1. What do you understand by investment risk? Classify the traditional sources of investment risk and mention whether they are general sources of risk or specific sources of risk. How is interest rate risk related to inflation risk?
2. Define the various forms of the market efficiency. State the anomalies in the Efficient Market Hypothesis.
3. Discuss the CAPM and its application in portfolio selection. Explain the relationship between SML, CML and Characteristic Line.
4. What are the basic assumptions of Arbitrage Pricing Theory (APT)? Discuss the problems associated with the empirical testing of APT.
5. Distinguish between performance measurement and performance evaluation of an investment portfolio. Describe the Sharpe, Treynor and Jensen measures of portfolio returns.
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Financial risk is an umbrella term for any risk associated with any form of financing. Risk may be taken as downside risk, the difference between the actual return and the expected return (when the actual return is less), or the uncertainty of that return.
Risk related to an investment is often called investment risk. Risk related to a company's cash flow is called business risk.
there are three distinct risks you must guard against; they are business risk, valuation risk, and force of sale risk.
Investment Risk #1: Business Risk
Business risk is, perhaps, the most familiar and easily understood. It is the potential for loss of value through competition, mismanagement, and financial insolvency. There are a number of industries that are predisposed to higher levels of business risk (think airlines, railroads, steel, etc).
The biggest defense against business risk is the presence of franchise value. Companies that possess franchise value are able to raise prices to adjust for increased labor, taxes or material costs. The stocks and bonds of commodity-type businesses do not have this luxury and normally decline significantly when the economic environment turns south.
Investment Risk #2: Valuation Risk
Recently, I found a company I absolutely love (said company will remain nameless). The margins are excellent, growth is stellar, there is little or no debt on the balance sheet and the brand is expanding into a number of new markets. However, the business is trading at a price that is so far in excess of it's current and average earnings, I cannot possibly justify purchasing the stock.
Why? I'm not concerned about business risk. Instead, I am concerned about valuation risk. In order to justify the purchase of the stock at this sky-high price, I have to be absolutely certain that the future growth prospects will increase my earnings yield to a more attractive level than all of the other investments at my disposal.
The danger of investing in companies that appear overvalued is that there is normally little room for error. The business may indeed be wonderful, but if it experiences a significant sales decline in one quarter or does not open new locations as rapidly as it originally projected, the stock will decline significantly. This is a throw-back to our basic principle that an investor should never ask "Is company ABC a good investment"; instead, he should ask, "Is company ABC a good investment at this price."
Investment Risk #3: Force of Sale Risk
You've done everything right and found an excellent company that is selling far below what it is really worth, buying a good number of shares. It's January, and you plan on using the stock to pay your April tax bill.
By putting yourself in this position, you have bet on when your stock is going to appreciate. This is a financially fatal mistake. In the stock market, you can be relatively certain of what will happen, but not when. You have turned your basic advantage (the luxury of holding permanently and ignoring market quotations), into a disadvantage.
Consider the following: If you had purchased shares of great companies such as Coca-Cola, Berkshire Hathaway, Gillette and Washington Post at a decent price in 1987 yet had to sell the stock sometime later in the year, you would have been devastated by the crash that occurred in October. Your investment analysis may have been absolutely correct but because you imposed a time limit, you opened yourself up to a tremendous amount of risk.
Being forced to sell your investments is really something known as liquidity risk, which is important enough I wrote a separate article about it to help you understand why it poses such a threat to your net worth.
Risk is an inherent part of investing. Generally, investors must take greater risks to achieve greater returns. Those who do not tolerate risk very well have a relatively smaller chance of making high earnings than do those with a higher tolerance for risk.
It's crucial to understand that there is an inescapable trade-off between investment performance and risk: Higher returns are associated with higher risks of price fluctuations. Stocks historically have provided the highest long-term returns of the three major asset classes and have been subject to the biggest losses over shorter periods. At the other extreme, short-term cash investments are among the safest of investments when it comes to price stability, but they have provided the lowest long-term returns.
Over short periods—even periods lasting a few years—lower-risk investments may provide better returns than higher-risk investments. But historically over long periods, riskier assets have provided higher returns.
There are various types of risk. We will discuss a few here:
This category of risk deals with the personal level of investing. The investor is likely to have more control over this type of risk compared to others.
Timing risk is the risk of buying the right security at the wrong time. It also refers to selling the right security at the wrong time. For example, there is the chance that a few days after you sell a stock it will go up several dollars in value. There is no surefire way to time the market.
Tenure risk is the risk of losing money while holding onto a security. During the period of holding, markets may go down, inflation may worsen, or a company may go bankrupt. There is always the possibility of loss on the company-wide level, too.
