FINANCIAL RISK

MANAGEMENT
CHAPTER 1: INTRODUCTION AND
THE TYPES OF FINANCIAL RISK

Instructor: Pham Nguyen Thanh Nhan

Faculty of Banking and Finance
 LEARNING OBJECTIVES
• Understand the financial risk
• Financial risk management and instruments
• Risk management process
• The differences between the practice of risk
management by end users and by dealers
 LEARNING OBJECTIVES
•Principles of effective risk management in an
organization
•Accounting for derivatives
•How some organizations lost money using
derivatives
•Responsibilities of senior management
 DEFINITION AND MEASURE THE RISK
• What is the risk?

• Who needs to manage the risk?

• What do they mean “risk appetite”?

 IDENTIFY THE RISK

Systematic RISK Unsystematic

risk Risk

Systematic risk? Financial risk? Business risk

IDENTIFY RISK

Currency
risk

Interest FINANCIA Commodity

rate risk L RISK risk

6
 IDENTIFY
• Operational riskRISK
• Model risk
• Liquidity risk
• Accounting risk
• Legal risk
• Tax risk
• Regulatory risk
• Settlement risk
 DERIVATIVES MARKET
• Based on your knowledge which you have gained from
derivatives market, financial market.. subjects- explain:

• Spot market? Its function

• Derivatives instruments? Explain in detail: what do they

purpose?
• Hint: derivatives, underlying assets, bonds, stocks,
 IDENTIFY THE DERIVATIVES
INSTRUMENTS
•Forward
•Futures
•Options
•SWAP
ÞYou need to work in pair to:
find the definition
explain dis/advantages…
RISK MANAGEMENT PROCESS

• How firms/banks recognize and prevent risk?

Group discussion:
• TRAP:
• Terminate
• Reduce
• Accept
• Pass on
 FINANCIAL RISK MANAGEMENT
•FRM: measure the risk- provision loss.
Identify the consequence, employ the derivatives
or other instruments to prevent/reduce/transfer
risk.
 MOTIVATIONS
•Reason?

•Action?
Hint: to predict and prevent risk?
MANAGEMENT PROCESS
Identify potential risks

Measure the risk and Define the instruments to

estimated the provision loss treatrisks

Analyze impacts of risks Evaluate benefits and cost of

instruments

Risk management strategies:

 Avoidance
 Sharing
 Reduction
 Retention

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Result Evaluation
 MANAGEMENT PROCESS
1. Beginning the risk identification
with the sources
of internal problems and benefits or those of
competitors. Measure the potential provision loss.
2. Minimizing, monitoring and controlling the impact
of risk realities or enhancing the opportunity
potential by applying coordinated and economical
resources
3. Evalating the strategies and its performance.
MANAGEMENT PROCESS- 1ST STAGE

• Identifying/classifyingthe assets and liabilities into

following types of risks: interest rate risk, currency risk,
other risks...
• Designing scenarios and assessing the impacts of those
scenarios to each type of risk=> firm value at VaR.
• Assuming the maximum provision loss..
MANAGEMENT PROCESS- 2ND STAGE

• This is the step of implementation.

• Corporations focus on risk management.
• At this stage of risk assessment, preventative and contingency should be
prepared so that there are no surprises as your move forward with action
plans.
Division A Division B
Exposed long to Japanese Exposed short to Japanese
interest rates. interest rates.
Has bank account in yen. Has floating rate loan in yen.
• MANAGEMENT PROCESS-
This is monitor the risk. 3 RD
STAGE
• Your main issues needs to know:
• What will happen if they occur and how to go about defusing
any disaster that arises. What next? Monitor the risks by
tracking involved variables and proposed possible threats to
chain reactions. As your tracking system identifies changes,
calmly treat the rising problem to avoid widespread ripple
effects and the triggering of a big risk.
• This brings us to the next important wave of risk management:
treating the risk. There are several ways to treat risk, and they
BENEFITS OF FRM

• Work in pair to list corporations’

benefits if they have a good FRM
MARKET RISK
• Market risk is the risk that the value of an investment will decrease due to changes in market factors. These factors will have
an impact on the overall performance on the financial markets and can only be reduced by diversification into assets that are
not correlated with the market – such as certain alternative asset classes.
• Market risk is sometimes called “systematic risk” because it relates to factors, such as a recession, that impact the entire
market.
• Here are several different risk factors that make up market risk.
• Currency risk: The risk that exchange rates will go up or possibly down
• Equity risk: The risk that share prices will go up or down
• Inflation risk: the potential for inflation to increase the price of all goods and services such that it undermines the value of
money
• Commodity risk: the possibility of commodity prices such as metals change value dramatically
• Interest rate risk: the risk that comes from an increase or decrease in interest rates
MARKET RISK

Option trading strategy

• Delta,
• Vega
• Gamma
• What are the Greek symbols meaning? Explain

• How about this: Delta-Gamma Hedging?

