Risk Is All Around Us

We now take a big step forward in our money and banking journey. “Safe” is in short supply; even if attained, “safe” can disappoint.

Debt instruments, even if issued by top quality credits such as the US government, can suddenly lose value if the interest rate environment goes sour (the Fed unexpectedly tightens by raising the fed funds target, for instance). And if you have to liquidate that asset sooner than planned, then that loss will have to be crystallised, maybe a large amount if you are sitting on long-dated bonds. It’s one manifestation of what we call market risk (there are other types we review later on in the course).

Knowing that in advance means that, before buying, investors will want higher yields the longer the maturity of the US government’s debt (both to cover for likely Fed tightening and for the anguish of living with such risks). Indeed, the US Treasury yield curve typically slopes upwards, unless there are recessionary rumours brewing.

Market risk is also present in the equity market. Recall that with equity there are no promises in the first place and that, with a high probability, prices will display roller-coaster features at times (specific, maybe even market, risk on steroids).

With debt, there are legally-binding promises but that does not mean that the borrower always delivers. Bonds can be unnervingly surprising at times! It’s what we call credit risk. We shall look at a number of examples by examining yield spreads against “gold-plated” US and German government paper. Banks, companies, even governments themselves can wobble – in terms of perception if not reality.

Managing risk is an important task, not just for banking professionals, but in our own daily lives. So we shall introduce concepts such as diversification (including hedging), together with supporting quantitative tools, notably covariances and correlations. We put theory into practice with a portfolio visualizer site. Other (free) tools you might find interesting include Fin Wiz and Sector SPDRs.

1 Oct 2019