FINANCIAL RISK MANAGEMENT
FNC-404
Instructor: Dr. Kumail Rizvi
15/01/2014
1
Kumail Rizvi, PhD, CFA, FRM
KUMAIL RIZVI
PHD FROM PARIS 1 (PANTHÉON SORBONNE) 2011
CFA 2010
FRM 2010
MSC MONEY BANKING AND FINANCE 2007
MSC COMPUTER SCIENCES 2003
MBECON (FINANCE) 2001
EXPERIENCE
GIFT UNIVERSITY
HAILEY COLLEGE OF COMMERCE, PUNJAB UNIVERSITY
PAK AIMS
IBP (INSTITUTE OF BANKERS PAKISTAN)
PARIS 1 (PANTHÉON SORBONNE)
UNIVERSITY OF CENTRAL PUNJAB (UCP)
LAHORE SCHOOL OF ECONOMICS (LSE)
SYNERGISTIC FINANCIAL ADVISORS (SFA)
SPM CONSULTING, DUBAI
SAS
IBM (INTERNATIONAL BUSINESS MACHINES)
GBM (GULF BUSINESS MACHINES)
15
/01
/201
4
2
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
RISK
Risk is the probability of loss?
(what about Risk Exposure to
Earthquake?)
Another perspective is that It is
exposure that in conjunction
with uncertainty defines risk!
Risk is the volatility of expected
outcomes (value of assets,
equity or earnings)
All outcomes or only negative
outcomes? (Left Tail)
Combination of Danger and
Opportunity.
15
/01
/201
4
3
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
RISK 1
5/0
1/2
01
4
4
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
Misconception continued,
spread virally and embraced
and accepted by QUANTS..
But what about events like
Russian Roulette??
However, we have to live with
it, else we would always make
some Suboptimal decisions or
wouldn’t make any decision at
all….
INTRODUCTION
Investment is an intrinsically risky activity.
Without risk, we have little possibility of reward.
Thus risk taking and risk management is an
innate characteristic of investment process.
15
/01
/201
4
5
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
INTRODUCTION
As an individual or a company engage in risk
activity like investment, different questions
arise:
What is an effective process for identifying,
measuring and managing risk?
Which risks are worth taking?
How can our success or lack of success in risk taking
be evaluated?
What information should be reported to stakeholders
concerning the risk of an enterprise or portfolio?
15
/01
/201
4
6
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
FINANCIAL RISK MANAGEMENT
Financial risk
management is the design
and implementation of
procedures for
identifying, measuring
and managing financial
risks.
15
/01
/201
4
7
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
FINANCIAL RISK MANAGEMENT
Risk Management is a process involving:
Identification of exposures to risk
Establishment of appropriate ranges for exposures
Measurement of these exposures on continuous basis
Execution of appropriate adjustments whenever exposure levels fall outside of target ranges.
Risk Management in its totality is all at once a proactive, anticipative, and reactive process that continuously monitors and controls risks.
15
/01
/201
4
8
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
Exposure is the size or value of
loss that would be realized if an
unexpected outcome occurred.
THE PRACTICE OF RISK MANAGEMENT 1
5/0
1/2
01
4
9
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
SOURCES OF RISK 1
5/0
1/2
01
4
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
10
Risks the corporation assumes willingly
To create competitive advantage
To add shareholders value
Includes:
Business decisions (e.g., investment, products, org structures)
Business environment (competition and macro economy)
Losses due to
financial market
activities
For example:
Interest rate exposure
Default on financial
obligations
Account receivable
Financial
For a non-financial
corporation, likely to
be non-core
Business
IDENTIFYING RISK
Financial Risk
Non-Financial Risk
15
/01
/201
4
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
11
IDENTIFYING RISK
Risk that an individual or corporation is exposed
to, take many different forms:
15
/01
/201
4
12
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
FINANCIAL RISK
Market Risk
Including:
Interest rate risk
Commodity Price Risk
Equity Price Risk
Exchange Rate Risk
Credit Risk
Liquidity Risk
15
/01
/201
4
13
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
MARKET RISK
Market risk is the risk associated with interest
rate, equity prices, commodity prices and
exchange rate.