There are two common risks on the company-wide level. The first, financial risk, is the danger that a corporation will not be able to repay its debts. This has a great affect on its bonds, which finance the company's assets. The more assets financed by debts (i.e., bonds and money market instruments), the greater the risk. Studying financial risk involves looking at a company's management, its leadership style, and its credit history.
Management risk is the risk that a company's management may run the company so poorly that it is unable to grow in value or pay dividends to its shareholders. This greatly affects the value of its stock and the attractiveness of all the securities it issues to investors.
Fluctuation in the market as a whole may be caused by the following risks:
Market risk is the chance that the entire market will decline, thus affecting the prices and values of securities. Market risk, in turn, is influenced by outside factors such as embargoes and interest rate changes. See Political risk below.
Liquidity risk is the risk that an investment, when converted to cash, will experience loss in its value.
Interest rate risk is the risk that interest rates will rise, resulting in a current investment's loss of value. A bondholder, for example, may hold a bond earning 6% interest and then see rates on that type of bond climb to 7%.
Inflation risk is the danger that the dollars one invests will buy less in the future because prices of consumer goods rise. When the rate of inflation rises, investments have less purchasing power. This is especially true with investments that earn fixed rates of return. As long as they are held at constant rates, they are threatened by inflation. Inflation risk is tied to interest rate risk, because interest rates often rise to compensate for inflation.
Exchange rate risk is the chance that a nation's currency will lose value when exchanged for foreign currencies.
Reinvestment risk is the danger that reinvested money will fetch returns lower than those earned before reinvestment. Individuals with dividend-reinvestment plans are a group subject to this risk. Bondholders are another.
National And International Risks
National and world events can profoundly affect investment markets.
Economic risk is the danger that the economy as a whole will perform poorly. When the whole economy experiences a downturn, it affects stock prices, the job market, and the prices of consumer products.
Industry risk is the chance that a specific industry will perform poorly. When problems plague one industry, they affect the individual businesses involved as well as the securities issued by those businesses. They may also cross over into other industries. For example, after a national downturn in auto sales, the steel industry may suffer financially.
Tax risk is the danger that rising taxes will make investing less attractive. In general, nations with relatively low tax rates, such as the United States, are popular places for entrepreneurial activities. Businesses that are taxed heavily have less money available for research, expansion, and even dividend payments. Taxes are also levied on capital gains, dividends and interest. Investors continually seek investments that provide the greatest net after-tax returns.
Political risk is the danger that government legislation will have an adverse affect on investment. This can be in the form of high taxes, prohibitive licensing, or the appointment of individuals whose policies interfere with investment growth. Political risks include wars, changes in government leadership, and politically motivated embargoes.
The secret, in other words, is to take calculated risks, not reckless risks.
In financial terms, among other things, it implies the possibility of receiving lower than expected return, or not receiving any return at all, or even not getting your principal amount back.
Every investment opportunity carries some risks or the other. In some investments, a certain type of risk may be predominant, and others not so significant. A full understanding of the various important risks is essential for taking calculated risks and making sensible investment decisions.
Seven major risks are present in varying degrees in different types of investments.
This is the most frightening of all investment risks. The risk of non-payment refers to both the principal and the interest. For all unsecured loans, e.g. loans based on promissory notes, company deposits, etc., this risk is very high. Since there is no security attached, you can do nothing except, of course, go to a court when there is a default in refund of capital or payment of accrued interest.
Given the present circumstances of enormous delays in our legal systems, even if you do go to court and even win the case, you will still be left wondering who ended up being better off - you, the borrower, or your lawyer!
So, do look at the CRISIL / ICRA credit ratings for the company before you invest in company deposits or debentures.
The market value of your investment in equity shares depends upon the performance of the company you invest in. If a company's business suffers and the company does not perform well, the market value of your share can go down sharply.
This invariably happens in the case of shares of companies which hit the IPO market with issues at high premiums when the economy is in a good condition and the stock markets are bullish. Then if these companies could not deliver upon their promises, their share prices fall drastically.
When you invest money in commercial, industrial and business enterprises, there is always the possibility of failure of that business; and you may then get nothing, or very little, on a pro-rata basis in case of the firm's bankruptcy.
A recent example of a banking company where investors were exposed to business risk was of Global Trust Bank. Global Trust Bank, promoted by Ramesh Gelli, slipped into serious problems towards the end of 2003 due to NPA-related issues.
However, the Reserve Bank of India's [ Get Quote ] decision to merge it with Oriental Bank of Commerce [ Get Quote ] was timely. While this protected the interests of stakeholders such as depositors, employees, creditors and borrowers was protected, interests of investors, especially small investors were ignored and they lost their money.
