Financial Risk Management

1. Financial Risk Management Zvi Wiener Following P. Jorion,Financial Risk Manager Handbook FRM

2. Chapter 12Identification of Risk Factors Following P. Jorion 2001 Financial Risk Manager Handbook FRM

3. Absolute and Relative Risk • Absolute risk - measured in dollar terms • Relative risk - measured relative to benchmark index and is often called tracking error. Zvi Wiener

4. Directional Risk Directional risk involves exposures to the direction of movements in major market variables. beta for exposure to stock market duration for IR exposure delta for exposure of options to undelying Zvi Wiener

5. Non-directional Risk Non-linear exposures, volatility exposures, etc. residual risk in equity portfolios convexity in interest rates gamma - second order effects in options vega or volatility risk in options Zvi Wiener

6. Market versus Credit Risk Market risk is related to changes in prices, rates, etc. Credit risk is related to defaults. Many assets have both types - bonds, swaps, options. Zvi Wiener

7. Risk Interaction You buy 1M GBP at 1.5 $/GBP, settlement in two days. We will deliver $1.5M in exchange for 1M GBP. Market risk Credit risk Settlement risk (Herstatt risk) Operational risk Zvi Wiener

8. Dollar duration Exposure and Uncertainty Losses can occur due to a combination of A. exposure (choice variable) B. movement of risk factor (external variable) Zvi Wiener

9. Exposure and Uncertainty Market loss = Exposure * Adverse movement in risk factor Zvi Wiener

10. Market exposure Specific risk Specific Risk Specific risk - risk due to issuer specific price movements Zvi Wiener

11. FRM-97, Question 16 The risk of a stock or bond which is NOT correlated with the market (and thus can be diversified) is known as: A. interest rate risk. B. FX risk. C. model risk. D. specific risk. Zvi Wiener

12. Continuous process - diffusion • Discontinuities • Jumps in prices, interest rates • Price impact and liquidity • market closure • discontinuity in payoff: • binary options • loans Zvi Wiener

13. Emerging Markets Emerging stock market - definition by IFC (1981) International Finance Corporation. Stock markets located in developing countries (countries with GDP per capita less than $8,625 in 1993). Zvi Wiener

14. Liquidity Risk Difficult to measure. Very unstable. Market depth can be used as an approximation. Liquidity risk consists of both asset liquidity and funding liquidity! Zvi Wiener

15. Funding Liquidity Risk of not meeting payment obligations. Cash flow risk! Liquidity needs can be met by • using cash • selling assets • borrowing Zvi Wiener

16. Highly liquid assets • tightness - difference between quoted mid market price and transaction price. • depth - volume of trade that does not affect prices. • resiliency - speed at which price fluctuations disappear. Zvi Wiener

17. Flight to quality Shift in demand from low grade towards high grade securities. Low grade market becomes illiquid with depressed prices. Spread between government and corporate issues increases. Zvi Wiener

18. On-the-run • recently issued • most active • very liquid • after a new issue appears they become off-the-run • liquidity premium can be compensated by repos/reverse repos Zvi Wiener

19. FRM-98, Question 7 Which of the following products has the least liquidity? A. US on-the-run Treasuries B. US off-the-run Treasuries C. Floating rate notes D. High grade corporate bonds Zvi Wiener

20. FRM-98, Question 7 Which of the following products has the least liquidity? A. US on-the-run Treasuries B. US off-the-run Treasuries C. Floating rate notes D. High grade corporate bonds Zvi Wiener

21. FRM-97, Question 54 “Illiquid” describes an instrument which A. does not trade in an active market B. does not trade on any exchange C. can not be easily hedged D. is an over-the-counter (OTC) product Zvi Wiener

22. FRM-97, Question 54 “Illiquid” describes an instrument which A. does not trade in an active market B. does not trade on any exchange C. can not be easily hedged D. is an over-the-counter (OTC) product Zvi Wiener

23. FRM-98, Question 6 A finance company is interested in managing its balance sheet liquidity risk. The most productive means of accomplishing this is by: A. purchasing market securities B. hedging the exposure with Eurodollar futures C. diversifying its sources of funding D. setting up a reserve Zvi Wiener

24. FRM-98, Question 6 A finance company is interested in managing its balance sheet liquidity risk. The most productive means of accomplishing this is by: A. purchasing market securities B. hedging the exposure with Eurodollar futures C. diversifying its sources of funding D. setting up a reserve Zvi Wiener

25. FRM-00, Question 74 In a market crash the following is usually true? I. Fixed income portfolios hedged with short Treasuries and futures lose less than those hedged with IR swaps given equivalent duration. II. Bid offer spreads widen due to less liquidity. III. The spreads between off the run bonds and benchmark issues widen. A. I, II & III C. I & III B. II & III D. None of the above Zvi Wiener

26. FRM-00, Question 74 In a market crash the following is usually true? I. Fixed income portfolios hedged with short Treasuries and futures lose less than those hedged with IR swaps given equivalent duration. II. Bid offer spreads widen due to less liquidity. III. The spreads between off the run bonds and benchmark issues widen. A. I, II & III C. I & III B. II & III D. None of the above Zvi Wiener