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RISK IN FINANCIAL MARKET

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RISK IN FINANCIAL MARKET
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Abhijeet S
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RISK IN FINANCIAL MARKET - September 3rd, 2010

RISK IN FINANCIAL MARKET
  • market risk,

  • Interest rate risk ,
  • credit risk,

  • off-balance-sheet risk,

  • technology and operational risk,

  • foreign exchange risk,

  • country risk,

  • liquidity risk,

  • insolvency risk



Market Risk

  • Incurred in trading of assets and liabilities (and derivatives).

  • Examples: Barings & decline in ruble.

  • Trend to greater reliance on trading income rather than traditional activities increases market exposure.

  • Trading activities introduce other perils as was discovered by Allied Irish Bank’s U.S. subsidiary, AllFirst Bank when a rogue trader successfully masked large trading losses on foreign exchange positions



Interest rate risk
  • Interest rate risk resulting from intermediation:

  • Mismatch in maturities of assets and liabilities.

  • Balance sheet hedge via matching maturities of assets and liabilities is problematic for FIs.

  • Refinancing risk.

  • Reinvestment risk




Credit Risk

Risk that promised cash flows are not paid in full.
Firm specific credit risk
Systematic credit risk
High rate of charge-offs of credit card debt in the 80s and 90s
Obvious need for credit screening and monitoring
Diversification of credit risk


Off-Balance-Sheet Risk
  • Increased importance of off-balance-sheet activities

  • Letters of credit

  • Loan commitments

  • Derivative positions

  • Speculative activities using off-balance-sheet items create considerable risk


Technology and Operational Risk
  • Risk of direct or indirect loss resulting form inadequate or failed internal processes, people, and systems or from external events.
  • Some include reputational and strategic risk

  • Technological innovation has seen rapid growth

  • Automated clearing houses



Foreign Exchange Risk

  • Returns on foreign and domestic investment are not perfectly correlated.

  • FX rates may not be correlated.

  • Example: $/DM may be increasing while $/ decreasing.

  • Undiversified foreign expansion creates FX risk.

  • Note that hedging foreign exposure by matching foreign assets and liabilities requires matching the maturities as well*.

  • Otherwise, exposure to foreign interest rate risk is created.

Country or Sovereign Risk
  • Result of exposure to foreign government which may impose restrictions on repayments to foreigners.

  • Lack usual recourse via court system.

  • Examples: South Korea, Indonesia, Thailand.
  • More recently, Argentina.


Liquidity Risk
  • Risk of being forced to borrow, or sell assets in a very short period of time.

  • Low prices result.

  • May generate runs.

  • Runs may turn liquidity problem into solvency problem.

  • Risk of systematic bank panics
.



Insolvency Risk
  • Risk of insufficient capital to offset sudden decline in value of assets to liabilities.

  • Continental Illinois National Bank and Trust

  • Original cause may be excessive interest rate, market, credit, off-balance-sheet, technological, FX, sovereign, and liquidity risks.
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