It is the risk that declining prices or volatility of
prices in these financial markets will result in a
loss.
Market Risk includes:
Absolute risk
Relative risk
Basis risk
Volatility risk
15
/01
/201
4
14
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
MARKET RISK INCLUDES……..
Absolute Risk focuses on the volatility of total
returns.
Relative Risk is referred to as tracking error since
it is usually measured relative to a benchmark
index or portfolio.
Basis Risk is the risk that the price of a hedging
instrument and the price of the asset being
hedged are not perfectly correlated.
Volatility Risk is the risk of loss from changes in
the actual or implied volatility of market prices.
15
/01
/201
4
15
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
CREDIT RISK
Apart from the market risk, credit risk is the
primary risk faced by economic agents.
Credit risk is the risk of loss caused by the
possibility of default or non-payment by a
counterparty or debtor in a financial transaction.
Credit Risk includes:
Sovereign risk
Settlement risk
15
/01
/201
4
16
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
CREDIT RISK INCLUDES…….
Sovereign Risk is the risk resulting from a
country’s action. It differs from other forms of
credit risks as it is country specific. A country’s
willingness and ability to repay its obligations
are often factors looked at when evaluating the
sovereign risk. Sovereign risk often stems from
country’s political or legal system.
Settlement Risk is the risk that a counterparty
will fail to deliver its obligation after the party
has made its delivery.
15
/01
/201
4
17
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
LIQUIDITY RISK
Liquidity risk is the possibility of sustaining
significant losses due to the inability to
sufficiently liquidate a position at a fair price.
For traded securities, the size of the bid-ask
spread, stated as a proportion of security price,
is frequently used as an indicator of liquidity.
Liquidity Risk includes:
Asset or Trading liquidity risk
Funding liquidity risk
15
/01
/201
4
18
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
LIQUIDITY RISK INCLUDES.……..
Asset Liquidity Risk, which is sometimes called
market or trading liquidity risk, results from a
large position size forcing transactions to
influence the price of securities.
Funding Liquidity Risk, which is sometimes
called cash-flow risk, refers to the risk that a
financial institution will be unable to raise cash
necessary to roll over its debts; to fulfill the cash,
margin, or collateral requirements of
counterparties; or to meet capital withdrawals.
15
/01
/201
4
19
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
NON-FINANCIAL RISK
Operational Risk
includes:
Model Risk
People Risk
Legal Risk
Business Risk
Includes:
Strategic Risk
Macroeconomic Risk
Political Risk
Regulatory risk
Tax Risk
Accounting Risk
15
/01
/201
4
20
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
OPERATIONAL RISK
Operational Risk is the risk of loss from failures
in a company’s systems and procedures or from
external events.
These risks can arise from:
Computer breakdowns (including bugs, viruses, and
hardware problems)
Human errors or frauds
Events completely outside of companies control
including “act of God” and terrorist actions
15
/01
/201
4
21
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
MODEL, PEOPLE & LEGAL RISKS
Model Risk is the risk that a model is incorrect or
misapplied; in investment, it often refers to
valuation models.
People Risk relates to the risk associated with
fraud perpetrated by internal employees and/or
external individuals.
Legal Risk is the risk of a loss due to legal issues
including lawsuits, fines, penalties, and/or
damages.
15
/01
/201
4
22
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
BUSINESS RISK
Business Risk is the risk that a firm is subjected to during daily operations and includes the risks that result from business decisions and business environment.
It includes strategic risk (the risk inherent in the decisions of senior management in setting a business strategy), macroeconomic risk (the risk that economy will slow and demand for product will fall, political risk etc.
The ability to effectively manage business risk is a core competency for stronger firms.
15
/01
/201
4
23
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
OTHER RISKS
Regulatory Risk is the risk associated with the
uncertainty of how a transaction will be
regulated or with the potential for regulations to
change.
