Department of Management Sciences, National University of Modern

Languages

Assignment
Submitted by:
Shahraz Mushadi
Roll NO: 31466
Subject: FRM
Submitted to: Sir Nadeem
Class: MBA (3.5)4th Evening
Date: 15-05-2020
Content
Elaborate the following terms:
⮚ Market Risk Measurement Management

⮚ Credit Risk measurement and Management

⮚ Operational risk

⮚ Liquidity and Treasury Risk measurement and Management

⮚ Risk management and Investment management

 Market Risk Measurement Management
Market Risk
Market risk is the risk of losses in positions arising from movements in market
prices. There is no unique classification as each classification may refer to different
aspects of market risk.
Market Risk Management
Market risk encompasses the risk of financial loss resulting from movements in
market prices. Market risk is rated based upon, but not limited to, an assessment
of the following evaluation factors:
The sensitivity of the financial institution's earnings or the economic value of its
capital to adverse changes in interest rates, foreign exchanges rates, commodity
prices, or equity prices.
The ability of management to identify, measure, monitor, and control exposure to
market risk given the institution's size, complexity, and risk profile.
The nature and complexity of interest rate risk exposure arising from non-trading
positions.
Where appropriate, the nature and complexity of market risk exposure arising
from trading and foreign operations.
This topic also provides specific guidance on interest-rate risk, which is the
exposure of a bank's current and future earnings and capital arising from adverse
movements in interest rates, and the market risk capital rule, which establishes
regulatory capital requirements for bank holding companies and state member
banks with significant exposure to certain market risks.
Measurement of Market Risk
Market risk measures can be broadly classified as nominal measures and factor-
sensitivity measures.
Nominal Measures
Nominal or notional measurements are the most basic methodologies used in
market-risk management. They represent risk positions based on the nominal
amount of transactions and holdings. Typical nominal measurement methods may
summarize net risk positions or gross risk positions. Nominal measurements may
also be used in conjunction with other risk-measurement methodologies. For
example, an institution may use nominal measurements to control market risks
arising from foreign-exchange trading while using duration measurements to
control interest rate risks.
For certain institutions with limited, noncomplex risk profiles, nominal measures
and controls based on them may be sufficient to adequately control risk. In
addition, the ease of computation in a nominal measurement system may provide
more timely results. However, nominal measures have several limitations.
Often, the nominal size of an exposure is an inaccurate measure of risk since it
does not reflect price sensitivity or price volatility. This is especially the case with
derivative instruments. Also, for sophisticated institutions, nominal measures
often do not allow an accurate aggregation of risks across instruments and
trading desks.

Factor-Sensitivity Measures
Basic factor-sensitivity measures offer a somewhat higher level of measurement
sophistication than nominal measures. As the name implies, these measures
gauge the sensitivity of the value of an instrument or portfolio to changes in a
primary risk factor. For example, the price value of a basis point change in yield
and the concept of duration are often used as factor-sensitivity measures in
assessing the interest-rate risk of fixed-income instruments and portfolios. Beta,
or the measure of the systematic risk of equities, is often considered a first-order
sensitivity measure of the change in an equity-related instrument or portfolio to
changes in broad equity indexes.
Duration provides a useful illustration of a factor-sensitivity measure. Duration
measures the sensitivity of the present value or price of a financial instrument
with respect to a change in interest rates. By calculating the weighted average
duration of the instruments held in a portfolio, the price sensitivity of different
instruments can be aggregated using a single basis that converts nominal
positions into an overall price sensitivity for that portfolio. These portfolio
durations can then be used as the primary measure of interest-rate risk exposure.
Alternatively, institutions can express the basic price sensitivities of their holdings
in terms of one representative instrument. Continuing the example using duration,
an institution may convert its positions into the duration equivalents of one
reference instrument such as a four-year U.S. Treasury, three-month Eurodollar,
or some other common financial instrument. For example, all interest-rate risk
exposures might be converted into a dollar amount of a ‘‘two-year’’ U.S. Treasury
security. The institution can then aggregate the instruments and evaluate the risk
as if the instruments were a single position in the common base.
While basic factor-sensitivity measures can provide useful insights, they do have
certain limitations—especially in measuring the exposure of complex instruments
and portfolios. For example, they do not assess an instrument’s convexity or
volatility and can be difficult to understand outside of the context of market
events. Examiners should ensure that factor sensitivity measures are used
appropriately and, where necessary, supported with more sophisticated measures
of market-risk exposure.

