RISK AND UNCERTAINITY IN THE DECISION MAKING 1. Introduction Risk is everywhere. It is not hard to find risk. In almost every thing that we do and situations we face, there is a corresponding risk behind it. However, we cannot just run from it. All we can do to move forward is to manage this risk, or if not, at least lessen the risk involve. We can never tell what will happen unless we try to overcome it. Whether we like it or not, the world is such an unpredictable place.
Moreover, as long as future uncertainties exist, which might cause adverse effects for individuals, the world remains to be a place in which risk must be managed. 2. Classifications of Risks Facing the Business Risk is defined as any source of randomness that may adversely affect a person or corporation. In connection with this, risk management is the reaction to such risk by individuals or businesses as they attempt to make sure that the risks in which they are exposed to are the risks in which they think they are actually being exposed to and want to be exposed.
. Market Risk Market risk arises from the event of a change in some market-determined asset price, reference rate, or index. The said events define market risk further into two categories. The first event-type defines market risk based on the asset class type whose price changes impact the exposure in question. One common form of asset class-based market risk is the risk on interest rate, or risk that the balance sheet assets, liabilities, and off-balance sheet items of the firm (including its derivatives) will change in value as interest rates change.
Other asset class-driven classifications of market risk include the changes in the value of an exposure attributable to exchange rates’ fluctuations, commodity prices, and values of equity. Risk factors are any market-determined price, rate, or index value that impacts the flow of cash of an exposure. The discount rate comes into play when we are talking of the asset’s present value, although convention does not classify it as a risk factor. It is also typically improper to decompose risk factors into the non-traded exposures that may underlie them.
Aside from the risk factors that influence the exposure value, the market risk of an exposure is also characterized on the basis of the way these risk factors impact its value. In this case, market risk is classified by the use of fraternity row (colorful argot). Similar trade practitioners and academics tend to refer to five types of market risk using Greek or Greek-sounding letters. These are delta, gamma, theta, and rho. Delta refers to the risk that the exposure’s value will deteriorate as the price or value of some risk factor changes, all else equal.
An example is a bond affected by the changes in the rates of interest. Here, the risk factor is the interest rate. As interest rates increases, the effect is opposite to the prices of bonds. Same is true with the value of a machine. This is the discounted NPV of future cash flows generated by that machine. Due to the involvement of interest rates in the said situation, an upward movement in rates results in a downward pressure on the machine’s present value. Gamma, on the other hand, is the risk that delta will change due to the value change of an underlying risk factor.
Sometimes it is also termed as convexity risk or risk in change rate. Applying this to the previous example of bonds (the fall in prices of bond due to the rise of interest rates), the amount of price change here, depends on the level of interest rates. Increases in interest rates, which are large in its nature, might cause larger declines in bond-price compared to the small increases in interest rates. The risk that volatility changes in the underlying risk factor will cause a change in the exposure value that goes with many names. Among them are vega, lambda, kappa, and tau.
For purchased options (longs), the thing that poses the risk is the volatility declines. For options written (short), lower volatility increases the odds for profits by the reduction of opportunities for unprofitable exercise against the short to occur. Theta is the one who measures the risk to certain exposures exclusively because of the passage of time. Take insurance as an example. It is an asset that decays or wastes as time passes. For each day passed on the unused insurance policy, there is a corresponding one day less for the value of the insurance contract.
The final one is the rho, defined as the risk that the interest rates, which are used in discounting cash flows in the future in present value calculations, will change and impose unexpected losses on the part of the firm. For most exposures, the discount rate is the rate of borrowing or lending that corresponds to the contract’s maturity. For some contracts, like swaps, there is the use of yield curve for discounting cash flows. Therefore, any shifts in the level of any of the interest rates may cause effects to the cash flows. 4. Liquidity RiskAnother type of risk is the liquidity risk.
