FRM- 1 Flashcards
Reason for Launching Risk Governance Program
Failure in Risk Handling and Risk Governance leading to 2008 Economic Crises
Relationship between Enterprise and Risk
- Risk is linked with Production Activities of Enterprise
2. Enterprise is characterized by Uncertainty in its Operations to meet Customers’ Need
Role of Directors in Enterprise Management
Effective Oversight of Risk- Taking
Aim of Risk Governance Program
- Help Directors in Improving their Risk Management Oversight
- Enhance Risk Oversight Structures, Processes and Competence
Impact of Poor Risk Handling and Governance
Loss in Job, Goods and Services
Base of Risk-Taking Issues
Impact on the Value of the Firm
Various Definitions Related to Risk
- Focus only on Negative Implications of Risk
2. No Clear Distinction between Risk and Uncertainity
Two symbols Describing Risk
- Danger
2. Opportunity
Two symbols Imply
Danger and Opportunity Comes Hand-in-Hand
Good Risk-Taking Organization
- Planning for Crisis in Good Times
2. Looking for Opportunities in Bad Times
Risk Profile
Various Risks Faced by an Organization
Need of Risk Profile
- Aware of Risks Faced by the organization
2. Effective Risk Management as well as Risk Governance
Risk Profile Same for Every Organization & Industry
No
Next Step after Risk Profile
- Classifying the various risks into 3 groups:
a. Risks to be passed on to the owners
b. Risks to be hedged
c. Risks to be exploited - Risk Treatment Process
Risk profile made by Different Persons
- Different Due To
2. Different Experience
In Organization
- Clear Understanding of Various Risks Faced
2. Spell Out the Potential Risks
Risk Management
- Minimizing Exposure to the Wrong Risks
2. Increasing Exposure to the Good Risks
Corporate Governance
- Structures and Processes Direction and Control of Companies
- Relationship between Management, Board of Directors, Controlling Shareholders, Minority Shareholders and Other Stakeholders
Perspectives on Corporate Governance
- Agent Theory: Aligning Shareholders and Internal Agent
- Transaction Cost Theory
- Stewardship Theory: Managed and Guided in an Opportune manner (Achievement, Meaningfulness, Altruism of Human Motives)
- Resource Dependence Theory
- Stakeholder Theory: Agreements with Multiple Stakeholders on Various Directions that Create Value or Result into Risks if Neglected
Risk Governance
Director’s way of Authorizing, Optimizing and Monitoring Risk-Taking
Risk Governance Includes
- Skills
- Infrastructure (Organization Structure, Control, Information Systems)
- Culture
Good Risk Governance Defines
- Accountability
- Authority
- Communication and Reporting Mechanisms
Responsibility of Risk Oversight
- Board
- Risk Committee
- Audit and Risk Committee
Purpose of Risk Management
Making Firm More Valuable
Most Common Method for Valuation of a firm
Discounting of Future Cash flows through Risk-Adjusted Cost of Capital (CAPM)
Benefits of CAPM
- No Firm Risks
2. Only Market Risks
Criteria for Selecting a Risk Management Strategy
Value-Maximizing Risk Management Strategy
ERM
Enterprise Risk Management
ERM Vs. Previous Approach of Risk Management
- Holistic Approach of Managing Risks
- Previous Approache Focused on Handling of Risks by their Respective Departments
- Focuses on Value-Creation while Focusing on Risk Managment
Handling all the Risks Together
Better understanding of where:
- Risks could Multiply
- Risks could Cancel each other
- Risks could be Exploited
ERM’s Coordinated Function
- Chief risk officer
- Risk Governance
- Board’s Oversight
Two ERM Approaches
- COSO II ERM
2. CAS ERM Framework
COSO II ERM framework
- Committee of Sponsoring Organizations of the Treadway Commission
- Strategic, Operational, Reporting and Compliance Objectives
CAS ERM Framework
- Casualty Actuarial Society
2. Hazard, Financial, Strategic and Operational Risks
Risk Policy
Types and Degrees of Risks In Pursuit of Goals
Benefits of Risk Policy
- Limits Risk Profile
2. Aggregate Risk- Aversion of Decision-Makers
Attitude of Decision-Makers
Important Towards Risk- Aversion
Risk- Appetite
Amount of Risk in Pursuit of Long- Term Objectives
Risk- Tolerance
Boundaries of Risk- Appetite
Risk- Universe
Full Range of Risks
Pursuing Value- Maximization Risk Strategy
Assess Risk- Taking within Context of Valuation Methodlogy
2 Approaches for Adjusting Value for Risk
- Risk- Adjusted Discount Rate
2. Certainty Equivalents Cash Flow
Risk- Adjusted Discount Rate
