Market risk is the potential for loss in securities resulting from fluctuations in market aspects reminiscent of rates of interest, currency values, foreign exchange/commodity spot rates and equity prices. These risks are inherent in all traded securities, from corporate bonds to commodities. Any variety of security could also be exposed to multiple risks concurrently, which is why market risk is of critical importance to investors and financial institutions.
Added to those risks is model risk, which is related to developing and using a model to find out financial results and decision making. An inefficient or incorrect modeling technique can sometimes have drastic effects on the business. Understanding and managing this risk is subsequently essential to creating informed financial decisions and protecting yourself from potential losses.
More on market risk
Different risk aspects within the structure of the safety determine the sort and extent of market risk it carries. The mostly studied and observed forms of market risk are rate of interest risk, credit risk, foreign exchange risk, equity risk and commodity risk. A single security could have just a number of of those risks. For example, a company bond carries not only credit risk but additionally rate of interest risk, and whether it is denominated in a foreign currency, it also carries currency risk. In general terms, we will consider market risk because the fluctuation in the worth of a security resulting from market-related risk aspects reminiscent of rates of interest and stock price movements. However, it has far-reaching implications as these security valuations are used to make further decisions, reminiscent of investments, regulatory compliance and portfolio optimization, depending on the profile of the corporate or risk manager.
More on model risk
A model consists of varied components, namely inputs/data, assumptions, logic/process and final result. An inefficient or incorrect modeling technique along any of those process components can sometimes have drastic effects on the corporate. The SR11-7 Regulatory framework defines how model risks needs to be managed by banks and is relevant for other financial institutions.
Market risk and model risk: dependencies
Although market and model risk represent different dimensions of risk, they’re intertwined in a sequential manner. This is obvious because an organization’s quantification or determination of market risk and any decisions resulting from it are often presented because the result of monetary models. When company managers give attention to efficiently managing market risk, the method also includes equally efficient management of model risk. Therefore, it is beneficial to think about these two risks along side one another when estimating the fee, time and resources to administer an organization’s investment or market-related risks.
An example of this may be using a financial model to find out the worth of a portfolio of securities, which in turn influences a buy/sell decision. If the valuation model makes incorrect assumptions by not making an allowance for diversification/hedging effects within the portfolio, this may result in incorrect decisions that not only have financial implications for the corporate, but also can pose reputational and regulatory risks.
Model risk is a critical risk that have to be effectively managed by financial institutions, not only to make informed market risk management decisions or meet regulatory requirements, but additionally to survive and thrive. In cases where firms use third-party providers for pricing and valuation, model risk is exacerbated as most providers also use models to reach at their numbers. In such cases, clients must conduct due diligence to be certain that the third-party providers’ models are validated and/or audited.
Regulatory use case
The Basic review of the trading book (FRTB) is a market risk regulatory framework with quite a few quantitative techniques utilized by the regulator to quantify the market risk carried in banks’ trading books in the shape of capital requirements. A key change on this regulatory framework is the move away from existing Value at Risk (VaR) based techniques to calculations of market risk metrics based on expected shortfall. This move requires existing market risk models to be modified or, in some cases, built from scratch to efficiently perform these bespoke FRTB calculations. This leads to a considerable amount of model-related risk resulting from recent assumptions, input data, modified code/software and adjusted output metrics. If FRTB model assumptions are modified, capital requirements can vary significantly. Applying this framework to administer market risk more efficiently introduces additional costs and complexities to administer the model risk inherent in recent or updated bespoke models to perform these FRTB-specific calculations.
Key finding
Risk managers need to think about market and model risk from a single perspective to achieve a whole picture of their market-related investment and trading risks, in addition to the management costs, complexities, time and regulatory requirements.
References
[1] https://www.bis.org/bcbs/publ/d457.htm
[2] https://www.federalreserve.gov/supervisionreg/srletters/sr1107.htm
