sartaj.hussain What is Financial Risk? • Risk is the probability that the realized return would be different from the anticipated/expected return on investment. • Risk is a measure of likelihood of a bad financial outcome. • All other things being equal risk will be avoided. • All other things are however not equal and that a reduction in risk is accompanied by a reduction in expected return.
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sartaj.hussain
What is Financial Risk?
• Risk is the probability that the realized return would be different from the anticipated/expected return on investment.
• Risk is a measure of likelihood of a bad financial outcome.
• All other things being equal risk will be avoided.
• All other things are however not equal and that a reduction in risk is accompanied by a reduction in expected return.
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Financial Risks
Financial Risks
CreditCredit
Interest RateInterest Rate
MarketMarket
LiquidityLiquidity
OperationalOperational
Foreign ExchangeForeign Exchange
Other Risks, Country Risk,Settlement risk, performance risk
Other Risks, Country Risk,Settlement risk, performance risk
Some major financial risks
Some major financial risks
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Commercial Commercial BankingBanking
Commercial Commercial BankingBanking
Investment Investment BankingBanking
Investment Investment BankingBanking
TradingTradingTradingTrading
OthersOthersOthersOthers
Business PolesBusiness PolesBusiness PolesBusiness Poles Business LinesBusiness LinesBusiness LinesBusiness Lines
• Risk of decline in credit standing of an obligor.
• Market value loss due to change in credit standing of issuer.
• Difficulty in measurement on ex ante basis.
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Credit risk in banking portfolio:Credit risk in banking portfolio:
• Prolonged Delinquency.
• Deterioration in the credit standing of borrower
• Restructuring of debt obligations.
• Bankruptcies.
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Credit risk in Trading portfolio:Credit risk in Trading portfolio:
• Deterioration in the rating of a debt.
• Credit risk valued in market prices.
• Pre & post default comparison.
• Upward movement in the required yield.
• Highly customised derivative.
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Illustration: Downgrading of rating & movement in required yield on a security.
Consider a one year commercial paper with a face value of Rs 100.Consider a one year commercial paper with a face value of Rs 100.
Case A:Case A: Annual Yield, when the paper has a AAA rating, Assume that the market price of the instrument is 93.50, and its term to maturity is 254 days.
yieldyield = 100-93.50 X365 = 9.98%9.98%
93.50 254
Case B: Case B: Annual Annual Yield, when rating of paper changes to BB-, market price of instrument is adjusted to move yield upwards. Assume there is no change in term to maturity.
yieldyield = 100-92.50 X365 = 11.65%11.65%
92.50 254
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Liquidity Risk:Liquidity Risk: Composition
• Funding Risk.
• Market Liquidity Risk.
• Asset Liquidity Risk.
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Funding Risk:
• Inability to raise funds at normal cost.
• Market perception about a borrowing entity
• Linkages of credit standing and cost of funds
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Market Liquidity Risk:
• Liquidity crunches due to lack of volume.
• Funding risk due to market weakness.
• Distress on asset prices.
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Asset Liquidity Risk:
• Asset specific rather than market created.
• More prevalent in long term assets.
• Exotic products.
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Consequence of liquidity risk:
• Sale of asset on distressed prices.
• Borrowing extremely high rates.
• Depositors runs.
• Refusal of Lenders to further funding.
• Massive withdrawal of funds by financial institutions.