READING 1 : THE NEED FOR RISK MANAGEMENT

Training For FRM Part 1 Program

Session By Ratan Gupta

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Risk and Sources of Risk

Risk can be defined as volatility of unexpected outcomes Sources of Risk Natural Man Made

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Types of Risk

Business Risk Risk that corporation assumes willingly to create competitive advantage. This results from business environment and decision.
Includes Macroeconomic and Strategy Risks

Financial Risk Possible Risk arising due to the firms financial market activity
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

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Significant Market Events

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.
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Function and Purpose of Financial Institutions

Acts as financial Intermediaries People trust these intermediaries => Lower the cost of financial transactions The institutions create instruments to manage risk Risk Advisory

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

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Derivatives and Leverage

Are instruments designed to manage financial risk efficiently Derives its value from some underlying asset like equity, bond, index, reference interest rate Zero Sum Game These instruments are leveraged Leverage is double-edged sword Derivatives Market is Very Big, many times the worlds GDP

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Financial Risk Management

Design and Implementation of Process For Risk Identification Measurement Management

VaR is one of the most important Risk Measurement Tool

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Value At Risk (VaR)

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.

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Other Risk Management Tools

Stop Loss Limit It Limits the loss in a position

Notional Limit Limit on the amount of investment

Exposure Limit Limit on the Risk Factor Delta in case of options Duration in case of Bonds

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Comparison of Risk Management Tools

Method (Across) Characteristics (Down) Type Calculation Explanation Aggregation

Stop Loss Ex-post Easy Easy Yes

Notional Ex-ante Easy Easy No

Exposure Ex-ante Difficult Difficult No

VaR Ex-ante Difficult Easy Yes

Watch out for the superiority of VaR over other methods

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Types of Financial Risk

Market Risk Liquidity Risk Credit Risk Operational Risk

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Type

Market Risk

Absolute Risk Relative Risk

Type - On the basis of market movement Directional Risk Non-Directional Risk Basis Risk Volatility Risk

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Liquidity Risk

Asset Risk or market/product Liquidity Risk Happens when transaction cant be conducted at the prevailing prices Put Limit on the exposure that the firm can have on illiquid assets Funding Risk or cash flow risk Unable to raise cash to meet financial obligation

Liquidity Risk has forced many firms to go out of business

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Types

Credit Risk

Default Risk Settlement Risk Sovereign Risk Credit Event Change in the ability of counterparty to perform obligation Exposure The amount which is at risk Recovery Rate Amount which is expected to be received in case of default Relationship between Market and Credit Risk
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Types

Operational Risk

Model Risk People Risk Internal or External Fraud

Legal Risk Regulatory Risk

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