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Financial Risk Management Best Practice

Best Practice

Internationally renowned finance leaders, experts and educators distil and summarize the most important aspects of finance best practice. Each Best Practice essay has an Executive Summary for quick reference, outlining the main points. The Making It Happen feature illustrates practical applications, and where relevant authors have provided illustrative case studies and definitions.

  • A Holistic Approach to Business Risk Management
    by Terry Carroll
    After arguably the greatest credit crisis in history, it is unsurprising that lenders, borrowers, and investors alike have become preoccupied with financial risk. Its magnitude seems to have dwarfed all other business risk considerations. It can be hard to take a pragmatic view when the strictures in the financial markets may have put the corporation at risk, but the correct perspective is for all risk to be captured in a holistic...
  • A Total Balance Sheet Approach to Financial Risk
    by Terry Carroll
    We are living in some of the most volatile times in the history of the global financial markets. One of the reasons is exactly because they have become truly global. As banks seek to restore profitability, they may increase their offering of “treasury products” to customers. This article argues that these should be considered only in the context of a total balance sheet approach rather than transaction by transaction.
  • A Value-At-Risk Framework for Longevity Trend Risk
    by Stephen J. Richards
    “Whereas a catastrophe can occur in an instant, longevity risk takes decades to unfold.” The Economist (2012)Longevity risk is different from many others faced by insurers and pension schemes because the risk lies in the long-term trend taken by mortality rates. However, although longevity is typically a long-term risk, it is often necessary to pose questions over a short-term horizon, such as a year.Two useful questions in risk management and...
  • Climate Change and Alternative Risk Financing: Adapting Current Methods for Assessing and Transferring Weather Risks
    Climate experts use scientific principles to correlate the Earth’s thermal balance with known historical atmospheric conditions (e.g. greenhouse gas (GHG) concentrations) and then use statistical principles to extrapolate climate change processes. From this basis they are able to simulate and project specific reproductions of the observed features of historical climate change into the future using ‘four-dimensional’ modeling software run on...
  • Correcting the Financial Crisis Failures of Asset-Liability Management (ALM) Risk Management
    by Jerome L. Kreuser
    Asset–liability management (ALM) is a term whose meaning has evolved. Its use began in banks and insurance companies and has now extended to most financial institutions and corporations. The term risk management has also evolved. When we use the term “ALM risk management,” we do so in the spirit of Zenios and Ziemba (2007).1 We use the term ALM for managing institutional strategic objectives over a period measured in months and years. A suitable...
  • Dangers of Corporate Derivative Transactions
    by David Shimko
    It’s easy for managers to overlook risks. Financial risk managers may ignore nonfinancial risks. Business managers responsible for a particular line item (such as costs) may downplay risks unrelated to their particular line item. Firms often manage their risks compartmentally—for example: the treasury department for foreign exchange and interest rates; the procurement department for commodity purchases; and the insurance department for...
  • ERM for Emerging Risks in General Insurance
    by George C. Orros
    This article focuses on the practical application of enterprise risk management (ERM) principles for general insurance undertakings in our world of “unknown unknowns” and the emergence of unexpected risks over time. Consideration is given to how the chief risk officer (CRO) can focus within an ERM risk and opportunity management framework, balancing risks against opportunities, while being resilient in the face of “unknown unknowns” and their...
  • Expected Shortfall—VaR Without VaR’s Drawbacks
    by Carlo Acerbi
    In the mid-1990s, value at risk (VaR) marked a true revolution in the practice of financial risk management. Fostered by the 1996 Amendment to the Basle Capital Accord, and standardized thanks to the diffusion of risk metrics methods, it soon became (and probably still is) the benchmark risk measure in finance. Why it was so successful is easy to understand. VaR conveys immediate information about a portfolio’s riskiness, showing the potential...
  • Factoring Problem Loan Assumptions into Asset–Liability Management (ALM) Modeling
    by Gary Deutsch
    An essential part of the interest rate risk (IRR) management process is the analysis and documentation of IRR assumptions. Since all methods used to analyze the rate sensitivity of financial instruments require estimates of the amount and timing of their cash flows, the embedded prepayment options found in many types of loans must also be estimated. These estimates must include the level and speed of prepayments for an expected rate environment....
  • Financial Impact of Longevity Risk
    by S. Erik Oppers
    Longevity risk is the risk that actual life spans of individuals or of whole populations will exceed expectations. People have been living longer lives for at least a century now, and this has obvious benefits. But governments, private companies, and individuals all potentially face financial risks if people on average live longer than expected. In particular, defined-benefit pension plans, insurance companies that offer life annuities, and...
