A Workout in Computational Finance

17 Risk Management

In order to manage risk, it is important to be aware of the different kinds of risks an institution may face. The list of particular risks will evolve over time as the institution’s environment and internal processes change. In this chapter, we focus solely on the market risk and how it can be measured. For an introduction to financial enterprise risk management, we refer the reader to Sweeting (2011). Market risk is present for all institutions that have an exposure to or interact with capital markets. Underlying risk factors such as interest rates, foreign exchange rates, credit spread and credit score have direct influence on both the asset (bonds, equities, . . . ) and the liability side. Interest rate risk arises when unanticipated developments shift the yield curve or change its shape. Foreign exchange risk arises when cashflows of a financial institution are in different currencies. Credit spread risk arises due to changes in the credit spread, affecting the value of assets. The term credit risk itself often refers to default risk. For credit institutes with a large number of loans to individuals and small businesses, the credit risk is often the largest risk. Counter-party risk is also a form of credit risk, and refers to the fact that the counterparty of a financial transaction may not be able to deliver the payment. With the appearance of credit linked derivatives such as CDOs, n^th to default bonds and swaps, credit risk and its accurate modeling ...