The discipline can be qualitative and quantitative; as a specialization of
risk management, however, financial risk management focuses more on when and how to
hedge,[5] often using financial instruments to manage costly exposures to risk.[6]
In the banking sector worldwide, the
Basel Accords are generally adopted by internationally active banks for tracking, reporting and exposing operational, credit and market risks.[7][8]
In
investment management[11] risk is managed through diversification and related optimization; while further specific techniques are then applied to the portfolio or to individual stocks as appropriate.
In all cases, the last "
line of defence" against risk is
capital, "as it ensures that a firm can continue as a
going concern even if substantial and unexpected losses are incurred".[12]
There is therefore a fundamental debate relating to "Risk Management" and
shareholder value.[5][14][15] The discussion essentially weighs the value of risk management in a market versus the cost of
bankruptcy in that market: per the
Modigliani and Miller framework, hedging is irrelevant since diversified shareholders are assumed to not care about firm-specific risks, whereas, on the other hand hedging is seen to create value in that it reduces the
probability of financial distress.
When applied to financial risk management, this implies that firm managers should not hedge risks that investors can hedge for themselves at the same cost.
[5] This notion is captured in the so-called "hedging irrelevance proposition":[16] "In a
perfect market, the firm cannot create value by hedging a risk when the price of bearing that
risk within the firm is the same as the
price of bearing it outside of the firm."
In practice, however, financial markets are not likely to be perfect markets.[17][18][19][20] This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management, wherein they have to determine which risks are cheaper for the firm to manage than the shareholders. Here,
market risks that result in unique risks for the firm are commonly the best candidates for financial risk management.[21]
Application
As outlined, businesses are exposed, in the main, to market, credit and operational risk. A broad distinction [12] exists though, between
financial institutions and non-financial firms - and correspondingly, the application of risk management will differ. Respectively:[12]
For Banks and Fund Managers, "credit and market risks are taken intentionally with the objective of earning returns, while operational risks are a
byproduct to be controlled".
For non-financial firms, the priorities are reversed, as "the focus is on the risks associated with the business" - ie the production and marketing of the services and products
in which expertise is held - and their impact on revenue, costs and cash flow, "while market and credit risks are usually of secondary importance as they are a byproduct of the main business agenda".
(See related discussion re
valuing financial services firms as compared to other firms.)
In all cases, as above, risk capital is the last "
line of defence".
Correspondingly, and broadly, calculations [26][25] are built
as follows:
For (i) on
the "Greeks", the sensitivity of the price of a derivative to a change in its underlying factors; as well as on
the various other measures of sensitivity, such as
DV01 for the sensitivity of a
bond or
swap to interest rates, and
CS01 or
JTD for exposure to
credit spread.
For (ii) on
value at risk, or "VaR", an estimate of how much the investment or area in question might lose with a given probability in a set time period, with the bank holding
"economic"- or “
risk capital” correspondingly;
common parameters are 99% and 95% worst-case losses - i.e. 1% and 5% - and one day and two week (
10 day) horizons.[27]
The regulatory capital quantum is calculated via specified formulae: risk weighting the exposures per highly standardized asset-categorizations, applying the aside frameworks, and the resultant capital — at least 12.9% [28] of these
Risk-weighted assets (RWA) — must then be held
in specific "tiers" and is measured correspondingly via the
various capital ratios.
In certain cases, banks are allowed to use their own estimated risk parameters here; these
"internal ratings-based models" typically result in less required capital, but at the same time
are subject to strict minimum conditions and disclosure requirements.
As mentioned, additional to the capital covering RWA, the aggregate
balance sheet will require capital for
leverage and
liquidity; this is monitored via [29] the
LR,
LCR, and
NSFR ratios.
Regulatory changes, are also twofold.
The first change, entails an
increased emphasis[34] on
bank stress tests.
[35]
These tests, essentially a simulation of the balance-sheet for a given scenario, are typically linked to the macroeconomics, and provide an indicator of how sensitive the bank is to changes in economic conditions, whether it is
sufficiently capitalized, and of its ability to respond to market events.
The second set of changes, sometimes called "
Basel IV", entails the modification of several regulatory capital standards (
CRR III is the EU implementation). In particular
FRTB addresses market risk, and
SA-CCR addresses counterparty risk;
other modifications
are being phased in from 2023.
Desks, or areas, will similarly be
limited as to their VaR quantum (total or incremental, and under various calculation regimes), corresponding to their allocated economic capital; a loss which exceeds the VaR threshold is termed a "VaR breach". RWA is correspondingly monitored from desk level [37] and upward.
Periodically,
[47]
these all are estimated under a given stress scenario —
regulatory and,
[48]
often,
internal —
and risk capital,
together with these limits if indicated,[49] is correspondingly revisited (or optimized [50]).
Here, more generally, these tests
provide estimates for scenarios beyond the VaR thresholds, thus “preparing for anything that might happen, rather than worrying about precise likelihoods".[51]
The approaches taken center either on a hypothetical or
historical scenario,
[34][26]
and may apply increasingly sophisticated mathematics
[52][26]
to the analysis.
A key practice,
[53]
incorporating and assimilating the above, is to assess the
Risk-adjusted return on capital, RAROC, of each area (or product). Here,[54]economic return is divided by allocated-capital; and this result is then compared [54][22] to the target-return for the area — usually, at least the
equity holders' expected returns on the bank stock [54] — and identified under-performance can then be addressed. (See similar
below re. DuPont analysis.)
