Risk ManagementMistakestoAvoidChapter 24RiskManagementandFinanciallnstitutions3e,Chapter24,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 24, Copyright © John C. Hull 2012 Chapter 24 Risk Management Mistakes to Avoid 1
Big Losses (Business Snapshot 24.1, page 510)Allied Irish Bank ($700 million)Barings ($1 billion)Enron'sCounterparties($billionsinlawsuits)HammersmithandFulham($600million)Kidder Peabody ($350 million)LTCM ($4 billion)National WestminsterBank ($130 million)Orange County ($2 billion)Procter and Gamble ($90 million)Soc Gen ($7 billion)Subprime Mortgage Losses ($ tens of billions)UBS (2.3 billion)2RiskManagementandFinancialInstitutions3e,Chapter24,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 24, Copyright © John C. Hull 2012 Big Losses (Business Snapshot 24.1, page 510) ⚫ Allied Irish Bank ($700 million) ⚫ Barings ($1 billion) ⚫ Enron’s Counterparties ($ billions in lawsuits) ⚫ Hammersmith and Fulham ($600 million) ⚫ Kidder Peabody ($350 million) ⚫ LTCM ($4 billion) ⚫ National Westminster Bank ($130 million) ⚫ Orange County ($2 billion) ⚫ Procter and Gamble ($90 million) ⚫ Soc Gen ($7 billion) ⚫ Subprime Mortgage Losses ($ tens of billions) ⚫ UBS (2.3 billion) 2
Risk LimitsS (page 509-512)Risk must be quantified and risk limits setExceeding risk limits not acceptable even whenprofits result Do not assume that you can outguess themarketBe diversified Scenario analysis and stress testing is important3RiskManagementandFinancialInstitutions3e,Chapter24,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 24, Copyright © John C. Hull 2012 Risk Limits (page 509-512) ⚫ Risk must be quantified and risk limits set ⚫ Exceeding risk limits not acceptable even when profits result ⚫ Do not assume that you can outguess the market ⚫ Be diversified ⚫ Scenario analysis and stress testing is important 3
ManagingtheTradingRoom(page512-514) Do not give too much independence to startradersSeparate the front middle and back officeDo not blindly trust modelsBe conservative in recognizing inceptionprofitsDo not sell clients inappropriate productsBeware easy profitsRiskManagementandFinancialInstitutions3e,Chapter24,CopyrightJohnC.Hull20124
Risk Management and Financial Institutions 3e, Chapter 24, Copyright © John C. Hull 2012 Managing the Trading Room (page 512-514 ) ⚫ Do not give too much independence to star traders ⚫ Separate the front middle and back office ⚫ Do not blindly trust models ⚫ Be conservative in recognizing inception profits ⚫ Do not sell clients inappropriate products ⚫ Beware easy profits 4
Liquidity Risk (page 514-517)The credit crisis of 2007 has emphasized theimportance of liquidity riskNeed to ensure that liquidity funding needs canbe met in stressed market conditionsBeware when many are following the samestrategyUsing short-term borrowings for long-termfunding can be dangerousMarket transparency is importantRiskManagementandFinancialInstitutions3e,Chapter24,CopyrightJohnC.Hull20125
Risk Management and Financial Institutions 3e, Chapter 24, Copyright © John C. Hull 2012 Liquidity Risk (page 514-517) ⚫ The credit crisis of 2007 has emphasized the importance of liquidity risk ⚫ Need to ensure that liquidity funding needs can be met in stressed market conditions ⚫ Beware when many are following the same strategy ⚫ Using short-term borrowings for long-term funding can be dangerous ⚫ Market transparency is important 5
Lessons for Non-FinancialCorporations (page 517-518)It is important to fully understand theproducts you tradeBeware of hedgers becomingspeculatorsIt can be dangerous to make theTreasurer's department a profit center6RiskManagementandFinancialInstitutions3e,Chapter24,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 24, Copyright © John C. Hull 2012 Lessons for Non-Financial Corporations (page 517-518) ⚫ It is important to fully understand the products you trade ⚫ Beware of hedgers becoming speculators ⚫ It can be dangerous to make the Treasurer’s department a profit center 6
A Final Point (page518-519)Three types of riskKnownUnknownUnknowableFlexibility is importantRiskManagementandFinancialInstitutions3e,Chapter24,CopyrightJohnC.Hull20127
A Final Point (page 518-519) ⚫ Three types of risk ⚫ Known ⚫ Unknown ⚫ Unknowable ⚫ Flexibility is important Risk Management and Financial Institutions 3e, Chapter 24, Copyright © John C. Hull 2012 7