10:33 am - Wednesday June 28, 2017

Trends in Risk and Margin

Any activity is associated with risk – a loss or gain. Financial risk management is not about avoiding risk. Rather, it is about understanding and communicating risk, so that risk can be taken more confidently and in a better way. (David Koenig, The Professional Risk Manager Handbook)

A financial risk is a chance that an investment’s actual return will be different than original expected. Or all of the original investment. A fundamental connect in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this is that investors need to be compensated to taking on additional risk.

Financial institutions provide important benefits through their various functions: borrowing and lending, price determination, information aggregation and coordination, liquidity and efficiency Due to these multifarious functions, financial institutions encounter many risks in their operations and they can be categorized as – Credit Risk, Country Risk, Operational Risk, Off balance sheet Risk, Liquidity Risk, Technology Risk, Interest Rate Risk, Market Risk, Exchange Risk and Sovereign Risk. (COOL TIMES?).

In addition, one may be exposed to wrong way risk too. ISDA (International Swaps and Derivatives Association) defines this risk as that occurs when exposure to counterparty is adversely correlated with the credit quality of that counterparty. In short, it arises when default risk and credit exposures increase together.

Of course all these risks (alone or together) create yet another risk – reputation risk.

Margin requirements are an effective tool in managing financial risks. In short, a margin is collateral that the holder of financial exposure has to deposit to cover some or all of the risk.

Margining is particularly critical when (a) products are inherently leveraged, are significantly volatile, have long duration, or may be difficult to close out; (b) positions held are of a significant size; (c) the exposures generated by participants are significant compared to their underlying financial strength; or (d) other risk controls do not adequately limit credit exposures.

There are various types of margin – initial margin, variation margin, portfolio margin, cross margin.

Reliable, timely price information from continuous, transparent, and liquid markets is critical for margin models and methodologies to operate accurately and effectively.

For some markets, such as OTC markets, prices may not be available or reliable because of the lack of a continuous liquid market. In contrast to an exchange-traded market, there may not be a steady stream of live transactions on which to determine current market prices. Although independent third party sources may be preferable, in some cases, participants themselves may be a sufficient source of price data. However, one may need to implement a system that ensures that prices submitted by participants are reliable and accurately reflect the value of exposures.

In margin management, one should appropriately address the issue of procyclicality adequately. Procyclicality typically refers to changes in risk-management practices that are positively correlated with business or credit cycle fluctuations and that may cause or exacerbate financial instability. It is also essential to analyze and monitor margin model performance and overall margin coverage by conducting periodical backtesting and stress testing.

Risk and Margin have reassumed their role and relevance particularly after the recent crises in financial markets. There is now an increased awareness and interest in pursuing the following pursuits in risk measurement and margin management.

– Margin benchmarking
– Real time margin calculation and management
– Margin management across portfolios
– Margin calls through electronic messaging route
– Operational risk reduction through straight through processing / total automation
– Margin simulation, Stress testing capability with flexible What if scenarios
– New Model creation and Scenario generation
– Constantly managing the ratio of Risk tolerance versus Value at risk
– Use of numerical statistical method to calculate risk parameters

You may agree by deploying financial technology alone real time risk measurement and margin management can be effectively achieved.

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