Business free essay: Current Market Trends: Risk Management
Current Market Trends: Risk Management
Critically assess the most important trends in global financial crisis that have affected financial markets, institutions and the economy from 2007 to 2009
Important lessons that can be learnt from the recent global economic crisis are purely based on risk prepared and management practices capable of averting any financial challenge. A general reluctance to handle risk with caution can be translated by all facts to have been the cause of economic downturns observed from 2007. According to Hubbard (2009, p6) reluctance to employ the best risk assessment techniques prevents the management from realizing how potent and hazardous a risk would be. The author therefore attributes failure to mitigate risk to wrong technique for measuring the risk and its gravity. To illustrate this position, the author finds fault with the manner in which top risk management firms and federal agencies conducted their risk assessment resulting in wrong approach to mitigate the risks. A cascade of ill-informed interventions could only worsen the case for the economic crisis that hit the financial markets for the better part of 2008 through 2009 and whose impact is still being felt to date. It is clear that the most important trend in the modern economic world entails risk assessment, which must be done right at all cases to avoid miscalculations resulting into multiplier disasters.
House ownership was at the centre of interest for the financial markets, having been established in the USA to such low risk levels that the major global financial players willingly ventured in it. As Fraser and Simkins (2010, p272) observe, a high demand for housing attracted high prices and supply was fast catching up to share in the benefits. The Federal Reserve was allowing the lowest interest rates for the first time in the history of the market.
Modern operations of the financial market must have mechanisms of interest-rate regulation and mitigation (Crouhy, Galai and Mark, 2006, p184). According to the author, volatility of the market should dictate the amount of caution that the management takes to mitigate the associated risks. For instance, the lending institutions should be aware of interpreting the balance sheet indicators of a possible risk. This should assist in determining when to conduct a review of the risk assessment technique and its timing. Effects of interest rate on the balance sheet assets, regarding their movements, are manifested in liabilities and should be used to translate the changes in a risky environment. Mitigation of possible risk should be approached from the perspective that emphasizes on the level of volatility of the market using such indicators. Interest rate volatility should be used by the management to set the limit that an institution can accommodate comfortably regarding the targeted earnings in the volatile market. Volatile market limits are set regarding the capacity of the institution, usually done on worst-case scenarios (Lo, 2010, p34).
Interest rate and liquidity risks are calculated in volatile scenarios to such an extent that the management can shield the institution from unprecedented flux in the market. Using the above explained worst-case scenario mitigation technique, net interest income (NII) and net worth (NW) figures of the institution become very important (Hubbard, 2009, p183). Using the projections of the volatility of the financial market, the management can set worst-case scenarios of for instance Maximum Negative Impact (MNI) of about 2 billion US dollars from the NW or about 300 billion US dollars from NII of the institution. To assist risk assessment and mitigation procedures, computer packages that apply simulations using the institutions’ NII or NW are now available.
According to Das (2005, p400), liquidity is very important in determination and mitigation of financial market risk in the modern age. Possibilities that the recent economic crisis was influenced by liquidity values lie in the premise that market risk and liquidity have a strong link that can be used in advance to avert looming danger.
According to Ryan (2008, p1), the American financial market is founded on mechanisms of credit and its control, which can be used to create unlimited opportunities out of derivative assets. The financial market was fast adopting the trend of creation of new forms of credit which made the financial market a challenge to control. The new lines of revenue that the financial market initially had were then to decline fast, exposing the market to lack of sustainability. Mortgage lending opened up a series of other lending instruments which opened up loopholes in the initial mortgage lending causing a dramatic fall in interests. Cheap credit was fast to appear in the market and the uptake exposed the market to risks that the market could not respond to within the short time available. The trend in the market at the time was characterised by the presence of only one type of commodity; housing. The demand for housing increased to overwhelm the supply and effectively induce a bad form of inflation.
Poulou (2010, p1) cites the bailout pattern adopted by governments to rescue the financial system as one of irresponsible reactions that the financial crisis requires. With the high levels of unemployment in the population, the author expects that more stringent steps ought to have been put in place. It is clear that the category of players to whom the blame for swollen risk can be attributed have not been indicted. According to the author, the Wall Street and investment banks ought to be answerable to the financial crimes that they perpetrated to the world economy by tampering with the core of the global financial system.
