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Unit 22. Financial Risks

Unit 22. Financial Risks. I. Definition of Financial Risks. Definition- Financial risks are defined as the possibility of losses of an investment by a financial institution in financial markets due to the influences of unexpected and uncertain factors beforehand.

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Unit 22. Financial Risks

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  1. Unit 22. Financial Risks

  2. I. Definition of Financial Risks

  3. Definition-Financial risks are defined as the possibility of losses of an investment by a financial institution in financial markets due to the influences of unexpected and uncertain factors beforehand. • Firms will encounter various types of risks as their businesses expand. In consequence, the risk management function has to respond to the reorganization of firm’s business strategy. • It is now widely recognized both by firms and the official regulatory bodies (官方监管机构) that an effective risk management function not only needs to be organized on a firm-wide basis, but also needs to cover all material aspects of risk in financial markets.

  4. II. Types of Financial Risks

  5. A. Market Risk • Market risk, the risk to an institution’s financial condition arising from adverse movements in the level or volatility of market prices is, in essence, the firm’s exposure to the sensitivity of value of a financial instrument or portfolio to changes in market parameters. These parameters include foreign exchange rates interest rates, equity market indices, and commodity prices.

  6. B. Credit Risk (信用风险) • The traditional view of credit risk within banks was limited to the risk of the outright default of the counter-party. In an environment where banks were committed to loans for the full term of their life, and could only obtain repayment from the borrower itself. The recognition of the importance of specific risk in securities markets has in turn led to a broader interpretation of the native of credit risk. • Instead of just being the exposure to the outright default of the counter-party, credit risk can be seen in the broader sense as the risk of a loss in the economic value of a firm’s assets as a result of a change in the ability of a firm’s counter-parties to perform on their obligations.

  7. C . Settlement Risk (结算风险) • Settlement risk is present in all dealing transactions where firms exchange cash for securities or to honor their obligations under trading contracts, it is particularly characteristic of foreign exchange trading because of the fact that in a cross-border exchange-for-value currency trade (say an exchange of US dollars for Japanese Yen), cash payments are made in one currency (Japanese Yen) well before funds are received in the other currency (US dollars).

  8. D. Liquidity Risk (流动性风险) • The central importance of liquidity risk to financial firms, both in terms of the liquidity of trading positions and the availability of adequate funding, was shown most clearly in the collapse of Drexel Burnham Lambert in February 1990. The reason that Drexel ran into difficulties was because it had built up a sizable inventory position in illiquid high yielding bonds, which it was unable to sell in the market when it needed to obtain funding for its positions.

  9. E. Operational Risk (操作风险) • Operational Risk covers a broad range of risks that are internal to the firm, and has in the past received rather less attention than other aspects of risk.However, attention is increasingly being focused on this issue because of the scale of the losses that firms have suffered as a result of breakdowns in internal controls. There is a typical example help to indicate the diversity of operational risk and the scale of the losses that can arise as a result.

  10. E. Operational Risk (操作风险) • A typical Example of Operational Risk: Peter Yang, an apparently successful fund manager at Morgan Grenfall Asset Management in London, created a loss of US $ 1 billions for Deutsche Bank by failing to follow the investment guidelines for the mutual fund he was managing and investing instead in highly speculative unlisted stocks. When the scale of the problem was finally revealed, Deutsche Bank had to step in and compensate for any loss they might have incurred as a result of Young’s unconventional actions.

  11. F. Legal Risk • The scope of legal risk, and of regulatory risk, to which it is closely related, has increased significantly as firms have moved to enhance their earnings from new instruments and from fee-based and client advisory businesses. The risk includes not only the question of whether documentation is enforceable, but also whether the firm has discharged its own legal and regulatory responsibilities to its customers appropriately. The loss to a firm of such a failure, even in the absence of a formal legal judgment against it, can be significant.

  12. III. The Risk Management Process

  13. (1) Risk Identification (风险识别) It refers to the need for a firm to define and understand the nature of the risk which it faces,and it is an essential part of any risk management process. (2) Risk Measurement (风险衡量) A central objective of any risk management system must be that it enables the firm to assess and manage the risk that it faces in a consistent basis. In order to do this the firm has to develop a measurement methodology that allows comparison to be made across the different dimensions of risk, and enables risk considerations to be factored into performance measurement and capital allocation decisions. (3) Risk Analysis and Monitoring (风险监测) Risk analysis and monitoring is the operational process whereby the firm ensures that it is operating within its defined risk policies and procedures.   (4)Risk Reporting (风险汇报) Risk reporting is the process under which the firm repots on risk internally through its MIS systems as well as to its regulators and to its shareholders. It is an increasingly important part of the risk management process, as firms seek ways to improve their ability to measure their performance and return on equity on a risk-adjusted basis. (5) Risk Verification and Audit(风险确认和审计 ) Risk verification and audit also includes the requirement for an audit of the risk management process, by internal and external auditors.

  14. IV. Basic Techniques of risk-reducing management

  15. (1)Risk Avoidance: A conscious decision not to be exposed to a particular risk. People may decide to avoid the risks of going into certain professions and firms may avoid certain businesses because they are considered too risky. But it is not always feasible to avoid risks. (2) Loss Prevention and Control: Actions taken to reduce the likelihood or severity of losses. Such actions can be taken prior to, concurrent with or after a loss occurs. (3) Risk Retention: Absorbing the risk and covering losses out of one’s own resources. (4) Risk Transfer: Transferring the risk to others selling a risky asset to others and buying insurance in a typical example of this technique of reducing risks.

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