Question

Explain the difference between market risk and credit risk. Are techniques for

managing market risk appropriate for managing credit risk?

EMERGENCY PLEASE HELP

Answer 1

Market Risk

Market risk is the possibility of an investor experiencing losses due to factors that affect the overall performance of the financial markets in which he or she is involved. Market risk, also called "systematic risk," cannot be eliminated through diversification, though it can be hedged against in other ways. Sources of market risk include recessions, political turmoil, changes in interest rates, natural disasters and terrorist attacks. Systematic, or market risk tends to influence the entire market at the same time.

This can be contrasted with unsystematic risk, which is unique to a specific company or industry. Also known as “nonsystematic risk,” "specific risk," "diversifiable risk" or "residual risk," in the context of an investment portfolio, unsystematic risk can be reduced through diversification.

Credit Risk

Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual obligations. Traditionally, it refers to the risk that a lender may not receive the owed principal and interest, which results in an interruption of cash flows and increased costs for collection. Although it's impossible to know exactly who will default on obligations, properly assessing and managing credit risk can lessen the severity of loss. Interest payments from the borrower or issuer of a debt obligation are a lender's or investor's reward for assuming credit risk.

Credit risk means the chance that you won't get all your money back, market risk means the risk that the value of your investment can fluctuate.

The first is relevant to interest-bearing investments such as mortgage trusts and bank deposits - the second is relevant to property and shares.

Even though cash type investments are traditionally regarded as less risky than shares, my preference is for shares.

various techniques used to manage the risk arising from market fluctuations in prices and rates. The key points are summarized as follows.

• Value at risk (VaR) is the minimum loss in either currency units or as a percentage of portfolio value that would be expected to be incurred a certain percentage of the time over a certain period of time given assumed market conditions.

• VaR requires the decomposition of portfolio performance into risk factors.

• The three methods of estimating VaR are the parametric method, the historical simulation method, and the Monte Carlo simulation method.

• The parametric method of VaR estimation typically provides a VaR estimate from the left tail of a normal distribution, incorporating the expected returns, variances, and covariances of the components of the portfolio.

• The parametric method exploits the simplicity of the normal distribution but provides a poor estimate of VaR when returns are not normally distributed, as might occur when a portfolio contains options.

• The historical simulation method of VaR estimation uses historical return data on the portfolio’s current holdings and allocation.

• The historical simulation method has the advantage of incorporating events that actually occurred and does not require the specification of a distribution or the estimation of parameters, but it is only useful to the extent that the future resembles the past