26. Risk optimisation and responses Flashcards
How can risk management optimise risk-return profile?
- Support business’ selective growth
- Use risk-adjusted pricing to support profitability
- Control size and probability of potential losses by setting limits
- Establish risk management techniques
How does risk management support business’ selective growth
o Processes to assess new opportunities
o Capital and resource allocation to activities with high risk-adjusted returns
How does risk management use risk-adjusted pricing to support profitability
o Must reflect risk costs and expenses
o NPV and EVA based on book values – not fully reflective
How does risk management control size and probability of potential losses by setting limits
o Exposure limits
o Stop loss limits – trigger action if losses reached
o Sensitivity limits – designed to stop potential losses from extreme events being beyond certain bounds
How does risk management establish risk management techniques
o Active portfolio management
o Reduce risk e.g. duration matching
o Risk transfer eg insurance
What are the fundamental concepts of portfolio management
- Risk
- Reward
- Diversification
o Reduce overall risk by investing in diff things not perfectly positively correlated - Leverage
o Borrow $ and invest it, so increase potential risk return profile - Hedging
o Entering agreement reducing risk because position taken is negatively correlated with existing position
Give examples of risk-return measures
- Risk adjusted return on capital (RAROC)
- Sharpe Ratio
- Others
o Return adjusted on risk adjusted assets: net income/risk-adjusted assets
o Risk adjusted return on assets
o Return on risk adjusted capital
o Risk adjusted return on risk adjusted assets
How can we optimise risk
- Must align strategy with stakeholder expectations
- Balance risk and reward
- As N gets large if we hold equal weightings in assets, proportion related to individual variances»_space; 0 and the proportion relating to covariance»_space; average covariance terms
- Can use mean variance portfolio theory
o Investors wish to construct portfolio (efficient portfolio) if assets giving max return given level of risk or min risk given level of return - Separation theorem: efficient portfolio of risky assets is separate from person’s individual risk-return preferences.
What is the separation theorem
Efficient portfolio of risky assets is separate from person’s individual risk-return preferences.
What are the benefits of active portfolio management
- Unbundles business into components
- Risk aggregation mechanism
- Framework to set risk concentration limits and asset allocation targets
- Influences investment, transfer pricing & capital allocation
Give examples of risk transfer
- Insurance
- Reinsurance
- Coinsurance
- Sharing risk with ph via product design
- Securitisation
- Derivatives
- ART
- Outsourcing
What are the factors affecting the effectiveness of risk transfer
- Cost
- Market capacity
- Counterparty risk
- Liquidity risk
- Regulation
- Other constraints:
o Contract t&cs limiting risk transfer
o Transferring org needs to assess if it has expertise to execute risk transfer and monitor effectiveness
o Volume and type of risk transfer must align with risk appetite/tolerances
How can you reduce risk
aka risk mitigation, treatment or management
* Reduce likelihood or
* Reduce loss/impact
Give examples of how you can reduce risk
- Diversification
- Reduce random fluctuation risk by increasing portfolio size
- Hedging
- A-L matching
- Strong internal controls and governance: operational
- Robust underwriting and pricing: mortality/insurance
- Due diligence and tightly worded agreements: counterparty
- Intelligent remuneration and bonus structures: agency risk
- Capital / funding: insolvency
Outline how you’d remove risk
- Can remove by avoidance
- Factors to consider:
o Cost
o Impact on likelihood of project reaching objectives
o Lost opportunities
