FINANCIAL RISK MANAGEMENT

FNC-404

Instructor: Dr. Kumail Rizvi

15/01/2014

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Kumail Rizvi, PhD, CFA, FRM

KUMAIL RIZVI

PHD FROM PARIS 1 (PANTHÉON SORBONNE) 2011

CFA 2010

FRM 2010

MSC MONEY BANKING AND FINANCE 2007

MSC COMPUTER SCIENCES 2003

MBECON (FINANCE) 2001

EXPERIENCE

GIFT UNIVERSITY

HAILEY COLLEGE OF COMMERCE, PUNJAB UNIVERSITY

PAK AIMS

IBP (INSTITUTE OF BANKERS PAKISTAN)

PARIS 1 (PANTHÉON SORBONNE)

UNIVERSITY OF CENTRAL PUNJAB (UCP)

LAHORE SCHOOL OF ECONOMICS (LSE)

SYNERGISTIC FINANCIAL ADVISORS (SFA)

SPM CONSULTING, DUBAI

SAS

IBM (INTERNATIONAL BUSINESS MACHINES)

GBM (GULF BUSINESS MACHINES)

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RISK

Risk is the probability of loss?

(what about Risk Exposure to

Earthquake?)

Another perspective is that It is

exposure that in conjunction

with uncertainty defines risk!

Risk is the volatility of expected

outcomes (value of assets,

equity or earnings)

All outcomes or only negative

outcomes? (Left Tail)

Combination of Danger and

Opportunity.

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RISK 1

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Misconception continued,

spread virally and embraced

and accepted by QUANTS..

But what about events like

Russian Roulette??

However, we have to live with

it, else we would always make

some Suboptimal decisions or

wouldn’t make any decision at

all….

INTRODUCTION

Investment is an intrinsically risky activity.

Without risk, we have little possibility of reward.

Thus risk taking and risk management is an

innate characteristic of investment process.

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INTRODUCTION

As an individual or a company engage in risk

activity like investment, different questions

arise:

What is an effective process for identifying,

measuring and managing risk?

Which risks are worth taking?

How can our success or lack of success in risk taking

be evaluated?

What information should be reported to stakeholders

concerning the risk of an enterprise or portfolio?

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FINANCIAL RISK MANAGEMENT

Financial risk

management is the design

and implementation of

procedures for

identifying, measuring

and managing financial

risks.

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FINANCIAL RISK MANAGEMENT

Risk Management is a process involving:

Identification of exposures to risk

Establishment of appropriate ranges for exposures

Measurement of these exposures on continuous basis

Execution of appropriate adjustments whenever exposure levels fall outside of target ranges.

Risk Management in its totality is all at once a proactive, anticipative, and reactive process that continuously monitors and controls risks.

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Exposure is the size or value of

loss that would be realized if an

unexpected outcome occurred.

THE PRACTICE OF RISK MANAGEMENT 1

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SOURCES OF RISK 1

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Risks the corporation assumes willingly

To create competitive advantage

To add shareholders value

Includes:

Business decisions (e.g., investment, products, org structures)

Business environment (competition and macro economy)

Losses due to

financial market

activities

For example:

Interest rate exposure

Default on financial

obligations

Account receivable

Financial

For a non-financial

corporation, likely to

be non-core

Business

IDENTIFYING RISK

Financial Risk

Non-Financial Risk

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IDENTIFYING RISK

Risk that an individual or corporation is exposed

to, take many different forms:

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FINANCIAL RISK

Market Risk

Including:

Interest rate risk

Commodity Price Risk

Equity Price Risk

Exchange Rate Risk

Credit Risk

Liquidity Risk

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MARKET RISK

Market risk is the risk associated with interest

rate, equity prices, commodity prices and

exchange rate.

It is the risk that declining prices or volatility of

prices in these financial markets will result in a

loss.

Market Risk includes:

Absolute risk

Relative risk

Basis risk

Volatility risk

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MARKET RISK INCLUDES……..

Absolute Risk focuses on the volatility of total

returns.

Relative Risk is referred to as tracking error since

it is usually measured relative to a benchmark

index or portfolio.

Basis Risk is the risk that the price of a hedging

instrument and the price of the asset being

hedged are not perfectly correlated.

Volatility Risk is the risk of loss from changes in

the actual or implied volatility of market prices.

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CREDIT RISK

Apart from the market risk, credit risk is the

primary risk faced by economic agents.

Credit risk is the risk of loss caused by the

possibility of default or non-payment by a

counterparty or debtor in a financial transaction.

Credit Risk includes:

Sovereign risk

Settlement risk

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CREDIT RISK INCLUDES…….

Sovereign Risk is the risk resulting from a

country’s action. It differs from other forms of

credit risks as it is country specific. A country’s

willingness and ability to repay its obligations

are often factors looked at when evaluating the

sovereign risk. Sovereign risk often stems from

country’s political or legal system.

Settlement Risk is the risk that a counterparty

will fail to deliver its obligation after the party

has made its delivery.

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LIQUIDITY RISK

Liquidity risk is the possibility of sustaining

significant losses due to the inability to

sufficiently liquidate a position at a fair price.

For traded securities, the size of the bid-ask

spread, stated as a proportion of security price,

is frequently used as an indicator of liquidity.

