Market risk · RiskAtoms Academy

By the end you will be able to

1Identify interest rate, equity, FX, commodity and credit spread risk in a portfolio.
2Tell market risk apart from credit risk when a bond loses value.
3Estimate a portfolio's gain or loss from a scenario, one risk factor at a time.
4Explain why market risk sits in the banking book as well as the trading book.

Why it matters

In 2022, as interest rates rose fast, long-dated government bonds in the UK, the US and the euro area lost a large part of their value. No government missed a payment. The bonds were safe from default, and still fell. That is market risk.

Core explanation

Five prices that move everything

Market risk is the risk of losing money because market prices move. You met its pieces in Level 1: Foundations of Finance: bond prices fall when yields rise (L1.4.06: The price-yield relationship), and a foreign asset loses value when its currency falls (L1.6.07: Currency risk for companies and investors). Market risk puts them together.

A portfolio may hold thousands of positions, but their values are driven by a handful of risk factors. Risk managers group them into five families:

Risk factor	What moves	Who feels it
Interest rates	Government bond yields and swap rates	Anyone holding bonds, loans or swaps
Equity prices	Share prices and indices	Shareholders, equity funds, option desks
FX	Exchange rates	Anyone holding assets or debts in another currency
Commodities	Prices of oil, gas, metals, crops	Producers, airlines, commodity traders
Credit spreads	The extra yield on risky bonds	Holders of corporate bonds and credit derivatives

Options add one more factor: volatility, because an option's price depends on how much the market expects prices to swing (L1.7.09: What drives an option’s price).

Credit spreads: market or credit? When a company defaults, its lenders lose money: credit risk. But a bond can also fall while its issuer pays every coupon, because investors start demanding a wider credit spread for that kind of borrower. That price move is market risk. A useful test: if no one has failed to pay and no rating has changed, and the price fell because the market re-priced risk, it is market risk. Defaults and downgrades belong to L2.2.03: Credit and counterparty risk.

One position, several factors. A position often carries more than one factor at once. For a UK bank, a euro-denominated corporate bond carries euro interest rates, the issuer's spread and the euro against the pound. Spotting all of them is the first skill of a market risk manager.

Tag itTag each position's risk factors

You are a market risk analyst at Example Bank plc, which reports in pounds. Switch on every factor that moves each position's value in pounds.

A 10-year UK government bond (gilt)
A 5-year US Treasury bond
A euro bond issued by a German carmaker
Shares in a Japanese electronics firm, bought in yen
A long FTSE 100 index future
A sterling interest rate swap: receive fixed, pay floating
A long position in Brent crude oil, priced in US dollars
€500m held as cash in a euro account

Not only traders. Banks split their balance sheet into a trading book (positions held to trade, valued at market prices daily) and a banking book (loans, deposits, bonds held to collect interest). Market risk lives in both. A fixed-rate mortgage loses value when rates rise just like a bond does; this is interest rate risk in the banking book (IRRBB). Insurers carry market risk mostly through their huge bond portfolios.

ExploreExample Group: where the risks sit

Pick a risk type to light up the lines that carry it. Pick a line to see why.

Example Bank plc

£ billions · assets carrying market risk: £430bn (86%)

Assets

Liabilities

Example Insurance SE

€ millions · assets carrying market risk: €63,000m (90%)

Assets

Liabilities

Market risk

The risk of loss from moves in market prices and rates: interest rates, equity prices, exchange rates, commodity prices and credit spreads.

Where this goes next

M3.1: Market risk measures market risk properly, with value at risk, expected shortfall and stress tests; M3.5: Interest rate risk in the banking book and ALM covers IRRBB. The capital rules for the trading book are in M4.3: Market risk capital (FRTB) and CVA.

The formal version

Loss = sensitivity × move, factor by factor

A first estimate of a position's gain or loss is its sensitivity to each factor times the factor's move. It is percentage arithmetic (M-A01: Percentages), so here it is on a few lines. For a position worth $V$ :

\Delta V \approx \sum_{\text{factors } k} \text{sensitivity}_k \times \text{move}_k

Each family has a simple sensitivity:

\text{Shares, commodities: } \Delta V \approx V \times \text{(\% price change)}

\text{Foreign currency: } \Delta V \approx V \times \text{(\% change in the currency)}

\text{Bonds (rates or spread): } \Delta V \approx -D \times \Delta y \times V

Here $D$ is the bond's modified duration from L1.4.08: Duration, and $\Delta y$ the change in yield as a decimal (0.5 percentage points = 0.005). A spread move changes the yield too, so the same formula applies.

Conventions

Values in pounds. Rate and spread moves in percentage points (1pp = 100 basis points). A currency move is the foreign currency's change against the pound: −5% means the dollar or euro buys 5% fewer pounds. The estimate is first-order: it ignores convexity and the small cross effect of, say, a share price and a currency moving together.

Try it

Example Bank plc's £30bn of trading assets from L1.8.02: A bank’s balance sheet, split into six positions: £10bn of gilts, £5bn of US Treasuries, £6bn of euro corporate bonds, £4bn of UK shares, £2bn of US shares and £3bn of gold. At the starting settings (rates +0.5pp, spreads +0.5pp, shares −10%, the dollar and euro −5%, gold −10%) the book loses £2.4bn, 8% of the bank's £30bn equity. Now move the pound the other way and watch the currency loss turn into a cushion.

