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FINANCIAL RISKS

FINANCIAL AND NON-FINANCIAL RISKS


Financial Risks
All risks derived from events in
the external financial markets.
The possibility of a financial
loss in an investment or
speculation. (www.qfinance.com)
All risks associated with
financial transactions.
Non-Financial Risks all
other forms of risks
TYPES OF FINANCIAL RISKS
Market Risk
Interest Rate Risk
Foreign Exchange Risk
Equity Price Risk
Commodity Price Risk
Reinvestment Risk
Liquidity Risk
Credit/Default Risk
Concentration Risk
Country Concentration
Credit Concentration
Supplier Concentration
Customer Concentration
MARKET RISK
Risk associated with the
movements of prices of goods,
services, commodities, and
investments.
Risk associated with interest
rates, exchange rates, stock
prices, and commodity prices.
Linked to supply and demand
in various marketplaces.
VOLATILITY
A statistical measure of the
dispersion of returns for a
given security or market
index.
The amount of uncertainty
or risk about the size of
changes in a securitys
value.
A higher the volatility means
that a securitys value can
potentially be spread out
over a larger range of values.
CAMELS RATING
Supervisory rating system used by BSP to assess the
banks overall condition.
Capital Adequacy

Asset Quality

Management Capability

Earnings

Liquidity

Sensitivity (to market risk)


RISK AND RETURN TRADE-OFF

Equities
R
I
Bonds
S
K
Money
Market

Time
Deposit

Low Return RETURN High Return


TYPES OF MARKET RISK
Interest Rate Risk
Foreign Exchange Risk

Equity Price Risk

Commodity Price Risk


INTEREST RATE RISK
Risk that the value of a security will decrease as
interest rates increase.
Affects the prices of fixed income securities (bonds)
more than equities (stocks).
Accounts for majority of the risks involved with fixed
income investing.
DURATION
The no. of period to maturity of fixed income
securities (expressed in years).
A measure of the sensitivity of the price of a fixed-
income security to a change in interest rates.
The higher the duration, the bigger the effect of
fluctuations in interest rates to the price of the bond.
HOLD-TO-MATURITY BONDS
Bonds that are held to maturity have less interest rate
risks because:
Holders of the bond are not interested in the fluctuation of
interim prices
Principal amount received on maturity date is not affected
by interest rates
However, opportunity gain/loss arise due to
fluctuations in market rates.
REINVESTMENT RISK
Risk that entity will not be able to get a similar
attractive investment when a previously held fixed
income security is disposed off or has matured.
Incurs in a decreasing interest rate environment
INTEREST RATE VS. REINVESTMENT RISK
Market Rate
Interest Rate
Risk

Reinvestment
Risk
FOREIGN EXCHANGE RISK
Exposure to an unanticipated changes in exchange
rates between currencies.
TYPES OF FOREIGN EXCHANGE EXPOSURE
Translation/Accounting Exposure forex exposure
resulting to change in value of Assets and Liabilities
as reflected in the financial statements (foreign
currency denominated securities).
Transaction/Contractual Exposure forex
exposure as a result of contractual obligations in
another currency (ex. imports, exports).
Operating/Economic Exposure forex exposure
that affects the companys earnings and future cash
flows (ex. offshore revenues paid in foreign currency).
EQUITY PRICE RISK
The risk of loss as a result of volatility in
equity prices.
Measured by the standard deviation of the
price of equities over a certain period.
COMMODITY PRICE RISK
The threat that a change in the price of a production
input will adversely impact a producer who uses that
input. Commodity production inputs include raw
materials like cotton, corn, wheat, oil, sugar, soybeans,
copper, aluminum and steel.
Factors that can affect commodity prices include
political and regulatory changes, seasonal variations,
weather, technology and market conditions.
Commodity price risk is often hedged by major
consumers.
LIQUIDITY RISK
The current and prospective risk to earnings or
capital arising from a financial institutions inability to
meet its obligations when they come due without
incurring unacceptable losses or costs.
Ability of an entity to pay its short-term obligations.
CAUSES OF LIQUIDITY RISKS
No demand for the asset in the market
Volume of asset that needs to be sold

Tedious/long selling process (ex. Real estate)

Too much maturing debt

Not enough working capital


TYPES OF LIQUIDITY RISKS
Funding Liquidity Risk
Inability to meet investment and funding requirements
arising from cash flow mismatches without incurring
unacceptable losses or costs.
Market Liquidity Risk
The risk that an institution cannot easily eliminate or
offset a particular position because of inadequate liquidity
in the market.
CREDIT/DEFAULT RISK
Risk of loss caused by a counterparty or debtors
failure to make a promised payment.
Risk Premium the yield spread on top of a market
benchmark (risk-free rate) to compensate for the
greater amount of risk
Credit Risk Managers Bond PMs and bank loan
officers
FUNDAMENTAL ANALYSIS IN CREDIT RISK
Evaluation of corporate fundamentals
Calculation of credit scores
Concensus Information rely on rating agencies and
credit bureaus
CREDIT RATING AGENCIES
CONCENTRATION RISK
The risk inherent by putting
all eggs in one basket.-
www.respectrisk.com

The risk incurring a greater


loss by clustering assets or
resources instead of
diversifying them.
CORRELATION
The statistical measure of the strength of the
relationship between two variables.
Positively Correlated two variables move in the
same direction (if one increases, the other also
increases.
Negative Correlated two variables move at the
opposite direction (if one increases, the other
decreases).
CORRELATION

Asset A

x
Asset B

y
TYPES OF CONCENTRATION RISK
Country Concentration
Credit Concentration

Supplier Concentration

Customer Concentration
COUNTRY CONCENTRATION
Concentration risk associated with having a
significant exposure in a single or few countries.
CREDIT CONCENTRATION
The potential of a significant
loss that threatens a lenders
core operations associated a
large exposure to a single or
few borrowers.
Single Borrowers Limit
(SBL) restriction set by the
BSP which limits a bank from
granting loans to a single
entity to a maximum amount
of 25% of its capital.
SUPPLIER CONCENTRATION
Risk associated with having a single or few suppliers.
Results to a high bargaining power of suppliers.
CUSTOMER CONCENTRATION
Risk associated with having a highly concentrated
customer base.
Results to a high bargaining power of customers.
CASE LIAM MCNULTY
Liam McNulty is the risk manager for a large multinational
agricultural concern, Agripure. The company grows its own
corn, wheat, and soybeans but pays large sums of third
parties for pesticides, fertilizer, and other supplies. For this,
it must borrow heavily to finance its purchases. Customers
typically purchase Agripures goods on credit. Moreover,
Agripure buys and sells its products and raw materials
worldwide, often transacting in the domestic currency of its
customers and suppliers. Finally, to finance its own
expansion, Agripure intends to issue stock.

Recommend and justify the risk exposures that McNulty


should report as part of an enterprise risk management
system for Agripure.