MEASURE VALUE AT RISK (VAR)

• Value at risk (VaR) is a statistic that measures and quantifies

the level of financial risk within a firm, portfolio or position
over a specific time frame. This metric is most commonly
used by investment and commercial banks to determine the
extent and occurrence ratio of potential losses in their
institutional portfolios.
• Riskmanagers use VaR to measure and control the level of
risk exposure. One can apply VaR calculations to specific
positions or whole portfolios or to measure firm-wide risk
exposure.
MEASURE VALUE AT RISK (VAR)

• Value at risk (VaR) is a statistic that measures and quantifies the

level of financial risk within a firm, portfolio or position over a
specific time frame.
• This metric is most commonly used by investment and commercial
banks to determine the extent and occurrence ratio of potential
losses in their institutional portfolios.
• Investment banks commonly apply VaR modeling to firm-wide risk
due to the potential for independent trading desks to
unintentionally expose the firm to highly correlated assets.
CREDIT RISK
• Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual
obligations. Traditionally, it refers to the risk that a lender may not receive the owed principal and interest,
which results in an interruption of cash flows and increased costs for collection. Excess cash flows may be
written to provide additional cover for credit risk. Although it's impossible to know exactly who will default on
obligations, properly assessing and managing credit risk can lessen the severity of a loss. Interest payments
from the borrower or issuer of a debt obligation are a lender's or investor's reward for assuming credit risk.
• Key:
• Credit risk is the possibility of losing a lender takes on due to the possibility of a borrower not paying back a
loan.
• Consumer credit risk can be measured by the five Cs: credit history, capacity to repay, capital, the loan's
conditions, and associated collateral.
• Consumers posing higher credit risks usually end up paying higher interest rates on loans.

• Explain how to avoid/reduce credit risk?

FRM IN THE FUTURE

•View-driven risk management

•Needs-driven risk management

THE STRUCTURE OF THE RISK MANAGEMENT
INDUSTRY
End Users
Firms that engage in derivatives transactions to manage their
risk.
Mostly non-financial corporations, but also pension funds,
mutual funds, U.S. state and local governments, foreign
governments, endowments, and other private organizations.
In corporations the treasury department is usually responsible
for derivatives transactions.
THE STRUCTURE OF THE RISK MANAGEMENT
INDUSTRY

Dealers
Financial institutions that make a market in
derivatives. They stand willing to take either side
of a derivatives transaction.
They typically hedge their risk and earn a profit
off of the difference between their buying and
selling prices.
THE STRUCTURE OF THE RISK MANAGEMENT
INDUSTRY (CONTINUED)

Other Participants in the Risk Management

Industry

consultants, including accounting, management

consulting, and personnel search
software firms
law firms
ORGANIZING THE RISK MANAGEMENT FUNCTION
IN A COMPANY
Good risk management requires a sound organization structure that begins
with responsibility at the top.
Dealers usually have an independent risk manager who reports to the CEO,
has access to relevant information, and authority to block or initiate
certain transactions.
Corporate risk management should also be centralized but is often
decentralized.
Many corporations run the treasury as a profit center, which is not
conducive to sound risk management.
 ORGANIZING THE RISK MANAGEMENT FUNCTION
Separation of front office from back office.
IN A COMPANY (CONTINUED)
Legal counsel, accounting, and auditing are critical, but
accounting and auditing do not substitute for risk
management.
Risk management is a continuous process requiring regular
evaluation and comparison to objectives.
Under enterprise risk management, the management of all
risks is under a single area of responsibility.
RISK MANAGEMENT ACCOUNTING

• The concept of hedge accounting: accounting in which gains

and losses on derivatives are tied to gains and losses on hedged
instruments.
• Global standards are prescribed by the International
Accounting Standards Board (IASB) having prescribed the
appropriate methods of accounting for derivatives with their
IAS 39- Accounting for Derivative Instruments and Hedging
Activities.
• In
general, derivatives are marked to market and must appear
on financial statements
RISK MANAGEMENT ACCOUNTING (CONTINUED)

• Fair Value Hedges: The firm is hedging the market value of an

asset or liability. The gain/loss on the derivative as well as the
instrument being hedged is recorded and reflected in current
earnings.
• Example: Firm holds security and hedges with a derivative.
Before the end of the hedge, the security loses $100,000 in
value and the derivative gains $96,000. It does the
following entries:
RISK MANAGEMENT ACCOUNTING (CONTINUED)

• Debit Derivative 96,000

• Credit Unrealized Gain on Derivative 96,000

• Debit Unrealized Loss on Security 100,000

• Credit Security 100,000
• This affects net income as well as the balance sheet.
Income decreases by $4,000. Assets decrease by $4,000.
• These hedges must be properly justified, and carefully
documented to be eligible for accounting this way.
RISK MANAGEMENT ACCOUNTING (CONTINUED)

