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Risk Management

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Risk Management Terminology

Risk management terminology can be confusing, so here's a rundown of key definitions.

In order to clarify some of the lingo that is thrown around in the world of risk management, WS&T called upon its sources to define some of the terms that are most widely used.

Asset Liability Management: The process of coordinating the management of an entity's assets with the management of its liabilities.

Credit Derivative: A credit derivative is a financial transaction whose payoff depends on whether or not a credit event, such as a bankruptcy, default, upgrade or downgrade, occurs. Another variation is a credit basket, where, for example, if any one of five companies defaults, it's considered a credit event.

Credit Risk: Exposure to loss relating to a change in the credit worthiness of a counterparty which may impact the counterparty's ability to fulfill its obligations under a contractual agreement.Changes in credit worthiness can be due to changes in the counterparty's credit rating or a default.

Credit risk can be divided as:

Settlement risk-which exists during the period from trade
execution to trade settlement. An example would be the
two-day settlement period for a spot foreign exchange
trade. There is a risk that the counterparty may not make
good on its obligations under the transaction.

Pre-settlement risk-risk that a counterparty does not fulfill all its
obligations under a contract, such as an interest rate swap.

Integrated Risk Management: The monitoring of credit, market and liquidity risk simultaneously.

Market Liquidity Risk: The risk that a position cannot be easily unwound or offset at the price quoted in the market due to lack of market depth or market disruption.

Market Risk: The sensitivity of the market value of a portfolio to changes in financial asset prices such as:

-Interest rates,
-Foreign exchange rates,
-Equity prices, and
-Commodity prices.

Monte Carlo Simulation: A simulation process whereby the value of a variable (e.g. equity price) is simulated over a future period of time. The simulation assumes that the variable follows a defined randomly generated process with a given drift and volatility.

Operational Risk: The risk of loss that arises from inadequate systems, controls, human error or other management failure that does not relate to strategic, market or credit activities

Risk Management: Policies and procedures for the management, monitoring and control of risk exposures.

VaR: VaR is a measure of the loss in market value of a position/portfolio, which is expected over a given holding period for a given confidence interval. The underlying premise of VaR is that the historical volatility and correlation's between different types of risk factors can be used to estimate the overall variation in the value of different and numerous cashflows.

*Sources: Richard Houston, Financial Risk Management, Arthur Andersen; Richard Tanenbaum, president of Savvysoft Corp.; and Chuck Jones and Michael Bishop, product managers at BARRA.

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