Risk Measurement and Management - Essay Example

? due: Risk Measurement and Management Interest rate risk This emerges when the value of aninvestment will change as a result of change in the absolute level of interest rates, in the range between two interest rates or like the yield curve relationship (Davidson, 2001). These changes frequently affect securities unequally and can be minimized through diversification or hedging. Diversification can be done by venturing into fixed income securities with different periods while hedging is done through the swap of interest rate. It affects the value of bonds directly as compared to stocks thus a major risk to all bond holders. The increase in interest rate reduces the bond prices while their decrease inflates the bond prices. Therefore, as interest rate increase, the cost of holding a bond reduces because investor are able to recognize grater yields by opting to other investments that result into high interest rates(Allen, 2004). Interests’ rate risk may emerge as a result of basis risk, yield curve risk, repricing risks and optionality. Measurement These are instruments that help in detecting the level of interest rates to show how the risk can be managed effectively. These measurement tools involve repricing, maturity and duration models. The repricing model This model is also known as the funding gap model whereby a book worth accounting cash flow scrutiny of the repricing gap between the interests revenue gained on assets and the interest spent on liabilities over specific duration. Repricing gap is the variance amid the rate sensitive assets and liabilities (Ahmed, Beatty & Bettinghaus, 2004). Repricing model therefore, illustrates for example how a bank calculates the gaps in each basket by looking at the level of sensitivity of each asset and liability also known as time pricing. Repricing model is shown below: =?NIIi = (GAPi) ?Ri = (RSAi - RSLi) ?Ri (this applies to any i bucket) Weaknesses The repricing model does not show the true exposure of the market value effects thus affecting in the determination of the rate of risk. There is over aggregation whereby there is a mismatch within the buckets (Davidson, 2001).Liabilities may be repriced at diverse times than assets in one basket. Finally, runoffs are experienced by this model whereby there are periodic cash flows on principal and interest amortization payments on long term assets like conventional mortgages that can invested again at the market rates. The maturity model This model involves the market value of accounting whereby the assets and liabilities are revalued as per the current level of interest rates. This is actually shows how changes in interest rates influence the value of bonds, for instance: 1year bond, 10%coupon, $100 face value=10% In this case if the sales at par is worth $100, then if the rate of interest rise to 11% then the value of the bond would reduce to $99.10 resulting into a capital loss of $0.90per $100.Consequenlty, it is noted that interest rates reduce the market charges of both assets and liabilities of an F1.If the bond is within a period of 2 yeas then: At R=10%, sells at per At R=11%, principal=98.29 dollars Whereby the capital loss would be $(98.29-100) = -1.71%.Hence,when the maturity of a fixed asset or liability prolongs then there is a greater fall in price and market value for any given rise in the level of interest rates. When this model is considered with a portfolio of assets and liabilities then there will be a tragic situation especially if the bank encounters an extreme asset liability mismatch. This is also encountered in the case of deep discount that is zero coupon bonds where the problem is extreme and disastrous implications emerge. For instance,1% increase in interest rate, minimizes the value of the 10 years bond by -23.73 per $100 hence showing a completely and massive insolvency (Brennan & Schwartz, 1979). Therefore, maturity matching and interests rates exposure does not result into a good measurement criterion since it does not work. The duration model The duration model and duration gap are more precise measures of an F1’s interest rates risk exposure. This involves the elasticity of interest rate which is the interest sensitivity of an asset or liability value. This model is a more complete measure at takes into account time of arrival of al cash flows as well as maturity of an asset or a liability. This model applies the following formula as shown below: Duration model which is also known as the weighted average maturity measures interest rate risk that is changes in present value of securities when the interest rate changes. Generally banks can control its duration gap but cannot control its interest rates (Berkowitz & Brien, 2000). When the duration gap is positive then it implies that the value of assets is greater than the value of liabilities. Therefore, the bank will be worried since an upsurge in the rate of interest will reduce the value of the bank. If the duration gap is negative, then it implies that the