Chap 1 Crouhy.pptx

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  • 7/30/2019 Chap 1 Crouhy.pptx


    Whether we like it or not, mankind now has acompletely integrated, international financial andinformational marketplace capable of moving moneyand ideas to any place on this planet in minutes.

    Source: Walter Wriston of Citibank, in a speech to theInternationalMonetary Conference, London, June 11,1979.

  • 7/30/2019 Chap 1 Crouhy.pptx


    Risk is the likelihood of losses resulting from events such aschanges in market prices. Events with a low probability ofoccurring, but that may result in a high loss, are particularlytroublesome because they are often not anticipated.

    There are three main sources of financial risk:

    1. Financial risks arising from an organizations exposure tochanges in market prices, such as interest rates, exchange rates,and commodity prices

    2. Financial risks arising from the actions of, and transactions with,

    other organizations such as vendors, customers, andcounterparties in derivatives transactions

    3. Financial risks resulting from internal actions or failures of theorganization, particularly people, processes, and systems

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    Financial risk management is a process todeal with the uncertainties resulting fromfinancial markets. It involves assessing thefinancial risks facing an organization and

    developing management strategies consistentwith internal priorities and policies.

    Risk management and risk taking are notopposite

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    Identify Risk Exposure

    Measure and Estimate Risk Exposure

    Find Instruments and facilities to shift or trade risk

    Assess Costs and Benefits of Instruments

    (Cont. next slide)

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    Assess Effects of Risk Exposures Assess Cost andBenefits

    Form a Risk Mitigation Strategy Avoid




    Evaluate Performance

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    Huge market for credit derivatives- insuranceto protect against credit default

    Credit derivatives to banks, hedge funds or

    other institutional investors

    Failures of hedge funds LTCM in 1998

    Financial Scandals (Enron, WorldCom, GlobalCrossing and Quest in the US to Parmalat inEurope

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    There are serious concerns that derivative marketsmake it easier to take on large amounts of risk, andthat the herd behavior of risk managers after acrisis gets underway (e.g., selling risky asset classeswhen risk measures reach a certain level) actuallyincreases market volatility.

    Every risk management mechanism that allows us tochange the shape of cash flows, such as deferring anegative outcome into the future, may work to theshort-term benefit of one group of stakeholders in a

    firm (e.g., managers) at the same time that it isdestroying long-term value for another group (e.g.,shareholders or pensioners).

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    Risk is not synonymous with the sizeof a cost orof a loss.

    The real risk is that the costs will suddenly rise in

    an entirely unexpected way, or that some othercost will appear from nowhere and steal themoney weve set aside for our expected outlays.The risk lies in how variable our costs andrevenues really are.

    Expected Loss (or expected cost)

    Unexpected Loss (or unexpected cost)

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    1. Identify the risk factors2. Probabilities of various outcomes

    (Institutions stated risk appetite for its

    various activities)

    3. Correlation between risk factors

    There is often a distinct difference in the

    behavior and relationship of risk factorsduring normal business conditions and duringstressful conditions such as financial crises.

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    In the world of credit risk, real estatelinkedloans area famous example of this: they areoften secured with real estate collateral,which tends to lose value at exactly the same

    time that the default rate for propertydevelopers and owners rises.

    In this case, the recovery rate risk on anydefaulted loan is itself closely correlated withthe default-rate risk.

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    Risk management becomes not the process of controlling and reducing

    expected losses (which is essentially a budgeting, pricing, and businessefficiency concern), but the process of understanding, costing, andefficiently managing unexpected levels of variability in the financialoutcomes for a business. Under this paradigm, even a conservativebusiness can take on significant amount of risk quite rationally, in lightof

    Its confidence in the way it assesses and measures the unexpected losslevels associated with its various activities

    The accumulation of sufficient capital or the deployment of other riskmanagement techniques to protect against potential unexpected losslevels

    Appropriate returns from the risky activities, once the cost of riskcapital and risk management is taken into account

    Clear communication with stakeholders about the companys target riskprofile (i.e., its solvency standard once risk taking and risk mitigation areaccounted for)

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    To achieve a higher rate of return on average, oneoften has to assume more risk. But the transparencyof the trade-off between risk and return is highlyvariable.

    However, in the case of risks that are not associatedwith any kind of market-traded financial instrument,the problem of making transparent the relationshipbetween risk and reward is much more profound.

    A key objective of risk management is to tackle thisissue and make clear the potential for large losses inthe future arising from activities that generate anapparently attractive stream of profits in the shortrun.

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    Organizations with a poor risk management and riskgovernance culture sometimes allow powerful businessgroups to exaggerate the potential returns whilediminishing the perceived potential risks.

    Bonuses are paid today on profits that may later turn out

    to be illusory, while the cost of any associated risks ispushed, largely unacknowledged, into the future

    History shows that, when the stakes are high enough,regulators all around the world have colluded with localbanking industries to allow firms to misrecord andmisvalue risky assets on their balance sheets, out of fearthat forcing firms to state their true condition will promptmass insolvencies and a financial crisis.

