Financial risk management

Banks and other wholesale institutions face various financial risks in conducting their business, and how well these risks are managed and understood is a key driver behind profitability, as well as of the quantum of capital they are required to hold. The major focus is on credit and market risk, and especially through regulatory capital, includes operational risk. Credit risk is inherent in the business of banking, but additionally, these institutions are exposed to counterparty credit risk. (Both are to some extent offset by margining and collateral; the management is of the net-position.) Large banks are also exposed to Macroeconomic systematic risk - risks related to the aggregate economy the bank is operating in[16] (see Too big to fail). Financial risk management in banking has grown markedly in importance, since the Financial crisis of 2007–2008. [17] (This has given rise [17] to dedicated degrees and professional certifications.)

The discipline [18][19] [5][6] is, as outlined, simultaneously concerned with (i) managing, and as necessary hedging, the various positions held by the institution — both trading positions and long term exposures; and (ii) calculating and monitoring the resultant economic capital, as well as regulatory capital under Basel III. The calculations here are mathematically sophisticated, and within the domain of quantitative finance. Broadly, calculations [19] for (i) are built on the "Greeks", and the other measures of exposure to market factors, such as DV01 for sensitivity to interest rates; and for (ii) on Value at Risk, or "VaR", an estimate of how much the investment in question might lose with a given probability in a set time period, and the bank holds economic “risk capital” correspondingly. The regulatory capital quantum is calculated via specified formulae: risk weighting the exposures per highly standardized asset-categorizations, and the resultant capital - at least 12.9% of these Risk-weighted assets - must then be held in specific "tiers" and is measured correspondingly.

As the financial crisis exposed holes in the mechanisms used for hedging — see FRTB and Tail risk § Role of the global financial crisis (2007-2008) — the methodologies employed have had to evolve:

• A core technique continues to be Value at Risk — applying the traditional parametric and "Historical" approaches — but now supplemented [19] with the more sophisticated Conditional value at risk / expected shortfall and Extreme value theory (and PFE and EE for regulatory). For the underlying mathematics, these may utilize mixture models, PCA, volatility clustering, and other techniques.[20]

• Additional to these, [19] are various forms of stress test and scenario analytics — typically linked to the macroeconomics — and related economic capital optimization.

• For the daily direct analysis of the positions at the desk level, as a standard, measurement of the Greeks now inheres the volatility surface — through local- or stochastic volatility models — while for interest rates, discounting and analytics are under a "multi-curve framework".

• Model risk is addressed through regular validation of the models used by the bank's various divisions; for VaR models, backtesting.

Re implementation, Investment banks, particularly, employ dedicated "Risk Groups", i.e. Middle office teams monitoring the firm's risk exposure to, and the profitability and structure of, its various businesses, products, asset classes, desks, and / or geographies. By increasing order of aggregation: Financial institutions will typically [18] set limit values for each of the Greeks or other measures that their traders must not exceed, and traders will then hedge, offset, or reduce periodically if not daily - see below; Desks, or areas, will similarly be limited as to their VaR quantum (total or incremental, and under various calculation regimes), corresponding to their allocated economic capital; And their concentration risk will be checked against thresholds set for various types of risk; Finally, leverage will be monitored, at very least re regulatory requirements. Periodically, these all are re-estimated for a given stress scenario, [21] and risk capital - together with these limits - is correspondingly revisited. (Achieving this requires that banks maintain a significant investment in sophisticated systems, risk software, and related staff.)

Middle office also maintains the following functions, often overlapping these Groups: Corporate Treasury is responsible for monitoring funding, capital structure, and liquidity risk, and for the FTP framework allowing for comparable performance evaluation among business units; Product Control is primarily responsible for insuring traders mark their books to fair value and for "explaining" the daily P&L; Credit Risk monitors the bank's debt-clients on an ongoing basis, re both exposure and performance. See Financial analyst § Middle office.

In corporate finance and financial management, financial risk management, as above, is concerned more generally with business risk - risks to the business’ value, within the context of its business strategy and capital structure. [22] The scope here - ie in non-financial firms [8] - is thus broadened [7] [23] [24] (re banking) to overlap enterprise risk management, and financial risk management then addresses risks to the firm's overall strategic objectives, incorporating various (all) financial aspects [25] of the exposures and opportunities arising from business decisions, and their link to the firm’s appetite for risk, as well as their impact on share price. In many organizations, risk executives are therefore involved in strategy formulation: "the choice of which risks to undertake through the allocation of its scarce resources is the key tool available to management." [26]

Re the standard framework, [25] the discipline largely focuses on business and operations, as outlined. Here, the management is ongoing — see further description below — typically within FP&A or corporate treasury. This is coupled with the use of insurance: credit risk is usually addressed via provisioning and credit insurance, and specifically identified operational risks are likewise insured against [24] where this treatment is deemed appropriate. Market risk, in this context, [8] is concerned mainly with changes in commodity prices, interest rates, and foreign exchange rates, and any adverse impact due to these on cash flow and profitability, and hence share price.

