What is Financial Risk Modelling?

 is the practice of measuring risks in various domains of finance viz. financial markets,
banking, insurance etc. It is the most important part of pricing financial instruments and
also helps in regulation of financial activities like investment banking, and lending.
Financial risks can be classified broadly into the following categories:

 Market Risk - is the change in value of assets due to changes in the underlying
economic factors such as interest rates, foreign exchange rates, macroeconomic
variables, stock prices, and commodity prices. All economic entities that own
assets face market risk.

For example, bills receivable of software exporters that are denominated

in foreign currencies are exposed to exchange rate fluctuations; while value of
bonds/government securities owned by investors depend on prevailing interest
rates. Organizations with huge exposures, either have a dedicated treasury
department, or outsource market risk management to banks. The role of modelling
in measuring market risk is to forecast the changes in the economic factors, and
assess their impact on the asset value. The most popular measure for expressing
market risk is Value-at-Risk, which is ' the maximum loss' from an unfavourable
event, within a given level of confidence, for a given holding period. Various
financial instruments like options, futures, forwards, swaps etc. can be used
effectively to hedge the market risk. Availability of huge data on various markets
has facilitated the development of many sophisticated models.

 Credit Risk - is the change in value of a debt due to changes in the perceived
ability of counterparties to meet their contractual obligations (or credit rating).
Also known as default risk or counterparty risk, credit risk is faced by lending
institutions like banks, investors in debt instruments of corporate houses, and by
parties involved in contractual agreements like forward contracts. There are
independent agencies that assess the credit risk in form of credit ratings. Credit
rating is an opinion (of the credit rating agency) on the ability of the organization
to perform its contractual obligations (pay the principle and/or interest of the loan)
on a timely basis. Each level of rating indicates a probability of default.
International credit rating agencies (like Moody's, Fitch, and S&P) use
quantitative models along with their experience to predict the credit ratings.
Credit scoring models of banks and lending institutions use stock prices (if
available), financial performance and sector specific data, and macroeconomic
forecasts to predict the credit rating. Although credit ratings for retail lending are
not available, credit scoring models for individuals are gaining popularity. Credit
risk can be transferred using credit derivatives, and also by
securitization. An attempt by a consortium of international banks (Basel
Accords) to set regulatory standards for lending institutions has lead to
development of better and robust credit assessment models.
  Operational Risk - is defined as the risk of loss resulting from inadequate or failed
internal processes, people, and systems or from external events. In this sense all
organizations face operational risk. But for a financial institution/bank operational
risk can be defined as the possibility of loss due to mistakes made in carrying
out transactions such as settlement failures, failures to meet regulatory
requirements, and untimely collections. As of today, there is neither a concept nor
a model for measuring operational risk that has gained acceptance by financial
engineers. There have been efforts by international banks, and financial
institutions to indigenously develop models, none of which are available in public
domain. Till date insurance is the only avenue to manage (transfer)
operational risk. Due to absence of sound techniques, not many insurance
companies offer cover for operational risk.

RISK MEASURE

Financial Ratios

 Are primarily used to assess a company's capital structure and current risk level as
evaluated in relation to the company's debt level. The ability of a company to manage its
outstanding debt effectively is critical to the company's financial soundness and operating
ability.
 Some of the financial ratios that are most commonly used by investors and analysts to
assess a company's financial risk level and overall financial health include the debt-to-
capital ratio, the debt-to-equity ratio, the interest coverage ratio and the degree of
combined leverage.

 The debt-to-capital ratio - is a measure of leverage that provides a basic

picture of a company's financial structure in terms of how it is capitalizing
its operations and an indication of its financial soundness. The debt-to-
capital ratio is simply a comparison of a company's total short-term
debt and long-term debt obligations to its total capital provided by
both shareholders' equity and debt financing. Lower debt-to-capital ratios
are generally preferred, as they indicate a higher proportion of equity
financing to debt financing.
Formula:
 The debt-to-equity ratio (D/E) - is a key financial ratio that provides a
more direct comparison of debt financing to equity financing. It is also an
indicator of a company's ability to meet outstanding debt obligations.
Again, a lower ratio value is generally preferred, as this indicates the
company is financing operations more through its own resources than
through taking on debt. Companies with stronger equity positions are
usually better able to weather temporary downturns in revenue or
unexpected needs for additional capital investment. Higher D/E ratios may
negatively impact a company's ability to secure additional financing when
needed.