The numerator, risk-adjusted return, is achieved trading-return less a
term and risk appropriate funding cost as charged
by Treasury to the business-unit under the bank's
funds transfer pricing (FTP) framework;
[55]direct costs are (sometimes) also subtracted.[53]
The denominator is the area's allocated capital, as above, increasing as a function of position risk.
[56][57][53]
RAROC is calculated both ex post as discussed, used for performance evaluation (and related
bonus calculations),
and ex ante - i.e.
expected return less
expected loss - to decide whether a particular business unit should be expanded or contracted.
[58]
It is common for large corporations to have dedicated risk management teams — typically within
FP&A or
corporate treasury — reporting to the
CRO; often these overlap the
internal audit function (see
Three lines of defence).
For small firms, it is impractical to have a formal risk management function, but these typically apply the above practices, at least the first set, informally, as part of the
financial management function; see
discussion under
Financial analyst.
Fund managers, classically,[89] define the risk of a
portfolio as its
variance[11] (or
standard deviation), and through
diversification the
portfolio is optimized so as to achieve the lowest risk for a given targeted return, or equivalently the highest return for a given level of risk;
these risk-efficient portfolios form the "
Efficient frontier" (see
Markowitz model).
The logic here is that returns from different assets are highly unlikely to be perfectly
correlated, and in fact the correlation may sometimes be negative.
In this way, market risk particularly, and other financial risks such as
inflation risk (see below) can at least partially be moderated by forms of diversification.
A key issue, however, is that the (assumed) relationships are (implicitly) forward looking.
As observed in the
late-2000s recession historic relationships can break down, resulting in losses to market participants believing that diversification would provide sufficient protection (in that market, including funds that had been explicitly set up to avoid being affected in this way[90]).
A related issue is that diversification has costs: as correlations are not constant it may be necessary to regularly
rebalance the portfolio, incurring
transaction costs, negatively impacting
investment performance;[91]
and as the fund manager diversifies, so this problem compounds (and a large fund may also exert
market impact).
See
Modern portfolio theory § Criticisms.
Here, guided by the analytics, Fund Managers (and
traders) will apply specific risk hedging techniques.[89][11]
As appropriate, these may relate to the portfolio as a whole or to individual holdings:
Fund managers may engage in
portfolio insurance, a hedging strategy developed to limit the losses an investor might face from a declining
index of stocks without having to sell the stocks themselves. This strategy involves selling
Stock market index futures during periods of price declines. The proceeds from the sale of the futures help to offset paper losses of the owned portfolio. Alternatively, and more commonly,[93] they will
buy a put on a
Stock market index option so as to hedge. In both cases the logic is that the (diversified) portfolio is likely highly correlated with the
stock index it is part of; thus if stock prices decline, the larger index will likewise decline, and the derivative holder will profit.[94] (Inflation, which affects all securities,[95] can to some extent be hedged using
inflation-linked bonds;[96] diversification here is achieved by including
tangible assets and
commodities in the portfolio.[97])
Bond portfolios, when e.g. a component of an
Asset-allocation fund or other
diversified portfolio, are typically managed similar to equity above: the Fund Manager will hedge her bond allocation with
bond index futures or options.[98][99][94] In other contexts, the concern may be the
net-obligation or net-
cashflow. Here the fund manager employs
Interest rate immunization or
cashflow matching. Immunization is a strategy that ensures that a change in interest rates will not affect the value of a fixed-income portfolio (an increase in rates
results in a decreased instrument value). It is often used to ensure that the value of a
pension fund's assets (or an asset manager's fund) increase or decrease in an exactly opposite fashion to their liabilities, thus leaving the value of the pension fund's surplus (or firm's equity) unchanged, regardless of changes in the interest rate. Cashflow matching is similarly a process of hedging in which a company or other entity matches its cash outflows - i.e., financial obligations - with its cash inflows over a given time horizon.
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^
abVan Deventer, Nicole L, Donald R., and Kenji Imai. Credit risk models and the Basel Accords. Singapore: John Wiley & Sons (Asia), 2003.
^
abDrumond, Ines. "Bank capital requirements, business cycle fluctuations and the Basel Accords: a synthesis." Journal of Economic Surveys 23.5 (2009): 798-830.
^
abcdefSee "Market Risk Management in Non-financial Firms", in Carol Alexander, Elizabeth Sheedy eds. (2015). The Professional Risk Managers’ Handbook 2015 Edition.
PRMIA.
ISBN978-0976609704
^Don Chance and Michael Edleson (2021). Introduction to Risk Management. Ch 10 in "Derivatives".
CFA Institute Investment Series.
ISBN978-1119850571
^
abManaging financial risks; summary of Ch. 51 in: Pascal Quiry; Yann Le Fur; Antonio Salvi; Maurizio Dallochio; Pierre Vernimmen (2011). Corporate Finance: Theory and Practice (3rd ed.). Wiley.
ISBN978-1119975588
^Aggarwal, Raj, "The Translation Problem in International Accounting: Insights for Financial Management." Management International Review 15 (Nos. 2-3, 1975): 67-79. (Proposed accounting framework for evaluating and developing translation procedures for multinational corporations).
^
abcdeFor discussion and examples re calculating the appropriate "optimal hedge ratio", and then executing, see: Roger G . Clarke (1992).
"Options and Futures: A Tutorial".
CFA Institute Research Foundation