Risk ManagementThe NeedAlaleh Mani2013

Definition and source of Risk

Risk= Unexpected variable of price or earning.

Business Risk: Management decision making risk.Business Strategy riskMacroeconomic risk

Extreme Market MovementEvents caused volatility which resulted in financial losses and raised the need for the Risk Management: 1971 Exchange rate broke1973 Oil shock1987 Black Monday1989 Japanese bubble1997 Asian contagion 1998 Russian default2001 September 112007 Credit crisis

Globalization / DeregulationThese two factors increased the importance of risk management:

Deregulation in banks caused interest rate sensitivity.Globalization caused more exposure to currency exchange.

Some related definition Derivatives: a zero sum game Leverage: allow Derivatives to be a useful

hedging instrument due to:1. Limited initial cash outlay2. low transaction cost. Value at risk: Maximum of loss over time with at

level of confidence. VAR is an statistical measure:1. Historical VAR2. Delta-normal VAR3. Monte Carlo VAR

VAR VAR is ex-ante measure

VAR is difficult to calculate

VAR is comparable across different business.

VAR is for risk budgeting

Other Risk management tools Stop- loss limit:After loss occurred Co. eliminates the position to

limit the loss. Ex-post ,Aggregated, easy to calculate. Notional limits:limit the notional amount Exposure limits: limit the risk factor though it is hard to calculate

Exposures:Factors fail to measure to qualify the volatility of factors and the correlation between them

1.Duration for interest rate :effect interest rate changes on bond price

2.Beta for Equity Market

3.Delta for Option

Valuation The process of discounting future expected

value of an asset to determine the current price

E(value)= mean of distribution of possible valueVAR explain the future distribution.

Derivatives valuation : risk neutral pricing to prevent the persistence of arbitrage situations.

Types of Major Risk Market Risk

Liquidity Risk

Credit Risk

Operational Risk

Market Risk Price volatility in financial Market:

Absolute Risk: directly on return volatility

Relative Risk: tracking error the risk to a benchmark

Basic Risk: if hedging instrument doesn’t correlate with underlying asset

Liquidity Risk

Asset Liquidity Risk= Market Liquidity risk= trading liquidity risk

when large transaction influence the price

Fundinig liquidity risk=cash flow risk when a financial institute is unable to raise cash

to roll over its debt or ..

credit Risk Credit risk: counterparty obligation default

Sovereign risk: country willingness to pay it obligation

Settlement risk counterparty default in paying obligation

Operational Risk Model risk: loss due to misapplied model

People Risk: internal employee or external fraud

Legal risk: lawsuit, penalties, fines cause value loss

No reputational or strategic risk included