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    We can also divide up our risk portfolio according to the type ofrisk that we are running.

    Credit risk is the risk of loss following a change in the factorsthatdrive the credit quality of an asset. These include adverseeffects arising from credit grade migration, including default,and the dynamics of recovery rates.

    Market risk is the risk of losses arising from changes in marketriskfactors. Market risk can arise from changes in interest rates,foreign exchange rates, or equity and commodity price factors.

    Operational risk refers to financial loss resulting from a host ofpotential operational breakdowns that we can think of in terms

    of people risks, process risks, and technology risks (e.g., frauds,inadequate computer systems, a failure in controls, a mistake inoperations, a guideline that has been circumvented, or a naturaldisaster).

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    Understanding the various types of risk is importantbecause each category demands a different (butrelated) set of risk management skills.

    Giving a name to something allows us to talk about

    it, control it, and assign responsibility for it.Classification is an important part of the effort tomake an otherwise ill-defined risk measurable,manageable, and transferable. Yet the classificationof risk is also fraught with danger because as soon aswe define risk in terms of categories, we create the

    potential for missed risks and gaps inresponsibilitiesfor being blind-sided by risk as itflows across our arbitrary dividing lines.

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    The creation ofsilos of expertise that are separated fromone another in terms of personnel, risk terminology, riskmeasures, reporting lines, systems and data, and so on.

    Risk measurement tools such as VaR and economic capitalare evolving to facilitate integrated measurement and

    management of the various risks (market, credit, andoperational) and business lines.

    An enterprise-wide risk management ERM system is adeliberate attempt to break through the tendency of firmsto operate in risk management silos and to ignoreenterprise risks, and an attempt to take risk intoconsideration in business decisions much more explicitlythan has been done in the past.

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    Over the last few years, it has become increasingly difficult todistinguish risk management tools from capital management tools,since risk, according to the unexpected loss risk paradigm weoutlined earlier, increasingly drives the allocation of capital in risk-intensive businesses such as banking and insurance. Similarly, it hasbecome difficult to distinguish capital management tools from

    balance sheet management tools, since risk/reward relationshipsincreasingly drive the structure of the balance sheet.

    Enterprise Risk Management continues to generate interest amongrisk managers, executives, the board of directors and shareholders.

    Given the core role of risk management in financial institutions, itseems intuitive that ERM might be the final destination forcompanies wanting to demonstrate advanced capabilities. For all thehype, however, ERM continues to be an elusive concept that varieswidely in definition and implementation, and reaching full maturitymay take several years.

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    Assigning numbers to risk is incredibly useful forrisk management and risk transfer, its alsopotentially dangerous. Only some kinds ofnumbers are truly comparable, but all kinds ofnumbers tempt us to make comparisons.

    For example, using the face value or notionalamount of a bond to indicate the risk of a bondis a flawed approach. A million-dollar position inpar value 10-year Treasury bonds does not

    represent at all the same amount of risk as amillion dollar position in a 4-year par valueTreasury bond.

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    VaR measure works well as a risk measureonly for markets operating under normalconditions and only over a short period, suchas one trading day. Potentially, its a very

    poor and misleading measure of risk inabnormal markets, over longer time periods,or for illiquid portfolios.

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    The role of the risk manager is not to try toread a crystal ball, but to uncover the sourcesof risk and make them visible to key decisionmakers and stakeholders in terms of

    probability. If risk is not made transparent to key

    stakeholders, or those charged with oversighton their behalf, then the risk manager hasfailed.

    Regulators and Institutions audit Function

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    Organizations as a whole had no concerted program tocontrol operational risk, which was managed at the linelevel, where the priority was often to reduce costs(expected losses that reduced line profitability) rather thanenterprise risk (unexpected loss levels that might threatenthe whole organization).

    Through the 1980s and 1990s, there were huge advancesin risk management tools and techniques withinspecialized areas.

    These advances came at the cost of silo risk management,

    i.e., a tendency to consider the risks of activities orbusiness lines in isolation, without considering how thoserisks interrelate and affect other business lines and theenterprise as a whole.

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    The measurement of market risk has evolved from simpleindicators, such as the face value or notional amount foran individual security, through more complex measures ofprice sensitivities:

    Such as the duration and convexity of a bond, to thesophisticated combination of the latest VaR methodology,

    stress testing, and scenario analysis.

    The chief risk officer (CRO) is a relatively new role thatbrings together an institutions risk disciplines under oneperson. The CRO is usually a member of the managementcommittee. That means that risk management now has a

    seat at the executive top table. The worlds major financialinstitutions are implementing sophisticated ERM programsthat embrace a dramatic growth in tools aimed atcontrolling operational risk.

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    Practices, personnel, markets, and instruments have beenevolving and interacting with one another continually overthe last decade to set the stage for the next riskmanagement triumphand disaster.

    Rather than being a set of specific activities, computer

    systems, rules, or policies, risk management is betterthought of as a set of concepts that allow us to see andmanage risk in a particular and dynamic way.

