Financial risk management
Module 1: What is financial risk?
Terms: uncertainty==> exposure==> risk (risk arises as a result of exposure)
- Uncertainty: Investment opportunity
- Exposure: the possibility of loss or gain
- Risk: Risk is the probability of the occurrence of an unfavourable event that will have a
negative effect on the performance (probability of loss).
Risk is a probabilistic event; that is, risk is an unfavourable event that may occur with probability (p)
or may not occur with probability (1-p).
Risk has two aspects:
- Occurrence probability
- Event effect
Risk function is: Risk = (Probability, Effect)
There are three main sources of financial risk:
- Financial risks arising from an organization’s exposure to changes in market prices, such as
interest rates, exchange rates, and commodity prices.
- Financial risks arising from the actions of, and transactions with, other organizations such as
vendors, customers, and counterparties in derivatives transactions.
- Financial risks resulting from internal actions or failures of the organization, particularly
people, processes, and systems.
- Financial Leverage (FL): is the composition of the Liability & Equity side used by the firm to
finance its Assets.
- IF L>E FL is higher.
- IF ROA > borrowing costs Higher FL leads to Higher ROE.
Risk Identification: Types of Financial Risks
- Credit Risk: Is the potential that a bank’s borrower or counterparty will fail to meet its
obligations in accordance with agreed terms.
- Operational Risk: The risk of loss resulting from inadequate or failed internal processes,
people, and systems, or from external events (Def. includes, Legal risk).
- Liquidity Risk: Is the ability to fund increases in assets and meet obligation as they become
due.
Funding LR: The inability of a bank to raise funds in the market at a cost equivalent to that of
the other similar banks.
Asset LR: The inability of the bank to sell assets in the market
Specific liquidity risk: is the risk that a particular institution will lose liquidity. This might
happen if the institution's credit rating fell or something else happened which might cause
counterparties to avoid trading with or lending to the institution.
Systemic liquidity risk: affects all participants in a market. It is the risk that an entire market
will lose liquidity. Financial markets tend to lose liquidity during periods of crisis or high
volatility.
, - Market risk: Is the risk that movements in the market prices will adversely affect the value of
on-or off-balance sheet positions.
Interest rate risk, equity risk, currency risk and commodity risk: Is the exposure of a bank’s
financial condition to adverse movements in interest rates that influence negatively the
income, cash flows and market value of a company.
There are many on-off balance sheet Items that generate cash flows that are interest rate
driven: ex Loans, Deposits, Interest rate derivatives and Securities of deposits.
Market risk can occur in:
- Trading activities
- Lending activities
FX Risk arises from:
- Spot or Forward FX position
- Future income/expenses in foreign currencies
Equity risk can be a result of:
- General market risk
- Specific market risk: Diversification
Commodity is a physical product that is traded on a secondary market. Commodities are classified
under the following headings:
- Grains: Corn, Soybeans
- Softs: Coffee, Sugar,
- Metals: Gold, Silver
- Meats: Cows, Sheep,
- Power & Energy: Gas, Oil.
Commodity risk refers to the effect of unexpected changes in commodity prices have on the income,
cash flows and market value of a company.
Module 2: Value at risk
“What loss level is such that we are X% confident it will not be exceeded in N business days?”
Value at Risk: is an attempt to provide a single number to summarize
the total risk in a portfolio of assets.
- Value at Risk is aimed at making a statement of the following form:
We are X percent sure that we will not lose more than V dollars in the next K days. The variable V is
the VaR of the portfolio. It is a function of two parameters: K (time horizon) and X (confidence level).
- Regulators base the capital they require banks to keep on VaR.
- The market-risk capital is k times the 10-day 99% VaR where k is at least 3.0.
- We assume: The daily change in the value of a portfolio is linearly related to the daily returns from
market variables. The returns from the market variables are normally distributed.
Instead of calculating the 10-day, 99% VaR directly analysts usually calculate a 1-day 99% VaR and
assume: 10- day VaR 10 1- day VaR
This is exactly true when portfolio changes on successive days come from independent identically
distributed normal distributions.
