Entrepreneurs understand owning and operating a business involves accepting a level of risk: risk that your business may not succeed, risk that you may not recover your investment. The amount of risk varies between businesses and is an important factor in determining a business's value. The two main types of risk small business owners are exposed to are financial risk and business risk.
Financial risk refers to the chance a business's cash flows are not enough to pay creditors and fulfill other financial responsibilities. The level of financial risk, therefore, relates less to the business's operations themselves and more to the amount of debt a business incurs to finance those operations. The more debt a business owes, the more likely it is to default on its financial obligations. Taking on higher levels of debt or financial liability therefore increases a business's level of financial risk.
Business risk refers to the chance a business's cash flows are not enough to cover its operating expenses like cost of goods sold, rent and wages. Unlike financial risk, business risk is independent of the amount of debt a business owes. There are two types of business risk: systematic risk and unsystematic risk. Business risk is the risk that results from your decisions about the products and services you offer. When you decide to develop and market a particular product, there's a risk that the product won't work as well as you hoped or that your marketing campaign will fail. Other business risks include changes in the cost of raw materials or shipping and managing technological developments that affect sales or manufacturing.
This risk refers to the chance an entire market or economy will experience a downturn or even fail. Economic crashes, recessions, wars, interest rates and natural disasters are common sources of systematic risk. Any business operating in the market is exposed to this risk, and the amount of systematic risk does not vary between businesses in the same market. Therefore there is little small business owners can do to decrease their exposure to systematic risk.
Unsystematic risk describes the chance a specific company or line of business will experience a downturn or even fail. Unlike systematic risk, unsystematic risk can vary greatly from business to business. Sources of unsystematic risk include the strategic, management and investment decisions a small business owner faces every day. Investors decrease their exposure to unsystematic risk by diversifying their portfolio and holding ownership in a variety of companies operating in a variety of industries.
Effect of Risk on Worth
A business's exposure to risk negatively relates to worth. A business more exposed to risk is worth less than an identical business exposed to less risk. Reducing risk is therefore important not only in helping your business succeed but also in maximizing its value.
When you own or manage a business, there's always a risk of loss or failure. Your decisions can affect how much risk your company faces, whether it's a financial risk, the risk of adopting a bad business strategy or the risk of your employees making mistakes. Business analysts have divided the risks companies face into subcategories, two of which are operational risk and business risk.
Operational risks exist in the way your company tries to carry out your decisions. Even if you decide on the right product to manufacture, weaknesses in your supply chain, outdated manufacturing equipment or a poor sales force can make it impossible to generate the profits you anticipate. A risk-management strategy that focuses on management decisions and ignores how the staff operates can leave you with a dangerously high risk level. If your IT department doesn't maintain Internet security, for example, one hacking incident could cost you vital corporate information or customers' credit card numbers.
There's rarely a 100 percent safe path in the business world. Developing a new product or moving into a new market carries a risk of losing money, but not expanding or growing can be just as risky, allowing more daring competitors to gain market share. When weighing alternatives, look at the probability of business risk from each choice and the consequences if the worst happens. Then you have to balance the chance of success against the loss to your company if you fail.
Managing Operational Risk
Strategic business decisions may seem full of risk, but lower-level operational risks can be a bigger challenge, as there are so many points where your operations can go off the rails. What you can do is make sure there are control systems in place to keep your staff following the right procedures. Other protective steps include insurance and having a contingency plan in place. If your equipment breaks down, for instance, having a plan to keep operating until insurance covers the losses could be vital
Risk that the changes in one or more assets that support an asset-backed security will significantly impact the value of the supported security. Risks include interest rate, term modification, and prepayment risk.
A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial and can arise in a number of circumstances, for example:
- A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit, or other loan.
- A company is unable to repay asset-secured fixed or floating charge debt.
- A business or consumer does not pay a trade invoice when due.
- A business does not pay an employee's earned wages when due.
- A business or government bond issuer does not make a payment on a coupon or principal payment when due.
- An insolvent insurance company does not pay a policy obligation.
- An insolvent bank won't return funds to a depositor.
- A government grants bankruptcy protection to an insolvent consumer or business.
To reduce the lender's credit risk, the lender may perform a credit check on the prospective borrower, may require the borrower to take out appropriate insurance, such as mortgage insurance, or seek security over some assets of the borrower or a guarantee from a third party. The lender can also take out insurance against the risk or on-sell the debt to another company. In general, the higher the risk, the higher will be the interest rate that the debtor will be asked to pay on the debt. Credit risk mainly arises when borrowers unable to pay due willingly or unwilingly.
Types of credit risk
A credit risk can be of the following types
- Credit default risk — The risk of loss arising from a debtor being unlikely to pay its loan obligations in full or the debtor is more than 90 days past due on any material credit obligation; default risk may impact all credit-sensitive transactions, including loans, securities and derivatives.
- Concentration risk — The risk associated with any single exposure or group of exposures with the potential to produce large enough losses to threaten a bank's core operations. It may arise in the form of single name concentration or industry concentration.
- Country risk — The risk of loss arising from a sovereign state freezing foreign currency payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk); this type of risk is prominently associated with the country's macroeconomic performance and its political stability.
