Financial risk management

1. Framework
A. Identification of the risk

Financial Risk
There are three kinds of financial risk: market risk, liquidity risk and credit risk.
Market Risk
Price Risk
The risk of a decline in the value of a security or a portfolio.

Interest Rate Risk
The risk that the value of an investment will change due to a change in the absolute level of interest rates.

Example
Dexia had a great interest rate risk. They had a lot of mortgage loans (long term). They financed the long term liabilities with short term assets. This increased the interest rate risk. According to the yield curve, short term loans have lower interest rates. You can solve the problem of interest rate risk by using an interest rate swap. The market value of loan declines  Margin you need to pay as collateral  Liquidity risk increases. Dexia made an enormeous fault. To solve the problem of a little financial risk, they used an instrument that added more additional risk than the initial risk. This is an example of poor financial risk management.
Currency Rate Risk
The risk that the value of a security declines due to a change in the currency rate.

Transactional CRR
Economic CRR: your major clients are situated in an area with another currency
Accounting CRR: translation problem

Example

CR
US
Belgium
Consolidated
2012
1$ = 1€
100$
100€
200€
2013
1$ = 0,5€
100$
100€
150€
Liquidity rate risk
The risk of running out of liquidity. This is the most dangerous. It is a second degree financial risk. Second degree because it is caused by a financial instrument.
Credit risk
The risk that your client cannot pay back a loan. It is a second degree financial risk.
Non-financial Risk
This is an operational risk. It has to do with bad government. You can have internal & external government.
B. Measurement of the risk ( PWP Some Traditional Risk Measures)
The Greeks
When you are dealing with derivatives, you have to use an arbitrage-free pricing model. Sensitivy