Enterprise Risk Management, 2nd Edition

CHAPTER 26Market Risk Management and Common Elements with Credit Risk Management

 

RICK NASON, PhD CFA

Associate Professor Finance, Dalhousie University

 

INTRODUCTION TO CREDIT RISK AND MARKET RISK

Credit risk is the potential for gain¹ or loss due to changes in the creditworthiness of a customer or counterparty. Market risk is the potential for gain or loss due to changes in market conditions such as interest rates, commodity prices, exchanges rates, and other economic and financial variables such as stock prices or housing starts.

Credit and market risks differ from other risks, such as operational risks, in the sense that credit and market risks, as the name implies, are priced and observed in the capital markets. As such, tools and strategies exist to both measure and manage these risks while the measurement of most other types of risk are necessarily more subjective.

Due to their quantitative nature, along with the availability of data, credit and market risks are probably the most studied and analyzed of the various risks that a manager needs to control. The availability of testable models, abundance of data, and mathematical elegance of the field, however, mask the fact that credit and market risk management still remains as much of an art as it does a science. The lure of mathematical models for risk management is always strong, but the risk manager does well to remember that the only perfect hedge is in a Japanese Garden.

In this and the following chapter a framework ...