The greatest risk of buying shares in many budding enterprises is the promoter himself, who by overstretching or swindling may ruin the business.
Money has only a limited value if it is not readily available to you as and when you need it. In financial jargon, the ready availability of money is called liquidity. An investment should not only be safe and profitable, but also reasonably liquid.
An asset or investment is said to be liquid if it can be converted into cash quickly, and with little loss in value. Liquidity risk refers to the possibility of the investor not being able to realize its value when required. This may happen either because the security cannot be sold in the market or prematurely terminated, or because the resultant loss in value may be unrealistically high.
Current and savings accounts in a bank, National Savings Certificates, actively traded equity shares and debentures, etc. are fairly liquid investments. In the case of a bank fixed deposit, you can raise loans up to 75% to 90% of the value of the deposit; and to that extent, it is a liquid investment.
Some banks offer attractive loan schemes against security of approved investments, like selected company shares, debentures, National Savings Certificates, Units, etc. Such options add to the liquidity of investments.
The relative liquidity of different investments is highlighted in Table 1.
Liquidity of Various Investments
Liquidity Some Examples
Very high Cash, gold, silver, savings and current accounts in banks, G-Secs
High Fixed deposits with banks, shares of listed companies that are actively traded, units, mutual fund shares
Medium Fixed deposits with companies enjoying high credit rating, debentures of good companies that are actively traded
Low and very low Deposits and debentures of loss-making and cash-strapped companies, inactively traded shares, unlisted shares and debentures, real estate
Don't, however, be under the impression that all listed shares and debentures are equally liquid assets. Out of the 8,000-plus listed stocks, active trading is limited to only around 1,000 stocks. A-group shares are more liquid than B-group shares. The secondary market for debentures is not very liquid in India. Several mutual funds are stuck with PSU stocks and PSU bonds due to lack of liquidity.
Purchasing power risk, or inflation risk
Inflation means being broke with a lot of money in your pocket. When prices shoot up, the purchasing power of your money goes down. Some economists consider inflation to be a disguised tax.
Given the present rates of inflation, it may sound surprising but among developing countries, India is often given good marks for effective management of inflation. The average rate of inflation in India has been less than 8% p.a. during the last two decades.
However, the recent trend of rising inflation across the globe is posing serious challenge to the governments and central banks. In India's case, inflation, in terms of the wholesale prices, which remained benign during the last few years, began firming up from June 2006 onwards and topped double digits in the third week of June 2008. The skyrocketing prices of crude oil in international markets as well as food items are now the two major concerns facing the global economy, including India.
Ironically, relatively "safe" fixed income investments, such as bank deposits and small savings instruments, etc., are more prone to ravages of inflation risk because rising prices erode the purchasing power of your capital. "Riskier" investments such as equity shares are more likely to preserve the value of your capital over the medium term.
Interest rate risk
In this deregulated era, interest rate fluctuation is a common phenomenon with its consequent impact on investment values and yields. Interest rate risk affects fixed income securities and refers to the risk of a change in the value of your investment as a result of movement in interest rates.
Suppose you have invested in a security yielding 8 per cent p.a. for 3 years. If the interest rates move up to 9 per cent one year down the line, a similar security can then be issued only at 9 per cent. Due to the lower yield, the value of your security gets reduced.
The government has extraordinary powers to affect the economy; it may introduce legislation affecting some industries or companies in which you have invested, or it may introduce legislation granting debt-relief to certain sections of society, fixing ceilings of property, etc.
One government may go and another come with a totally different set of political and economic ideologies. In the process, the fortunes of many industries and companies undergo a drastic change. Change in government policies is one reason for political risk.
Whenever there is a threat of war, financial markets become panicky. Nervous selling begins. Security prices plummet. In case a war actually breaks out, it often leads to sheer pandemonium in the financial markets. Similarly, markets become hesitant whenever elections are round the corner. The market prefers to wait and watch, rather than gamble on poll predictions.
International political developments also have an impact on the domestic scene, what with markets becoming globalized. This was amply demonstrated by the aftermath of 9/11 events in the USA and in the countdown to the Iraq war early in 2003. Through increased world trade, India is likely to become much more prone to political events in its trading partner-countries.
Market risk is the risk of movement in security prices due to factors that affect the market as a whole. Natural disasters can be one such factor. The most important of these factors is the phase (bearish or bullish) the markets are going through. Stock markets and bond markets are affected by rising and falling prices due to alternating bullish and bearish periods: Thus:
• Bearish stock markets usually precede economic recessions.
• Bearish bond markets result generally from high market interest rates, which, in turn, are pushed by high rates of inflation.
• Bullish stock markets are witnessed during economic recovery and boom periods.
• Bullish bond markets result from low interest rates and low rates of inflation.
