Risk basics

Main role of the financial markets

To channel funds from those who have surplus funds to those who need funds for investment in tangible assets To distribute the risk arising from investment in tangible assets to those who are willing to accept it

Risk is inherent in the financial markets

What is risk?
Uncertainty
about a future event where the outcome is important to us

May be presented as:

The uncertainty The probability of the negative outcome The cost of the negative outcome
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Risk management - ISO 31000

Risk = Effect of uncertainty on objectives Risk management = Identification, assessment, and prioritisation of risks Coordinated and efficient application of resources to minimise, monitor, control the probability and/or impact of negative events So managing risk means: Understanding how risk arises Measuring the risk Monitoring the risk Deciding how much risk we can accept Acting to control the risk
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Acceptability of risk
Risks are more acceptable if they can be measured and controlled, and if there is a prospect of reward
Measuring a risk means we can price it Controlling a risk means we can adjust it to match our risk tolerance

What types of risk arise in the securities markets?

Investment risks
Credit risk, interest rate risk, exchange rate risk etc
Inherent in making investments Risk of loss but also possibility of reward Risk vs reward trade-off

Allow efficient risk transfer

Operational risks
Error, fraud, disaster etc Minimise through best practice at individual firms

Structural risks
Risks that arise out of imperfection in market structure
Trading, Pre-settlement, Settlement, Regulatory risk

Minimize these for benefit of whole market

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INVESTMENT RISKS: Investing in bonds

200 100

-100

-200 Purchase Year 1 Year 2 Year 3 Year 4 Year 5

Investment risk = the risk that the present value of the investment will fall Present value of bond = sum of expected future cash flows, discounted by required rate of return
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INVESTMENT RISKS: Investing in bonds

200 100

-100

-200

Credit risk Issuer may not meet its obligations on a bond as they fall due Exchange rate risk Future cash flows may lose value due to currency movements Interest rate risk Future cash flows may become less attractive due to higher market interest rates
Purchase Year 1 Year 2 Year 3 Year 4 Year 5

Credit risk on government bonds?

Generally regarded as risk-free when issued:
in local currency in the local market Government can print money to cover debt obligations May not be able to repay foreign currency debt Local currency convertibility (and rate) may be a risk for foreign investors

So sovereign credit rating in the international markets may be less than AAA
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Credit risk on governmentguaranteed bonds?

Depends on the terms of the guarantee
Explicit, full, irrevocable and unconditional?

How long will repayment take? Will there be legal costs / uncertainty?

Normally trade at a small risk premium over government bonds

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Credit risk on corporate bonds

Rank above equities in event of bankruptcy May rank below other bond issues (subordination)
Liquidator, government tax, wages etc Senior bonds Subordinated bonds Equity

Risk management tools:

External credit rating / internal credit assessment Bond guarantee from 3rd party Diversification Credit derivatives
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Exchange rate risk

200 100

-100

-200 Purchase Year 1 Year 2 Year 3 Year 4 Year 5

For investor: Risk that currency of bond will lose value against target currency For issuer: Risk that currency of bond will gain value against target currency Risk of holding an instrument depends on the investors / issuers objectives
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Exchange rate risk: example

Currency mismatch was one of the main causes of the 1997-98 Asian financial crisis Issuers issued bonds denominated in USD to finance domestic projects
Future liabilities in USD Assets in local currency

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Interest rate risk

200 100

-100

-200 Purchase Year 1 Year 2 Year 3 Year 4 Year 5

Value of bond varies inversely with market interest rates

If market rates rise, present value of the bond falls If market rates fall, present value of the bond rises
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Measuring interest rate sensitivity: Duration

Measures sensitivity of price to market interest rates
= % reduction in price / % increase in rates = weighted average years to maturity of the cash flows

Reflects maturity date, coupon, cash flows For zero coupon bonds, duration = tenor
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Duration calculation is only valid for small changes in rates

Sensitivity is not constant, varies as rates change Rate of change of sensitivity is called convexity
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Measuring interest rate sensitivity: Convexity

Measures sensitivity of duration to interest rates Inverse relationship between convexity and sensitivity (high convexity = less sensitive)
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Duration & convexity only measure sensitivity, not risk

Price sensitivity to interest rate movements is measured by duration and convexity But how likely are the rate movements?
Can we estimate based on history or on fundamental economic assumptions? Implied volatility can be derived from option pricing if the market is efficient But this is circular, assumes the market is making correct assumptions

So measuring duration and convexity is not the same as measuring risk

Shows only the link between rates and price
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Is a short duration less risky?

