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]
Within non-financial corporates,[9][10] the scope is broadened to overlap enterprise risk management, and financial risk management then addresses risks to the firm's overall strategic objectives.
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]
Given these, 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 are able to determine which risks are cheaper for the firm to manage than for 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, the analytics [27][26] are based 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.[28]These calculations are mathematically sophisticated, and within the domain of quantitative finance.
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%[29] 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[30] the LR, LCR, and NSFR ratios.
Regulatory changes, are also twofold.
The first change, entails an increased emphasis[35] on bank stress tests.[36]
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.
Financial institutions will set[38][26][39]limit values for each of the Greeks, or other sensitivities, that their traders must not exceed, and traders will then hedge, offset, or reduce periodically if not daily; see the techniques listed below. These limits are set given a range [40] of plausible changes in prices and rates, coupled with the board-specified risk appetite[41] re overnight-losses.[42]
Desks, or areas, will similarly be limited as to their VaR quantum (total or incremental, and under various calculation regimes), corresponding to their allocated [43] economic capital; a loss which exceeds the VaR threshold is termed a "VaR breach". RWA is correspondingly monitored from desk level[38] and upward.
Each area's (or desk's) concentration risk will be checked[44][37][45] against thresholds set for various types of risk, and / or re a single counterparty, sector or geography.
Relatedly,[30]liquidity risk is monitored: LCR measures the ability of the bank to survive a short-term stress, covering its total net cash outflows over the next 30 days with "high quality liquid assets"; NSFR assesses its ability to finance assets and commitments within a year. Any "gaps", also, must be managed.[46]
Periodically,[49]
these all are estimated under a given stress scenario — regulatory and,[50]
often, internal —
and risk capital, [22]together with these limits if indicated,[22][51] is correspondingly revisited (or optimized[52]).
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".[53]The approaches taken center either on a hypothetical or historical scenario,[35][27]and may apply increasingly sophisticated mathematics[54][27] to the analysis.
A key practice,[55] incorporating and assimilating the above, is to assess the Risk-adjusted return on capital, RAROC, of each area (or product). Here,[56]"economic profit" is divided by allocated-capital; and this result is then compared[56][23] to the target-return for the area — usually, at least the equity holders' expected returns on the bank stock[56] — and identified under-performance can then be addressed. (See similar below re. DuPont analysis.)
The numerator, risk-adjusted return, is realized 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;[57]direct costs are (sometimes) also subtracted.[55]The denominator is the area's allocated capital, as above, increasing as a function of position risk;[58][59][55] several allocation techniques exist.[43]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.[60]
In corporate finance, and financial management more generally,[64][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.[65]The scope here - ie in non-financial firms[12] - is thus broadened[9][66][67](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[68] 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."[69]
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,[89] correspondingly, from spreadsheets (invariably as a starting point, and frequently in total[90]) through commercial EPM and BI tools, often BusinessObjects (SAP), OBI EE (Oracle), Cognos (IBM), and Power BI (Microsoft).
Investment management
Fund managers, classically,[91] 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[92]).
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;[93]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.[91][11]As appropriate, these may relate to the portfolio as a whole or to individual holdings:
To protect the overall portfolio, [95] Fund Managers may sell the Stock market index future or buy puts on the Stock market index option;[96][97] the respective sensitivities, portfolio beta and option delta, determine the number of hedge-contracts required. [95] For both, the logic is that the (diversified) portfolio is likely highly correlated with the stock index it is part of: thus if the portfolio-value declines, the index will have declined likewise with the derivative holder profiting correspondingly.[95] Fund managers may (instead) engage in "portfolio insurance", a dynamic hedging process that involves selling index futures during periods of decline and using the proceeds to offset portfolio losses.
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; with the number of contracts, a function of duration .[98][99][95] 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. See also Laddering.[100]
Further, and more generally, various safety-criteria may guide overall portfolio construction.
The Kelly criterion[106]will suggest - i.e. limit - the size of a position that an investor should hold in her portfolio.Roy's safety-first criterion[107]minimizes the probability of the portfolio's return falling below a minimum desired threshold.Chance-constrained portfolio selection similarly seeks to ensure that the probability of final wealth falling below a given "safety level" is acceptable.
