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EXECUTIVE SUMMARY
Financial risk management constitutes a very important role in corporate financial system, financing is the crucial function of providing an exploration of the corporate. The globalization of the Indian economy brought about significant changes in the Indian financial sector and has grown unexpectedly.
In this there is very high risk if the company shut down because the promoter and investor do not get fixed rate of return on their investment. Today many jobs are available in the finance institution for this purpose candidate shall complete courses like, chartered financial analysis (CFA), chartered financial planner (CFP), and chartered accountant (CA). It is necessary for firm to forecast and analyzing financial risk involved in the corporate sector.
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METHODOLOGY
The study is based on the secondary data, most of information is collected from the internet, books, journals, etc, on the financial risk management.
The data collected from various sources has been organized and framed as project report which can be to anyone who needs basic information about financial risk management.
There are many ways of managing financial risk of the firm but to knowing how to analyze and management of risk related to financial.
One should know the process and norms of the financial risk management.
People required to use intelligently their skills and knowledge related to financial risk management.
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Study will helpful in analyzing and maintaining risk involved in financial activities of the firm.
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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. The concepts of financial risk management change dramatically in the international realm. Multinational Corporations are faced with many different obstacles in overcoming these challenges. There has been some transactions exposure, accounting exposure, and economic exposure.
INTRODUCTION
Risk Management is the process of managing the risks involved in various activities. It is, in fact, a rapidly developing discipline which applies to any activity whether short or long term (IRM, AIRMIC, and ALARM, 2002: 1). Risk Management is being increasingly implemented in various disciplines, organizations and industries to minimize negative impacts and form a sound basis in decision making (Stoneburner, Goguen, and Feringa, 2002). Translation practice and industry, however, seems to be rather uninformed of the potentials Risk Management has to offer to it. This article, in fact, tries to develop the idea of risk management in translation and design a proper risk management plan for translation practice and industry based on ISO/DIS 31000 (2009) and the Risk Management Standard (2002) which is the result of the cooperation among the Institute of Risk Management
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(IRM), the Association of Insurance and Risk Managers (AIRMIC) and ALARM the National Forum for Risk Management in the Public Sector. It is also worth mentioning that the current article is in fact an excerpt from the author's undergoing PhD research.
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before they can gain some experience to come up with a proper scheme. That is all because, they have not been taught how to deal with decision making situations and risks involved in translation practice and industry during theireducation. Perhaps it is better to say, there has been no risk management guideline, scheme, or policy in the first place to be incorporated into translator training programs. It can be claimed that the process of risk management has always been there in translation practice and industry in the sense that translators and project managers in translation companies have always been subconsciously trying to control the risks pertinent to their activities. This is in fact what Pym has been trying to prove by interpreting the results of other researchers investigations in terms of risk management (Pym 2007; 2008).
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being well received by the society, etc. Therefore, reward can be defined as what the role players in translation practice and industry expect to achieve from doing their activities. It is also worth mentioning that rewards can fall under various categories, three of which have been pointed out by Pym (2008) as financial, symbolic or social. As you can see, success is mostly mutual, meaning that you benefit from your work if your recipients who can be your manager, your client, or the public are satisfied with your Risk in translation practice and industry, is better realized when in correlation with success. Therefore, risk would be the potential for events, decisions and consequences in translation practice and industry which constitute opportunities or threats to success. Risk itself can be divided into three categories of low,medium and high based on the probability or frequency of occurrence and the impact of occurrence. Also factors resulting in risks or drivers of risks (IRM et al, 2002) can be internal or external to translation activity or a mixture of both. There are five major risks which role players in translation practice and industry have to constantly deal with considering the types of activities they are engaged in: market risks, financial risks, project risks, production process risks, and product risks.
Market risks
Can be defined as those risks in the market which can positively or negatively affect the translation practice and industry and include among others market fluctuations and rivals.
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Financial risks
Are those risks which can affect the profitability of translation activity or translation companies in a positive or negative way. One example can be the current ups and downs in foreign exchange rates which may cause freelance translators and translation companies to revise the foreign currencies they accept either to benefit from what may appear to them as opportunity or prevent loss.
Project risks
Refer to the risks each new project brings with it which can affect the profitability of the translation activity or company, the production process and the final product of translation activity in a positive or negative way. Project risks include those risks regarding the clients reliability, project difficulty, software needed for the project, word count, deadline, human resources and the like. It might be argued that the remaining two categories can fall under the project risks category; however as you will see, due to their importance and different nature, production process risks and product risks have each formed a category, quite separate from the project risks category. By production process, the author is referring to the actual act of translation; thus,
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product risks
Are those risks which can positively or negatively affect the success of the final product of the translation process. Risks related to the acceptability, formatting and DTP issues of the translation product can be categorized under the product related risks.
From the definitions provided above, we can categorize market, financial, and project risks as externally driven risks and production process and product risks as internally driven risks. It is important to note that according to the definitions provided above, risks are not always considered as threats and they may ultimately constitute an opportunity for benefit and success. Furthermore, as you can see these risks can be interrelated and the occurrence of one can intensify the occurrence and impact of another.
RISK ASSESSMENT
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Risk Assessment is defined by the ISO/IEC Guide 73 as the overall process of risk analysis and risk evaluation.
RISK ANALYSIS
According to ISO/DIS 31000 (2009), Risk analysis is performed through: Risk Identification Risk Description Risk Estimation Risk Identification helps the role players in translation practice and industry find out their exposure to uncertainty (IRM et al, 2002: 5). To successfully identify possible risks, role players need to have professional knowledge of their job, be aware of the market condition and requirements, and know the legal, social, political and cultural environment in which they are working. Risk Description is meant to display the identified risks in translation practice and industry in a structured format which explains the name, scope, nature, and significance of the risk along with the role player's risk tolerance and control mechanism. Finally, Risk Estimation is made in terms of the probability of occurrence and the possible consequence of the risks in translation practice and industry. Role players need to use the result of the risk analysis process to produce a risk profile which gives a significance rating to each risk and provides a tool for prioritizing risk treatment efforts.
RISK EVALUATION
Risk evaluation is used to make decisions about the significance of risks to translation practice and industry and whether each specific risk should be accepted or treated. The decision needs to be made based on the risk criteria which can include associated costs and benefits, and legal requirements of dealing with each risk.
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RISK TREATMENT
According to IRM et al (ibid), risk treatment is the process of selecting and implementing measures to modify the risk. An important fact role players in translation practice and industry need to keep in mind is that risk treatment actions must be financially justifiable, meaning that they must be cost effective. Risk treatment actions in translation practice and industry need to be prioritized in terms of their potential to success and reward achievement and as mentioned earlier, they must be concerned with both positive and negative aspects of risk. Pym (2008, p. 20) has acknowledged the importance of such an approach in his law like formulation about how translators translate: Translators will tend to avoid risk by standardizing language and/or channeling interference, if and when there are no rewards for them to do otherwise. Four major strategies role players can implement in order to successfully manage risks in the translation practice and industry, are explained below with an example for each of them.
Risk Avoidance (avoiding or eliminating the risk): e.g. during the process of translation, you come across a complex sentence and there is the fear that some part of the meaning implicit in the original text might be lost or the reader would not be able to understand the meaning if the
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sentence is translated as a complex sentence. Therefore, you decide to avoid the risk by breaking the original sentence and translating it into a compound sentence. One possible reward: avoiding misunderstanding, or achieving communication! What explained is called explicitation according to Baker (1996, p.180) and is one of Bakers proposed universals. However, bear in mind that explicitation is not exclusive to risk avoidance and may be used as a risk reduction strategy in another context.
Risk Reduction/Mitigation (reducing or mitigating the risk): e.g. while translating, you come across a term which does not have any equivalence in the target language and its translation turns into an awkward phrase. To reduce the risk of miscommunication, you may resort to transliteration. One possible reward: achieving communication! Risk Transfer (outsourcing or transferring the risk): e.g. you have translated a book but you are not sure about the market response and dont want to budget for the publication. Therefore you would try to transfer the risk by managing to convince a publication company to publish the translation and pay for the publication expenses and in return you revoke your request for royalty. One possible reward: you get published!
