Corporates analyze market risks (in particular FX risks) in terms of three key exposures: transaction exposures, economic exposures, and translation exposures. Let us discuss each of these exposures.

<strong>Transaction Exposures</strong>

Transaction exposures arise because of adverse changes in prices. For example, a US based company buying goods from a Japanese company will incur transaction risk because it is exposed to the exchange rate fluctuation (specifically rising yen).

The first step in analyzing the risk of any transaction is to decompose the risk of a transaction into component risks. Even a single transaction can have multiple component risks. For example, a USD-based investment manager with a DEM-denominated convertible bond position has the following component risks:

<strong>FX risk:</strong> Exposure to DEM depreciating vs. USD @ Interest rate risk: Exposure to rising rates, which make bond prices fall

<strong>Spread risk:</strong> Exposure to rising credit spreads (that is, deteriorating credit quality of issuer), which makes bond prices fall

<strong>Volatility risk:</strong> Exposure to falling equity volatility, which reduces the value of the equity conversion option

<strong>Equity risk:</strong> Exposure to falling stock price of the underlying company

These individual component risks can then be aggregated across a portfolio of instruments to highlight common risk factors.

<strong>Examples of Transaction Exposure</strong><strong> </strong>
<ul>
	<li>Purchasing      or selling on credit when prices are stated in a foreign currency.</li>
	<li>Borrowing      or lending funds when repayment is to be made in a foreign currency.</li>
	<li>Being      a party to an unperformed foreign exchange forward contract.</li>
	<li>Acquiring      assets or incurring liabilities denominated in a foreign currency.</li>
</ul>
<strong>Economic Exposure</strong>

Economic exposure is the risk associated with changes in exchange rates, local regulations or business environment, which could disadvantage the company’s long-term economic model or favor the services or products of a competitor. This type of exposure is very difficult to mitigate.

Economic exposures due to foreign exchange movements are becoming a significant issue as markets are opening up and becoming deregulated. Changes in foreign exchange rates in particular can significantly change the competitive landscape.

For example, in our earlier example the US-based company might find that a rising dollar vs. yen would hurt product sales in Japan and furthermore give Japanese competitors an edge in U.S. markets. Therefore, while the US company has transaction exposure to rising yen, it has an economic exposure to falling yen vs. dollar.

At this point, it must be noted, that even purely domestic companies, with no foreign operations can be affected by fluctuation in exchange rates, due to competition from foreign companies. Similarly, changes in interest rates can also affect the firm because of the cost of the debt.

<strong>Translation Exposure</strong>

Translation exposure refers to foreign exchange or currency risk. It is the risk of adverse effects in a firm’s reported financial statements, or related financial ratios or borrowing covenant compliance, resulting from changes in the rates at which foreign currency-denominated assets and liabilities are translated into the reporting currency. This applies most commonly to the translation of monetary assets and liabilities and to the consolidation of overseas subsidiaries into group financial statements.

In our example, the US-based company’s Japanese operations are subject to translation exposure to USD.

Analyzing Market Risks: Three Key Exposures

In their normal course of business, corporations face a variety of risks. The primary risks involved are business risk, market risk, credit risk, and operational risk.

The corporations are expected to deal with different risk in different ways. They are expected to take business risk, manage market and credit risk, while mitigate operational risk.

Here are a few examples of how these risks can arise:

<strong>Business risk: </strong>Marketing and sales, Reputation

<strong>Market risk: </strong>Commodity, foreign exchange, interest rates, equity

<strong>Credit risk: </strong>Default, concentrations, country exposure, recovery

<strong>Operational risk: </strong>Controls, systems, data quality, fraud, product delivery, legal, regulatory
<h2>Understanding Risks</h2>
Let us look at the how firms should deal with various risks from a shareholder perspective.
<h3>Business Risk</h3>
Business risk is core to the existence of any business, and it refers to the probability of loss inherent in a firm's operations and environment (such as competition and adverse economic conditions) that may impair its ability to provide returns on investment. From a shareholder perspective, firms are paid to take business risk, and it is inherent in all business decisions, and investments, for example, marketing and promotion, sales strategy, etc.
<h3>Market and Credit Risk</h3>
Both market risk, and credit risk arise because of various business activity, for example, foreign exchange risk for an exporter, or importer, and credit risk in case of credit sales. Both these risks cannot be avoided in the normal course of business but they can be managed by using various techniques. From the market risk perspective, the firms are required to determine effective funding strategies and implement hedging programs for foreign exchange, commodity, or equity exposures that arise from a firm's core business activities. From the credit risk perspective, firms are expected to identify all potential sources of credit risk and also manage concentration risk.
<h3>Operational Risk</h3>
Basel II defines operational risk as the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Although the risks apply to any organization in business, this particular way of framing risk management is of particular relevance to the banking regime where regulators are responsible for establishing safeguards to protect against systemic failure of the banking system and the economy. It is in the best interest of the businesses to identify operational risk and mitigate it. Primary responsibility for mitigating operational risk typically rests with business managers. Internal auditors are charged with identifying operational risk issues in reviewing business activities.
<h3>Market Risk</h3>
Market risk is the most clearly defined and observed financial risk.

Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices. The associated market risks are:
<ul>
	<li><strong>Equity risk</strong>, the risk that stock prices and/or the implied volatility will change.</li>
</ul>
<ul>
	<li><strong>Interest rate      risk</strong>, the      risk that interest rates and/or the implied volatility will change.</li>
	<li><strong>Currency risk</strong>, the risk that foreign      exchange rates and/or the implied volatility will change.</li>
	<li><strong>Commodity      risk</strong>, the      risk that commodity prices (e.g. corn, copper, crude oil) and/or implied      volatility will change.</li>
</ul>

Typology of Risks

There are four major types of market risk:
<ul>
	<li>Interest Rate Risk</li>
	<li>Equity Price Risk</li>
	<li>Foreign Exchange Risk</li>
	<li>Commodity Price Risk</li>
</ul>
<h3><strong>Interest Rate Risk</strong></h3>
Interest rate risk is the risk that the value of a security will fall as a result of increase in interest rates. However, in complex portfolios, many different types of exposures can arise.

<strong>Basis risk: </strong>Banks can face basis risk if the interest-bearing assets and liabilities have different bases such as the London Interbank Offered Rate (LIBOR) versus the U.S. prime rate. In some circumstances different bases will move at different rates or in different directions, which can cause erratic changes in revenues and expenses.

<strong>Repricing risk: </strong>Banks can also face repricing risk, that is, the risk presented by assets and liabilities that reprice at different times and rates. For instance, a loan with a variable rate will generate more interest income when rates rise and less interest income when rates fall. If the loan is funded with fixed rated deposits, the bank's interest margin will fluctuate.

<strong>Yield curve risk: </strong>Yield curve risk is presented by differences between short-term and long-term interest rates.

Under normal circumstances, the short-term rates are lower than long-term rates, and banks earn profits by borrowing short-term money and investing in long-term assets. However, any change in the yield curve can dramatically affect bank’s earnings.

<strong>Options risk: </strong>The optionality embedded in some assets and liabilities gives rise to options risk. This can be seen in the prepayment speeds of the mortgage loans, with changing interest rates. Falling interest rates will cause many borrowers to refinance and repay their loans, leaving the bank with uninvested cash when interest rates have declined. Alternately, rising interest rates cause mortgage borrowers to repay slower, leaving the bank with more loans based on prior, lower interest rates. Option risk is difficult to measure and control.
<h3><strong>Equity Price Risk</strong></h3>
Equity price risk refers to the risk arising from the volatility in the stock prices.

While talking about equity risk, it is important to differentiate between systematic risk and unsystematic risk.

Systematic risk refers to the risk due to general market factors and affects the entire industry. It cannot be diversified away.

Unsystematic risk is the risk specific to a company that arises due to the company specific characteristics. According to portfolio theory, this risk can be eliminated through diversification.
<h3><strong>Foreign Exchange Risk</strong></h3>
Foreign exchange risk arises because of the fluctuations in the currency exchange rates.

Companies may be exposed to the foreign exchange risk in their normal course of business because of the unhedged positions or because on imperfect hedges.
<h3><strong>Commodity Price Risk</strong></h3>
Commodity Price Risk refers to the risk of unexpected changes in a commodity price, such as the price of oil.

These commodities may be grains, metals, gas, electricity etc.

Commodity risk affects various sections of people:
<ul>
	<li>Producers (Farmers, plantation companies, and mining companies)</li>
	<li>Buyers (Cooperatives, commercial traders, etc)</li>
	<li>Exporters</li>
	<li>Governments</li>
</ul>

Types of Market Risk

Over the past few years, financial institutions have faced severe difficulties due to various reasons. However, the major cause of the banking problem is directly related to lax credit standards for borrowers and counterparties, poor portfolio risk management, or a lack of attention to changes in economic or other circumstances leading to a deterioration in the credit standing of a bank's counterparties.

Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. The goal of credit risk management is to maximize a bank's risk adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions.
<h3><strong>When Credit Risk Arises</strong></h3>
For most banks, loans are the largest and most obvious source of credit risk; however, other sources of credit risk exist throughout the activities of a bank, including in the banking book and in the trading book, and both on and off the balance sheet. Banks are increasingly facing credit risk (or counterparty risk) in various financial instruments other than loans, including acceptances, interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions. The two most important factors to consider when evaluating credit risk are:
<ul>
	<li>Counterparty      creditworthiness</li>
	<li>Portfolio      concentrations</li>
</ul>
<h4><strong>Counterparty Creditworthiness</strong></h4>
Counterparty credit risk can be identified by application of traditional counterparty credit analysis and monitoring.

Ratings agencies such as S&amp;P and Moody's assign credit ratings to companies by analyzing factors such as industry, size, leverage, quality of assets, management, strategy, earnings, growth, diversification, and country.

We can project expected future probabilities of default and ratings migrations for each credit rating using historical data of defaults and ratings changes. Another important factor to consider in assessing creditworthiness is projected recovery rate in the event of default.
<h4><strong>Portfolio Concentrations</strong></h4>
To find hidden concentrations in portfolios, we analyze common factors that affect the well-being of firms, such as industry, sensitivity to commodity prices, and sensitivity to interest rates. In the end, an understanding of the credit risks will help portfolio managers to better identify pockets of concentration and opportunities for diversification better.
<h3><strong>Integration of Market and Credit risk</strong></h3>
An important area of research these days is the integration of credit and market risk.

An example here is the case of the bond, in which you have both credit as well as market risk. The credit risk comes in because of defaults, downgrades, and upgrades, and the market risk comes because of the fact that you can have spreads moving against or for you, and also the interest rate component moving against or for you.

An integration of these two components to come up with a capital which you'll allocate to this entire position which you'll have both market and credit risk components is an important area of focus.

Overview of Credit Risk

The transition matrix below shows the probability of default and credit rating migrations for each credit rating.

Transition matrices can be calculated by observing the historical pattern of rating change and default. They have been published by S&amp;P and Moody's rating agencies.

To read the table, find today's rating on the left and follow along that row to the column that represents the rating at the risk horizon. For instance, the leftmost bottom figure of 0.17% says that there is a 0.17% chance that a

CCC rated credit will migrate to AAA at the end of the year. Observe how the probability of AAA or AA credits defaulting over 1 year is so miniscule, it rounds to 0.
<p style="text-align: center;"><img class="aligncenter size-full wp-image-1118" title="rating1" src="https://financetrain.com/wp-content/uploads/2010/10/rating1.png" alt="" width="601" height="325" /></p>
<p style="text-align: center;"><img class="aligncenter size-full wp-image-1119" title="rating2" src="https://financetrain.com/wp-content/uploads/2010/10/rating2.png" alt="" width="600" height="324" /></p>

Defaults and Ratings Changes

Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk.

Legal risk includes, but is not limited to, exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements.
<h3><strong>Sources of Operational Risk</strong></h3>
The definition refers to loss resulting from the following four sources, which are now explained in more detail in order to aid understanding of the definition:

<strong> </strong>

<strong>Inadequate or failed internal processes: </strong>Financial institutions operate a myriad of processes to deliver their products to customers. Process risk can arise at any stage of an end to end process in the value chain. For example, marketing material can be mailed to the wrong customers, account opening documentation can turn out not to be robust, transactions can be processed incorrectly, etc.

<strong>People: </strong>Operational risk losses can occur due to worker compensation claims, violation of employee health and safety rules, organized labour activities and discrimination claims. People risks can also include inadequate training and management, human error, lack of segregation, reliance on key individuals, lack of integrity, honesty, etc.

<strong>Systems: </strong>The growing dependence of financial institutions on IT systems is a key source of operational risk.

Data corruption problems, whether accidental or deliberate, are regular sources of embarrassing and costly operational mistakes.

<strong>External events: </strong>This source of operational risk has at least two discernible dimensions to it, firstly the extent to which a chosen business strategy pursued by a bank may expose it to adverse external events, and secondly external events that impact it independently, emanating from the business environment in which it operates.
<h3><strong>Operational Risk Classification</strong></h3>
For the purpose of collecting and organizing data, Basel Committee recommends that operational losses are estimated as per different banking business lines and types of risk.

