The World of Finance

Hello Risk

Dr HK Pradhan
Professor of Finance & Economics
XLRI Jamshedpur
We live in a world of
uncertainty…

Financial Crisis, Currency Crisis,

Banking Crisis, Deposit Runs,
Liquidity Crisis, Credit Defaults,
Oil price shocks…
Low probability but high impact events
dominate finance
1987 U.S. Stock Market Crash

• Interplay between stock

markets and index
options and futures
markets
• Use of program trading
by large institutional
investing companies
• Herd behavior endured a
crash
 The Great Bond Market Turbulence of 1994
Ref: Anatomy of the Bond Market turbulence of 1994 – Caludio Borio & Robert N McCauley

1994: January – 34th straight month of economic expansion, low

rates, historically low bond yields -Fed Effective Fund rate 3%
Fed Fund rate 3% Fed Fund rate 5.5% Month 6-month 5-Year 30-Year
IN January 1994 in December 1994 Jan 94 3.25 5.02 6.23
Jan 95 6.40 7.54 7.71
Federal funds effective rate (%)
8 Daily Treasury Yield Curve Rates (%)
7 3 Mo 6 Mo 5 Yr 30 Yr
8.5
6
5
6.5
4
3
2 4.5
1
0
2.5
Oct/91

Oct/92

Oct/93

Oct/94

Oct/95
Jan/91

Jan/92

Jan/93

Jan/94

Jan/95
Jul/91

Jul/92

Jul/93

Jul/94

Jul/95
Apr/91

Apr/92

Apr/93

Apr/94

Apr/95

Source: Federal Reserve Source: US Department of Treasury

3 Mo 30 Yr
8

2
May…

Nov/…

May…

Nov/…

May…

Nov/…
Mar/…

Sep/…

Mar/…

Sep/…

Mar/…

Sep/…
Jul/91

Jul/92

Jul/93
Jan/91

Jan/92

Jan/93

Daily Treasury Yield Curve Rates (%)

Currency Crisis 1997(East Asia), Russia
1998, Mexico 1994
Indian Rupee
 Subprime Crisis of 2008
• The introduction of exotic loans,
adjustable rate mortgages, and
relaxed standards allowed for an
increase in subprime mortgage
lending.
• Hedge funds worldwide borrowed
money to invest heavily in
subprime mortgages.
• When interest rates rose and
housing prices fell., monthly
mortgage rates for subprime
borrowers skyrocket
• Housing slump meant they do not
have enough credit standing to
refinance or through sale.
• Resulting rates of delinquency and
foreclosures
 2015 Crisis in Greece
• Government debt remained
consistently above 100%
of GDP post 1990
essentially due to
• Government’s plan to
jumpstart economy and
inability to limit public
spending
• Rampant corruption
• Tax evasion
• Structural issues in the
economy
 Brexit & the Sinking Pound
• UK votes to leave the
EU.
• The pound suffers
one of its worst days
ever - falling to a 30-
year low.
• £1 equivalent to
$1.33.
Commodity Boom & Burst
 China’s Bubble & Adjustments
Bubble situation created
• Relaxed restrictions on domestic
stock market, alarming surge in 150%
first-time stock traders.
• Relaxed debt policies to attract 30%
investors for stock trading,
20%
“Margin Trading“
• Optimism by state-run media
• Cheerlead investments in surging
market.
• Selling state-owned junk assets to
people

Bubble bursts with

stock price crush &
Devaluation of Yuan.
 so here is the high risk finance…
• Its about taking the right risk,
incorporating the right risk in
pricing and capital
• It is probabilistic, you need to
measure it
• You can’t manage without
measuring
 Financial Risks
Let us define on few concepts..
MARKET RISK