Risk Retention (accepting the risk and budgeting for it): e.g. the publication company you work with, does not accept to pay for the publication of a book you have chosen to translate or have already translated; however for some reason, you are determined to translate and
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publish the book and decide to take the risk and pay for the publication expenses. One possible reward: self satisfaction perhaps! Also you get published!) These strategies can be used separately or in combination based on the freelance translators and translation companies risk management plan.
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translation job. After checking issues such as client reliability, job difficulty, word count, and deadline of the project, the project manager is now considering the rate suggested by the client. The following table represents the project description:
client, reliable Bus manual Translation Difficult; Technical 30000 words Tight; 10 days SDL Trados Not provided 0.06 USD per word
Companys ideal rate for such job 0.08 USD per word
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Credit risk
is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk. Investor losses include lost principal and interest, decreased cash flow, and increased collection costs, which arise in a number of circumstances:
A consumer does not make a payment due on a mortgage loan, credit card, line of credit, or other loan
A business does not make a payment due on a mortgage, credit card, line of credit, or other loan
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A business or consumer does not pay a trade invoice when due A business does not pay an employee's earned wages when due A business or government bond issuer does not make a payment on a coupon or principal payment when due
An insolvent insurance company does not pay a policy obligation An insolvent bank won't return funds to a depositor A government grants bankruptcy protection to an insolvent consumer or business.
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that financial risk management will come in the same. Risk management is certainly a good manner to save companies asset & keep distance from liabilities. But financial risk management is not a big part of risk management. Yes some how it's related I can not push aside. Finance theory provides that a middle level company should take a project when shareholder value will increase. And it has been also seen that share holders value creates by business manager, which is also known as investors when you are applying your thoughts for optimizing financial risk management means, business managers should not prevaricate risks those investors can protect them the same cost. This impression is captured by the coverage irrelevance suggestion: In market, the company can create value by covering a risk when the price of abiding that risk within the enterprise is the same as the price of carrying out the company. Now the etiquette of financial risk management is getting changed world wide. Some where financial risk management is related to enterprise risk management (ERM) that is the extent of financial risk management, in a sense, the financing contingency. This concept is somewhere elusive that has different meanings to different people. Companies have experimented with the concept, which combines financial risk management, contingency plans and purchasing insurance in a single business unit. But some expertise professionals are there who can maintain both.
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Financial risk management is applied in different ways if you see organizationally. In the board, there may be a risk committee. Usually there has some kind of risk committee composed of senior managers. In practice, several names are given to these two committees. Just like CRO (chief risk officer) and HRM (Head of the risk management). These designation looks into the risk management. They look into the financial risk management which includes credit risks, operational risks, and market risks. The financial world requires professionals with strong analytical & mathematical skills basically this is the combination of finance with mathematics, economics, accountancy, and risk management. Prepare you for a career in investment management and risk management. You can choose one of two specializations: Risk Management Professional and Chartered Financial Analysis.
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Market Risk Credit Risk Liquidity Risk Operational Risk reputation risk
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County Risk
Now how will you manage financial risk? Here you will find five ways to manage financial risk:
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Yes, Insurance is right way to manage your finance. You will see that there is very less percentages that have got the right amount of insurance. Many people takes an enormous risk of not having auto insurance coverage, while many more are jumping out in medical insurance, health insurance or any major coverage. Unfortunately, sometimes to cover the premiums there is not enough in the budget. But if you can afford it, do be sure to keep policies should be up to date and adequate for their circumstances.
When I read about the problems of workers in the auto industry, I can understand about the importance of developing multiple way of income. My best advice is that invest your money as earliest possible to start working for you. You should about your money that its source of another income generator, other ways to create new revenue Here is some evidence that demonstrates that diversification of the stock market works and is the best way to balance the overall portfolio risk.
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Always try to keep your savings under FDCI limits, and remember that if your bank gets folded then you can lost your money as your banker will give you guarantee up to certain FDIC limits.
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like the volatility, the currency market, the way the sector, inflation risks, liquidity and other things. This is often compared with measures of overall risk, requiring the company to identify sources that can measure and then to address these issues.
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The measures of financial risk, it may be quantitative or qualitative. With the financial risk management, which focuses on the methods and the exact time frame in which a company must be covered by existing financial instruments? In this way, they can minimize their attention on the risks especially costly. In general, measures of financial risk used by banks and major financial institutions. The choice of a large system of risk management will help banks track, report and expose the operation, market risk and credit. With this advantage, we can identify things that have to deal with so that to avoid risks in financial matters.
When you're in any company and you have to deal with financial risk measures, you should know when to use this system. It is important to remember that the states of the theory of finance, i.e. financial economics that a company must have a project in which most increases shareholder value. That said, finance troy shows that managers in a particular company will not be able to create value for investors when they take the projects that shareholders may be made at a similar cost.
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To better understand, you can apply theory to manage financial risk. Here it is assumed that managers should not hedge risks that investors can be twisted for them. Yes, financial markets are not perfect. They have their own shortcomings as well as other markets and businesses worldwide. However, financial risk management for administrators will be able to have more opportunities for them to create better shareholder value.
The main key is to determine is that among the risks are less costly to the company shareholders. However, one must always take into account market risks that may result in different and unique risks. With this, we can conclude that the best candidates for financial risk measurement. Financial risk management should include the reduction of hazards through the use of safety and quality control. There should also be risk financing alternatives that may include captive and auto insurance.
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setting of credit limits. Some products also require security, most commonly in the form of property. Credit scoring models also form part of the framework used by banks or lending institutions grant credit to clients. For corporate and commercial borrowers, these models generally have qualitative and quantitative sections outlining various aspects of the risk including, but not limited to, operating experience, management expertise, asset quality, and leverage and liquidity ratios, respectively. Once this information has been fully reviewed by credit officers and credit committees, the lender provides the funds subject to the terms and conditions presented within the contract (as outlined above). Credit risk has been shown to be particularly large and particularly damaging for very large investment projects, so-called megaprojects. This is because such projects are especially prone to end up in what has been called the "debt trap," i.e., a situation where due to cost overruns, schedule delays, etc. the costs of servicing debt becomes larger than the revenues available to pay interest on and bring down the debt.
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Sovereign risk
Sovereign risk is the risk of a government becoming unwilling or unable to meet its loan obligations, or reneging on loans it guarantees. The existence of sovereign risk means that creditors should take a two-stage decision process when deciding to lend to a firm based in a foreign country. Firstly one should consider the sovereign risk quality of the country and then consider the firm's credit quality. Five macroeconomic variables that affect the probability of sovereign debt rescheduling are:
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Domestic money supply growth The probability of rescheduling is an increasing function of debt service ratio, import ratio, variance of export revenue and domestic money supply growth. Frenkel, Karmann and Scholtens also argue that the likelihood of rescheduling is a decreasing function of investment ratio due to future economic productivity gains. Saunders argues that rescheduling can become more likely if the investment ratio rises as the foreign country could become less dependent on its external creditors and so be less concerned about receiving credit from these countries/investors.
Counterparty risk
Counterparty risk, known as default risk, is the risk that an organization does not pay out on a bond, credit derivative, 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.
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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. A good introduction can be found in a paper by Michael Pykhtin and Steven Zhu.
Risk-based pricing: Lenders generally charge a higher interest rate to borrowers who are more likely to default, a practice called risk-based pricing. Lenders consider factors relating to the loan such as loan
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purpose, credit rating, and loan-to-value ratio and estimates the effect on yield (credit spread).
