Financial Risk Management - Essay Example

?Download the original attachment ? Financial Risk Management Introduction: Many financial and non-financial organizations currently report the significance of value-at-risk (VaR), a risk that calculates for possible losses. Domestic uses of VaR and other complicated risk measures are on the increase in many financial institutions, where, for instance, a banks risk group can set VaR limits, both probabilities and amounts, for fund management and trading operations. At the business level, managers use VaR as a standard summery of market risk exposure. A benefit of the VaR which is a, the great value theory, is that it may be computed without full information of the return allocation. Semi or fully non-parametric estimation processes are obtainable for downside risk estimation. Additionally, at an adequately low confidence level the VaR calculate explicitly concentrates regulators and risk manager’s attention on uncommon losses, than on potential catastrophic great losses. The general use of VaR based risk management is that, it has become increasingly significant in the study of the belongings the option market, and the stock market of these constraints. For instance, organizations with a VaR constraint may be willing to purchase out of the money put choices on the market portfolio so as to limit their downside risk. If multiple organizations follow the similar risk management plan, then this will clearly lift the equilibrium costs of these options. In addition the form of the returns of stock distribution in equilibrium will be influenced by the management efforts of collective risk. As an outcome, it is possible that the allocation of stock returns will become more heavy-tailed. This would involve the effort to control market risk, and therefore to decrease default risk, has it unfavorably increased the chance of such events. A part of the Long Tern Capital Management (LTCM) strategy was to expect that the increase between various rates would become limited, especially, the increases among the rates of corporate bonds and treasury bonds which are at an uncommonly high historical level. “LTCM was considered unique among hedge funds because of the large scale of its activities and size of its positions in certain markets.” (Long Term Capital Management 1999). 2. Background Barings Bank Francis Baring established Barings Bank in 1762, in UK. The British government paid commissions to Barings to raise funds to finance wars in the mid 1800s against US and France. Barings was regarded as the London's biggest 'American House.' (The Fall of Barings Bank n.d). Between 1860 and1890, Barings was also occupied in offering loans to Argentina. Barings was on the verge of bankruptcy in 1890 when Argentina failed to make bond payments. However, major banks in London like the Bank of England came forward to assist the bank. This disaster had a key impact on Barings and it persuaded the bank to shift all its business to the North American continent. Barings started a consultancy to advice people especially like those who belong to aristocratic class, in their assets management. The bank began to grow well and continued to earn considerable profits. In 1980s, the bank commenced its operation in US again and acquired the stock broking support of Henderson Crosthwaite, which later on came to be known as BSL. Barings Bank collapsed in 1995, because of the actions of Nick Leeson, a trader who misappropriated almost $1.4 billion. “The loss was due to a huge exposure to Japanese stock market.” (Barring Banks and Nick Leeson n.d). Industry analysts says that the fall of the Barings is a classic instance of poor risk management practices. The bank had entirely failed to set up an appropriate financial system, operational control system and managerial system. Due to the absence of efficient supervision and control, Leeson got the opportunity to perform his illegal trading activities and that too without being detected for a considerable period of time. The collapses of Barings Bank were happened only because of the wrong trading of one of its trader. He invested money in to the Singapore international monitory exchange. By this wrong investment he made a loss of almost 1.4 billion dollar. It adversely affected the bank, and eventually the bank had to stop functioning. It is the analysis of the events that beings to light the reasons that led to the collapse of the Barings Bank, and the reasons were inadequate systems of management control, supervision and risk management. It points out to the inefficiency of the management and staff of Barings. Following are the main reason for the failure of Barings Bank ?       