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Financial risk |
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Credit risk |
Market risk |
Liquidity risk |
Investment risk |
Business risk |
Profit risk |
Non-financial risk |
Financial risk management is the practice of protecting economic value in a firm by managing exposure to financial risk - principally operational risk, credit risk and market risk, with more specific variants as listed aside. As for risk management more generally, financial risk management requires identifying the sources of risk, measuring these, and crafting plans to mitigate them. [1] [2] See Finance § Risk management for an overview.
Financial risk management as a "science" can be said to have been born [3] with modern portfolio theory, particularly as initiated by Professor Harry Markowitz in 1952 with his article, "Portfolio Selection"; [4] see Mathematical finance § Risk and portfolio management: the P world.
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 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]
Neoclassical finance theory - i.e., financial economics - prescribes that a firm should take on a project if it increases shareholder value. [13] Finance theory also shows that firm managers cannot create value for shareholders or investors by taking on projects that shareholders could do for themselves at the same cost; see Theory of the firm and Fisher separation theorem.
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]
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".
Specific banking frameworks |
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Market risk |
Credit risk |
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Counterparty credit risk |
Operational risk |
Banks and other wholesale institutions face various financial risks in conducting their business, and how well these risks are managed and understood is a key driver behind profitability, as well as of the quantum of capital they are required to hold. [22] Financial risk management in banking has thus grown markedly in importance since the Financial crisis of 2007–2008. [23] (This has given rise [23] to dedicated degrees and professional certifications.)
The major focus here is on credit and market risk, and especially through regulatory capital, includes operational risk. Credit risk is inherent in the business of banking, but additionally, these institutions are exposed to counterparty credit risk. Both are to some extent offset by margining and collateral; and the management is of the net-position. Large banks are also exposed to Macroeconomic systematic risk - risks related to the aggregate economy the bank is operating in [24] (see Too big to fail).
The discipline [25] [26] [7] [8] is, as outlined, simultaneously concerned with (i) managing, and as necessary hedging, the various positions held by the institution - both trading positions and long term exposures; and (ii) calculating and monitoring the resultant economic capital, as well as the regulatory capital under Basel III — which covers also leverage and liquidity — with regulatory capital as a floor. The calculations here are mathematically sophisticated, and within the domain of quantitative finance.
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. 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.
The financial crisis exposed holes in the mechanisms used for hedging (see Fundamental Review of the Trading Book § Background, Tail risk § Role of the global financial crisis (2007-2008), Value at risk § Criticism, and Basel III § Criticism). As such, the methodologies employed have had to evolve, both from a modelling point of view, and in parallel, from a regulatory point of view.
Regarding the modelling, changes corresponding to the above are: (i) For the daily direct analysis of the positions at the desk level, as a standard, measurement of the Greeks now inheres the volatility surface — through local- or stochastic volatility models — while re interest rates, discounting and analytics are under a "multi-curve framework". Derivative pricing now embeds counterparty and other considerations [30] through the CVA and XVA "valuation adjustments"; these also carry regulatory capital. (ii) For Value at Risk, the traditional parametric and "Historical" approaches, are now supplemented [31] [26] with the more sophisticated Conditional value at risk / expected shortfall, Tail value at risk, and Extreme value theory. For the underlying mathematics, these may utilize mixture models, PCA, volatility clustering, copulas, and other techniques. [32] Extensions to VaR include Profit-, Margin-, Liquidity-, Earnings- and Cash flow at risk, as well as Liquidity-adjusted VaR. For both (i) and (ii), model risk is addressed [33] through regular validation of the models used by the bank's various divisions; for VaR models, backtesting is especially employed.
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.