How to manage risks
Not all the seven types of risks may be present at one time, in any single investment. Secondly, many-a-times the various kinds of risks are interlinked. Thus, investment in a company that faces high business risk automatically has a higher liquidity risk than a similar investment in other companies with a lesser degree of business risk.
It is important to carefully assess the existence of each kind of risk, and its intensity in whichever investment opportunity you may consider. However, let not the very presence of risk paralyse you into inaction. Please remember that there is always some risk or the other in every investment option; no risk, no gain!
What is important is to clearly grasp the nature and degree of risk present in a particular case – and whether it is a risk you can afford to, and are willing to, take.
Success skill in managing your investments lies in achieving the right balance between risks and returns. Where risk is high, returns can also be expected to be high, as may be seen from Figure 1.
The Risk-Return Trade-Off
Once you understand the risks involved in different investments, you can choose your comfort zone and stay there. That's the way to wealth.
The risk/reward relationship is likely the most fundamental concept of finance. But “risk” is such a vague term that I think it can be helpful to break it down into more tangible components.
Time as a Component of Risk
When it comes to money, time is a key ingredient. It can take an otherwise very risky investment and make it significantly less risky–possibly even conservative.
For example, a friend of mine is buying a condo in Manhattan. While prices have come down recently, they are still astronomically high. My buddy is worried about buying this condo because he fears that prices might drop. If he does buy the condo, the reward is pride of ownership and (possibly) a good long-term investment. But the risk that he’s thinking about is the risk of overpaying for his pad.
Why is he thinking about that?
He’s completely forgotten about the element of time. He’s not going to sell his condo this year or next. He’s not going to fund his down payment by going into credit card debt. He’s got the cash just sitting there. And the odds are, he’ll hold on to that place for the next 20 years. It doesn’t matter what the price of the condo does over the next few years because that will have no impact on him.
When you think about risk and reward, don’t forget about time. Consider your risk over your intended or likely time frame.
Probability of Loss
The next component of risk is probability. Yes, it’s important to understand what a bad outcome might look like, but in order to make a good decision, we have to be mindful of the chances of something catastrophic happening.
Think about driving your car. There is always the possibility of getting into a terrible accident when you get into an automobile. But the odds of a catastrophic accident are so remote that most people don’t have a problem getting into a car and driving downtown.
Investments are no different. When you make an investment, there are always risks. You can take steps to reduce those risks, but you can never eliminate them. Because risk exists, does that mean you shouldn’t take action? It may…if the probability of that bad outcome is significant. But if the probability is very low, you (usually) shouldn’t let it stop you.
Magnitude of Loss
The final component of risk is magnitude. The odds of something happening might be very low, but the magnitude of the consequence might be so great that you still can’t take the chance.
Consider robbing a bank: Even if you have what appears to be the perfect plan, it’s a bad move. The idea of going to jail is so repulsive that it makes the proposition a non-starter. In this case, the magnitude of the consequence is so high that it almost doesn’t matter that the odds of experiencing that negative outcome are low.
Similarly, even if you have a “sure thing” investment, it’s still important to diversify. If you put everything into one ostensibly low-risk investment and that one-in-a-million bad outcome occurs, your life savings will be history, and you won’t have enough money to retire.
When considering magnitude of risk, rather than thinking in terms of dollars, it can be helpful to think in terms of impact. For example, Bill Gates can lose $10,000, and it won’t impact him at all. He can still live on any island he likes. You might also be able to lose $10,000 without it having a huge impact on your life. But somebody struggling with debt can’t afford that risk. Such a loss would be a game-changer and, therefore, not an acceptable proposition.
In summary, when investing, you need to understand what you are risking, how likely that risk is to appear, and how the magnitude and probability of that risk change over time.
The Components of Risk
When a firm makes an investment, in a new asset or a project, the return on that investment can be affected by several variables, most of which are not under the direct control of the firm. Some of the risk comes directly from the investment, a portion from competition, some from shifts in the industry, some from changes in exchange rates and some from macroeconomic factors. A portion of this risk, however, will be eliminated by the firm itself over the course of multiple investments and another portion by investors as they hold diversified portfolios.
The first source of risk is project-specific; an individual project may have higher or lower cashflows than expected, either because the firm misestimated the cashflows for that project or because of factors specific to that project. When firms take a large number of similar projects, it can be argued that much of this risk should be diversified away in the normal course of business. For instance, Disney, while considering making a new movie, exposes itself to estimation error - it may under or over estimate the cost and time of making the movie, and may also err in its estimates of revenues from both theatrical release and the sale of merchandise. Since Disney releases several movies a year, it can be argued that some or much of this risk should be diversifiable across movies produced during the course of the year.
