Have you ever watched the British movie Rogue Trader? It tells the true story of Nick Leeson, an employee of Barings Bank whose speculative trading resulted in wiping out of the bank that existed for 200 years. Lesson that came at a cost was, “It is important to define unambiguous risk limits for traders and then monitor carefully that the limits are being adhered to”.
A slight mistake but a blunder by a new employee forced a financial institution to do something it had never done before. A regular client traded cattle futures contracts daily, squaring off his position at the end of the day. This new employee, instead of selling at the end of the day went long in 1 cattle futures contract resulting in two long positions. By the time this mistake was realized market was closed and the financial institution had to send the employee for the physical delivery of cattle! Moral of the story is that proper risk management practices need to implemented.
These are just a couple of examples among the many in the financial industry. Whether one likes it or not, risk is inherent in the financial industry. Risk can be referred as the chances of having an unexpected or negative outcome. Any action or activity that leads to loss of any type can be termed as risk. There are different types of risks that a firm might face and needs to overcome. Widely, risks can be classified into three types: Business Risk, Non-Business Risk and Financial Risk. In this post we will discuss about financial risk.
Financial Risk as the term suggests is the risk that involves financial loss to firms. Financial risk generally arises due to instability and losses in the financial market caused by movements in stock prices, currencies, interest rates and more.
Financial risk is one of the high-priority risk types for every business. Financial risk is caused due to market movements that include host of factors. Based on this, financial risk can be classified into various types such as Market Risk, Credit Risk, Liquidity Risk, Operational Risk and Legal Risk.
This type of risk arises due to movement in prices of financial instrument. Market risk is caused due to movement in stock price, interest rates, inflation, currency and properties.
This type of risk arises when one fails to fulfill their obligations towards their counter parties.
This type of risk arises out of inability to execute transactions.
This type of risk arises out of operational failures such as mismanagement or technical failures.
This type of financial risk arises out of legal constraints such as lawsuits. Whenever a company needs to face financial loses out of legal proceedings, it is legal risk.
Of all the types mentioned above market risk is the darling of portfolio managers.
Since risk cannot be eliminated but can only be managed, managing it or “hedging the risk” is the crucial component. Since market risk is dependent on factors like stock prices and interest rates, mitigating it are a blend of art and science.
Managing financial risk also known as hedging is done using derivative products. The most commonly used derivatives for hedging are options, futures, swaps and swaptions. It should be remembered that hedging is done to protect from downward risks and not for speculative purposes. Following example illustrates how derivatives are used for hedging.
A pension fund is considering investment in a security “ABC” one year from now. ABC is currently rallying at $105 and the pension fund is not willing to pay more than $120 after a year. The pension fund could buy a call option on the security ABC with a strike price of $120. If the price after an year is above $120 the pension fund could exercise call option and buy the security at $120. If the price of ABC is less than or equal to $120 then the call option expires worthless and the pension fund can buy ABC from the exchange.
As a measure of risk, Value at risk aka VaR is the most commonly used metric. It provides consolidated view which incorporates the portfolio’s exposure to risk sensitivities. VaR calculates an expected loss amount that may not be exceeded at a specified confidence interval over a given holding period, assuming normal market conditions. The higher the portfolio’s VaR, the greater its expected loss and exposure to market risks.
Let us consider a broader and generic case study – that of gold mining companies. These companies have a big exposure to the price of gold. Since it takes years to extract gold from the mine, it is natural for gold mining companies to consider hedging. Some gold mining companies do not hedge because they would like to benefit from increase in the gold price and are willing to take any loss that might incur from not hedging. Other companies choose to hedge. They estimate the number of ounces they will produce each month for the next few years and enter into short futures or forward contracts to lock in the price that will be received.
Hedging is a way of reducing risk. It is a double edged sword. At one end the downward risk is taken care of but on the other end profits are also capped. Arguments both in the favor as well as against risk management have sound voices but it should be remembered that the objective of risk management is to reduce the downward risk and with this comes a caveat that the upside potential is limited.