Other Types of Market Risk

Paul Newson

While interest rate risk is probably the most significant market risk to which a banking book is subject, it is important to appreciate that a banking book may also on occasion be subject to other market risks. This chapter will consider foreign exchange, equity and asset spread risk in turn, looking at their likely possible sources, how they might be measured and what hedging solutions a bank might consider.

FOREIGN EXCHANGE RISK

Foreign exchange risk exists for any currency where there is an imbalance between the assets and liabilities denominated in that currency. An excess of assets over liabilities in a particular currency – termed a “long position” – means the bank is at risk of that currency depreciating relative to the bank’s base currency. An excess of liabilities over assets – a “short position” – puts the bank at risk of that currency appreciating.

Generally speaking, in its banking book a bank will seek to minimise its level of foreign exchange risk, which can usually be achieved simply by transacting a foreign exchange deal to close the position: selling the long currency and buying the short currency. However, due to operational and other reasons there will