Covenants: Lenders may write stipulations on the borrower, called covenants, into loan agreements:
Refrain from paying dividends, repurchasing shares, borrowing further, or other specific, voluntary actions that negatively affect the company's financial position
Repay the loan in full, at the lender's request, in certain events such as changes in the borrower's debt-to-equity ratio or interest coverage ratio
Credit insurance and credit derivatives: Lenders and bond holders may hedge their credit risk by purchasing credit insurance or credit derivatives. These contracts transfer the risk from the lender to the seller (insurer) in exchange for payment. The most common credit derivative is the credit default swap.
Tightening: Lenders can reduce credit risk by reducing the amount of credit extended, either in total or to certain borrowers. For example, a
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distributor selling its products to a troubled retailer may attempt to lessen credit risk by reducing payment terms from net 30 to net 15.
Diversification: Lenders to a small number of borrowers (or kinds of borrower) face a high degree of unsystematic credit risk, called concentration risk. Lenders reduce this risk by diversifying the borrower pool.
Deposit insurance: Many governments establish deposit insurance to guarantee bank deposits of insolvent banks. Such protection discourages consumers from withdrawing money when a bank is becoming insolvent, to avoid a bank run, and encourages consumers to hold their savings in the banking system instead of in cash.
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EAD Exposure at default EL Expected loss ERM Enterprise risk management LGD Loss given default PD Probability of default KMV quantitative credit analysis solution acquired by credit rating agency Moody's PAR Portfolio at Risk
As with other forms of risk, the potential loss amount due to market risk may be measured in a number of ways or conventions. Traditionally, one convention is
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to use Value at Risk. The conventions of using Value at risk is well established and accepted in the short-term risk management practice. However, 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 specified period. Over short time horizons, this limiting assumption is often regarded as reasonable. However, over longer time horizons, many of the positions in the portfolio may have been changed. The Value at Risk of the unchanged portfolio is no longer relevant. The Variance Covariance and Historical Simulation approach to calculating Value at Risk also assumes that historical correlations are stable and will not change in the future or breakdown under times of market stress. In addition, care has to be taken regarding the intervening cash flow, embedded options, changes in floating rate interest rates of the financial positions in the portfolio. They cannot be ignored if their impact can be large.
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Funding liquidity - Risk that liabilities: Cannot be met when they fall due Can only be met at an uneconomic price Can be name-specific or systemic
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lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity. Liquidity risk tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty that owes it a payment defaults, the firm will have to raise cash from other sources to make its payment. Should it be unable to do so, it too will default. Here, liquidity risk is compounding credit risk. A position can be hedged against market risk but still entail liquidity risk. This is true in the above credit risk examplethe two payments are offsetting, so they entail credit risk but not market risk. Another example is the 1993 Metallgesellschaft debacle. Futures contracts were used to hedge an Over-thecounter finance OTC obligation. It is debatable whether the hedge was effective from a market risk standpoint, but it was the liquidity crisis caused by staggering margin calls on the futures that forced Metallgesellschaft to unwind the positions. Accordingly, liquidity risk has to be managed in addition to market, credit and other risks. Because of its tendency to compound other risks, it is difficult or impossible to isolate liquidity risk. In all but the most simple of circumstances,
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comprehensive metrics of liquidity risk do not exist. Certain techniques of asset-liability management can be applied to assessing liquidity risk. A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis. Any day that has a sizeable negative net cash flow is of concern. Such an analysis can be supplemented with stress testing. Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults. Analyses such as these cannot easily take into account contingent cash flows, such as cash flows from derivatives or mortgage-backed securities. If an organization's cash flows are largely contingent, liquidity risk may be assessed using some form of scenario analysis. A general approach using scenario analysis might entail the following high-level steps: Construct multiple scenarios for market movements and defaults over a given period of time Assess day-to-day cash flows under each scenario. Because balance sheets differ so significantly from one organization to the next, there is little standardization in how such analyses are implemented. Regulators are primarily concerned about systemic and implications of liquidity risk.
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Immediacy
Immediacy refers to the time needed to successfully trade a certain amount of an asset at a prescribed cost.
Resilience
Hachmeister identifies the fourth dimension of liquidity as the speed with which prices return to former levels after a large transaction. Unlike the other measures resilience can only be determined over a period of time.
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Liquidity at risk Greenspan (1999) discusses management of foreign exchange reserves. The Liquidity at risk measure is suggested. A country's liquidity position under a range of possible outcomes for relevant financial variables (exchange rates, commodity prices, credit spreads, etc.) is considered. It might be possible to express a standard in terms of the probabilities of different outcomes. For example, an acceptable debt structure could have an average maturityaveraged over estimated distributions for relevant financial variablesin excess of a certain limit. In addition, countries could be expected to hold sufficient liquid reserves to ensure that they could avoid new
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borrowing for one year with a certain ex ante probability, such as 95 percent of the time. Scenario analysis-based contingency plans
The FDIC discuss liquidity risk management and write "Contingency funding plans should incorporate events that could rapidly affect an institutions liquidity, including a sudden inability to securitize assets, tightening of collateral requirements or other restrictive terms associated with secured borrowings, or the loss of a large depositor or counterparty.". Greenspan's liquidity at risk concept is an example of scenario based liquidity risk management.
Derivatives
Bhaduri, Meissner and Youn discuss five derivatives created specifically for hedging liquidity risk.: Withdrawal option: A put of the illiquid underlying at the market price. Bermudan-style return put option: Right to put the option at a specified strike.
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Return swap: Swap the underlying's return for LIBOR paid periodicially. Return swaption: Option to enter into the return swap. Liquidity option: "Knock-in" barrier option, where the barrier is a liquidity metric.
Case Studies
Amaranth Advisors LLC 2006
Amaranth Advisors lost roughly $6bn in the natural gas futures market back in September 2006. Amaranth had a concentrated, undiversified position in its natural gas strategy. The trader had used leverage to build a very large position. Amaranths positions were staggeringly large, representing around 10% of the global market in natural gas futures. Chincarini notes that firms need to manage liquidity risk explicitly. The inability to sell a futures contract at or near the latest quoted price is related to ones concentration in the security. In Amaranths case, the concentration was far too high and there were no natural counterparties when they needed to unwind the positions. Chincarini (2006) argues that part of the loss Amaranth incurred was due to asset illiquidity. Regression analysis on the 3 week return on natural gas future contracts from
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August 31, 2006 to September 21, 2006 against the excess open interest suggested that contracts whose open interest was much higher on August 31, 2006 than the historical normalized value, experienced larger negative returns.
LTCM - 1998
Long-Term Capital Management (LTCM) was bailed out by a consortium of 14 banks in 1998 after being caught in a cash-flow crisis when economic shocks resulted in excessive mark-to-market losses and margin calls. The fund suffered from a combination of funding and asset liquidity. Asset liquidity arose from LTCM failure to account for liquidity becoming more valuable (as it did following the crisis) . Since much of its balance sheet was exposed to liquidity risk premium its short positions would increase in price relative to its long positions. This was essentially a massive, unhedged exposure to a single risk
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factor.LTCM had been aware of funding liquidity risk. Indeed, they estimated that in times of severe stress, haircuts on AAA-rated commercial mortgages would increase from 2% to 10%, and similarly for other securitiles. In response to this, LTCM had negotiated long-term financing with margins fixed for several weeks on many of their collateralized loans. Due to an escalating liquidity spiral, LTCM could ultimately not fund its positions in spite of its numerous measures to control funding risk.
Operational risk
An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates. It also includes other categories such as fraud risks, legal risks, physical or environmental risks. A widely used definition of operational risk is the one contained in the Basel II regulations. This definition states that operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. The approach to managing operational risk differs from that applied to other types of risk, because it is not used to generate profit. In contrast, credit risk is exploited by lending institutions to create profit, market risk is exploited by traders and fund managers, and insurance risk is exploited by insurers. They all however manage operational risk to keep losses within their risk appetite - the
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amount of risk they are prepared to accept in pursuit of their objectives. What this means in practical terms is that organisations accept that their people, processes and systems are imperfect, and that losses will arise from errors and ineffective operations. The size of the loss they are prepared to accept, because the cost of correcting the errors or improving the systems is disproportionate to the benefit they will receive, determines their appetite for operational risk. Determining appetite for operational risk is a discipline which is still in its infancy. Some of the issues and considerations around this process are outlined in this Sound Practice paper published by the Institute for Operational Risk in December 2009.
