We say in this case that P and Q are equivalent probability measures. The First Fundamental Theorem of Asset Pricing This article provides insufficient context for those unfamiliar with the subject. A measure Q that satisifies i and ii is known as a risk neutral measure. A complete market is one in which every contingent claim can be replicated. This page was last edited on 9 Novemberat Recall that the probability of an event must be a number between 0 and 1. EconPapers: Martingales and stochastic integrals in the theory of continuous trading In this lesson we will present the first fundamental theorem of asset pricing, a result that provides an alternative way to test the existence of arbitrage opportunities in a given market.
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Metrics details Abstract This study aims to identify risk management strategies undertaken by the commercial banks of Balochistan, Pakistan, to mitigate or eliminate credit risk. The findings of the study are significant as commercial banks will understand the effectiveness of various risk management strategies and may apply them for minimizing credit risk. This explanatory study analyses the opinions of the employees of selected commercial banks about which strategies are useful for mitigating credit risk.
Quantitative data was collected from employees of commercial banks to perform multiple regression analyses, which were used for the analysis. This study highlights these four risk management strategies, which are critical for commercial banks to resolve their credit risk.
By definition, credit risk describes the risk of default by a borrower who fails to repay the money borrowed. Diversification is the allocation of financial resources in variety of different investments and has also long been understood to minimize such risk.
Regulators also require banks to improve internal governance practices in order to ensure transparency and ethical standards to keep the customers satisfied with their products and services. Customers expect the financial institutions to have strong policies that can safeguard their interests and protect them.
One critical success factor for financial institutions lies in their realization of the importance of credit risk and devising solid strategies — such as hedging, diversification and managing their capital adequacy ratio — to avoid shortcomings that could lead to operational catastrophe. Credit risks faced by banks have fundamental impact on the performance because, even few large customers default on loans would cause huge problems for it.
The objective of the Credit Risk Management CRM process is to maximize the cost-adjusted rate of return of a particular bank by maintaining exposure to credit risk acceptable to its shareholders. Banks have to navigate the credit risk associated with the overall portfolio as well as external risks that may be due to macroeconomic factors in the economy.
Banks must also compare the credit risk relationships with other risks. Another specific case of credit risk applies to the method of trying to settle banking transactions. Until and unless both parties settle their payments in a timely manner, bank suffers from opportunity loss. Corporate governance may also have large effect on the risk management strategies used by the bank for reducing credit risks. Research suggests that it is imperative that banks engage in prior planning in order to avoid future problems Andrews, Majority of commercial banks provide several services that could help them mitigate or manage risk.
The significance of effective risk management strategies have been highlighted by many researchers and practitioners over time to assist banks and other financial institutions. CRM became an obvious necessity for commercial banks, especially after the global financial crisis, in which it was primarily subprime mortgages that caused a liquidity crisis Al-Tamimi, According to Al-Tamimi , ensuring the efficient practice of risk management may not be expensive but the implementation should be done in a timely manner in order to ensure smooth banking operations.
A financial institution, just like a constituent part of any other major economic sector, aims to meet incurred expenses, increase the return on invested capital and maximize the wealth of its shareholders. Problem statement In , across the world, the credit crisis began as a result of mass issuing of sub-prime mortgages to individuals in the United States leading to defaults, which caused outwardly-rippling problems for financial institutions all across the world.
The decision to over-extend credit to high-risk customers may increase short-term profitability for individual banks, though in aggregate, this lending behavior was seen to become a major challenge to the risk management structures of the economy as a whole.
This phenomenon is equally applicable to banks across the globe, including banks in Pakistan. Due to unstable and volatile nature of the political and financial environment in Pakistan, banks are affected by many types of risk, including risks to foreign exchange rates, liquidity, operations, credit and interest rates.
Balochistan is the least developed part with largest geographical area in Pakistan. There are limited opportunities for small businesses and majority of businesses are run in informal form with poor documentation. Majority of commercial banks face problems like loan documents verification and loan processing. Therefore, the adoption of proper risk management strategies can help understand and mitigate the credit risk faced by commercial banks of Balochistan.
Research objective This study aims to identify the different risk management strategies that can influence the management of credit risk by commercial banks.
