The exact definition of aggregate risk can be very complicated, but in simple terms, it can be defined as how exposed an institution is to foreign exchange counterparty risk due to one client.
Furthermore, the basis of aggregate risk is that if a lot of different deals or agreements are riding on the actions of one client, then should anything happen to prevent the said client from upholding their side of the bargain then the losses might be significant.
The aggregate risk that is too high due to over-commitment to one client should be identified as quickly as possible and rectified by diversifying and distributing the risks across different clients.
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Who Uses Aggregate Risk in Financial Analysis?
Banks and large financial institutions generally are the ones who use aggregate risk analysis. The larger number of clients they deal with combined with the increasing amounts of money being requested means that banks cannot afford to overlook the aggregate risk of a single client.
They have whole departments dealing with aggregate risk management to protect the institution in uncertain times such as credit crunch, recession, or cases of insolvency.
When We Should Use Aggregate Risk?
An aggregate risk assessment should be done in cases where a single individual is doing multiple transactions, deals, and agreements with the same counterparty. In such a case the limits of risk extended to that client are determined on credit history and clients who are new or have a poor credit score, should be handled with caution.
How To Calculate Aggregate Risk?
The best way to calculate the aggregate risk from a single client is to look at all the individual agreements made between the two parties and calculate them as separate from each other. In such a case, the concept of diminishing returns has to be accounted for, because the cost of these individual assessments and the time taken to do them should not be so high as to render the task unfeasible.
Moreover, in these calculations, the risks associated with each agreement should be clearly defined, and its impact on the overall risk assessment noted. There will always be some degree of uncertainty and when all is said and done, global events that affect the economy cannot always be predicted.
Examples of Aggregate Risk
A general example of aggregate risk is an analysis of the agreements between two corporations that have long-term dealings with each other. We will designate them Company A and Company B for clarity.
Company A has realized that the portfolio of agreements with Company B has become quite large which has resulted in risk aggregation. Company A then conducts a series of risk analysis assessments on the individual agreements with Company be to achieve significant risk decomposition up to a level that is deemed acceptable.
Upon completion of the aggregate risk assessment, Company A realizes that the risks are much higher than can be safely tolerated; therefore, it issues Company B with an ultimatum that freezes any additional agreements until the finalization of some of the open ones.
Relationship Between Aggregate Risk and FX Returns
Any form of foreign exchange involves dealing with another individual on the opposite side of the agreement. In cases where a cumulative amount of exchange is done repeatedly with the same individual, an aggregate risk assessment has to be done.
It has to be determined whether the risk of incurring huge financial losses is eclipsed by the potential gains that will be received from such agreements. It is not enough to just assume that a large number of agreements constitute an intolerable aggregate risk.
In some cases, a single individual with two agreements can pose a higher aggregate risk than one who is engaged in multiple dealings. The nature of forex trading has always been a risky enterprise, so care aggregate risk assessment has to be done.
Conclusion
Aggregate risk assessment was long ago proved to be an effective tool to shield large institutes from potentially devastating financial losses. However, it is a tool that needs to be used carefully, because when wielded with over-zealousness, it can have the effect of diminishing returns by preventing potentially profitable investments. It is therefore essential to not only know how to properly conduct an aggregate risk assessment but also to use desecration when deciding when to do it. The risk must not outweigh the gains, but they will never disappear altogether.
The world of foreign exchange is a volatile and, quite often, very risky one. There is usually no way of knowing when or how the tides will shift, and the only clues are based on an analysis of historical trends.In such cases, and when large investments are involved, the danger of losing a lot of money is very real and is calculated as the aggregate risk.