Dear community members,
Some days ago I was discussing with a friend about the concept of Risk, about its nature.
In a classic view, common on most of the Financial Institutions, Market Risk and Default Risk are different entities with some common characteristics. From that perspective they have traditionally been managed separately.
In my humble opinion, with the globalization of the Financial System and the increasing complexity of the traded Financial Instruments a wider approach covering Market and Default Risk in a systemic view is necessary.
Let’s look at a very simple example; as a Financial Institution giving a Mortgage Loan, typically we can require a Real Estate collateral for Default Risk Mitigation purposes.
Unfortunately as the recent Real Estate bubble has taught us, the default risk related to the Loan has not been mitigated but, at least partially, transferred to the Market Risk representing the value of the collateral. So basically, what we see is that Default and Market Risk are deeply related.
Another example could be the evaluation of the market risk of an issued Bond backed by a pool of debts in a securitization process; the market risk associated to that bond is deeply related to the default risk of the debts backing the bond.
Also, if we look to the derivatives market, by buying an exchange rate swap, we could try to mitigate the market (exchange rate) risk of a specific investment by paying a premium. But in fact, we’re not fully making the market risk disappear, as part of it, maybe tiny, has been transferred to the default risk of the counterpart. The influence of the OTC derivatives on the last Financial Crisis could be an interesting example.
If Market and Default Risk are so intimately related, that in many cases we can observe transfers from one to the other, as different manifestations of the same reality, a complete view should look at them together with a systemic approach.
Looking forward to read your thoughts.
Kindest Regards.
Ferran.
Some days ago I was discussing with a friend about the concept of Risk, about its nature.
In a classic view, common on most of the Financial Institutions, Market Risk and Default Risk are different entities with some common characteristics. From that perspective they have traditionally been managed separately.
In my humble opinion, with the globalization of the Financial System and the increasing complexity of the traded Financial Instruments a wider approach covering Market and Default Risk in a systemic view is necessary.
Let’s look at a very simple example; as a Financial Institution giving a Mortgage Loan, typically we can require a Real Estate collateral for Default Risk Mitigation purposes.
Unfortunately as the recent Real Estate bubble has taught us, the default risk related to the Loan has not been mitigated but, at least partially, transferred to the Market Risk representing the value of the collateral. So basically, what we see is that Default and Market Risk are deeply related.
Another example could be the evaluation of the market risk of an issued Bond backed by a pool of debts in a securitization process; the market risk associated to that bond is deeply related to the default risk of the debts backing the bond.
Also, if we look to the derivatives market, by buying an exchange rate swap, we could try to mitigate the market (exchange rate) risk of a specific investment by paying a premium. But in fact, we’re not fully making the market risk disappear, as part of it, maybe tiny, has been transferred to the default risk of the counterpart. The influence of the OTC derivatives on the last Financial Crisis could be an interesting example.
If Market and Default Risk are so intimately related, that in many cases we can observe transfers from one to the other, as different manifestations of the same reality, a complete view should look at them together with a systemic approach.
Looking forward to read your thoughts.
Kindest Regards.
Ferran.
1 comment:
Absolutely true. Risks them selves come market risk , settlement tosk , performance risk , liquidity risk and the list goes on. With hedging only a particular kind of risk can be eliminated. But how can we evaluate the effects of these multiple risks which are interlinked to each other ?
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