Market Risk for Financial Institutions is defined as the risk related to the uncertainty of earnings on its trading portfolio. Value of the investing portfolio is affected as well, because of its exposure to the same market conditions. Usually, the value of the trading portfolio is influenced by the changes in interest and currency rates, liquidity, and credit spreads.
Financial Institution's trading portfolio is different from the investment portfolio based on the time horizon and liquidity. Trading portfolio contains the following tools: assets, liabilities and derivative contracts that can be quickly bought or sold without an adverse impact on their price on organized financial markets. The investment portfolio mostly consists of illiquid assets and liabilities with longer time horizons. As the result of the increasing securitization of bank loans, in particular, mortgages, the trading assets became more liquid because of the appearance of the new financial instruments, for example, mortgage-backed securities (MBS).
Recent market conditions, including credit crunch in the US market, have brought more attention to the off-balance sheet items. The amount of such items can comprise a significant part of the total assets. All that calls for constant monitoring and review process.
The important aspect of Market Risk is the ability to express it in absolute terms (e.g. dollar amount) against some established benchmark. These benchmarks are set by the company itself according to its size, industry, risk tolerance, liquidity needs, and market conditions.
Normally, tradable assets are viewed as those that are held for the horizon of less then one year or even shorter. Furthermore, it is increasingly important to monitor the fluctuation in value of those assets with the help of Value-at-Risk (VaR), especially if those changes pose threat to their solvency.
Investments, on the opposite side, usually have holding periods of more than one year. These assets include foreign direct investments. Due to the currency fluctuations the value of the assets also changes. Hedging activities and funding foreign investments in foreign currencies can prevent losses.
Often the trading portfolios have a significant amount of fixed income securities, in particular investment grade bonds. Value of such bonds is highly influenced by the rating assigned by one of the rating agencies (S&P, Moody's, etc). If the issuer of debt is downgraded from the investment grade to a high yield status, its debt loses a considerable part of its value. Moreover, this decreases liquidity of those assets, bringing the market value of high yield bonds further down.
Liquidity is an important characteristic of the market therefore it has an essential effect on the trading portfolio of Financial Institutions. Inability to maintain certain level of liquidity both for the assets within the trading portfolio and on the market may decrease its value that will deteriorate the market price of the trading portfolio.
The diversity of market conditions and its implications on the trading and investing portfolios of Financial Institutions drives the necessity to create a comprehensive enterprise wide approach to address the potential negative effect of the market risk.