Assessing credit risk
Credit analysis and Consumer credit risk
Significant resources and sophisticated programs are used to analyze and manage risk. Some companies run a credit risk department whose job is to assess the financial health of their customers, and extend credit (or not) accordingly. They may use in house programs to advise on avoiding, reducing and transferring risk. They also use third party provided intelligence. Companies like Standard & Poor's, Moody's, Fitch Ratings, DBRS, Dun and Bradstreet, Bureau van Dijk and Rapid Ratings International provide such information for a fee
Most lenders employ their own models (credit scorecards) to rank potential and existing customers according to risk, and then apply appropriate strategies. With products such as unsecured personal loans or mortgages, lenders charge a higher price for higher risk customers and vice versa. With revolving products such as credit cards and overdrafts, risk is controlled through the setting of credit limits. Some products also require collateral, usually an asset that is pledged to secure the repayment of the loan.
Credit scoring models also form part of the framework used by banks or lending institutions to grant credit to clients. For corporate and commercial borrowers, these models generally have qualitative and quantitative sections outlining various aspects of the risk including, but not limited to, operating experience, management expertise, asset quality, and leverage and liquidity ratios, respectively. Once this information has been fully reviewed by credit officers and credit committees, the lender provides the funds subject to the terms and conditions presented within the contract (as outlined above).
Commodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity etc. A commodity enterprise needs to deal with the following kinds of risks:
- Price risk (Risk arising out of adverse movements in the world prices, exchange rates, basis between local and world prices)
- Volume risk
- Cost risk (Input price risk)
- Political risk
Groups at Risk
There are broadly four categories of agents who face the commodities risk:
- Producers (farmers, plantation companies, and mining companies) face price risk, cost risk (on the prices of their inputs) and quantity risk
- Buyers (cooperatives, commercial traders and trait ants) face price risk between the time of up-country purchase buying and sale, typically at the port, to an exporter.
- Exporters face the same risk between purchase at the port and sale in the destination market; and may also face political risks with regard to export licenses or foreign exchange conversion.
- Governments face price and quantity risk with regard to tax revenues, particularly where tax rates rise as commodity prices rise (generally the case with metals and energy exports) or if support or other payments depend on the level of commodity prices.
Sovereign credit risk is the risk of a government being unwilling or unable to meet its loan obligations, or reneging on loans it guarantees. Many countries have faced sovereign risk in the late-2000s global recession. The existence of such risk means that creditors should take a two-stage decision process when deciding to lend to a firm based in a foreign country. Firstly one should consider the sovereign risk quality of the country and then consider the firm's credit quality.
Five macroeconomic variables that affect the probability of sovereign debt rescheduling are:
- Debt service ratio
- Import ratio
- Investment ratio
- Variance of export revenue
- Domestic money supply growth
The probability of rescheduling is an increasing function of debt service ratio, import ratio, variance of export revenue and domestic money supply growth. The likelihood of rescheduling is a decreasing function of investment ratio due to future economic productivity gains. Debt rescheduling likelihood can increase if the investment ratio rises as the foreign country could become less dependent on its external creditors and so be less concerned about receiving credit from these countries/investors.
A counterparty risk, also known as a default risk, is a risk that a counterparty will not pay as obligated on a bond, derivative, insurance policy, or other contract. Financial institutions or other transaction counterparties may hedge or take out credit insurance or, particularly in the context of derivatives, require the posting of collateral. Offsetting counterparty risk is not always possible, e.g. because of temporary liquidity issues or longer term systemic reasons.
Counterparty risk increases due to positively correlated risk factors. Accounting for correlation between portfolio risk factors and counterparty default in risk management methodology is not trivial.
Mitigating credit risk
Lenders mitigate credit risk in a number of ways, including:
- Risk-based pricing — Lenders may charge a higher interest rate to borrowers who are more likely to default, a practice called risk-based pricing. Lenders consider factors relating to the loan such as loan purpose, credit rating, and loan-to-value ratio and estimates the effect on yield (credit spread).
- Covenants — Lenders may write stipulations on the borrower, called covenants, into loan agreements, such as:
- Periodically report its financial condition,
- Refrain from paying dividends, repurchasing shares, borrowing further, or other specific, voluntary actions that negatively affect the company's financial position, and
- Repay the loan in full, at the lender's request, in certain events such as changes in the borrower's debt-to-equity ratio or interest coverage ratio.
- Credit insurance and credit derivatives — Lenders and bond holders may hedge their credit risk by purchasing credit insurance or credit derivatives. These contracts transfer the risk from the lender to the seller (insurer) in exchange for payment. The most common credit derivative is the credit default swap.
- Tightening — Lenders can reduce credit risk by reducing the amount of credit extended, either in total or to certain borrowers. For example, a distributor selling its products to a troubled retailer may attempt to lessen credit risk by reducing payment terms from net 30 to net 15.
- Diversification — Lenders to a small number of borrowers (or kinds of borrower) face a high degree of unsystematic credit risk, called concentration risk. Lenders reduce this risk by diversifying the borrower pool.
- Deposit insurance — Governments may establish deposit insurance to guarantee bank deposits in the event of insolvency and to encourage consumers to hold their savings in the banking system instead of in cash.
Foreign investment risk
Risk of rapid and extreme changes in value due to: smaller markets; differing accounting, reporting, or auditing standards; nationalization, expropriation or confiscatory taxation; economic conflict; or political or diplomatic changes. Valuation, liquidity, and regulatory issues may also add to foreign investment risk.
