Risk
Market, credit, and liquidity risk
Market risk is measured with rate gaps and value at risk, credit risk with expected loss, and liquidity risk with a 30-day coverage buffer.
Definition
Market risk is the exposure of value to moves in prices, rates, and currencies. Credit risk is the exposure to promises not kept. Liquidity risk is the exposure to being unable to raise cash without a distressed sale.
Each has a simple first measure: the rate-sensitive gap shows the earnings effect of a rate move, value at risk summarises price risk at a stated confidence, and the liquidity coverage ratio tests survival through a stressed month.
Intuition
Every measure is a simplification with a horizon and an assumption. The value of the measure is that it forces the assumption into the open where it can be argued with.
When to use it
- Reviewing a bank or fund balance sheet for direction of exposure.
- Setting limits that a trading desk cannot exceed.
- Explaining why capital and liquidity buffers are separate requirements.
When not to use it
- Treating value at risk as a worst case; it says nothing beyond the threshold.
- Measuring only one risk when the three are correlated under stress.
Formula
Rate-sensitive gap
Gap = Rate-sensitive assets − Rate-sensitive liabilities
How much more reprices on one side of the balance sheet.
Formula
Change in net interest income
ΔNII = Gap × Δrate
The first-order earnings effect of a rate move.
Formula
Parametric value at risk
VaR = z × σ × Position value
A loss threshold exceeded on a stated share of days.
- z
- Confidence multiplier, 1.645 at 95%
- σ
- Standard deviation of returns over the horizon
Formula
Liquidity coverage ratio
LCR = High-quality liquid assets ÷ Net cash outflows over 30 days
Whether the firm can fund a stressed month from sellable assets.
Worked example
A one-point rate move
A balance sheet holds ৳500 million of rate-sensitive assets and ৳620 million of rate-sensitive liabilities. Rates rise by one percentage point.
- 1
Measure the gap
500 − 620 = −120 million.
- 2
Apply the move
ΔNII = −120 million × 1% = −1.2 million.
- 3
Check the other measure
A duration view would also show a fall in the value of long-dated assets.
The negative gap costs ৳1.2 million of net interest income for a one-point rise, before any hedging.
Common mistakes
- Quoting a value at risk without its horizon and confidence level.
- Assuming a rate gap captures the effect on the value of long-dated assets.
- Sizing a liquidity buffer on normal, rather than stressed, outflows.
How it connects
is part of
The source is a component of the target idea.
- Financial risk management: Market, credit, and liquidity risk are the components of the discipline.
relates to
Useful to study together, in either order.
- Bond duration and interest-rate risk: Duration is one of the market-risk measures in the set.