Risk management : three study cases about credit and operational risk

Résumé du document

You will be examining three organizations. Each organization is slightly different. Your task is to determine several strategies to mitigate the credit or operational risk in each organization. For each firm, describe the recommended strategy and discuss the position of the firm.
The credit or default risk is the possibility for a bond issuer to not be able to pay back the interest and principal in the time. The most secured bonds are issued by federal government, followed by municipalities and corporation.
The operational risk is " the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events".

Firm 1 is a large multinational organization with operations in several countries. The company's industry is currently experiencing an economic downturn. While the firm is currently in good shape, it wishes to avoid bad news as it is concerned about further economic downturns. The firm owns a variety of bonds in its investment portfolio. They are not currently worried about market risk. If the bonds were to decline in value due to credit events, the firm would experience losses it wishes to avoid. What approaches or strategies could you recommend to mitigate this risk?

Firm 2 is a large, regional bank. In the past, the bank mainly conducted business in its geographic region. Senior management recently decided to expand its business in other countries. There are two general strategies driving this decision. First, the bank plans to expand the investment portfolio and buy sovereign bonds. These bonds are expected to be from emerging market countries and denominated in the currency of the issuer. Second, the bank will also make loans to companies in other countries that may or may not be denominated in other currencies. The bank has traded foreign currency for its clients, but always on an agency basis. What would you recommend to mitigate the potential credit risk?

Firm 3 is a large commercial bank. The bank has been experiencing high error rates in its processing of trades in bonds and currencies. This high failure rate is causing it to lose some clients due to the high cost of fixing errors. How would you go about assessing the situation and recommending improvements to the settlement process?

Extraits

[...] Under this manner, the protection buyer doesn't cope with the credit risk of protection seller. There is the possibility to choose credit risk due to the fact that these transactions are rated by rating agencies. The unfunded credit derivative is a contract between two parties which are in charge of making payments relating to the contract (premium payment and any cash of physical settlement amounts) but without resorting to other assets. The credit derivatives have the advantage to unbundle credit risk from other financial instrument and allows users to trade and manage credit risk separately from other risk and cash flows. [...]

[...] The translation exposure[30][31], also called accounting exposure[32], is the risk and effects of currency exchange rate changes (by denomination in foreign currency) on consolidated results and balance sheet of a firm (equities, assets, liabilities and income)[33]. For instance, an organization has a $ income with a $ exchange rate in year n. In year the company will make again a $ income but with a 0,9 $ exchange rate: thus, there will be a risk of currency exchange rates in case of conversion in euro. To manage translation exposure, we can quote three techniques[34] : fund flows adjusting, forward contracts and exposure netting. [...]

[...] The product mix will take the form of operations diversification for a company. For example, we could create a natural operating hedge to remove the exchange rate effects and to consolidate costs in combining the production and exporting of a produced merchandise with an importing operation that import competitive consumer goods from foreign manufacturers. The product sourcing will consist in the diversification of inputs sources in reducing operating cost but the enterprise should take in account the factors as potential costs and suppliers relationships. [...]

[...] An investor who is the holder of debenture and who wishes to cover itself against the value reduction can buy put on these bonds (the option sell or put enables to sell the underlying asset to the exercise price). Strictly speaking, it is an option on classical securities. Thanks to the options using, the bond issuer also can cover itself against a rate raising. The difference between the market rate of an issuer or issuer category and the State's borrowing rate (without risk) is named “premium risk”. The “premium risk” which is assessed by the allocated rating, is connected to the issuer quality. There exists indexed options on this “premium risk”. [...]

[...] The credit option give the right to the issuer to cut the payments linked to the bond if a pre-defined market variable varies significantly (influence on the credit risk exposure). In return, the issue price is less high, what allows to attract investors. The total return swap[13][14] permits to exchange the performance of any asset hold against a reference variable like Euribor. Thus, the purchaser protection can transfer completely the credit risk generated by the underlying asset to the seller. [...]