for risk controlling and processes.
1.1 Uncertainty, Risk and Exposure to Risk
Risk has been defined in various ways across time. Some definitions focus on the probability of an event, others refer to the uncertainty of outcomes, positive or negative, and others to risks as the subset of uncertainty that can be quantified.1
Risk in finance is defined as the randomness of the return of investments, including both positive and negative outcomes. Under this view, a greater expected return is associated with a greater variability of outcomes.
In the financial industry, the view of risk is different. Risk is defined by the uncertainty that has adverse consequences on earnings or wealth, or the uncertainty associated with negative outcomes only. This view is that of regulators and risk managers. Regulations aim at enhancing the resiliency of financial firms and of the financial system in stressed conditions. Risk managers see their role as being accountable for identifying, assessing and controlling the likelihood and the consequences of adverse events for the firm.
Under this view, risk is seen as the potential of loss resulting from the interaction with uncertainty. The interaction arises from the exposure of financial firms to such randomness. Exposure is the extent to which a business could be affected by certain factors that may have a negative impact on earnings. For example, exposure to foreign exchange rate is the size of revenues in foreign currency; exposure to interest rates can be measured by the size of debt indexed on market rates.
The uncertainty cannot be eliminated but the exposure to uncertainty can be changed. Examples are numerous. A firm having revenues in foreign currency can borrow in the same foreign currency to minimize the earning impact of foreign exchange rate fluctuations. A firm lending floating rate can reduce the fluctuations of net interest income, the interest revenue minus interest cost, etc., by borrowing floating rate.
Exposures can be long or short. Being long is the conventional practice for investing in assets or portfolios. The holder of an asset is long and the risk is that the asset value declines. A short position can be seen as the mirror image of long positions and gains when asset values move down. In investing, a short position is the sale of a borrowed asset, such as a stock, which is later bought back for returning the assets to the lender of the security. In the event of a downside movement, the borrower of the stock buys back the stock at a lower price, hence makes a gain.
Hedging risks can be achieved by taking inverse exposures to long positions. Holding a stock is a long position, which takes a loss if the equities decline. A short position is symmetrical. When a party has both a long and a short position in the same stock, the gains and losses exactly offset. Hence, a perfectly hedged position is subject to uncertainty, but is not exposed to risk.
Hedging can be achieved with cash instruments, but is commonly done with derivatives. Derivatives are instruments, the value of which derives from other underlying assets. For example, the above firm willing to hedge its long exposure in foreign currency could enter into a contract, setting today the future exchange rate for converting foreign revenues in the home currency. This is easier than trying to borrow in the foreign currency. Because of their flexibility, derivatives are extensively used.
1.2 Broad Classes of Financial Risk
Financial risks are defined according to the sources of uncertainty. The broad classes of financial risks are credit risk, market risk, liquidity risk and interest rate risk, divided into subclasses relative to the specific events that trigger losses.
Credit risk is the risk of losses due to borrowers' default or deterioration of credit standing. Default risk is the risk that borrowers fail to comply with their debt obligations. Default triggers a total or partial loss of the amount lent to the counterparty.
Credit risk also refers to the deterioration of the credit standing of a borrower, which does not imply default, but involves a higher likelihood of default. The book value of a loan does not change when the credit quality of the borrower declines, but its economic value is lower because the likelihood of default increases. For a traded debt, an adverse migration triggers a decline of its quoted price.
Recovery risk refers to the uncertain value of recoveries under default. Recoveries depend on the seniority of debt, on any guarantee attached to the transaction and on the workout efforts of the lender. The loss after workout efforts is the loss given default.
Counterparty credit risk exists when both parties of a transaction are potentially exposed to a loss when the other party defaults. A swap contract exchanging fixed for floating interest flows between two parties is a typical example. The party who receives more than it pays is at risk with the other party. The exposure might shift from one party to the other, and its size varies, as a result of the movements of interest rates. Counterparty credit risk exists when exposures are market driven.
Market risk is the risk of losses due to adverse market movements depressing the values of the positions held by market players. The market parameters fluctuating randomly are called “risk factors”: they include all interest rates, equity indexes or foreign exchange rates.
Market risk depends on the period required to sell the assets as the magnitude of market movements tends to be wider over longer periods. The liquidation period is lower for instruments easily traded in active markets, and longer for exotic instruments that are traded on a bilateral basis (over the counter). Market risk is a price risk for traded instruments. Instruments that are not traded on organized markets are marked-to-market because their gains or losses are accounted for as variations of value whether or not materialized by a sale.
Liquidity risk is broadly defined as the risk of not being able to raise cash when needed. Banking firms raise cash by borrowing or by selling financial assets in the market.
Funding liquidity refers to borrowing for raising cash. Funding liquidity risk materializes when borrowers are unable to borrow, or to do so at normal conditions. Asset liquidity refers to cash raised from the sale of assets in the market as an alternate source of funds, for example in market disruptions. Asset liquidity also refers to the risk that prices move against the buyer or seller as a result of its own trades when the market cannot absorb the transactions at the current price. Asset liquidity risk also arises when too many players do similar trades. For example, banks raising cash from liquidation of assets in the adverse conditions of the 2008 crisis faced substantial losses from the deep discounts in their trades.
Extreme lack of liquidity results in failure. Such extreme conditions are often the outcome of other risks, such as major markets or credit losses. These unexpected losses raise doubts with respect to the credit standing of the organization, making lenders refrain from further lending to the troubled institution. Massive withdrawals of funds by the public, or the closing of credit lines by other institutions, are potential outcomes of such situations. To that extent, liquidity risk is often a consequence of other risks.
The interest rate risk is the risk of declines of net interest income, or interest revenues minus interest cost, due to the movements of interest rates. Most of the loans and receivables of the balance sheet of banks, and term or saving deposits, generate revenues and costs that are interest rate driven.
Any party who lends or borrows is subject to interest rate risk. Borrowers and lenders at floating rates have interest costs or revenues indexed to short-term market rates. Fixed-rate loans and debts are also subject to interest rate risk. Fixed-rate lenders could lend at higher than their fixed rate if rates increase and fixed-rate borrowers could benefit from lower interest rates when rates decline. Both are exposed to interest rate fluctuations because of their opportunity costs arising from market movements.
Knight, F. H. (1921), Risk, Uncertainty and Profit, New York.
