Lecture 1 - Intro FRM

FINANCIAL RISK MANAGEMENT
FNC-404
Instructor: Dr. Kumail Rizvi
15/01/2014
Kumail Rizvi, PhD, CFA, FRM
2011
2010
2010
2007
2003
2001
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KUMAIL RIZVI
PHD FROM PARIS 1 (PANTHON SORBONNE)
CFA
FRM
MSC MONEY BANKING AND FINANCE
MSC COMPUTER SCIENCES
MBECON (FINANCE)
EXPERIENCE
GIFT UNIVERSITY
HAILEY COLLEGE OF COMMERCE, PUNJAB UNIVERSITY
PAK AIMS
IBP (INSTITUTE OF BANKERS PAKISTAN)
PARIS 1 (PANTHON 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)
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)
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All outcomes or only negative

outcomes? (Left Tail)
Combination
Opportunity.
of
Danger
and
3
RISK
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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
wouldnt make any decision at
all.
4
INTRODUCTION
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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.
INTRODUCTION
As an individual or a company engage in risk
activity like investment, different questions
arise:
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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?

Financial risk
management is the design
and implementation of
procedures for
identifying, measuring
and managing financial
risks.
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Risk Management is a process
involving:
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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.
Exposure is the size or value of

loss that would be realized if an
unexpected outcome occurred.
THE PRACTICE OF RISK MANAGEMENT
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SOURCES OF RISK
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
For a non-financial
corporation, likely to
be non-core
Risks the corporation

assumes willingly
Financial
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Business
10
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Financial Risk
Non-Financial Risk
IDENTIFYING RISK
IDENTIFYING RISK
Risk that an individual or corporation is exposed
to, take many different forms:
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FINANCIAL RISK
Market Risk
Including:
Credit Risk
Liquidity Risk
Interest rate risk

Commodity Price Risk
Equity Price Risk
Exchange Rate Risk
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MARKET RISK
Absolute risk
Relative risk
Basis risk
Volatility risk
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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:
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MARKET RISK INCLUDES..

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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.
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CREDIT RISK
Sovereign risk
Settlement risk
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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:
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CREDIT RISK INCLUDES.

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Sovereign Risk is the risk resulting from a

countrys action. It differs from other forms of
credit risks as it is country specific. A countrys
willingness and ability to repay its obligations
are often factors looked at when evaluating the
sovereign risk. Sovereign risk often stems from
countrys 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.
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LIQUIDITY RISK
Asset or Trading liquidity risk

Funding liquidity risk
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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:
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LIQUIDITY RISK INCLUDES...

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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.
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NON-FINANCIAL RISK
Operational Risk
includes:
Model Risk
People Risk
Legal Risk
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Business Risk
Includes:
Strategic Risk
Macroeconomic Risk
Political Risk
Regulatory risk
Tax Risk
Accounting Risk
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OPERATIONAL RISK
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
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Operational Risk is the risk of loss from failures

in a companys systems and procedures or from
external events.
These risks can arise from:
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MODEL, PEOPLE & LEGAL RISKS

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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.
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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.
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OTHER RISKS
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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.
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ILLUSTRATION: IDENTIFYING RISKS
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Market Risk
Credit Risk
Liquidity Risk
Operational Risk
MEASURING RISK
MEASURING MARKET RISK

Few conventional techniques are available to
measure market risk.
Standard Deviation; referred to as

Assets
Volatility typically represented by Greek letter
Tracking error measures the volatility of a
portfolios
return in excess of the benchmark
portfolios 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.
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There are few errors in some formulas: Do

correct them
28
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MEASURING MARKET RISK

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During 1990s, a new technique emerged as the

financial
service
industrys
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.
31
VALUE AT RISK: EXAMPLE
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.
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The VAR of a portfolio is $1.5 million for one

day with a probability of 0.05.
VAR as Minimum:
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MEASURING LIQUIDITY RISK
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.
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One traditional measure of liquidity risk is BidAsk Spread (for actively traded securities).
A new technique to measure liquidity risk is a
Liquidity-Adjusted VAR.
35
MEASURING CREDIT RISK
The likelihood of loss a probabilistic concept
Recovery
In every transaction, a given probability exists that the

counterparty will default.
When default occurs, there is usually a portion of
investment that creditors are able to recover called recovery
rate
15/01/2014
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:
Associated amount of loss
This is the amount that is lost by the creditors after

appropriately assessing the magnitude of recovery.
36
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MEASURING CREDIT RISK

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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.
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MEASURING NON-FINANCIAL RISKS

Non-financial risks are intrinsically very difficult
to measure.
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.
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
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40

Lecture 1 - Intro FRM

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FINANCIAL RISK MANAGEMENT

Kumail Rizvi, PhD, CFA, FRM

Kumail Rizvi, PhD, CFA, FRM

Kumail Rizvi, PhD, CFA, FRM

Risk is the probability of loss?

All outcomes or only negative

Kumail Rizvi, PhD, CFA, FRM

However, we have to live with

Investment is an intrinsically risky activity.

Kumail Rizvi, PhD, CFA, FRM

Kumail Rizvi, PhD, CFA, FRM

What is an effective process for identifying,

FINANCIAL RISK MANAGEMENT

Kumail Rizvi, PhD, CFA, FRM

FINANCIAL RISK MANAGEMENT

Identification of exposures to risk

Risk Management in its totality is

Exposure is the size or value of

Kumail Rizvi, PhD, CFA, FRM

THE PRACTICE OF RISK MANAGEMENT

Interest rate exposure

Kumail Rizvi, PhD, CFA, FRM

Risks the corporation

Kumail Rizvi, PhD, CFA, FRM

Kumail Rizvi, PhD, CFA, FRM

Kumail Rizvi, PhD, CFA, FRM

Interest rate risk

Kumail Rizvi, PhD, CFA, FRM

Market risk is the risk associated with interest

MARKET RISK INCLUDES..

Absolute Risk focuses on the volatility of total

Kumail Rizvi, PhD, CFA, FRM

Apart from the market risk, credit risk is the

CREDIT RISK INCLUDES.

Sovereign Risk is the risk resulting from a

Kumail Rizvi, PhD, CFA, FRM

Asset or Trading liquidity risk

Liquidity risk is the possibility of sustaining

LIQUIDITY RISK INCLUDES...

Asset Liquidity Risk, which is sometimes called

Kumail Rizvi, PhD, CFA, FRM

Kumail Rizvi, PhD, CFA, FRM

Computer breakdowns (including bugs, viruses, and

Operational Risk is the risk of loss from failures

MODEL, PEOPLE & LEGAL RISKS

Model Risk is the risk that a model is incorrect or

Kumail Rizvi, PhD, CFA, FRM

Business Risk is the risk that a

Regulatory Risk is the risk associated with the

ILLUSTRATION: IDENTIFYING RISKS

Kumail Rizvi, PhD, CFA, FRM

MEASURING MARKET RISK

Kumail Rizvi, PhD, CFA, FRM

Standard Deviation; referred to as

There are few errors in some formulas: Do

MEASURING MARKET RISK

During 1990s, a new technique emerged as the

VALUE AT RISK: EXAMPLE

There is a 5 percent chance that the portfolio will lose

The probability is 95 percent that the portfolio will

Kumail Rizvi, PhD, CFA, FRM

The VAR of a portfolio is $1.5 million for one

MEASURING LIQUIDITY RISK