Brehm Ch 2 Flashcards
Define decision analysis
using simulation to drive corporate decision making
Describe 3 evolutionary steps of decision analysis process
- Deterministic project analysis
Uses a single deterministic forecast for project CFs to produce an objective function like PV or internal RoR.
This analysis may demonstrate some sensitivities to critical variables. - Risk analysis
Forecasts of distributions of critical variables are input into a MC simulation process to produce a distribution of the PV of CFs. - Certainty equivalent
Expands upon risk analysis by quantifying the intuitive risk judgment using a utility function (corporate risk preference).
Describe how uncertainty is handled in each step of decision analysis process.
- Deterministic project analysis: uncertainty is handled judgmentally rather than stochastically.
- Risk analysis: risk judgment is still applied intuitively.
- Certainty equivalent: utility function does not replace judgment. Instead, it formalizes judgment to that it can be consistently applied.
Explain how efficient market theory removes need for certainty.
Since investors can diversify away firm-specific risk, it does not have a risk premium and should be ignored.
The goal of firm managers is to maximize shareholder value, so they should ignore firm-specific risk as well.
This is why certainty equivalent approach is not appropriate for public companies.
Provide 2 counter arguments to the belief that market theory removes need for certainty.
- It is difficult to determine which risks are firm-specific and which risks are systematic.
Attempts have been made to determine which corporate decisions affect the stock price and which do not, but results are inconclusive. - Market-based risk signals (such as risk-adjusted rate) often lack the refinement needed for manages to mitigate or hedge the risk.
- Risk-adjusted discount rate (market-based risk signal) reflects risk only if there is a time lag. For many kinds of risks, time aspect is unimportant since risk is instantaneous (jump risk).
List the 5 major elements involved in internal risk modelling.
- Data classification and organizational scheme
- Capture exposures and loss history
- Estimate event frequency and severity distribution, Corporate hedging, Correlation and shock scenarios
- Develop aggregate loss distributions
- Corporate risk tolerance, CoC allocated, Cost benefit analysis on mitigation and hedging
List the 4 objectives of Internal Risk Model (IRM) mechanism
- Starts with an aggregate loss distribution, with many sources of risk (such as LOBs)
- Quantifies the impact of the possible aggregate loss outcomes on the corporation
- Assigns a cost to each amount of impact
- Attributes cost back to the risk sources
Define Corporate Risk Tolerance
Refers to the organization’s:
1. size
2. financial resources
3. ability
4. willingness
to tolerate volatility.
Explain how an efficient frontier can be used to select an insurance portfolio.
In order to translate impacts to costs, corporations must define explicit risk preferences.
For example, suppose a firm has identified an efficient frontier of possible insurance portfolios (portfolios that minimize risk for a given RoR).
The firm can plot these portfolios on a standard efficient frontier graph where y-axis is risk and x-axis is return.
The firm can then plot its current portfolio and see how it compares with efficient frontier.
If current portfolio has same return but more risk, then it is suboptimal.
List 3 questions a firm should try to answer when selecting one of the efficient portfolios.
- How much risk is the firm willing to tolerate?
- How much reward is the firm willing to give up for a given reduction in risk?
- Are the risk-reward tradeoffs available along the efficient frontier acceptable to the firm?
The 1st question requires an answer to the firm’s risk tolerance.
The second question requires the firm to express its risk preferences explicitely.
Describe how RORAC is determined.
Financial firms should rely on allocating the cost of capital (rather than the capital itself).
One way to do so is by allocating risk capital first and then using it to assign the cost of that risk capital to portfolio elements.
The cost is the product of the risk-adjusted capital and a hurdle rate.
This product is known as the Return on Risk-Adjusted Capital (RORAC).
Under RORAC, risk capital for financial intermediary is the amount needed to guarantee the performance of contractual obligations at default-free level.
Briefly describe an alternative to RORAC.
The cost of risk capital can be determined directly without allocating risk capital first.
Describe how RORAC can be used to determine if an activity is worth pursuing.
Once we have the Cost of Capital, a good way to determine if an activity is worth pursuing is by calculating the economic value added (EVA).
EVA = NPV Return - CoC
Activities with positive EVA should be pursued.
Explain how cost-benefit analysis (CBA) can be used to select risk mitigation strategies.
Once capital allocation is complete, a cost-benefit analysis can be used to determine which mitigation strategies should be pursued.
If we are using EVA approach where the CoC is determined directly, we would implement strategies that produce positive incremental EVA.
If we are using capital allocation approach where we have allocated risk capital, we would pursue activities where the benefit exceeds the costs of implementation.
Define economic capital.
Typically, economic capital refers to the VaR (value at risk).
Identify 4 advantages of using economic capital for ERM analysis.
- Provides a unifying measure for all risks across an organization.
- More meaningful to management than risk-based capital or capital adequacy ratios.
- Forces the firm to quantify the risks it faces and combine them into a probability distribution.
- Provides a framework for setting acceptable risk levels for the organization as a whole AND for individual business units.
Briefly describe why calculating VaR for all risks combined and then allocated down to individual units is beneficial.
Because it provides a consistent measurement of risk across units.
Briefly explain why a rounded number is usually selected for the target level.
Ex: 1-in-3333 VaR instead of 1-in-3467 VaR
The target level is often selected so that the economic capital is slightly less than the actual capital being held.
Define Moment-Based Measures and provide 2 examples of such measures.
Use the moment of a random variable, such as the change in capital over an accounting period.
Ex:
1. variance
2. standard deviation
Identify 2 disadvantages of using variance or standard deviation as risk measure.
For each, provide an alternative.
- Favorable deviations are treated the same as unfavourable ones.
Use semi-standard deviation since it only uses unfavourable deviations. - As quadratic measures, they may not adequately capture market attitudes to risk (understated).
Use skewness since uses higher moment, thus might better capture market attitude.
OR
Use exponential moments since they capture the effect of large losses on risk exponentially, the they might better capture market attitude.
Describe tail-based measures.
Tail-based measures emphasize large losses only.
Describe the 5 types of tail-based measures
- VaR: percentile of the probability distribution
- TVaR: expected loss at a specified probability level and beyond
- XTVaR: calculated as TVaR - mean.
When mean is financed by other funding, then capital is only needed for losses above the mean. - EPD: calculated by multiplying (TVaR - VaR) by the complement of the specified probability level.
Ex: EPD@96% = (TVaR - VaR)*(1-96%) - Value of default put option: when capital and/or reinsurance is exhausted, firm has the right to default on its obligations and put the claims to the policyholders.
The market value of this risk is the value of the default put option.
It is usually estimated using options pricing methods.
Provide an advantage and disadvantage of using VaR as tail-based risk measure.
Advantage: emphasizes large losses
Disadvantage: only looks at one point in the distribution
Provide an advantage and disadvantage of using TVaR as tail-based risk measure.
Advantage: reflects losses that exceed VaR
Disadvantage: losses are reflected linearly in the tail and does not reflect the fact that a risk that is twice as large is more than twice as bad.