Background
Since the mid-1990s, the topics of market risk and credit risk have been the subject of much debate and research, with the result that financial institutions have made significant progress in the identification, measurement and management of both these forms of risk. However, it is worth mentioning that the near collapse of the U.S. financial system in September 2008 is a clear indication that our ability to measure market and credit risk is far from perfect. Globalization and deregulation in financial markets, combined with increased sophistication in financial technology, have introduced more complexities into the activities of banks and therefore their risk profiles. These reasons underscore banks' and supervisors' growing focus upon the identification and measurement of operational risk.
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Events such as the September 11 terrorist attacks, rogue trading losses at Socit Gnrale, Barings, AIB and National Australia Bank serve to highlight the fact that the scope of risk management extends beyond merely market and credit risk. The list of risks (and, more importantly, the scale of these risks) faced by banks today includes fraud, system failures, terrorism and employee compensation claims. These types of risk are generally classified under the term 'operational risk'.
Definition
The Basel Committee defines operational risk as:
"The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events." However, the Basel Committee recognizes that operational risk is a term that has a variety of meanings and therefore, for internal purposes, banks are permitted to adopt their own definitions of operational risk, provided that the minimum elements in the Committee's definition are included.
Scope exclusions
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The Basel II definition of operational risk excludes, for example, strategic risk the risk of a loss arising from a poor strategic business decision. Other risk terms are seen as potential consequences of operational risk events. For example, reputational risk (damage to an organization through loss of its reputation or standing) can arise as a consequence (or impact) of operational failures - as well as from other events.
Internal Fraud - misappropriation of assets, tax evasion, intentional mismarking of positions, bribery
2. External Fraud- theft of information, hacking damage, third-party theft and forgery 3. Employment Practices and Workplace Safety - discrimination, workers compensation, employee health and safety
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4. Clients, Products, & Business Practice- market manipulation, antitrust, improper trade, product defects, fiduciary breaches, account churning 5. Damage to Physical Assets - natural disasters, terrorism, vandalism 6. Business Disruption & Systems Failures - utility disruptions, software failures, hardware failures
7.
Execution, Delivery, & Process Management - data entry errors, accounting errors, failed mandatory reporting, negligent loss of client assets.
Difficulties
It is relatively straightforward for an organization to set and observe specific, measurable levels of market risk and credit risk because models exist which attempt to predict the potential impact of market movements, or changes in the cost of credit. It should be noted however that these models are only as good as the underlying assumptions, and a large part of the recent financial crisis arose because the valuations generated by these models for particular types of investments were based on incorrect assumptions.
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By contrast it is relatively difficult to identify or assess levels of operational risk and its many sources. Historically organizations have accepted operational risk as an unavoidable cost of doing business. Many now though collect data on operational losses - for example through system failure or fraud - and are using this data to model operational risk and to calculate a capital reserve against future operational losses. In addition to the Basel II requirement for banks, this is now a requirement for European insurance firms who are in the process of implementing Solvency II, the equivalent of Basel II for the banking sector.
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based on annual revenue of each of the broad business lines of the Financial Institution Advanced Measurement Approaches based on the internally developed risk measurement framework of the bank adhering to the standards prescribed (methods include IMA, LDA, Scenariobased, Scorecard etc.) The Operational Risk Management framework should include identification, measurement, monitoring, reporting, control and mitigation frameworks for Operational Risk.
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Many large financial intermediary firms use risk modeling to help portfolio managers assess the amount of capital reserves to maintain, and to help guide their purchases and sales of various classes of financial assets. Formal risk modeling is required under the Basel II proposal for all the major international banking institutions by the various national depository institution regulators. In the past, risk analysis was done qualitatively but now with the advent of powerful computing software, quantitative risk analysis can be done quickly and effortlessly. Modeling the changes by distributions with finite variance is now known to be inappropriate. Benot Mandelbrot found in the 1960s that changes in prices in financial markets do not follow a Gaussian distribution, but are rather modeled better by Lvy stable distributions. The scale of change, or volatility, depends on the length of the time interval to a power a bit more than 1/2.
Diversification
In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituents. Therefore, any risk-averse investor will diversify to at least some extent, with more risk-averse investors diversifying more completely than less risk-averse investors.
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Diversification is one of two general techniques for reducing investment risk. The other is hedging. Diversification relies on the lack of a tight positive relationship among the assets' returns, and works even when correlations are near zero or somewhat positive. Hedging relies on negative correlation among assets, or shorting assets with positive correlation. It is important to remember that diversification only works because investment in each individual asset is reduced. If someone starts with $10,000 in one stock and then puts $10,000 in another stock, they would have more risk, not less. Diversification would require the sale of $5,000 of the first stock to be put into the second. There would then be less risk. Hedging, by contrast, reduces risk without selling any of the original position.[2] The risk reduction from diversification does not mean anyone else has to take more risk. If person A owns $10,000 of one stock and person B owns $10,000 of another, both A and B will reduce their risk if they exchange $5,000 of the two stocks, so each now has a more diversified portfolio.
Examples
The simplest example of diversification is provided by the proverb "don't put all your eggs in one basket". Dropping the basket will break all the eggs. Placing each egg in a different basket is more diversified. There is more risk of losing one egg, but less risk of losing all of them. In finance, an example of an undiversified portfolio is to hold only one stock. This is risky; it is not unusual
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for a single stock to go down 50% in one year. It is much less common for a portfolio of 20 stocks to go down that much, even if they are selected at random. If the stocks are selected from a variety of industries, company sizes and types (such as some growth stocks and some value stocks) it is still less likely. Further diversification can be obtained by investing in stocks from different countries, and in different asset classes such as bonds, real estate, private equity, infrastructure and commodities such as heating oil or gold. Since the mid-1970s, it has also been argued that geographic diversification would generate superior risk-adjusted returns for large institutional investors by reducing overall portfolio risk while capturing some of the higher rates of return offered by the emerging markets of Asia and Latin America.
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one does not know in advance which assets will perform better, this fact cannot be exploited in advance. The ex post return on a diversified portfolio can never exceed that of the top-performing investment, and indeed will always be lower than the highest return (unless all returns are ex post identical). Conversely, the diversified portfolio's return will always be higher than that of the worstperforming investment. So by diversifying, one loses the chance of having invested solely in the single asset that comes out best, but one also avoids having invested solely in the asset that comes out worst. That is the role of diversification: it narrows the range of possible outcomes. Diversification need not either help or hurt expected returns, unless the alternative non-diversified portfolio has a higher expected return.[7] But risk averse investors may find it beneficial to diversify into assets with lower expected returns, thereby lowering the expected return on the portfolio, when the risk-reduction benefit of doing so exceeds the cost in terms of diminished expected return.
Maximum diversification
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Given the advantages of diversification, many experts recommend maximum diversification, also known as buying the market portfolio. Unfortunately, identifying that portfolio is not straightforward. The earliest definition comes from the capital asset pricing model which argues the maximum diversification comes from buying a pro rata share of all available assets. This is the idea underlying index funds. One objection to that is it means avoiding investments like futures that exist in zero net supply. Another is that the portfolio is determined by what securities come to market, rather than underlying economic value. Finally, buying pro rata shares means that the portfolio overweights any assets that are overvalued, and underweights any assets that are undervalued. This line of argument leads to portfolios that are weighted according to some definition of economic footprint, such as total underlying assets or annual cash flow. Risk parity is an alternative idea. This weights assets in inverse proportion to risk, so the portfolio has equal risk in all asset classes. This is justified both on theoretical grounds, and with the pragmatic argument that future risk is much easier to forecast than either future market value or future economic footprint.