Tax Risk arises because of the uncertainty
associated with tax laws.
Accounting Risk arises from uncertainty about
how a transactions should be recorded and the
potential for accounting rules and regulations to
change.
15
/01
/201
4
24
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
ILLUSTRATION: IDENTIFYING RISKS
15
/01
/201
4
25
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
MEASURING RISK Market Risk
Credit Risk
Liquidity Risk
Operational Risk
15
/01
/201
4
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
26
MEASURING MARKET RISK
Few conventional techniques are available to
measure market risk.
Standard Deviation; referred to as Asset’s
Volatility typically represented by Greek letter
Tracking error measures the volatility of a
portfolio’s return in excess of the benchmark
portfolio’s return.
Beta measures the sensitivity to market movements
and is a linear risk measure
Duration measures the sensitivity of a bond or a
bond portfolio to a small parallel shift in the yield
curve and is a linear measure.
Convexity measures how interest rate sensitivity
changes with changes in interest rates.
15
/01
/201
4
27
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
15
/01
/201
4
28
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
There are few errors in some formulas: Do
correct them
15
/01
/201
4
29
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
15
/01
/201
4
30
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
MEASURING MARKET RISK
During 1990s, a new technique emerged as the
financial service industry’s premier risk
measurement technique – called as Value at Risk
(known as VAR)
VAR is a probability-based measure of loss
potential for a company, fund, a portfolio, a
transaction or a strategy.
Specifically, Value at Risk (VAR) is an estimate of
the loss (in money terms) that we expect to be
exceeded with a given level of probability over a
specified time period.
15
/01
/201
4
31
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
VALUE AT RISK: EXAMPLE
The VAR of a portfolio is $1.5 million for one
day with a probability of 0.05.
VAR as Minimum:
There is a 5 percent chance that the portfolio will lose
at least $1.5 million in a single day.
VAR as Maximum:
The probability is 95 percent that the portfolio will
loss no more than $1.5 million in a single day.
15
/01
/201
4
32
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
15
/01
/201
4
33
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
15
/01
/201
4
34
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
MEASURING LIQUIDITY RISK
One traditional measure of liquidity risk is Bid-
Ask Spread (for actively traded securities).
A new technique to measure liquidity risk is a
Liquidity-Adjusted VAR.
It has been introduced as one of the implicit
assumption in risk management with VAR that
positions can be liquidated when they approach or
move outside pre-agreed limits.
15
/01
/201
4
35
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
MEASURING CREDIT RISK
Credit risk is present when there is a positive
probability that one party owing money will
renege on the obligation.
Credit losses have three dimensions:
The likelihood of loss – a probabilistic concept
In every transaction, a given probability exists that the
counterparty will default.
Recovery
When default occurs, there is usually a portion of
investment that creditors are able to recover called recovery
rate
Associated amount of loss
This is the amount that is lost by the creditors after
appropriately assessing the magnitude of recovery.
15
/01
/201
4
36
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
15
/01
/201
4
37
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
MEASURING CREDIT RISK
VAR is used to measure market risk; but VAR is
also used, albeit with greater difficulty, to
measure credit risk. This measure is called
Credit VAR or Default VAR.
Like ordinary VAR, it reflects the minimum loss
with a given probability during a period of time.
15
/01
/201
4
38
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
MEASURING NON-FINANCIAL RISKS
Non-financial risks are intrinsically very difficult
to measure.
Some of them even can easily be thought of as not
measureable in any precise mathematical way. For
example: Regulatory risk, Accounting risk, Tax risk
and Legal risk
Until few years ago, idea of measuring of
operational risk was practically unheard of.
However, explicit mention of operational risk
requirement in the Basel II and III regulations has
created incentives for bank to think of some
techniques to measure operational risk.
15
/01
/201
4
39
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM
15
/01
/201
4
40
Ku
ma
il Riz
vi, P
hD
, CF
A, F
RM