Market Risk Fundamentals

Market Risk Fundamentals 🎢

Imagine you’re on a roller coaster. Sometimes it goes up, sometimes it zooms down. You never know exactly what’s coming next. That’s what market risk feels like for banks and investors!

The Big Picture: What is Market Risk?

Market risk is the chance that you might lose money because prices in the market go up or down.

Think of it like this: You buy a toy for $10 today. Tomorrow, everyone wants that toy, so it’s worth $15! Great news! But wait… the day after, a newer toy comes out, and your toy is only worth $5 now. 😱

That’s market risk in action.

Banks and big companies face this every single day with:

• 💵 Money from different countries (currencies)
• 📈 Company stocks (equity)
• ⛽ Things like oil, gold, and wheat (commodities)

Value at Risk (VaR) 📊

The “How Much Could I Lose?” Question

VaR is like a weather forecast, but for money!

Simple Example:

A bank says: “Our VaR is $1 million at 95% confidence for one day.”

What does this mean?

🌤️ “On 95 out of 100 normal days, we won’t lose more than $1 million.”

But remember — on 5 of those 100 days, we MIGHT lose more!

How VaR Works (The Ice Cream Shop Story)

Imagine you own an ice cream shop.

You look at your worst days. Your VaR tells you: “On a bad day, expect to make only $70-$80.”

graph TD
    A["Collect Past Data"] --> B["Sort From Worst to Best"]
    B --> C["Find the 5% Worst Point"]
    C --> D[That's Your VaR!]

Real Bank Example: A bank holds $100 million in investments. Their VaR analysis shows:

• 95% of the time, daily loss won’t exceed $2 million
• They keep extra cash ready just in case!

Currency Risk 💱

When Money Changes Its Mind

You know how 1 apple doesn’t always cost the same at different stores? The same happens with money from different countries!

Story Time:

Little Emma from the USA wants to buy a toy from Japan. The toy costs 1,000 Japanese Yen.

The toy’s Japanese price never changed! But Emma pays different amounts because currency values move like waves.

Real-World Impact

Example: A US Company Sells Cars in Europe

The company sells a car for €20,000 in Germany.

graph TD
    A["Sell Car: €20,000"] --> B{Exchange Rate?}
    B -->|1 EUR = 1.10 USD| C["Receive $22,000"]
    B -->|1 EUR = 0.90 USD| D["Receive $18,000"]
    C --> E["Happy! 😊"]
    D --> F["Ouch! 😟"]

$4,000 difference — just because of currency movement!

Equity Risk 📉📈

The Stock Market Roller Coaster

When you buy a piece of a company (called a “stock” or “share”), you become a tiny owner!

But here’s the catch: The price changes EVERY DAY based on:

• 📰 News about the company
• 🌍 What’s happening in the world
• 😊😟 How people FEEL about the future

The Lemonade Stand Story

You buy a share in your friend’s lemonade stand for $10.

None of these changed how good the lemonade tastes! But people’s expectations changed the price.

Two Types of Equity Risk

1. Company-Specific Risk: Only affects ONE company

   • Example: The CEO quits suddenly

2. Market-Wide Risk: Affects EVERYONE

   • Example: A recession hits the whole country

Commodity Risk ⛽🌾💎

Stuff From the Earth

Commodities are real, physical things:

• 🛢️ Oil and gas
• 🥇 Gold and silver
• 🌾 Wheat and corn
• ☕ Coffee and cocoa

Why Prices Go Crazy

The Orange Juice Story:

Imagine Florida grows most of America’s oranges.

Real Example: Oil Prices

graph TD
    A["World Events"] --> B{Oil Supply & Demand}
    B --> C["War in Oil-Producing Country"]
    B --> D["New Electric Cars = Less Oil Needed"]
    B --> E["Cold Winter = More Heating Oil"]
    C --> F["Price Goes UP"]
    D --> G["Price Goes DOWN"]
    E --> F

Banks that lend to oil companies worry: “What if oil prices crash and they can’t pay us back?”

Basis Risk 🎯

When Your Shield Has a Hole

Basis risk happens when your protection doesn’t match your problem perfectly.

The Umbrella Story

Imagine you’re worried about rain, so you buy an umbrella. But…

Real Banking Example

A bank owns shares in Small Tech Company ABC.

They want protection, so they buy insurance tied to the Big Tech Index (like all tech companies together).

Problem: Small Tech ABC doesn’t move exactly like the Big Tech Index!

graph TD
    A["You Own: Apple Stock"] --> B["You Buy Protection For: All Fruit Index"]
    B --> C{Do They Move Together?}
    C -->|Not Always!| D["BASIS RISK EXISTS"]
    C -->|Yes, Always| E["No Basis Risk"]

The gap between what you own and what you’re protected for = Basis Risk

Market Risk Hedging 🛡️

Building Your Financial Shield

Hedging = Making a backup plan so you don’t lose too much money.

Think of it like wearing a helmet when you ride a bike. You hope you won’t fall, but if you do — you’re protected!

Common Hedging Tools

The Farmer’s Smart Move

Problem: Farmer Sarah grows wheat. She worries prices will drop before harvest.

Solution: She signs a Forward Contract

Trade-off: Hedging protects from bad outcomes but might limit great outcomes!

Hedging Diagram

graph TD
    A["Identify Your Risk"] --> B["Choose Hedging Tool"]
    B --> C["Forward: Lock Price Now"]
    B --> D["Option: Pay for Protection"]
    B --> E["Swap: Exchange Cash Flows"]
    C --> F["Risk Reduced!"]
    D --> F
    E --> F

Putting It All Together 🧩

Banks face market risk from many directions at once:

graph TD
    A["MARKET RISK"] --> B["Currency Risk"]
    A --> C["Equity Risk"]
    A --> D["Commodity Risk"]
    B --> E["Use Hedging!"]
    C --> E
    D --> E
    E --> F["Measure with VaR"]
    F --> G["Watch for Basis Risk!"]

Quick Summary

The Golden Rule

🌟 You can’t eliminate market risk, but you can MEASURE it (VaR) and MANAGE it (hedging)!

Remember This! 🧠

Market Risk = The chance that market prices move against you

Like that roller coaster we talked about at the start:

• VaR tells you how scary the drop might be
• Hedging is your safety harness
• But sometimes the harness doesn’t fit perfectly (basis risk!)

You’re now ready to think like a risk manager! 🎉