<img class="aligncenter size-full wp-image-1124" title="operationalrisk" src="https://financetrain.com/wp-content/uploads/2010/10/operationalrisk.png" alt="" width="624" height="519" />

Overview of Operational Risk

Event risk involves a severe and sudden shock that can arise from any general type of risk, including human error, operational risk, natural disasters, currency devaluations, and stock market crashes.

<strong>Difficult to predict</strong>

Event risks are difficult to predict, but once an event strikes, we know there will be aftershocks. Hence, it is important to readjust quickly to new conditions--this means re-evaluating risks, looking for new risk concentrations, and taking corrective action if necessary.

<strong>Liquidity</strong>

Events can trigger liquidity crises that may make it difficult to readjust or find funding for positions.

<strong>Contagion</strong>

Often the initial shock is not the worst: One event can precipitate other events and lead to contagion across markets, which becomes systemic risk that affects everyone.
<h3><strong>Stress Testing</strong></h3>
One way to prepare for event risks is to conduct regular stress testing. The greatest challenge in stress testing is generating credible worst-case scenarios that show how particular events could affect all relevant markets. For example, we might have a stress test of the U.S. markets: A computer virus cripples Microsoft operating systems and the U.S. equity market starts to sell off. How far will it go? How will other global markets react?
<h3><strong>Crisis Management</strong></h3>
A crisis management process should be in place to prepare for potential events. Essential to crisis management are:
<ul>
	<li>Appointing a central point of leadership with quick and comprehensive access to information</li>
	<li>Defining a process for communicating within and outside the firm</li>
</ul>
In volatile market conditions, liquidity often dries up. In the above-mentioned October '97 liquidity crisis in Brazil, traders reported that bid offer spreads (when available) were so wide that it was difficult to tell whether the yield curve was upward or downward sloping. Without reliable (and tradeable) quotes for securities, there can be no trading--you won't be able to get out of your position.

Liquidity risk can also be viewed from the funding perspective--that you will not be able to raise sufficient funding for your illiquid assets.

Although it helps to analyze various liquidity indicators for each security (for example, bid-offer spreads, daily volumes traded, average trade size, number of market makers), liquidity risk is difficult to measure in a consistent manner (liquidity risk modeling could be the next breakthrough in risk management methodology).
<h3><strong>Contagion</strong></h3>
Events in one market can easily trigger large movements in other markets in a domino effect. Therefore, we must understand that the benefits of diversification cannot always be counted on=particularly during crises. Risk managers should always be aware of contagion risk and identify potentially hidden concentration risk by understanding the connections between markets.

Contagion is an effect of globalization, where markets are all interconnected and risk can spread quickly.

The effects of contagion are illustrated in the fall of Peregrine. This Hong Kong investment bank sent the global markets reeling on January 12, 1998, when contagion occurred. What precipitated Peregrine's fall was overconcentration in Asia, in particular an Indonesian $265 million loan to a taxi company named PT Steady Safe. Peregrine's fall sent shockwaves throughout the global markets.

Event Risk and Its Management

Systemic risks, as opposed to unique or firm-specific risks, are the most troublesome because they have the potential to affect anyone. Systemic risks may arise from common factors (for example, market and economic factors, weather, natural disasters, computer viruses, war) and can influence the whole market's well-being.

Unlike firm-specific risk, systemic risk cannot be diversified away--in fact, systemic risk is the residual risk when we have diversified away all specific risk.

<strong>Common factors</strong>

There are common factors in systemic risks.
<ul>
	<li>Virtually unrestrained availability of credit</li>
</ul>
<ul>
	<li>Sizable concentrations of risk that were not perceived as such</li>
</ul>
<ul>
	<li>A relaxed acceptance of financial asset inflation--often fueled by cumulative public policy excesses</li>
</ul>
<strong>Examples of Systemic Risk</strong>

Examples of systemic risk include:

1. The fall of pegged Southeast Asian currencies, resulting in drastic economic slowdown throughout Asia

2. Japan's 80's lending excesses, resulting in mountains of bad debt still crippling its financial system

3. U.S. stock market crashes (for example, '04, '29, '87)

4. 80's S&amp;L crisis

5. What is the next one?

Systemic Risk

Identifying Risks

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Identifying Risks

Lessons

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