It occurs in the event when cash inflows and current balances are not sufficient for it to cover the outflow requirements of cash. It often necessitates asset liquidation that is costly in nature, for the generation of temporary cash inflows. Market liquidity risk is also included in this type of risk. Market liquidity risk is the risk that is inhibited by volatile markets in the liquidation of losing transactions and/or the establishment of new transactions in hedging existing market risk exposures. The basis for liquidity risk is the risk of cash flows when they occur in time. . Credit Risk This is the risk of the actual or possible nonperformance of the firm. This can be subdivided into a variety of dimensions. Two of them are the settlement versus pre-settlement credit risk, and the direct versus indirect credit risk. Pre-settlement credit risk arises from the possibility of a party’s failure to make favorable future settlements, or settlements not yet initiated. This results to the counterparties’ exposure to the risk of unexpected replacing of valuable assets in its then-current market prices.
On the contrary, settlement risk is associated with the firm’s failure during the settlement window, or the time-period between the transaction’s confirmation and its final settlement. Herstatt risk is another term for this type of credit risk. One way of mitigating this settlement risk is by netting. Example is the cash flows in the same currency, if ever possible. Instead of A owing B $10 and B owing A $12, the net payment of $2 from B to A is the only cash flow that occurs within the settlement.
Although this type of bilateral netting reduces the settlement risk of many financial transactions, contracts involving the exchanging of funds in different currencies or in assets, are impossible to be netted. Therefore, it is subjected to full settlement risk. On the other hand, direct credit risk is the risk of the failure of the counterparty in delivering the required assets or funds or an increase in the perceived probability of the occurrence of such failure in the future. The former is called default risk, while the latter is termed as a downgrade risk.
The direct credit risk borne by a company for both cases is limited to the counterparties and security issuers who have direct contractual relations to that company. Sometimes called credit-dependent market risk or spread risk, indirect credit risk is the risk that the value of an asset declines due to the credit rate change of some firms who have no direct dealings with the enterprise. Explained in a clearer way, the present value of a bundle of cash flows can alter the risk when the quality of a third party credit seems to change. Take this case as an example.
Company Ludlum loses money due to the banks’ (who determine LIBOR) experience of an increase in perceived default risk. As a result, it produces an upward pressure on LIBOR relative to the default-free Treasury rate. For Ludlum, this is the market risk brought about by swap, although it is partly driven by the participants’ credit risk. They are the one who determines the swap’s reference rate. 6. Operational RiskOperational risk is the risk imposed by situations such as failures in computer systems, internal supervision and control, or events like natural disasters.
This further cause unexpected losses on a firm’s derivative positions. Other aspects relate to the quality of personnel and internal controls. One type of operational risk is the irresponsible trading activities by employees, or better known as fraud. On the contrary, the employment of unqualified personnel characterized by their inability to carry out their tasks responsibly is also an operational risk. It can also have similar consequences like that of fraud. In the case of operational risk, problems tend to rise.
This is either due to the inadequate attention paid to some process or system, or to the personnel’s failure to perform their duties or ill-specified responsibilities. Therefore, people tend to be at the root for most operational risks, which comes from a questionable decision made by someone, either on purpose or by mistake. 7. Legal Risk Legal risk is the risk of a firm to incur a loss if the contract they thought to be enforceable turns to be the opposite in the actual situation.
The Global Derivatives Study Group (1993) has identified several sources of legal risk for innovative financial instruments often associated with risk management. This includes conflicts between the formation of oral contracts and the statutes of frauds in some countries and jurisdictions, the capacity of particular entities in entering specific types of transactions, the enforceability of closeout netting, and the legality of financial instruments. Additionally, sudden changes in the laws and regulations can expose firms to potential losses, as well. 8.
Measuring and Monitoring of RiskOnce the company has already identified the risk exposures to which they are involved with, the risk management process of the firm now must include the process of actual comparison of the identified risks to the tolerances of bearing those risks as defined by the stakeholders of the firm. The means of the monitoring and comparison is independent of the means of the risk measurement. Some firms may opt to the exploration of alternative methods of risk measurement to enhance their learning on the way of expressing their risk tolerances.
One of the most basic forms of reporting market risk is the nominal exposure report, a report indicating the amount of capital at risk in a given exposure or portfolio of exposures. Think about a pension plan treating equity and fixed income risk as normal risks. They consider it as a need to be able to fund its obligations. Suppose a currency exposure is a risk, which deems to be unnecessary for the plan’s liability funding purposes. Therefore, currency exposure is being tracked and measured, even relative to a policy-defined maximum.