Comment on the role, application and failures of credit defaults swaps in risk management practice in financial institutions or corporations
The most infamous application of credit default swaps (CDS) and its failure in the context of 2008/9 economic crisis is perhaps the one observed at American Insurance Group (AIG). According to Hubbard (2009, p58), CDS is a market instrument whose application by mortgage banks is aimed at reducing possible risk of mortgage customers from defaulting. In simpler language, the author relates CDS as an insurance cover that mortgage lending banks take to protect themselves in case the borrowers fail to obey their repayment obligation. Regulations for a standard insurance cover are however fundamentally different from those of CDS. This implies that the risks involved for the two instruments are also fundamentally different. Failure to account for the risk involved by insurance companies, such as the giant AIG, proved to be a bitter pill to swallow for its actuaries. The assumption that the mortgage business as a risk stood the same chance of probability as ordinary insurance risk is a major inaccuracy that anybody would have spotted from afar.
According to Hampton (2009, p60) the banks immediately started to venture into dangerous ground by offering virtually new form of mortgages that nobody thought would be risky. Adjustable interest rate mortgages (ARMs) were on offer in the market, with assurances to borrowers that any mortgage out of a customer’s financial ability could now be approved, for the first time in the history of the mortgage market. Initial package was irresistible since the interest rates were very low for the initial couple of years. The lucrative part came on the mechanism of the clearance of the debt when it became necessary to raise the interest rates later on in the program. The owner would sell the house if the occupant defaulted, selling it at a profit.
Capital available to the banks with regard to regulation of the limits of lending that banks have, it became apparent that there was no boundary Hampton (2009, p61). Unregulated financial players in the nature of financial banks started to enter into the mortgage business having realized that the mortgage industry was entering a lucrative era in the USA. Further developments were in the offing when these unregulated global players of the financial market bought numerous mortgages and issued them as packages referred to as collateralized debt obligations (CDOs). The operation of the mortgage market changed since banks could now venture elsewhere with the arrival of investment banks. Stated income loans became the next line of business.
Subprime credit was the other alternative that the financial institutions were dealing with in large scale prior to the collapse of the system (Haslet, 2010, p437). The Treasury allowed borrowing to such risky levels that when the system collapsed, nothing could have been used to stop it. Bankruptcy was looming due to the heavy lending, coupled to the unbalanced mortgage lending that had dramatically changed attracting lucrative securities earnings. Huge financial players from across the globe had made their entry into the US mortgage business and their misfortune was to be transferred back to their mother companies. According to Haslet (2010, p439) securitization of instruments led to the unbalanced lending patterns whose risks rose to unprecedented all time high. It is therefore in this mix-up that credit defaults swaps (CDS) and other securities got caught up in a risk related puzzle that no one was in the capacity to solve.
With all the uncertainty of the cascade transactions outcome, tension then began to grow form where the mortgage market revealed the cracks that analysts refused to appreciate. It was too late to initiate measures to salvage the situation and secure economic fortunes at the global arena.
Crouhy, M., Galai, D. & Mark, R. (2006) The essentials of risk management. New York, NY: McGraw Hill Professional
Das, S. (2005) Risk management: the swaps & financial derivatives library. Clementi Loop, Singapore: John Wiley and Sons
Figlewski, S. & Levich, R. M. (2002) Risk management: the state of the art. Norwell, MA: Kluwer Academic Publishers
Fraser, J. & Simkins, B. (2010) Enterprise risk management: today’s leading research and best practices for tomorrow’s executives. Hoboken, NJ: John Wiley and Sons
Hampton, J. J. (2009) Fundamentals of enterprise risk management: how top companies assess risk, manage exposures and seize opportunities. New York, NY: AMACOM Div American Management Association
Hubbard, D. W. (2009) The failure of risk management: why it’s broken and how to fix it. Hoboken, NJ: John Wiley and Sons
Lo, A. W. (2010) Hedge funds: an analytic perspective. Princeton, NJ: Princeton University Press
Poulou, P. (2010) Documentary Explores Roots of Financial Crisis. [online] Available from: <http://sofiaecho.com/2010/12/19/1013934_documentary-explores-roots-of-financial-crisis> [accessed 24 March 2011]
Ryan, G. (2008) The 2008-9 Financial Crisis- Causes and Effects. [online] Available from: < http://cashmoneylife.com/economic-financial-crisis-2008-causes/ > [accessed 24 March 2011]
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