Formula:

 Interest coverage ratio - is a basic measure of a company's ability to

handle its short-term financing costs. The ratio value reveals the number
of times that a company can make the required annual interest payments
on its outstanding debt with its current earnings before taxes and interest.
A relatively lower coverage ratio indicates a greater debt service burden
on the company and a correspondingly greater risk of default or
financial insolvency.

A lower ratio value means a lesser amount of earnings available to

make financing payments, and it also means the company is less able to
handle any increase in interest rates. Generally, an interest coverage ratio
of 1.5 or lower is considered indicative of potential financial problems
related to debt service. However, an excessively high ratio can indicate the
company is failing to take advantage of its available financial leverage.

Formula:
 How Risk are Managed
 Two (2) broad Risk Management Strategies:

 Risk Decomposition – to identify risk one by one and handle each one
separately.
 Risk Aggregation – to reduce risks by being well diversified.

Risk vs Return for Investors

 There is a trade-off between risk and return when money is invested

 The greater the risk, the higher the return

 Expected return – weighted average of the possible returns, where the weight
applied to a particular return equals the probability of that return occurring.

Table 1.1

Probability Return
0.05 +50%
0.25 +30%
0.40 +10%
0.25 -10%
0.05 -30%

The Efficient Frontier

 is the set of optimal portfolios that offers the highest expected return for a defined level
of risk or the lowest risk for a given level of expected return.
 Portfolios that lie below the efficient frontier are sub-optimal because they do not provide
enough return for the level of risk. Portfolios that cluster to the right of the efficient
frontier are also sub-optimal because they have a higher level of risk for the defined rate
of return.
HOW IT WORKS (EXAMPLE):

 In 1952, Harry Markowitz published a formal portfolio selection model in The Journal of
Finance. He continued to develop and publish research on the subject over the next
twenty years, eventually winning the 1990 Nobel Prize in Economics for his work on the
efficient frontier and other contributions to modern portfolio theory.
 According to Markowitz, for every point on the efficient frontier, there is at least one
portfolio that can be constructed from all available investments that has the expected risk
and return corresponding to that point.
 An example appears below. Note how the efficient frontier allows investors to understand
how a portfolio's expected returns vary with the amount of risk taken.
Arbitrage Pricing Theory

 Is a multi-factor asset pricing model based on the idea that an assets returns can be
predicted using the linear relationship between the asset’s expected return and a number
of macroeconomic variables that capture systematic risk. It is a useful tool for analyzing
portfolios from a value investing perspective, in order to identify securities that may be
temporarily mispriced.
 APT is more flexible than the CAPM, it is more complex. The CAPM only takes into
account one factor market risk, while the APT formula has multiple factors. And it takes
a considerable amount of research to determine how sensitive a security is to various
macroeconomics risk.
 APT factors are the systematic risk that cannot be reduced by the diversification of an
investment portfolio. The macroeconomics factors that have proven most reliable as price
predictors include unexpected changes in inflation, gross national product (GNP),
corporate bond spreads and shifts in the yield curve. Other commonly used factors are
gross domestic product (GDP), commodities prices, market indices and exchange rates.

The Arbitrage Pricing Theory Model

Risk vs. Return for Companies

 Overall Risk of the Companies

 Accept and Reject Decisions
 Systematic and Non-systematic Risk

 The nature of bankruptcy cost once a bankruptcy has been announced customers and
suppliers become less inclined to do business with the company; assets sometimes
have to be sold quickly at prices well below those that would be realized in an orderly
sale; the value of important intangible assets such as the company’s brand name and
its reputation in the market are often destroyed; the company is no longer run in the
best interest of shareholders; large fees are often paid to accountants and lawyers; an
so on.