The Need for Risk Management 1:

Learning Objectives

• Define risk & describe some of the major sources of risk
• Differentiate between business & financial risks & give examples of each
• Relate significant markets events of the several past decades to the growth of the risk mngt ind.
• Describe the functions & purposes financial institutions as they relate to frm.
• Define what a derivative contract is & how it differs from a security
• Define frm
• Define VaR and describe how it is used in risk mngt
• Describe the advantages and disadvantages of VaR relative to other risk mngt tools such as stop-loss limits, notional limits & exposure limits.
• Compare and contrast valuation and risk mngt, using VaR as an example
• Define & describe the four major types of financial risks: market, liquidity, credit & operational

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What exactly is risk?: the volatility of unexpected outcomes, which can represent the value of assets, equity or earnings. Can be classified broadly into business and financial risks

Business risks are those which corp assumes willingly to create a competitive advantage and add to value for shareholders. Includes The business decisions, companies makes and the business environment in which they operate. Includes strategic risk. Judicious exposure to business risk is a core competency of all business activity

Financial risk which relate to possible losses owing to financial market activities. For industrial corp, exposure to fin risks can be optimized carefully so that firms can concentrate on what they do best-manage exposure to business risks

In contrast, the primary function of financial institutions is to manage fin risks actively. The purpose of financial inst. is to assume, intermediate, or advise on financial risks, they must measure financial risk as precisely as possible in order to control and price them properly.

What are Derivatives?

Mapping process

Mapping replaces positions in instruments by exposures to fundamental risk. A position in a forward contract is equivalent to the same notional amount invested directly in the spot market, leveraged by cash so that there is zero net initial investment. The leverage makes the derivative an efficient instrument for hedging and speculation owing to very low transaction costs. On the other hand, the absence of an upfront cash payment makes it more difficult to asses the potential downside risk. Hence derivatives risks have to be monitored carefully.

The Toolbox of Risk Management

Value at Risk, statistical risk measure of potential losses

Summarizes the worst loss over a target horizon that will not be exceeded with a given level of confidence. Describes the quantile of the projected distribution of gains and losses over the target horizon.

To price options, for instance, we need to make an assumption about the distribution the distribution of the driving risk factor. The option then is priced by taking the present value of the expected option value at maturity.

Types of Financial Risks

Generally, financial risks are classified into the broad categories of market risks, liquidity risks, credit risks and operational risks. These risks may interact with each other

Market Risk: is the risk of losses owing to movements in the level or volatility of market prices. Can take two forms: absolute risk, measured in dollars terms (or in relevant currency), and relative risk, measured relative to a benchmark index. While the former focuses on the volatility of total returns, the latter measures risk in terms of tracking error, or deviation from index.

Can be classified into: Directional risks, involve exposures to the direction of movements in financial variables, such as stock prices, interest rates, exchange rates and commodity prices. And Non-directional risks, then, involve the remaining risk, which consist of nonlinear exposures and exposures to hedged positions or to volatilities.

Liquidity Risk: is usually treaty separately from the other risks. Takes two forms, asset-liquidity risk, a.k.a market/product-liquidity risk, arises when a transaction cannot be conducted at prevailing market prices owing to the size of the position relative to normal trading lots. The risk varies across categories of asset and across time as a function of prevailing market conditions.

Founding-liquidity risk, a.k.a. clash-flow risk, refers to the inability to meet payments obligations, which may force early liquidation, thus transforming "paper" losses into realized losses. Interacts with product-liquidity risk if the portfolio contains illiquid assets that must be sold at less than fair market value.

Credit Risk: is the risk of losses owing to the fact that counterparties may be unwilling or unable to fulfill their contractual obligations. Its effect is measured by the cost of replacing cash flows if the other party defaults. This loss encompasses the exposure, or amount at risk, and the recovery rate, usually measured in terms of "cents on the dollar."

Should be defined as the potential loss in market-to-market value that may be incurred owing to the occurrence of a credit event. Changes in market prices of debt owing to changes in credit ratings or in the market´s perception of default also can be viewed as credit risk, creating some overlap between credit risk and market risk. Credit risk also includes sovereign risk. One particular form of credit risk is settlement risk, this arises when the counterparty may default after the institution already made its payment; on settlement day, the exposure to counterparty default equals the full value of the payments due. The presettlement exposure is only the netted value of the two payments.

Operational Risk: is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

Model risk is part of inadequate internal processes. This refers to the risk of losses owing to the fact that valuation models may be flawed. To guard against model risk, models must be subjected to independent evaluation using market prices, when available, or objective out-of-sample evaluations.

People risk includes internal or external fraud,  such as situations where traders intentionally falsify information. This is also related to market risk. Rogue traders typically falsify their positions after they incur a large market loss.

Operational  risk also includes legal risk, which arises from exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements.