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Key Risk Dimensions Giving Rise to Market and Credit Exposure
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Dimension Risk taker Risk factor Country or region Maturity or duration Instrument or instrument type Counterparty
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Example Position, portfolio, trading desk, business unit Equity, interest rate, foreign-exchange currency, and commodity Europe, Americas, Asia Pacific 1 week, 1 month, 3 months . . . 30 years Cash, options, forwards, futures Cr dit Suisse, UBS, Morgan Stanley
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Counterparty trading limits should be in place to limit credit exposure due to market-driven instruments, such as swaps and forwards. The management of credit exposure for market-driven instruments is discussed further in 3. Business risk is not included in the definition of risk used in this book (see 1). Business and market risk are two key sources of risk that can impact a company s ability to achieve earnings or cash-flow targets (see Figure 2-2). The relative magnitude of business risk to market risk varies from company to company and thus reflects the approach and polF I G U R E 2-1
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Key Risk Dimensions Giving Rise to Market and Credit Exposure. (Source: Modified from RiskMetrics Group, Risk Management: A Practical Guide, New York: RiskMetrics Group, 1999, p. 15. Copyright 1999 by RiskMetrics Group, all rights reserved. RiskMetrics is a registered trademark of RiskMetrics Group, Inc., in the United States and in other countries. Reproduced with permission of RiskMetrics Group, LLC.)
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Cr i sk it R ed
Region Market Risk Risk Factor Horizon Instrument
Risk Taker Market Risk Region Risk Factor Duration Instrument
Credit Risk
F I G U R E 2-2
Differentiation Between Market Risk and Business Risk. (Source: Modified from RiskMetrics Group, CorporateMetrics Technical Document, New York: RiskMetrics Group, 1999, p. 5, chart 1. Copyright 1999 by RiskMetrics Group, all rights reserved. CorporateMetrics is a registered trademark of RiskMetrics Group, Inc., in the United States and in other countries. Reproduced with permission of RiskMetrics Group, LLC.)
Equity Foreign exchange Product placement Commodity Reputation Interest rate Sales
Liquidity Data quality Controls People
Transition Concentration Counterparty Default Country
Transactions Systems
icy for managing both types of risks; it also helps set the tone for a company s risk management culture and awareness. When discussing business risk, we are referring to the uncertainty (positive and negative) related to the business decisions that companies make and to the business environment in which companies operate. For example, business risk can arise from investment decisions and strategy, product development choices, marketing approaches, product placement issues, and client behavior uncertainty. Broadly speaking, these are decisions with an inherent long-term horizon and involve structural risks that companies are paid to take in order to generate profits. Companies evaluate and take business risks in areas based on their expertise and, to varying degrees, with significant influence over potential returns. In contrast, market risk refers to the uncertainty of future financial results that arises from market-rate changes. Market risk can impact on a company s business in many different ways. For example, operating margins can be eroded due to the rising prices of raw materials or depreciating currencies in countries in which a company has foreign sales (direct market risk impact). Changes in the market environment may eventually force companies to adjust the prices of their products or services, potentially altering sales volumes or competitiveness, depending on the positioning and market exposures of the company s competitors (the indirect impact of market risk on business results). Some organizations may be paid to take market risks (e.g., financial organizations), but most seek to manage the impact of market risk on financial results (this is especially true of most nonfinancial organizations). Financial organizations have overlapping business and market risks. However, as their raw materials are currencies, interest rates, etc., fi-
Market Risk
nancial organizations have to keep business and market risks separated to realize success from intended business strategies and decisions, and from the risk-return relationship of these decisions.