Shorter duration by itself does not necessarily reduce risk for the investor
If rates increase, price will fall less than on longer duration bond If rates decrease, earnings on reinvestment will be lower

Longer duration by itself does not necessarily reduce risk for the issuer
If rates increase, refinancing costs for the issuer will be lower than for a shorter duration bond If rates decrease, opportunity to refinance at lower rate will be lost

Need to view risk in the context of the objectives of the market participant
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Interest rate risk - summary

For the investor who is long:
The risk that rates will increase Lower market price / opportunity cost

For the investor who is short:

The risk that rates will decrease Higher market price

For the borrower who needs to refinance:

The risk that rates will increase Higher refinancing cost

For the borrower who has long term finance:

The risk that rates will decrease Opportunity cost / higher cost of early redemption
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Liquidity risk
Asset liquidity risk (for investors)
Risk of not being able to sell an asset when funds are needed

Liability liquidity risk (for issuers)

Risk of not being able to refinance when a bond matures

Components of liquidity
Tightness Depth Resiliency
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Bid-ask spreads for government bonds (December 2009)

30

25

20

15

10

0
Korea Malaysia Singapore Thailand Hong Kong China Philippines Vietnam Indonesia

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Survey: What is most important now in risk management?

Value at risk and other portfolio measurement tools Liquidity 28.90% 34.20%

Counterparty risk

21.10%

Leverage

7.90%

Currency risk

5.30%

Operational / transaction risk

2.60%

Source: AsianInvestor Magazine November 2010 Survey of Asian Top 200 Institutional Investors

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Risk factors in the Vietnam market

Structural risks
Risks that arise out of imperfection in market structure
A cost to the market Cannot easily be managed Tend to inhibit trading Aim should be to minimise these risks

In Vietnam, appears to be a number of such risks which could be relatively easily eliminated or reduced
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Some trading risks in Vietnam

Ex-coupon date for T-bonds not standard
VSD announce on website for each bond International practice: standard ex date period (e.g. Singapore 3 bus days, Australia 7 cal days, UK 10 bus days)

Confusion re status of VDB bonds

Which ones are government bonds, which are guaranteed and terms of guarantee Investors may rely on bond code which may be misleading
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Trading risks in Vietnam (2)

Free movement of bonds (if needed for sale)
Takes 3-4 days to transfer a bond from SBV account to banks account at VSD Collateral substitution not possible

Trade confirmations in OTC market

No standard template Hard copy needed International practice: standard form, electronic confirmations, confirm by end of T
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Pre-settlement risk
Risk that between trade date and settlement date, counterparty will become unable to settle
Need to sell - risk that price falls after trade date Need to buy - risk that price rises after trade date More likely to be adverse than favourable! Risk is increased where prices are volatile Risk is increased in illiquid markets Risk reduced by shorter settlement period Has been a major factor in driving markets towards shorter settlement periods

Also known as replacement risk

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Pre-settlement risk in Vietnam Bond settlement period

Strictly T+1
Can only be input for T+1, but most trades are for longer, 2-5 days+ because of paperwork Parties must wait for S-1 before input of trades legal grey area, major risk, and affects stats

International standard: T+1 but with flexibility to agree longer period

International investors prefer T+2 / T+3 due to time zone and custodian operations
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Pre-settlement risk in Vietnam Trade repudiation

Comments from market participants:
Parties may repudiate trades if the market moves sharply against them No requirement for phone recording This risk increases as result of the strict T+1 rule

International practice
Code of conduct Recording of all telephone trades
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Settlement risk
Risk of delivering (bonds, cash) and not receiving (cash, bonds) in settlement process
Reduced by use of DVP at central depository Simultaneous movement of cash against securities Increased by time delay between delivering and receiving, high-value settlements, manual procedures at depository Reduced by use of Central Counterparty (CCP)

Also known as principal risk or Herstatt risk

Defaulted on USD: DEM trades in 1974 Ceased operations after banks had paid DEM, before they had received USD
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Settlement risk in Vietnam (1)

Cash settlement process
Provided by a commercial bank (BIDV) Not clear whether there is a binding obligation to extend overdrafts to VSD participants in case of funds shortfall

International practice
Central bank provides final cash settlement Commercial banks may act as agents for participants Obligations of all parties are clearly defined

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Settlement risk in Vietnam (2)

Finality of settlement
When is settlement final and irrevocable? Can settlement result be reversed by the courts at a later date?

International practice
Finality of settlement written into law
E.g. US, UK, EU, HK, Singapore

Driven by need for certainty in FX settlements

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Regulatory risk
Can be major factor in cross-border investment decisions
Thailand (2006) Vietnam not seen as a particular problem

Things to avoid
Sudden and frequent changes in regulations Short notice to market, short time to prepare Lack of clarity / inconsistency

Importance of market consultations

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