Concentration risk is a banking term denoting the overall spread of a bank's outstanding accounts over the number or variety of debtors to whom the bank has lent money. This risk is calculated using a concentration ratio which explains what percentage of the outstanding accounts each bank loan represents. For example, if a bank has 5 outstanding loans of equal value each loan would have a concentration ratio of .2; if it had 3, it would be .333.
Various other factors enter into this equation in real world applications, where loans are not evenly distributed or are heavily concentrated in certain economic sectors. A bank with 10 loans, valued at 10 dollars a piece would have a concentration ratio of .10; but if 9 of the loans were for 1 dollar, and the last was for 50, the concentration risk would be considerably higher. Also, loans weighted towards a specific economic sector would create a higher ratio than a set of evenly distributed loans because the evenly spread loans would serve to offset the risk of economic downturn and default in any one specific industry damaging the bank's outstanding accounts.
Risk of default is an important factor in concentration risk. The basic issue raised by the concept of default risk is: does the risk of default on a bank's outstanding loans match the overall risk posed by the entire economy or are the bank's loans concentrated in areas of higher or lower than average risk based on their volume, type, amount, and industry.
Types of Concentration Risk
There are two types of concentration risk. These types are based on the sources of the risk. Concentration risk can arise from uneven distribution of exposures (or loan) to its borrowers. Such a risk is called Name Concentration risk. Another type is Sectoral Concentration risk which can arise from uneven distribution of exposures to particular sectors, regions, industries or products.
Monitoring and Managing Concentration Risk
Most financial institutions have policies to identify and limit concentration risk. This typically involves setting certain thresholds for various types of risk. Once these thresholds are set, they are managed by frequent and diligent reporting to assess concentration areas and identify elevated thresholds.
A key component to the management of concentration risk is accurately defining thresholds across various concentrations to minimize the combined risks across concentrations.
In banking and finance, refinancing risk is the possibility that a borrower cannot refinance by borrowing to repay existing debt. Many types of commercial lending incorporate balloon payments at the point of final maturity; often, the intention or assumption is that the borrower will take out a new loan to pay the existing lenders.
A borrower that cannot refinance their existing debt and does not have sufficient funds on hand to pay their lenders may have a liquidity problem. The borrower may be considered technically insolvent: even though their assets are greater than their liabilities, they cannot raise the liquid funds to pay their creditors. Insolvency may lead to bankruptcy, even when the borrower has a positive net worth.
In order to repay the debt at maturity, the borrower that cannot refinance may be forced into a fire sale of assets at a low price, including the borrower's own home and productive assets such as factories and plants.
Most large corporations and banks face this risk to some degree, as they may constantly borrow and repay loans. Refinancing risk increases in periods of rising interest rates, when the borrower may not have sufficient income to afford the interest rate on a new loan.
Most commercial banks provide long term loans, and fund this operation by taking shorter term deposits. In general, refinancing risk is only considered to be substantial for banks in cases of financial crisis, when borrowing funds, such as inter-bank deposits, may be extremely difficult.
Refinancing is also known as rolling over debt of various maturities, and so refinancing risk may be referred to as rollover risk
Country risk refers to the risk of investing or lending in a country, arising from possible changes in the business environment that may adversely affect operating profits or the value of assets in the country. For example, financial factors such as currency controls, devaluation or regulatory changes, or stability factors such as mass riots, civil war and other potential events contribute to companies' operational risks. This term is also sometimes referred to as political risk; however, country risk is a more general term that generally refers only to risks affecting all companies operating within or involved with a particular country.
Political risk analysis providers and credit rating agencies use different methodologies to assess and rate countries' comparative risk exposure. Credit rating agencies tend to use quantitative econometric models and focus on financial analysis, whereas political risk providers tend to use qualitative methods, focusing on political analysis. However, there is no consensus on methodology in assessing credit and political risks.
Interest rate risk
Interest rate risk is the risk that arises for bond owners from fluctuating interest rates. How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes in the market. The sensitivity depends on two things, the bond's time to maturity, and the coupon rate of the bond.
Calculating interest rate risk
Interest rate risk analysis is almost always based on simulating movements in one or more yield curves using the Heath-Jarrow-Morton framework to ensure that the yield curve movements are both consistent with current market yield curves and such that no riskless arbitrage is possible. The Heath-Jarrow-Morton framework was developed in the early 1991 by David Heath of Cornell University, Andrew Morton of Lehman Brothers, and Robert A. Jarrow of Kamakura Corporation and Cornell University.
There are a number of standard calculations for measuring the impact of changing interest rates on a portfolio consisting of various assets and liabilities. The most common techniques include:
- Marking to market, calculating the net market value of the assets and liabilities, sometimes called the market value of portfolio equity
- Stress testing this market value by shifting the yield curve in a specific way.
- Calculating the value at risk of the portfolio
- Calculating the multi-period cash flow or financial accrual income and expense for N periods forward in a deterministic set of future yield curves
- Doing step 4 with random yield curve movements and measuring the probability distribution of cash flows and financial accrual income over time.
- Measuring the mismatch of the interest sensitivity gap of assets and liabilities, by classifying each asset and liability by the timing of interest rate reset or maturity, whichever comes first.
- Analyzing Duration, Convexity, DV01 and Key Rate Duration.
Interest rate risk at banks
The assessment of interest rate risk is a very large topic at banks, thrifts, saving and loans, credit unions, and other finance companies, and among their regulators. The widely deployed CAMELS rating system assesses a financial institution's: (C)apital adequacy, (A)ssets, (M)anagement Capability, (E)arnings, (L)iquidity, and (S)ensitivity to market risk.
