The Trade Lifecycle: Behind the Scenes of the Trading Process, 2nd Edition

Chapter 11 Market Risk Control

The purpose of the market risk control department in a financial entity is to monitor and control the exposure to market risk. Market risk is the risk to changes in market conditions.

We can illustrate market risk with a simple example. Suppose one buys an oil painting as an investment. The price paid for the painting was GBP 150,000. The value of the painting on any given day is the amount someone in the market will pay for it – this could be more or less than the purchase price. We say the oil painting is subject to market risk. The risk is the amount that is lost by a change in price. If the painting could only be sold for GBP 100,000, the risk would be GBP 50,000. In this case, it is only subject to one type of market fluctuation, but in general an asset can be subject to many different market forces. In addition to looking at day-to-day price fluctuations we can look at market risk in other ways, for example VaR – what is the maximum loss I could reasonably expect to make in a day (week, month, etc) – and some of these approaches are addressed below.

Of course for a painting, market risk is one of the less important risks – fire, damage and theft are other more relevant risks. For financial assets too there are other risks – legal (can we be sure we own it?), counterparty (credit) risk, documentation risk and others. This chapter just assesses market risk.

Before examining the process of market risk management, let us look at various ways ...