Market risk

Risk is classified by what causes the loss rather than by how large it is. Market risk is the exposure to a change in a price: an exchange rate, an index level, a commodity price, a share price or an interest rate. Credit risk is the exposure to somebody failing to pay. Liquidity risk is the exposure to not being able to deal at all, or only at a distance from the last price. Operational risk covers failures of systems and processes. A single event routinely produces several of them at once, which is why they are defined separately.

It is usually decomposed a second time, into the part attributable to the whole market and the part specific to one instrument. Beta is the conventional measure of the first, and the distinction matters because diversification addresses the specific part and leaves the market wide part behind. Holding more instruments that move together reduces less than a count of them suggests, which is the observation behind the remark that correlations rise in a crisis.

Measurement is contested and the disagreement is substantive. Standard deviation of returns treats an upward move and a downward move as equivalent. Value at risk states a loss that a stated percentage of periods historically stayed within, and says nothing about how bad the remainder were. Expected shortfall was adopted by supervisors partly to address that. All of these are estimated from a past sample, so they describe the range a market has moved in rather than the range it can move in, and the residual is what a black swan event names. In a margined position, losses are calculated on the full contract value and are not limited to the amount deposited, which is the reason market risk is measured against the contract rather than against the collateral.