Foundations of Risk Management

Foundations of Risk Management

Introduction Level 1

Foundations of Risk Management Topics 1. 2. CORPORATE RISK MANAGEMENT: A PRIMER 3. CORPORATE GOVERNANCE AND RISK MANAGEMENT 4. WHAT IS ERM? 5. RISK-TAKING AND RISK MANAGEMENT BY BANKS 6. FINANCIAL DISASTERS 7. THE CREDIT CRISIS OF 2007 8. RISK MANAGEMENT FAILURES: WHAT ARE THEY AND WHEN DO THEY HAPPEN? > DELINEATING EFFICIENT PORTFOLIOS 9. THE STANDARD CAPITAL ASSET PRICING MODEL 10. APPLYING THE CAPM TO PERFORMANCE MEASUREMENT: SINGLE-INDEX PERFORMANCE MEASUREMENT INDICATORS 11. ARBITRAGE PRICING THEORY AND MULTIFACTOR MODELS OF RISL AND RETURN 12. INFORMATION RISK AND DATA QUALITY MANAGEMENT 13. PRINCIPLES FOR EFFECTIVE RISK DATA AGGREGATION AND RISK REPORTING 14. GARP CODE OF CONDUCT 1

THE CONCEPT OF RISK : Risk arises from the uncertainty regarding an entity s future losses as well as future gains. Risk is not necessarily related to the size of the potential loss rather important concern is the variable of the loss, which was not anticipated. Risk Management includes the sequence of activities aimed to reduce or eliminate an entry s potential to incur expected losses & manage the unexpected variability of costs. Risk Management involves tradeoff between risk & return i.e., how much incremental risk an entity will take in order to generate incremental gains. 2

THE RISK MANAGEMENT PROCESS : Identify risk exposures Measure and estimate risk exposures Find instruments and facilities to shift or trade risks Assess effects of exposures Assess costs and benefits of instruments Form a risk mitigation strategy: Avoid Transfer Mitigate Keep Evaluate performance 3

Risk Management Challenges: Back in 2002, Alan Greenspan, then chairman of the U.S. Federal Reserve Board, made some optimistic remarks about the power of risk management to improve the world, but the conditionality attached to his observations proved to be rather important: The development of our paradigms for containing risk has emphasized dispersion of risk to those willing, and presumably able, to bear it. If risk is properly dispersed, shocks to the overall economic system will be better absorbed and less likely to create cascading failures that could threaten financial stability. Concentration risk Corporate governance failure Use of complex derivative strategies May not be effective on an overall economic basis Excessive assumption of risk may lead to widespread economic crisis 6 4

MEASURING AND MANAGING RISK: Quantitative Measures Value at risk (VaR) States a certain loss amount and its probability of occurring. VaR is a useful measure for liquid positions operating under normal market circumstances over a short period of time. Economic capital Economic capital refers to holding sufficient liquid reserve to cover a potential loss. Qualitative Assessment Scenario analysis takes into account nonquantifiable risk factors. Worst-case scenario analysis done to get an idea of the full magnitude of potential losses. Stress testing is a form of scenario analysis that examines a financial outcome based on a given stress on the entity. Enterprise Risk Management (ERM) ERM takes an integrative approach to risk management within an entire entity. Senior risk committees of the entity examines that risks, which affecting the entire entity. 7 5

EXPECTED AND UNEXPECTED LOSS : Expected Loss How much an entity expects to lose in the normal course of business. It can often be computed in advance (and provided for) with relative ease because of the certainty involved. Unexpected loss How much an entity could loss outside of the normal course of business. It is generally more difficult to predict, compare, and provide for in advance because of the uncertainly involves. 8 6

Correlation Risk: Unfavorable Events B Unfavorable Events A Unfavorable Events C Potential loss rises to unexpected levels 9 7

RISK AND REWARD: Factors affecting risk & return Credit risk Risk tolerance of investor Publicly/non-publically traded securities Risk governance culture in organization 10 8

RISK CLASSES : Market Risk Credit Risk Liquidity Risk Operational Risk Legal & Regulatory Risk Business Risk Strategic Risk Reputation Risk 11 9

RISK CLASSES : Financial Risk Equity price risk Interest rate risk Trading risk General market risk Specific risk Market risk Foreign exchange risk Gap risk Financial Risks Commodity price risk Transaction risk Issue risk Credit risk Portfolio concentration Issuer risk Counterparty credit risk 12 10

RISK CLASSES : Price Risk Market risk is the risk that changes in financial market prices and rates will reduce the value of a security or a portfolio. General market risk component The risk that the market as a whole will fall in value Price Risks Specific market risk component Unique to the particular financial transaction under consideration 13 11

RISK CLASSES : Market Risk Equity price risk the risk associated with volatility in stock prices Market risk Interest rate risk Foreign exchange risk the value of a fixed-income security will fall as a result of an increase in market interest rates curve risk basis risk Foreign exchange risk arises from open or imperfectly hedged positions in particular foreign currency denominated assets and liabilities leading to fluctuations in profits or values as measured in a local currency. Commodity price risk Higher volatilities and larger price discontinuities 14 12

RISK CLASSES : Credit Risk Credit risk is the risk of an economic loss from the failure of a counterparty to fulfill its contractual obligations, or from the increased risk of default during the term of the transaction. Default risk debtor s incapacity or refusal to meet his/her debt obligations Credit risk Bankruptcy risk Downgrade risk is the risk of actually taking over the collateralized, or escrowed, assets of a defaulted borrower or counterparty is the risk that the perceived creditworthiness of the borrower or counterparty might deteriorate Settlement risk is the risk due to the exchange of cash flows when a transaction is settled 15 13

RISK CLASSES : Liquidity Risk Funding liquidity risk a firm s ability to raise the necessary cash to roll over its debt; to meet the cash, margin, and collateral requirements of counterparties; and to satisfy capital withdrawals. Liquidity Risks Trading liquidity risk an institution will not be able to execute a transaction at the prevailing market price because there is, temporarily, no appetite for the deal on the other side of the market. 16 14

RISK CLASSES : Operational Risks Operational risk refers to potential losses resulting from a range of operational weaknesses including inadequate systems, management failure, faulty controls, fraud, and human errors; in the banking industry, operational risk is also often taken to include the risk of natural and man-made catastrophes (e.g., earthquakes, terrorism) and other nonfinancial risks. 17 15

RISK CLASSES : Legal & Regulatory Risks Legal and regulatory risk arises for a whole variety of reasons; it is closely related to operational risk as well as to reputation risk (discussed below). 18 16

RISK CLASSES : Business Risks Business risk refers to the classic risks of the world of business, such as uncertainty about the demand for products, or the price that can be charged for those products, or the cost of producing and delivering products. 19 17

RISK CLASSES : Strategic Risks Strategic risk refers to the risk of significant investments for which there is a high uncertainty about success and profitability. 20 18

RISK CLASSES : Reputation Risks Reputation risk can be divided into two main classes: the belief that an enterprise can and will fulfil its promises to counterparties and creditors; and the belief that the enterprise is a fair dealer and follows ethical practices. 21 19

RISK CLASSES : Systemic Risks Systemic risk, in financial terms, concerns the potential for the failure of one institution to create a chain reaction or domino effect on other institutions and consequently threaten the stability of financial markets and even the global economy. 22 20