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Financial Risk Manager - Reading 1 - The Need for Risk Management
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Financial Risk Manager - Reading 1 - The Need for Risk Management

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This presentation covers the first reading of FRM (GARP) program. …

This presentation covers the first reading of FRM (GARP) program.
The reading which is covered here is
Chapter 1- The Need for Risk Management
The AIM that we are trying to capture here.

• Define risk and describe some of the major sources of risk.
• Differentiate between business and financial risks and give examples of each.
• Relate significant market events of the past several decades to the growth of the risk management industry.
• Describe the functions and purposes of financial institutions as they relate to financial risk management.
• Define what a derivative contract is and how it differs from a security.
• Define financial risk management.
• Define Value-at-Risk (VaR) and describe how it is used in risk management.
• Describe the advantages and disadvantages of VaR relative to other risk management tools such as stop-loss
limits, notional limits, and exposure limits.
• Compare and contrast valuation and risk management, using VaR as an example.
• Define and describe the four major types of financial risks: market, liquidity, credit, and operational; and
their forms.

The AIM are prescribed by GARP and is their copyright.

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  • 1. READING 1 : THE NEED FOR RISK MANAGEMENTTraining For FRM Session ByPart 1 Program Ratan Gupta Brought To You By www.KnowledgeVarsity.com For Live and Online Class Details Call : +91-94487-06666 © Copyright 2011 Knowledge Varsity | www.knowledgevarsity.com | Page No. 1
  • 2. A Risk and Sources of RiskRisk can be defined as volatility of unexpected outcomesSources of Risk Natural Man Made © Copyright 2011 Knowledge Varsity | www.knowledgevarsity.com | Page No. 2
  • 3. B Types of RiskBusiness Risk Risk that corporation assumes willingly to create competitive advantage. This results from business environment and decision. Includes Macroeconomic and Strategy Risks Financial Risk Possible Risk arising due to the firm’s financial market activity Risk due to issuance of Equity, debt and the volatility in the pricesIt is important that Non-financial firms hedge the Financial Risk.However they should not hedge the business risk.For financial firms the financial risk is the business risk © Copyright 2011 Knowledge Varsity | www.knowledgevarsity.com | Page No. 3
  • 4. C Significant Market Events• Fixed exchange rate system broke down in 1971• Oil price shock in 1973, 1991, 2008• Black Monday, Oct 19, 1987, US market fell by 23%• Japanese stock bubble, Nikkei fell from 39,000 to 17,000 in 3 years• Asian turmoil of 1997, wiped 3/4th equity capitalization of Malaysia, Thailand, Indonesia & Korea• Russian default in 1998• Mortgage crisis in 2007• Default of Lehman, near bankruptcy of AIG, US Govt takeover of Fannie Mae and Freddie Mac – 2008• European Debt Crisis, Default of MF Global - 2011 These events created high volatility. Huge Financial Loss Risk Management would have resulted in containing the losses World has seen Globalization and deregulation, as a result the risk is not bounded by borders. © Copyright 2011 Knowledge Varsity | www.knowledgevarsity.com | Page No. 4
  • 5. D Function and Purpose of Financial InstitutionsActs as financial IntermediariesPeople trust these intermediaries => Lower the cost of financial transactionsThe institutions create instruments to manage riskRisk AdvisoryBecause of all the above these institutions should be at the top to evaluateand manage the risks © Copyright 2011 Knowledge Varsity | www.knowledgevarsity.com | Page No. 5
  • 6. E&F Derivatives and LeverageAre instruments designed to manage financial risk efficientlyDerives its value from some underlying asset like equity, bond, index,reference interest rateZero Sum GameThese instruments are leveragedLeverage is double-edged swordDerivatives Market is Very Big, many times the world’s GDP © Copyright 2011 Knowledge Varsity | www.knowledgevarsity.com | Page No. 6
  • 7. G Financial Risk ManagementDesign and Implementation of Process For Risk Identification Measurement Management VaR is one of the most important Risk Measurement Tool © Copyright 2011 Knowledge Varsity | www.knowledgevarsity.com | Page No. 7
  • 8. G Value At Risk (VaR)VaR is the worst loss over a target horizon that will not be exceeded with a givenlevel of confidence (or probability)The focus is on the tail of the distributionMost of the financial institutions use VaR measureVaR can be derived from the probability distribution of the future portfolio value. © Copyright 2011 Knowledge Varsity | www.knowledgevarsity.com | Page No. 8
  • 9. H Other Risk Management ToolsStop Loss Limit It Limits the loss in a positionNotional Limit Limit on the amount of investmentExposure Limit Limit on the Risk Factor Delta in case of options Duration in case of Bonds © Copyright 2011 Knowledge Varsity | www.knowledgevarsity.com | Page No. 9
  • 10. I Comparison of Risk Management ToolsMethod (Across) Stop Loss Notional Exposure VaRCharacteristics (Down)Type Ex-post Ex-ante Ex-ante Ex-anteCalculation Easy Easy Difficult DifficultExplanation Easy Easy Difficult EasyAggregation Yes No No Yes Watch out for the superiority of VaR over other methods © Copyright 2011 Knowledge Varsity | www.knowledgevarsity.com | Page No.10
  • 11. J Types of Financial RiskMarket RiskLiquidity RiskCredit RiskOperational Risk © Copyright 2011 Knowledge Varsity | www.knowledgevarsity.com | Page No.11
  • 12. J Market RiskType Absolute Risk Relative RiskType - On the basis of market movement Directional Risk Non-Directional Risk Basis Risk Volatility Risk © Copyright 2011 Knowledge Varsity | www.knowledgevarsity.com | Page No.12
  • 13. J Liquidity RiskAsset Risk or market/product Liquidity Risk Happens when transaction cant be conducted at the prevailing prices Put Limit on the exposure that the firm can have on illiquid assetsFunding Risk or cash flow risk Unable to raise cash to meet financial obligationLiquidity Risk has forced many firms to go out of business © Copyright 2011 Knowledge Varsity | www.knowledgevarsity.com | Page No.13
  • 14. J Credit RiskTypes Default Risk Settlement Risk Sovereign RiskCredit Event Change in the ability of counterparty to perform obligationExposure The amount which is at riskRecovery Rate Amount which is expected to be received in case of default Relationship between Market and Credit Risk © Copyright 2011 Knowledge Varsity | www.knowledgevarsity.com | Page No.14
  • 15. J Operational RiskTypes Model Risk People Risk Internal or External Fraud Legal Risk Regulatory Risk © Copyright 2011 Knowledge Varsity | www.knowledgevarsity.com | Page No.15