Description
Financial Risk Management: Risk vs Exposure
Risk vs. Exposure
Financial Risk Management
• Risk and exposure have minor differences in their meaning • Risk refers to the probability of loss • Exposure is the possibility of loss • Risk is the result of exposure • Risk provides the basis for opportunities
Risk vs. Exposure
Probability of loss
High prob. with small size High prob. with huge size
Risks in Financial Institutions
• Operational Risk • Financial Risks
– – – – Market Risk Credit Risk Liquidity Risk Inflation Risk
Low prob. with small size
Low prob. with huge size
Potential size of loss
Financial Risks
• Market Risk
– Interest rate risk – Price Risk – Foreign exchange risk
Interest Rate Risk
• The risk incurred by a FI when the maturities of its assets and liabilities are mismatched
– Refinancing risk – Reinvestment risk
• Credit risk
Price Risk
• Price risk is usually measured as the potential gain/loss in a position/portfolio that is associated with a price movement. • Stock price risk, bond price risk, commodity price risk
Foreign Exchange Risk
• The risk that exchange rate changes can affect the value of an FI’s assets and liabilities located abroad
– Transaction exposure – Translation exposure – Competitive exposure
Credit Risk
• The risk that the promised cash flows from loans and securities held by FIs may not be paid in full.
– Firm-specific credit risk – Systematic credit risk
Dealing with Risk
• • • • Accept Transfer Avoid Manage
• The magnitude of credit risk of a firm is described by credit rating.
Risk Management
• “Risk management is a process by which a company alters the risk it faces to make it equal to the risk it desires.” – Greg Krissek • Insurance • Diversification • Hedging
Diversification as FRM Tool
• Diversification among counterparties reduces default risks • Diversification among investment assets reduces the magnitude of loss • Diversification of customers, suppliers, and financing sources reduces transaction risks
Risk Management and Firm Value
• • • • • • RM makes cash flows as smooth as possible RM ensures future capital investments RM reduces the costs of financial distress RM may reduce the tax burden RM may lead to better performance evaluation It is less costly for a firm to hedge than for a stockholder. • Firms may have better market information than individuals.
Risk Management Process
Derivatives
Derivatives management Framework
Forwards Futures
Individual Components
Options Swaps
Derivatives Markets
• Exchange traded
– Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading – Contracts are standard there is virtually no credit risk
Who Trades Derivatives?
• Market-makers and dealers stand ready to buy or to sell: they take the other side of a transaction for whomever wants to trade
– Although they accommodate customers, market-makers and dealers make money on transaction fees, and try not to take excessive risk
• Over-the-counter (OTC)
– A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers – Contracts can be non-standard and there is some small amount of credit risk
• Arbitrageurs trade to take advantage of prices that are temporarily wrong • Speculators get extra leverage in betting on future movements in the price of an asset. • Hedgers use the instruments to reduce risk associated with price of an asset.
doc_474847541.pdf
Financial Risk Management: Risk vs Exposure
Risk vs. Exposure
Financial Risk Management
• Risk and exposure have minor differences in their meaning • Risk refers to the probability of loss • Exposure is the possibility of loss • Risk is the result of exposure • Risk provides the basis for opportunities
Risk vs. Exposure
Probability of loss
High prob. with small size High prob. with huge size
Risks in Financial Institutions
• Operational Risk • Financial Risks
– – – – Market Risk Credit Risk Liquidity Risk Inflation Risk
Low prob. with small size
Low prob. with huge size
Potential size of loss
Financial Risks
• Market Risk
– Interest rate risk – Price Risk – Foreign exchange risk
Interest Rate Risk
• The risk incurred by a FI when the maturities of its assets and liabilities are mismatched
– Refinancing risk – Reinvestment risk
• Credit risk
Price Risk
• Price risk is usually measured as the potential gain/loss in a position/portfolio that is associated with a price movement. • Stock price risk, bond price risk, commodity price risk
Foreign Exchange Risk
• The risk that exchange rate changes can affect the value of an FI’s assets and liabilities located abroad
– Transaction exposure – Translation exposure – Competitive exposure
Credit Risk
• The risk that the promised cash flows from loans and securities held by FIs may not be paid in full.
– Firm-specific credit risk – Systematic credit risk
Dealing with Risk
• • • • Accept Transfer Avoid Manage
• The magnitude of credit risk of a firm is described by credit rating.
Risk Management
• “Risk management is a process by which a company alters the risk it faces to make it equal to the risk it desires.” – Greg Krissek • Insurance • Diversification • Hedging
Diversification as FRM Tool
• Diversification among counterparties reduces default risks • Diversification among investment assets reduces the magnitude of loss • Diversification of customers, suppliers, and financing sources reduces transaction risks
Risk Management and Firm Value
• • • • • • RM makes cash flows as smooth as possible RM ensures future capital investments RM reduces the costs of financial distress RM may reduce the tax burden RM may lead to better performance evaluation It is less costly for a firm to hedge than for a stockholder. • Firms may have better market information than individuals.
Risk Management Process
Derivatives
Derivatives management Framework
Forwards Futures
Individual Components
Options Swaps
Derivatives Markets
• Exchange traded
– Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading – Contracts are standard there is virtually no credit risk
Who Trades Derivatives?
• Market-makers and dealers stand ready to buy or to sell: they take the other side of a transaction for whomever wants to trade
– Although they accommodate customers, market-makers and dealers make money on transaction fees, and try not to take excessive risk
• Over-the-counter (OTC)
– A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers – Contracts can be non-standard and there is some small amount of credit risk
• Arbitrageurs trade to take advantage of prices that are temporarily wrong • Speculators get extra leverage in betting on future movements in the price of an asset. • Hedgers use the instruments to reduce risk associated with price of an asset.
doc_474847541.pdf