Financial risk management

[6] In all cases, the last "line of defence" against risk is capital, "as it ensures that a firm can continue as a going concern even if substantial and unexpected losses are incurred".

[5][14][15] The discussion essentially weighs the value of risk management in a market versus the cost of bankruptcy in that market: per the Modigliani and Miller framework, hedging is irrelevant since diversified shareholders are assumed to not care about firm-specific risks, whereas, on the other hand hedging is seen to create value in that it reduces the probability of financial distress.

A broad distinction[12] exists though, between financial institutions and non-financial firms - and correspondingly, the application of risk management will differ.

For non-financial firms, the priorities are reversed, as "the focus is on the risks associated with the business" - ie the production and marketing of the services and products in which expertise is held - and their impact on revenue, costs and cash flow, "while market and credit risks are usually of secondary importance as they are a byproduct of the main business agenda".

For (ii) on value at risk, or "VaR", an estimate of how much the investment or area in question might lose with a given probability in a set time period, with the bank holding "economic"- or “risk capital” correspondingly; common parameters are 99% and 95% worst-case losses - i.e. 1% and 5% - and one day and two week (10 day) horizons.

[36] These tests, essentially a simulation of the balance sheet for a given scenario, are typically linked to the macroeconomics, and provide an indicator of how sensitive the bank is to changes in economic conditions, whether it is sufficiently capitalized, and of its ability to respond to market events.

The second set of changes, sometimes called "Basel IV", entails the modification of several regulatory capital standards (CRR III is the EU implementation).

To operationalize the above, Investment banks, particularly, employ dedicated "Risk Groups", i.e. Middle Office teams monitoring the firm's risk-exposure to, and the profitability and structure of, its various business units, products, asset classes, desks, and / or geographies.

[37] By increasing order of aggregation: Periodically,[49] these all are estimated under a given stress scenario — regulatory and,[50] often, internal — and risk capital,[22] together with these limits if indicated,[22][51] is correspondingly revisited (or optimized[52]).

More generally, these tests provide estimates for scenarios beyond the VaR thresholds, thus “preparing for anything that might happen, rather than worrying about precise likelihoods".

[55] A key practice,[56] incorporating and assimilating the above, is to assess the Risk-adjusted return on capital, RAROC, of each area (or product).

Here,[57] "economic profit" is divided by allocated-capital; and this result is then compared[57][23] to the target-return for the area — usually, at least the equity holders' expected returns on the bank stock[57] — and identified under-performance can then be addressed.

In the Front Office - since counterparty and funding-risks span assets, products, and desks - specialized XVA-desks are tasked with centrally monitoring and managing overall CVA and XVA exposure and capital, typically with oversight from the appropriate Group.

Performing the above tasks — while simultaneously ensuring that computations are consistent [62] over the various areas, products, teams, and measures — requires that banks maintain a significant investment [63] in sophisticated infrastructure, finance / risk software, and dedicated staff.

Large institutions may prefer systems developed entirely "in house" - notably [64] Goldman Sachs ("SecDB"), JP Morgan ("Athena"), Jane Street, Barclays ("BARX"), BofA ("Quartz") - while, more commonly, the pricing library will be developed internally, especially as this allows for currency re new products or market features.

The forex risk-management discussed here and above, is additional to the per transaction "forward cover" that importers and exporters purchase from their bank (alongside other trade finance mechanisms).

Chance-constrained portfolio selection similarly seeks to ensure that the probability of final wealth falling below a given "safety level" is acceptable.

Ahead of an anticipated movement in any of these factors, the Manager may then, as indicated, reduce holdings, hedge, or purchase offsetting exposure.

Inflation for example, although impacting all securities,[113] can be managed [114][115] at the portfolio level by appropriately [116] increasing exposure to inflation-sensitive stocks (e.g. consumer staples), and / or by investing in tangible assets, commodities and inflation-linked bonds; the latter may also provide a direct hedge.

Here, they will use attribution analysis preemptively so as to diagnose the source early, and to take corrective action: realigning, often factor-wise, on the basis of this "feedback".

Widely used platforms are provided by BlackRock (Aladdin), Refinitiv (Eikon), Finastra, Murex, Numerix, MPI and Morningstar.