Downs in Risk Management

[kik92]

Hi,

One of the "downs" of risk management is the following:

It's proving difficult to make truly unified measurements of different kinds of risk and to understand the destructive power of risk interactions (e.g credit and liquidity risk).

Could someone kindly explain "the destructive power of risk interactions (e.g credit and liquidity risk)" in more detail?

Thanks!

 

[David Harper CFA FRM]

This is a key theme in modern risk (and the FRM) in part because the typology of risk types (ie, the list of risk factors) has expanded. The modern exercise is "analytical:" risk categories and risk factors are identified; then measured and/or mapped; then aggregated. The more risk factors that a firm identifies, by definition, the more possible "interactions" between risk factors exist. For example, if you are short an interest rate swap (ie, receive floating), your market risk is lower interest rates (value drops) but your credit exposure to the counterparty occurs as rates increase. Are the market and credit risk independent? Maybe and maybe not. If interest rates rise (i.e., MtM gain for you) and, related to this, the default probability increases for your counterparty, you have wrong-way risk which is the classic example of "destructive interaction." The quick mathy answer is correlation, but if these factors interact, it is unlikely they relate via linear correlation; especially in a worse case, scenario, their dependence (as a non-linear generalization of correlation) might increase. Dowd's answer is copulas, but it's very difficult to quantify these dependencies in the tail.

Here is Jorion from the FRM Handbook:
"27.1.2 Risk Interactions: Risk categories do not always fit into neat, separate silos. Operational risk can create market and credit risk, and vice versa. For instance, collateral payments in swaps decrease credit risk by marking to market on a regular basis but create a greater need for cash flow management, which increases operational and liquidity risk. The reverse can also occur as an operational failure; for example, incorrect confirmation of a trade can lead to inappropriate hedging or greater market risk. Incorrect data entry of swap terms can create incorrect market risk measurement as well as incorrect credit exposures. Another important example is the interaction between market risk and credit risk. Wrong-way trades are those where market risk amplifies credit risk. Consider, for example, a swap between a bank and a speculator. If the bank loses money on the swap, credit risk is not an issue, because the bank has no credit exposure. If the bank makes a large profit on the swap, however, this must be at the expense of the speculator. If the loss to the other party is sufficiently large, the speculator could default precisely because of the swap. Therefore, such trades are inherently more dangerous than those where the counterparty is a hedger. In the case of a hedger, the loss on the swap should be offset by a gain on the hedged position. As a result, hedging trades are safer for the bank. Thus, complex interactions can arise across risk types." -- Jorion, Philippe; GARP (Global Association of Risk Professionals) (2010-12-28). Financial Risk Manager Handbook: FRM Part I / Part II (Wiley Finance) (Kindle Locations 17378-17389). Wiley. Kindle Edition.

 

[kik92]

Thanks a lot David