Risk Management in a Fair Valuation World

Abstract

This paper considers the impact that the current trend towards fair valuation of assets and liabilities is likely to have on risk measurement and management practices within the financial services industry. The paper analyses the different sorts of risks faced by organisations such as asset managers, pension funds, banks and insurers, and seeks to identify how their approach to the measurement and management of these sorts of risks might change as fair valuation becomes more entrenched. It argues that what it describes as traditional 'time series' based risk measurement is likely to be progressively displaced over time by a greater emphasis on what the paper refers to as 'derivative pricing' (or 'fair value' or 'market consistent') based risk modelling. It comments on the trend towards liability driven investment. The paper focuses on 'financial' risks (market, credit, liquidity and, more generally, asset/liability risk) rather than 'operational' risks, whilst noting that the dividing line between the two can be open to interpretation. Insurance risk is seen as in some respects straddling both camps.

Entity-wide risk management for pension funds

“…(2011). 3.3 It is clear from the above risk descriptions (see also Kemp, 2005) that there can be some overlap between risk categories, in the sense that some commentators categorise some risks in one way while others may categorise them differently. The actual classification adopted may in the end be determined by the convenience of application for particular purposes25.…”

“…Nowadays, derivatives such as credit default swaps exist in which a premium is paid in return for payment (or value transfer) in the event of a company defaulting. As explained in Kemp (2005), extensive utilisation by a scheme of this risk mitigation strategy may have additional consequences as far as the sponsor is concerned. The third parties providing the ‘insurance’ may seek to hedge their own risks by, in effect, shorting any bonds or other debt that the sponsor has issued, making it more difficult for the sponsor to raise further capital if needed.…”