1.3 Market Risk
Business activities entail a variety of risks. For convenience, we distinguish between different categories of risk: market risk, credit risk, liquidity risk, etc. Although such categorization is convenient, it is only informal. Usage and definitions vary. Boundaries between categories are blurred. A loss due to widening credit spreads may reasonably be called a market loss or a credit loss, so market risk and credit risk overlap. Liquidity risk compounds other risks, such as market risk and credit risk. It cannot be divorced from the risks it compounds. A convenient distinction for us to make is that between market risk and business risk.
Market risk is exposure to the uncertain market value of a portfolio. Suppose a trader holds a portfolio of commodity forwards. She knows what its market value is today, but she is uncertain as to its market value a week from today. She faces market risk.
Business risk is exposure to uncertainty in economic value that cannot be marked-to-market. The distinction between market risk and business risk parallels the distinction between market-value accounting and book-value accounting. Suppose a New England electricity wholesaler is long a forward contract for on-peak electricity delivered over the next 12 months. There is an active forward market for such electricity, so the contract can be marked to market daily. Daily profits and losses on the contract reflect market risk. Suppose the firm also owns a power plant with an expected useful life of 30 years. Power plants change hands infrequently, and electricity forward curves don’t exist out to 30 years. The plant cannot be marked to market on a regular basis. In the absence of market values, market risk is not a meaningful notion. Uncertainty in the economic value of the power plant represents business risk.
Most risk metrics apply to a specific category of risks. There are market risk metrics, credit risk metrics, etc. We do not categorize risk measures according to the specific operations those measures entail. We characterize them according to the risk metrics they are intended to support. Gamma—as used by options traders—is a metric of market risk. There are various operations by which we might calculate gamma. We might:
- use a closed form solution related to the Black-Scholes formula;
- value the portfolio at three different underlier values and interpolate a quadratic polynomial; etc.
Each method defines a risk measure. We categorize them all as measures of gamma, not based upon the specific operations that define them, but simply because they all are intended to support gamma as a risk metric.
Describe two different risk measures, both of which are intended to support duration as a risk metric.