Market Risk
What the exam tests
Market risk questions test your ability to measure exposure to interest rates, foreign exchange, equities, and commodities, and to interpret sensitivity and VaR outputs. Pakistani context includes PKR exchange-rate movements, SBP policy-rate changes, and PSX equity exposure.
Core rules and concepts
- Market risk is loss from adverse movements in market prices or rates.
- Key measures include duration, DV01, beta, delta, and VaR.
- Modified duration estimates bond price sensitivity to small yield changes: percentage price change is approximately minus duration times the yield change.
- FX exposure is measured by net open position and translated into base-currency loss.
- Diversification reduces portfolio risk but does not eliminate basis risk or correlation breakdown.
- VaR is a probabilistic loss estimate at a confidence level and horizon; it is not a worst-case loss.
Worked example
A bond portfolio has market value PKR 2 billion and modified duration 4.5. Yields rise by 75 basis points. The estimated loss is 4.5 × 0.0075 × PKR 2 billion = PKR 67.5 million. The reasoning: duration gives the percentage price change for a small parallel shift in yields. If the yield rise is large or the curve twists, duration becomes less accurate and convexity or scenario analysis is needed.
Traps that cost marks
Do not call VaR the maximum possible loss. Do not apply duration to large yield moves without acknowledging convexity. Do not ignore basis risk when hedging with a correlated instrument. Do not compare VaR numbers with different confidence levels or horizons without adjustment. Do not treat a PKR depreciation as an automatic loss for every firm; it depends on the net open position.