The main risks of any financial product are market risk, credit risk, and liquidity risk. When we reference credit risk, we are including both market-based credit risk, where widening of credit spreads is indicative of credit quality deterioration, as well as counterparty credit risk. This may be caused by the loss in the market value of the portfolio holdings or market illiquidity. Similarly, liquidity risk includes the funding liquidity as well as the market liquidity of different asset classes. In general, these risks are treated separately as if they are totally Independent of each other. That assumption is untrue as any loss in market value impacts both funding costs as well as credit quality loss. Similarly, any loss in liquidity can impact the credit performance risk as well as the market prices of an asset. If we measure the market, credit, and liquidity risk separately, this risk can be significantly understated as the coupling can be highly non-linear, thus increasing the losses several orders of magnitude. The following presentation discusses this coupling of market, credit, and liquidity risk as well as the difficulties in measuring them in addition to possible solutions to hedge them.

1. COUPLING OF MARKET RISK,
CREDIT RISK, AND LIQUIDITY RISK
Rabinder K. Koul
Managing Director and Head of Risk Services
Gateway Partners

2. INTRODUCTION
Gateway Partners is a Registered Investment
Advisor (RIA) dedicated to providing our clients
with best-in-class risk management solutions.
Gateway Partners has the expertise to identify,
measure and manage market, credit, liquidity,
operational, and regulatory risk at the executive
level of numerous large financial Institutions. This
translates into first class solutions for our clients.
We have the unique expertise to address the
issues of traceability of regulatory information
provided to regulators and to provide end-to-end
transparency on regulatory reports.

3. INTERACTION OF MARKET AND
CREDIT RISK & LIQUIDITY RISK
1. What is Market Risk
2. What is Credit Risk
3. Interaction between Market and Credit Risk
4. Liquidity Risk
5. Funding Risk

4. WHAT IS MARKET RISK
Market risk is the loss in a financial institution’s
portfolio due to the price and volatility in financial
markets. The level change and volatility are also
responsible for the upside of the assets in the
portfolio. This is reflected by the change in level and
the volatility in markets given below.

5. TRADITIONAL MARKET
RISK DRIVERS
Equity Markets
1. Equity price and price changes
2. Equity volatility
Interest Rate LIBOR and Swap Markets
1. Interest rate level change
2. Basis risk
3. Interest rate volatility
Governmental Funding Rate Markets
1. OIS funding
Treasury Markets
1. Short term treasury rates
2. Long term treasury rates

6. FX Risk:
1. Spot rate levels
2. Spot rate volatility
3. Forward rates
4. Forward rate volatility
Commodity Risk
1. Price risk
2. Volatility risk
TRADITIONAL MARKET
RISK DRIVERS

7. Credit Products
1. Rate risk
2. Spread risk
Mortgage Loan Markets
1. Swap rates
2. Current coupon rates
3. Commitment spreads
4. Prepayment risk
TRADITIONAL MARKET
RISK DRIVERS

8. Commercial Loan Market Risk
1. Commercial loan rates risk
2. Commercial loan spread risk
Credit Card Markets
1. Credit card spread risk
TRADITIONAL MARKET
RISK DRIVERS

9. CREDIT RISK
Credit risk is the possibility of loss of principal
amount in credit and debt markets due to
changes in the credit ratings of the borrower or
possibility of the default by the obligor and the
changes in the recovery rates along with cost of
recovery.

10. CREDIT RISK
Drivers of credit risk include:
• Rating Migration Risk
• Default Risk
• Recovery Rate Risk
However, default risk and recovery rate information is
hidden in the credit spread of the counterparty.

11. TRADITIONAL CREDIT RISK
Credit Products
1. Spread risk
2. Rating based spreads
3. Credit Spread = Probability of Default x Loss Given
Default
Mortgage Loan Markets
1. Default risk
Commercial Loan Market Risk
1. Commercial loan refinancing risk
2. Commercial loan write off risk
3. Default risk
Credit Card Markets
1. Default risk

12. INTERACTION BETWEEN
MARKET AND CREDIT RISK
• Historically, market and credit risks have been treated
separately as if these risk are independent of each other.
This has been primarily because of practical considerations.
• These risks are measured and managed separately, as is the
measurement of economic and risk capital. The two are
simply added together to arrive at the combined result.
• However, the economic factors which drive market risk are
also the drivers of credit risk as we have partially seen in
previous enumeration of these risks. The coupling between
the two is much more intimate, and in fact can have
compounding effects on each other.
• The distinction between the two has further been blurred
by credit risk transfer markets and mark-to-market
accounting of certain held to maturity banking book
positions.

