Enterprise Risk Management: From Incentives to Controls, 2nd Edition

CHAPTER 13

Market Risk Management

What is market risk? A general definition might be something like the following: Market risk is the exposure to potential loss that would result from changes in market prices or rates. All companies are exposed to some forms of market risk. The level and form of market risk exposure differs by industries, and by companies within an industry. The relevant prices or rates (sometimes called the market risk factors) might include equity or commodity prices, interest rates, and foreign exchange rates. For example, one form of market risk faced by a financial institution would be its exposure to changes in interest rates if the durations of its assets and liabilities are mismatched. Other market risks at financial institutions might arise from proprietary trading and market-making activities.

An international corporation, on the other hand, might be exposed to foreign exchange movements if its offshore revenues and expenses are denominated in different currencies. Even if these were denominated in the same currencies, foreign exchange risk would exist when it came to repatriating offshore earnings into the corporation's home currency. An energy firm is exposed to energy price movements if a change in an input price (the price of crude oil, say) is not matched by a change in an output price (the price of petroleum or jet fuel). Additionally, the value of an energy firm's reserves is directly linked to market prices.

While different industries face specific ...