Abstract

This article defines and describes methods for measuring three of the prominent risks of trading: valuation risk, market risk and counterparty credit risk. A fourth risk, operational risk, will not be discussed. The first section of the article describes the essential components of discounted cash flow models used for valuation, identifies the sources of valuation error and classifies the types of market factors needed to measure market value. The second section of the article describes the nature of and the methods that can be used to measure, monitor and limit market risk. A similar analysis of counterparty credit exposure and counterparty credit risk follows. Finally, the nature of and methods for measuring market risk and counterparty credit exposure will be compared and contrasted.

Introduction

The term ‘risk’ is used in finance in two different but related ways: as the magnitude of (a) the potential loss or (b) the standard deviation of the potential revenue (or income) of a trading or investment portfolio over some period of time.

Our discussion and analysis of market risk and counterparty credit risk will almost exclusively focus on risk as potential loss. That is, we will describe methods for measuring, in a specified context, the potential loss of economic value of a portfolio of financial contracts. The context that needs to be specified includes the time frame over which the losses might occur (e.g. a day, a year), the confidence level at which the potential loss will be measured (e.g. 95%, 99%) and the types of loss that would be attributed to the risk being measured (e.g. losses due to changes in market rates vs.