Credit Risk measurement and Management

Credit Risk
A credit risk is the risk of default on a debt that may arise from a borrower failing
to make required payments. In the first resort, the risk is that of the lender and
includes lost principal and interest, disruption to cash flows, and increased
collection costs. The loss may be complete or partial.
Credit Risk Management
Credit risk refers to the probability of loss due to a borrower’s failure to make
payments on any type of debt. Credit risk management is the practice of
mitigating losses by understanding the adequacy of a bank’s capital and loan loss
reserves at any given time – a process that has long been a challenge for financial
institutions.
The global financial crisis – and the credit crunch that followed – put credit risk
management into the regulatory spotlight. As a result, regulators began to
demand more transparency. They wanted to know that a bank has thorough
knowledge of customers and their associated credit risk. And new Basel III
regulations will create an even bigger regulatory burden for banks.

To comply with the more stringent regulatory requirements and absorb the higher
capital costs for credit risk, many banks are overhauling their approaches to credit
risk. But banks who view this as strictly a compliance exercise are being short-
sighted. Better credit risk management also presents an opportunity to greatly
improve overall performance and secure a competitive advantage.
Challenges to Successful Credit Risk Management
 Inefficient data management. An inability to access the right data when it’s
needed causes problematic delays.
 No group wide risk modeling framework. Without it, banks can’t generate
complex, meaningful risk measures and get a big picture of group wide risk.
 Constant rework. Analysts can’t change model parameters easily, which
results in too much duplication of effort and negatively affects a bank’s
efficiency ratio.
 Insufficient risk tools. Without a robust risk solution, banks can’t identify
portfolio concentrations or re-grade portfolios often enough to effectively
manage risk.
 Cumbersome reporting. Manual, spreadsheet-based reporting processes
overburden analysts and IT.

Best Practices in Credit Risk Management

The first step in effective credit risk management is to gain a complete

understanding of a bank’s overall credit risk by viewing risk at the individual,
customer and portfolio levels.
While banks strive for an integrated understanding of their risk profiles, much
information is often scattered among business units. Without a thorough risk
assessment, banks have no way of knowing if capital reserves accurately reflect
risks or if loan loss reserves adequately cover potential short-term credit losses.
Vulnerable banks are targets for close scrutiny by regulators and investors, as well
as debilitating losses.
The key to reducing loan losses – and ensuring that capital reserves appropriately
reflect the risk profile – is to implement an integrated, quantitative credit risk
solution. This solution should get banks up and running quickly with simple
portfolio measures. It should also accommodate a path to more sophisticated
credit risk management measures as needs evolve. The solution should include:

 Better model management that spans the entire modeling life cycle.
 Real-time scoring and limits monitoring.
 Robust stress-testing capabilities.
 Data visualization capabilities and business intelligence tools that get
important information into the hands of those who need it, when they need it.
 Operational risk
Operational risk is "the risk of a change in value caused by the fact that actual
losses, incurred for inadequate or failed internal processes, people and
systems, or from external events, differ from the expected losses".

Operational risk focuses on how things are accomplished within an

organization and not necessarily what is produced or inherent within an
industry. These risks are often associated with active decisions relating to how
the organization functions and what it prioritizes. While the risks are not
guaranteed to result in failure, lower production, or higher overall costs, they
are seen as higher or lower depending on various internal management
decisions.