    The biggest task in risk management is no longer to buildspecialized mathematical measures of risk (although this

    endeavor certainly continues). Perhaps it is to put downdeeper risk management roots in each organization.

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    1. Market risk is the risk that changes in financial market pricesand rates will reduce the dollar value of a security or aportfolio.

    Price risk for fixed income products can be decomposed into ageneral market-risk component(the risk that the market as awhole will fall in value) and

    a specific market-risk component, unique to the particularfinancial transaction under consideration, that also reflects thecredit risk hidden in the instrument.

    Basis risk is a term used in the risk management industry todescribe the chance of a breakdown in the relationship betweenthe price of a product, on the one hand, and the price of theinstrument used to hedge that price exposure, on the other.Again, it is really just a context-specific form of market risk.

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    Financial Risk

    Market Risk Credit Risk Equity Price Risk Transaction Risk

    Interest-rate risk Portfolio concentrationForeign exchange risk

    Commodity price risk

    Trading Risk Issue Risk

    Gap risk Issuer RiskCounterparty Risk

    General Market Risk

    Specific Risk

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    Interest-rate risk It is the risk that the value of a fixed income security will

    fall as a result of an increase in market interest rates.

    But in complex portfolios of interest-rate-sensitive assets,many different kinds of exposure can arise from

    differences in the maturities, nominal values, and resetdates of instruments and cash flows that are asset like(i.e.longs) and those that are liability-like (i.e., shorts).

    For example, three month Eurodollar instruments andthree-month Treasury bills both naturally pay three-month interest rates. However, these rates are notperfectly correlated with each other, and spreads betweentheir yields may vary over time.

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    Equity Price RiskThis is the risk associated with volatility in stockprices.

    The general market risk of equity refers to the

    sensitivity of an instrument or portfolio value to achange in the level of broad stock market indices.

    The specific or idiosyncratic risk of equity refers tothat portion of a stocks price volatility that isdetermined by characteristics specific to the firm,such as its line of business, the quality of itsmanagement, or a breakdown in its productionprocess.

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    Foreign exchange risk It arises from open or imperfectly hedged

    positions in a particular currency.

    These positions may arise as a natural

    consequence of business operations, rather thanfrom any conscious desire to take a tradingposition in a currency.

    The major drivers of foreign exchange risk areimperfect correlations in the movement ofcurrency prices and fluctuations in internationalinterest rates.

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    Commodity Price Risk The price risk of commodities differs considerably from

    interest-rate and foreign exchange risk, since mostcommodities are traded in markets in which theconcentration of supply in the hands of a few suppliers canmagnify price volatility.

    Other fundamentals affecting a commoditys price includethe ease and cost of storage, which varies considerablyacross the commodity markets (e.g., from gold, toelectricity, to wheat).

    Commodities can be classified as:Hard, high price/weight value, soft and energycommodities

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    Credit risk is the risk that a change in the creditquality of a counterparty will affect the value of asecurity or a portfolio.

    Default, whereby a counterparty is unwilling or

    unable to fulfill its contractual obligations, is theextreme case; however, institutions are also exposedto the risk that a counterparty might be downgradedby a rating agency.

    The value it is likely to recover is called the recovery

    value, or the recovery rate when it is expressed as apercentage; the amount it is expected to lose iscalled the loss given default.

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    Liquidity risk comprises both funding liquidity risk and asset liquidityrisk, although these two dimensions of liquidity risk are closely related.

    1. Funding liquidity risk relates to a firms ability to raise the necessarycash to roll over its debt; to meet the cash, margin, and collateralrequirements of counterparties; and (in the case of funds) to satisfycapital withdrawals.

    Funding liquidity risk can be managed by holding cash and cashequivalents, setting credit lines in place, and monitoring buying power.

    Buying power refers to the amount that a trading counterparty canborrow against assets under stressed market conditions.

    2. Asset liquidity risk, often simply called liquidity risk, is the risk that an

    institution will not be able to execute a transaction at the prevailingmarket price because there is, temporarily, no appetite for the deal onthe other side of the market.

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    Operational risk refers to potential lossesresulting from inadequate systems,management failure, faulty controls, fraud,and human error.

    Operational risk includes fraudfor example,when a trader or other employee intentionallyfalsifies and misrepresents the risks incurredin a transaction.

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    Legal and regulatory risk arises for a whole

    variety of reasons and is closely related toreputation risk. For example, a counterpartymight lack the legal or regulatory authority toengage in a risky transaction.

    Business Risk Business risk refers to the classic risks of the

    world of business, such as uncertainty about the

    demand for products, the price that can becharged for those products, or the cost ofproducing and delivering products.

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    Strategic RiskIt refers to the risk of significant investments forwhich there is a high uncertainty about success andprofitability. If the venture is not successful, then thefirm will usually suffer a major write-off, and its

    reputation among investors will be damaged.

    Reputation RiskReputation risk is taking on a new dimension afterthe accounting scandals that defrauded theshareholders, bondholders, and employees of manymajor corporations during the boom in the equitymarkets in the late 1990s.