Categories of Market Risks in Annual Reports
Banks naturally need to understand the profile of their market risk. Banks market risk comprise of temporary profits and losses, economic long-term risks and the volatilities. At the end of each financial year banks desire to be familiar with the amount of risk they have accumulated and how the risk compares with the bank overall risk, (Maugis, 2010, np.).
Market risks are risks of potential losses in the trading books of banks as a result of the fluctuation in prices of equity, rates of foreign exchange, prices of commodities, credit spreads and other indicators which exists in public markets (eba.europa, eu, 2018, np.). The market risks categorized in the annual reports of the four banks include; interest rate risks, foreign exchange risk, equity prices risks, commodity prices risks, credit spread risks, assets correlation risks and implied volatile risks.
The market risks of Australia and New Zealand Bank come from the balance sheet and other trading activities. In Australia and New Zealand Bank, Market risks are divided into traded market risk and non-traded market risk. Traded market risk arises as a result of loss which occurs from financial instruments changes as a result of price factor movements in physical and derivatives positions of trading, (shareholder.anz.com,2018, np). Traded market risks are further divided into five categories which are as follows
Currency risks and this are potential losses which occur from fluctuations in foreign exchange rates and other indirect volatilities. Interest rates risks; these are losses which occur from changes in indirect volatilities and fluctuations of foreign exchange rates. Credit spread risks; these are losses which potentially occur from margin movements or relative spread to a benchmark. Commodity risks; they are risks of losses which occur from changes in prices of commodities or due to their indirect volatilities. Equity risks; they are market risks which occur as a result of changes in prices of equity
The second category is the non-traded market risks. This comprises of the risk of losses which their occurrence is associated with the managing of non-traded foreign exchange exposures, interest rate risk and liquidity risk. The non-traded risks also cover the banking book interest risks. The risk of loss of non-traded risks is as a result of; adverse changes in general and changes in relative levels interest rates from diverse tenors, differences between the actual and the interest margin expected, due to the valuation of risks which are associated with options and the bank products.
Commonwealth Bank of Australia also categorizes its market risks as traded and non-traded market risks. The traded market risks in Commonwealth Bank of Australia occur due to the group involved in financial markets while in customer service. The traded market risks arise due to the group involved in the following categories of trading; Debt, interest rate, foreign exchange, commodity and equity. The non-traded market risks arise from; banking books interest risks, insurance business market risks, guarantees and shareholders capital,(commbank.com.au,2018, np)
Market risks according to this bank arise due to gains or losses from business trading practices which occur due to market movements. This bank divides market risk into traded and non-traded market risks. Under traded market risks, the risks are categorized into six which comprise of; inflation risk, credit, commodity, volatility, interest rate and foreign exchange risks. The non-trading market risk in this bank comes from the banking book interest rate risk. The banking book interest risks occur from the re-pricing risk, optionality risk, yield curve risk and basis risk. (nab.com.au, 2018, np).
Categories of Risks in Australia and New Zealand Bank Annual Report
This group also categorizes its market risks into two; traded market risks and non-traded market risks. Traded market risks comprise of the following categories; volatility risks, credit spread, equity price, commodity, interest rate and foreign exchange risks. Non traded market risks include the following categories; foreign exchange, credit spread and interest rate risks, (westpacgroup.com.au, 2018, np).
Australia and New Zealand bank measures and manages its market risks using sensitivity analysis, value at risk method and stress testing. Using this method, Australia and New Zealand bank is able to gauge its possible daily losses using the market historical movements. Undervalue at risk, the risk is calculated using one to ten-day holding periods and also it gauges using a 99% confidence interval to know the probability of loss occurrence.
Australia and New Zealand bank manage the balance sheet so as to sustain liquidity and interest rate risk at acceptable levels, diminish negative effects of interest rates on the market value of the banking book and earnings,(shareholder.anz.com,2018, np).
Interest rate risk management is done by reporting using the value at risk method and scenario analysis. Scenario analysis is utilized so as to test the effects of extreme exposure to interest rate risk.
Foreign exchange risk management; the subsidiaries associates and branches of Australia and New Zealand Bank render the group vulnerable to this risk. The valuation changes due to foreign exchange risk are reported in equity currency translation reserve
Commonwealth Bank of Australia measures and manages its market risk using; Value at risk method, economic value and next 12 months earning methodology,(commbank.com.au,2018, np). The confidence level of value at risk of Commonwealth Bank of Australia is 97.5% which is lower than that of Australia and New Zealand bank.
