Overview of risk management
- Not even risk free rates are riskless
Reasons:
- Inflation Risk: Even if a government bond pays a fixed interest rate, inflation can erode its
purchasing power over time. If the inflation rate exceeds the interest rate, the real return on
the investment becomes negative.
- Credit Risk: Although governments are typically considered to have a lower default risk
than corporations, there have been historical instances where governments have defaulted on
their debt.
- Liquidity Risk: In certain market conditions, it might be difficult to sell a government bond
at its fair market value, especially if the market is illiquid.
- Interest Rate Risk: If interest rates rise after you purchase a bond, the market value of your
bond will typically decline. This is because investors will demand a higher yield for new
bonds issued at the higher interest rate.
Origins of risk
Definition:
- The volatility of unexpected outcomes, generally the value of assets or liabilities of interest
- Higher volatility, higher risk
Risk Management industry can be traced directly to the increased volatility in the financial
markets since the early 1970s (Reasons: The Nixon Shock, The 1970s Energy Crisis and
Inflation, Deregulation….)
Different types of risk:
a) Market risk: A risk that changes in financial market prices and rates will reduce the value
of a security or a portfolio
- Interest rate risk: A sub-type of market risk
In simple term, it is the risk that the value of a fixed-income security will fall as a result of an
increase in market interest rates.
- Equity price risk: Associated with volatility in stock prices
The general market risk of equity refers to the sensitivity of an instrument or portfolio value
to a change in the level of broad stock market indices
- Foreign exchange risk:
Arises from open or imperfectly hedged positions in particular foreign currency denominated
assets and liabilities leading to fluctuations in profits or values as measured in a local
currency
- Commodity price risk:
Differs considerably from interest rate and foreign exchange risk since most commodities are
traded in markets in which the concentration of supply is in the hands of a few suppliers who
can magnify price volatility.
b) Credit risk: The risk of an economic loss from the failure of a counterparty to fulfill its
contractual obligations, or from the increased risk of default during the term of the
transaction
- Liquidity risk: The risk that an institution won’t be able to execute a transaction at the
prevailing market price because there is no appetite for the deal on the other side of the
market.
- Operational risk: Potential losses resulting from a range of operational weaknesses
- Business risk: Uncertainty about the demand for products, or the price that can be charged
for those products, or the cost of producing and delivering products.
- Strategic risk: The risk of significant investments for which there is a high uncertainty about
success and profitability.
Why risk management necessary?
- It is the application of risk analysis to financial, strategic, systems, human and
organizational problems to improve performance.
- Reducing risk through hedging is good: By taking an offsetting position in a related
instrument, you can reduce your exposure to risk and potentially limit your losses.
-> Raises the value of future cash flows as they will be discounted at a lower rate
- Reducing risk through hedging can be bad too:
+) Costs: Hedging strategies often involve costs, such as transaction fees, margin
requirements, or the cost of buying options. These costs can erode your potential profits,
especially if the market moves in your favor.
+) Ineffectiveness: Hedging strategies are not always perfectly effective. Market conditions
can change rapidly, and hedging instruments may not always provide the desired protection.
+) Complexity: Some hedging strategies can be complex and difficult to understand. If you
don't fully understand the risks and benefits of a hedging strategy, you may make poor
decisions.
+) Missed opportunities: Hedging can limit your upside potential. If the market moves
significantly in your favor, hedging can prevent you from realizing the full benefit of your
investment.
Steps in the Risk Management Process
- Determine the corporation’s objectives
- Identify the risk exposures
- Quantify the exposures
- Assess the impact
- Examine alternative risk management tools
- Select appropriate risk management approach
- Implement and monitor program
