Financial Risk Management Harvard Case Solution & Analysis

 Importance of Field of Stochastic

Risk management is all about from wider perspective discipline for “Living with the possibility that future events on financial markets may create adverse effects” In relation to risk management in financial institutions these negative affects normally results in large losses on a portfolio of assets. Such as banks and insurance companies due to adverse changes in financial market could make losses on the portfolio of assets.

For example losses on the portfolio of market traded securities due to falling market prices. Such as stocks and bonds may cause loss due to adverse changing in market prices. Losses on the pools of bonds or loans could incur due to default of issuer and borrower this is known as credit risk. These are the future events on financial markets that needs to be carefully considered in financial risk management since these events have potential to create adverse changes in financial markets.

No profit could be made without taking any risk. This is the main reason for financial institutions to take actively on risk.The key role of financial risk management is to measure and manage risks in order to reduce the expected loss due to adverse changes in the financial markets.

Financial institutions by using its expertise can take on risk and manage these risks in order to protect themselves for future uncertainty by various techniques. Different techniques which are used in managing the financial risk by financial institutions are diversification, hedging or repackaging risk and transferring the risk to markets by insurance etc. (Anon., n.d.).

In the field of stochastic, quantitative risk management is very important, since it provides better ways to protect and hedge against future adverse events on financial markets. Risk management has always been an embedded part of the banks and insurance companies, the use of quantitative and mathematical techniques has increased over the past years.

Currently, even regulators and supervisory authorities ask financial institutions to increase the usage of quantitative and mathematical technique while performing risk management process.

The field of stochastic definitely plays a very important role in quantitative risk management due to random nature of future event on financial addition to this there are many other techniques from convex analysis and numerical methods are often being used by the financial institution in order to offset its position against adverse effects.

In order to measure the risk of portfolio quantitative scale are needed and quantitative scale are used for a different purposes. Amount of risk capital needed which relates to the riskiness of the portfolio of investments in order to measure the risk and Value at Risk is used to measure the risk. Value at risk shows the maximum loss that could occur at a specific time with certain percentage(Anon., n.d.).

Probability theory and statistical theory are used and it assist in predicting the future events. Credit rating of a firm are provided by the credit agencies, these agencies use statistical data and probabilities in order to provide credit rating for the companies. On the basis of the probabilities they rate the companies.

Financial institutions by using probabilities on the basis of past events can predict future events on the financial markets it helps them to offset their position against adverse effects of financial market. On the basis of two economic theories the theoretical relationship has been developed of risk and expected return.

The two theories are portfolio theory and capital market theory. The portfolio theory is concerned with the appropriate selection of the portfolios that assist in maximization of expected returns consistent with the risk appetite of the individual.

Capital theory mainly emphasize on the relationship between security returns and risk. In banks, risk is considered as quantification i.e. risk capital. The main reason for the close relationship between risk and capital is that objective of the bank’s capital is to protect the bank from severe losses(Anon., n.d.).

            The current financial industry, banking, insurance companies and investment sectors heavily place reliance on the current risk analysis and risk management since complexity of the financial product has grown. Due to this, reliable and accurate risk management are essential in order to protect and hedge against adverse changes in future markets (Anon., n.d.).Financial Risk Management Case Solution

            Sound quantitative risk model is very essential for all financial institutions. The implementation of this risk model has been increasing rapidly over the past years since complexity of business and financial markets has increased. Quantitative risk management is more important and beneficial as compare to qualitative risk management in order to provide realistic outcome and results of future events on the financial markets..................

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