- Discount Rate reflects the Risk of the Cash Flows
2. CF are taken as E (CF)
Certainty Equivalents Cash Flow
- CE (CF) reflects the Risk of the Cash Flows
2. Discount- Rate is the Risk- Free Rate
Adjusting Value for Risk is also known as:
Risk- Adjusted Value (RaV)
3 Steps to obtain RaV
- Expected Cash Flows: Probability across different scenarios and Cash Flows for different scenarios
- Risk-Adjusted Discount Rate: Risk-Free Rate + Risk Premium
- Present Value of the Cash Flows
Inputs for Risk-Adjusted Discount Rate:
- Cost of Equity:
a. Risk- Free Rate
b. Beta
c. Risk Premium - Cost of Debt:
a. Risk- Free Rate
b. Default Spread
c. Marginal Tax-Rate
Characteristics of Risk-Free Rate
- No Default Risk: There is no uncertainty about the return on the investment (Not all Government Securities are Risk- Free)
- No Reinvestment Risk: 6-month T-bills may have different risk-free rate than 10-years T-bills ( Time Horizon Matters)
Relationship between Risk- Free Rate and Currencies
Expected Inflation
Beta
Measure of Relative Risk
Measuring Beta
Slope of the Regression of Returns on the Stock against Market Index
Disadvantages of Regression Technique
- Historical Beta: Does not take into account current business mix and financial leverage
- Estimated with Error
- Depends on the Regression Structure as well as the Market Index taken
Beta should Reflect:
- Products and Services: Fad/ Necessities
- Fixed Cost Structure: High Fixed Cost implies High Beta
- Financial Leverage: Higher Debt means Higher Fixed Cost (Interest Expenses)
Another Way of Calculating Beta:
Weighted Average of the Betas of the Businesses in which the Firm Operates, corrected for Financial Leverage
Firms with Multiple Businesses
Hurdle Rate for each Businesses Separately
Equity Risk Premium
Additional Premium for investing in a Risky Asset
Calculating Risk Premium
- Historical based on comparing of Risk-Premium with investment in Stocks against T-Bills/ T- Bonds
- Forward- Looking Premium
Disadvantage of Historical Risk Premium
Significant Amount of Error involved
Forward-Looking Premium:
Based on current Stock Price and Future Cash Flows
Adjustment for Country Risk
- Emerging Market: Political Instability and Nature of Economy
- Adjust using Default Spread
Default Spread
- Based on Rating Agencies’s Default Spread Relative to Different Ratings
- Implied Interest Rate
- Synthetic Bond Rating based on Financial Ratios
Default Spread Depends on:
- Economic Uncertainty
2. Investors’ Risk Aversion
Two More Inputs necessary for Cost of Capital:
- Tax Rate
- Market-value Weights (Weights may sometimes depend on the Target Weights for the entire business instead of Actual Funding Mix)
Methods for Adjusting Expected Cash Flows for Risk
- Utility Functions (Difficult)
- Subjective Decrease- Different Judgments of Value based on Different Risk Aversion
- Risk-adjusted Cash Flow
Formula for Risk-Adjusted Cash Flow
Multiply each Cash Flow with Risk-Free Rate and divide by Risk-Adjusted Discount Rate with both Rates raise to Appropriate Power according to Time-Period
Different Investments Have
Different Hurdle Rates due to Different Risk Exposures
ERM
- Creates Business Value through Integrated Process of Identification, Estimation, Assessment, Handling, and Controlling of Risk
- Recognizes Imperfection of Market, Imperfection of Diversification and Bankruptcy Costs
CAPM Deals with Risk Management
No
Define ERM
- Manage Market Risk, Credit Risk, Operational Risk and Economic Capital and Risk Transfer to Maximize a Firm’s Value
- Managing Uncertainty
- Identification, Assessment and Handling of Risks through Corporate Actions to Monitor, Control and Minimize their Adverse Effects or Maximize the Realization of Opportunities
- Methodically addressing Risks associated to various activities with the goal of Achieving Sustained Benefit within Each Activity and across Portfolio of all Activities
Corporate Finance and ERM
Both focuses on Maximizing Firms Value or Shareholder’s Value
AIRMIC
Association of Insurance and Risk Managers
Risk Management Process
- Risk Policy
- Risk Profile
- Likelihood and Consequences
- Value-based Model for Estimating Impact on Firm Value
- Risk Treatment
AIRMIC Framework
- Risks and Enterprise’s Objectives
- Risk Assessment
- Risk Treatment
- Risk Monitoring
Risks and Enterprise’s Objectives
- Resources for Risk Management and Risk Treatment
- Degree of Risk Aversion and Risk Policy
