Financial institutions face new challenges arising from the rapid growth of derivatives, financial innovations, the mix of mathematical models and computing power in risk management, as well as a "shadow" banking network made up of investment banks and the new regulatory framework.

Although the 2008 financial crisis might suggest that financial risks are sometimes able to get ahead of the world's ability to manage them, demand for financial risk management professionals is on the rise. The number of Financial Risk Manager (FRM) exam takers posted an annual average growth of 43 percent over the past three years.

The 2008 financial crisis was a shock for individual investors in part because of financial innovations involving a number of structured financial products such as Credit Default Swaps (CDS), Collateralized Debt Obligations (CDO), synthetic CDOs, etc. CDS are bilateral contracts which transfer defined credit risk from one party to another. The CDS buyer makes a series of payments periodically to another in return for compensation in the event of a bond default. It is an asymmetric bet. It looks similar to an insurance policy in which the premium you pay is a fraction of the compensation made by your insurance firm in case of bankruptcy. By the same token, however, the CDS is also a speculative bet against the market.

CDOs are similar to a mutual fund that purchases various mortgage bonds including subprime mortgages for people with weak credit, generating a pooled vehicle within a pooled vehicle.

To attract investors, CDOs are rated by risk groups which are called tranches. Senior tranches mean the most secure part of the bond. Equity refers to the riskiest part of the CDO, which pays the highest return but is the first to lose if the underlying bonds default. Mezzanine is the tranche that lies between the equity and the senior tranches. In other words, CDOs have various tranches that offer investors different rights over this portfolio.

Generally speaking, most triple-A bonds, the highest credit rating, implies a 1-in-10,000 probability of default in its first year. Similarly, most double-A bonds point to a 1-in-1,000 chance of default. Having purchased many different subprime mortgage bonds, the risk of CDOs is repackaged as another diversified portfolio of assets through a complex statistical modeling process called tranching technique. The CDO can be re-rated as triple-A bonds from diversified pools of lower-rated bonds because it appears that they are diverse enough that they would be highly unlikely to go bust all at once.

In theory, triple-A CDOs or synthetic CDOs are likely to behave the same way as triple-A corporate bonds. The big question is how well this theory will work in the real world. But in the wake of the financial crisis, things are different.

One of the major CDS sellers is a unit of the triple-A-rated insurance giant American International Group (AIG) called AIG Financial Products (FP). Given its high credit rating, AIG FP did not need to place reserves to cover potential losses in normal circumstances.

Portfolio investment consists of two major risks - market risk which refers to a risk of an individual stock such as business risk, financial leverage or earnings volatility; and market risk or systemic risk which refers to any fluctuation of macroeconomic variables such as interest rates, business cycles or extreme cases such as war.

Unfortunately, insurance firms cannot handle systemic risk because only government can take on that kind of risk. Arguably, that is why we cannot purchase insurance covering terrorism or war. Thus it is not hard to understand why AIG FP recorded $40 billion in losses from its dealings in complex CDS and other derivatives in 2008.

Dr Ringo Chan is Program Director at University of Hong Kong SPACE. The views expressed are entirely his own.

(HK Edition 10/12/2010 page2)