Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition

2.2 Financial Risk

Financial risk management has experienced a revolution over the last two decades. This has been driven by infamous financial disasters due to the collapse of large financial institutions such as Barings (1995), Long-Term Capital Management (1998), Enron (2001), Worldcom (2002), Parmalat (2003) and Lehman Brothers (2008). Such disasters have proved that huge losses can arise from insufficient management of financial risk and cause negative waves throughout the global financial markets. Financial risk is typically sub-divided into a number of different types that will be described below.

2.2.1 Market Risk

Market risk arises from the (short-term) movement of market prices. It can be a linear risk, arising from an exposure to the movement of underlying variables such as stock prices, interest rates, foreign exchange rates, commodity prices or credit spreads. Alternatively, it may be a non-linear risk arising from the exposure to market volatility as might arise in a hedged position. Market risk has been the most studied financial risk of the past two decades, with quantitative risk management techniques widely applied in its measurement and management. This was catalysed by some serious market risk-related losses in the 1990s (e.g., Barings) and the subsequent amendments to the Basel I capital accord in 1995 that allowed financial institutions to use proprietary mathematical models to compute their capital requirements for market risk. Indeed, market risk has mainly ...