Pitfalls in Managing Financial Risk
One of the biggest issues in managing financial risk is the proliferation and ever-deepening complexity of models. However, uncorking the model genies can lead to a lot of information that is beyond the comprehension of mere mortals—and the vast majority of businessmen and women. There are often so many moving parts that it takes a large team of people—generally with Ph.D’s—to manage the model. Costly.It often becomes challenging to explain the outputs, why the movements develop and occur in that manner. It is easy for management to lose confidence in the models. At that point, models cease to serve their primary purpose, which is helping to support the mitigation and monitoring of risk.
Conversely, many companies think they can avoid investment in models entirely by relying on credit rating agencies and other simple outside assessments of risk. This often leads to poor assumptions about the real behavior of risk. Be relentless about identifying and examining the behavior of specific financial instruments. Pay heed to the maxim, “If it looks too good to be true, it probably is.” Your suspicions should increase if you see a situation where the risk is purported to be low, but returns are very high. Ensure that your calculations and models are based on reasonable assumptions, and that they are designed to reflect how the cash flows behave.
Red Flags
Beware of “low-risk, high-return” financial instruments. If something sounds too good to be true, it probably is. Certain asset-backed securities, which provide cash flows based on other cash flows from credit or lending assets, are a good example. Before the subprime crisis, many of these were rated AAA (highest quality; very low probability of loss). However, they provided returns of up to 20 percent—way too high for AAA-rated instruments, which generally return less than 5 percent. The underlying assets were not well analyzed, and there were very low-quality assets buried within the overall asset groups. When economic conditions turned, these low-quality assets defaulted. This drove the value of the securities—and those 20 percent returns—down to nearly nothing.
You can’t avoid all risks, and even if you could it wouldn’t be a good idea, because you would never grow your business or make money. For the same reasons, you can’t mitigate all risks. And even if you could completely mitigate all risks, the cost of tackling each in totality would be prohibitive. With financial risk mitigation, for example, you would need to pay for the hedging instruments, as well as the people required to trade and monitor them. It might cost the organization as much—and maybe a lot more—to do the mitigation as it does to ride the risk.
The Least You Need to Know
◆ Financial risk affects every business.
◆ Specialized models are used for each type of financial risk. Understand which ones are appropriate for your business.
◆ Reserves are held for expected losses. Buffers are used to offset unexpected losses, which are the true risk.
◆ Resist the temptation to overmitigate financial risks. Doing so can be costly and may not be effective.
..................Content has been hidden....................
You can't read the all page of ebook, please click here login for view all page.