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Introduction to Risk Management

FIN 500Q: Quantitative Risk Management

Introduction to Risk Management

What is risk?

• Risk strongly relates to uncertainty and thus randomness.

• Downside risk is exposure to bad outcomes, generally in

the value of assets or liabilities of interest.

• Upside risk is the potential of outcomes exceeding

expectations.

• Main focus of risk management is on downside risk: the

likelihood of loss or less-than expected returns.

Risk management is the process by which risk exposures are

identified, measured, and controlled.
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Introduction to Risk Management

• Business risks – those that firms willingly assume to create

value. For example, the choice of a certain technology
exposes firms to changes in value from new technological
innovations.

• Non-business risks – those arising from factors other than

those decided by the firm, e.g., shifts in the economy or the
political environment.

• Risk management enables firms to optimize their exposure

to non-business risks so that they can concentrate on what
they do best – assume appropriate business risks.

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Risk Factors and Exposures

• Example of non-business risks: fluctuating market prices of

input goods.

• Consider Starbucks, which has to buy coffee beans every

month. The price of coffee beans is volatile:

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Risk Factors and Exposures

• We say that the price of coffee beans is a risk factor and

Starbucks has exposure to that risk factor.

• If Starbucks knows the amount of coffee beans it needs in

the future, the exposure to coffee beans price risk is known.

• If the demand for coffee beans is random, e.g. depending

on economic conditions, then the exposure is also random.

• Using financial derivative contracts, Starbucks can (and

does!) hedge against coffee beans price changes. [Details]

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Types of Financial Risks

• Market risk – arises from the movements in the level or the

volatility of market prices.
1. Directional risk – exposures to the direction of movement in
financial variables. Linear approximations work well for such
risks – e.g., beta for exposure to stock price movements,
duration for exposure to interest rates, and delta for
exposure of options to the underlying asset price.
2. Non-directional risks – nonlinear exposures (such as
straddle positions) or exposure to volatilities. Second order
or quadratic exposures are measured by convexity when
dealing with interest rates, and gamma when dealing with
options.

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Types of Financial Risks

• Credit risk – counterparties may be unwilling or unable to

fulfill their contractual obligations (default). Often leads to
bankruptcy or costly negotiations.
• Its effect is measured by the cost of replacing cash flows if
the other party defaults. The recovery rate is the proportion
paid back to the lender

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Types of Financial Risks

• Liquidity risk
• Asset liquidity risk – transaction cannot be conducted at
“fair” market prices due to the size of the position relative to
the normal trading lots. In some markets such as major
currencies and US Treasury bonds, most positions can be
liquidated easily. In some others (e.g., exotic OTC derivatives
or emerging market equities), any transaction can quickly
affect prices.
• Funding liquidity risk – refers to the inability to raise funding
to make payments and meet withdrawals. This inability may
force early liquidation, thus transforming “paper” losses into
realized losses. This is especially true for portfolios that are
leveraged and subject to margin calls from lenders.

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Types of Financial Risks

• Operational risk – arises from human or technical errors.

Includes fraud (situations where traders intentionally falsify
information), management failure, and inadequate
procedures and controls. Also includes back-office
operations, which deal with the recording of transactions
and reconciliation of individual trades with the firm’s final
aggregate position.

Example (Fat-finger errors [Wiki]):

• In 2001, UBS sold 610,000 Dentsu-shares at ¥6, instead of
6 Dentsu-shares at ¥610,000.
• Tokyo Stock Exchange did not cancel the trades.
• UBS had to buy back the shares at market-value which
caused them a loss of US$100m.

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Types of Financial Risks

• Legal risk – arises when a transaction is unenforceable by

law, often related to credit risk since counterparties that
lose money will often attempt to find legal grounds to
invalidate the transaction. Often companies are also sued
by disgruntled shareholders for their use of derivatives.

• Model risk – risks associated with using a misspecified

(inappropriate) model for measuring risk. Think, for
instance, of using the Black-Scholes model for pricing an
exotic option when assumptions are violated (e.g.
non-normally distributed returns).

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History of Risk Management

• Basic ideas and tools for risk management go back to

ancient times.

• Dunbar (2000) interprets a passage in the Code of

Hammurabi from Babylon of 1800 BC as early evidence of
the use of options to hedge against crop failures.

• De la Vega (1688) observes derivative trading on the

Amsterdam exchange:
“If I may explain opsies [further, I would say that] through the payment of
the premiums, one hands over values in order to safeguard one’s stock
or to obtain a profit. One uses them as sails for a happy voyage during a
beneficent conjuncture and as an anchor of security in a storm.”

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Growth of the Risk Management Industry

• Massive growth of the risk management industry can be

traced to academic (Black-Scholes-Merton framework) and
IT innovation, combined with increased volatility of
financial markets since the early 1970s.
Some important events:

• Exchange rate shock in 1971, leading to collapse of Bretton

Woods system (1973) and floating currencies with volatile
exchange rates.