Poor Management and Regulatory Control The Barings banks collapsed because the internal control and audit systems of the bank were clearly deficient in detecting what exactly was happening with Leeson’s derivative trading. They could have understood the trading of Leeson, by adopting proper managerial control. It includes the internal audit of the organization. Internal audit is done to understand the business culture, process and systems. Internal audit provides the assurance that the internal control systems are adequate to reduce risk and it also ensure efficiency and effectiveness of work to achieve the organizational goal. Internal control is the function of the manager which includes planning, organizing, staffing and directing. the entire control system in its entirety, include three step, they are setting up the standard of performance, comparing the current performance with the existing slander, detecting whether there is any deviation between the slandered performance and current performance. Corrective measures are to be taken, if any deviation is found between them. The lack of this managerial control system adversely affects the working of any organization. Due to poor supervision and defective control system the bank provided the opportunity to Nick Leeson to carry on his unauthorized trading activities. The management also failed to detect his moves. There was no internal communication, and therefore no proper communication and sufficient communication between the regulators in United Kingdom, japan and Singapore ensured. ?       Poor Supervision of Employees Supervision of the employees is an important factor for the success of any business. Lack of good supervision resulted in the failure of Barings Bank. The supervisors of the bank were also responsible for the collapse. The responsibility of this setback lies with the board of directors of Barings Bank.   ?       Lack of Good Risk Management “Risk management involves assessing and quantifying business risks, then taking measures to control or reduce them” (Kolakowski 2012). In every business, risk plays an important role. So the management should be aware of VaRious resources and VaRious factors of risk. Effective risk management can reduces the risk of the business. The need of value at risk was not there in the case of Barings Bank, even if it were to reveal Leeson’s risk. The different types of financial risks involve exchange rate risk, equity price risk, commodity price risk, credit risk, operational risk etc. Operational risk may be in the form of fraud and inadequate controls. The Barings Bank has failed to adopt independent internal audit system and this resulted in the poor assessment of risk, and risk handling. The failure to assess the operational risk enabled Lesson to go ahead with his fraudulent activities. “Value at Risk, known as VaR, is a common tool for measuring and managing risk in the financial industry.” (Value At Risk Advantages: Why Use VAR in Risk Management 2007). http://www.macroption.com/value-at-risk-VaR-advantages/ The Value-at-Risk concept is an attempt to summarize an estimation of price risk concerned with the portfolio of derivatives and other financial assets. The main advantages of VaR are, ?       The management can identify and measure risk (future value) ?       It is easy to explain, as VaR is helps to understand the value at risk feature of different asset and portfolios, and it can be easily calculated by using finance software.   The disadvantages of VaR are,  ?     Estimation is difficult, sensitivity estimation methods are used, making it possible to create a false sense of security, tend to undervalue worst-case outcome, and fails to integrate positive outcomes, ?       By using VaR techniques Barings Bank’s management could easily identify the risk associated with the trading of derivatives and different portfolios. John Meriwether and the Rise of LTCM Prior to diving into the events which contribute to the fall and rise of the Long?Term Capital Management (LTCM), it is essential to have insight into the backgrounds of those who were engaged in the practice. The most prominent figure is John Meriwether, the founder of fixed income arbitrage at Salomon Brothers. Meriwether recruited some highly talented mathematicians, physicists and economists to this business who later on becomes the chief founders of LTCM. The fundamental idea behind the strategy of implementing mathematical models is the convergence of spreads assumption that made Meriwether the highly esteemed idol trader at Salomon. Due to some instance of dishonor, Meriwether left the business and had established LTCM, using the business strategies at Salomon. The fall of LTCM In the summer of the year 1998, while the spreads started to expand as they were in 1978, the set of relationships that permitted “LTCM.” (Bulter et al 2007). Instead of accomplishing early successes, they had to face heavy collapse. It was at this time, Russia failed to pay on its debt, resulting in the reduction of several investments of LTCM. As leftovers of LTCM’s trading strategy were revealed, most of the Wall Street business groups which had really made related trades that were also harmfully affected by Russian fall down. Since other investors ran away towards liquid assets like short?term bonds and retracted from long?term bonds, spreads increased again, resulting in sharp declines in the LTCM’s portfolio’s value. Since they couldn’t meet all the cash obligations, they sold off trades and investments and compensated the losses. People who had similar investments began to sell them off on getting the information. This move was an attempt to cut losses at first, but afterwards this attempt was used as a real attack on LTCM, with the aim of reducing the fund value further to achieve easier acquirement target. 3. Analysis of Whether the Correct Application of Prevent Financial Disasters as in Barings Banks and Long-Term Capital Management Analysis of Long-Term Capital Management The LTCM's failure has been extensively attributed to its use of VaR (Value at Risk); the troubling implication that the process presently utilized to set requirements of capital adequacy for banking sector is woefully insufficient. VaR itself is not the reason, however. To a certain extent it was the means by which this risk management tool was utilized. LTCM employed the parameter of the model appropriate for a commercial bank, but completely inappropriate for hedge fund. The reasons for the collapse of Long-Term Capital Management are Russian Sovereign default, flight to liquidity across the global fixed income markets and the Domino Effect. “Russian Sovereign Default” (LTCM Case Study n.d). The immediate cause for LTCM disaster was the failure of Russian government in fulfilling its responsibility. In theory, if Russia failed to pay on its bonds, its currency value would decline, and income could be made in the forex market that would balance the loss on bonds. Unfortunately, the banks assuring the hedge of ruble closed down when Russian ruble collapsed, and the government prohibited additional currency trading. This caused considerable loss for LTCM and these losses were not big enough to bring down the hedge fund. The Flight to Liquidity  The crucial cause of LTCM disaster was the flight to liquidity over international fixed income markets. As Russia's troubles became worse, managers of fixed-income portfolio began to transfer their assets to further liquid assets. This is because the panic investors shifted their money to Treasuries and into the liquid portion of U.S. Treasury market, which is relatively safer. This international flight to liquidity hit the Treasuries like a goods-train. The spread among the yields on off-the-run Treasuries and on-the-run Treasuries widened noticeably. The increased value of liquidity became valuable and its short positions improved in price than its long positions. This is fundamentally an unhedged exposure to single risk aspect.  “Systemic Risk: The Domino Effect.” (Case Study LTCM – Long-Term Capital Management 2010). The analysis done earlier clarifies why LTCM failed. But it does not describe why these failures threaten the constancy of international financial markets. It is because of the similar positions practically enjoyed by all the investors of leveraged Treasury bond had. The two reasons for the lack of difference in opinion in the market are: ?       Practically, all the leveraged players who run sophisticated models repeat that off-the-run Treasuries are considerably cheap compared to that of on-the-run Treasuries. ?       Many of the investment banks achieved order flow information  in their transactions with LTCM. In fact, one participant of industry recommended that Russian crisis was the ultimate blow on a domino effect which had started months ago. By assigning value?at?risk restrictions to trading desks and individual traders, big organizations stop the accretion of over risky positions while providing traders elasticity within those restrictions However, if unfavorable market movements arise up to or beyond the borders, the traders concerned have no option but to attempt to cut their losses and trade, although it is a tremendously disadvantageous act. Critically, they also signify enhanced relationships between the former insecurely related markets, transversely with the risk that appeared to be abridged by diversification. 4. Case Studies This case study deals with Barings Bank, and examines how with the function of VaR measurement method, the crisis could have been prevented. The Barings bank which was developed in 1765 was the oldest merchant bank in Singapore. The bank provided finance and advice to a large number of clients. It has collapsed as a result of the fraudulent activities of one of its trader, the trader lost huge amount of money when he invested it in the International monetary exchange as derivative securities. The failure illustrated that the Bank require internal management very badly. The shareholders of Barings Bank didn’t bother to supervise the managing of the corporation. The traders were not restricted in risky dealings, and as a result it increased. It well known that the Bank of England had strived its best to provide financial guarantee to Barings. But even that couldn’t prevent Barings from being insolvent. Specialists judge that it was a correct choice. An organization which was weakly administered should withdraw. This is also an excellent example for risk management. Top management at Barings did not have a proper understanding of Leeson’s business though it was making high income for the bank. The Barings business established a convincing necessitate for independent risk management. The following are some of the causes that led to the crisis of the bank: ?       Lack of proper follow up on the internal audit. ?       Lack of recognizing of the risks of the business: The main failure of the Barings bank is due to the failure of operational risk management. ?       Poor understanding of the derivatives: Barings’ senior management did not spend adequate time and effort in understanding the use of derivatives.  As they did not make any serious attempt to examine the method the profits were booked. ?       Poor supervision of the functions of the bank. With the decline of the bank, the managers and employees understood the importance of control and risk management. Every practical internal control system must distinguish and recognize the possibility for deception or mistake due to insufficient separation of duties.  