The second source of risk is competitive risk, whereby the earnings and cashflows on a project are affected (positively or negatively) by the actions of competitors. While a good project analysis will build in the expected reactions of competitors into estimates of profit margins and growth, the actual actions taken by competitors may differ from these expectations. In most cases, this component of risk will affect more than one project, and is therefore more difficult to diversify away in the normal course of business by the firm. Disney, for instance, in its analysis of revenues from its Disney retail store division may err in its assessments of the strength and strategies of competitors like Toys�R�Us and WalMart. While Disney cannot diversify away its competitive risk, stockholders in Disney can, if they are willing to hold stock in the competitors
The third source of risk is industry-specific risk �� those factors that impact the earnings and cashflows of a specific industry. There are three sources of industry-specific risk. The first is technology risk, which reflects the effects of technologies that change or evolve in ways different from those expected when a project was originally analyzed. The second source is legal risk, which reflects the effect of changing laws and regulations. The third is commodity risk, which reflects the effects of price changes in commodities and services that are used or produced disproportionately by a specific industry. Disney, for instance, in assessing the prospects of its broadcasting division (ABC) is likely to be exposed to all three risks; to technology risk, as the lines between television entertainment and the internet are increasing blurred by companies like Microsoft, to legal risk, as the laws governing broadcasting change and to commodity risk, as the costs of making new television programs change over time. A firm cannot diversify away its industry-specific risk without diversifying across industries, either with new projects or through acquisitions. Stockholders in the firm should be able to diversify away industry-specific risk by holding portfolios of stocks from different industries.
The fourth source of risk is international risk. A firm faces this type of risk when it generates revenues or has costs outside its domestic market. In such cases, the earnings and cashflows will be affected by unexpected exchange rate movements or by political developments. Disney, for instance, was clearly exposed to this risk with its 33% stake in EuroDisney, the theme park it developed outside Paris. Some of this risk may be diversified away by the firm in the normal course of business by investing in projects in different countries whose currencies may not all move in the same direction. Citibank and McDonalds, for instance, operate in many different countries and are much less exposed to international risk than was Wal-Mart in 1994, when its foreign operations were restricted primarily to Mexico. Companies can also reduce their exposure to the exchange rate component of this risk by borrowing in the local currency to fund projects; for instance, by borrowing money in pesos to invest in Mexico. Investors should be able to reduce their exposure to international risk by diversifying globally.
The final source of risk is market risk: macroeconomic factors that affect essentially all companies and all projects, to varying degrees. For example, changes in interest rates will affect the value of projects already taken and those yet to be taken both directly, through the discount rates, and indirectly, through the cashflows. Other factors that affect all investments include the term structure (the difference between short and long term rates), the risk preferences of investors (as investors become more risk averse, more risky investments will lose value), inflation, and economic growth. While expected values of all these variables enter into project analysis, unexpected changes in these variables will affect the values of these investments. Neither investors nor firms can diversify away this risk since all risky investments bear some exposure to this risk.
Why Diversification Reduces or Eliminates Firm-Specific Risk
Why do we distinguish between the different types of risk? Risk that affect one of a few firms, i.e., firm specific risk, can be reduced or even eliminated by investors as they hold more diverse portfolios due to two reasons.
• The first is that each investment in a diversified portfolio is a much smaller percentage of that portfolio. Thus, any risk that increases or reduces the value of only that investment or a small group of investments will have only a small impact on the overall portfolio.
• The second is that the effects of firm-specific actions on the prices of individual assets in a portfolio can be either positive or negative for each asset for any period. Thus, in large portfolios, it can be reasonably argued that this risk will average out to be zero and thus not impact the overall value of the portfolio.
In contrast, risk that affects most of all assets in the market will continue to persist even in large and diversified portfolios. For instance, other things being equal, an increase in interest rates will lower the values of most assets in a portfolio. Figure 3.5 summarizes the different components of risk and the actions that can be taken by the firm and its investors to reduce or eliminate this risk.
While the intuition for diversification reducing risk is simple, the benefits of diversification can also be shown statistically. In the last section, we introduced standard deviation as the measure of risk in an investment and calculated the standard deviation for an individual stock (Disney). When you combine two investments that do not move together in a portfolio, the standard deviation of that portfolio can be lower than the standard deviation of the individual stocks in the portfolio. To see how the magic of diversification works, consider a portfolio of two assets. Asset A has an expected return of A and a variance in returns of 2A, while asset B has an expected return of B and a variance in returns of 2B. The correlation in returns between the two assets, which measures how the assets move together, is AB. The expected returns and variance of a two-asset portfolio can be written as a function of these inputs and the proportion of the portfolio going to each asset.
portfolio = wA A + (1 - wA) B
2portfolio = wA2 2A + (1 - wA)2 2B + 2 wA wB A B
wA = Proportion of the portfolio in asset A
The last term in the variance formulation is sometimes written in terms of the covariance in returns between the two assets, which is
AB = A B
The savings that accrue from diversification are a function of the correlation coefficient. Other things remaining equal, the higher the correlation in returns between the two assets, the smaller are the potential benefits from diversification. The following example illustrates the savings from diversification.
