What is Market Risk? Understanding Interest Rate, FX, Equity & Commodity Risks in Banks

8th December, 2025

Banks operate in markets where prices and rates shift constantly. These movements can influence the value of loans, investments, deposits and trading positions. When these changes impact a bank’s earnings or the value of its portfolios, the result is market-related exposure. This is why market risk in banking is considered one of the core pillars of financial risk management.

Understanding the different market risk components allows banks to strengthen their balance sheets, meet regulatory expectations and make more informed decisions across treasury, lending and investment activities.

Also Read: What Is Risk Management in Banking

What is market risk in banking?

Market risk in banking refers to the possibility that a bank will suffer losses because the value of its assets or liabilities changes due to shifts in market conditions such as interest rates, foreign exchange rates, equity prices or commodity prices.

Unlike credit risk (which is about borrower defaults) or operational risk (which stems from internal failures), market risk arises from external, market-driven events. In a global and interconnected financial environment, these external risks are pervasive and can affect banks even if borrower fundamentals are strong.

Because banks hold a mix of loans, bonds, investments, foreign-currency exposures and, at times, commodity-linked instruments, either in their trading book or banking book, they are exposed to multiple types of market risk.

Four types of market risk in banking

Market risk can be classified into four types, namely, interest rate risk, foreign exchange 9FX) risk, equity risk and commodity risk. These risks are discussed below:

1. Interest Rate Risk

Interest rate risk occurs when changes in market interest rates affect the bank’s earnings or the economic value of its assets and liabilities.

This risk often arises because banks fund long-term loans or bonds (at fixed rates) through short-term deposits or other liabilities that reprice more frequently. When interest rates shift, the mismatch in repricing can compress the bank’s net interest margin or reduce the present value of its longer-term assets.

Some of this risk is captured under a category known as Interest Rate Risk in the Banking Book (IRRBB), where banks measure how interest rate changes impact the economic value of equity over various scenarios.

2. Foreign Exchange (FX) Risk

FX risk arises when a bank has assets, liabilities, or future cash flows denominated in foreign currencies. If exchange rates move unfavorably, the value of these positions may decline, leading to losses.

For banks operating internationally or handling foreign-currency transactions for clients, managing FX risk becomes essential. The volatility in exchange rates can affect both the valuation of existing positions and the cash flows on prospective deals, making the bank’s capital and earnings vulnerable.

3. Equity Risk

Equity risk is the risk of loss arising from adverse movements in the price or volatility of stocks, equity indices, or equity-linked instruments that a bank holds, whether as investments, collateral, or trading positions.

Since equity markets may react sharply to economic events, political developments or market sentiment, banks with significant equity exposure must be prepared for sudden value swings that can erode their portfolio value.

4. Commodity Risk

Commodity risk, sometimes called commodity price risk, affects banks when they hold positions in commodities or commodity-linked instruments (e.g. derivatives, commodity-backed securities). Price fluctuations in commodities such as oil, metals, or agricultural products can cause these positions to lose value.

Although many banks are not heavily exposed to commodities compared to specialized trading houses, this risk remains relevant for those active in commodity financing, commodity-linked derivatives or treasury operations involving commodity-backed positions.

Also Read: Liquidity Risk vs Interest Rate Risk

Why market risk for banks matter

Impact on earnings and capital: Fluctuations in interest rates, exchange rates or market prices can erode a bank’s net interest income, reduce the value of its investment portfolio, or depreciate its foreign-currency holdings, directly affecting profitability and capital adequacy.
Regulatory requirements: Regulatory frameworks, especially under the Bank for International Settlements (BIS) and associated accords, mandate that banks maintain sufficient capital against market risk, conduct stress-testing, and hold capital buffers to absorb potential losses.
Volatility and unpredictability: Market risk stems from macroeconomic shifts, interest-rate policy changes, geopolitical events or commodity-price cycles. These factors are often outside the control of individual banks. Without diligent management, even strong banks can become vulnerable.
Holistic exposure: Banks typically hold diversified portfolios, like loans, bonds, equities, foreign-currency positions, making them exposed to multiple risk types simultaneously. A comprehensive approach is therefore essential.

How banks manage market risk

Banks adopt several strategies to manage and mitigate market risk. Key among them:

Measurement and monitoring: Use statistical tools such as Value at Risk (VaR) to estimate potential losses over a given time horizon and confidence level.
Stress testing and scenario analysis: Since normal-market assumptions may fail during extreme events, banks run stress-tests and extreme-scenario simulations to check capital resilience under adverse conditions.
Diversification and limit-setting: Establish limits for exposures across interest rate, FX, equity and commodity positions; avoid excessive concentration in any one area.
Asset-Liability Management (ALM): Especially to manage interest rate risk, banks match the maturities and repricing schedules of assets and liabilities to reduce mismatch risk (as in IRRBB frameworks).
Hedging where appropriate: Use derivatives, such as interest-rate swaps, currency forwards, commodity futures, to hedge exposures, when consistent with regulatory policy and internal risk limits.

Also Read: Risk Culture in Banks

Practical implications for banking professionals and risk managers

For banking professionals, understanding market risk and its components is not just theoretical. It shapes decision-making in lending, treasury operations, asset-liability management, and compliance.

When structuring a loan or bond portfolio, one must consider interest rate repricing schedules and potential mismatches.
For foreign-currency operations or cross-border exposures, FX risk must be quantified and hedged appropriately.
Equity investments or holdings as collateral require careful monitoring of market conditions and volatility.
Commodity-linked exposures, though less common in commercial banking, call for sensitivity analysis against commodity-price cycles or external shocks.

Given the regulatory and business importance, many banking institutions also maintain a dedicated risk-management framework, often overseen by an Asset-Liability Management Committee (ALCO) or a Risk Management Committee, with clear policies, limits and reporting protocols.

Strengthen Your Market Risk Expertise Today!

Market risk in banking, whether arising from interest rate movements, exchange-rate volatility, equity price swings or commodity-price changes, presents a real and ever-present threat to a bank’s earnings, capital and stability. Given global interconnectedness and volatile markets, banks must proactively identify, measure, monitor and mitigate these market risks.

A structured risk-management approach combining robust measurement, diversification, hedging, asset-liability management and regular stress-testing is essential. For professionals seeking a deeper, practical understanding of these concepts, formal training and hands-on frameworks provide the strongest foundation.

If you want to build a comprehensive understanding of market risk and learn how banks manage interest rate, FX, equity and commodity risk - check out the detailed course Market Risk Management in Banking on Smart Online Course in association with Risk Management Association of India.

Enroll Today! Market Risk Management in Banking