FRM AIM: Within credit risk (a) Describe and differentiate between exposure and recovery rate (b)describe credit event and how it may relate to market risk (c)describe sovereign risk and its sources (d) describe settlement risk and its sources
Exposure vs Recovery Rate:
| Properties |
Exposure |
Recovery Rate |
| Definition |
Size or value of loss that would happen when credit event occurred |
Recovery of partial losses through sale of assets after loss has occurred |
| Value |
This will include full value of losses |
Fraction of the losses |
Credit Event:
- Changes in the counterparty ability to fulfill financial obligations that was previously agreed upon
- Credit Event can occur because of market or credit risk
- Sovereign risk that occur because of country specific actions can lead to credit event
- Ratings agencies like Moody’s, Standard & Poor have ratings that issues guidelines on companies performance and position to meet the financial obligations from time to time
Settlement Risk:
- Risk of full losses because of settlement risk
- Pre settlement risk can mitigate the effects of the settlement risk because of payment before delivery
- Operational risk occurs because of poor management decisions, poor management control, rogue traders, wrong model usage in analyzing risk
- Because of losses arising out of operational risk credit ratings of the firm may be hit that causes credit risk
- Because of the credit risk for the firm its value of the securities in the market will decrease resulting in market risk
Model Risk:
- Arises because of application of wrong models in assessing risk
- Ex: Prices used in assessing risk in a model may be wrong which might lead to an indication of lower risk for a particular security where the actual risk of security performance is quite low
People Risk:
- Risk because of rogue traders who may have falsified reports about the financial status of the company during audit
- Risk because of powerful people in the company using their position to sufficiently expose the firm by buying underperforming derivatives
Legal Risk:
- Loss in value of the firm caused by fighting lawsuits, penalties/damage claims etc
- Ex: Samsung payment of more than 1 billion dollar for infringing the patent held by apple
- Drug companies settlement to patients because of the drug introduced by these companies causing side effects to the patients
FRM AIM Relate Significant market events of the past several decades to the growth of risk management industry:
Following are the basic definitions for a few terms that we will encounter in the FRM chapters:
Volatility:
Uncertainty in the change in the value of a security
Measured in terms of standard deviation or variance (square of standard deviation)
Sensitivity:
Degree of reaction to a change in event in terms of the price of a security
Measured in terms of the probability of occurrence of an event provided certain events that happen at that time
Deregulation:
Less government regulation (intervention) or policing on certain industries
Aimed at creating competition in a industry
Increases fair play among the major competitors and investment climate in the industry concerned
Example: Deregulation in banks have led to reaction in interest rates
Globalization:
Doing business outside of current borders
Prone to currency exchange risk
Example: Outsourcing/Off shoring of jobs to China and India
