Chapter 7: Measuring Financial Market Risk

We now start Part III, which deals with managing market risk. The unit consists of four chapters. This chapter is the first, of course and it provides an introduction to the tools used in measuring market risk. Recall that market risk is the risk arising from movements in interest rates, exchange rates, commodity prices, and stock prices. These types of risks are those that arise from the volatility of prices and rates in their respective markets. In measuring these risks, we will use a number of risk management models. Risk management models have much in common with many financial models, but they do have some important differences. Most financial models are designed to capture the relationship between expected return and risk and, in so doing, they help us determine a fair price for an asset. For that reason, they are often called pricing models. The primary objective of risk management models is not the pricing of assets, but the measurement and control of the risks arising from those assets. Also, pricing models typically assume that market participants act rationally and align their desired risks with their risk tolerances. Risk management models make no such assumptions. The desired risks and risk tolerances are exogenous factors determined by risk managers, CEOs, or whoever is responsible for determining the amount of risk taken by the entity. Risk management models provide guidance on how to measure and control risk, so that the risk taken can be aligned with the desired risk for a given market participant…