Investment diversification was a well-established practice long before Markowitz published his paper on portfolio selection in 1952.2 The development of the modern portfolio theory and of option pricing theories had its roots some decades before Markowitz. These mostly quantitative approaches were not the first to provide diversification for their customers, because such approaches were modeled on the investment trusts of Scotland and England, which began in the middle of the nineteenth century, and diversification had occurred even earlier. In The Merchant of Venice, Shakespeare has the merchant Antonio say: My ventures are not in one bottom trusted, Nor to one place; Nor is my whole estate Upon the fortune of this present year; Therefore, my merchandise makes me not sad.3 Prior to Markowitz s 1952 article, there was no adequate quantitative theory of investment established that covered the effects of diversification when risks are correlated, distinguished between efficient and inefficient portfolios, and analyzed risk return trade-offs on the portfolio as a whole. In order to understand the benefits and pitfalls of the theories and models currently used for regulatory and management purposes, it is necessary to understand the development of portfolio theory. In 1935, Hicks discussed the need for an improved theory of money and the desirability of building a theory of money along the same lines as the already existing theory of value.4 Hicks introduced risk into his analysis. Specifically, he noted: The risk-factor comes into our problem in two ways: First, as affecting the expected period of investment, and second, as affecting the expected net yield of investment. 5 Hicks represents the probabilities of risk dispersions by a mean value and by some appropriate measure of dispersion. Hicks was a forerunner of Tobin6 in seeking to explain the demand for money as a consequence of the investor s desire for low risk as well as high return. Beyond that, there is little similarity between the two authors. Hicks, unlike Tobin or the appendix in Hicks7 (1962), did not designate standard deviation or any other specific measure of dispersion as representing risk for the purposes of analysis. Hicks could not demonstrate a formula relating risk on the portfolio to risk on individual assets. Hicks did not distinguish between efficient and inefficient portfolios, lacked a coherent image of an efficient frontier, and gave no hint of any
kind of theorem explaining that all efficient portfolios that include cash have the same allocation of distribution among risky assets. Hicks s article on liquidity (1962) is more precise about the formulation of risk by mentioning the standard deviation as a measure of certainty and the mean.8 The formalization was spelled out in a mathematical appendix to Hicks (1962) titled The Pure Theory of Portfolio Investment and in a footnote on page 796 of the work that presents a -efficient set diagram. The appendix presents a mathematical model that is almost identical to Tobin s, but with no reference to Tobin s work. The difference between the Hicks and Tobin models is that Hicks assumed that all correlations are zero, whereas Tobin permitted any nonsingular covariance matrix. Specifically, Hicks presented the general formula for portfolio variance, written in terms of correlations rather than covariances. Hicks (1962) derived the Tobin conclusion that among portfolios which include cash, there is a linear relationship between portfolio mean and standard deviation, and that the proportions among risky assets remain constant along this linear portion of the efficient frontier. Hicks presented what later was called the Tobin separation theorem. Marschak (1938) was clearer in formulating risk by constructing an ordinal theory of choice under uncertainty.9 He assumed a preference ordering in the space of parameters of probability distributions in the simplest form expressed by the mean and the variance. From this formulation to the analysis of portfolio selection in general is the shortest of steps, but one not fully taken by Marschak,10 though he made tentative moves in this direction, expressing preferences for investments by indifference curves in the mean-variance space. Marschak s 1938 work is a landmark on the road to a theory of markets whose participants act under risk and uncertainty, as later developed in Tobin11 and the CAPMs.12 It is the most significant advance of economic theory regarding risk and uncertainty prior to the publication of von Neumann and Morgenstern in 1944.13 The asset allocation decision had not been adequately addressed by neoclassical economists at the time of Marschak. The methodology of deterministic calculus is adequate for the decision of maximizing a consumer s utility subject to a budget constraint (as part of the neoclassic approach), whereas portfolio selection involves making a decision amidst uncertainty. Under these circumstances, the probabilistic notions of expected return and risk become very important. In 1938, Williams highlighted the importance of diversification.14 He concluded that probabilities should be assigned to possible values of a security and the mean of these values used as the value of that security. He also concluded that by investing in many securities, risk could be virtually eliminated. This presumption, that the law of large numbers applies to a portfolio of securities, cannot be accepted. The returns from securities are too intercorrelated. Diversification cannot eliminate all variance. Williams
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