2.2 Introducing market risk

Typically, market risk can be divided into several sub types. Most of the splitting is obvious, but some of the more exotic risk types remain very broad. The ideal breakdown depends heavily on the specific portfolio whose market risk shall be quantified. A basic approach fitting most portfolios of private investors, not too broad, not too granular, is chosen in OCTARISK. The following types of risk are defined:

• FX: Forex risk captures the market movements of exchange rate values. These movements relative to the reporting currency (in our case EUR) affect financial assets in foreign currencies only.
• EQ: Equity risk is related to the movement of equity markets. It will be typically broken down into sub-categories like countries, regions or other types of aggregation (e.g. developed market, emerging market, frontier markets).
• COM: Commodity risk. This is a rather broad type of risk, often correlated to other risk types (e.g. equity). Commodity risk tries to capture the movement of spot and future / forward commodity prices, as well as commodity linked equities.
• IR: Interest rate risk is related to the movement of interest rate values. This is the most important type of risk for cash flow bearing instruments.
• SPREAD: Spread risk is related to the movement of spread rates. This is the second most important type of risk for cash flow bearing instruments.
• INFLATION: Inflation risk is related to the not anticipated changes in inflation rates, e.g. changes in the inflation expectation curve. This risk type affects inflation linked instruments only.
• RE: Real estate risk, where typically it will be distinguished between movements of market values of REITs (Real Estate Investment Trusts) and housing prices. This risk type can also be broken down into sub-categories like different countries, regions or other categories (e.g. developed markets, emerging markets).
• VOLA: Implied volatility risk, e.g. the anticipated future movement of implied volatility of equity instruments or swaps.
• ALT: Alternative market risk, used as a container for every other type of risk not already captured (e.g. Bitcoins, infrastructure)

The OCTARISK projects focuses on these risk types. For each risk type, appropriate risk factors can be chosen. One risk factor is a typical representative of a particular risk type. Most often, several risk factors are needed to describe the granular behavior of a market risk type, e.g. it is necessary to describe the specific characteristics of countries, regions or currencies. For example, two risk factors can be used to describe the international equity market movements: Developed markets and emerging market. If desired, developed market can be further split into North America, Europe and Asia to describe risk diversification effects between these broad regions. After the selection of risk factors, stochastic models are chosen, calibrated and subsequently used for scenario generation.