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Managing Risks in Commercial and Retail Banking by AMALENDU GHOSH

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CHAPTER 16

Market Risk Framework

16.1 MARKET RISK CONCEPT

Market risk is the risk of losses that arise from movements in market risk variables. Its impact is on the bank's earnings and capital. The erosion in the value of assets and the earnings occurs from adverse changes in interest rates, foreign exchange rates, security prices, equity prices, and commodity prices. Like credit risk, market risk exists in both individual transactions and portfolios. Banks have to deal with market risks in daily transactions like the sale and purchase of sovereign securities, corporate equities, foreign currencies, options, futures, and the like, and in portfolios of investments in government securities, Treasury bills, corporate bonds and equities, besides the derivatives portfolios like the swaps portfolio, options portfolio, and futures portfolio. Market risk exists mainly in the trading book, because banks undertake the sale and purchase of financial instruments and derivative products in the short term to make a profit, but it also exists in the banking book since they hold investments in their books for long periods to earn interest and make gains from redemption values on maturity dates. Market risk arises due to the volatility in the movement of market risk variables; the larger the volatility, the greater is the amount of potential loss or gain.

16.2 MARKET RISK TYPES

Market risk emerges in five forms:

1. Liquidity risk.

2. Interest rate risk.

3. Foreign exchange risk.

4. Equity price ...

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