That risk measurement is the key to effective and efficient risk management needs no emphasis. This paper examines sensitivity of stock returns of 30 Indian banks (included in CNX500 index) to three risk factors—interest rate, inflation rate and fluctuation in exchange rate. The study uses monthly data for the period April 1, 2005 to March 31, 2014. By applying ‘pooled regression technique’, the study indicates that returns of Indian banks are statistically (significantly) impacted by the above-mentioned risk factors as well as overall market returns. With the exception of short-term interest rates, all the risks are positively related to banks’ returns. A disaggregative analysis based on public sector banks (16) and private sector banks (14) reveals somewhat similar findings. This analysis of banks’ risk exposure is expected to be of immense practical use in framing/designing operational policies as well as risk management in Indian banks.

The key to effective risk management is risk measurement. Even risk prioritization depends largely on quantification of risk exposure. Banks’ exposure towards market risks has puzzled academicians, economists and practitioners alike. Adler and Dumas (1984) suggest that exposure should be defined in terms of what one has at risk. But most of the studies exploring this phenomenon are centered on data from developed countries. In the light of the contribution of emerging markets to globalization and world economy, it seems imperative to analyze the risk exposures of organizations, particularly banks in developing countries. It is worth mentioning that market risk refers to the risk to an institution resulting from movements in market prices, in particular, changes in interest rates, foreign exchange rates, and equity and commodity prices (Basel Committee on Banking Supervision, 2006). Interest rate risk is of particular importance to banks as movements in interest rates can lead to asset liability mismatches, narrow net interest margin, etc. Similarly, fluctuations in exchange rates can significantly affect the profits and returns of banks due to banks’ foreign positions, which may lead to translation and transaction gains or losses. Further, changes in the rate of inflation alter the consumers’ purchasing power and their ability to borrow and save. In addition, it affects the costs and revenues of corporates. This, in turn, affects banking business and its returns.

Applied Finance Journal, Market Risk Exposure, Evidence, CNX500, Real Effective Exchange Rate (REER), Wholesale Price Index (WPI), Indian Banking Industry.