This document discusses the need for risk management. It outlines several events in the 1970s and 2000s that caused financial losses and volatility, raising the need for effective risk management. Globalization and deregulation also increased the importance of risk management by exposing organizations to more currency and interest rate risks. The document then defines various risk management tools like Value at Risk (VAR) and stop-loss limits and discusses how to measure different types of risk like market, liquidity, credit, and operational risk.

1. Risk
Management
The Need
Alaleh Mani
2013

2. Definition and source of Risk
Risk= Unexpected variable of price or earning.
Business Risk:
 Management decision making risk.
Business Strategy risk
Macroeconomic risk

3. Extreme Market Movement
Events caused volatility which resulted in financial
losses and raised the need for the Risk
Management:
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

5. Globalization / Deregulation
These two factors increased the importance of risk
management:
Deregulation in banks caused interest rate
sensitivity.
Globalization caused more exposure to currency
exchange.

6. 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

8. VAR
 VAR is ex-ante measure
 VAR is difficult to calculate
 VAR is comparable across different business.
 VAR is for risk budgeting

9. Other Risk management tools
 Stop- loss limit:
After loss occurred Co. eliminates the position to limit
the loss.
Ex-post ,Aggregated, easy to calculate.
 Notional limits:
limit the notional amount
 Exposure limits:
limit the risk factor though it is hard to calculate

10. Exposures:
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

11. Valuation
 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.

12. Types of Major Risk
 Market Risk
 Liquidity Risk
 Credit Risk
 Operational Risk

13. Market 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

14. Liquidity Risk
 Asset Liquidity Risk= Market Liquidity risk= trading
liquidity risk
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 ..

15. credit Risk
 Credit risk: counterparty obligation default
 Sovereign risk: country willingness to pay it
obligation
 Settlement risk counterparty default in paying
obligation

16. Operational Risk
 Model risk: loss due to misapplied model
 People Risk: internal employee or external fraud
 Legal risk: lawsuit, penalties, fines cause value
loss
 No reputational or strategic risk included