A large portion of the (S)ensitivity in CAMELS is interest rate risk. Much of what is known about assessing interest rate risk has been developed by the interaction of financial institutions with their regulators since the 1990s.
Interest rate risk is unquestionably the largest part of the (S)ensitivity analysis in the CAMELS system for most banking institutions. When a bank receives a bad CAMELS rating equity holders, bond holders and creditors are at risk of loss, senior managers can lose their jobs and the firms are put on the FDIC problem bank list.
In addition to being subject to the CAMELS system, the largest banks are often subject to prescribed stress testing. The assessment of interest rate risk is typically informed by some type of stress testing.
Do you know this animal called Libor?
The four standard market risk factors are equity risk, interest rate risk, currency risk, and commodity risk:
Types of Market Risks
There is no unique classification of market risks, each classification may refer to different aspects of market risk. Some types are:
Equity risk, the risk that stock or stock indices (e.g. Euro Stoxx 50, etc. ) prices and/or their implied volatility will change.
- Interest rate risk, the risk that interest rates (e.g. Libor, Euribor, etc.) and/or their implied volatility will change.
- Currency risk, the risk that foreign exchange rates (e.g. EUR/USD, EUR/GBP, etc.) and/or their implied volatility will change.
- Commodity risk, the risk that commodity prices (e.g. corn, copper, crude oil, etc.) and/or their implied volatility will change.
- Margining risk results from uncertain future cash outflows due to margin calls covering adverse value changes of a given position.
All businesses take risks based on two factors: the probability an adverse circumstance will come about and the cost of such adverse circumstance. Risk management is the study of how to control risks and balance the possibility of gains.
Measuring the potential loss amount due to market risk
As with other forms of risk, the potential loss amount due to market risk may be measured in a number of ways or conventions. Traditionally, one convention is to use value at risk (VaR). The conventions of using VaR are well established and accepted in the short-term risk management practice.
However, VaR contains a number of limiting assumptions that constrain its accuracy. The first assumption is that the composition of the portfolio measured remains unchanged over the specified period. Over short time horizons, this limiting assumption is often regarded as reasonable. However, over longer time horizons, many of the positions in the portfolio may have been changed.
The VaR of the unchanged portfolio is no longer relevant.The Variance Covariance and Historical Simulation approach to calculating VaR also assumes that historical correlations are stable and will not change in the future or breakdown under times of market stress.
In addition, care has to be taken regarding the intervening cash flow, embedded options, changes in floating rate interest rates of the financial positions in the portfolio. They cannot be ignored if their impact can be large.
Financial risk, market risk, and even inflation risk, can at least partially be moderated by forms of diversification.
The returns from different assets are highly unlikely to be perfectly correlated and the correlation may sometimes be negative. For instance, an increase in the price of oil will often favour a company that produces it, but negatively impact the business of a firm such an airline whose variable costs are heavily based upon fuel. However, share prices are driven by many factors, such as the general health of the economy which will increase the correlation and reduce the benefit of diversification. If one constructs a portfolio by including a wide variety of equities, it will tend to exhibit the same risk and return characteristics as the market as a whole, which many investors see as an attractive prospect, so that index funds have been developed that invest in equities in proportion to the weighting they have in some well known index such as the FTSE.
However, history shows that even over substantial periods of time there is a wide range of returns that an index fund may experience; so an index fund by itself is not fully diversified. Greater diversification can be obtained by diversifying across asset classes; for instance a portfolio of many bonds and many equities can be constructed in order to further narrow the dispersion of possible portfolio outcomes.
A key issue in diversification is the correlation between assets, the benefits increasing with lower correlation. However, this is not an observable quantity, since the future return on any asset can never be known with complete certainty. This was a serious issue in the Late-2000s recession when assets that had previously had small or even negative correlations suddenly starting moving in the same direction causing severe financial stress to market participants who had believed that their diversification would protect them against any plausible market conditions, including funds that had been explicitly set up to avoid being affected in this way.
Diversification has costs. Correlations must be identified and understood, and since they are not constant it may be necessary to rebalance the portfolio which incurs transaction costs due to buying and selling assets. There is also the risk that as an investor or fund manager diversifies their ability to monitor and understand the assets may decline leading to the possibility of losses due to poor decisions or unforeseen correlations.
Foreign exchange risk
Foreign exchange risk also known as FX risk, exchange rate risk or currency risk is a financial risk that exists when a financial transaction is denominated in a currency other than that of the base currency of the company. Foreign exchange risk also exists when the foreign subsidiary of a firm maintains financial statements in a currency other than the reporting currency of the consolidated entity. The risk is that there may be an adverse movement in the exchange rate of the denomination currency in relation to the base currency before the date when the transaction is completed. Investors and businesses exporting or importing goods and services or making foreign investments have an exchange rate risk which can have severe financial consequences; but steps can be taken to manage (reduce) the risk.
Types of exposure
A firm has transaction exposure whenever it has contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency. To realize the domestic value of its foreign-denominated cash flows, the firm must exchange foreign currency for domestic currency. As firms negotiate contracts with set prices and delivery dates in the face of a volatile foreign exchange market with exchange rates constantly fluctuating, the firms face a risk of changes in the exchange rate between the foreign and domestic currency. It refers to the risk associated with the change in the exchange rate between the time an enterprise initiates a transaction and settles it.