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. The variance-minimizing value of q is , which is strictly between 0 and 1. Using this value of q
in the expression for the variance of portfolio return gives the latter as , which is less than what it would be at either of the undiversified values q = 1 and q = 0 (which respectively give portfolio return variance of and ). Note that the favorable effect of diversification on
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In general, the presence of more assets in a portfolio leads to greater diversification benefits, as can be seen by considering portfolio variance as a function of n, the number of assets. For example, if all assets' returns are mutually uncorrelated and have identical variances , portfolio variance is
minimized by holding all assets in the equal proportions 1 / n.[10] Then the portfolio return's variance equals var[(1 / n)x1 + (1 / n)x2 + ... + (1 / n)xn] = = , which is monotonically decreasing in n.
The latter analysis can be adapted to show why adding uncorrelated risky assets to a portfolio,[11][12] thereby increasing the portfolio's size, is not diversification, which involves subdividing the portfolio among many smaller investments. In the case of adding investments, the portfolio's return is instead of (1 / n)x1 + (1 / n)x2 + ... + (1 / n)xn, and the variance of the portfolio return if the assets are uncorrelated is
which is increasing in n rather than decreasing. Thus, for example, when an insurance company adds more and more uncorrelated policies to its portfolio, this expansion does not itself represent diversificationthe diversification occurs in the spreading
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of the insurance company's risks over a large number of part-owners of the company.
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should not carry any extra expected return. Still other models do not accept this contention. An empirical example relating diversification to risk reduction In 1977 Elton and Gruber[14] worked out an empirical example of the gains from diversification. Their approach was to consider a population of 3290 securities available for possible inclusion in a portfolio, and to consider the average risk over all possible randomly chosen n-asset portfolios with equal amounts held in each included asset, for various values of n. Their results are summarized in the following table. It can be seen that most of the gains from diversification come for n30. Average Standard Deviation of Annual Ratio of Portfolio Standard Deviation to Standard Deviation of a
1 2 4
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6 8 10 20 30 40
Systematic risk
In finance, systematic risk, sometimes called market risk, aggregate risk, or undiversifiable risk, is the risk associated with aggregate market returns. By contrast, unsystematic risk, sometimes called specific risk, idiosyncratic risk, residual risk, or diversifiable risk, is the company-specific or industryspecific risk in a portfolio, which is uncorrelated with aggregate market returns. Unsystematic risk can be mitigated through diversification, and systematic risk can not be.[1]
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Systematic risk should not be confused with systemic risk, the risk of loss from some catastrophic event that collapses the entire financial system.
Example
For example, consider an individual investor who purchases $10,000 of stock in 10 biotechnology companies. If unforeseen events cause a catastrophic setback and one or two companies' stock prices drop, the investor incurs a loss. On the other hand, an investor who purchases $100,000 in a single biotechnology company would incur ten times the loss from such an event. The second investor's portfolio has more unsystematic risk than the diversified portfolio. Finally, if the setback were to affect the entire industry instead, the investors would incur similar losses, due to systematic risk.
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Systematic risk is essentially dependent on macroeconomic factors such as inflation, interest rates and so on. It may also derive from the structure and dynamics of the market.
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the asset, that is, on the covariance of the returns on the asset and the aggregate returns to the market. Lenders to small numbers of borrowers (or kinds of borrowers) face unsystematic risk of default. Their loss due to default is credit risk, the unsystematic portion of which is concentration risk.
Hedge
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of over-the-counter and derivative products, and futures contracts.
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Public futures markets were established in the 19th century[1] to allow transparent, standardized, and efficient hedging of agricultural commodity prices; they have since expanded to include futures contracts for hedging the values of energy, precious metals, foreign currency, and interest rate fluctuations.
Etymology
Hedging is the practice of taking a position in one market to offset and balance against the risk adopted by assuming a position in a contrary or opposing market or investment. The word hedge is from Old English hecg, originally any fence, living or artificial. The use of the word as a verb in the sense of "dodge, evade" is first recorded in the 1590s; that of insure oneself against loss, as in a bet, is from 1670s.
Examples
Agricultural commodity price hedging
A typical hedger might be a commercial farmer. The market values of wheat and other crops fluctuate constantly as supply and demand for them vary, with occasional large moves in either direction. Based on current prices and forecast
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levels at harvest time, the farmer might decide that planting wheat is a good idea one season, but the forecast prices are only that forecasts. Once the farmer plants wheat, he is committed to it for an entire growing season. If the actual price of wheat rises greatly between planting and harvest, the farmer stands to make a lot of unexpected money, but if the actual price drops by harvest time, he could be ruined. If at planting time the farmer sells a number of wheat futures contracts equivalent to his anticipated crop size, he effectively locks in the price of wheat at that time: the contract is an agreement to deliver a certain number of bushels of wheat to a specified place on a certain date in the future for a certain fixed price. The farmer has hedged his exposure to wheat prices; he no longer cares whether the current price rises or falls, because he is guaranteed a price by the contract. He no longer needs to worry about being ruined by a low wheat price at harvest time, but he also gives up the chance at making extra money from a high wheat price at harvest times.
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A stock trader believes that the stock price of Company A will rise over the next month, due to the company's new and efficient method of producing widgets. He wants to buy Company A shares to profit from their expected price increase. But Company A is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the Company A shares were underpriced, the trade would be a speculation. Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (number of shares price) of the shares of Company A's direct competitor, Company B. The first day the trader's portfolio is:
Long 1,000 shares of Company A at $1 each Short 500 shares of Company B at $2 each
(Notice that the trader has sold short the same value of shares) If the trader was able to short sell an asset whose price had a mathematically defined relation with Company A's stock price (for example a put option on Company A shares), the trade might be essentially riskless. In this case, the risk would be limited to the put option's premium. On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. Company A, however, because it is a stronger company, increases by 10%, while Company B increases by just 5%: Long 1,000 shares of Company A at $1.10 each: $100 gain
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Short 500 shares of Company B at $2.10 each: $50 loss (In a short position, the investor loses money when the price goes up.) The trader might regret the hedge on day two, since it reduced the profits on the Company A position. But on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash: 50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since Company A is the better company, it suffers less than Company B: Value of long position (Company A): Day 1: $1,000 Day 2: $1,100 Day 3: $550 => ($1,000 $550) = $450 loss Value of short position (Company B): Day 1: $1,000 Day 2: $1,050 Day 3: $525 => ($1,000 $525) = $475 profit Without the hedge, the trader would have lost $450 (or $900 if the trader took the $1,000 he has used in short selling Company B's shares to buy Company A's shares as well). But the hedge the short sale of Company B gives a profit of $475, for a net profit of $25 during a dramatic market collapse.
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Types of hedging
Hedging can be used in many different ways including foreign exchange trading.[3] The stock example above is a "classic" sort of hedge, known in the industry as a pairs trade due to the trading on a pair of related securities. As investors became more sophisticated, along with the mathematical tools used to calculate values (known as models), the types of hedges have increased greatly. Hedging strategies Examples of hedging include: Forward exchange contract for currencies Currency future contracts Money Market Operations for currencies Forward Exchange Contract for interest Money Market Operations for interest Future contracts for interest This is a list of hedging strategies, grouped by category. Financial derivatives such as call and put options
Risk reversal: Simultaneously buying a call option and selling a put option. This has the effect of simulating being long on a stock or commodity position.
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Delta neutral: This is a market neutral position that allows a portfolio to maintain a positive cash flow by dynamically re-hedging to maintain a market neutral position. This is also a type of market neutral strategy.