  • Formulating a Contingency Funding Plan to Manage Liquidity Risks
    by Gary Deutsch
    Managing the funding activities of a financial institution has become quite challenging as the global economy continues to develop economic linkages that can lead to unexpected volatility and systemic problems. The European Union, the United States, Asia, and other world economies have become connected through trade and currencies, and changing cultures and demographics such that it is no longer possible to focus solely on local or regional...
  • How Should Insurers Optimally Manage Market Risk?
    by Patrick O. J. Kelliher
    Market risk is a key risk for most life insurers, many of whom need to manage guarantees on volatile portfolios of assets. For general insurers, the importance of market risk varies depending on the tail of the business, but investment income is a key driver of profitability and market risk encompasses variations in this income. The author’s experience is of the life insurance market in the United Kingdom, where there is a bias in coverage...
  • Integrated Corporate Financial Risk Policy
    by David Shimko
    Risk can be described as the threat of an adverse outcome. Many firms take the benchmark strategy of doing nothing (i.e., investing in Treasury Bills), and measure their risk in absolute terms relative to the strategy of doing nothing. Others measure their risk-taking behavior relative to what might be considered risky benchmarks. Mutual funds, for example, do not focus on the absolute risk of their portfolios; rather, they determine how far...
  • Introduction to Islamic Financial Risk Management Products
    by Qudeer Latif, Susi Crawford
    To consider the basics of Islamic financial risk management products it is helpful to summarize the Islamic principles and jurisprudence on which Islamic finance is based.Speculation: contracts which involve speculation (maysir) are not permissible (haram) and are considered void. Islamic law does not prohibit general commercial speculation, but it does prohibit speculation which is akin to gambling, i.e. gaining something by chance rather than...
  • Investment Risk in Islamic Finance
    by Kamal Abdelkarim Hassan, Hassan Ahmed Yusuf
    At the inception of Islamic finance, Islamic economists advocated change and developed a policy for Islamic banking practice and process, arguing that the main aspect of conventional banking—riba (interest)—required immediate rectification if Islamic banking was to exist. To achieve this goal, profit and loss sharing methods were introduced, along with other products such as ijarah (lease) and murabahah (cost plus). The rest of the technical...
  • Longevity and Annuities—The challenge of giving a secure pension
    by Dominic Grimley
    Life expectancy has improved substantially; we know this because the UK has a relatively strong record of storing and analysing data on deaths. The annuity providers have models to consider how life expectancy varies by age, sex and wealth; and how benefit size and postcode can indicate the likely wealth of people. Where health and lifestyle information is available, the calculation can be refined much further to take into account the likely...
  • Managing Counterparty Credit Risk
    by David Shimko
    Counterparty risk is the risk to each party of a contract that the counterparty will not live up to its contractual obligations; it is otherwise known as default risk.Counterparty risk relates closely to performance risk. It arises whenever one entity depends on another to honor the terms of a contract. If a parts supplier fails to provide steering wheels to General Motors, GM will be damaged because of its inability to deliver complete cars....
  • Managing Interest Rate Risk
    by Will Spinney
    Almost all firms are exposed to interest rate risk, but it can manifest itself in different ways. A proper response to this risk can only come following a full understanding of the context of the firm and its strategy, along with a full evaluation of the risk. Firms should generate a well thought out key performance indicator (KPI) and then apply one or more of the many tools available in the market to transfer interest rate risk.
  • Managing Liquidity Risk in a Financial Institution: The Dangers of Short-Term Liabilities
    by David Shimko
    The assets and liabilities of a firm can be segregated into their short-term and long-term components. Short-term assets include cash, cash equivalents, marketable securities, and marketable inventories—i.e., any asset that can be converted in a short period of time to cash. Long-term assets include assets that cannot easily be converted to cash, such as plant and equipment, reputation, good will, and the present value of future growth...
  • Modeling Market Risk
    by Marius Bochniak
    Every financial institution with a portfolio exposed to market risk should have a model in place which is designed to measure that risk. Such a model allows one to control and to limit the market risk taken by each desk or by the traders and to charge each portfolio position a cost of capital required to cover its market risk. Success in meeting these objectives serves the interests of the stakeholders in the firm.The measures of market risk...
  • Obstacles to the Further Development of the Longevity Swaps Market for Pension Funds
    by Martin Bird, Tim Gordon
    The combined liabilities of occupational pension plans in the United Kingdom are around £1 trillion. These liabilities are predominantly defined-benefit, consisting of immediate and deferred annuities, and therefore the majority of the benefit payments depend on the longevity of the beneficiaries. Given that these pension plans are materially exposed to longevity risk—i.e. the risk that their beneficiaries may live longer than expected—and the...