EVENT RISK SPREAD RISK

OPERATIONAL CONCENTRATIO
RISK N RISK

RISK

SYSTEMIC RISK LIQUIDITY RISK

SETTLEMENT
COUNTRY RISK
RISK

CREDIT RISK
Market Risks
• Unprecedented Volatility
• Associated with the impact of changes
in market prices on the outstanding
positions
• Banking book
• Trading book
• Changes in prices can have important
implications on an institution's
outstanding positions/obligations, on
a MTM basis
Risk of losing return
Small possibility of losing large
Market risk factors
• Equity price risk
– Unprecedented volatility in equity prices, global
factors dominate fluctuations, role of cross border
capital flows
• Interest rate risk/ Mismatch risk
– Arises on all interest sensitive instruments
– Instruments that have variable rates are exposed to
interest rate risk
• Currency risk
– Volatility and swings in exchange rates, cross-currency
risks
• Commodity price risk
– Commodity price cycles, gold & oil price gyrations
 Significant Tail Risk
• If portfolio returns were
normally distributed, then the
mean and volatility would fully
characterize risk.
• Portfolio returns of several asset
classes are materially non-
normal.
• Extreme equity returns occur far
more frequently than would be
predicted by a normal
distribution, resulting in a heavy
tail losses
• For a non-normal portfolio, no
single measure completely
describes portfolio risk.
Concentration Risk
• Like diversification enhances return, so
also it reduces risk
• Risk concentration in certain maturity
buckets, sectors, regions, or instruments
or special class of instruments, and
underlying exposure
– Example: Sub-prime crisis was also
due to large concentration of
exposure in sub-prime mortgages
 Correlation Structures
Strong correlation Weak correlation Negative correlation
FRF

FRF

FRF
GBP GBP GBP

r = 80% r = 20% r = -60%

Correlations reflect the historical co-movement in returns and range between -1 and 1.
A correlation of 1 means that returns move together perfectly
A correlation of -1 implies perfect opposite movements
A 0 (zero) correlation implies independence.

Standard deviation shows how risky individual assets are,

Correlations show how asset risks are interrelated.
Global Asset Correlations

Source : Marko Kolanovic, JPMC, “Rise of Global Asset Correlations”

Correlations in Turbulent Times
cov ij  rij i j
Volatility Spillover
• Emerging markets are no
longer insulated
• Emerging market asset
prices co-move in
tandem with global Sensex 2001-08
factors
• Global factors dominate
in asset pricing: where is
domestic CAPM?
 Inter-Market Spillover

Stocks & Bonds Bonds & Swaps

Bonds, Gold & Oil Copper & Gold

 Risk of Contagion
• Risk can be contagious when crisis in
one market transmits to another
Examples:
• Asian currency crisis of 1997
• Sub-prime crisis of 2007-08

Crisis can spread across markets due to integration of asset

markets (in global markets, for example)

Risk and liquidity management practices in other institutions

can be considered important
 Liquidity Risk
• Liquidity risk arises in a situation where
the volume of liquid assets can diminish
quickly in the face of unanticipated cash
flow obligations and/or a possible
difficulty in raising cash through
borrowing in a short period
• Liquidity situations in money markets or
bond markets creating costly rollover of
positions
• Liquidity trading risk: the inability to buy or sell an asset
without moving its price
• Liquidity funding risk: inability to fund a position continuously
at an unchanged price
 Financial Crises

• Investors panic behaviour

• Expecting a banking crisis,
depositors run, exacerbate
liquidity crisis
• Rush to safe heaven
– Treasury, Gold….
Rollover Risk
• Rollover risk arises when a position will have
to be rolled over at an unusually high cost or,
in extreme cases, cannot be rolled over at all
due to liquidity shortages.
• Liquidity risk has exacerbated roll over
risk…
• Example:
– Short term assets & liabilities an create significant
rollover problems and implications on money
markets
– For example, in case of interest rate risk, a
liability has to be rolled over at higher interest
rates, including changes in credit spreads, it may
be considered a type of market risk.
Spread Risk
• Spread Risk due to widening of spread across
asset classes
– Basis risk arising out of change in yield differences across
assets
– Changes in spread over a maturity (due to yield curve
shifts) or higher spread due to increased risk perception of
certain investors
– Country risk & credit spreads are understood to be
correlated
 Credit Risk
• Credit Risk is the risk nonperformance credit related
events, on portfolios with exposure to credit rating
changes, or default probability on loans or other financial
assets or by a counterparty risks on any financial
contracts or derivative contracts
• Examples:
– Counterparty risk : Failure of counterparty to meet
obligations e.g. credit defaults, or counterparty risk on
swaps or repurchase agreements
– Risk arising out of stressed assets, loans that have
implicit guarantees, contingent liabilities, credit
default contagion leading to systemic risk
– Collapse of the major investment banks (Lehman,
Bear Stern, Merrill) that had significant exposer to
mortgage market(Solvency risk)
Settlement risk

