value. In addition to these risks of losing all or part of your money, you are also foregoing the ability to invest your money for profit.
In reality there is no such thing as being of free of risk. All activities incur some sort of risk. Trading and its associated processes have many risks; the important thing is to be aware of risks and choose how to deal with them.
2.3 Quantifying risk
In order to quantify and manage risk, one must define:
■ the event upon which the risk is to be measured
■ the probability of the event occurring
■ the loss entailed if it occurs
■ the means by which some or all of the risk can be mitigated
■ the cost of mitigating risk.
Both probability and loss calculations are very important in order to have an appreciation of the risk. A catastrophic event that occurs with a remote probability may require greater protective action than an everyday event that causes a small loss.
In practice, it may be difficult to quantify either the probability or the amount of loss entailed or both. With finite resources, an organisation will need to spread the amount it spends on protection against risk according to priorities. However, even an estimation of risk should aid the process of assigning priority. Also, in deciding a future course of action, the organisation should weigh the benefits against the risks in order to arrive at a fair decision as to how to proceed.
In Table 2.1, we give three examples of risk events, a rough estimate of the probability of occurrence, the amount of loss should the event happen, the selected remedial action and the estimated cost of such action.
Table 2.1 Examples of risk events
2.4 Methods of dealing with risk
There are four main ways to deal with risk:
■ Ignore
An event carrying risk may be considered of negligible impact and so can be totally ignored. Alternatively, it may be more expensive to protect against the risk than to let the event occur – sometimes an organisation just has to take the hit.
For example, the loss to a hedge fund of being without electricity is negligible compared to the cost of installing its own generator.
■ Minimise
If it is impossible or too costly to remove the risk altogether, steps can be taken to either lessen its impact or reduce the probability of it occurring.
The skydiver may carry two parachutes in case one malfunctions. (He would rather not think about the probability of both not working!)
■ Avoid
Again, if it is too difficult to protect against a risky event or the benefits are not sufficient to justify the possible damage entailed, the risk can be totally avoided.
For example, the market risk department might rule that a trade is so risky it cannot be transacted despite the potential profit.
■ Remove
Removal of risk is certainly desirable, but often difficult to achieve.
An example of risk removal is house insurance. One transfers the risks associated with owning a house to an insurance company. (Obviously there is still a residual risk that the insurance company will default on its obligations, but legislation and regulation generally make this probability negligible.)
2.5 Managing risk
A successful organisation relies on good management. One key feature of management is assessing weaknesses and taking steps to tackle them. In order to do this, a good understanding of risk is essential. Many business functions within a financial entity are partly or fully concerned with the management of risk. All trading activities entail risk. As different parts of the trade lifecycle give rise to different risks, the success of the trade is dependent on the knowledge of its risks and the management of them. Since risk in all its manifestations is part of the business of financial trading, the company that can manage its risk best will be at a distinct advantage.
It should be said that managing risk is distinct from being risk-averse. There are many reasons why a trading desk might take on market risk and manage it successfully. Similarly an institution may decide on a more risky course of action because the likely benefits outweigh the possible losses. As long as the potential risks are understood and estimated, it can be said that risk is being managed.
2.6 Problems of unforeseen risk
No stakeholders in a business – investors, managers, employees and customers – want unforeseen risk. Due to its sudden effect, the organisation is ill-equipped to deal with it and its consequences are unknown. One of the major causes of the recent credit crunch was the failure of many organisations to take into account a particular risk: that so many American sub prime mortgage borrowers would be unable to repay their debt. Unforeseen risk points to poor management and supervision and reduces confidence in the financial entity. If risk is present, it should be identified and then sensible decisions can be taken about how to manage it.
2.7 Summary
A financial entity must accept that risks are an unavoidable part of the trading process. When an adverse scenario arises, it will fare better and be able to keep costs down if it is proactive in uncovering them, estimating their probability and effect and deciding best how to deal with them. Controlling risks does not necessarily mean being cautious in business – aggressive trading can reap big rewards. But recognising risk in all its manifestations is a fundamental part of managing the trading process.
Chapter 3
Understanding Traded Products – Follow the Money
To gain an understanding of financial trading one must distinguish between the concept of an asset class and that of a financial product. These terms are often confused. The aim of this chapter is to define a set of common financial products. In the following chapter we discuss asset classes. A financial product (or ‘product’) is a contract between two parties which determines an exchange of money or assets. There are many specific products tailored for the needs of one or both parties, but here we will discuss a set of common products existing in the financial world with a well-defined structure.
To help remove the confusion between products and asset classes, let us consider the everyday case of buying a sack of potatoes and the less frequent purchase of a washing machine. Essentially the process of acquisition of potatoes and washing machines is the same: you spend money and receive goods. However, since the type of vendor, the layout of the store, the delivery mechanism and various other factors are different, we normally view these two acquisitions in different ways. We may say that potatoes are in the asset class of perishable food and washing machines are in the asset class of domestic appliances. So the underlying process is the same but the asset classes are different.
The same is true for financial products. Buying shares is intrinsically the same as buying aluminium, sovereign bonds or purchasing dollars in exchange for euros. However, since the people and trading environments of each of these trades are very different, we generally group them into different asset classes. (The examples above corresponding