Applying public accounting rules causes firms with transactional exposures to be impacted by a process known as re-measurement. The current value of contractual cash flows are remeasured at each balance sheet date. If the value of the currency of payment or receivable changes in relation to the firm's base or reporting currency from one balance sheet date to the next, the expected value of these cash flows will change. U.S. accounting rules for this process are specified in ASC 830, originally known as FAS 52. Under ASC 830, changes in the value of these contractual cash flows due to currency valuation changes will impact current income.
A firm has economic exposure also known as forecast risk to the degree that its market value is influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments can severely affect the firm's market share position with regards to its competitors, the firm's future cash flows, and ultimately the firm's value. Economic exposure can affect the present value of future cash flows. Any transaction that exposes the firm to foreign exchange risk also exposes the firm economically, but economic exposure can be caused by other business activities and investments which may not be mere international transactions, such as future cash flows from fixed assets. A shift in exchange rates that influences the demand for a good in some country would also be an economic exposure for a firm that sells that good. Economic Exposures cannot be hedged as well due to limited data, and it is costly and time consuming. Economic Exposures can be managed by, product differention, pricing, branding, outsourcing.
A firm's translation exposure is the extent to which its financial reporting is affected by exchange rate movements. As all firms generally must prepare consolidated financial statements for reporting purposes, the consolidation process for multinationals entails translating foreign assets and liabilities or the financial statements of foreign subsidiaries from foreign to domestic currency. While translation exposure may not affect a firm's cash flows, it could have a significant impact on a firm's reported earnings and therefore its stock price. Translation exposure is distinguished from transaction risk as a result of income and losses from various types of risk having different accounting treatments.
A firm has contingent exposure when bidding for foreign projects or negotiating other contracts or foreign direct investments. Such an exposure arises from the potential for a firm to suddenly face a transactional or economic foreign exchange risk, contingent on the outcome of some contract or negotiation. For example, a firm could be waiting for a project bid to be accepted by a foreign business or government that if accepted would result in an immediate receivable. While waiting, the firm faces a contingent exposure from the uncertainty as to whether or not that receivable will happen. If the bid is accepted and a receivable is paid the firm then faces a transaction exposure, so a firm may prefer to manage contingent exposures.
If foreign exchange markets are efficient such that purchasing power parity, interest rate parity, and the international Fisher effect hold true, a firm or investor needn't protect against foreign exchange risk due to an indifference toward international investment decisions. A deviation from one or more of the three international parity conditions generally needs to occur for an exposure to foreign exchange risk.
Financial risk is most commonly measured in terms of the variance or standard deviation of a variable such as percentage returns or rates of change. In foreign exchange, a relevant factor would be the rate of change of the spot exchange rate between currencies. Variance represents exchange rate risk by the spread of exchange rates, whereas standard deviation represents exchange rate risk by the amount exchange rates deviate, on average, from the mean exchange rate in a probability distribution. A higher standard deviation would signal a greater currency risk. Economists have criticized the accuracy of standard deviation as a risk indicator for its uniform treatment of deviations, be they positive or negative, and for automatically squaring deviation values. Alternatives such as average absolute deviation and semi variance have been advanced for measuring financial risk.
Value at Risk
Practitioners have advanced and regulators have accepted a financial risk management technique called value at risk (VaR), which examines the tail end of a distribution of returns for changes in exchange rates to highlight the outcomes with the worst returns. Banks in Europe have been authorized by the Bank for International Settlements to employ VaR models of their own design in establishing capital requirements for given levels of market risk. Using the VaR model helps risk managers determine the amount that could be lost on an investment portfolio over a certain period of time with a given probability of changes in exchange rates.
Foreign exchange hedge
Firms with exposure to foreign exchange risk may use a number of foreign exchange hedging strategies to reduce the exchange rate risk. Transaction exposure can be reduced either with the use of the money markets, foreign exchange derivatives such as forward contracts, futures contracts, options, and swaps, or with operational techniques such as currency invoicing, leading and lagging of receipts and payments, and exposure netting.
Firms may adopt alternative strategies to financial hedging for managing their economic or operating exposure, by carefully selecting production sites with a mind for lowering costs, using a policy of flexible sourcing in its supply chain management, diversifying its export market across a greater number of countries, or by implementing strong research and development activities and differentiating its products in pursuit of greater inelasticity and less foreign exchange risk exposure.
Translation exposure is largely dependent on the accounting standards of the home country and the translation methods required by those standards. For example, the United States Federal Accounting Standards Board specifies when and where to use certain methods such as the temporal method and current rate method. Firms can manage translation exposure by performing a balance sheet hedge. Since translation exposure arises from discrepancies between net assets and net liabilities on a balance sheet solely from exchange rate differences. Following this logic, a firm could acquire an appropriate amount of exposed assets or liabilities to balance any outstanding discrepancy. Foreign exchange derivatives may also be used to hedge against translation exposure.
Many businesses were unconcerned with and did not manage foreign exchange risk under the Bretton Woods system of international monetary order. It wasn't until the switch to floating exchange rates following the collapse of the Bretton Woods system that firms became exposed to an increasing risk from exchange rate fluctuations and began trading an increasing volume of financial derivatives in an effort to hedge their exposure. The currency crises of the 1990s and early 2000s, such as the Mexican peso crisis, Asian currency crisis, 1998 Russian financial crisis, and the Argentine peso crisis, led to substantial losses from foreign exchange and led firms to pay closer attention to their foreign exchange risk.
