Market, Liquidity and Interest Rate Risk
Market risk
Sensitivities (Greeks, PV01, delta, vega) measure first-order exposure. VaR summarises potential loss at a confidence level over a horizon (e.g. 99%, one day) and can be parametric, historical or Monte Carlo. VaR is not subadditive, ignores the tail beyond the threshold, and depends heavily on the window chosen. Expected Shortfall (average loss beyond the VaR threshold) addresses tail blindness and is the Basel FRTB measure. Backtesting and P&L attribution validate models.
Liquidity and funding
LCR = HQLA ÷ net cash outflows over 30 days, ≥ 100%. NSFR = available stable funding ÷ required stable funding, ≥ 100%. Beyond ratios, manage funding concentration, intraday liquidity, collateral haircuts and a tested contingency funding plan. Liquidity risk often amplifies market stress - assets that look liquid become illiquid precisely when needed.
Interest rate risk in the banking book
Measure repricing gaps, duration gaps, EVE sensitivity and NII sensitivity. Include basis risk and embedded optionality such as prepayment and capped deposits.
Traps
- Reading VaR as a maximum loss.
- Comparing VaRs computed at different confidence levels or horizons.
- Assuming portfolio VaR equals the sum of component VaRs.
- Treating assets as HQLA without operational and haircut tests.
- Confusing EVE (long-horizon, value-based) with NII (short-horizon, earnings-based).
Rule of thumb: under i.i.d. returns, scale VaR by the square root of time - a 1-day 99% VaR of $1m approximates a 10-day VaR of about $3.16m - but never scale through a stressed period without re-estimating.