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The Present and Future of Financial Risk Management

Rashmi Sharma
Faculty of Prestige Institute of Management,Dewas

Abstract:
Current research on financial risk management applications of econometrics
centers on the accurate assessment of individual market and credit risks with
relatively little theoretical or applied econometric research on other types of
risk, aggregation risk, data incompleteness, and optimal risk control. We
argue that consideration of the model risk arising from crude aggregation
rules and inadequate data could lead to a new class of reduced-form
Bayesian risk assessment models. Logically, these models should be set
within a common factor framework that allows proper risk aggregation
methods to be developed. We explain how such a framework could also
provide the essential links between risk control, risk assessments, and the
optimal allocation of resources.
Keywords:
Economic capital, financial risk assessment, optimal allocation of
resources, RAROC, risk control, regulatory capital

The Present and Future of Financial Risk Management


Introduction
Financial risk management is the practice of creating economic value in a firm by using
financial instruments to manage exposure to risk, particularly Credit risk and market risk.
Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation
risks, etc. Similar to general risk management, financial risk management requires
identifying its sources, measuring it, and plans to address them. As a specialization of
risk management, financial risk management focuses on when and how to hedge using
financial instruments to manage costly exposures to risk.
In the banking sector worldwide, the Basel Accords are generally adopted by
internationally active banks for tracking, reporting and exposing operational, credit and
market risks.

When to use financial risk management


Finance theory (i.e., financial economics) prescribes that a firm should take on a project
when it increases shareholder value. Finance theory also shows that firm managers
cannot create value for shareholders, also called its investors, by taking on projects that
shareholders could do for themselves at the same cost. When applied to financial risk
management, this implies that firm managers should not hedge risks that investors can
hedge for themselves at the same cost. This notion is captured by the hedging irrelevance
proposition: In a perfect market, the firm cannot create value by hedging a risk when the
price of bearing that risk within the firm is the same as the price of bearing it outside of
the firm. In practice, financial markets are not likely to be perfect markets. This suggests
that firm managers likely have many opportunities to create value for shareholders using
financial risk management. The trick is to determine which risks are cheaper for the firm
to manage than the shareholders. A general rule of thumb, however, is that market risks
that result in unique risks for the firm are the best candidates for financial risk
management.

Financial instrument

Financial instruments are cash, evidence of an ownership interest in an entity, or a


contractual right to receive, or deliver, cash or another financial instrument

Categorization
Financial instruments can be categorized by form depending on whether they are cash
instruments or derivative instruments:
• Cash instruments are financial instruments whose value is determined directly
by markets. They can be divided into securities, which are readily transferable,
and other cash instruments such as loans and deposits, where both borrower and
lender have to agree on a transfer.
• Derivative instruments are financial instruments which derive their value from
the value and characteristics of one or more underlying assets. They can be
divided into exchange-traded derivatives and over-the-counter (OTC) derivatives.

Alternatively, financial instruments can be categorized by "asset class" depending on


whether they are equity based (reflecting ownership of the issuing entity) or debt based
(reflecting a loan the investor has made to the issuing entity). If it is debt, it can be further
categorised into short term (less than one year) or long term.

Foreign Exchange instruments and transactions are neither debt nor equity based and
belong in their own category

Matrix Table
Combining the above methods for categorization, the main instruments can be organized
into a matrix as follows:
Instrument Type
Asset Class Exchange-traded
Securities Other cash OTC derivatives
derivatives
Interest rate swaps
Interest rate caps
Debt (Long Bond futures
and floors
Term) Bonds Loans Options on bond
Interest rate
>1 year futures
options
Exotic instruments
Bills, e.g. T-
Debt (Short Deposits
Bills Short term interest Forward rate
Term) Certificates of
Commercial rate futures agreements
<=1 year deposit
paper
Stock options Stock options
Equity Stock N/A
Equity futures Exotic instruments
Foreign exchange
options
Foreign Spot foreign Outright forwards
N/A Currency futures
Exchange exchange Foreign exchange
swaps
Currency swaps
Some instruments defy categorization into the above matrix, for example repurchase
agreements.
Measuring Financial Instrument's Gain or Loss
The table below shows how to measure a financial instrument's gain or loss:
Instrument
Type Categories Measurement Gains and losses
Net income when asset is
Loans and derecognized or impaired (foreign
Assets Amortized costs
receivables exchange and impairment recognized
in net income immediately)
Available for Other comprehensive income
Deposit account -
Assets sale financial (impairment recognized in net income
Fair value
assets immediately)

Credit risk
Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of
credit (either the principal or interest (coupon) or both

Faced by lenders to consumers

Most lenders employ their own models (credit scorecards) to rank potential and existing
customers according to risk, and then apply appropriate strategies. With products such as
unsecured personal loans or mortgages, lenders charge a higher price for higher risk
customers and vice versa. With revolving products such as credit cards and overdrafts,
risk is controlled through careful setting of credit limits. Some products also require
security, most commonly in the form of property.