Clear and well defined separation of duties is essential to any successful risk control system. Separation of duties is also significant in ensuring the accuracy and truthfulness of relevant information. The usefulness of an efficiently planned system of controls and applied control activities considerably reduces mismatched duties vested in the same individual.  As the controls within Barings systems might have been suitably designed for their operational efficiency, it was always seen to be imperfect. The need of separation actually augmented the precise risks that management has over ruled. The message here is that in the expansion of a risk management and internal control system one should constantly value the time tested basics essential for successful internal controls. Malfunctioning always will leads any organization to an increased risk for indiscretion. The suggestions are very reflective particularly in the case of financial organization. While applying an internal control system is necessary that there are device in place for scrutinizing and measuring its efficiency. “A great risk management system should be used to avoid the 1.3 million dollars loss. If the VAR system could be comprehensively used, the loss might be avoided.” (Specialist Oxbridge Writing Service 2012). The system of risk management is very important in evaluating the risk involved in the business. The operation of VaR is imparted by the bankruptcy of Barings. If the Barings bank prepared the VaR system in place appropriately, they might have possibly analyze that what Leeson's actual VaR was, the factor which contributed towards VaR, whether the system were hedging each other or increasing to the risk. Many financial service firms had adopted elementary procedures of VaR, with broad deviation on the method it was calculated. “In the aftermath of numerous disastrous losses associated with the use of derivatives and leverage between 1993 and 1995, culminating with the failure of Barings, the British investment bank, firms was ready for more comprehensive risk measures.” (Damodaran 2008). Value at risk is very important for banks, commodity, securities firms, and energy merchants, and other business organizations in watching clearly their portfolio market risk. It is an evaluation applied by financial practitioners to calculate risk of a portfolio. The method was broadly accepted because of the decline of Barings Bank. The failure of Barings has necessitated for more efficient risk management procedures. 5. Conclusion / Recommendation: Risk is connected with the chance of adverse business conditions or downside risk. Risk management is the procedure of monitoring, identifying, calculating risk and implementing and developing strategies to manage that risk. Financial risk is normally any risk connected with any type of investment or financing decisions. Financial risk management is consequently concerned with the chance of real return being less than probable economic return in financial or projects assets. Financial risks are broad and they include Investment risks, insurance cover risks, credit management risk, liquidity risk, forex risk, stock price risk and interest rate risk. By assisting the consistent dimension of risk across distinct activities and assets, VaR permits financial institutions to check, report, and manage their risks in a method that efficiently connects risk control to need and actual financial exposures. Additionally, dependence on VaR can result in serious troubles when inappropriately used. VaR is helpful only to convinced financial institutions and that too in specific situations. When VaR is examined and described in such circumstances with no judgments of matching expected income, the information suggested by the VAR estimate could be particularly deceptive. VAR is an alternative to good management. Risk management is a procedure which includes factors much above the measurement of the risk. Though a sensible measurement of risk can show very helpful to certain financial institutions, it is somewhat useless without a strong organizational infrastructure and financial system, capable of sustaining the dynamic and complex method of risk control and risk taking. Recommendation: ?       The management of risks should necessarily be in concurrence with the business plan of the organizations. ?       Describe the determination of risks in each business and constantly across the organization. ?       Set off business for risk management, at the point adjacent to the possibility of risk. ?       The financial institution should increase measurement and record measures suitable to business practices. ?       Set up broad risk management method to evaluate individual, business and firm level management. ?       Applying of long term capital management “illustrates the danger of optimization biases.” (Jorion 2000). ?       VAR must be applied by financial institutions in a cautious manner. When an organization purposely undertakes definite risks as an element of its main business, VAR can assist as an excellent analytical examining instrument for those risks.      Reference List Barring Banks and Nick Leeson (n.d). [Online] Available at [Accessed on 9 May] Bulter, J. et al (2007). Long-Term Capital management case Study: The Role of Communication In its Collapse. Case Study LTCM – Long-Term Capital Management (2010). SUNGURD. [Online] Available at Read More