• Settlement risk reflects potential loss that the institutions, as a

counterparty, could suffer as a result of failure to settle, for
whatever reason other than the default, by another
counterparty
• Example:
– Such as credit exposure arising out of derivative
transactions
– OTC derivatives can have important settlement risks
Execution Risk

• Inability to control risk while executing strategies

• Example:
– Timing the market has become the most difficult task
– Stop-loss limits often based on trial & error methods
– Substantial risk which can arise while executing certain
strategies such as options
– Treasury operations have become extremely difficult due
to volatility, with open positions
Country Risk

• Country risk affects in many ways the cost and availability of

credit, pricing of global assets, spreads
• Examples
– External loans are affected by changes in credit ratings (by
S&P and Moody’s, etc)
– Global risks assessment for a country could be affected by
country risk revisions
• Country risk & sovereign risk ratings can influence risk and
rating of all other entities in an economy
Emerging Markets
Operational Risks
• Operational risk may FACILITIES

include “Everything else”:

potential for loss arising
from breakdowns in SYSTEM
policies and controls for
ensuring the proper
functioning of people, PEOPLE
systems and facilities.

• Include a range of different types of risks arising out of the

process of transactions processing; inadequacies or failures in
internal controls, or in systems and services; reputation risk;
security breaches; or natural disasters that affect business
activity, settlement process, legal contractual provisions, etc
are also examples of operational risks
 The Rogue Traders…

Fraud
• Some of the big losses were
simply followed by robust Nick Leeson Barrings
treasury performance

• Wall street is the only place

that people ride to in Rolls-
Royce to get advice from those Jerome Kerviel SocGen

who take the subway." –

Warren Buffett

Adoboli of UBS
Event Risk
• It has been seen that certain events have created
severe implications on financial markets (e.g.9/11)
– Events can trigger financial risk of unheeded
positions

• 1971 Collapse of Bretton Woods

• 1973, 79, … Oil shocks
• 1987 DOW collapses by 23%
• 1992 Sterling collapses in EMS
• 1994 Six hikes by Fed
• 1994 Dec Barrings Collapse
• 1997 SE Asian Meltdown
• 1998 Russian default
• 2001 Nine-Eleven
• 2002 War
• 2008 Lehman Crisis
• 20111 US Rating downgrade to AA+
Event risks make jumps in asset prices

• Asset prices exhibit jumps

from one state to another:
notable discontinuity
• Complete revaluation of
assets/liabilities
• Example: crash,
devaluation, one time
move in interest rates,
9/11, etc
 Systemic risk
• Systemic risk arises due to factors
external to the institution's own, or
due to macroeconomic crisis which
would affect certain positions in the
economy
• Examples
– Lender-of-last-resort role of
central banks (examples: fiscal
stimulus, massive bailouts
following global financial crisis,
rescue of banking system after
Asian Crisis of 1997
• Sound macroeconomic policy as well
as financial market stability and
credibility are understood to reduce
systemic risks
Regulatory risk
• Regulatory risk may arise due to the changes in
regulations affecting financial contracts, or an
instruction's inability to meet the regulatory
standards.
• Risk based margins, liquidity requirements, regulatory
capital, statutory guidelines, tax implications of capital
gain, etc, which are desirable, are costly, makes
institutions less competitive
• Example, banks not meeting Basel II standards, or even the
important question how safe is Basel II standards
• Regulators not sure how much risk is inherent in the system
 The risk pyramid

Levels of Risk
1. At the top of the pyramid, total market risk,
is the aggregation of all component risks.

2. In the middle, we see how financial

instruments are driven by common factors or
the underlying component risks.

3. At the lowest level, market risk arises from

fluctuating prices of financial instruments.
Residual risks:In addition to market risk,
the price of financial instruments may be
influenced by the following: spread risk,
basis risk, specific risk, and volatility risk.
Risks are related
Market Risks, liquidity, credit risk, concentration
risk, are correlated….

– Market risks can also be caused by other

forms of risks arising out of liquidity risk,
credit risk, concentration risk, etc
– Risk brings more regulations
 Governance Risk

Conflicts
Often exposure environment & risk management goals conflict in organizations
– CFO, Regulator, Treasury, CEO, Board & shareholders
 Question?
• Why do repeated FINANCIAL CRASH/CRISIS
happen in the presence of sophisticated
financial engineering skills, technology,
expertise & regulations in modern financial
markets?

• We need to address broader issues

• For now, let us understand from the risk
management perspectives
Let us move forward