Try itShock the trading book

Live risk factors →

Interest rates (all curves)+0.50pp

Credit spreads+0.50pp

Equity prices−10%

Dollar and euro against the pound−5%

Gold price−10%

Total gain or loss−£2.40bn

As a share of the bank's equity-8.0%

First-order estimate: each position moves by its sensitivity times the factor move, and the pieces are added. Real desks hedge most of this; here nothing is hedged, to show each factor.

Worked example

A stress scenario for the trading book

The risk team tests a severe scenario: yields up 1pp, spreads up 1pp, shares down 20%, and, as often happens when markets panic, the pound falls: the dollar and euro rise 10% against it. Gold, a classic safe haven, rises 15%. Work out each factor before you reveal it.

Factor by factor

Step 1 of 6

1
Interest rates
Duration times value, summed over the bonds: 6 × 10 + 4 × 5 + 5 × 6 = 110, so the book loses £1.10bn per percentage point. At +1pp: −£1.10bn.

Position (£bn)	Interest rates	Credit spreads	Equity prices	Exchange rates	Commodity prices	Total
UK government bonds (gilts) (10)	-0.60					-0.60
US Treasury bonds (5)	-0.20			0.50		0.30
Euro corporate bonds (6)	-0.30	-0.30		0.60		0.00
UK shares (4)			-0.80			-0.80
US shares (2)			-0.40	0.20		-0.20
Gold, priced in US dollars (3)				0.30	0.45	0.75
Total	-1.10	-0.30	-1.20	1.60	0.45	-0.55

Notice what the table shows. The same £30bn book could lose much more in a scenario where the pound rose. Which scenario hurts depends on the positions, which is why risk teams run many of them and look at the worst.

Regulatory lens

Trading book capital: the Basel Committee's market risk standard (the Fundamental Review of the Trading Book, FRTB, finalised in January 2019) groups sensitivities into risk classes that mirror this lesson: general interest rate risk, credit spread risk, equity, commodity and FX.
Banking book: the Basel IRRBB standard (2016) asks banks to measure how rate shocks change the value of their balance sheet and their net interest income, and supervisors flag banks where the hit is large.
Insurers: Solvency II's market risk module charges capital for interest rate, equity, property, spread, currency and concentration risk.

The calculations behind these charges are in M4.3: Market risk capital (FRTB) and CVA, M4.5: Liquidity and IRRBB regulation and M4.6: Solvency II and insurance regulation.

Sparks

SparkOrange County's bet on low rates

In 1994 the US Federal Reserve began raising rates and bond markets fell around the world. Orange County, California, had borrowed to buy bonds that paid off only if rates stayed low. It lost about $1.6 billion and filed for bankruptcy in December 1994: a public body undone by interest rate risk.

SparkMarket risk with no trading

Silicon Valley Bank did not lose its money trading. It bought long-dated bonds to hold, funded by deposits. When rates rose in 2022, their value fell, and when depositors left in 2023 it had to sell. The market risk was in the banking book all along (L2.1.07: Landmark failures: SVB and Archegos).

Key takeaways

Market risk is the risk of loss from moves in market prices: interest rates, equity prices, FX, commodities and credit spreads.
One position can carry several factors; list them all before measuring anything.
A bond falling because the market re-prices risk is credit spread risk, a market risk. Defaults and downgrades are credit risk.
First-order loss = sensitivity × move: % change × value for prices and currencies; −duration × Δy × value for bonds.
Factors can offset: a falling home currency cushions losses on foreign assets.
Market risk sits in the banking book too (IRRBB), not only on trading desks.

Reaction

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Glossary

Market risk: The risk of loss from moves in market prices and rates.
Risk factor: A market price or rate that drives the value of many positions, such as a yield, a share index or an exchange rate.
Sensitivity: How much a position's value changes for a given move in one risk factor.
Credit spread: The extra yield a bond pays over a government bond of the same maturity, for the risk of the issuer.
Modified duration: Modified duration: the approximate percentage fall in a bond's price for a 1 percentage point rise in its yield.
Trading book: Positions a bank holds to trade or to hedge trades, valued at market prices every day.
Banking book: Everything a bank holds that is not in the trading book, mainly loans, deposits and bonds held to collect interest.
IRRBB: Interest rate risk in the banking book: how rate changes affect the value and earnings of a bank's loans, deposits and bonds held to collect interest.
Stress scenario: A set of factor moves chosen to be severe but plausible, used to estimate a loss.

Deep Dives & Origins

Deep Dives

Hull, Risk Management and Financial Institutions (Wiley), the chapters on trading risks and interest rate risk. Intermediate.
Jorion, Value at Risk: The New Benchmark for Managing Financial Risk, 3rd edition (McGraw-Hill, 2006), the chapters on risk factors and mapping. Advanced.

Origins

BCBS, Minimum capital requirements for market risk, January 2019.
BCBS, Interest rate risk in the banking book, April 2016.
Commission Delegated Regulation (EU) 2015/35 (Solvency II), the articles on the market risk module.
Jorion, Big Bets Gone Bad: Derivatives and Bankruptcy in Orange County (Academic Press, 1995).

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