Overview of Risks and Risk Management CHAPTER 2

Overview of Risks and Risk Management

CHAPTER 2

2

Risk Versus Uncertainty


• Risk has many definitions; different economic entities will operationalize “risk” in different ways.

• In general, we can think of risk as a potential hazard that an entity would like to avoid if possible, all else equal.

• Knight makes a distinction between risk, which applies to a decision in which the outcome is unknown but the decision maker can quantify potential outcomes with some probabilities (“measurable risk”) or (“risk proper”), and uncertainty, in which the probabilities attached to outcomes or even the outcomes themselves are unknowable.

• Example of uncertainty: modeling mortgage-backed securities, investors and quants incorrectly thought they could quantify and control the risks associated with these instruments.

3

Systematic Versus Idiosyncratic Risk


• Factors assumed to affect the valuation of all assets in an asset class are referred to as common risk factors or systematic risk.

• In addition to systematic risks, there are factors called idiosyncratic risk that may be unique to the issuer of a particular asset. • An example of an idiosyncratic risk for a company would be a

prolonged strike by its employees, an uninsured natural disaster that destroys a principal manufacturing plant, the expropriation of major overseas manufacturing facilities by the government of the country in which the facilities are located, or a patent infringement.

• Standard asset pricing theories covered in this book suggest that investors should only be compensated for systematic risk.

• Idiosyncratic risk can be eliminated through the proper selection of assets so as to create to a diversified portfolio.

• Thus, systematic risk is referred to as nondiversifiable risk while idiosyncratic risk is referred to as diversifiable risk.

4

Fin. Risk Mgmt. & Identifying Fin. Risks


• Financial risk management involves the following activities: (1) identifying financial risks, (2) quantifying each identified risk, and (3) evaluating how to deal with each identified risk.

• Not all risks faced by households, financial entities, and businesses are always easy to identify.

• Some risks, unfortunately, are identified only after a financial problem or financial crisis occurs.

• The three general categories of financial risk that business, financial entities, and households face are (1) investment risk, (2) funding risk, and (3) systemic financial risk.

5

Quantifying Risk


• Not all risks can be quantified (recall Knightian uncertainty and “measurable risk” from the second slide).

• In finance, there are financial metrics that have been used to quantify many financial risks. • These metrics draw heavily on concepts in the fields of probability

and statistics. • So, if you want to work in finance, study these subjects hard!

• Models used in finance are based on assumptions and on estimated data (they may or may not have explicitly defined parameters).

• Some market observers argue that it was the failure of risk models used for quantifying risk of financial institutions that resulted in the 2008-2009 financial crisis.

6

Evaluating How to Deal with Each Risk


• Once the relevant risks are identified, corporate and household risk management involves evaluating how to deal with each risk. • The choices for dealing with each risk are: (1) retaining a risk, (2)

neutralizing a risk, or (3) transferring a risk. • Each identified risk can be treated differently.

• For each of the three choices – retention, neutralization, and transfer – there are in turn further decisions as to how the risk should be handled.

• The decision as to which identified risks a business or household should retain is based on an economic analysis of the expected benefits versus expected costs associated with bearing that particular risk.

7

Retained Risk


• Aggregating all the risks across any risk that a business or household has elected to bear produces what is called its retained risk.

• Any retained risk realized will have a potential adverse economic impact. • In the case of a business, it may adversely impact earnings, cash

flow, and the value of the business. • For a household, it may have a an adverse impact on income and

net worth.

• With respect to businesses, an unfunded retained risk is a retained risk for which potential losses are not financed until they occur.

• In contrast, a funded retained risk is a retained risk for which an appropriate amount is set aside up front (either as cash or as an identified source for raising funds) to absorb the potential loss.

8

Risk Neutralization I


• The management of retained risk is referred to as risk finance.

• If a business or household elects not to pursue a risk finance strategy (i.e. not retain the risk), there are two alternatives: neutralize the risk or transfer the risk. • Risk neutralization is a management policy whereby a business or

household acts on its own behalf to mitigate the outcome of an expected loss from an identified risk without transferring that risk to a third party.

• A risk neutralization strategy can involve mitigating the probability of the identified risk occurring or reducing the severity of the loss should the identified risk in fact occur.

• For a business, a risk neutralization strategy for some risks may be a natural outcome of the business itself or of financial factors affecting business.

