Financial Risk Management Overview - In house

Risk types

-Market/price risk – examples

-Settlement risk - examples

-Rates risk and how it arises with fixed as opposed to floating rate debt instruments

• • the yield/price calculation yield as compensation for perceived risks why yields vary

-Credit risk (single entity): default and recovery rate risk

-Counterparty risk – how this can arise with a swap

-Correlation risk

• • examples from equity and credit portfolios most investors are exposed to a rise in correlation

-Option risks

• • The key pricing inputs; above all, volatility Implied volatility Negative gamma – the risks of dynamic delta-hedging short positions Vega and the impact of a change in implied volatility

-Operational risk - examples: systems failure, rogue trader etc

Approaches to quantifying risk and their drawbacks

-Market/price risk:

• • • How it is calculated Regulatory VaR for banks Its weakness
    Fundamental analysis (in brief) Value at Risk

-Credit risk

• • Fundamental analysis (in brief) Calculating expected loss from Rating agency historical statistics for default and recovery rates Calculating implied default rates from bond and Credit Default Swap (CDS) spreads Default correlations: the difficulties and weaknesses of calculating and using them

-Counterparty risk: calculating potential credit exposure on a swap – the interplay of yield volatility, duration and credit risk

-Options risk:

• • calculating gamma and vega negative and positive gamma and vega

-Operational risk: the difficulties of quantification

Approaches to managing risk and their drawbacks

-Market/price risk

• • Portfolio diversification Residual risk Hedging: eg puts and their drawbacks

-Rates risk:

• • Hedging with swaps Margining Exposure limits Economic capital

-Credit risk

• • Charging a credit spread greater than expected loss The impact of competition Hedging: CDSs and their drawbacks

Basle II – its requirements and drawbacks