Analysis of risk

Analysis of Risk (Measurement of Risk):

It includes following methods:

Random Variables & Probability Distribution

Random Variables: Random Variable is variable whose out come is uncertain. For example, if a coin is to be flipped and the variables x is defined to be to be equal to Rs. 1 if heads appears and Rs. –1 if tails appears. Then prior to the coin flip, the value of x is unknown; that is x is random variables. Once the coin has been flipped and the outcome revealed, the uncertainty about x is revealed, because the value of x is then known.

Probability Distribution: It identifies all the possible outcomes for the random variables and the probability of the outcomes. Probability distribution indicates the proportion of expected outcome to the total out come. So, in this above example, the probability of appearing of heads and tails will be .5 in each case. Because there are only two expected out comes.

Types of liquidity risk

Liquidity risk can also be classified in to two parts.

Ø Assets Liquidity Risk

Ø Funding Liquidity Risk

Assets Liquidity Risk/ Market/ Product Liquidity Risk: It arises when a transaction cannot be conducted at prevailing market prices due to the size of the position related to normal trading lots. It can be managed by setting limits on certain markets or products and by means of diversification.

Funding Liquidity Risk: It is also known as cash flow risk, refer to the inability to meet payments obligations, which may force early liquidation, thus transforming paper losses in to realize losses. This especially a problem for portfolio that are leveraged and subject to margin calls from the lenders. Cash flow risk interacts with product liquidity risk if the portfolio contains illiquid assets that must be sold at less than fair market value.

Liquidity risk

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).

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 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 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.
Liquidity risk 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.

What is operational risk

Operational Risks: It arises from human & technical errors or accidents. This includes fraud, management failure and inadequate procedures & controls. Technical errors may be due to breakdowns in information, transaction processing, and settlement systems or any other problem in back office operations, which deals with the recording of transactions and reconsolidation of individual trades with the firms aggregate position.

It can also lead to market & credit risk, like if the settlements fail than it will create market risk & credit risk, since the cost may depend on movements in the market price.

The best protection against operational risks consists of redundancies of systems, clear separation of responsibilities with strong internal control and regular contingency planning.

What is Credit Risk

It originates from the fact that counter parties may willing or unable to fulfill their contractual obligations. Its effect is measured by the cost of replacing cash flows if other party defaults.

Credit risk should be defined as the potential loss in mark to market value that may incur due to occurrence of credit events. A credit event occurs when there is a change in the counter party’s ability to perform its obligation.

Credit risks can be of following two types-

Ø Sovereign Risk

Ø Settlement Risk

Sovereign Risk: It occurs like when countries impose foreign exchange controls that make it impossible for counter parties to honour their obligation. This type of risk is country specific.

Settlement Risk: It occurs when two payments are exchanged the same day. This risk arises when the counter party may default after institution already made its payments. Settlement risk is very real for foreign exchange transaction, which involves exchange of payments in different currencies at different times.

Credit risk is controlled by credit limits or notional, current & potential exposures and increasingly, credit enhancement features such as requiring collateral of marking to market.

Market Risks

It arises from movements in the level of market prices. It can be measured in two forms.

ü Absolute Risk

ü Relative Risk

Absolute Risk: It is measured in terms of relevant currency. It focuses on the movement of total return.

Relative Risk: It is measured in terms of related Bench Mark Index. It has emphasis on the deviation from index.

The market risk can be classified in to two following categories.

Ø Directional Risks

Ø Non-Directional Risks

Directional Risks: It involves exposures to the direction of movements in the financial variables, such as stock prices, interest rates, exchange rates & commodity prices. These exposures are measured by linear approximation such as beta for exposure to stock market movements.

Non-Directional Risks: It involves remaining risks, which consist of non-linear exposures to hedged position. Second order or quadratic exposures are measured by convexity when dealing with interest rates and gama when dealing with options.

Financial Risk Management

It refers to the design & implementation of procedure for controlling financial risks. Technological changes have arises from advances on two fronts.

Ø Physical Equipment

Ø Financial Theory

Physical Equipment: The availability of cheaper communications & computing power has led to innovations such as global 24 hours trading and online risk management systems.

Financial Theory: Modern finance theory has allowed institution to create price & control the risks of news financial instruments.

Types of Financial Risks:

1. Market Risks
2. Credit Risks
3. Operational Risks
4. Liquidity Risks

Risk Management in Banks

If a bank takes more risk it can expect to make more money, but the greater risk also increases the NPAs (Non Performing Assets) and looses its business badly which can force it to go out from business. There should be following two objective before the banks-

Ø To generate profit

Ø To stay in business

The function of risk management in banks is –

Ø To ensure that the total risk being taken is matched to the bank’s capacity for absorbing losses in case things go wrong.

Ø To help the CEO (Chief Executive Officer) direct the scare resources of capital to the opportunities that are expected to create the maximum return with the minimum risk.

Risk Management at Macro level: Like other banking functions risk, is also looked after by board of directors of the banks. The board has to maintain the balance between shareholder’s & debt-holder’s desires of taking risk. Apart from this it has to take in to account perception of rating agencies, regulators and its own desire to stay in business.

The board can oversee the three key functions of risk management.

Ø Determining the target debt rating.

Ø Determining the amount of available capital

Ø Allocating risk limits to each business unit/ segment with in the bank.

what are the sources of risk

Human Created: Business cycles, Inflation, Change in the government policies & wars.

Unforeseen Natural Phenomena: Disturbance in the weather like flood, drought, Cyclones & Earthquakes.

Other Sources: Long term economic growth, technological innovation that render existing technology obsolete.

Government Rules & Regulations: When the Government bans something or imposes some heavy duties & taxes on the turnover; it leads to decrease in the demand of goods & services.

Foreign Exchange Rate: It creates imbalances in the balance of payment as well as make favorable or unfavorable in the net business (export & Import) of goods & services from aboard.

What is risk identification

Risk Identification: It means to identify the sources & reasons of expected losses. There are various methods of identifying exposures. For examples, comprehensive checklist of common risk exposures can be obtained from risk management consultants & other sources. Loss exposures can also be identified through analysis of firm’s financial statements, discussions with managers through the firm, surveys of employees & discussion with the risk management consultant & insurance agents. Regardless of the specific method used, risk identification requires an overall understanding of business & specific legal & regulatory factors that affects the business.

One method of identifying individual exposures is to analyze the source & uses of funds in the present and planned for the future. Potential events that decrease in availability of funds or increase in the uses of funds represent risk exposures.