Variance of a portfolio: Disney and Aracruz
In illustration 3.1, we computed the average return and standard deviation of returns on Disney between January 1999 and December 2003. While Aracruz is a Brazilian stock, it has been listed and traded in the U.S. market over the same period.  Using the same 60 months of data on Aracruz, we computed the average return and standard deviation on its returns over the same period:
Disney Aracruz ADR
Average Monthly Return - 0.07% 2.57%
Standard Deviation in Monthly Returns 9.33% 12.62%
Over the period (1999-2003), Aracruz was a much more attractive investment than Disney but it was also much more volatile. We computed the correlation between the two stocks over the 60-month period to be 0.2665. Consider now a portfolio that is invested 90% in Disney and 10% in the Aracruz ADR. The variance and the standard deviation of the portfolio can be computed as follows:
Variance of portfolio = wDis2 2Dis + (1 - wDis)2 2Ara + 2 wDis wAraDis,Ara Dis Ara
= (.9)2(.0933)2+(.1)2(.1262)2+ 2 (.9)(.1)(.2665)(.0933)(.1262)
Standard Deviation of Portfolio = = .0881 or 8.81%
The portfolio is less risky than either of the two stocks that go into it. In figure 3.6, we graph the standard deviation in the portfolio as a function of the proportion of the portfolio invested in Disney:
As the proportion of the portfolio invested in Aracruz shifts towards 100%, the standard deviation of the portfolio converges on the standard deviation of Aracruz.
Risk is an unexpected variablity of asset prices and earning. There are two major sources of risk;
1. Business Risk:
is the risk that a firm is subjected to during daily operations and includes the risks that result from business decisions and the business environment. Business risk includes Strategic Risk and Macro Economic Risk.
Stretegic risk reflects risks inherent in the decision of senior management setting a business strategy.
Macro Economic Risk is inherent with the overall economic condition of the region and it has an impact over firm's operation and sales. One of the examples of business risk is that the economy will slow and demand for a product will fall.
2. Financial Risk:
is the result of a firm's financial market activities. Like interest rate movement after the issuance of floating rate bonds. In this case the issuing firm will be negatively impacted if market reates increase
Financial risk management is the practice of creating economic value in a FIRM by using FINANCIAL INSTRUMENTS to manage exposure to RISK, particularly CREDIT RISK and MARKET RISK. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc. Similar to general RISK MANAGEMENT , financial risk management requires identifying its sources, measuring it, and plans to address them. Financial risk management can be qualitative and quantitative. As a specialization of RISK management, financial risk management focuses on when and how to HEDGE using financial instruments to manage costly exposures to risk.
A general rule of thumb, however, is that MARKET RISKS that result in UNIQUE RISKS for the firm are candidates for financial risk management.
VARIOUS TYPES OF RISKS
-is the risk of loss due to movement in the level of
or volatility of market prices.
-takes two forms, asset liability risk and funding liquidity
2A] ASSET LIQUIDITY RISK
-also known as market / product liquidity risk, arises
when a transaction cannot be conducted
at the prevailing market prices due to the size of
the position relative to normal tracking lots.
2B]FUNDING LIQUIDITY RISK
-also known as cash flow risk, refers to the inability
to meet the payment obligation.
-is the risk of loss due to the fact that counter
parties may be unwilling or unable to fulfill
their contractual obligations.
-is generally defined as the risk of loss resulting
from failed or inadequate internal processes,
systems, and people or from external events.
STRATEGIES FOR MANAGING THESE RISKS
1.ROLE OF SENIOR MANAGEMENT
-dealers /end users should use derivatives,in a manner
consistent with the overall risk and capital policies
approved by the board.The policy should be clearly
defined ,including the purposes for which the
transactions are to be undertaken. The manager should
approve the procedure and controls to implement these
policies and management at all levels.
2.MEASURING MARKET RISKS
-dealer should use a consistent measure to calculate
daily the market risks of their derivative position and
compare it with the market risk limits. Market risks
is best measured as ''value at risk'' using probability
analysis based on a common confidence interval
and time horizon.
-dealer should regularly perform simulation to determine
how their portfolios perform under stress conditions.
4.INVESTING AND FUNDING FORECAST.