value of liabilities is more than the value of assets thus reducing the value of the bank. Duration model can also be used to minimize bank against interest rate risk, whereby the bank value in this case would be (=0) thus not affected by changes in interest rates. This model is essential for the Federal Backup Bank and the bank of international settlements in measuring and monitoring interest rate risk for banks (Fooladi & Roberts, 1992). This is referred to as immunization which is shown by the formula: A * DA=L* DL   Eventually, duration model is time consuming and costly to enable changes in the balance sheet to immunize. Immunization is dynamic challenge since it changes constantly thus requires continuous monitoring and periodic transformations and rebalancing for the banks to be immunized (Thornton, 2004). The duration of this model assumes linear connection between variations in interest rates and percentage in the current value thus the model becomes less accurate as interest rate rises. Management the risk Prior to using financial tools to manage interest rate risk, the firm should formulate a policy after identifying the risk appetite of key stake holders like directors. Interest rate risk can be managed by investing in fixed rate assets or investing in floating rate assets and the fixed rate through an interest swap (Ahmed, Beatty & Takeda, 1997). This is because, a fixed interest rate offers the investor with the bets rate of return despite the minor losses incurred. The borrowers can also convert a fixed amount loan back to an extra floating loan through a derivative like interest rate swap. Nevertheless, the borrower can consider using an interest rate swap of a certain product. This product permits the borrower to lock in its floating charges for a span of five years with its own financial institution if there are credit limits. Finally, liquidity risk can be managed when a borrower has a floating rate of funds thus it can shield itself from increasing rates of interest through an interest rate option (Soto, 2004). Therefore, if the rates fall, he retains the gain of the clearance in interest rates. The Basel capital accord fights for evaluation of the suitability and efficiency of the bank’s interest rate risks and in developing competent supervisory responses towards the systems put in place. Therefore, banks should have comprehensive management systems that evaluate and control interest rate exposures effectively (Basel Committee on Banking Supervision, 2001). This can be progressive if appropriate strategies and policies are put in place. The risk manager within the interest rate risk management system should be independent from the risk taking factors of the banks to avoid potential conflicts of interest. The management of the banks should ensure that the interest rate risk policies and procedures are clearly defined and correlating with the nature and complexity of the bank’s accomplishments. Challenges The challenges experienced in this case involve lack of attention in the implantation of an effective risk management for commercial banks with the central bank relaxing their controls (Bierwag, Kaufman, Schweitzer& Toevs, 1981). Therefore, many improvements are required in area such as interest rate risk awareness, training professional talents and risk prevention skills and building an interest rate risk management mechanism that can effectively control the interest rare risk. 2. Liquidity risk This is risk emerges due to the difficulty of selling an asset especially when the investment needs to be sold quickly. Inopportunely, a secondary market which is insufficient may limit the funds that can be created from the asset (Subramanian & Jarrow, 2001). Nevertheless, some assets are highly liquid and posses less liquidity risk for instance, stock of a publicly traded company, while others are more illiquid and have high liquidity risk such as a house. Measurement Measurements of liquidity risks ensure the determination of the level of the risks to enable its management before it results into extreme losses (Leinonen, 2005). Various techniques have been suggested to help in measuring risks these methods include: cash flow forecasting, financial ration analysis and assessment of funding facilities. Cash flow forecasting involves short term and long-term liquidity monitoring to enhance the availability of cash flows thus avoiding cash flow crisis.it is therefore important the at the company should indulge in frequent monitoring of the cash flows to enable in curbing the cash flow crisis (Fooladi & Roberts, 2000). Therefore, short term liquidity monitoring should be considered as well as long term liquidity checking which should be accessed by sensitivity analysis on the forecast to evaluate the impact of each strategy and level of business activity in line with prospective success of internal and external funding. Liquidity risks can also be measured by assessing the funding facilities. A serious assessment of available funds may find risks to the cash position of the