We expect to determine if these strategies contribute both to the reduction of credit risk as well as the efficient performance in fulfilling customer needs. Significance of the study This study aims to provide a basis for guidance for the commercial banks of Balochistan to adopt long-term performance-improving risk management strategies Campbell, The model for the study shows the impact of risk management strategies, including hedging, diversification, the capital adequacy ratio and corporate governance.
The research will also examine the impact of each risk management strategy individually in order to understand the importance of each strategy. The findings of this study are intended to contribute positively to society by demonstrating that the banks of Balochistan can develop effective strategies to improve their CRM. Additionally, policy makers can identify and generate appropriate policies to govern bank behavior in order to minimize risk.
Literature review Credit risk is considered as the chance of loss that will occur when the loan or any other line of credit by a particular debtor is not repaid Campbell, Since , financial experts around the world have researched and analyzed the primary factors underpinning the credit crisis to identify problematic behavior and effective solutions that can help financial institutions avoid catastrophe in the future.
Long ago, the Basel Committee on Banking Supervision Footnote 1 has also identified credit risk as potential threat to banking sector and developed certain banking regulations that must be maintained by the banks around the world. Owojori, Akintoye, and Adidu stated that there are legislative inadequacies in financial system especially in banking system that are effective as well as lack of uniform credit information sharing amongst banks.
Thus, it urges to the fact that banks need to emphasize on better risk management strategies which may protect them in the long run.
It is important as they perform variety of functions from project appraisals through credit disbursement, loan monitoring to loans collection. Therefore, a comprehensive human resource policy related their selection, training, placement, job evaluation, discipline, and remuneration need to be in placed to avoid any inefficiencies related to loan management and credit defaults.
Ho and Yusoff focused on researching Malaysian financial institutions and their management of credit risk. The study involved a sample of 15 foreign and domestic financial institutions from which the data was collected through questionnaires.
The findings demonstrated that the diversification of loan services leads to risk improvement, though it requires training employees and the commitment of employees to ensure that the financial institution will meet the requirements for best practice lending.
Brown and Wang conducted study about the challenges faced by Australian financial institutions due to credit risk over the period January to August The Australian financial institutions were not able to provide a wide variety of alternatives to their clients that led to higher risks as there was a lack of diversification in their services. The research suggested that corporate governance practices allow firms to adopt appropriate rules, policies, and procedures to ensure that the rights of all the stakeholders are fulfilled.
Hedging Footnote 2 is used by financial institutions to minimize the risk associated with the transactions conducted with the bank customers as it allows the bank to minimize the risk by offering flexible offers that allows customer to make their decisions effectively Dupire, The work of Karoui and Huang indicates that the super hedging strategy Footnote 3 could be implemented to achieve a surplus downside market risk as it possesses a duality of both the super hedging and open hedging approaches.
The prices of options can increase due to the volatility of the asset prices. If the prices of the financial instrument are fluctuating, then the price of the options contract might also be influenced as the buyers or sellers will be deriving their profit from the price of the financial security Hobson, Several factors are associated with the pricing of securities as these factors support the financial decisions that must be made by the investors.
The loans that the bank provides to the borrower are highly dependent on the conditions of the market. A highly volatile security market will influence the prices and interest rates of the securities being exchanged in such a market.
Financial markets are affected by the macroeconomic variables that influence the prices of the securities being exchanged. Hedging allows firms and their managers to incorporate policies that will maximize the value of the company as clients have a wide array of alternatives that allow them to make their decisions in an effective manner. The derivatives such as options, futures, forwards and swaps that are used by firms increase their financial stability by allowing the customers to have sufficient information that improves their decision making in different circumstances.
This enables managers to adopt practices that will benefit their organizations. Similarly, Levitt explained that hedging enables firms to extend its activities because the risk inherent to providing funds is reduced in such transactions, allowing more flexibility to all involved parties. Banks are able to maintain a particular level of reserved cash for the sake of managing the day to day operations that is decided based on the allocated capital adequacy ratio.
This enables the bank to maintain a balance of cash that is sufficient to meet the needs of the customers. This gives certainty to some funds that banks must maintain in order to address unforeseen circumstances.
The selective hedging concept has been used by firms for the sake of making investments that are based on a certain part of their portfolio that pose the most threat and not the entire portfolio of the financial instruments Stulz, The emphasis is on utilizing hedging at the right time for the specific customer that a company believes should be entering into a contract with flexible terms and conditions. With a certain degree of consensus the generalized soft cost consensus model was developed by defining the generalized aggregation operator and consensus level function.