Hedging is a method for reducing risk where a combination of assets are selected to offset the movements of each other. For instance when investing in a stock it is possible to buy an option to sell that stock at a defined price at some point in the future. The combined portfolio of stock and option is now much less likely to move below a given value. As in diversification there is a cost, this time in buying the option for which there is a premium. Derivatives are used extensively to mitigate many types of risk.
Reputational risk, often called reputation risk, is a risk of loss resulting from damages to a firm's reputation, in lost revenue; increased operating, capital or regulatory costs; or destruction of shareholder value, consequent to an adverse or potentially criminal event even if the company is not found guilty. Adverse events typically associated with reputation risk include ethics, safety, security, sustainability, quality, and innovation. Reputational risk can be a matter of corporate trust.
This type of risk can be informational in nature that may be difficult to realize financially. Extreme cases may even lead to bankruptcy (as in the case of Arthur Andersen). Recent examples of companies include: Toyota, Goldman Sachs, Oracle Corporation, NatWest and BP. The reputational risk may not always be the company's fault as per the case of the Chicago Tylenol murders after seven people died in 1982.
Operational risk is the risk of a change in value caused by the fact that actual losses, incurred for inadequate or failed internal processes, people and systems, or from external events including legal risk, differ from the expected losses. This definition, adopted by the European Union Solvency II Directive for insurers, is a variation from that adopted in the Basel II regulations for banks.
In October 2014, the Basel Committee on Banking Supervision proposed a revision to its operational risk capital framework that sets out a new standardized approach to replace the basic indicator approach and the standardized approach for calculating operational risk capital.
It can also include other classes of risk, such as fraud, security, privacy protection, legal risks, physical (infrastructure shutdown) or environmental risks.
Operational risk is a broad discipline, close to good management and quality management.
In similar fashion, operational risks affect client satisfaction, reputation and shareholder value, all while increasing business volatility.
Contrary to other risks such as credit risk, market risk, insurance risk, operational risks are usually not willingly incurred nor are they revenue driven. Moreover, they are not diversifiable and cannot be laid off, meaning that, as long as people, systems and processes remain imperfect, operational risk cannot be fully eliminated.
Operational risk is, nonetheless, manageable as to keep losses within some level of risk tolerance (the amount of risk one is prepared to accept in pursuit of his objectives), determined by balancing the costs of improvement against the expected benefits.
Wider trends such as globalization, the expansion of the internet and the rise of social media, as well as the increasing demands for greater corporate accountability worldwide, reinforce the need for proper operational risk management.
Until Basel II reforms to banking supervision, operational risk was a residual category reserved for risks and uncertainties which were difficult to quantify and manage in traditional ways.
Such regulations institutionalized operational risk as a category of regulatory and managerial attention and connected operational risk management with good corporate governance.
Of course, businesses in general, and other institutions such as the military, have been aware, for many years, of hazards arising from operational factors, internal or external. The primary goal of the military is to fight and win wars in quick and decisive fashion, and with minimal losses. For the military, and the businesses of the world alike, operational risk management is an effective process for preserving resources by anticipation.
Two decades from 1980 to the early 00s of globalization and deregulation combined with the increased sophistication of financial services around the world, have introduced additional complexities into the activities of banks, insurers and firms in general and therefore their risk profiles.
Since the mid-1990s, the topics of market risk and credit risk have been the subject of much debate and research, with the result that financial institutions have made significant progress in the identification, measurement and management of both these forms of risk.
However, the near collapse of the U.S. financial system in September 2008 is an indication that our ability to measure market and credit risk is far from perfect and eventually led to introduction of new regulatory requirements worldwide, including Basel III regulations for banks and Solvency II regulations for insurers.
Events such as the September 11 terrorist attacks, rogue trading losses at Société Générale, Barings, AIB, UBS and National Australia Bank serve to highlight the fact that the scope of risk management extends beyond merely market and credit risk.
These reasons underscore banks' and supervisors' growing focus upon the identification and measurement of operational risk.
The list of risks and, more importantly, the scale of these risks faced by banks today includes fraud, system failures, terrorism and employee compensation claims. These types of risk are generally classified under the term 'operational risk.
The identification and measurement of operational risk is a real and live issue for modern-day banks, particularly since the decision by the Basel Committee on Banking Supervision (BCBS) to introduce a capital charge for this risk as part of the new capital adequacy framework (Basel II).
The Basel II Committee defines operational risk as:
The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
However, the Basel Committee recognizes that operational risk is a term that has a variety of meanings and therefore, for internal purposes, banks are permitted to adopt their own definitions of operational risk, provided that the minimum elements in the Committee's definition are included.
The Basel II definition of operational risk excludes, for example, strategic risk - the risk of a loss arising from a poor strategic business decision.
Other risk terms are seen as potential consequences of operational risk events. For example, reputational risk, damage to an organization through loss of its reputation or standing, can arise as a consequence of operational failures - as well as from other events.