Faced by lenders to consumers

Most lenders employ their own models (credit scorecards) to rank potential and existing
customers according to risk, and then apply appropriate strategies. With products such as
unsecured personal loans or mortgages, lenders charge a higher price for higher risk
customers and vice versa. With revolving products such as credit cards and overdrafts,
risk is controlled through careful setting of credit limits. Some products also require
security, most commonly in the form of property.

Faced by lenders to business


Lenders will trade off the cost/benefits of a loan according to its risks and the interest
charged. But interest rates are not the only method to compensate for risk. Protective
covenants are written into loan agreements that allow the lender some controls. These
covenants may:
limit the borrower's ability to weaken their balance sheet voluntarily e.g., by buying back
shares, or paying dividends, or borrowing further.
allow for monitoring the debt requiring audits, and monthly reports
allow the lender to decide when he can recall the loan based on specific events or when
financial ratios like debt/equity, or interest coverage deteriorate.
A recent innovation to protect lenders and bond holders from the danger of default are
credit derivatives, most commonly in the form of a credit default swap. These financial
contracts allow companies to buy protection against defaults from a third party, the
protection seller. The protection seller receives a periodic fee (the credit spread) as
compensation for the risk it takes, and in return it agrees to buy the debt should a credit
event ("default") occur.

Faced by business
Companies carry credit risk when, for example, they do not demand up-front cash
payment for products or services. By delivering the product or service first and billing the
customer later - if it's a business customer the terms may be quoted as net 30 - the
company is carrying a risk between the delivery and payment.
Significant resources and sophisticated programs are used to analyze and manage risk.
Some companies run a credit risk department whose job is to assess the financial health
of their customers, and extend credit (or not) accordingly. They may use in house
programs to advise on avoiding, reducing and transferring risk. They also use third party
provided intelligence. Companies like Standard & Poor's, Moody's and Dun and
Bradstreet provide such information for a fee.
For example, a distributor selling its products to a troubled retailer may attempt to lessen
credit risk by tightening payment terms to "net 15", or by actually selling fewer products
on credit to the retailer, or even cutting off credit entirely, and demanding payment in
advance. Such strategies impact sales volume but reduce exposure to credit risk and
subsequent payment defaults.

Credit risk is not really manageable for very small companies (i.e., those with only one or
two customers). This makes these companies very vulnerable to defaults, or even
payment delays by their customers.
The use of a collection agency is not really a tool to manage credit risk; rather, it is an
extreme measure closer to a write down in that the creditor expects a below-agreed return
after the collection agency takes its share (if it is able to get anything at all).

Faced by individuals
Consumers may face credit risk in a direct form as depositors at banks or as
investors/lenders. They may also face credit risk when entering into standard commercial
transactions by providing a deposit to their counterparty, e.g. for a large purchase or a
real estate rental. Employees of any firm also depend on the firm's ability to pay wages,
and are exposed to the credit risk of their employer.
In some cases, governments recognize that an individual's capacity to evaluate credit risk
may be limited, and the risk may reduce economic efficiency; governments may enact
various legal measures or mechanisms with the intention of protecting consumers against
some of these risks. Bank deposits, notably, are insured in many countries (to some
maximum amount) for individuals, effectively limiting their credit risk to banks and
increasing their willingness to use the banking system.

Counterparty risk
Counterparty risk, otherwise known as default risk, is the risk that an organization does
not pay out on a credit derivative, credit default swap, credit insurance contract, or other
trade or transaction when it is supposed to. Even organizations who think that they have
hedged their bets by buying credit insurance of some sort still face the risk that the
insurer will be unable to pay, either due to temporary liquidity issues or longer term
systemic issues.
Large insurers are counterparties to many transactions, and thus this is the kind of risk
that prompts financial regulators to act, e.g. the bailout of insurer AIG.
On the methodological side, counterparty risk can be affected by wrong way risk, namely
the risk that different risk factors be correlated in the most harmful direction. Including
correlation between the portfolio risk factors and the counterparty default into the
methodology is not trivial, see for example Brigo and Pallavicini

Market risk
Market risk is the risk that the value of an investment will decrease due to moves in
market factors. The five standard market risk factors are:
• Equity risk, the risk that stock prices will change.
• Interest rate risk, the risk that interest rates will change.
• Currency risk, the risk that foreign exchange rates will change.
• Commodity risk, the risk that commodity prices (e.g. grains, metals) will change

Measuring
As with other forms of risk, market risk may be measured in a number of ways.
Traditionally, this is done using a Value at Risk methodology. Value at risk is well
established as a risk management technique, but it contains a number of limiting
assumptions that constrain its accuracy. The first assumption is that the composition of
the portfolio measured remains unchanged over the single period of the model. For short
time horizons, this limiting assumption is often regarded as acceptable. For longer time
horizons, many of the transactions in the portfolio may mature during the modeling
period. Intervening cash flow, embedded options, changes in floating rate interest rates,
and so on are ignored in this single period modeling technique.
Market risk can also be contrasted with specific risk, which measures the risk of a
decrease in

Use in annual reports of U.S. corporations


In the United States, a section on market risk is mandated by the SECin all annual reports
submitted on Form 10-K. The company must detail how its own results may depend
directly on financial markets. This is designed to show, for example, an investor who
believes he is investing in a normal milk company, that the company is in fact also
carrying out non-dairy activities such as investing in complex derivatives or foreign
exchange futures.