-dealers should periodically forecast the cash investing
and funding requirements arising from their derivative
5.INDEPENDENT MARKET RISK MANAGEMENT
-dealers should have a market risk management function,
with clear independent authority to ensure that the
following responsibilities are carried out
d]back tracking variance
e]review of pricing models
6.MEASURE CREDIT EXPOSURES
-dealers and end users should measure credit exposures
a]currency exposure >>>replace cost of transaction
b]potential exposure >>>future replacement cost of transaction
7.INDEPENDENT CREDIT RISK MANAGEMENT.
-credit risk management with clear independence
and authorities --responsible for approving
credit exposure measurement standards, setting
credit limits and monitor, review and action planning.
Liquidity risk management
(i) Centralisation vs decentralisation
The Working Group found that a key defining characteristic of financial groups’ liquidity risk
management is the degree of centralisation of the management function.
Group studied the degree of centralisation among groups and differences attributable to the
type of firm dominating the group.
Financial groups have adopted a variety of structures for managing liquidity risk that range
from highly centralised to highly decentralised. The degree of centralisation may be viewed
on a continuum, with a minimum level involving the development of general group-wide
policies and procedures and the submission to group-level management of regular reports on
each business unit’s performance and risk profile. A higher level of central control would be
for a group-wide risk management unit to manage risk throughout the organisation, either on
its own or in conjunction with managers of the operating units. At the tightest level of central
control, the centre manages functions on behalf of the operating units.
A group’s business model is an important factor in its decision regarding the degree of
centralisation of liquidity risk management. Groups also balance considerations of efficiency,
minimisation of funding costs, diversification of funding, management knowledge and
responsibility, and the feasibility of moving funds and collateral. Groups report that regulation
has only a limited impact on the degree of centralisation of liquidity risk management
Firms with a more centralised approach to liquidity risk management cited the benefits of a
common language and methodology throughout the organisation, the ability to add central
management resources and expertise to local expertise, and the ability to open centrally
managed cash and collateral resources to affected subsidiaries. However, firms generally
hold adequate liquid reserves at the local or subsidiary level to mitigate the risk that these
arrangements may be complicated when funds and collateral are in different currencies or
are not easily transferable between group entities.
Groups that are dominated by securities firms tend to take a highly centralised approach,
moving funds to wherever in the organisation they are needed in times of stress. At the
opposite end of the spectrum, groups conducting primarily an insurance business tend to
grant a large measure of autonomy to individual operating units, even when under stress.
Banking groups tend to expect local units to handle a crisis initially, but to provide increasing
funding and management assistance as the crisis escalates, up to a certain limit.
When referring to centralised or decentralised approaches to funding liquidity management, there are at least
two aspects to be considered: (1) the level(s) at which management policies and procedures, tools, metrics
and/or limits are designed and applied within a group; and (2) the extent to which liquidity may or may not flow
to certain parts of the group. This paper refers to the second aspect, unless otherwise noted.
The management of liquidity risk in financial groups
(ii) Metrics used for liquidity risk management
Most financial firms use a variety of metrics to monitor the level of liquidity risk to which they
are exposed. The basic approaches may be categorised into three types: the liquid assets
approach, the cash flow approach, and a mixture of the two.
Under the liquid assets approach, the firm maintains liquid instruments on its
balance sheet that can be drawn upon when needed. As a variation on this
approach, the firm may maintain a pool of unencumbered assets (usually
government securities) that can be used to obtain secured funding through
repurchase agreements and other secured facilities. (The relevant metrics in this
approach are ratios.)
Under the cash flow matching approach, the firm attempts to match cash outflows
against contractual cash inflows across a variety of near-term maturity buckets.
The mixed approach combines elements of the cash flow matching approach and
the liquid assets approach. The firm attempts to match cash outflows in each time
bucket against a combination of contractual cash inflows plus inflows that can be
generated through the sale of assets, repurchase agreement or other secured
borrowing. Assets that are most liquid are typically counted in the earliest time
buckets, while less liquid assets are counted in later time buckets.
Because, as stated above, most firms use several metrics, there will be some overlap in the
approaches taken by firms in the three sectors. Nonetheless, the Working Group’s survey
revealed notable sectoral leanings. The liquid assets approach is the most commonly used
approach in the securities sector for both normal and stress environments. It is used to a
lesser extent in the banking and insurance sectors. These two sectors place more emphasis
on the cash flow matching approach. When gaps in maturity buckets are unfavourable,
banks and insurance companies would utilise the mixed approach to help ensure that they
will be able to meet their obligations to provide cash to counterparties.