Basel II seven event type categories
The following lists the official Basel II defines the seven event types with some examples for each category:
- Internal Fraud - misappropriation of assets, tax evasion, intentional mismarking of positions, bribery
- External Fraud - theft of information, hacking damage, third-party theft and forgery
- Employment Practices and Workplace Safety - discrimination, workers compensation, employee health and safety
- Clients, Products, and Business Practice - market manipulation, antitrust, improper trade, product defects, fiduciary breaches, account churning
- Damage to Physical Assets - natural disasters, terrorism, vandalism
- Business Disruption and Systems Failures - utility disruptions, software failures, hardware failures
- Execution, Delivery, and Process Management - data entry errors, accounting errors, failed mandatory reporting, negligent loss of client assets
It is relatively straightforward for an organization to set and observe specific, measurable levels of market risk and credit risk because models exist which attempt to predict the potential impact of market movements, or changes in the cost of credit. It should be noted however that these models are only as good as the underlying assumptions, and a large part of the recent financial crisis arose because the valuations generated by these models for particular types of investments were based on incorrect assumptions.
By contrast it is relatively difficult to identify or assess levels of operational risk and its many sources. Historically organizations have accepted operational risk as an unavoidable cost of doing business. Many now though collect data on operational losses - for example through system failure or fraud - and are using this data to model operational risk and to calculate a capital reserve against future operational losses. In addition to the Basel II requirement for banks, this is now a requirement for European insurance firms who are in the process of implementing Solvency II, the equivalent of Basel II for the banking sector.
Methods of operational risk management
Basel II and various Supervisory bodies of the countries have prescribed various soundness standards for Operational Risk Management for Banks and similar Financial Institutions. To complement these standards, Basel II has given guidance to 3 broad methods of Capital calculation for Operational Risk
- Basic Indicator Approach - based on annual revenue of the Financial Institution
- Standardized Approach - based on annual revenue of each of the broad business lines of the Financial Institution
- Advanced Measurement Approaches - based on the internally developed risk measurement framework of the bank adhering to the standards prescribed methods include IMA, LDA, Scenario-based, Scorecard.
The Operational Risk Management framework should include identification, measurement, monitoring, reporting, control and mitigation frameworks for Operational Risk.
In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss or make the required profit.
Types of liquidity risk
Market liquidity – An asset cannot be sold due to lack of liquidity in the market – essentially a sub-set of market risk. This can be accounted for by:
- Widening bid or offer spread
- Making explicit liquidity reserves
- Lengthening holding period for VaR calculations
- Cannot be met when they fall due
- Can only be met at an uneconomic price
- Can be name-specific or systemic
Causes of liquidity Risk
Liquidity risk arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade for that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade.
Manifestation of liquidity risk is very different from a drop of price to zero. In case of a drop of an asset's price to zero, the market is saying that the asset is worthless. However, if one party cannot find another party interested in trading the asset, this can potentially be only a problem of the market participants with finding each other. This is why liquidity risk is usually found to be higher in emerging markets or low-volume markets.
Liquidity risk is financial risk due to uncertain liquidity. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity.
Market and funding liquidity risks compound each other as it is difficult to sell when other investors face funding problems and it is difficult to get funding when the collateral is hard to sell. Liquidity risk also tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty that owes it a payment defaults, the firm will have to raise cash from other sources to make its payment. Should it be unable to do so, it too will default. Here, liquidity risk is compounding credit risk.
A position can be hedged against market risk but still entail liquidity risk. This is true in the above credit risk example—the two payments are offsetting, so they entail credit risk but not market risk. Another example is the 1993 Metallgesellschaft Debacle. Futures contracts were used to hedge an Over-the-counter finance OTC obligation. It is debatable whether the hedge was effective from a market risk standpoint, but it was the liquidity crisis caused by staggering margin calls on the futures that forced Metallgesellschaft to unwind the positions.
Accordingly, liquidity risk has to be managed in addition to market, credit and other risks. Because of its tendency to compound other risks, it is difficult or impossible to isolate liquidity risk. In all but the simplest of circumstances, comprehensive metrics of liquidity risk do not exist. Certain techniques of asset liability management can be applied to assessing liquidity risk. A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis. Any day that has a sizeable negative net cash flow is of concern. Such an analysis can be supplemented with stress testing. Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults.
Analyses such as these cannot easily take into account contingent cash flows, such as cash flows from derivatives or mortgage-backed securities. If an organization's cash flows are largely contingent, liquidity risk may be assessed using some form of scenario analysis. A general approach using scenario analysis might entail the following high-level steps:
- Construct multiple scenarios for market movements and defaults over a given period of time
- Assess day-to-day cash flows under each scenario.
Because balance sheets differ so significantly from one organization to the next, there is little standardization in how such analyses are implemented.
Regulators are primarily concerned about systemic implications of liquidity risk.
Pricing of liquidity risk
Risk-averse investors naturally require higher expected return as compensation for liquidity risk. The liquidity-adjusted CAPM pricing model therefore states that, the higher an asset’s market-liquidity risk, the higher its required return.
A common method for estimating the upper bound for a security illiquidity discount is by using a Lookback option, where the premia is equal to the difference between the maximum value of a security during a restricted trading period and its value at the end of the period. When the method is extended for corporate debt it is shown that liquidity risk increases with a bond credit risk.
Measures of liquidity risk
Culp defines the liquidity gap as the net liquid assets of a firm. The excess value of the firm's liquid assets over its volatile liabilities. A company with a negative liquidity gap should focus on their cash balances and possible unexpected changes in their values.
As a static measure of liquidity risk it gives no indication of how the gap would change with an increase in the firm's marginal funding cost.
