Reading 1 - Foundation of Risk Management

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READING 1 : THE NEED FOR RISK

MANAGEMENT

Session By

Ratan Gupta

Training For FRM

Part 1 Program



Risk and Sources of RiskA

2

R

isk can be defined as volatility of unexpected outcomes

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Sources of Risk

Natural

Man Made



Types of RiskB

3

Business Risk

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Financial Risk

Risk that corporation assumes willingly to create competitive advantage.

This results from business environment and decision.

Possible Risk arising due to the firm¶s financial market activity

Includes

Macroeconomic and Strategy Risks

Risk due to issuance of Equity, debt and the volatility in the prices

It is important that Non-financial firms hedge the Financial Risk.

However they should not hedge the business risk.

For financial firms the financial risk is the business risk



Significant Market EventsC

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Fixed exchange rate system broke down in 1971 Oil price shock in 1973, 1991, 2008

Black Monday, Oct 19, 1987, US market fell by 23%

Japanese stock bubble, Nikkei fell from 39,000 to 17,000 in 3 years

Asian turmoil of 1997, wiped 3/4th equity capitalization of Malaysia, Thailand,

Indonesia & Korea

Russian default in 1998 Mortgage crisis in 2007

Default of Lehman, near bankruptcy of AIG, US Govt takeover of Fannie Mae

and Freddie Mac ± 2008

European Debt Crisis, Default of MF Global - 2011

These events created high volatility. Huge Financial Loss

Risk Management would have resulted in containing the losses

World has seen Globalization and deregulation, as a result the

risk is not bounded by borders.



Function and Purpose of Financial

InstitutionsD


Acts as financial Intermediaries

People trust these intermediaries => Lower the cost of financial transactions

The institutions create instruments to manage risk

RiskAdvisory

Because of all the above these institutions should be at the top to evaluate

and manage the risks



Derivatives and LeverageE & F


Are instruments designed to manage financial risk efficiently

Derives its value from some underlying asset like equity, bond, index,

reference interest rate

These instruments are leveraged

Leverage is double-edged sword

Derivatives Market is Very Big, many times the world¶s GDP

Zero Sum Game



Financial Risk ManagementG


Design and Implementation of Process For Risk

Identification

Measurement

Management

VaR is one of the most important Risk Measurement Tool



Value At Risk (VaR) G


VaR is the worst loss over a target horizon that will not be exceeded with a given

level of confidence (or probability)

The focus is on the tail of the distribution

Most of the financial institutions use VaR measure

VaR can be derived from the probability distribution of the future portfolio value.



Other Risk Management ToolsH


Stop Loss Limit

Notional Limit

Exposure Limit

It Limits the loss in a position

Limit on the amount of investment

Limit on the Risk Factor

Delta in case of options

Duration in case of Bonds



Comparison of Risk Management ToolsI


Method (Across)

Characteristics (Down)Stop Loss Notional Exposure VaR

Type Ex-post Ex-ante Ex-ante Ex-ante

Calculation Easy Easy Difficult Difficult

Explanation Easy Easy Difficult EasyAggregation Yes No No Yes

Watch out for the superiority of VaR over other methods



Types of Financial RiskJ


Market Risk

Liquidity Risk

Credit Risk

Operational Risk



Market RiskJ


Relative Risk

Type - On the basis of market movement

Directional Risk

Non-Directional Risk

Absolute Risk

Type

Volatility Risk

Basis Risk



Liquidity RiskJ


Funding Risk or cash flow risk

Asset Risk or market/product Liquidity Risk

Liquidity Risk has forced many firms to go out of business

Unable to raise cash to meet financial obligation

Happens when transaction cant be conducted at the prevailing prices

Put Limit on the exposure that the firm can have on illiquid assets



Credit RiskJ


Recovery Rate

Exposure

Amount which is expected to be received in case of default

The amount which is at risk

Credit Event

Change in the ability of counterparty to perform obligation

Relationship between Market and Credit Risk

Types

Default Risk

Settlement Risk

Sovereign Risk



Operational RiskJ


Types

Model Risk

People Risk

Legal Risk

Internal or External Fraud

Regulatory Risk

Reading 1 - Foundation of Risk Management

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