Three risks, three questions
Market risk asks what a move in prices does to the value of what you hold. Credit risk asks what happens if a borrower does not pay. Liquidity risk asks whether you can raise cash when you need it, without selling assets at a distressed price.
The three are often treated as separate departments, but in a crisis they feed each other. A price fall damages capital, falling capital makes funders nervous, and nervous funders withdraw cash, which forces asset sales that push prices down again.
Naming the risk precisely matters because each is measured and defended against differently: market risk with limits and hedges, credit risk with underwriting and provisioning, liquidity risk with buffers and funding plans.
Key points
- Market risk is about prices; credit risk is about promises; liquidity risk is about timing.
- Losses and funding stress are correlated in a downturn.
- Each risk needs its own measurement and its own buffer.
Market risk: the interest-rate gap
Gap = Rate-sensitive assets − Rate-sensitive liabilities
How much of the book reprices when rates move.
ΔNII = Gap × Δrate
The first-order effect of a rate move on earnings.
A firm holds 500 million of assets and 620 million of liabilities that reprice within a year. The gap is −120 million: more liabilities than assets reset when rates change.
If rates rise by 1 percentage point, net interest income falls by 120 × 1% = 1.2 million. A negative gap hurts when rates rise and helps when they fall; a positive gap does the reverse.
Gapping is a deliberately simple view. It ignores timing within the year and the effect on the value of long-dated assets, but it is a fast way to see which direction a balance sheet is exposed.
Key points
- A negative gap loses when rates rise.
- The size of the gap sets the size of the earnings move.
- Simple measures first, then refine if the exposure is material.
Market risk: value at risk
VaR = z × σ × Position value
The loss a position is expected to exceed only rarely over a set horizon and confidence level.
Value at risk compresses market risk into one number: the loss that should be exceeded only on a small share of days. A 95% one-day VaR of 26,320 says a loss larger than that is expected on about one day in twenty.
With a 1.6% daily standard deviation, a 10,00,000 position, and a 95% confidence multiplier of 1.645, VaR is 1.645 × 1.6% × 10,00,000 = 26,320.
VaR is a threshold, not a worst case. It says nothing about how bad the one day in twenty can be, which is exactly the day that matters most.
Key points
- VaR is a quantile of the loss distribution.
- Always state the horizon and the confidence level.
- VaR hides the size of the tail beyond it.
Liquidity risk: the 30-day buffer
LCR = High-quality liquid assets ÷ Net cash outflows over 30 days
Whether a firm can survive a stressed month.
The liquidity coverage ratio asks a blunt question: if funding stress hit today, could the firm pay its bills for the next 30 days using only assets it can sell quickly?
With 6,00,000 of high-quality liquid assets and 5,00,000 of stressed net outflows, the ratio is 120%. A reading above 100% means the buffer covers the assumed stress; below it means the firm is relying on funding that may not be there.
Liquidity is cheap to hold in calm markets and priceless in a panic. The buffer is deliberately unprofitable most of the time, which is exactly why it has to be required.
Key points
- Liquidity is about the next 30 days, not the next decade.
- Quality of the buffer matters as much as its size.
- A funding run can sink a solvent firm.
Interactive experiment
Bond duration and interest-rate risk
Price tells you what a bond is worth today. Duration tells you how much that price moves when yields change, and convexity corrects the estimate for larger moves.
dP/P ~ -Modified duration x dy + 1/2 x Convexity x dy^2
Your inputs
Amount repaid at maturity.
Annual coupon as a share of face value.
Time until the face value is repaid.
Return the market demands.
Shock to test, in percentage points.
Result
- Price
- ৳1,000
- Modified duration
- 7.4
- Estimated price change
- ৳-70
- Macaulay duration (years)
- 7.8
- Convexity
- 69.7
- DV01 (per basis point)
- ৳1
- Estimated new price
- ৳930
- Exact new price
- ৳930
- Price change
- -7.0%
Modified duration of 7.36 years means the fall in yield moves the price by roughly -7.01% before the convexity correction.
03 / Apply
Three risks, one week
Rates jump, the value of a bond portfolio falls, a large borrower misses a payment, and two corporate depositors move their balances out. Each event alone is manageable; together they consume the buffers that were sized for one risk at a time.
The assumptions
- The bond portfolio is marked to market.
- The defaulting borrower is the largest single exposure.
- Corporate deposits are the most rate-sensitive funding.
What to take away
01
Risks that look independent are correlated under stress.
02
Buffers sized for one risk are thin for three.
03
Concentration is a common thread across all three risks.
Your turn
0 of 4 answered
01Question
Rate-sensitive assets are ৳500 million and rate-sensitive liabilities are ৳620 million. If rates rise by 1 percentage point, what is the change in net interest income, in ৳ million?
02Question
A position is worth ৳10,00,000 with a daily standard deviation of 1.6%. Using a 95% multiplier of 1.645, what is the one-day value at risk?
03Question
High-quality liquid assets are ৳6,00,000 and stressed net outflows over 30 days are ৳5,00,000. What is the liquidity coverage ratio, in percent?
04Question
Which statement about value at risk is correct?
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Open the playgroundSources & further reading
Bank for International Settlements · Basel III framework ↗CFA Institute · Risk management overview ↗Educational sample content. Worked examples use hypothetical figures. Dates refer to the note's latest content update.