Market Risk Analysis

Typically, market risk includes changes in values of positions due to changes in underlying market prices such as stock prices, commodities prices, exchange rates and interest rates. More generally, market risk can also include changes in NPVs (net present values) of positions due to changes in cash flows (revenue and cost flows) which drive changes in market values of companies and business units.

Typically, market risk does not include changes in financial positions of counterparties, which eventually affect market values of any type of receivables from such counterparties. Such risks are identified as credit risk.

Market risks are driven by stochastic processes, and hence the degree of risk depends on type of exposure and on holding period. Regulatory definitions of market risk focus on 10 business day (Basel II market risk) and 12 months (Trading Book market risk and market risk involving long term derivatives positions in counterparty risk in Basel II and Solvency II).  Statistical measures used to quantify market risk range from 99% potential loss (standard Basel II market risk) to 99.5% potential loss (standard Solvency II market risk) to 99.9% potential loss (Trading Book market risk in Basel II).

The R/V Platform provides a general solution for market risk analyses, and reports all regulatory market risk measures in standard configuration. The system is based on Monte Carlo simulations of continuous time paths of underlying risk variables (prices, rates and yields). A very large number of such paths can be simulated (e.g. hundreds of thousands), and therefore reliable estimates are available for any regulatory measures being used.

In addition to regulatory requirements, by the technical construction risk measures for any time steps and horizons can be analysed and evaluated, which facilitates most comprehensive and reliable estimates and tools for economic capital analyses. For example, lifetime cash flows of any financial contracts or business operations can be simulated and thereby a complete NPV distribution of the position or the business can be established. This is the only known procedure to evaluate in a reliable way complex financial contracts such as many credit derivatives. From such distributions any standard statistical measures can be extracted.

Furthermore, extended market risk analyses allowing changes in counterparty quality and credit spreads can be conveniently performed in the R/V Platform for any time horizon and time steps.