What is market risk?

Due to changes in the value of existing assets, certain losses often occur. The possibility of their appearance is called market risk, which depends on the macroeconomic parameters of the financial system (changes in the exchange rate of currencies or precious metals, interest rates, market indices). With proper management, financial losses can be minimized.

Classification Option

There is a certain classification risks in a market economy. They can be of four types.

Price risk implies a possible fall in the value of securities and specific types of products. It can be stock or commodity.
Interest rate risk implies the probability of financial losses due to adverse fluctuations in rates on assets, liabilities and other instruments of banking institutions. Their increase leads to losses.
Currency risk includes the possibility of receiving financial damage when the exchange rates of monetary units and precious metals in the case of open positions.

Internal Management Methods

Under the inner market risk management It implies a way to reduce potential losses in the financial activities of a particular company.

Purchase of monetary units in the required volume. The company must have funds to close the currency position. Regulation can be implemented if the company has entered into many contracts for the import and export of products at the same time.
Diversification is relevant when signing contracts in the currencies of different countries whose exchange rates fluctuate in opposite directions. With payments and credits using a specific currency, a certain equilibrium of assets can be achieved.
Compensation is a way to adjust ruble prices while increasing the exchange rate.
A currency clause is entered directly into the export-import supply agreement. It may involve the calculation of the final amount in monetary units that are stable, as well as the inclusion of conditions for possible changes in value.

External management methods

To cut financial market risk to a minimum, you can use hedging, which is the conclusion of contracts with a third party. It involves reducing losses due to derivatives in the form of forwards, options or futures. This is usually practiced by brokers and large financiers.

In practice, hedging is used in situations where the company does not have a single currency position, since a certain percentage of contracts does not go beyond the existing risks. Thus, it is necessary to open transactions for specific amounts.

Modern financial institutions of the Russian Federation have the opportunity to conclude various options for futures contracts, so companies can consider hedging as the main tool. Such insurance robs some of the profits, but without it you can lose much more.

Control mechanism functions

Under bank risk management This implies limiting the possible financial damage that may be caused for a certain period with a given probability. For each type of currency transactions limits are set. Losses may result from changes in the rates of precious metals and foreign currencies, stock prices.

Introduction of control systems allows:

apply effective procedures for analyzing potential losses;
quantify likely damage;
develop risk reduction techniques;
make informed decisions on working with a portfolio;
establish a positive image for existing and potential customers;
improve the qualifications of employees of the institution;
show international agencies involved in ratings their capabilities.

The main methods to reduce losses

There are many ways to reduce market risks.

Forward agreement. This method of protection against possible financial damage involves the provision of a loan on a certain day at a fixed percentage or foreign currency exchange at a specific cost. When concluding such an agreement, a change in the interest rate or the exchange rate of the currency reduces the existing risks. Forward agreements have spread to over-the-counter markets.
Futures contracts. At their conclusion, the owner receives the right to sell or purchase any asset at a fixed price in the future. Futures are acquired and traded directly on the exchange. You can refuse them at any time by making a reverse transaction. With regard to forward agreements, serious problems are possible in avoiding obligations.
The option can be American or European. The first of them enables its holder to buy or sell a certain amount of assets at a price already set earlier at any time. As for the European option, it allows you to perform the same actions only after the expiration of the contract.
A swap is an agreement to exchange the proceeds of future payments of various assets. One of the options to reduce interest rate risk is to conclude a transaction between the two parties, under the terms of which they must pay a certain amount to each other under agreed obligations.
Insurance is also a way to protect against possible losses, but in Russia it has not received wide distribution.
Diversification is the process of including various types of securities in a portfolio with investment projects in order to avoid financial damage in the event of a fall in prices for some of them.
The introduction of position limits is carried out by banks in order to limit losses. Their approval is made taking into account analytical data and special calculations.
The approval of liabilities and assets directly by the terms can be carried out on the entire bank balance sheet or on specific resources. Return dates must be exactly the same in order to provide certain maneuverability in commercial activities.
The provision of loans with a floating interest rate allows banking institutions to take into account market fluctuations.

Common Market Risk Assessment Methods

There are several methods for analyzing probable losses in financial portfolios and instruments.

VaR (Cost at Risk).
Stress Testing (modern way).
Shortfall
Analytical approaches.

The most common was the first of them. VaR is a quantitative method market risk assessment when opening trading positions. The method allows you to express the result in units of the base currency. The basic parameter for analysis is the fluctuation of the rates and prices of financial instruments for a certain period of time.

VaR calculation option with parameters

This method is used for analysis. market risk on open positions of financial instruments. Despite the popularity of the method, it is not recommended to use it to estimate losses with non-linear price parameters. The main disadvantage of this calculation option is the assumption of the distribution of returns, which usually does not correspond to the real situation.

Var = V * Y * Q, where:

V is the value of the position that is currently open;

Y is the quantile of the natural distribution for a certain confidence level;

Q is the deviation of the risk factor from the previous value.

You can give an example of calculations.Suppose an investor owns shares for a total amount of 10 million rubles. The confidence level is 99 percent with a time horizon per day. The price volatility is 2.15. We get:

VaR = 20 * 2.33 * 2.15 = 100.19 million rubles.

Thus, the probability of loss for this amount is only 1 percent. On average, such losses are possible once every hundred days.

Risk Manager Procedure

Detection of currency components that can affect the financial results of the institution.
Conducting computational operations to determine the risk corridor, which is an acceptable rate fluctuation for the company.
Choosing the best way to manage possible financial losses over a set time interval.
Control over all currencies for a month.

In conclusion

Correct calculations market risk rates Avoid serious financial losses. However, the methods of the calculations must be correctly selected. Without proper management of possible losses, not one normal institution can exist.