• Example: Suppose that a company projects an annual loss of $100 million to $150 million from returns because of product defects.

9

Risk Neutralization II


• A company can introduce improved production processes to reduce the upper range of the potential loss.

• As an example involving a financial factor, a U.S.-headquartered company operating in both the U.S. and in countries in the eurozone will likely have cash inflows and outflows in euros. • As a result, the company faces one of the investment risks

discussed earlier in the slide, foreign exchange risk, which is the risk that the exchange rate moves adversely to the company’s exposure in that currency.

• But this risk has offsetting tendencies if there are both cash inflows and outflows in the same currency.

• Assuming the currency is the euro, the cash inflows are exposed to a depreciation of the euro relative to the USD, but the cash outflows are exposed to an appreciation of the USD.

• If company projects future cash inflows period of 80 million euros and a cash outflow over the same time period of 70 million euros, net exposure is 10 million euro inflow.

10

Risk Transfer I


• One may decide to transfer certain risks to a third party.

• This can be done by entering into a contract with another party willing to take on the risk that an entity wishes to transfer or by embedding that risk in some type of security (i.e., creating a market instrument whose payoff depends on the outcome of the risk that the company wishes to transfer).

• The most common risk transfer vehicle used by households is an insurance policy. • For example, home and auto insurance sold by property and

casualty (P&C) companies are vehicles used by households to obtain both asset protection resulting from some event and protection of a household’s wealth that could potentially be put at risk from a lawsuit in which a home or auto was involved.

• Life insurance policies are available to provide a guaranteed sum of money to the beneficiaries as a result of the death or loss of income of the wage earners in a household.

11

Risk Transfer II


• Annuities can be used to provide an income stream for a household during a wage earner’s retirement.

• Basically, insurance policies transfer risks from households to insurance companies. • There are other types of insurance, such as medical insurance and

disability insurance. • Businesses also use insurance companies to protect assets and

mitigate the damage that can be done by assets.

• There are capital market instruments called financial derivatives, or simply derivatives, that provide for the efficient transfer of risk.

• Although derivatives are too often mischaracterized in the popular press as speculative vehicles that can cause havoc in the financial markets, when properly utilized by market participants they can reduce the types of risk that we mentioned earlier in the slides.

12

Risk Transfer III


• In addition to derivatives, capital market instruments have been created by structured finance technology to transfer risk that was previously take on on by financial institutions such as banks and insurance companies to the investing public.

• At one time, depository institutions that originated commercial loans to corporations and consumer loans to individuals to purchase a home (residential property) retained those loans in their portfolio. • One of the solutions that depository institutions have adopted is to

sell the bonds that are backed by a pool (i.e. package of loans that they are originated).

• The bonds created are referred to as securitized products or asset-backed securities (ABS), and the process of creating them is referred to as asset securitization.

• The asset securitization process transfers the risks associated with the pool of loans to the investors who purchase the ABS.

13

Risk Transfer IV


• While asset securitization is often used by depository institutions, operating companies use this process to remove the risks associated with loans they grant to customers. • For example, automobile manufacturers make loans to customers for

the purpose of purchasing automobile. • By pooling automobile loans to create ABS, automobile

manufacturers transfer those risks to the investors who buy the securities.

• P&C companies are concerned with catastrophic events that can cause major losses. • To transfer the risk of such catastrophes to investors, P&C

companies created catastrophe bonds, nicknamed “cat bonds” by market participants.

• If a qualifying catastrophe occurs, the bondholder loses part or all of the principal they invested and the P&C company that issued the cat bond can use the funds not paid to bondholders to recoup some or all of the losses from the event.

14

Investment Risk


• In very general terms, investment risk refers to the likelihood that an investment or an investment strategy will have a performance outcome that is less than what the investor expected.

• Within the general category of investment risk there are various types of risk that can result in below-expectation performance.

• These risks include: • Credit risk • Price risk • Reinvestment risk • Inflation risk • Liquidity risk • Foreign exchange rate risk • Longevity risk

15

Credit Risk


• A major risk in the financial system is credit risk, which encompasses many forms of risk.

• Unfortunately, there is no standard definition for what it means.

