FinancialRisks (2)

7/23/2019 FinancialRisks (2)

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What is liquidity risk?

All firms, particularly financial institutions, require access to borrowed funds to carry

out their operations, from paying their near-term obligations to making long-term strategicinvestments. An inability to acquire such funding within a reasonable timeframe could place

a firm at risk.

Definition

Liquidity is generally defined as the ability of a financial firm to meet its debt obligations

without incurring unacceptably large losses. An example is a firm preferring to repay its

outstanding one-month commercial paper obligations by issuing new commercial paper

instead of by selling assets. Thus inability of the firm to meet its debt obligations is known as

liquidity risk. There are 2 parts to it: Funding Liquidity Risk and Market Liquidity Risk.

Funding liquidity risk is the risk that a firm will not be able to meet its current and

future cash flow and collateral needs, both expected and unexpected, without materially

affecting its daily operations or overall financial condition. Financial firms are especially

sensitive to funding liquidity risk since debt maturity transformation (for example, funding

longer-term loans or asset purchases with shorter-term deposits or debt obligations) is one

of their key business areas.

Market liquidity risk is asset illiquidity. This is an inability to easily exit a position

without making a loss. For example, we may own real estate but, owing to bad marketconditions, it can only be sold imminently at a lower price than the market price, resulting in

a loss. The asset surely has value, but as buyers have temporarily evaporated, the value

cannot be realized. Consider its virtual opposite, a U.S. Treasury bond. This bond

has extremely low liquidity risk: its owner can easily exit the position at the prevailing

market price. Small positions in S&P 500 stocks are similarly liquid. They can be quickly

exited at the market price.

In response to this well-known risk, financial firms establish and maintain liquidity

management systems to assess their prospective funding needs and ensure the funds are

available at appropriate times. A key element of these systems is monitoring and assessing

the firm’s current and future debt obligations and planning for any unexpected funding

needs, regardless of whether they arise from firm-specific factors, such as a drop in the

firm’s collateral value, or from systemic (economy-wide) factors. To balance its funding

demand, both expected and unexpected, with available supply, a firm must also incorporate

its costs and profitability targets.



Example:

Liquidity crisis during 2007-08:

Consider a bank ‘ABC’ that does not have a large depositor base. It will only be able to fund

a small part of its new loans from deposits. So it will finance new loans by selling the loans

that it originated to other banks and investors. This process of selling loans is known assecuritization. ABC would then take short-term loans to fund its new loans. So the bank was

dependent on two factors—demand for loans, which it sold to other banks, and availability

of credit in financial markets to fund those loans. When markets were under pressure in

2007 –2008, the bank wasn’t able to sell the loans it had originated. At the same time, it also

wasn’t able to secure short-term credit. Due to the financial crisis, a lot of investors took out

their deposits, causing the bank to have a severe liquidity crisis since it was not able to

service its debt obligations.

Use of collaterals and liquidity risk emerging from it:

Traditionally, collaterals are assets provided to secure an obligation. A more recentdevelopment is collateralized arrangements used to secure repurchase agreements,

securities lending and derivatives transactions. Under such a context a party who owes an

obligation to another party posts cash or securities to secure the obligation. In the event

that the party defaults on the obligation, the secured party may seize the obligation. In this

context, collateral is sometimes referred to as margin also. Because the value of the

collateral and value of the obligation can change, the secured party would typically want to

mark-to-market ie. Adjust the balances depending on the difference between the obligation

and the collateral value. In the event that the value of the collateral posted decreases

compared to the obligation, would result in a liquidity risk where in the secured party would

issue a margin call to post additional collateral.



What is Credit Risk?

The risk of loss of principal or loss of a financial reward stemming from a borrower's

failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises

whenever a borrower is expecting to use future cash flows to pay a current debt. Investors

are compensated for assuming credit risk by way of interest payments from the borrower or

issuer of a debt obligation. Credit risk is closely tied to the potential return of an investment,

the most notable being that the yields on bonds correlate strongly to their perceived credit

risk. The higher the perceived credit risk, the higher the rate of interest that investors will

demand for lending their capital. Credit risks are calculated based on the borrowers' overall

ability to repay. This calculation includes the borrowers' collateral assets, revenue-

generating ability and taxing authority (such as for government and municipal bonds).Credit

risks are a vital component of fixed-income investing, which is why ratings agencies such as

S&P, Moody's and Fitch evaluate the credit risks of thousands of corporate issuers and

municipalities on an ongoing basis.

Credit risk also denotes the volatility of losses on credit exposures in two forms—theloss in the credit asset’s value and the loss in the current and future earnings from the

credit.

Example:

During the subprime crisis, many banks made significant losses in the value of loans made to

high-risk borrowers—subprime mortgage borrowers. Many high-risk borrowers couldn’t

repay their loans. Also, the complex models used to predict the likelihood of credit losses

turned out to be incorrect.

Major banks all over the globe suffered similar losses due to incorrectly assessing thelikelihood of default on mortgage payments. This inability to assess or respond correctly to

credit risk resulted in companies and individuals around the world losing many billions of

U.S. dollars.

What is Counter Party Risk?

The risk to each party of a contract that the counterparty will not live up to its contractual

obligations. Counterparty risk as a risk to both parties and should be considered when

evaluating a contract. In most financial contracts, counterparty risk is also known as "defaultrisk".

Example:

if Joe agrees to lends funds to Mike up to a certain amount, there is an expectation that Joe

will provide the cash, and Mike will pay those funds back. There is still the counterparty risk

assumed by them both. Mike might default on the loan and not pay Joe back or Joe might

stop providing the agreed upon funds.

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FinancialRisks (2)