current business. The main areas of assessment are the scope to which the business relies on financial facilities and on one lender. The assessment also depends on the maturity profile, putting in to consideration that all the financings mature at the same time (Zask, 2000). It also involves assessing the strength of relationships with shareholders, the ability of the business to raise extra equity, status of financing facilities, and availability of funds in extreme crisis conditions like global financial crisis. The ratio analysis is used to determine the key areas of liquidity risk where by it measures both short term and long term liquidity risk. There are three major groups that is, indicators of operating cash flows, ratios of liquidity and financial strength. Indicators of operating cash flows such earnings prior interest and tax (EBIT), is an indicator of the short term capability to service debt (Subramanian & Jarrow, 2001). Ratios vary from firm to firm but a ratio that is below the standards should be critically assessed as it may indicate weakness to unexpected down turn in income. Ratios of liquidity must be used with caution as they might not show outcome of future operations. The ratios to be used for analysis here are quick and current ratios. Nevertheless, financial leverage is also important in the analysis since; it tends to show the level of liquid risk (Zask, 2000). The higher the ratio of debt to total funds, the greater its vulnerability and downturn in cash flows. Asset Liquidity Management (ALM) Liquidity risk management involves managing liquidity risks to lower the impact of the risks on the financial institutions’ assets. Therefore, the major insurance of liquidity takes place through the liability management (Leinonen, 2005). Liability management ensures that the bank has access to funds most commonly from the interbank market. Good liability management ensures proper diversification on the assets side to avoid financial crisis in the future. This is clearly seen when there is a sub prime crisis that shows undiversified funding sources in collaboration with liquidity risk of the assets. This liability management prefers two types of funding management that is, routine or day to day cash management and cash requirement during crisis events which are very unpredictable. Therefore, to avoid crisis as a result of liquidity then the banks should have cash reserves to curb the problem of liquidity risk. Banks should also pre-arrange financial or funding agreements in advance since, it is unpredictable when the crisis will occur. Liquidity risk management is curbed by the asset liquid management that rests on three pillars that is asset liability management information systems. In this case, proper management information systems are the key to Asset liability management process (Leinonen, 2005). This is actually needed when a lot of information is collected for assessment. The information should e adequate, accurate and expedient. The second pillar is the organization of asset liability management where by there should be a proper structure and assignment of various responsibilities. The top level management and the board should also be deeply involved to help in assessment thus reducing the level of liquidity risks. Finally, the last pillar is the asset management process which involves risk parameters, identification, measurement, management and policies and tolerance levels (Subramanian & Jarrow, 2001). Asset liability management involves banks taking used accrual accounting for all their assets and liabilities. The liabilities such as deposits, annuities are invested to assets such as loans, bonds and real estate. Through the emerging liquidity risk can reduced through this technique hence continual cash flows are experienced. Basel three is a regulatory standard on a bank market liquidity risk, stress testing and capital adequacy that is agreed on by members of the Basel group on banking supervision (Basel Committee on Banking Supervision, 2001). This level of Basel strengthens the requirements of the bank and incorporates regulations on the banks liquidity and leverage, thus a more formal scenario analysis is applied to regulate and control the effects of liquidity in the banks hence strengthening the accountability of loses due to liquidity risk. Challenges Liquidity risk measurement and management poses a major threat incase it is not handled with great caution. The crisis resulting form credits has resulted into liquidity risk management being front and center in the international banking industry. Frequent measurement should be done to curb this risk; however, various challenges are realized by banks as they try to handle this risk (Subramanian & Jarrow, 2001). The challenges result from the following areas. Jutting contractual cash flows for essential transactions while other institutions handle large transactions in the same economy poses a challenge to developing banks. Moving from stop gap solutions to long-term strategic model for management of risks and cascading the new governance structures at all levels is a challenge to the banks. It is hectic to have a clear guidance and requirements when global controllers are lacking proper alignment. This risk involves usage of big resources to establish changes in liquidity risk management. 