk charge (IRC) introduced to adequately capture credit risk. The EBA will also draft some draft regulatory standards to clarify and better articulate some requirements provided for in the new CRD IV/CRR (Capital Requirements Regulation – Regulation EU 575/2013) text.
The trading functions of banks and corporates come under the highest degree of scrutiny given the nature of the business they conduct and the perceived complexity surrounding certain financial transactions. Financial institutions are concerned that an unexpected and significant loss on a trading portfolio could indicate wider issues within the market risk framework.
Market risk refers to the risk of losses in the bank’s trading book due to changes in equity prices, interest rates, credit spreads, foreign-exchange rates, commodity prices, and other indicators whose values are set in a public market. To manage market risk, banks deploy a number of highly sophisticated mathematical and statistical techniques. Chief among these is value-at-risk (VAR) analysis, which over the past 15 years has become established as the industry and regulatory standard in measuring market risk.