• Most market participants refer to credit risk in the context of the failure of a borrower in a lending agreement to satisfy the contractual obligation to make timely payments of interest and repayment of principal. • Lending agreements, in this context, include loans and bonds. • Used in this way, credit risk refers to default risk.

• For example, when an individual borrows money from a bank to purchase a home, the lending arrangement exposes the lending bank to default risk – the risk that the borrowers will fail to repay the loan.

16

The Different Forms of Credit Risk


• Although the term credit risk is most commonly used with the meaning and in the context described in the previous slide, credit risk in a broader sense means the failure of a counterparty to a transaction to fulfil its obligation. • This form of credit risk, referred to as counterparty risk, exists not

only in financial market transactions but in many transactions in in everyday life.

• Example: when an individual purchases a subscription to a magazine and pays for that subscription fee up front, there is the risk that the magazine publisher will go out of business and therefore not fulfill its obligation to deliver the magazine.

• Credit spread is the additional compensation for default risk on a given bond above the interest rate on a default-free bond.

• Credit spread risk is the risk faced by bondholders from adverse movements in the bond price driven by concerns over the creditworthiness of the bond issuer.

17

Measuring Credit Risk I


• The measurement of default risk and counterparty risk requires an analysis of the ability of the issuer or counterparty to meet its obligations, i.e. to perform credit analysis. • Professional asset managers perform credit analysis, i.e. they

analyze issuer’s financial information and the specifications of the debt instrument itself in order to estimate the ability of the issuer to live up to its future contractual obligations.

• The credit analysts in these departments develop internal ratings that are used in making lending decisions.

• Investors who do not have access to their own credit analysis use to different degrees opinions about default risk as provided by private companies that perform credit analyses and cast their opinion in the form of a rating, referred to as a credit rating.

• The aforementioned private companies are referred to as credit rating agencies; the three major ratings agencies are Standard & Poor’s Corporation, Moody’s Investors Service, Inc., and Fitch.

18

Measuring Credit Risk II


• A credit scoring model takes information or attributes about the borrower and derives through statistical analysis a credit score.

• Based on the credit score, a lender may decide to grant a loan or to classify lenders into different credit risk classes.

• For individuals, the best-known credit scoring model is the one used to construct the FICO score. • The model assigns a percentage weight to such factors as length

of credit history and amount owed, all information provided by credit bureaus, to derive the FICO score.

• The FICO score, which ranges from 300 to 850, with higher scores indicating a better rating, is used in measuring credit risk for consumer credit decisions such as mortgage lending, auto loans, and credit card lines of credit.

• For corporations and governments, credit risk models are used to determine the probability of default and recovery rates.

19

Price Risk


• The price of an asset will change over time; the concern to an investor who owns an asset is that the price will decrease.

• Price risk is the risk of an adverse movement in the asset price. • If the investor owns the asset, this is the risk of a decrease in the

asset price. • If the investor is short the asset, this is the risk of an increase in

the asset price.

• The variables that affect an asset’s price are referred to as “risk factors” or simply “factors”. • In the case of a stock, one might believe that the price of the stock

is affected by the earnings of a company, the growth of those earnings, and the level of interest rates.

• It is reasonable to expect that the factors that drive the price of a bond are the level of interest rates in the market and the issuer’s credit rating.

20

Measuring Price Risk


• Given the factors that one would expect to drive an asset’s price, one must develop a model that links an asset’s price sensitivity to the factors.

• Such models are referred to as “asset pricing models”.

• Given an asset pricing model, one can measure an asset’s price risk exposure to each factor.

• That is, there may not be one measure of price risk for an asset but one for each factor.

• The exposure of an asset to a factor is referred to as its factor beta.

• The factor beta is estimated using various statistical models incorporating historical returns for the asset.

21

Special Case of Interest Rate Risk


• In the case of debt obligations such as bonds, the key drivers of the change in a bond’s price are the level of interest rates and the issuer’s credit risk.

• The level of interest rates is measured by the interest rate on what is viewed as a default-free security, securities issued by the U.S. Department of the Treasury.

• A mathematical relationship between the bond’s price and these two factors (i.e., Treasury rates and credit risk) can be developed to estimate the exposure of a bond to each of these factors.

• In general, the term duration is used to quantify the exposure of a bond’s price to changes in Treasury interest rates.

• The exposure of a bond’s price to changes in the issuer’s credit risk is referred to as credit spread duration because it refers to the exposure to changes in the credit spread.

