1. Page 1. Daniel HERLEMONT. Financial Risk Management. Identification of Risk Factors. Following P. Jorion,. Financial Risk Management Chapter 12. Daniel ...
Identification of Risk Factors Following P. Jorion, Financial Risk Management Chapter 12
Daniel HERLEMONT
Market Risks ABsolute vs relative (tracking error) risk Directional Risks beta for stock duration for bonds delta for options
Non Directional Risks / Non Linear Exposure Residual/Specific risks Convexity Gamma Volatility risk (vega) basis risk Daniel HERLEMONT
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Risk Interactions Consider the simple transaction of purchasing 1 millions £ spot. The current rate is 1.5$/£ for settlement in 2 business days This simple transaction involves Market risk Credit risk Settlement risk (Herstatt risk) Operational risk
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Source of loss decompisition Exposure and uncertainty bonds stocks options
Market Loss = Exposure X Adverse Movement in Financial Variable Daniel HERLEMONT
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Specific Risk Defined as the residual risk that is due to the issuer after accounting for general market factors
Specific Risk
Market Risk
Daniel HERLEMONT
Daniel HERLEMONT
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Discontinuity and Event Risk For a brownian motion the variance of changes in price over shrinking intervals has to shrink at the same rate as the time interval
This model does not account for Jumps
example: 1987 crash
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Event Risk Change in governments Change in economic policies civil wars, invasions, terrorism currency devaluations Stress Testing Daniel HERLEMONT
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Liquidity Risks Liquidity consists of both Asset liquidity also called market/product liquidity risk arises when transactions cannot be conducted at quoted prices due to the size of the required trade Funding Liquidity also called Cash Flow liquidity arises when institutions cannot meet payment obligations
Asset liquidity can be managed by setting limits on certain markets or products or by mean of diversification Fund liquidity can be managed by proper planning of cash flow needs Lessons learned from LCTM Daniel HERLEMONT
Asset Liquidity can be measured by a price quantity function which describe how the price is affected by a quantity transacted. High liquid market are characterized by Tightness (bid ask spread) Depth : measure the of the volume of trades without affecting the price too much Resiliency: measure of the speed at which price fluctuation from trades are dissipated
In contrast, illiquid market are market where transactions can quickly affect price OTC (such as exotics), emerging markets, ... Daniel HERLEMONT