Natural hedges
Many hedges do not involve exotic financial instruments or derivatives such as the married put. A natural hedge is an investment that reduces the undesired risk by matching cash flows (i.e. revenues and expenses). For example, an exporter to the United States faces a risk of changes in the value of the U.S. dollar and chooses to open a production facility in that market to match its expected sales revenue to its cost structure. Another example is a company that opens a subsidiary in another country and borrows in the foreign currency to finance its operations, even though the foreign interest rate may be more expensive than in its home country: by matching the debt payments to expected revenues in the foreign currency, the parent company has reduced its foreign currency exposure. Similarly, an oil producer may expect to receive its revenues in U.S. dollars, but faces costs in a
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different currency; it would be applying a natural hedge if it agreed to, for example, pay bonuses to employees in U.S. dollars. One common means of hedging against risk is the purchase of insurance to protect against financial loss due to accidental property damage or loss, personal injury, or loss of life.
Commodity risk: the risk that arises from potential movements in the value of commodity contracts, which include agricultural products, metals, and energy products.[4]
Credit risk: the risk that money owing will not be paid by an obligor. Since credit risk is the natural business of banks, but an unwanted risk for commercial traders, an early market developed between banks and traders that involved selling obligations at a discounted rate.
Currency risk (also known as Foreign Exchange Risk hedging) is used both by financial investors to deflect the risks they encounter when investing abroad and by non-financial actors in the global economy for whom multi-currency activities are a necessary evil rather than a desired state of exposure.
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Interest rate risk: the risk that the relative value of an interest-bearing liability, such as a loan or a bond, will worsen due to an interest rate increase. Interest rate risks can be hedged using fixed-income instruments or interest rate swaps.
Equity risk: the risk that one's investments will depreciate because of stock market dynamics causing one to lose money.
Volatility risk: is the threat that an exchange rate movement poses to an investor's portfolio in a foreign currency.
Volumetric risk: the risk that a customer demands more or less of a product than expected.
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markets in the 19th century, but over the last fifty years a large global market developed in products to hedge financial market risk. Futures hedging Investors who primarily trade in futures may hedge their futures against synthetic futures. A synthetic in this case is a synthetic future comprising a call and a put position. Long synthetic futures means long call and short put at the same expiry price. To hedge against a long futures trade a short position in synthetics can be established, and vice versa. Stack hedging is a strategy which involves buying various futures contracts that are concentrated in nearby delivery months to increase the liquidity position. It is generally used by investors to ensure the surety of their earnings for a longer period of time.
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Conversely, the retailer pays the difference to the producer if the pool price is lower than the agreed upon contractual strike price. In effect, the pool volatility is nullified and the parties pay and receive $50 per MWh. However, the party who pays the difference is "out of the money" because without the hedge they would have received the benefit of the pool price.
Securitization
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation (CMOs), to various investors. The principal and interest on the debt, underlying the security, is paid back to the various investors regularly. Securities backed by mortgage receivables are
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called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities(ABS). Critics have suggested that the complexity inherent in securitization can limit investors ability to monitor risk, and that competitive securitization markets with multiple securitizers may be particularly prone to sharp declines in underwriting standards. Private, competitive mortgage securitization is believed to have played an important role in the U.S. subprime mortgage crisis. In addition, off-balance sheet treatment for securitizations coupled with guarantees from the issuer can hide the extent of leverage of the securitizing firm, thereby facilitating risky capital structures and leading to an under-pricing of credit risk. Off balance sheet securitizations are believed to have played a large role in the high leverage level of U.S. financial institutions before the financial crisis, and the need for bailouts. The granularity of pools of securitized assets is a mitigant to the credit risk of individual borrowers. Unlike general corporate debt, the credit quality of securitised debt is non-stationary due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool
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performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches may experience dramatic credit deterioration and loss. Securitization has evolved from its tentative beginnings in the late 1970s to a vital funding source with an estimated outstanding of $10.24 trillion in the United States and $2.25 trillion in Europe as of the 2nd quarter of 2008. In 2007, ABS issuance amounted to $3.455 trillion in the US and $652 billion in Europe. WBS (Whole Business Securitization) arrangements first appeared in the United Kingdom in the 1990s, and became common in various Commonwealth legal systems where senior creditors of an insolvent business effectively gain the right to control the company.
Overview
In February 1970, the U.S. Department of Housing and Urban Development created the first transaction using a mortgage-backed security. The Government National Mortgage Association (GNMA or Ginnie Mae) sold securities backed by a portfolio of mortgage loans.
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To facilitate the securitization of non-mortgage assets, businesses substituted private credit enhancements. First, they over-collateralised pools of assets; shortly thereafter, they improved third-party and structural enhancements. In 1985, securitization techniques that had been developed in the mortgage market were applied for the first time to a class of non-mortgage assets automobile loans. A pool of assets second only to mortgages in volume, auto loans were a good match for structured finance; their maturities, considerably shorter than those of mortgages, made the timing of cash flows more predictable, and their long statistical histories of performance gave investors confidence. This early auto loan deal was a $60 million securitization originated by Marine Midland Bank and securitised in 1985 by the Certificate for Automobile Receivables Trust (CARS, 1985-1). The first significant bank credit card sale came to market in 1986 with a private placement of $50 million of outstanding bank card loans. This transaction demonstrated to investors that, if the yields were high enough, loan pools could support asset sales with higher expected losses and administrative costs than was true within the mortgage market. Sales of this type with no contractual obligation by the seller to provide recourse allowed banks to receive sales treatment for accounting and regulatory purposes (easing balance sheet and capital constraints), while at the same time allowing them to retain origination and servicing fees. After the success of this initial transaction, investors grew to accept credit card receivables as collateral, and banks developed structures to normalize the cash flows. Starting in the 1990s with some earlier private transactions, securitization technology was applied to a number of sectors of the reinsurance and insurance markets including life and catastrophe. This activity grew to nearly $15bn of issuance in 2006 following the disruptions in the underlying markets caused by Hurricane Katrina and Regulation XXX. Key areas of activity in the broad area of Alternative Risk Transfer include catastrophe bonds, Life Insurance Securitization and Reinsurance Sidecars.
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The first public Securitization of Community Reinvestment Act (CRA) loans started in 1997. CRA loans are loans targeted to low and moderate income borrowers and neighborhoods. As estimated by the Bond Market Association, in the United States, total amount outstanding at the end of 2004 at $1.8 trillion. This amount is about 8 percent of total outstanding bond market debt ($23.6 trillion), about 33 percent of mortgage-related debt ($5.5 trillion), and about 39 percent of corporate debt ($4.7 trillion) in the United States. In nominal terms, over the last ten years, (19952004,) ABS amount outstanding has grown about 19 percent annually, with mortgage-related debt and corporate debt each growing at about 9 percent. Gross public issuance of asset-backed securities remains strong, setting new records in many years. In 2004, issuance was at an all-time record of about $0.9 trillion. At the end of 2004, the larger sectors of this market are credit card-backed securities (21 percent), home-equity backed securities (25 percent), automobilebacked securities (13 percent), and collateralized debt obligations (15 percent). Among the other market segments are student loan-backed securities (6 percent), equipment leases (4 percent), manufactured housing (2 percent), small business loans (such as loans to convenience stores and gas stations), and aircraft leases.
Structure
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A suitably large portfolio of assets is "pooled" and transferred to a "special purpose vehicle" or "SPV" (the issuer), a tax-exempt company or trust formed for the specific purpose of funding the assets. Once the assets are transferred to the issuer, there is normally no recourse to the originator. The issuer is "bankruptcy remote," meaning that if the originator goes into bankruptcy, the assets of the issuer will not be distributed to the creditors of the originator. In order to achieve this, the governing documents of the issuer restrict its activities to only those necessary to complete the issuance of securities. Accounting standards govern when such a transfer is a sale, a financing, a partial sale, or a part-sale and part-financing.In a sale, the originator is allowed to remove the transferred assets from its balance sheet: in a financing, the assets are considered to remain the property of the originator. Under US accounting standards, the originator achieves a sale by being at arm's length from the issuer, in which case the issuer is classified as a "qualifying special purpose entity" or "qSPE". Because of these structural issues, the originator typically needs the help of an investment bank (the arranger) in setting up the structure of the transaction.
