Market risk arises from the unexpected movements in financial market variables like inflation, interest rate, foreign exchange rate etc. A bank‘s investment and loans are exposed to these market factors which can lead to loss for any adverse movement.
If the interest rate rises, the value of the assets in a portfolio increases and at the same time value of bonds decreases as bond prices are inversely related to the market interest rate. Suppose a bank has invested in a bond with par value USD 1000, coupon rate as 9% and yield rate at 9%. If the market interest rate rises, the market price of the bond decreases which can lead to loss in the bond portfolio.
At the same time, inflation can reduce the purchasing power and reduces the value of the assets. High inflation leads to high interest rate which again reduces the market value of bonds, as explained before. Also high inflation affects the economic growth and reduces the expected rate of return from the market.
Foreign currency risk arises if the banks operate in the foreign currency market. Suppose a bank buy one USD for Rs. 50 from a customer to sell it in the foreign currency market and the Rupee appreciates by Rs. 1 per USD the next day, then bank incurs Rs 1 loss per USD due to the adverse foreign currency movement. All these risks arise from different market variables.