Because it reflects man-made procedures and thinking processes, operational

risk can be summarized as a human risk; it is the risk of business operations
failing due to human error. It changes from industry to industry and is an
important consideration to make when looking at potential investment
decisions. Industries with lower human interaction are likely to have lower
operational risk.

Examples of Operational Risk

One area that may involve operational risk is the maintenance of necessary
systems and equipment. If two maintenance activities are required, but it is
determined that only one can be afforded at the time, making the choice to
perform one over the other alters the operational risk depending on which
system is left in disrepair. If a system fails, the negative impact is associated
directly with the operational risk.
Other areas that qualify as operational risk tend to involve the personal
element within the organization. If a sales-oriented business chooses to
maintain a subpar sales staff, due to its lower salary costs or any other factor,
this behavior is considered an operational risk. The same can be said for failing
to properly maintain a staff to avoid certain risks. In a manufacturing
company, for example, choosing not to have a qualified mechanic on staff, and
having to rely on third parties for that work, can be classified as an operational
risk. Not only does this impact the smooth functioning of a system, but it also
involves additional time delays.

The willing participation of employees in fraudulent activity may also be seen

as operational risk. In this case, the risk involves the possibility of repercussions
if the activity is uncovered. Since individuals make an active decision to commit
fraud, it is considered a risk relating to how the business operates.

Liquidity and Treasury Risk measurement and Management

Liquidity Risk measurement and management

Liquidity Risk
Liquidity risk is a financial risk that for a certain period of time a given financial
asset, security or commodity cannot be traded quickly enough in the market
without impacting the market price.

Liquidity Risk Management

Liquidity is a financial institution’s capacity to meet its cash and collateral

obligations without incurring unacceptable losses. Adequate liquidity is
dependent upon the institution’s ability to efficiently meet both expected and
unexpected cash flows and collateral needs without adversely affecting either
daily operations or the financial condition of the institution. Liquidity risk is the
risk to an institution’s financial condition or safety and soundness arising from
its inability (whether real or perceived) to meet its contractual obligations.

The primary role of liquidity-risk management is to

(1) Prospectively assess the need for funds to meet obligations and
 (2) Ensure the availability of cash or collateral to fulfill those needs at the
appropriate time by coordinating the various sources of funds available to the
institution under normal and stressed conditions.

Liquidity Risk Measurement

These following are the measurements of liquidity risk

Liquidity gap
Culp defines the liquidity gap as the net liquid assets of a firm. The excess value of
the firm's liquid assets over its volatile liabilities. A company with a negative
liquidity gap should focus on their cash balances and possible unexpected changes
in their values.
As a static measure of liquidity risk it gives no indication of how the gap would
change with an increase in the firm's marginal funding cost.

Elasticity
Culp denotes the change of net of assets over funded liabilities that occurs when
the liquidity premium on the bank's marginal funding cost rises by a small
amount as the liquidity risk elasticity. For banks this would be measured as a
spread over labor, for nonfinancial the LRE would be measured as a spread over
commercial paper rates.
Problems with the use of liquidity risk elasticity are that it assumes parallel
changes in funding spread across all maturities and that it is only accurate for
small changes in funding spreads.
Bid-offer spread
The bid-offer spread is used by market participants as an asset liquidity measure.
To compare different products, the ratio of the spread to the product's bid price
can be used. The smaller the ratio the more liquid the asset is.
This spread is composed of operational, administrative, and processing costs as
well as the compensation required for the possibility of trading with a more
informed trader.
Market depth
Hachmeister refers to market depth as the amount of an asset that can be
bought and sold at various bid-ask spreads. Slippage is related to the concept of
market depth. Knight and Satchell mention a flow trader needs to consider the
effect of executing a large order on the market and to adjust the bid-ask spread
accordingly. They calculate the liquidity cost as the difference of the execution
price and the initial execution price.
Immediacy
Immediacy refers to the time needed to successfully trade a certain amount of an
asset at a prescribed cost.
Resilience
Hachmeister identifies the fourth dimension of liquidity as the speed with which
prices return to former levels after a large transaction. Unlike the other measures,
resilience can only be determined over a period of time, i.e., resilience is the
capacity to recover.

