1. Market Risk
    1. Primary Sources of Market Risk
  2. Standardized Measurement Method
    1. Standardized Measurement Approach for Market Risk
    1. Managing insecurity with the SMA
  3. Internal Models Approach

3.1 Managing Market risk using internal models

1. Market Risk

Market risk is defined as the risk of losses on financial investments depending on the positions arising from movements in the market price such as On-Balance-Sheet and off-Balance-Sheet.  Market risk is also called as “systematic risk” since it relates to factors, such as a recession, which impact the entire market.  Therefore the value of an investment will decrease due to changes in market factors. The risks subject to the adverse price movements will affect the interest rate-related instruments and equities in.

1.1 Primary Sources of Market Risk

Market risk is well-known as un-diversifiable risk because it affects all asset classes which is unpredictable. By hedging a portfolio, an investor can diminish this type of risk.  Following are the four primary sources of risk which affect the overall market

·         Interest Rate Risk is the risk of increased instability due to a change in interest rates. Here the risk arise when there is a change of interest rates, such as basis risk, options risk, structure risk, and re-pricing risk.

·         Equity Price Risk is the risk that arises from security price volatility equity price. In worldwide financial crisis, equity price risk is systematic because it affects multiple asset classes whereas unsystematic risk can be mitigated through diversification

·         Foreign Exchange Risk is also called as Currency risk that arises when currency exchange rates are unstable. While carry out business globally, firms may be exposed to currency risk due to imperfect hedges.

·         Commodity Risk: Due to changes in politics, seasonal changes, technology, and current market conditions the price of commodity will fluctuate. Here arise a Commodity risk which affects various sectors of the market, such as airlines and casino gaming.

2. Standardised Measurement Method

SMM in market risk is said to be one of the methodology used to evaluate and analyses the risk of market in a standardised manner. From March 31, 2005, this standardised measurement method is normally used by banks in India.  Standardised measurement approach (SMA) aims at evaluating operational risk planned by the Basel Committee on Banking Supervision in 2016 where they focus on primary global standard setter. Therefore SMA is said as a replacement for all offered approaches, including internal models.

2.1 Standardised Measurement Approach for Market Risk

In October 2014, the Committee projected modification for standardised approaches and calculated operational risk capital.  The Committee’s review of banks’ operational risk modeling practices and capital outcomes discovered the Advanced Measurement Approach’s (AMA). Thus, the Committee removed the AMA from the regulatory framework.

The revised operational risk capital framework which is evaluated based on a single non-model-based method for the estimation of operational risk capital called Standardised Measurement Approach (SMA). The SMA results in the following

  • Simplicity and comparability approach,
  • Represent the risk sensitivity in advanced approach.
  • Promotes consistency in operational risk capital measurement.

2.2 Managing insecurity with the SMA

SMA performs to create more uncertainty for financial institutions and will further delay the comparability of cross-industry operational risk capital data following its implementation in 2022.  One of the most significant sources of uncertainty, and the biggest challenge to data comparability, has been the discrimination provided to national regulators to:

  • Eliminate loss history from the SMA calculations, and even disclose historical operational risk losses with is erased

While these elements of the SMA helps to address disquiets of backward-looking nature, and create vagueness about historical operational losses. This will show the differences of SMA calculations managed by different institutions and will built up new avenues for regulatory commercialization across jurisdictions.  In the perspective of the opposing impacts of SMA across the globe, particular local regulators have already signaled a willingness to create national operational risk capital requirements in addition.  

3. Internal Models Approach

One more alternative methodology called Internal Models Approach (IMA) is available to manage market risk. The allowable models under IMA used to calculate a value-at-risk (VaR) based measure of exposure to market risk.

3.1 Managing Market risk using internal models

Managing Market risk using internal models covers all aspects of the minimum capital requirements for market risk, including the boundary between the trading book and the banking book, the standardized approach and the internal models approach (IMA).

  • As a first step towards full implementation of the FRTB framework, the European Union recently introduced an obligation for banks to report their capital requirements based on the new rules to their supervisor.
  • Next, the European Commission is expected to submit a legislative proposal on how to turn the reporting obligation into a binding capital requirement for banks.
  • A new market risk metric,
  • Greater sensitivity to market illiquidity and
  • Model approval at the trading desk level.

Hope this article explains in detail the market risk and managing uncertainty with SMM and IMA to reduce risk.

In order to get approval from bank, the External commercial borrowing (ECB) has set up a working group with representatives and the national competent authorities to develop the FRTB IMA application and approved the process more broadly, to coordinate the implementation of the new market risk rules from the perspective of the banking supervisor.

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BankReed Admin

Banking Professional with 16 Years of Experience. The idea to start this Blogging Site is to Create Awareness about the Banking and Financial Services.

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