Market risk, also called systemic risk, is about the undesirable changes in market conditions that may cause financial loses. The following are the most common types of market risks:
- Interest rates
- Currency exchange rates
- Commodity prices
- Equity prices
Market Risk Control Framework
Establishing a market risk control framework is important for organizations exposed to fluctuations in the financial markets. A control framework should encompass processes, systems, and strategies to address market risks. A market risk framework should comply with regulatory and compliance requirements and follow industry best practices. The following are key industry-best practices to implement a market risk control framework.
Define Scope
The first thing to do is define the market risk scope; that is, identify the market risks the organization should focus on, primarily, because of exposure. Subsequently, the scope will help define the objectives of the market risk control framework.
Governance and Oversight Committee
A governance and oversight committee, with clearly defined accountability, is necessary for the implementation of a market risk control framework. This committee should have representation from several key areas such as finance, audit, risk and compliance, and trading. This committee should be responsible for overseeing the market risk control framework.
Risk Identification
Risk identification is about identifying and categorizing market risks so that they can be assessed and measured using qualitative and quantitative tools (next).
Risk Measurement
After identifying market risks, the next step is to measure and quantify risk exposures. Here, you would establish qualitative and quantitative tools and models such as Value at Risk (VaR), stress testing, and scenario analysis. Subsequently, you would determine market risk limits for each identified market risk and trading activities such as trading desks and portfolios.
Risk Monitoring & Reporting
Regular risk monitoring is important to ensure that risk exposures fall within established limits defined during the risk measurement phase. A risk monitoring system should be setup with appropriate thresholds and triggers to alert about real-time market risk exposures that would require immediate attention. A risk reporting process should be in place to inform key stakeholders, such as regulatory authorities and a Governance & Oversight Committee, in an accurate and timely manner of critical events.
Apply Risk Limits and Controls
Apply risk limits to the various identified risk types and trading activities, such as trading desks and portfolios.
Conduct Scenario Analysis and Stress testing
Scenario analysis and stress testing activities allow organizations to assess market conditions that may cause financial loses, affecting portfolios and capital adequacy.
Risk Mitigation
A mitigation strategy is a plan to mitigate market risks. Mitigation strategies include hedging, diversification, elimination or avoidance of specific assets, to name a few.
Documentation
It is important to document the entire market risk control framework and make it visible and accessible to key stakeholders.
Monitoring and Testing
Ensure continuous monitoring and testing. Monitoring and testing are necessary steps to ensure the effectiveness of the models and control procedures. Monitoring and testing are also necessary steps to ensure the effectiveness of the risk control framework.
Control Review
Conduct periodic reviews of the market risk control framework to ensure relevance to new and existing market conditions, changes in regulations, etc.
Training and Communication
Regular communication and training is essential to a solid risk control framework.
Response Plan
An incident or response plan is key to develop as a proactive measure to unexpected market events and loses.