Risk management
All businesses take risks based on two factors: the probability an adverse circumstance
will come about and the cost of such adverse circumstance.

Risk management
The objective of risk management is to reduce different risks related to a preselected
domain to the level accepted by society. It may refer to numerous types of threats caused
by environment, technology, humans, organizations and politics. On the other hand it
involves all means available for humans, or in particular, for a risk management entity
(person, staff, organization). The main ISO standards on risk management include .
Risk management is a structured approach to managing uncertainty related to a threat, a
sequence of human activities including: risk assessment, strategies development to
manage it, and mitigation of risk using managerial resources.
The strategies include transferring the risk to another party, avoiding the risk, reducing
the negative effect of the risk, and accepting some or all of the consequences of a
particular risk.
Some traditional risk managements are focused on risks stemming from physical or legal
causes (e.g. natural disasters or fires, accidents, ergonomics, death and lawsuits).
Financial risk management, on the other hand, focuses on risks that can be managed
using traded financial instruments.
Basel Accord
The Basel Accord(s) or Basle Accord(s) (see spelling section below) refers to the
banking supervision Accords (recommendations on banking laws and regulations), Basel
I and Basel II issued by the Basel Committee on Banking Supervision (BCBS). They are
called the Basel Accords as the BCBS maintains its secretariat at the Bank of
International Settlements in Basel, Switzerland and the committee normally meets there.

The Basel Committee


The Basel Committee consists of representatives from central banks and regulatory
authorities of the Group of Ten (economic) countries, plus others (specifically
Luxembourg and Spain). The committee does not have the authority to enforce
recommendations, although most member countries (and others) tend to implement the
Committee's policies. This means that recommendations are enforced through national
(or EU-wide) laws and regulations, rather than as a result of the committee's
recommendations - thus some time may pass between recommendations and
implementation as law at the national level.

Spelling
The Basel Committee is named after the Swiss town of Basel. In early publications, the
committee sometimes used the English spelling "Basle" or the French spelling "Bâle,"
names that are sometimes still used in the press. More recently, the Committee has
deferred to the predominantly German population of the region and used the spelling
"Basel."

Conclusion

Banks and other industry participants are aggressively exploring


Techniques to better understand and manage conventional concentrations
of credit, as well as concentrations based on less obvious risk correlation’s.
In order to be successful, banks will need new types of information as
Well as new ways to analyze the data, including the ability to assess their
Relative position vis-à-vis industry competitors and peers. This Risk
Analysis Service issue, the second in a series, explains the way banks
Manage credit concentrations today. In the upcoming series, RMA and
AFS will mine industry middle market loan data to understand its
applicability in identifying potential correlations that can help banks
mitigate risk in credit concentrations.

References
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Faulkner. 0-85941-332-2.
• Charles, Tapiero (2004). Risk and Financial Management: Mathematical and
Computational Methods, John Wiley & Son. ISBN 0-470-84908-8.

• Lam, James (2003). Enterprise Risk Management: From Incentives to Controls, John
Wiley. ISBN-13 978-0471430001.

• van Deventer, Donald R., Kenji Imai and Mark Mesler (2004). Advanced Financial
Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate
Risk Management, John Wiley. ISBN-13: 978-0470821268.

• Principles for the management of credit risk from the Bank for International
Settlement

• Investopedia. Counterparty risk. Retrieved 2008-10-06

• Tom Henderson. Counterparty Risk and the Subprime Fiasco. 2008-01-02. Retrieved
2008-10-06

• Brigo, Damiano and Andrea Pallavicini (2007). Counterparty Risk under Correlation
between Default and Interest Rates. In: Miller, J., Edelman, D., and Appleby, J.
(Editors), Numerical Methods for Finance, Chapman Hall. ISBN
158488925X.Related SSRN Research Paper

• Bluhm, Christian, Ludger Overbeck, and Christoph Wagner (2002). An Introduction


to Credit Risk Modeling, Chapman & Hall/CRC. ISBN 978-1584883265.

• Damiano Brigo and Massimo Masetti (2006). Risk Neutral Pricing of Counterparty
Risk, in: Pykhtin, M. (Editor), Counterparty Credit Risk Modeling: Risk
Management, Pricing and Regulation, Risk Books. ISBN 1-904339-76-X.

• de Servigny, Arnaud and Olivier Renault (2004). The Standard & Poor's Guide to
Measuring and Managing Credit Risk, McGraw-Hill. ISBN 978-0071417556.

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and Management, Princeton University Press. ISBN 978-0691090467.

• FAQ on the United States SEC Market Disclosure Rules

• http://www.bis.org: The site of the Bank of International Settlements.

• http://bis2information.org: Practical articles, on BIS2 and risk modelling, submitted


by professionals to help create an industry standard.