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The market risk management is an important aspect in the changing business environment and there are several journals, articles, books have been written to define the concept of market risk management. According to Al-Tamimi & Al-Mazrooei (2007), in the current global business environment, financial institutions face different types of risk such as liquidity risk, credit risk, foreign exchange risk, interest risk and market risk. These risks state that banking business is a quite risky business and risk management is an important part of prudent banking practices. A banking business faces two types of risks such as systematic and unsystematic risk (Al-Tamimi and Al-Mazrooei 2007). Both risks are different from each other as systematic risk is related with overall market risk, while unsystematic risk is related with a specific firm.
Al-Tamimi and Al-Mazrooei (2007) also defined that through the use of different risk mitigation and transmission techniques, systematic risk can be reduced. There are three basic risk mitigation strategies such as avoiding risk, transferring risk and managing risk. Avoiding of risk is a simple risk mitigation strategy. Financial intermediaries use this strategy by minimizing risky transactions and by simplifying their business strategy. In transfer risk mitigation strategy, firms transfer their risk to third parties, who may be an insurance company or some specified group of people (Al-Tamimi and Al-Mazrooei 2007). Some risk cannot be avoid and transferred to the third party and this is the reason that for such risks firms use appropriate risk management techniques. These are the different types of risk mitigation strategies based over the extent of risk within the organization.
Sounders and Cornett (2008) also supported the view of Al-Tamimi and Al-Mazrooei (2008) as their research explains following types of risk that are faced by the financial institutions. But at the same time, their research results also explains the reason behind the occurrence of these risks for the financial institutions –
Interest Rate Risk– Interest rate risk is faced by financial centers due to mismatch in maturities of their assets and liabilities. It is because both primary securities that are purchased by financial institutions and secondary securities that are sold by these centers may have different maturity dates (Sounders and Cornett 2008).
Market Risk– Financial institutions face market risk due to the changes in foreign exchange rate, interest rate, and commodity rate as these changes affects the value of assets and liabilities of financial institutions.
Off-Balance Sheet Risk– Due to contingent assets and liabilities some time financial institutions face off-balance sheet risk.
Credit Risk– When the customers of financial institutions fail to repay their loan and securities, it is termed as credit risk.
Foreign Exchange Risk– Financial institutions face foreign exchange risk due to changes in foreign exchange rate as it affects the value of assets and liabilities (Sounders and Cornett 2008).
Insolvency Risk– Insolvency risk arises, when an organization has less amount of capital to offset the value of its assets relative to its liabilities (Sounders and Cornett 2008). Generally, insolvency risk arises due to other risks such as market risk, interest risk, and credit risk etc. that are faced by these institutions.
Country and Sovereign Risk– The interventions of foreign governments pose the country and sovereign risk due to interruption in repayment to foreign investors. Repudiation and rescheduling are two different manners that reflect such situation. In repudiation, borrowers cancel all their current and future foreign debt obligations, while in rescheduling, country declares some delays for its debt obligations and seeks for change in credit terms.