(iii) Cross-border issues
A key issue in group liquidity risk management is the extent to which individual business
units domiciled in jurisdictions other than that of the parent are expected or have the ability to
handle liquidity pressures with their own resources. In this regard, a number of groups
differentiate between jurisdictions with hard, convertible currencies and those with non-
convertible currencies. Approaches to cross-border liquidity risk management range from a
group’s expectation that non-domestic units stand alone and independently access funding
liquidity in a stress situation to a central provider of funding liquidity across the group, up to a
certain limit. The latter approach is consistent with the more centralised liquidity risk
management model generally found in securities groups. An in-between approach is most
common in the banking sector, with a variety of shadings as to how quickly and to what
extent the central liquidity provider enters into the picture. In the insurance sector, there is
the expectation that the individual units will stand alone, although there is some access to the
parent as a lender-of-last resort in severe stress scenarios.
Firms note that cross-border liquidity risk management is subject to the requirements of
maintaining cash and collateral in both domestic and foreign currencies, which involves a
trade-off between maintaining readily available liquid assets for contingent funding needs in
various entities within the group versus the costs of maintaining such assets.
The management of liquidity risk in financial groups
Financial groups’ three main alternative approaches to addressing cross-border issues
include holding liquid assets (i) in a single entity concentrated in one location, (ii) in a single
entity in a number of locations, and (iii) in a number of subsidiaries in various locations.
Approximately 30 percent of the surveyed firms operating primarily in the banking or
securities sectors take an approach that entails centrally managed pools of liquid assets in
an entity widely diversified by location, time zone, currency or central bank access. (No
insurer-led group is known to have this approach.)
(iv) Cross-currency issues
Major financial groups noted the presence of cross-currency/cross-time-zone liquidity risk,
that is, the risk that arises when a firm relies on a cash inflow or asset in one currency to
meet an obligation in another currency, often in another time zone. However, currency risk
appears not to be limited to groups with international activity; some firms noted that they face
significant cross-currency liquidity risk because they raise large amounts in foreign
currencies and swap them into the currencies needed by their business, both for cost-of-
funding and diversification reasons.
Most firms assume continuous convertibility of the major currencies, even in their stress
scenarios. Some firms nonetheless monitor the extent of cross-currency liquidity risk at group
level by calculating group liquidity risk for each currency material to their business or by
monitoring imminent currency borrowing needs across the group. Liquidity risk management
of soft currencies (ie currencies incurring material foreign exchange risk) can involve either a
prohibition of asset/liability mismatches or the exclusion of mismatched assets and cash
inflows from the calculation of the group’s liquidity risk profile. Securities firms address
currency risk by maintaining parent-level liquidity reserves overseas, as well as by
maintaining excess liquidity in foreign subsidiaries.
(v) Cross-affiliate issues
A key issue for the Working Group was the extent to which the parent or subsidiary units of a
group would provide liquidity to affiliates under stress and the implications of cross-affiliate
transfers of funds and collateral across national borders, sectors, and currencies.
Liquidity support from parents is not common in the insurance sector, given generally strict
regulatory restrictions on funds transfers from one insurance subsidiary to another. Parent
support is more common in the banking and securities sectors, where parent firms often
serve as a source of strength and ensure that there are resources at both the parent and
subsidiary levels to address liquidity events as they arise. This is consistent with the
tendency towards the centralisation of liquidity risk management in these sectors, as greater
centralisation generally contributes to a structure in which affiliates are expected to provide
liquidity support to one another.
Most groups opined that reputational contagion (ie when market counterparties assume that
a problem at one affiliate implies a solvency problem for the group as a whole) is the most
likely mechanism by which a liquidity problem in one affiliate would spread to other parts of
the group, especially if the group follows a centralised approach to liquidity risk management.
To mitigate contagion, surveyed firms stressed the importance of communication with
counterparties, credit rating agencies, and other stakeholders. In addition to a highly effective
communication function, group-wide CFPs, liquidity pools, and multiple sources of funding
were identified as mechanisms that may mitigate reputational contagion. In addition, some
firms with decentralised liquidity management opined that such a decentralised approach
The management of liquidity risk in financial groups
could mitigate reputational contagion to some extent, as long as the approach is well-
communicated and understood by the market ex ante.
Groups also noted that liquidity pressures can spread through various cross-affiliate funding
channels. An entity that provides regular funding to affiliates may be unable to continue
providing the normal funding on which its affiliates rely when it faces its own liquidity strain or
one affiliate is in need of extraordinary funding. Groups often establish internal limits on
liquidity risk at the group level. Stress testing is viewed as a useful tool in determining group
limits. Many firms also have limits at subsidiary levels to reduce the subsidiary’s reliance on
funding from the parent in order to reduce the likelihood of contagion from stresses felt
elsewhere in the organisation