Price risk

Price risk refers to the changes in earnings due to changes in the value of portfolios
of financial instruments; it is therefore a critical risk for dealers. The absence of
historical data on defaults, and on correlations between default events, complicates
the precise measurement of price risk and makes the contingent exposures of credit
derivatives more difficult to forecast and fully hedge than a financial derivatives
book. As a result, many dealers try to match, or perfectly offset, transaction exposures.
Other dealers seek a competitive advantage by not running a matched book.
For example, they might hedge a total return swap with a default swap, or hedge a
senior exposure with a junior exposure. A dealer could also hedge exposure on one
company with a contract referencing another company in the same industry (i.e. a
proxy hedge). As dealers manage their exposures more on a portfolio basis, significant
basis and correlation risk issues can arise, underscoring the importance of stress
testing the portfolio.

Investors seeking exposure to emerging markets often acquire exposures denominated
in currencies different from their own reporting currency. The goal in many of
these transactions is to bet against currency movements implied by interest rate
differentials. When investors do not hedge the currency exposure, they clearly assume
foreign exchange risk. Other investors try to eliminate the currency risk and execute
forward transactions. To offset correlation risk which can arise, an investor should
seek counterparties on the forward foreign exchange transaction who are not strongly
correlated with the emerging market whose currency risk the investor is trying to
hedge.