To operationalize the above, Investment banks, particularly, employ dedicated "Risk Groups", i.e. Middle office teams monitoring the firm's risk-exposure to, and the profitability and structure of, its various businesses, products, asset classes, desks, and / or geographies. [36] By increasing order of aggregation:
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]
Other teams, overlapping the above Groups, are then also involved in risk management. Corporate Treasury is responsible for monitoring overall funding and capital structure; it shares responsibility for monitoring liquidity risk, and for maintaining the FTP framework. Middle Office maintains the following functions also: Product Control is primarily responsible for insuring traders mark their books to fair value — a key protection against rogue traders — and for "explaining" the daily P&L; the "unexplained" component, of particular interest to risk managers. Credit Risk monitors the bank's debt-clients on an ongoing basis, re both exposure and performance. In the Front Office, specialized XVA-desks are tasked with centrally monitoring and managing overall CVA and XVA exposure and capital, typically with oversight from the appropriate Group. [30]
Performing the above tasks — while simultaneously ensuring that computations are consistent [59] over the various areas, products, teams, and measures — requires that banks maintain a significant investment [60] in sophisticated infrastructure, finance / risk software, and dedicated staff. Risk software often deployed is from FIS, Kamakura, Murex, Numerix and Refinitiv. Large institutions may prefer systems developed entirely "in house" - notably [61] Goldman Sachs ("SecDB"), JP Morgan ("Athena"), Jane Street, Barclays ("BARX"), BofA ("Quartz") - while, more commonly, the pricing library will be developed internally, especially as this allows for currency re new products or market features.
In corporate finance, and financial management more generally, [62] [10] financial risk management, as above, is concerned with business risk - risks to the business’ value, within the context of its business strategy and capital structure. [63] The scope here - ie in non-financial firms [12] - is thus broadened [9] [64] [65] (re banking) to overlap enterprise risk management, and financial risk management then addresses risks to the firm's overall strategic objectives, incorporating various (all) financial aspects [66] of the exposures and opportunities arising from business decisions, and their link to the firm’s appetite for risk, as well as their impact on share price. In many organizations, risk executives are therefore involved in strategy formulation: "the choice of which risks to undertake through the allocation of its scarce resources is the key tool available to management." [67]
Re the standard framework, [66] then, the discipline largely focuses on operations, i.e. business risk, as outlined. Here, the management is ongoing [10] — see following description — and is coupled with the use of insurance, [68] managing the net-exposure as above: credit risk is usually addressed via provisioning and credit insurance; likewise, where this treatment is deemed appropriate, specifically identified operational risks are also insured. [65] Market risk, in this context, [12] is concerned mainly with changes in commodity prices, interest rates, and foreign exchange rates, and any adverse impact due to these on cash flow and profitability, and hence share price.
Correspondingly, the practice here covers two perspectives; these are shared with corporate finance more generally:
Multinational corporations are faced with additional challenges, particularly as relates to foreign exchange risk, and the scope of financial risk management modifies significantly in the international realm. [79] Here, dependent on time horizon and risk sub-type — transactions exposure [82] (essentially that discussed above), accounting exposure, [83] and economic exposure [84] — so the corporate will manage its risk differently. Note that the forex risk-management discussed here and above, is additional to the per transaction "forward cover" that importers and exporters purchase from their bank (alongside other trade finance mechanisms).
Hedging-related transactions will attract their own accounting treatment, and corporates (and banks) may then require changes to systems, processes and documentation; [85] [86] see Hedge accounting, Mark-to-market accounting, Hedge relationship, Cash flow hedge, IFRS 7, IFRS 9, IFRS 13, FASB 133, IAS 39, FAS 130.
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.
The discipline relies on a range of software, [87] correspondingly, from spreadsheets (invariably as a starting point, and frequently in total [88] ) through commercial EPM and BI tools, often BusinessObjects (SAP), OBI EE (Oracle), Cognos (IBM), and Power BI (Microsoft).
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.
Addressing these issues, more sophisticated approaches have been developed in recent times, both to defining risk, and to the optimization itself. (Respective examples: (tail) risk parity, focuses on allocation of risk, rather than allocation of capital; the Black–Litterman model modifies the "Markowitz optimization", to incorporate the views of the portfolio manager. [92] ) Relatedly, modern financial risk modeling employs a variety of techniques — including value at risk, historical simulation, stress tests, and extreme value theory — to analyze the portfolio and to forecast the likely losses incurred for a variety of risks and scenarios.
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:
In parallel with the above optimization and hedging, [103] managers — active and passive — also monitor and manage tracking error, i.e. underperformance vs a "benchmark". Here they will (may) use attribution analysis preemptively so as to diagnose the source early, and to take corrective action. As relevant, they will similarly use style analysis to address style drift. See also Fixed-income attribution.