• Oil price shocks starting in 1973 were accompanied by high

inflation and wild swings in interest rates.

• On Black Monday, October 19, 1987, US stocks collapsed

by 23 percent, wiping out $1 trillion in capital. 11
Volatility Around the World

• The Japanese stock price bubble finally deflated at the end

of 1989, sending the Nikkei index from 39 000 to 17 000
three years later. A total of $2.7 trillion in capital was lost,
leading to an unprecedented financial crisis in Japan.

• The Asian turmoil of 1997 wiped off about three-fourth of

the dollar capitalization of equities in Indonesia, Korea,
Malaysia, and Thailand.

• The Russian default in August 1998 sparked a global

financial crisis that culminated in the failure of a big hedge
fund, Long Term Capital Management. Prices of corporate
and government bonds in all continents fell together with
US Treasuries being one of the few safe havens.
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Volatility Around the World

• During the spring 2000 burst of the internet/technology

bubble, the NASDAQ fell to a fourth of its peak value.
Default rates on outstanding junk bonds spiked from a low
of around 2% in 1999 to over 12% by early 2001.

• The 2008 credit crisis that originated from the U.S. housing
market dragged the global economy into a recession. The
financial sector was heavily impacted by liquidity shocks
([details]) which spilled over to the real economy.

• The February–March 2020 global stock market crash due

to the COVID-19 pandemic had some of the worst daily
movements in history.

• The above crises were essentially unpredictable.

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Risk Management Industry Response

• Derivative securities can be used to hedge financial risks.

• Derivatives securities markets have exploded in recent

decades.

• Much of the growth can be attributed to the growth of the

Over The Counter (OTC) markets.

• The dollar value of outstanding positions, measured in

Notional Amounts, grew from $1 trillion in 1986 to $600
trillion by 2008 (and has been relatively stable since).

• The value of US GDP is about $21 trillion, so the notional

amounts are nearly 30 × GDP!

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Risk Management Industry Response

• OTC markets are decentralized markets trading highly

customized securities that can hedge specific risks
identified by businesses/individuals.

• Must remember that notional amounts can be misleading,

as a large number of contracts have small net values.

• For example, a contract that is worth $1 million to one side

and −$1 million to the other side counts as a notional of $1
million but may have a net value close to zero.

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Derivatives Can Be Dangerous

• Derivatives are very versatile: can be used for hedging,

speculation, or arbitrage.

• High leverage and complexity can cause problems, and

traders with a mandate to hedge risks or follow arbitrage
strategy can become speculators (consciously or
unconsciously).

• Example: SocGen’s big loss in 2008

• Jérôme Kerviel was a trader tasked with looking for
arbitrage opportunities.
• He took on big positions and created fictitious trades to
make it appear he was hedged, while he was speculating.
• In January 2008, his unauthorized trading was uncovered by
SocGen. The bank unwound his positions, losing billions.
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Derivatives Can Be Dangerous

Kerviel was assigned to arbitrage discrepancies between

European stock index futures and cash equity prices.

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Why Risk Management?

• Shareholder perspective: financial risk management can

increase the value of a corporation. Main reason for
voluntary risk management. We will discuss this extensively
in the next few lectures.

• Societal perspective: risk management might be required

by regulator, as is the case for financial institutions.
• Microprudential regulation: prevent insolvency of individual
institutions to protect customers and policyholders.
• Macroprudential regulation: prevent disruptions in entire
financial system, due to spillover effects. Systemically
important companies are central in the network. Too big to
fail can create moral hazard when firms are implicitly or
explicitly guaranteed to get bailed out.

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Regulation: Banking Sector

• Basel I (1988) took an important step towards international

minimum capital standards for banks. Initial focus was on
credit risk. Approach was fairly coarse and measured risk in
an insufficiently differentiated way.

• Basel II (2004) redefined the way of calculating minimum

capital ratios, dividing bank assets into tiers based on
liquidity and risk level. Risk measurement is integral.

• Basel III (2011) is an internationally agreed set of measures

developed by the Basel Committee on Banking Supervision
in response to the financial crisis of 2007-09. The measures
aim to strengthen the regulation, supervision, and risk
management of banks. It is still being implemented.
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Regulation: Insurance Sector

• The insurance industry worldwide has also been subject to

increasing risk regulation in recent times.

• Development of Solvency II framework in European Union:

risk-sensitive treatment of capital requirements of
insurance companies.

• In the US, insurance regulation has traditionally been a

matter for state governments. The National Association of
Insurance Commissioners (NAIC) provides support to state
insurance regulators.

• Ongoing initiatives to promote own risk and solvency

assessment (ORSA) and to have convergence of banking
and insurance regulation.
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