Treasury Risk measurement and Management

Treasury Risk
Treasury Risk is the risk associated with the management of an enterprise's
holdings – ranging from money market instruments through to equities trading.
Treasury Risk Management and measurement
Treasury management (or treasury operations) includes management of an
enterprise's holdings, with the ultimate goal of managing the firm's liquidity and
mitigating its operational, financial and reputational risk. Treasury Management
includes a firm's collections, disbursements, concentration, investment and
funding activities. In larger firms, it may also include trading in bonds, currencies,
financial derivatives and the associated financial risk management.
Most banks have whole departments devoted to treasury management and
supporting their clients' needs in this area. Smaller banks are increasingly
launching and/or expanding their treasury management functions and offerings,
because of the market opportunity afforded by the recent economic environment
(with banks of all sizes focusing on the clients they serve best), availability of
highly seasoned treasury management professionals, access to industry standard,
third-party technology providers' products and services tiered according to the
needs of smaller clients, and investment in education and other best practices. A
number of independent treasury management systems (TMS) are available,
allowing enterprises to conduct treasury management internally.

Risk management and Investment management

Risk Management
Risk management is the identification, evaluation, and prioritization of risks
(defined in ISO 31000 as the effect of uncertainty on objectives) followed by
coordinated and economical application of resources to minimize, monitor,
and control the probability or impact of unfortunate events or to maximize the
realization of opportunities.

Risks can come from various sources including uncertainty in financial markets,
threats from project failures (at any phase in design, development, production,
or sustaining of life-cycles), legal liabilities, credit risk, accidents, natural
causes and disasters, deliberate attack from an adversary, or events of
uncertain or unpredictable root-cause. There are two types of events i.e.
negative events can be classified as risks while positive events are classified as
opportunities. Risk management standards have been developed by various
institutions, including the Project Management Institute, the National Institute
of Standards and Technology, actuarial societies, and ISO standards. Methods,
definitions and goals vary widely according to whether the risk management
method is in the context of project management, security, engineering,
industrial processes, financial portfolios, actuarial assessments, or public
health and safety.

Strategies to manage threats (uncertainties with negative consequences)

typically include avoiding the threat, reducing the negative effect or probability
of the threat, transferring all or part of the threat to another party, and even
retaining some or all of the potential or actual consequences of a particular
threat. The opposite of these strategies can be used to respond to
opportunities (uncertain future states with benefits).

Certain risk management standards have been criticized for having no

measurable improvement on risk, whereas the confidence in estimates and
decisions seems to increase.

For example, one study found that one in six IT projects were "black swans"
with gigantic overruns (cost overruns averaged 200%, and schedule overruns
70%).

Investment Management

Investment management refers to the handling of financial assets and other

investments—not only buying and selling them. Management includes devising
a short- or long-term strategy for acquiring and disposing of portfolio holdings.
It can also include banking, budgeting, and tax services and duties, as well.

The term most often refers to managing the holdings within an investment
portfolio, and the trading of them to achieve a specific investment objective.
Investment management is also known as money management, portfolio
management, or wealth management.
Professional investment management aims to meet particular investment
goals for the benefit of clients whose money they have the responsibility of
overseeing. These clients may be individual investors or institutional investors
such as pension funds, retirement plans, governments, educational institutions,
and insurance companies.

Investment management services include asset allocation, financial statement

analysis, stock selection, monitoring of existing investments, and portfolio
strategy and implementation. Investment management may also include
financial planning and advising services, not only overseeing a client's portfolio
but coordinating it with other assets and life goals. Professional managers deal
with a variety of different securities and financial assets, including bonds,
equities, commodities, and real estate. The manager may also manage real
assets such as precious metals, commodities, and artwork. Managers can help
align investment to match retirement and estate planning as well as asset
distribution.