  • Optimal Long-Term Property and Casualty ALM with Risk Capital Control
    by Giorgio Consigli, Massimo di Tria
    Increasing competition and record property and casualty (P&C) insurance claims reported by global players in recent years (Comité Européen des Assurances, 2010) have generated remarkable pressure on the financial stability of P&C divisions within insurance firms, leading to increased technical reserves and higher capital requirements. At the same time investment management divisions have expanded, reinforcing the role of insurers as...
  • Own Risk and Solvency Assessment (ORSA): Strategy, People, and Complexity
    by Neil Cantle
    Modern risk management is hard. The difficulty arises primarily because modern business is complex. When we look at the strategy our business is trying to deliver we see a forest of multiple factors—which depend on other factors, which in turn interact with others. It really is hard to “see the wood for the trees” and make sense of it all. This chapter explains how to make sense of modern risk and the role that people play within it, and it...
  • Quantifying Corporate Financial Risk
    by David Shimko
    Consider the case of a company that has experienced six months of cash flows this year and wants to forecast the next six months. The usual way to do this is to predict a cash flow growth rate—expected, high, and low—and to base the analysis on these choices. A sample cash flow projection might be illustrated graphically in Figure 1.Figure 1. Deterministic cash flow forecast for last six months In reality, of course, several different cash flow...
  • Risk Management of Islamic Finance Instruments
    by Andreas Jobst
    Since only interest-free forms of finance are considered permissible in Islamic finance, financial relationships between financiers and borrowers are not governed by capital-based investment gains but by shared business risk (and returns) in lawful activities (halal). Any financial transaction under Islamic law implies direct participation in performance of the asset, which constitutes entrepreneurial investment that conveys clearly identifiable...
  • Should Governments Step In and Start Issuing Longevity Bonds?
    by David Blake, Tom Boardman, Andrew Cairns
    Insurance companies and defined-benefit plans face the risk that retirees might live longer than expected. This risk might adversely affect both the willingness and ability of financial institutions to supply retired households with financial products to manage their wealth decumulation (the conversion of a person’s accumulated pension assets into pension income). Longevity bonds are instruments that would allow financial institutions to hedge...
  • Small and Medium-Sized Enterprises and Risk in the Gulf Cooperation Council Countries: Managing Risk and Boosting Profit
    by Omar Fisher
    Small and medium-sized businesses (SMEs) across the Gulf Cooperation Council (GCC) region, many of which are family-owned enterprises, bear the same risks as Fortune 1000 companies. A common definition of a SME is a business with fewer than 250 employees and revenues below US$68 million (Dhs 250 million), whereas the real difference lies in scale and complexity. We have found in working with many types of business that most business owners in...
  • Spectral Measures of Risk—Where Risk Theory and Risk Practice Overlap
    by Carlo Acerbi
    In 1997, a groundbreaking paper (5) appeared with the explicit objective of establishing the properties that a portfolio risk measure should satisfy to comply with fundamental principles of financial risk. The authors listed four such axioms and coined the phrase “coherent measures of risk” (CMRs) to denote those measures that satisfy them. They observed that there are an infinite number of CMRs, actually a whole class, and they described this...
  • Stress-Testing in Asset and Liability Management: A Coherent Approach
    by Alex Canavezes, Mario Schlener
    In light of recent extreme events, such as the collapse of Lehman Brothers in 2008, both the financial services industry and its regulators have keenly felt the need to complement traditional percentile-based risk management tools (such as value-at-risk (VaR) or economic capital) with stress tests and scenario analyses.Following the logic of Dermine (2003), asset and liability management (ALM) can be interpreted as the main management tool for...
  • To Hedge or Not to Hedge
    by Steve Robinson
    Business has become increasingly international, and companies cannot ignore the impact of currency changes on cash flows, profitability, and their asset and liability position. No company is wholly immune—the cash received from exporting is affected by the relationship between the currency used by the customer to pay and the currency in which the cost of providing the product or service is denominated.Many commodity prices have been volatile,...
  • Tools for Measuring Interest Rate Risk
    by Steven V. Mann
    One can understand risk intuitively as the chance of an unpleasant surprise. Financial institutions must be able to manage their exposure to risk. To accomplish this task, they must be able to identify the risks to which they are exposed and measure that exposure. Numerous types of risk put a financial institution in harm’s way. One major exposure is to interest rate risk. Interest rate risk has two dimensions—level risk and curve risk. Level...
  • Understanding and Applying Funds Transfer Pricing
    by Hovik Tumasyan
    In its simplest form funds transfer pricing (FTP) is the process whereby the treasury of a bank (its funding center) aggregates funds centrally and then redistributes them throughout the business units, balancing funding resource excesses and shortages and thus creating an internal market for liquidity. If there is still a deficit for funds, the treasury raises more funds from the capital markets, and if there is an excess of funds, treasury...

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