Zvi Wiener

1
Financial Risk Management

• Zvi Wiener
• Following
• P. Jorion, Financial Risk Manager Handbook

2
Chapter 12Identification of Risk Factors

• Following P. Jorion 2001
• Financial Risk Manager Handbook

3
Absolute and Relative Risk

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

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

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

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.

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

8
Exposure and Uncertainty

• Losses can occur due to a combination of
• A. exposure (choice variable)
• B. movement of risk factor (external variable)

9
Exposure and Uncertainty

• Market loss
• Exposure Adverse movement in risk factor

10
Specific Risk
Specific risk - risk due to issuer specific price
movements
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.

12

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

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).

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!

15
Funding Liquidity

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

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.

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.

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

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

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

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

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

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

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

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

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