Module 1: What is financial risk?
Terms: uncertainty==> exposure==> risk (risk arises as a result of exposure)
- Uncertainty: Investment opportunity
- Exposure: the possibility of loss or gain
- Risk: Risk is the probability of the occurrence of an unfavourable event that will have a
negative effect on the performance (probability of loss).
Risk is a probabilistic event; that is, risk is an unfavourable event that may occur with probability (p)
or may not occur with probability (1-p).
Risk has two aspects:
- Occurrence probability
- Event effect
Risk function is: Risk = (Probability, Effect)
There are three main sources of financial risk:
- Financial risks arising from an organization’s exposure to changes in market prices, such as
interest rates, exchange rates, and commodity prices.
- Financial risks arising from the actions of, and transactions with, other organizations such as
vendors, customers, and counterparties in derivatives transactions.
- Financial risks resulting from internal actions or failures of the organization, particularly
people, processes, and systems.
- Financial Leverage (FL): is the composition of the Liability & Equity side used by the firm to
finance its Assets.
- IF L>E FL is higher.
- IF ROA > borrowing costs Higher FL leads to Higher ROE.
Risk Identification: Types of Financial Risks
- Credit Risk: Is the potential that a bank’s borrower or counterparty will fail to meet its
obligations in accordance with agreed terms.
- Operational Risk: The risk of loss resulting from inadequate or failed internal processes,
people, and systems, or from external events (Def. includes, Legal risk).
- Liquidity Risk: Is the ability to fund increases in assets and meet obligation as they become
due.
Funding LR: The inability of a bank to raise funds in the market at a cost equivalent to that of
the other similar banks.
Asset LR: The inability of the bank to sell assets in the market
Specific liquidity risk: is the risk that a particular institution will lose liquidity. This might
happen if the institution's credit rating fell or something else happened which might cause
counterparties to avoid trading with or lending to the institution.
Systemic liquidity risk: affects all participants in a market. It is the risk that an entire market
will lose liquidity. Financial markets tend to lose liquidity during periods of crisis or high
volatility.
, - Market risk: Is the risk that movements in the market prices will adversely affect the value of
on-or off-balance sheet positions.
Interest rate risk, equity risk, currency risk and commodity risk: Is the exposure of a bank’s
financial condition to adverse movements in interest rates that influence negatively the
income, cash flows and market value of a company.
There are many on-off balance sheet Items that generate cash flows that are interest rate
driven: ex Loans, Deposits, Interest rate derivatives and Securities of deposits.
Market risk can occur in:
- Trading activities
- Lending activities
FX Risk arises from:
- Spot or Forward FX position
- Future income/expenses in foreign currencies
Equity risk can be a result of:
- General market risk
- Specific market risk: Diversification
Commodity is a physical product that is traded on a secondary market. Commodities are classified
under the following headings:
- Grains: Corn, Soybeans
- Softs: Coffee, Sugar,
- Metals: Gold, Silver
- Meats: Cows, Sheep,
- Power & Energy: Gas, Oil.
Commodity risk refers to the effect of unexpected changes in commodity prices have on the income,
cash flows and market value of a company.
Module 2: Value at risk
“What loss level is such that we are X% confident it will not be exceeded in N business days?”
Value at Risk: is an attempt to provide a single number to summarize
the total risk in a portfolio of assets.
- Value at Risk is aimed at making a statement of the following form:
We are X percent sure that we will not lose more than V dollars in the next K days. The variable V is
the VaR of the portfolio. It is a function of two parameters: K (time horizon) and X (confidence level).
- Regulators base the capital they require banks to keep on VaR.
- The market-risk capital is k times the 10-day 99% VaR where k is at least 3.0.
- We assume: The daily change in the value of a portfolio is linearly related to the daily returns from
market variables. The returns from the market variables are normally distributed.
Instead of calculating the 10-day, 99% VaR directly analysts usually calculate a 1-day 99% VaR and
assume: 10- day VaR 10 1- day VaR
This is exactly true when portfolio changes on successive days come from independent identically
distributed normal distributions.