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Issuance
To be able to buy the assets from the originator, the issuer SPV issues tradable securities to fund the purchase. Investors purchase the securities, either through a private offering (targeting institutional investors) or on the open market. The performance of the securities is then directly linked to the performance of the assets. Credit rating agencies rate the securities which are issued to provide an external perspective on the liabilities being created and help the investor make a more informed decision. In transactions with static assets, a depositor will assemble the underlying collateral, help structure the securities and work with the financial markets to sell the securities to investors. The depositor has taken on added significance under Regulation AB. The depositor typically owns 100% of the beneficial interest in the issuing entity and is usually the parent or a wholly owned subsidiary of the parent which initiates the transaction. In transactions with managed (traded) assets, asset managers assemble the underlying collateral, help structure the securities and work with the financial markets in order to sell the securities to investors. Some deals may include a third-party guarantor which provides guarantees or partial guarantees for the assets, the principal and the interest payments, for a fee.
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The securities can be issued with either a fixed interest rate or a floating rate under currency pegging system. Fixed rate ABS set the coupon (rate) at the time of issuance, in a fashion similar to corporate bonds and T-Bills. Floating rate securities may be backed by both amortizing and non-amortising assets in the floating market.
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signifying a lower risk, while the lower-credit quality subordinated classes receive a lower credit rating, signifying a higher risk.[14] The most junior class (often called the equity class) is the most exposed to payment risk. In some cases, this is a special type of instrument which is retained by the originator as a potential profit flow. In some cases the equity class receives no coupon (either fixed or floating), but only the residual cash flow (if any) after all the other classes have been paid. There may also be a special class which absorbs early repayments in the underlying assets. This is often the case where the underlying assets are mortgages which, in essence, are repaid every time the property is sold. Since any early repayment is passed on to this class, it means the other investors have a more predictable cash flow. If the underlying assets are mortgages or loans, there are usually two separate "waterfalls" because the principal and interest receipts can be easily allocated and matched. But if the assets are income-based transactions such as rental deals it is not possible to differentiate so easily between how much of the revenue is income and how much principal repayment. In this case all the income is used to pay the cash flows due on the bonds as those cash flows become due. Credit enhancements affect credit risk by providing more or less protection to promised cash flows for a security. Additional protection can help a security achieve a higher rating, lower protection can help create new securities with differently desired risks, and these differential protections can help place a security on more attractive terms. In addition to subordination, credit may be enhanced through:
A reserve or spread account, in which funds remaining after expenses such as principal and interest payments, charge-offs and other fees have been paid-off are accumulated, and can be used when SPE expenses are greater than its income.
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Third-party insurance, or guarantees of principal and interest payments on the securities. Over-collateralisation, usually by using finance income to pay off principal on some securities before principal on the corresponding share of collateral is collected. Cash funding or a cash collateral account, generally consisting of short-term, highly rated investments purchased either from the seller's own funds, or from funds borrowed from third parties that can be used to make up shortfalls in promised cash flows. A third-party letter of credit or corporate guarantee.
A back-up servicer for the loans. Discounted receivables for the pool.
Servicing
A servicer collects payments and monitors the assets that are the crux of the structured financial deal. The servicer can often be the originator, because the servicer needs very similar expertise to the originator and would want to ensure that loan repayments are paid to the Special Purpose Vehicle. The servicer can significantly affect the cash flows to the investors because it controls the collection policy, which influences the proceeds collected, the charge-offs and the recoveries on the loans. Any income remaining after payments and expenses is usually accumulated to some extent in a reserve or
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spread account, and any further excess is returned to the seller. Bond rating agencies publish ratings of asset-backed securities based on the performance of the collateral pool, the credit enhancements and the probability of default.[13] When the issuer is structured as a trust, the trustee is a vital part of the deal as the gate-keeper of the assets that are being held in the issuer. Even though the trustee is part of the SPV, which is typically wholly owned by the Originator, the trustee has a fiduciary duty to protect the assets and those who own the assets, typically the investors.
Repayment structures
Unlike corporate bonds, most securitizations are amortized, meaning that the principal amount borrowed is paid back gradually over the specified term of the loan, rather than in one lump sum at the maturity of the loan. Fully amortizing securitizations are generally collateralised by fully amortizing assets such as home equity loans, auto loans, and student loans. Prepayment uncertainty is an important concern with fully amortizing ABS. The possible rate of prepayment varies widely with the type of underlying asset pool, so many prepayment
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models have been developed in an attempt to define common prepayment activity. The PSA prepayment model is a well-known example. A controlled amortization structure is a method of providing investors with a more predictable repayment schedule, even though the underlying assets may be nonamortissing. After a predetermined revolving period, during which only interest payments are made, these securitizations attempt to return principal to investors in a series of defined periodic payments, usually within a year. An early amortization event is the risk of the debt being retired early. On the other hand, bullet or slug structures return the principal to investors in a single payment. The most common bullet structure is called the soft bullet, meaning that the final bullet payment is not guaranteed on the expected maturity date; however, the majority of these securitizations are paid on time. The second type of bullet structure is the hard bullet, which guarantees that the principal will be paid on the expected maturity date. Hard bullet structures are less common for two reasons: investors are comfortable with soft bullet structures, and they are reluctant to accept the lower yields of hard bullet securities in exchange for a guarantee.
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Securitizations are often structured as a sequential pay bond, paid off in a sequential manner based on maturity. This means that the first tranche, which may have a one-year average life, will receive all principal payments until it is retired; then the second tranche begins to receive principal, and so forth.[14] Pro rata bond structures pay each tranche a proportionate share of principal throughout the life of the security. Structural risks and misincentives Originators (e.g. of mortgages) have less incentive towards credit quality and greater incentive towards loan volume since they do not bear the long-term risk of the assets they have created and may simply profit by the fees associated with origination and securitization.
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securities issued by the trust all based on one set of receivables. After this transaction, typically the originator would continue to service the receivables, in this case the credit cards. There are various risks involved with master trusts specifically. One risk is that timing of cash flows promised to investors might be different from timing of payments on the receivables. For example, credit card-backed securities can have maturities of up to 10 years, but credit card-backed receivables usually pay off much more quickly. To solve this issue these securities typically have a revolving period, an accumulation period, and an amortization period. All three of these periods are based on historical experience of the receivables. During the revolving period, principal payments received on the credit card balances are used to purchase additional receivables. During the accumulation period, these payments are accumulated in a separate account. During the amortization period, new payments are passed through to the investors. A second risk is that the total investor interests and the seller's interest are limited to receivables generated by the credit cards, but the seller (originator) owns the accounts. This can cause issues with how the seller controls the terms and conditions of the accounts. Typically to solve this, there is language written into the securitization to protect the investors and potential vegetables. A third risk is that payments on the receivables can shrink the pool balance and under-collateralize total investor interest. To prevent this, often there is a required minimum seller's interest, and if there was a decrease then an early amortization event would occur.
Issuance trust
In 2000, Citibank introduced a new structure for credit card-backed securities, called an issuance trust, which does not have limitations, that master trusts sometimes do, that requires each issued series of securities to have both a senior and subordinate tranche. There are other benefits to an issuance trust: they
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provide more flexibility in issuing senior/subordinate securities, can increase demand because pension funds are eligible to invest in investment-grade securities issued by them, and they can significantly reduce the cost of issuing securities. Because of these issues, issuance trusts are now the dominant structure used by major issuers of credit card-backed securities.
Grantor trust
Grantor trusts are typically used in automobile-backed securities and REMICs (Real Estate Mortgage Investment Conduits). Grantor trusts are very similar to pass-through trusts used in the earlier days of securitization. An originator pools together loans and sells them to a grantor trust, which issues classes of securities backed by these loans. Principal and interest received on the loans, after expenses are taken into account, are passed through to the holders of the securities on a pro-rata basis.