3. Operational Risk This is a risk incurred due to unsuccessful internal processes, people and systems or from outside events (Chorafas, 2004). This risk seeks to identify why a loss occurred and at the broadest level entails the breakdown by four causes that is, people, external factors, systems and processes. Therefore, operation risk results from the execution of a company’s business activities. Operational risk events can lead to substantial losses especially in the various areas of an organization. These losses are as internal fraud whereby there are intentional misreporting of positions, theft from employees and interior trading on a personal employee’s account (Cruz, 2001). Secondly, there exists external fraud that involves cheque kiting, damage from computer hacking, forgery of documents and robbery. Loses can also incurred from various employment practices and work place safety. Such losses result from compensation of workers, employee violation regarding health and safety rules, organized activities of labor, discrimination claims and losses from general liability. Losses can also be incurred from clients, products and business practices that result from misuse of confidential information of the customer, inappropriate trading activities on the bank’s account, laundering of money, selling of unauthorized products and fiduciary breaches (Chorafas, 2004). Natural calamities are other sources of losses due to operational risks. These kinds of losses include vandalism, terrorism, earthquakes, floods and fires. All these lead to the damage of physical assets of a particular organization. Conversely, losses due to this kind of risk come from business disruption and failure of the key systems in the business. This can involve hardware and software downfall, problems emerging from telecommunications and outages from utilities. Finally, losses resulting from execution, delivery and process management include collateral management failures, incomplete legal documentation, unauthorized access given to client accounts, errors from data entry vendor disputes and non client counterparts mis performance. In consequent to this, inadequate controls can also lead to various losses in banks; this majorly comes from the control breakdowns. Lack of control culture contributes to operational risk as it emerges due to management’s inattention and negligence in control atmosphere, insufficient guidance and ineffective management accountability (Cruz, 2001). Insufficient recognition and assessment of the risk of certain roles whether on or off balance sheet increases the risk level thus more losses are incurred. Inability to determine and assess the risks of emerging products and activities or appraise the assessment when significant changes happen in the business environment makes it more risky for the banks. Recently, it has been noted that control systems that work well for traditional products is unable to handle more complicated products. In addition, losses might also result from absence of the core control activities like duty segregation, operating performance reviews, reconciliations, approvals and verifications (Chorafas, 2004). Loses can also result from inadequate communication of information among management levels within the bank. Eventually, major financial losses can also be experienced form inadequate monitoring programs. Models in operational risks This risk is more difficult to measure as compared to market or credit risks due to lack of available main data, knowledge of what to measure and redundant data. This type of risk is an ill defined that is, inside measurement (Chorafas, 2004). This implies that the risk is mostly linked to measures of internal performance involving methodologies, technologies, processes, people and business terminology and culture. The models applied while measuring the impact of operational risks are basic indicator approach, standardized approach and internal measurement approach. The basic indicator approach assign operational risks capital using one indicator as a proxy for a banks overall operational risk exposure. Gross income is proposed as the indicator where by each bank holds a capital for operational risk equivalent to the amount of a fixed proportion, ?, multiplied by its specific amount of gross income (Cruz, 2001). This model is easy to implement since, it is universally applicable across banks to obtain an operational risk charge. Its simplicity comes in where the price of only limited responsiveness to specific requirements of a firm hence more suitable for small banks with a modest range of business activities. This approach is limited to small banks and thus cannot hence, inapplicable to be applied to larges bank with sophisticated framework. The