The cost is properly reviewed from the perspective of the individual experts and the moderator. Economic significance of the two soft consensus cost models is also assessed. The usability of the model for the real-world context is checked by applying it to a loan consensus scenario that is based on online data from a lending platform. Machine learning methods are employed by researchers that are trying to respond to systemic risks with the help of financial market data.
Machine learning methods are used for understanding the outbreak and contagion of the systemic risk for improving the current regulations of the financial market and industry.
The paper studies the research and methodologies on measurement of financial systemic risk with the help of big data analysis, sentiment analysis and network analysis.
If the principle and interest of the loan is repaid in a timely manner that would help the banks ensure smooth flow of their operations, and the economic activities in the society are improved as the standard of living of people also improves with such financial assistance that is provided by commercial banks Keats, As banks enter into such contracts with several customers, the level of the its incurred risk increases; management likewise becomes more complex with a more diverse group of customers Kargi, The lost category focusing on the inability of the bank to recover particular products restricts a bank from reaching the set targets thus causing a bank to fail in attaining the objectives of profitability that have been set.
The incurrence of a large amount of high-risk debt is often difficult for banks to manage unless the managers have undertaken appropriate strategies for mitigating the risk in addition to enhancing their financial performance. This on-hand capital requirement, also called the capital adequacy ratio, is beneficial as it allows banks to more easily manage potential, sudden financial losses Keats, Kithinji provides specific evidence that the management of credit risk does not influence the profitability of banks in Kenya.
In fact, the Kargi study on Nigerian banks from to revealed a healthy relationship between appropriate CRM Credit Risk Management and bank performance. Poudel emphasized the significant role played by CRM in the improvement of financial performance of banks in Nepal between and Strict requirements of maintaining higher capital that is around Heffernan stated that CRM is crucial for predicting proper bank financial performance.
Banks that avoid risk management face several challenges, including their own survival in the current highly competitive financial environment. To compete successfully with other commercial financial institutions, banks rely on a diversification of products and financial services to improve portfolio performance, including attracting more customers. Diversified services allow customers to select the most appropriate financial assistance in light of their individual needs.
It is also important to have effective behavior monitoring models to ensure that bank employees are careful in minimizing the operational risks by providing maximum information to the customers about the financial instruments and the restrictions imposed by the bank for the sake of protecting the interests of the financial institution. It appears along with the capital movement that is mostly concerned with the rise in the collapse of the overall financial market.
It is difficult to prevent money laundering since it has a plausible sort of trade characterization. The aim of the paper is to develop monitoring methods that have accurate recognition along with classified form of supervision of the trade based money laundering with the help of multi class knowledge driven classification algorithms that are linked with the micro and macro prudential regulations. Selecting the most eligible customers for a loan is also essential to managing credit risk: a bank can screen through a list of customers to identify the ones who have a higher probability of repayment within the specified time duration, according to the terms and conditions of the contract.
Hentschel and Kothari emphasized that using different derivatives is significant for the leverage of the financial institution. Dolde, highlighted that several banks are vulnerable to various risks, therefore, banks have undertaken specific precautionary measures like training their employees, developing better credit policies and reviewing the credit rating of the customers applying for the loans Dolde, Diversification is adopted by corporations for increasing the returns of the shareholders and minimizing risk.
This shows a considerable inclination of the business sector to emphasize diversification instead of single trade. Much research has been conducted focusing on the activities of companies during recent times; most have found a rise in the prevalence of diversified firms Datta et al.
Based on a model presented by Felix , which showed risk management strategies of hedging, capital adequacy ratio and diversification may be used to explain credit risk that a bank faces.
Mazushakar When applied to binomial markets, this theorem gives a very precise condition that is extremely easy to verify see Tangent. When the plisak price process is assumed to follow a more general sigma-martingale or semimartingalethen the concept of arbitrage is too narrow, and a stronger concept such as no free lunch with vanishing risk must be used to describe these opportunities in an infinite dimensional setting. A measure Q that satisifies i and ii is known as a risk neutral measure. A complete market is one in which every contingent claim can be replicated.
Impact of risk management strategies on the credit risk faced by commercial banks of Balochistan