Liquidity Risk includes:

Asset or Trading liquidity risk

Funding liquidity risk

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LIQUIDITY RISK INCLUDES.……..

Asset Liquidity Risk, which is sometimes called

market or trading liquidity risk, results from a

large position size forcing transactions to

influence the price of securities.

Funding Liquidity Risk, which is sometimes

called cash-flow risk, refers to the risk that a

financial institution will be unable to raise cash

necessary to roll over its debts; to fulfill the cash,

margin, or collateral requirements of

counterparties; or to meet capital withdrawals.

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NON-FINANCIAL RISK

Operational Risk

includes:

Model Risk

People Risk

Legal Risk

Business Risk

Includes:

Strategic Risk

Macroeconomic Risk

Political Risk

Regulatory risk

Tax Risk

Accounting Risk

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OPERATIONAL RISK

Operational Risk is the risk of loss from failures

in a company’s systems and procedures or from

external events.

These risks can arise from:

Computer breakdowns (including bugs, viruses, and

hardware problems)

Human errors or frauds

Events completely outside of companies control

including “act of God” and terrorist actions

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MODEL, PEOPLE & LEGAL RISKS

Model Risk is the risk that a model is incorrect or

misapplied; in investment, it often refers to

valuation models.

People Risk relates to the risk associated with

fraud perpetrated by internal employees and/or

external individuals.

Legal Risk is the risk of a loss due to legal issues

including lawsuits, fines, penalties, and/or

damages.

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BUSINESS RISK

Business Risk is the risk that a firm is subjected to during daily operations and includes the risks that result from business decisions and business environment.

It includes strategic risk (the risk inherent in the decisions of senior management in setting a business strategy), macroeconomic risk (the risk that economy will slow and demand for product will fall, political risk etc.

The ability to effectively manage business risk is a core competency for stronger firms.

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OTHER RISKS

Regulatory Risk is the risk associated with the

uncertainty of how a transaction will be

regulated or with the potential for regulations to

change.

Tax Risk arises because of the uncertainty

associated with tax laws.

Accounting Risk arises from uncertainty about

how a transactions should be recorded and the

potential for accounting rules and regulations to

change.

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ILLUSTRATION: IDENTIFYING RISKS

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MEASURING RISK Market Risk

Credit Risk

Liquidity Risk

Operational Risk

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MEASURING MARKET RISK

Few conventional techniques are available to

measure market risk.

Standard Deviation; referred to as Asset’s

Volatility typically represented by Greek letter

Tracking error measures the volatility of a

portfolio’s return in excess of the benchmark

portfolio’s return.

Beta measures the sensitivity to market movements

and is a linear risk measure

Duration measures the sensitivity of a bond or a

bond portfolio to a small parallel shift in the yield

curve and is a linear measure.

Convexity measures how interest rate sensitivity

changes with changes in interest rates.

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There are few errors in some formulas: Do

correct them

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MEASURING MARKET RISK

During 1990s, a new technique emerged as the

financial service industry’s premier risk

measurement technique – called as Value at Risk

(known as VAR)

VAR is a probability-based measure of loss

potential for a company, fund, a portfolio, a

transaction or a strategy.

Specifically, Value at Risk (VAR) is an estimate of

the loss (in money terms) that we expect to be

exceeded with a given level of probability over a

specified time period.

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VALUE AT RISK: EXAMPLE

The VAR of a portfolio is $1.5 million for one

day with a probability of 0.05.

VAR as Minimum:

There is a 5 percent chance that the portfolio will lose

at least $1.5 million in a single day.

VAR as Maximum:

The probability is 95 percent that the portfolio will

loss no more than $1.5 million in a single day.

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MEASURING LIQUIDITY RISK

One traditional measure of liquidity risk is Bid-

Ask Spread (for actively traded securities).

A new technique to measure liquidity risk is a

Liquidity-Adjusted VAR.

It has been introduced as one of the implicit

assumption in risk management with VAR that

positions can be liquidated when they approach or

move outside pre-agreed limits.

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MEASURING CREDIT RISK

Credit risk is present when there is a positive

probability that one party owing money will

renege on the obligation.

Credit losses have three dimensions:

The likelihood of loss – a probabilistic concept

In every transaction, a given probability exists that the

counterparty will default.

Recovery

When default occurs, there is usually a portion of

investment that creditors are able to recover called recovery

rate

Associated amount of loss

This is the amount that is lost by the creditors after

appropriately assessing the magnitude of recovery.

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MEASURING CREDIT RISK

VAR is used to measure market risk; but VAR is

also used, albeit with greater difficulty, to

measure credit risk. This measure is called

Credit VAR or Default VAR.

Like ordinary VAR, it reflects the minimum loss

with a given probability during a period of time.

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MEASURING NON-FINANCIAL RISKS

Non-financial risks are intrinsically very difficult

to measure.

Some of them even can easily be thought of as not

measureable in any precise mathematical way. For

example: Regulatory risk, Accounting risk, Tax risk

and Legal risk

Until few years ago, idea of measuring of

operational risk was practically unheard of.

However, explicit mention of operational risk

requirement in the Basel II and III regulations has

created incentives for bank to think of some

techniques to measure operational risk.

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