Managers may also employ factor models[108] (generically APT) to measure exposure to macroeconomic and market risk factors[109] using time series regression. Ahead of an anticipated movement in any of these factors, the Manager may then, as indicated, reduce holdings, hedge, or purchase offsetting exposure.
Inflation for example, although impacting all securities, [110] can be managed [111][112] at the portfolio level by appropriately [113] increasing exposure to inflation-sensitive stocks, and / or by investing in tangible assets, commodities and inflation-linked bonds; the latter may also provide a direct hedge. [114]
McNeil, Alexander J.; Frey, Rüdiger; Embrechts, Paul (2015), Quantitative Risk Management. Concepts, Techniques and Tools, Princeton Series in Finance (revised ed.), Princeton, NJ: Princeton University Press, ISBN 9780691166278, MR 2175089, Zbl 1089.91037
Miller, Michael B. (2019). Quantitative Financial Risk Management. John Wiley. ISBN 9781119522201.
Roncalli, Thierry (2020). Handbook of Financial Risk Management. Chapman & Hall. ISBN 9781138501874.
Tapiero, Charles (2004). Risk and Financial Management: Mathematical and Computational Methods. John Wiley & Son. ISBN 0-470-84908-8.
van Deventer; Donald R.; Kenji Imai; Mark Mesler (2004). Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management. John Wiley. ISBN 978-0-470-82126-8.
Wernz, Johannes (2021). Bank Management and Control: Strategy, Pricing, Capital and Risk Management (2 ed.). Springer. ISBN 978-3030428686.
Corporations
Baranoff, Etti; Brockett, Patrick; Kahane, Yehuda (2009). Risk Management for Enterprises and Individuals. Saylor. ISBN 9780982361801.
Blunden, Tony; Thirlwell, John (2021). Mastering Risk Management. FT Publishing International. ISBN 978-1292331317.
Lam, James (2003). Enterprise Risk Management: From Incentives to Controls. John Wiley. ISBN 978-0-471-43000-1.
Myint, Stanley; Famery, Fabrice (2019). The Handbook of Corporate Financial Risk Management. Risk Books. ISBN 978-1782723929.
Portfolios
Baker, H. Kent; Filbeck, Greg (2015). Investment Risk Management. Oxford Academic. ISBN 978-0199331963.
Cowell, Frances (2013). Risk-Based Investment Management in Practice. Palgrave Macmillan. ISBN 978-1-137-34639-1.
Fabozzi, Frank J.; Sergio M. Focardi; Petter N. Kolm (2004). Financial Modeling of the Equity Market: From CAPM to Cointegration. Hoboken, NJ: Wiley. ISBN 0-471-69900-4.
Fabozzi, Frank J.; Petter N. Kolm; Dessislava Pachamanova; Sergio M. Focardi (2007). Robust Portfolio Optimization and Management. Hoboken, New Jersey: John Wiley & Sons. ISBN 978-0-471-92122-6
Grinold, Richard; Kahn, Ronald (1999). Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Controlling Risk (2nd ed.). McGraw Hill. ISBN 978-0070248823.
Harvey, Campbell; Rattray, Sandy; Van Hemert, Otto (2021). Strategic Risk Management: Designing Portfolios and Managing Risk. Wiley Finance. ISBN 978-1119773917.
Maginn, John L.; Tuttle, Donald L.; Pinto, Jerald E.; McLeavey, Dennis W. (2007). Managing Investment Portfolios: A Dynamic Process (3rd ed.). Springer. ISBN 978-0470080146.
Paleologo, Giuseppe A. (2021). Advanced Portfolio Management: A Quant's Guide for Fundamental Investors (1st ed.). Wiley. ISBN 978-1119789796.
Rasmussen, M. (2003). Quantitative Portfolio Optimisation, Asset Allocation and Risk Management. Palgrave Macmillan. ISBN 978-1403904584.
Schulmerich, Marcus; Leporcher, Yves-Michel; Eu, Ching-Hwa (2015). Applied Asset and Risk Management. Springer. ISBN 978-3642554438.
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