Interest rate risk management and measuring are done using two methods; economic value and use of the next 12 months. All the other elements of market risks are measured using Value at risk method.
The internal interest rate of this bank is measured using numerous method compared to Commonwealth Bank of Australia and Australia and New Zealand bank. The methods include; historical simulation, balance sheet static, value at risk, earnings at risk, 99 per cent level of confidence and three months holding period. Interest rate risks of banking book are only measured using two methods which are earning at risk and value at risk, (nab.com.au,2018, np).
Different from the other three, it measures and manages some of its marketing risks using limits. The limits are; value at risk limit, net interest income at risk and structural limits. The other methods are stress testing and value analysis, (westpacgroup.com.au, 2018, np). Westpac bank manages its risk by meeting their compliance and regulations requirements. They also set adequate controls which help in guarding against risk. Westpac group also measures their risk profile well in order to help in risk management.
Market risks in Westpac are managed by trading desks with delegated responsibilities. The marketing risks management is done by managers according to their level of experience, strengths and level of risk concentration. Westpac also performs daily monitoring of recent exposure and the use of limits. It also performs stress testing and back testing of value at risk results on daily basis. The asset and liability management overseas the non -traded market risks,(westpacgroup.com.au,2018, np).
Categories of Market Risks in Commonwealth Bank of Australia
In the National Australia Bank, in order to minimize risks, risk management is done by counterparty, industry sector and by geographical region. The bank establishes policies which help in governing huge exposures to market risk, (nab.com.au,2018, np).
In the Commonwealth Bank of Australia, the management measures market risks using value at risk method and uses those results the financial effects of market risks,(commbank.com.au,2018, np)
Under Australia and New Zealand Bank, in order to minimize risks, the responsibility of managing daily market risks is delegated to credit and market risk committee. Risk management has been made a joint responsibility in order to minimize market risks. Market risk control team assign limits to various market risks on daily basis and as a result minimize market risks,(shareholder.anz.com,2018, np).
Advantages and disadvantages of methods used in measuring market risks.
This method is easily understandable. Banks using this method are able to interpret and analyze the values simply. The values of value at risk method are comparable. Value at risks method enables users to easily compare various types of assets using different portfolios. This method is used as a global standard of measurement. Every bank uses this method due to the valuation of market risks for new products, (Yakov, 2005, pp.338).
Value at risk method can give misleading information. The confidence level of this method is 99% which may indicate false information because 99% is not the same as 100%. Value at risk does not give results from the negative side, it only indicates that the probability of loss is 1% and this may not be true because the potential loss due to market risks may be higher than 1%. Value at risk method presents difficulties in the measurement of market risks in high portfolios. Different assets cannot be added together while measuring market risks and for this reason, it creates additional problems. Measurement of market risks using the three different methods of value at risk produce different results (Chipalkati and Datar, 2000, pp.174).
Measurement of market risks using this method is simple. It does not have the assumption of no normal distribution. It does not require compulsory calculations of standard deviations and correlations of asset returns.
Implementation of historical simulation is very tiresome. For one to get the standard deviations and correlations, one has to come up with estimates of different securities which may lead to misleading information. It is difficult to measure the returns of securities which are not normally distributed. The measurement results have large standard errors
Sensitivity analysis provides variables which assist in forecasting cash flows and this makes the measurement to be easy. It exposes estimates which are inappropriate and this guides on the selection of measurement variables, (Corporate finance institute, 2018, np)
Sensitivity analysis does not offer focus concerning the measurement variables interrelationships. It fails to provide a clear-cut outcome, (Tsanakas and Millosovich 2015, pp,30-38).
Stress testing provides banks with value prevention in terms of oversight, market risk management and strategic management. The results from stress testing analysis act as a sense of security. The tools for stress testing generate results which are trusted, (lear, 1984, pp.40).
Stress testing gives too many predictions which outlive its usefulness. This framework also lacks systematic risk. Too much trust in stress testing gives managers a false sense of security, (Staff, 2018, np.)
A bank can minimize risks by establishing committees which oversee and monitors risks using various risks measuring and management techniques. Banks can conduct day to day evaluation of risks for example risks associated with commodity prices, (Dds.ca.gov, 2018, np). Value at risk method serves as the best way for measurement and management of risks. Banks should endeavour to update stocks after every three months so as to be able to manage risks appropriately and this can be done through the use of value at risk method. Banks should be able to calculate and evaluate the risks that may occur due future market changes for example in terms of prices and be able to come up with ways of minimizing them, (Balbas and Garrido,2014, pp.467-468)
References
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