Value at Risk
As Walter Wriston, former chairman of Citigroup, said “All of life is the management of risk, not its elimination” and nowadays modern banking is about controlling risk and returns. The ability of a financial institution to control risk is a key factor that determines its success or its failure in markets. As the late financial crisis has demonstrated institutions that were not properly prepared to face the crisis, failed and they were either bailed out by governments or serve economists as bad example. This is the reason risk management is an important field of every financial institution.
-Risk and types of Financial Risk
As Philippe Jorion (2007) mentions a definition for risk can be the volatility of unanticipated outcomes and can be created by natural disasters, such as the recent earthquake in Japan that is reported to cause a drop of 3% of the oil price in the first few days after it, or it can created by human activities such as technological innovation which might create unemployment. Phillip Best (1998) argues that risk matters only when it causes financial losses and financial risk is the one linked with financial assets and portfolios and is classified in broader categories; market risk, credit risk, liquidity risk and operational risk. There is evidence that these types of risk can affect one another. Market risk is the one linked with the movements of the price level of market. Credit risk is generated when parties involved in an economic contract are either incapable or reluctant to satisfy their commitments. Jorion (2007) classifies liquidity risk into two forms; asset liquidity risk and funding liquidity risk. Jorion (2007, p. 23):
Asset liquidity risk…arises when a transaction cannot be conducted at prevailing market prices owing to the size of the position relative to normal trading lots…varies across categories off assets and across time as a function of prevailing market conditions…Funding risk refers to inability to meet payments obligations which may force early liquidation, thus transforming “paper” losses into realized losses.
Finally operational risk can be created from various factors such as “control failure”, referring to a failure to control market exposures, “liquidity risk”, created by lack of funds, “money transfer risk”, loss due to unsuccessful settlement, “model risk”, when a financial instrument is not properly valued. Due to the fact that operational risk is affected by lots of factors is also hard to measure it. (Best, 1998, p. 2-4)
The creation of financial markets helped in the field of protection against risk through derivatives, but it didn’t solve the problem. Controlling risk after the recent financial crisis is as important as ever, and everyone in the field is trying to improve the necessary means to do it. Regulators announced measures against excessive risk taking in an attempt to avoid another financial crisis and risk managers are trying to improve their...