MARKET RISK

 Market risk, in simplest terms, is price risk, or “exposure to (adverse) price change.” For a dealer in foreign exchange, two major elements of market risk are exchange rate risk and interest rate risk—that is, risks of adverse change in a currency rate or in an interest rate. Exchange rate risk is inherent in foreign exchange trading. A trader in the normal course of business—as he buys or sells foreign currency to a customer or to another bank—is creating an “open” or “uncovered” position (long or short) for his bank in that currency, unless he is covering or transferring out of some previous position.Every time a dealer takes a new foreign exchange position—in spot, outright forwards, currency futures, or currency options—that position is immediately exposed to the risk that the exchange rate may move against it, and the dealer remains exposed until the transaction is hedged or covered by an offsetting transaction. The risk is continuous—and a gap of a few moments or less can be long enough to see what was thought to be a profitable transaction changed to a costly loss. Interest rate risk arises when there is any mismatching or gap in the maturity structure. Thus, an uncovered outright forward position can change in value, not only because of a change in the spot rate (foreign exchange risk), but also because of a change in interest rates (interest rate risk), since a forward rate reflects the interest rate differential between the two currencies. In an FX swap, there is no shift in foreign exchange exposure, and the market risk is interest rate risk. In addition to FX swaps and currency swaps, outright forwards, currency futures, and currency options are all subject to interest rate risk. There are two forms of market risk—an adverse change in absolute prices, and an adverse change in relative prices.With respect to relative price changes,“basis risk”is the possibility of loss from using, for example, a U.S. dollar position to offset Argentine currency exposure (in the expectation that the Argentine currency will move in step with the U.S. dollars), and then seeing the Argentine currency fail to maintain the relationship with the U.S. dollar that had been expected. It can also occur if a short-term interest rate that was used to offset a longer-term interest rate exposure fails to maintain the expected relationship because of a shift in the yield curve. To limit basis risk, traders try to stay well informed of statistical correlations and covariances among currencies,as well as likely yield curve trends. Various mechanisms are used to control market risk, and each institution will have its own system. At the most basic trading room level, banks have long maintained clearly established volume or position limits on the maximum open position that each trader or group can carry overnight, with separate—probably less restrictive—intraday or “daylight” limits on the maximum open position that can be taken during the course of a trading session. These limits are carefully and closely monitored, and authority to exceed them, even temporarily, requires approval of a senior officer.

MARKET RISK