Liquidity risk elasticity
Culp denotes the change of net of assets over funded liabilities that occurs when the liquidity premium on the bank's marginal funding cost rises by a small amount as the liquidity risk elasticity. For banks this would be measured as a spread over libor, for non-financials the LRE would be measured as a spread over commercial paper rates.
Problems with the use of liquidity risk elasticity are that it assumes parallel changes in funding spread across all maturities and that it is only accurate for small changes in funding spreads.
Measures of asset liquidity
The bid-offer spread is used by market participants as an asset liquidity measure. To compare different products, the ratio of the spread to the product's bid price can be used. The smaller the ratio the more liquid the asset is.
This spread is composed of operational, administrative, and processing costs as well as the compensation required for the possibility of trading with a more informed trader.
Hachmeister refers to market depth as the amount of an asset that can be bought and sold at various bid-ask spreads. Slippage is related to the concept of market depth. Knight and Satchell mention a flow trader needs to consider the effect of executing a large order on the market and to adjust the bid-ask spread accordingly. They calculate the liquidity cost as the difference of the execution price and the initial execution price.
Immediacy refers to the time needed to successfully trade a certain amount of an asset at a prescribed cost.
Hachmeister identifies the fourth dimension of liquidity as the speed with which prices return to former levels after a large transaction. Unlike the other measures resilience can only be determined over a period of time.
Managing liquidity risk
Liquidity-adjusted value at risk
Liquidity-adjusted VAR incorporates exogenous liquidity risk into Value at Risk. It can be defined at VAR + ELC (Exogenous Liquidity Cost). The ELC is the worst expected half-spread at a particular confidence level.
Another adjustment, introduced in the 1970s with a regulatory precursor to today's VAR measures, is to consider VAR over the period of time needed to liquidate the portfolio. VAR can be calculated over this time period. The BIS mentions "... a number of institutions are exploring the use of liquidity adjusted-VAR, in which the holding periods in the risk assessment are adjusted by the length of time required to unwind positions.
Liquidity at risk
Alan Greenspan (1999) discusses management of foreign exchange reserves. The Liquidity at risk measure is suggested. A country's liquidity position under a range of possible outcomes for relevant financial variables (exchange rates, commodity prices, credit spreads, etc.) is considered. It might be possible to express a standard in terms of the probabilities of different outcomes. For example, an acceptable debt structure could have an average maturity—averaged over estimated distributions for relevant financial variables—in excess of a certain limit. In addition, countries could be expected to hold sufficient liquid reserves to ensure that they could avoid new borrowing for one year with a certain ex ante probability, such as 95 percent of the time.
Scenario analysis-based contingency plans
The FDIC discuss liquidity risk management and write "Contingency funding plans should incorporate events that could rapidly affect an institution’s liquidity, including a sudden inability to securitize assets, tightening of collateral requirements or other restrictive terms associated with secured borrowings, or the loss of a large depositor or counterparty." Greenspan's liquidity at risk concept is an example of scenario based liquidity risk management.
Diversification of liquidity providers
If several liquidity providers are on call then if any of those providers increases its costs of supplying liquidity, the impact of this is reduced. The American Academy of Actuaries wrote; While a company is in good financial shape, it may wish to establish durable, ever-green (always available) liquidity lines of credit. The credit issuer should have an appropriately high credit rating to increase the chances that the resources will be there when needed.
Amaranth Advisors LLC – 2006
Amaranth Advisors lost roughly $6bn in the natural gas futures market back in September 2006. Amaranth had a concentrated, undiversified position in its natural gas strategy. The trader had used leverage to build a very large position. Amaranth’s positions were staggeringly large, representing around 10% of the global market in natural gas futures. Chincarini notes that firms need to manage liquidity risk explicitly. The inability to sell a futures contract at or near the latest quoted price is related to one’s concentration in the security. In Amaranth’s case, the concentration was far too high and there were no natural counterparties when they needed to unwind the positions. Chincarini (2006) argues that part of the loss Amaranth incurred was due to asset illiquidity. Regression analysis on the 3 week return on natural gas future contracts from August 31, 2006 to September 21, 2006 against the excess open interest suggested that contracts whose open interest was much higher on August 31, 2006 than the historical normalized value, experienced larger negative returns.
Northern Rock – 2007
Nationalisation of Northern Rock
Northern Rock suffered from funding liquidity risk in September 2007 following the subprime crisis. The firm suffered from liquidity issues despite being solvent at the time, because maturing loans and deposits could not be renewed in the short-term money markets. In response, the FSA now places greater supervisory focus on liquidity risk especially with regard to high-impact retail firms.
LTCM – 1998
Long-Term Capital Management (LTCM) was bailed out by a consortium of 14 banks in 1998 after being caught in a cash-flow crisis when economic shocks resulted in excessive mark-to-market losses and margin calls. The fund suffered from a combination of funding and asset liquidity. Asset liquidity arose from LTCM failure to account for liquidity becoming more valuable as it did following the crisis. Since much of its balance sheet was exposed to liquidity risk premium its short positions would increase in price relative to its long positions.
This was essentially a massive, unhedged exposure to a single risk factor. LTCM had been aware of funding liquidity risk. Indeed, they estimated that in times of severe stress, cuts on AAA-rated commercial mortgages would increase from 2% to 10%, and similarly for other securities. In response to this, LTCM had negotiated long-term financing with margins fixed for several weeks on many of their collateralized loans. Due to an escalating liquidity spiral, LTCM could ultimately not fund its positions in spite of its numerous measures to control funding risk.