Owner trust
In an owner trust, there is more flexibility in allocating principal and interest received to different classes of issued securities. In an owner trust, both interest and principal due to subordinate securities can be used to pay senior securities. Due to this, owner trusts can tailor maturity, risk and return profiles of issued securities to investor needs. Usually, any income remaining after expenses is kept in a reserve account up to a specified level and then after that, all income is returned to the seller. Owner trusts allow credit risk to be mitigated by overcollateralization by using excess reserves and excess finance income to prepay securities before principal, which leaves more collateral for the other classes.
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Reduces funding costs: Through securitization, a company rated BB but with AAA worthy cash flow would be able to borrow at possibly AAA rates. This is the number one reason to securitize a cash flow and can have tremendous impacts on borrowing costs. The difference between BB debt and AAA debt can be multiple hundreds of basis points. For example, Moody's downgraded Ford Motor Credit's rating in January 2002, but senior automobile backed securities, issued by Ford Motor Credit in January 2002 and April 2002, continue to be rated AAA because of the strength of the underlying collateral and other credit enhancements.[13] Reduces asset-liability mismatch: "Depending on the structure chosen, securitization can offer perfect matched funding by eliminating funding exposure in terms of both duration and pricing basis." Essentially, in most banks and finance companies, the liability book or the funding is from borrowings. This often comes at a high cost. Securitization allows such banks and finance companies to create a self-funded asset book. Lower capital requirements: Some firms, due to legal, regulatory, or other reasons, have a limit or range that their leverage is allowed to be. By securitizing some of their assets, which qualifies as a sale for accounting purposes, these firms will be able to remove assets from their balance sheets while maintaining the "earning power" of the assets. Locking in profits: For a given block of business, the total profits have not yet emerged and thus remain uncertain. Once the block has been securitized, the level of profits has now been locked in for that company, thus the risk of profit not emerging, or the benefit of super-profits, has now been passed on. Transfer risks (credit, liquidity, prepayment, reinvestment, asset concentration): Securitization makes it possible to transfer risks from an entity that does not want to bear it, to one that does. Two good examples of this are catastrophe bonds and Entertainment Securitizations. Similarly, by securitizing a block of business (thereby locking in a degree of profits), the company has effectively freed up its balance to go out and write more profitable business. Off balance sheet: Derivatives of many types have in the past been referred to as "off-balance-sheet." This term implies that the use of derivatives has no
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balance sheet impact. While there are differences among the various accounting standards internationally, there is a general trend towards the requirement to record derivatives at fair value on the balance sheet. There is also a generally accepted principle that, where derivatives are being used as a hedge against underlying assets or liabilities, accounting adjustments are required to ensure that the gain/loss on the hedged instrument is recognized in the income statement on a similar basis as the underlying assets and liabilities. Certain credit derivatives products, particularly Credit Default Swaps, now have more or less universally accepted market standard documentation. In the case of Credit Default Swaps, this documentation has been formulated by the International Swaps and Derivatives Association (ISDA) who have for a long time provided documentation on how to treat such derivatives on balance sheets. Earnings: Securitization makes it possible to record an earnings bounce without any real addition to the firm. When a securitization takes place, there often is a "true sale" that takes place between the Originator (the parent company) and the SPE. This sale has to be for the market value of the underlying assets for the "true sale" to stick and thus this sale is reflected on the parent company's balance sheet, which will boost earnings for that quarter by the amount of the sale. While not illegal in any respect, this does distort the true earnings of the parent company. Admissibility: Future cash flows may not get full credit in a company's accounts (life insurance companies, for example, may not always get full credit for future surpluses in their regulatory balance sheet), and a securitization effectively turns an admissible future surplus flow into an admissible immediate cash asset. Liquidity: Future cashflows may simply be balance sheet items which currently are not available for spending, whereas once the book has been securitized, the cash would be available for immediate spending or investment. This also creates a reinvestment book which may well be at better rates.
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Disadvantages to issuer
May reduce portfolio quality: If the AAA risks, for example, are being securitized out, this would leave a materially worse quality of residual risk. Costs: Securitizations are expensive due to management and system costs, legal fees, underwriting fees, rating fees and ongoing administration. An allowance for unforeseen costs is usually essential in securitizations, especially if it is an atypical securitization. Size limitations: Securitizations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions. Risks: Since securitization is a structured transaction, it may include par structures as well as credit enhancements that are subject to risks of impairment, such as prepayment, as well as credit loss, especially for structures where there are some retained strips.
Advantages to investors
Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis) Opportunity to invest in a specific pool of high quality assets: Due to the stringent requirements for corporations (for example) to attain high ratings, there is a dearth of highly rated entities that exist. Securitizations, however, allow for the creation of large quantities of AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are required to invest in only highly rated assets, have access to a larger pool of investment options. Portfolio diversification: Depending on the securitization, hedge funds as well as other institutional investors tend to like investing in bonds created through securitizations because they may be uncorrelated to their other bonds and securities. Isolation of credit risk from the parent entity: Since the assets that are securitized are isolated (at least in theory) from the assets of the originating entity, under securitization it may be possible for the securitization to receive a higher credit rating than the "parent," because the underlying risks are different. For example, a small bank may be considered more risky than the mortgage
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loans it makes to its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying higher interest.
Risks to investors
Liquidity risk Credit/default: Default risk is generally accepted as a borrowers inability to meet interest payment obligations on time. For ABS, default may occur when maintenance obligations on the underlying collateral are not sufficiently met as detailed in its prospectus. A key indicator of a particular securitys default risk is its credit rating. Different tranches within the ABS are rated differently, with senior classes of most issues receiving the highest rating, and subordinated classes receiving correspondingly lower credit ratings. However, the credit crisis of 20072008 has exposed a potential flaw in the securitization process loan originators retain no residual risk for the loans they make, but collect substantial fees on loan issuance and securitization, which doesn't encourage improvement of underwriting standards. Event risk Prepayment/reinvestment/early amortization: The majority of revolving ABS are subject to some degree of early amortization risk. The risk stems from specific early amortization events or payout events that cause the security to be paid off prematurely. Typically, payout events include insufficient payments from the underlying borrowers, insufficient excess Fixed Income Sectors: Asset-Backed Securities spread, a rise in the default rate on the underlying loans
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above a specified level, a decrease in credit enhancements below a specific level, and bankruptcy on the part of the sponsor or servicer.
Currency interest rate fluctuations: Like all fixed income securities, the prices of fixed rate ABS move in response to changes in interest rates. Fluctuations in interest rates affect floating rate ABS prices less than fixed rate securities, as the index against which the ABS rate adjusts will reflect interest rate changes in the economy. Furthermore, interest rate changes may affect the prepayment rates on underlying loans that back some types of ABS, which can affect yields. Home equity loans tend to be the most sensitive to changes in interest rates, while auto loans, student loans, and credit cards are generally less sensitive to interest rates. Contractual agreements Moral hazard: Investors usually rely on the deal manager to price the securitizations underlying assets. If the manager earns fees based on performance, there may be a temptation to mark up the prices of the portfolio assets. Conflicts of interest can also arise with senior note holders when the manager has a claim on the deal's excess spread. Servicer risk: The transfer or collection of payments may be delayed or reduced if the servicer becomes insolvent. This risk is mitigated by having a backup servicer involved in the transaction.
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CONCLUSION
It is quite obvious that both students of translation and professional role players in the translation industry can benefit from the integration of a systematic and comprehensive financial risk management plan into translator training programs, translation practice, and translation industry, Students will become familiar with the market environment, will be prepared for their future professional prospects and will enter the industry with more knowledge and self confidence while professional role players will save time and energy in handling everyday financial risks of the activity and increase their productivity and profitability. Such integration also alleviates the stress and tension both may encounter in handling financial risks of the practice and industry.
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So to increase the volume of profitability, industry strives to increase transparency, strictly enforce corporate norms, and provide more value added services to customer, investor, and government.
BIBLIOGRAPHY
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