Financial Risk Management
FBA1023 2025-2026
Dr. Tianqi Luo
[Link]@[Link]
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FRM in Country Level
• Sovereign risk
• Systemic risk & Systematic risk
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Sovereign risk
Government default on its debt
Reasons for default:
• High debt issuance – high government cost
• Low revenue
• Technical reason
Consequences:
• Downgraded credit rating
• Hamper investment from overseas
• Slow down economic growth
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Source: OECD Database
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Russia's Technical Default
• In 2022, Russia went through a technical default after it
became unable to pay its dollar-denominated foreign
currency obligations.
• Following the invasion of Ukraine, the U.S. and its allies
sanctioned the Russian government, effectively cutting the
government off from foreign currency and banking
networks.
• The Russian government argued that the default was
effectively created by Western sanctions since the country
had plenty of foreign currency in its now-frozen accounts.
• But the failure to pay caused Moody's to downgrade Russian
bonds to junk status, and the country faced its first foreign
debt default since 1918.
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European Debt Crisis
• Why the eurozone was established?
• Why bailout after default?
• Why quantitative easing?
• What is the role of Ireland?
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Global Financial Crisis
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Systemic risk
• Interconnectedness: Financial institutions and markets are
interconnected through a web of financial obligations and
contracts. The failure of a significant player can lead to a
domino effect, impacting others.
• Too Big to Fail: Systemic risk often involves institutions
considered "too big to fail" due to their size,
interconnectedness, or importance to the financial system.
• Contagion: Systemic risk can lead to contagion, where
problems in one part of the financial system spread to others,
potentially leading to widespread financial instability or crisis.
• Externalities: Systemic risk events can create negative
externalities, where the actions of one or more entities have
adverse effects on others that were not involved in those
actions.
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Reflection: Changes in Stress Testing
• Prior to the recent 2007 financial crisis, stress testing
was primarily based on Historical or hypothetical
scenarios.
• GFC revealed numerous weaknesses in banks, such lack
of proper recognition of extreme shocks and presence of
significant system-wide correlations (feedback and
spillover effects) between different markets, risks, and
portfolio positions.
• Shorter test durations and historical or hypothetical
scenario-based testing were key weaknesses in stress
testing practices.
• Actual events showed longer duration of stress
conditions and breakdown of historical statistical
relationships.
Systematic risk & Systemic risk
• Systemic risk and systematic risk, while
sounding similar, refer to distinct concepts.
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Systematic risk
• Systematic risk, refers to the risk inherent to the entire
market or market segment.
• This type of risk, also known as market risk or
undiversifiable risk, affects all securities in a similar
manner and cannot be mitigated just through
diversification.
• Factors contributing to systematic risk include economic
recessions, political instability, changes in interest rates,
and natural disasters.
• Beta (β), primarily used in the capital asset pricing model
(CAPM), is a measure of the volatility–or systematic risk–
of a security or portfolio compared to the market as a
whole.
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Characteristics:
• Non-diversifiable: Unlike specific risks that affect individual stocks
or sectors, systematic risk impacts the entire market, making it
impossible to avoid through diversification.
• External Factors: Systematic risk arises from external factors that
affect all companies and industries, not just a particular sector or
entity.
Examples of Systematic Risk
• Interest Rate Changes: An increase in interest rates can lower the
present value of future cash flows, affecting all stocks and bonds.
• Recession: Economic downturns can lead to decreased consumer
spending and lower corporate earnings across the board.
• Geopolitical Events: Events such as wars or terrorist attacks can
create uncertainty, leading to market-wide declines.
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