22

Reinvestment Risk


• Reinvestment risk is the risk that when proceeds are received from an investment, they will have to be invested at an interest rate that is less when the original investment was made.

• Investors in bonds face reinvestment risk. • Consider the case of an investor purchasing a 30-year U.S.

Treasury bond in 1984 with a yield of 13%. • The investor cannot actually expect to receive a 13% yield on their

assets between 1984 and 2014 because they would have to reinvest their interest payments in shorter maturity assets. • In 1994, the 20 year Treasury yielded 7.5%. • In 2004, the 10-year Treasury yielded 3.5%. • Thus, realized reinvestment risk would have prevented the

investor from obtaining a 13% risk-free return year-over-year from 1984 to 2014.

• Since the interest rate cannot fall much more than 3.4% (zero is the lower bound), an investor purchasing a 30-year bond has much less reinvestment risk in 2004 than in 1984.

23

Inflation Risk


• Inflation occurs when the prices of most goods and services rise, resulting in a reduction of purchasing power. • When income rises at a rate less than the inflation rate, then the

standard of living of households decline. • In retirement panning, failing to take into account inflation can

result in a retirement income supporting a lower standard of living during retirement than was expected.

• When an investor invests in assets to generate retirement income, the real return that the investor realizes is the return after adjusting for the inflation rate. • Inflation risk, also referred to as purchasing power risk, is the risk

that the real return will be less than the inflation rate. • Inflation risk is the risk of earning a negative real return.

• There are bonds, called inflation adjusted bonds, issued by the U.S. Department of the Treasury, financial institutions, and nonfinancial corporations that have protection against inflation risk.

24

Liquidity Risk


• Liquidity allows investors the flexibility to rebalance a portfolio (i.e., by buying and selling assets) in order to implement an investment strategy. • Liquidity can be viewed in terms of the potential loss that an

investor may realize if the investor wishes to sell immediately instead of engaging in a costly and time-consuming search to identify a buyer willing to pay a higher price.

• A financial asset’s liquidity may depend not only the quantity that the investor wishes to sell (or buy) but also on the quantity to be transacted.

• While an investor may wish to sell a small quantity of an asset that is liquid, there may be illiquidity if a large quantity of the asset is to be sold.

• Liquidity risk for an asset can be defined as the risk that when an investor executes a trade for an asset, prevailing market conditions will be such that the cost will be higher and there will be an adverse impact on the price at which the trade is executed.

25

Foreign Exchange Rate Risk


• When an investor acquires an asset whose cash flows are not denominated in the investor’s domestic currency, there is the risk that the currency will change at the time of receipt of the cash flow such that fewer units of the domestic currency are realized. • More specifically, there is the risk that the currency in which a

cash flow is paid (i.e., the foreign currency) will depreciate relative to the domestic currency.

• This risk is referred to as foreign exchange rate risk or currency risk.

• There is potentially another risk associated with investing in an asset whose cash flows are denominated in a foreign currency. • A foreign government may prevent its currency from being fully

converted into a convertible currency; a convertible currency can be freely exchanged into another currency.

• The risk of loss associated with an action taken by a foreign government to make its currency inconvertible is called convertibility risk.

26

Longevity Risk


• From an investment risk perspective, longevity risk is the risk of living beyond the age used for financial planning purposes.

• Consider the cash of the head of a household who in consultation with a financial adviser estimates that in order to retire 25 years from now and maintain a certain standard of living, he or she must earn a 7% annual rate of return on the retirement portfolio. • The risk is that the actual return will fall far short of a 7% annual

rate of return such that the individual will have to postpone retirement and/or reduce his or her standard of living in retirement.

• The investment risks discussed earlier are the ones that might cause the shortfall in the target return of 7%.

• When the individual consults with his or her financial adviser, the projected that must be earned will depend on how long the individual is expected to live after retirement.

• That is, it depends on the individual's expected lifetime.

27

Mitigating Longevity Risk


• For a household, one solution available is for an individual to purchase an annuity from a life insurer. • Different types of annuities are available, but one that deals

directly with longevity risk is a deferred start income annuity where for a single premium paid at retirement the annuitant is provided with payments for a number of years beyond which the annuitant is unlikely to live.

• Suppose an individual is expected to retire at age 65 and for planning purposes anticipates living another 14 years, to 80.