Correspondingly, the practice here covers two perspectives; these are shared with corporate finance more generally:

1. Both risk management and corporate finance share the goal of enhancing, or at least preserving, firm value; and here,[7][25] businesses devote much time and effort to (short term) liquidity-, cash flow- and performance monitoring, and to model-based analytics more generally,[27][28] and specifically re business-operations, to understanding their break even dynamics, contribution margin and operating leverage, and to the careful monitoring of revenue. Risk management then also overlaps short term cash- and treasury management, especially as impacted by capital and funding as above; see also Treasurer § Corporate treasurers and Asset and liability management. In some large firms, analysts may employ more sophisticated stochastic models, [28][29] in, for example, financing activity prediction problems, and for risk analysis ahead of a major investment.
2. Firm exposure to long term market (and business) risk is a direct result of previous capital investment decisions. Where applicable here [8][25] — usually in large corporates and under guidance from their investment bankers — risk analysts will manage and hedge their exposures using traded financial instruments to create commodity-, cash flow- and foreign exchange hedges (the latter, is over and above the per transaction "forward cover" that importers and exporters purchase from their bank; see also below). Because company specific, "over-the-counter" (OTC) contracts tend to be costly to create and monitor — i.e. using financial engineering and / or structured products — ”standard” derivatives that trade on well-established exchanges are often preferred. These include [9][25] options, futures contracts, forward contracts, and swaps; the "second generation" exotic derivatives usually trade OTC. Complementary to this hedging, periodically, Treasury may also adjust the capital structure so as to accommodate increased business risk.

Multinational Corporations are faced with additional challenges, particularly as relates to foreign exchange risk, and the scope of financial risk management modifies dramatically in the international realm; here dependent on time horizon, and risk sub-type — transactions exposure, [30] accounting exposure,[31] and economic exposure. [32] — so the corporate will manage its risk differently.

It is common for large corporations to have dedicated risk management teams, reporting to the CRO; often these overlap with the internal audit function. For small firms, it is impractical to have a formal risk management function, but these typically apply the above practices — at least the first set — informally, as part of the financial management function; see Financial analyst § Corporate and other.

Note that hedging-related transactions will attract their own accounting treatment, and corporates (and banks) may then require changes to systems, processes and documentation; [33] see Hedge accounting, Mark-to-market accounting, Hedge relationship (finance), FASB 133, IAS 39, IFRS 9.

Efficient Frontier. The hyperbola is sometimes referred to as the "Markowitz bullet", and its upward sloped portion is the efficient frontier if no risk-free asset is available. With a risk-free asset, the straight capital allocation line is the efficient frontier.

Fund managers, [34] classically, define the risk of a portfolio as its variance (or standard deviation), and through diversification the portfolio is optimized so as to achieve the lowest risk for a given targeted return, or equivalently the highest return for a given level of risk; these risk-efficient portfolios form the "Efficient frontier" (see Markowitz model). The logic here is that returns from different assets are highly unlikely to be perfectly correlated, and in fact the correlation may sometimes be negative. In this way, market risk particularly, and other financial risks such as inflation risk, can at least partially be moderated by forms of diversification.

A key issue in diversification, however, is that the (assumed) relationships are (implicitly) forward looking. As observed in the late-2000s recession historic relationships can break down, resulting in losses to market participants believing that diversification would provide sufficient protection (in that market, including funds that had been explicitly set up to avoid being affected in this way[35]). A related issue is that diversification has costs: as correlations are not constant it may be necessary to regularly rebalance the portfolio, incurring transaction costs; and as the fund manager diversifies, so this problem compounds. See Modern portfolio theory § Criticisms.

Addressing these issues, more sophisticated approaches have been developed in recent times, both to defining risk, and to the optimization itself; see Post-modern portfolio theory and Financial economics § Portfolio theory. Further, modern financial risk modeling employs a variety of techniques — including value at risk, historical simulation, stress tests, and extreme value theory — to analyze the portfolio and to forecast the likely losses incurred for a variety of risks and scenarios. Relatedly, [36] managers also seek to understand any tracking error, i.e. underperformance vs a "benchmark", and here often use attribution analysis preemptively so as to diagnose the source early, and to take corrective action.

Additional to these (improved) diversification and optimization measures, and given these analytics, Fund Managers will apply specific risk hedging techniques as appropriate;[34] these may relate to the portfolio as a whole or to individual stocks.

• Fund managers may engage in portfolio insurance, a hedging strategy developed to limit the losses an investor might face from a declining index of stocks without having to sell the stocks themselves. This strategy involves selling Stock market index futures during periods of price declines. The proceeds from the sale of the futures help to offset paper losses of the owned portfolio. Alternatively, and more commonly, [37] they will buy a put on a Stock market index option so as to hedge. In both cases the logic is that the (diversified) portfolio is likely highly correlated with the stock index it is part of; thus if stock prices decline, the larger index will likewise decline, while the derivative holder will profit.
• Fund managers, or traders, may also wish to hedge a specific stock's price. Here, they may likewise buy a single-stock put, or sell a single-stock future. An alternative is to engage in a "Long/short" strategy: if the trader believes that a share should increase in value (e.g. as it is underpriced given recent news) but is concerned about its overall industry correcting, then she may hedge out the industry-related risk by short selling shares from a direct, yet weaker, competitor.
• Bond portfolios are typically managed via Interest rate immunization or cashflow matching. Immunization is a strategy that ensures that a change in interest rates will not affect the value of a fixed-income portfolio (See Bond valuation § Present value approach: an increase in rates results in a decreased instrument value). Immunization is often used to ensure that the value of a pension fund's assets (or an asset manager's fund) increase or decrease in an exactly opposite fashion to their liabilities, thus leaving the value of the pension fund's surplus (or firm's equity) unchanged, regardless of changes in the interest rate. Cashflow matching is similarly a process of hedging in which a company or other entity matches its cash outflows (i.e., financial obligations) with its cash inflows over a given time horizon.
• For derivative portfolios, and positions, "the Greeks" are a vital risk management tool - these measure sensitivity to a small change in a given underlying parameter so that the portfolio can be rebalanced accordingly by including additional derivatives with offsetting characteristics.