The market risk of a credit institution results from a combination of many risk factors. Interest rate changes, exchange rate and stock price fluctuations, all influence the value of a credit institution’s assets. Market risk represents potential loss due to market price changes, and can be used as a key figure when reaching judgments about the necessary equity cover for an enterprise, the limiting of positions, or the desired minimum return on a portfolio.

In order to achieve a more comprehensive level of control, market risk has to be split up into its component parts. Market risk can be divided into the following risk categories:

• Interest rate risk
• Currency risk
• Index risk
• Volatility risk
• Price risk

Every risk category can be further divided into specific partial risks. In the interest area, there are sub-markets for swaps, bonds, money market transactions, etc., and each one has the corresponding partial risks. Partial risks are generally different for every currency area.

In the risk hierarchy, you define how the market risk is split up into its components. Risk factors form the basis of risk hierarchies. By definition, a risk factor cannot be divided up into further components. At the same time, risk factors also represent the price factors for the instruments in the portfolio.

In the interest area, the key rates are defined as risk factors. The idea behind key rates is to define the temporal progression of a yield curve for several specific terms using interest rates. The key rates are depicted as zero coupon rates. The interest rates for the remaining terms are determined directly from the key rates. As key rates are implicitly selected when you choose a yield curve structure, it is not absolutely necessary for you to explicitly define the key rates of a yield curve structure in the risk hierarchy. Only do this in cases where you specifically want an evaluation for the key rates defined in the risk hierarchy.

With stocks, the stock price is represented on a market index. It is assumed that the stock price development is directly dependent on the market index.

Using risk hierarchies in evaluations allows a detailed representation of the influence of different risk factors. The risks defined in the risk hierarchy are shown in the evaluations.

Every level of a risk hierarchy is a consolidation level. Market risk is the consolidation level at the very top of the risk hierarchy.

Risk hierarchies are built by starting with the market risk and working down to the individual risk factors. You determine the composition of the risk hierarchy by defining a structure.