Given the complexity of these analyses and techniques, Fund Managers typically rely on sophisticated software (as do banks, above). Widely used platforms are provided by BlackRock (Aladdin), Eikon, Finastra, Murex, Numerix, MPI and Morningstar.
Financial institutions
Corporations
Portfolios
In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the underlying. Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets.
Finance is the study and discipline of money, currency and capital assets. It is related to and distinct from economics, which is the study of the production, distribution, and consumption of goods and services. Based on the scope of financial activities in financial systems, the discipline can be divided into personal, corporate, and public finance.
A hedge fund is a pooled investment fund that holds liquid assets and that makes use of complex trading and risk management techniques to improve investment performance and insulate returns from market risk. Among these portfolio techniques are short selling and the use of leverage and derivative instruments. In the United States, financial regulations require that hedge funds be marketed only to institutional investors and high-net-worth individuals.
Long-Term Capital Management L.P. (LTCM) was a highly leveraged hedge fund. In 1998, it received a $3.6 billion bailout from a group of 14 banks, in a deal brokered and put together by the Federal Reserve Bank of New York.
Financial economics is the branch of economics characterized by a "concentration on monetary activities", in which "money of one type or another is likely to appear on both sides of a trade". Its concern is thus the interrelation of financial variables, such as share prices, interest rates and exchange rates, as opposed to those concerning the real economy. It has two main areas of focus: asset pricing and corporate finance; the first being the perspective of providers of capital, i.e. investors, and the second of users of capital. It thus provides the theoretical underpinning for much of finance.
In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk" or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender or debtholder.
A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.
Credit risk is the possibility of losing a lender holds due to a risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.
A financial analyst is a professional, undertaking financial analysis for external or internal clients as a core feature of the job. The role may specifically be titled securities analyst, research analyst, equity analyst, investment analyst, or ratings analyst. The job title is a broad one: in banking, and industry more generally, various other analyst-roles cover financial management and (credit) risk management, as opposed to focusing on investments and valuation; these are also discussed in this article.
A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets.
In finance, a portfolio is a collection of investments.
A structured product, also known as a market-linked investment, is a pre-packaged structured finance investment strategy based on a single security, a basket of securities, options, indices, commodities, debt issuance or foreign currencies, and to a lesser extent, derivatives. Structured products are not homogeneous — there are numerous varieties of derivatives and underlying assets — but they can be classified under the aside categories. Typically, a desk will employ a specialized "structurer" to design and manage its structured-product offering.
Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial loss and uncertainty about its extent.
Financial modeling is the task of building an abstract representation of a real world financial situation. This is a mathematical model designed to represent the performance of a financial asset or portfolio of a business, project, or any other investment.
Foreign exchange risk is a financial risk that exists when a financial transaction is denominated in a currency other than the domestic currency of the company. The exchange risk arises when there is a risk of an unfavourable change in exchange rate between the domestic currency and the denominated currency before the date when the transaction is completed.
The following outline is provided as an overview of and topical guide to finance:
A portfolio manager (PM) is a professional responsible for making investment decisions and carrying out investment activities on behalf of vested individuals or institutions. Clients invest their money into the PM's investment policy for future growth, such as a retirement fund, endowment fund, or education fund. PMs work with a team of analysts and researchers and are responsible for establishing an investment strategy, selecting appropriate investments, and allocating each investment properly towards an investment fund or asset management vehicle.
Quantitative analysis is the use of mathematical and statistical methods in finance and investment management. Those working in the field are quantitative analysts (quants). Quants tend to specialize in specific areas which may include derivative structuring or pricing, risk management, investment management and other related finance occupations. The occupation is similar to those in industrial mathematics in other industries. The process usually consists of searching vast databases for patterns, such as correlations among liquid assets or price-movement patterns.
Corporate finance is the area of finance that deals with the sources of funding, and the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value.
An X-Value Adjustment is an umbrella term referring to a number of different “valuation adjustments” that banks must make when assessing the value of derivative contracts that they have entered into. The purpose of these is twofold: primarily to hedge for possible losses due to other parties' failures to pay amounts due on the derivative contracts; but also to determine the amount of capital required under the bank capital adequacy rules. XVA has led to the creation of specialized desks in many banking institutions to manage XVA exposures.
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