13. • The recent financial crisis has shown us the strong
coupling and compounding effects between market
and credit risk that create large losses in institutional
portfolios. It has also shown how the loss of liquidity
can act as a coupler between market and credit risk.
• As we have seen, market and credit risk is separated by
identifying credit risk with the default or rating
migration of a counterparty. Market risk on the other
hand can be seen as the fluctuation of asset prices as a
function of market factors as enumerated previously
(e.g., commodity prices, exchange rate of interest
rates, etc.). This fluctuation of asset prices gives rise to
the riskiness of the asset, thus, the change in the
probability of default.
INTERACTION BETWEEN
MARKET AND CREDIT RISK

14. Some empirical studies in Europe have shown that shocks to short term
interest rates have a larger effect on a firm’s default when its credit risk
model accounts for the feedback of these shocks in credit models.
Example of Market and Credit Risk Coupling
• Adjustable Rate Loans: Adjustable rate loans have coupons that
change as interest rates change. If we assume that a loan does not
default, the bank has no market risk as that risk has been passed
on to the borrowers. If the credit risk is computed separately from
the market risk, then we keep the interest rate fixed at the current
level. However, this calculation misses the impact of interaction
between the market and credit risks. For example, if the
probability of default increases with an increase in interest rates,
we will be underestimating the actual probability of default.
Therefore, the sum of market and credit risk is underestimated.
INTERACTION BETWEEN
MARKET AND CREDIT RISK

15. Example of Market and Credit Risk Coupling
• Carry trades and foreign currency loans: Consider a trade
where one borrows funds in a low interest rate currency and
lends the funds at a higher interest rate currency. If the low
interest rate currency lender computes the market and
credit risk separately, the market risk is computed by
assuming that borrower is not going to default, in which case
only market risk is left. That is because of the fluctuation of
current FX and interest rates. To measure credit risk
separately from market risk, we assume that interest rates
and the FX rates are not changing. Then credit risk does not
depend on these factors. However, if the probability of
default depends upon whether the trade is profitable, then
the total risk computed is underestimated.
INTERACTION BETWEEN
MARKET AND CREDIT RISK

16. Example of Market and Credit Risk Coupling
• Matching long and short positions in OTC derivatives: Suppose a
bank buys OTC derivatives from one counterparty and sells the
same OTC derivatives to another counterparty. In such a situation,
the bank is market risk neutral. Suppose the market value of the
OTC derivatives does not change in the market. In case of default
by counterparty, its deliverable can be purchased at the same
price. Hence, there is no credit risk. However, if the value of the
derivative changes, and one counterparty defaults at the same
time, the change in market value and default together generate a
loss for the bank. During the Russian crisis in 1998, this mechanism
created losses in foreign currency forwards when western
countries held USD/ruble forwards with Russian banks with
opposite positions with western customers.
INTERACTION BETWEEN
MARKET AND CREDIT RISK

17. LIQUIDITY RISK
• Liquidity risk is the risk arising through the liquidity
in asset markets due to outstanding volume, and
the demand in the markets for the asset class.
• It also includes the availability of a firms’ cash
liquidity so that routine market activities can
continue, like servicing margin, etc.

18. LIQUIDITY RISK
What is Market Liquidity?
• A market is liquid if the transactions of the asset in the market
can take place easily and rapidly without significantly moving the
market value of the asset.
• Depth of the market in a particular asset class that measures the
size of assets can be transacted without making additional
availability of the asset class difficult. It also depends upon the
number of participants in the market, hence, price transparency.
• It depends upon the effect on bid-ask spread of the asset price
when the asset of a particular size is transacted.
• The rapidity of the transaction in an asset refers to the speed
and ease in which the transaction takes place so that the market
returns to normal as quickly as possible.
• Dependence of market liquidity upon the funding liquidity.

19. FUNDING RISK
Funding risk is the risk arising due to funding
the market activity of borrowing assets and
servicing these assets in response to the
changing price of these assets.