• At age 65 the individual can purchase an annuity by paying a single premium, with the annuity payments made by the insurer to the individual beginning at age 80.

• Life insurers have developed various solutions for dealing with longevity risk by using structured finance to create longevity bonds, bonds whose payment at the maturity date depends on the longevity of some specified population.

28

Funding Risk


• Funding risk, also referred to as financing risk, is the risk associated with obtaining funds.

• There are four types of funding risk: • Leverage risk • Funding liquidity risk • Timing risk • Fixed-floating financing risk

29

Leverage Risk


• When individuals or businesses borrow funds, they are said to be using financial leverage, or simply leverage. • There are benefits and risk associated with the use of leverage by

businesses. • The risk should be obvious: it is the risk that the corporation fails

to earn a return on the amount borrowed greater than the cost of borrowing.

• Leverage risk is the adverse financial impact resulting from the use of leverage.

• The leverage ratio is the amount of funds provided by the corporation’s common stockholders (referred to as equity) divided by the total amount of funds that the corporation has available to invest. • Total assets = Equity + Debt • Leverage ratio = Equity/Total assets • Leverage multiplier = Total assets/Equity

30

Funding Liquidity Risk


• It is not uncommon for participants in financial markets to be forced to settle financial obligations immediately at the request of the lender. • For example, a bank’s depositors may for some reason want to

withdraw funds from a bank at the same time. • The bank must have the ability to satisfy those obligations

immediately.

• Another example is a highly leveraged investor whose borrowing agreement grants the lender the right to request the immediate payment of the amount borrowed.

• The ability of the borrower to settle its debt obligations immediately is referred to as funding liquidity.

• Funding liquidity risk is then the risk that over a specific horizon, an entity will not be able to settle obligations with immediacy.

31

Timing Risk


• Timing risk is the risk associated with the timing of raising capital.

• More specifically, it is the risk that the cost of obtaining funds will be higher than expected at some future date when the funds are needed.

• State and local governments share the same timing risk as businesses. • They raise funds and are concerned with the interest rate that they

must pay. • The risk is that governments may have to raise funds at a time

when interest rates are higher than they currently are.

• Households face timing risk, particularly with home purchases. • Postponement of the purchase may result in having to pay a higher

mortgage rate. • If the purchase is postponed, housing prices may increase.

32

Fixed-floating Financing Risk


• Another form of funding risk involves the decision to pay a fixed interest rate over the entire time period for which the funds are borrowed (referred to as fixed-rate borrowing) or to pay an interest rate that varies periodically (variable-rate borrowing or floating-rate borrowing).

• This form of funding risk is referred to as fixed-floating financing risk.

• With floating-rate borrowing, the interest rate is reset (i.e., changes) at designated times and is reset according to a formula. • The formula has two components, a reference rate (some interest

rate that changes over time) plus a constant amount. • For example, the most common reference rate is the London

interbank offered rate (LIBOR). • The constant amount is referred to as the margin.

33

Systemic Financial Risk


• In general, the term systemic risk refers to the probability that an entire system will collapse or fail. • When applied to finance, systemic risk is referred to as systemic

financial risk. • The example typically given to illustrate systemic financial risk is a

run on the bank (i.e., bank depositors simultaneously withdrawing their funds from a bank).

• Prior to the protection offered to bank depositors in the United States through federal deposit insurance, the inability of one bank to meet the demands for the withdrawal of deposits caused not only the failure of that bank but also a chain reaction that produced runs on other banks.

• Although there is no universally accepted definition of systemic financial risk, the basic notion is that the interconnectedness of financial institutions throughout the world can through contagion cause major disruptions to the global financial system.

34

Financial Innovation


• Price risk-transferring innovations provide market participants with more efficient means for dealing with price or exchange rate risk.

• Reallocating the risk of default is the function of credit risk-transferring instruments.

• Liquidity-generating innovations do three things. • They increase the liquidity of the market. • They allow borrowers to draw on new sources of funds. • They allow market participants to circumvent capital constraints

imposed by regulations.

• Instruments to increase the amount of debt funds available to borrowers and to increase the capital base of financial and nonfinancial institutions are the functions of credit-generating innovations and equity-generating innovations, respectively.

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Overview of Risks and Risk Management CHAPTER 2