Definition and source of Risk
Risk= Unexpected variable of price or earning.
Management decision making risk.
Business Strategy risk
Extreme Market Movement
Events caused volatility which resulted in financial
losses and raised the need for the Risk
1971 Exchange rate broke
1973 Oil shock
1987 Black Monday
1989 Japanese bubble
1997 Asian contagion
1998 Russian default
2001 September 11
2007 Credit crisis
Globalization / Deregulation
These two factors increased the importance of risk
Deregulation in banks caused interest rate
Globalization caused more exposure to currency
Some related definition
Derivatives: a zero sum game
Leverage: allow Derivatives to be a useful hedging
instrument due to:
1. Limited initial cash outlay
2. low transaction cost.
Value at risk: Maximum of loss over time with at
level of confidence.
VAR is an statistical measure:
1. Historical VAR
2. Delta-normal VAR
3. Monte Carlo VAR
VAR is ex-ante measure
VAR is difficult to calculate
VAR is comparable across different business.
VAR is for risk budgeting
Other Risk management tools
Stop- loss limit:
After loss occurred Co. eliminates the position to limit
Ex-post ,Aggregated, easy to calculate.
limit the notional amount
limit the risk factor though it is hard to calculate
Factors fail to measure to qualify the volatility of
factors and the correlation between them
1.Duration for interest rate :effect interest rate
changes on bond price
2.Beta for Equity Market
3.Delta for Option
The process of discounting future expected value
of an asset to determine the current price
E(value)= mean of distribution of possible value
VAR explain the future distribution.
Derivatives valuation : risk neutral pricing to
prevent the persistence of arbitrage situations.
Types of Major Risk
Price volatility in financial Market:
Absolute Risk: directly on return volatility
Relative Risk: tracking error the risk to a benchmark
Basic Risk: if hedging instrument doesn’t correlate
with underlying asset
Asset Liquidity Risk= Market Liquidity risk= trading
when large transaction influence the price
Fundinig liquidity risk=cash flow risk
when a financial institute is unable to raise cash to
roll over its debt or ..
Credit risk: counterparty obligation default
Sovereign risk: country willingness to pay it
Settlement risk counterparty default in paying
Model risk: loss due to misapplied model
People Risk: internal employee or external fraud
Legal risk: lawsuit, penalties, fines cause value
No reputational or strategic risk included