Chapter 24

The Management of Risk

Chapter 8 introduced the concepts of market risk, credit risk and operational risk. This chapter examines market risk and credit risk in more detail, examines the role of a centralised risk management function and provides a brief introduction to credit control and Value-at-Risk (VaR). VaR is one of the analytical techniques that are used by investment professionals to measure and control such risks.

24.1 FORMS OF MARKET RISK

Currency risk is the risk caused by movements in exchange rates. It is often subdivided into transaction risk; the risk that exchange rate movements affect the values of individual transactions; and translation risk, the risk that foreign currency assets held on the balance sheet decline due to exchange rate movements. Accounting procedures designed to avoid translation risk were examined in section 14.3.7.

Interest rate risk is the risk to a portfolio caused by fluctuating interest rates. All investors and borrowers are affected by changes to the levels of interest rates, but some parties run positions that are affected by changes in the shape of the yield curve (refer to section 3.4.1). For example, a firm that has borrowed money for short-term periods and invested it in long dated bonds would be adversely affected if the yield curve rapidly inverted.

Equity risk is the general market risk of rises or falls of individual share prices or stock market levels in general.

Volatility risk is the risk in the value of options ...

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