standardized model shows a further refinement along the evolving spectrum of approaches in measuring operational risk. This method differs with the basic indicator in that banks duties are divided into several standardized units and business lines (Chorafas, 2004). This reflects the differing risk profiles across banks as shown by the extensive business activities. The mentioned business units and lines of this model mirrors those established by a firm initiative to collect internal loss data in continuous manner. Therefore, continuous working with the organization would determine the kind of business activities and line involved in this framework. The internal measurement model shows discretion to individual banks on the use if internal loss of data as the method to estimate the needed capital is uniformly initiated by the supervisors (Gordon-Hart, 2004). When implementing this model, the supervisors would impose quantitative and qualitative standards to determine the integrity of the measurement approach, adequacy of the internal control environment and data quality. This approach give banks incentives to gather internal loss data in a step by step manner hence this model is positioned as a vital step along the evolutionary path that lead banks to the most complicated approaches. Challenges Banks and other financial institutions always face challenges as they try to manage or measure operational risks. These challenges first entails lack of position equivalence where by there is lack of a measurable amount in operational risk which is fundamental difference from market or credit risk (Alexander, 2001). Validation difficulties are also a problem to the banks since it reduces the reliability of the models in predicting outcomes in future. Context dependency and relevance of data loss which is affected by consistent change of organizations and evolution of the surroundings in which they operate thus lowering the relevance of information over time. Consequently, other challenges result from completeness of the portfolio of operational risk exposure therefore making it difficult to determine whether the portfolio of operational risk for a bank is complete. Bibliography Ahmed, A. S., Beatty, A. & Takeda, C., 1997: Evidence on interest rate risk management and derivatives usage by commercial banks’, Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=33922 Ahmed, A. S., Beatty, A. & Bettinghaus, B., 2004:‘Evidence on the efficacy of interest-rate risk disclosures by commercial banks’: International Journal of Accounting, 39 (3), p. 22 251. Alexander, C., 2001: Mastering risk: Volume 2 Applications. FT Prentice Hall Allen, L. ,2004 :Comment on "Evidence on the efficacy of interest rate risk disclosures by commercial banks" by Ahmed, Beatty, and Bettinghaus’, International Journal of Accounting, 39 (3), p. 253-255. Basel Committee on Banking Supervision, 2001: Principles for the Management and Supervision of Interest Rate Risk. Basel, Switzerland. Bierwag, G. O., Kaufman, G. G., Schweitzer, R. & Toevs, A., 1981: The art of risk management in bond portfolios: Journal of Portfolio Management, 7 (3), p. 27-36. Bierwag, G. O. & Roberts, G. S., 1990: Single factor duration models: Canadian tests’, Journal of Financial Research, 13 (1), p. 23-38. Brennan, M. J. & Schwartz, E. S, 1979: A continuous time approach to the pricing of bonds’, Journal of Banking & Finance, 3 (2/3/4), p. 133-155. Berkowitz, J. And J. O.Brien, 2000: The Performance of Large-Scale Portfolio Valuation Models Manuscript, Federal Reserve Board. Cruz, M., 2001: Mathematical models for pricing and hedging operational risks’, in Alexander, C. (2001) Mastering risk: Volume 2 Applications. FT Prentice Hall, p. 187-199. Chorafas, D. N., 2004: Operational risk control with Basel II basic principles and capital requirements. Amsterdam: Elsevier Butterworth-Heinemann. Davidson, S., 2001: How should we be looking at interest rate exposure: Community Banker, 10 (5), p. 42-43. Fooladi, I. J. & Roberts, G. S., 1992: Bond portfolio immunization: Canadian tests’: Journal of Economics & Business, 44 (1), p. 3-17. Fooladi, I. J. & Roberts, G. S., 2000: Risk management with duration analysis: Managerial Finance, 26 (3), p. 18-28. Gordon-Hart, S, 2004: Basel 2: The risk to the global consensus: Balance Sheet, 12 (1), p. 22- 26. Leinonen, H., 2005: Liquidity, risks and speed in payment and settlement systems: a simulation approach. Helsinki: Suomen Pankki. Soto, G. M., 2004: Duration models and IRR management: A question of dimensions?’, Journal of Banking & Finance, 28 (5), p. 1089-1110. Subramanian, A. & Jarrow, R. A., 2001: The liquidity discount’: Mathematical Finance, 11 (4), p. 447-474. Thornton, D. B., 2004: Discussion of "Evidence on the efficacy of interest rate risk disclosures by commercial banks: International Journal of Accounting, 39 (3), p. 257-262. Zask, E., 2000: Global investment risk management: protecting international portfolios against currency, interest rate, equity, and commodity risk. New York: McGraw Hill Read More