• Cash Flow Hedges: The firm is hedging the risk of a future

cash flow. The derivative is marked to market and shows
on the balance sheet but the gain/loss shows up in a
temporary account, Other Comprehensive Income (OCI),
which is an equity account. At the end of the hedge, OCI
is closed out, and any balance adjusts the amount
recorded to the cash flow being hedged. Also gains/losses
must be separated into “effective” and “ineffective”
components.
• Cash
RISK MANAGEMENT
Flow ACCOUNTING (CONTINUED)
Hedges (continued)
• Example: A firm plans to borrow $1 million in six months by
issuing a discount note. It buys an FRA to hedge. Rates go
down and it incurs a loss on the FRA of $10,000. Eventually the
FRA expires with a loss of $12,000 and the note is issued at 7%,
generating a cash inflow of (1 - .07)$1,000,000 = $930,000.
During the interim, it enters the following:
• Debit OCI 10,000
• Credit FRA 10,000
 • Cash
RISK MANAGEMENT ACCOUNTING (CONTINUED)
Flow Hedges (continued)
• When it takes out the loan, it enters the following:
• Debit Cash 930,000
• Credit Notes Payable 930,000

• Debit FRA 10,000

• Debit OCI 2,000
• Credit Cash 12,000
RISK MANAGEMENT
• Cash ACCOUNTING (CONTINUED)
Flow Hedges (continued)
• Debit Notes Payable 12,000
• Credit OCI 12,000
• Thus, it received $930,000 in cash and set up a liability of
$930,000. It removed the FRA from the books and
recorded a $2,000 further loss in OCI. It paid out $12,000
to cover the FRA loss and zeroed out OCI. It reduced the
note balance to $918,000, reflecting the net amount of
cash it received.
 RISK MANAGEMENT ACCOUNTING (CONTINUED)
Cash Flow Hedges (continued)
This was a perfect hedge. Suppose in the interim
period the loss was $11,000 but the effective part
was $10,000. Thus, the gain/loss on the derivative
does not perfectly match the gain/loss on the
hedged instrument. It would do the following:
Debit Current Income 1,000
Debit OCI 10,000
 RISK MANAGEMENT ACCOUNTING (CONTINUED)

• Cash Flow Hedges (continued)

• At expiration let the loss on the FRA be $15,000, of which
only $12,000 is effective. Then we
• Debit FRA 11,000
• Credit OCI 11,000

• Debit Current Income 2,000

• Debit OCI 1,000
• Debit Notes Payable 12,000
• Credit Cash 15,000
RISK MANAGEMENT ACCOUNTING (CONTINUED)

• Cash Flow Hedges (continued)

• We remove the FRA from liabilities and all but $1,000
from OCI. We zero out OCI and reduce Current Income by
$2,000. Notes payable goes from $930,000 to $918,000
(the Notes Payable entry above is the same), reflecting a
loss of $12,000. Of the $12,000 loss, the ineffective part
is $2,000, which goes into Current Income and combines
with the $1,000 loss already in Current Income.
• There is still some uncertainty about how firms are to
identify effective and ineffective parts of hedges.
 RISK MANAGEMENT ACCOUNTING (CONTINUED)
Foreign Investment Hedges: Procedures for these
had been in effect for a number of years. Certain
transactions qualify for Fair Value and Cash Flow
hedge accounting.
Speculation: Gains/losses are marked to market
and recorded in current income.
 RISK MANAGEMENT ACCOUNTING (CONTINUED)

• Some Problems in IAS

• No clear prescription for what constitutes
effective/ineffective hedging.
• Embedded derivatives must be separated.
• No hedge accounting for bonds held to maturity.
• Difficulty of arriving at derivatives’ values.
• Does not permit macro (firm-wide) hedges.
AVOIDING DERIVATIVES LOSSES

Four case studies:

Metagesellschaft: To Hedge or Not to
Hedge?
Orange County, California: Playing the Odds
Barings PLC: How One Man Blew up a Bank
Proctor & Gamble: Going Up in Suds
RISK MANAGEMENT INDUSTRY STANDARDS

• Professional organizations, such as PRMIA and GARP,

help establish industry standards
• Risk management industry standards have been
proposed by several different organizations at several
different times, examples include:
• Group of 30 Report
• Risk Standards Working Group
RESPONSIBILITIES OF SENIOR MANAGEMENT

• Senior management is ultimately responsible for all

organizational activities. With respect to risk
management, these responsibilities can be summarized
as:
• Establish written policies
• Define roles and responsibilities
• Identify acceptable strategies
• Ensure that personnel are qualified
• Ensure that control systems are in place
A senior derivatives trader, interviewed recently by
Risk, was asked how he thought the derivatives market
would develop over the next five years. His response
was a spin on an old joke - each desk will comprise a
sophisticated trading model, a trader, and a dog. The
model will make all the trading decisions; the trader
acts as a back-up in case the model crashes; and the dog
is trained to bite the trader if he or she tries to touch
the model in any other circumstance.

Nick Sawyer
Risk, September 2006, p. 6 Ch. 16:
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