Financial Risk Management
Classifying risk
Be able to name and illustrate the main categories: market risk (interest rate, currency, equity, commodity), credit risk (default and settlement), liquidity risk (funding and market liquidity), operational risk (people, processes, systems, external events), and strategic, legal and reputational risk. Enterprise risk management links these to a risk register with owners, likelihood, impact and mitigating controls.
Tools
Forwards are customised contracts settled at maturity; futures are standardised, exchange-traded and margined daily; options give the buyer a right (premium paid, loss limited to premium) while the seller carries the obligation and larger exposure; swaps exchange cash-flow streams, most commonly fixed for floating. Duration measures bond price sensitivity to interest rate changes. Value at Risk estimates the maximum loss at a given confidence level over a stated horizon - it is not a worst-case loss. Gap analysis compares rate-sensitive assets and liabilities.
Traps
- Saying VaR is the maximum possible loss; it is a threshold exceeded in the tail.
- Confusing who pays the premium and who bears unlimited loss in an option.
- Assuming futures eliminate risk rather than transferring and re-pricing it through margin calls.
- Ignoring basis risk when the hedge instrument does not exactly match the exposure.
Worked example
A bond portfolio worth 10 million has a modified duration of 5. If yields rise by 1% (100 basis points), the approximate value change = −5 × 1% × 10m = −500,000. Rule of thumb: percentage price change ≈ −duration × change in yield.