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Chapter Ten
Market Risk
Chapter Outline
Introduction
Market Risk Measurement
Calculating Market Risk Exposure
The RiskMetrics Model
l The Market Risk of Fixed-Income Securities
l Foreign Exchange
l Equities
l Portfolio Aggregation
Historic or Back Simulation
l The Historic (Back Simulation) Model versus RiskMetrics
l The Monte Carlo Simulation Approach
Regulatory Models: The BIS Standardized Framework
l Fixed Income
l Foreign Exchange
l Equities
The BIS Regulations and Large Bank Internal Models
Summary
Solutions for End-of-Chapter Questions and Problems: Chapter Ten
1. What is meant by market risk?
Market risk is the uncertainty of the effects of changes in economy-wide systematic factors that affect earnings
and stock prices of different firms in a similar manner. Some of these market-wide risk factors include volatility,
liquidity, interest-rate and inflationary expectation changes.
2. Why is the measurement of market risk important to the manager of a financial institution?
Measurement of market risk can help an FI manager in the following ways:
a. Provide information on the risk positions taken by individual traders.
b. Establish limit positions on each trader based on the market risk of their portfolios.
c. Help allocate resources to departments with lower market risks and appropriate returns.
d. Evaluate performance based on risks undertaken by traders in determining optimal bonuses.
e. Help develop more efficient internal models so as to avoid using standardized regulatory models.
3. What is meant by daily earnings at risk (DEAR)? What are the three measurable components? What is the
price volatility component?
DEAR or Daily Earnings at Risk is defined as the estimated potential loss of a portfolios value over a one-day
unwind period as a result of adverse moves in market conditions, such as changes in in
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