RISK ANALYSIS

Abstract

This review paper presents the applications of Risk analysis in the financial sector. Financial risk analysis is an important tool for companies for decision-making processes, which has played a significant role during and after the financial crisis. This paper presents an overview of financial risk analysis, explaining its main types, and showing how each of them can be measured. The final part focuses on the importance of this analysis, considering its effects during the financial crisis.

1   Introduction

The history of risk analysis is ancient. Around 3200 B.C., a group called Asipu used to be consultants for decisions involving risk. They studied the problem, collected data and presented different alternatives, assigning likely outcomes to each of them. Another example is the use of the risk assessment by the Athenians, as cited during the Pericles’ Funeral Oration:

We Athenians, in our own persons, take our decisions on policy or submit them to proper discussions: for we do not think that there is an incompatibility between words and deeds; the worst thing is to rush into action before the consequences have been properly debated. And this is another point where we differ from other people. We are capable at the same time of taking risks and of estimating them beforehand.

In previous years, in order to assess the risk, many developed mathematical methods that are used to estimate the effect of one action, but there is still a link between the past and the present, that is the basic form of the trial and error method [1]. Nowadays, our society is built on risk management and every field has its own risk modelling: in medicine, for example, it is used to analyse the effect of a treatment on a disease; in engineering, many constructions would not exist without the risk assessment, neither all the modern technology that we have.

With the economy, it is important to analyse the risk of a decision, i.e. the introduction of new market policy, price changing, investment risks and so on. In finance, the management sector looks at the wealth of the company, trying to estimate the effect of the interaction with external and internal factors.

This review paper is organized as follows: section 2 presents a brief overview of risk analysis and financial risk; section 3 illustrates the main financial risk types, defining each of them, and presenting an overview of some quantitative methods to calculate them. In section 4, the case study focuses on the financial crisis, and it shows the importance of the right management of these indicators, especially for credit and liquidity risk. Furthermore, some regulations about it are discussed and compared. Section 5 summarizes the paper, concluding with a personal review.

2 Risk Analysis

Risk analysis can be defined as the process of identifying sources of potential negative outcomes and estimating the likelihood, in order to define which outcome requires actions and how to implement them. Giving a quantitative definition of risk [2]:

It can be defined as a triplet (S_i, P_i, X_i), where S_i a scenario identification or description, P_i is the probability of that scenario, and X_i is the consequence or evaluation measure of that scenario, i.e., the measure of damage.

The following table shows all possible scenarios with the related likelihood and consequence.