- Strategic Objectives and Operational goals compatible with Above
Risk Assessment
- Risk Analysis
2. Risk Evaluation
Risk Analysis
- Risk Identification
2. Risk Estimation
Risk Identification
- Exposure to Uncertainty
2. Downside and Upside Risks
Tools for Risk Identification
- Brainstorming
- Questionnaires
- Risk Assessment Workshops
- Incident Investigation
- Industry Benchmarks
- Business Studies on Business Processes both Internal as well as External
- Scenario Analysis
- Auditing and Inspection
Risk Maps
- Name
- Qualitative Description
- Up/ Downside Scenarios
- Probability of Occurrence
- Person handling Risk
- Techniques to Monitor
- Preliminary Evaluation of the Economic Impact of the Scenarios
Risk Estimation
- Probability of Event
2. Impact on Cash Flows
3 Methods for Risk Estimation
- Purely Qualitative
- Semi Quantitative
- Purely Quantitative
Purely Qualitative
- Qualitative Scaling
2. Probability- Impact Matrix
P-I Matrix
- Qualitative Scale for Probability of Occurrence
- Qualitative Scale for Impact
- Qualitative Scale for Risk-Rating
Disadvantage of Purely Qualitative Estimate
- Highly Subjective
2. Only for Pure Downside Risks
Semi Quantitative
- Quantifying the Qualitative Scaling
2. Risk Rating by Multiplying Probability Score with Impact Score: Severity Risk Index or Risk Score
Pure Quantitative
- Focus on the Distribution of Probability of Risky Events
2. 4 Steps
4 Steps in Pure Quantitative Estimation
- Causal Model
- Probability Distribution of Inputs
- Probability Distribution of Outputs
- Validate the Model
Risk Evaluation
- Enterprise Value
2. Significance of Risk to the Organization based on the Risk Policy
Risk Treatment
- Risk Avoidance
- Risk Transfer
- Risk Reduction
- Risk Retention
Risk Transfer
- Risk Hedging
- Insurance Policies/ Derivatives
- Smoothness of Cash Flows or Lowering of Cost of Capital
- Various Tools available for Risk Transfer
Reason for Risk Transfer
Cost of RT < Enterprise Value Generated
Risk Retention
- Risk Neglected
2. Firm’s Risk Strategy
Risk Reduction
Portfolio Diversification
Risk Monitoring
- Risks Retained
- Business Variables as Sources of Risks Assumed
- Obsolescence of Risk Analysis
- Quality and Effectiveness of Risk Process
Benefits of Probabilistic Approaches
- More Data-Intensive View of Uncertainty
2. Focus not Only on Uncertainty in Expected Cash Flows
3 Probabilistic Approaches
- Sensitivity Analysis
- Scenario Analysis
- Simulations
Sensitivity Analysis
- Assess Sensitivity of Decision Outcomes to Changes in Key Assumptions
- Analysis Focus on 2 or 3 Most Important Variables
Use of Scenario Analysis
- Macroeconomic Environment Dependent
2. Competitive Response
Scenario Analysis
- Possible Scenarios- Values and
- Their Probabilities
- Calculate the Expected Value
Use of Decision Trees
Sequential Risks
Simulations
- Distribution of Values
2. Distribution of Inputs
Value at Risk (VaR)
- Confidence Interval
- Specified Level of Loss
- Fixed Time-Period over which Risk is Assessed
VaR Requires
- Bank’s Capital
- Regulatory Limit
- VaR Limit Based on Above
Disadvantages of VaR
- Large Standard Error
2. Black Swan
Black Swan
Break from Normal Distributions and Historical Data Patterns
VaR Limit
Trading Positions Closed or Modified
Doubts
- Decision Outcomes
2. Regulatory Limits
RM Affects Value By
- Increasing Return and
2. Reducing Variance in Return
4 Key Inputs of Firm Value
- Cash Flow Generation from Assets and Investments
- Expected Growth Rate in Cash Flows
- Time Period: Length of Competitive Advantage Period
- Discount Rate : Reflecting Riskiness of the Firm and Funding Mix
Reducing Downside Risks Refers To
Risk-Hedging
Increasing Exposure to Upside Risks Refers To
Risk-Taking
Cost of Hedging Depends On
- Type of Risk Hedged
2. Product Used to Hedge
Cost of Hedging
- Explicit Costs
2. Implicit Costs
Explicit Costs
- Reflected in Financial Statements
2. E.g. Insurance/ Put Options
Implicit Costs
- Affects Earnings But Not Reflected in Financial Statements
- E.g. Futures/ Forwards
Framework for Risk Hedging
- Benefits > Cost
- Less Costly for Firm or Investors
- Investors Capable of Hedging the Risk
Approaches to Hedging
- Investment Choices
- Financing Choices
- Insurance
- Derivatives
Choice of Hedging
- Type of Risk
2. Firm’s Aim from Hedging
Hedging Decision Not Based On
- Inertia
2. Fear
Risk Management Must
Create Value for the Firm
Doubts
- Expected Growth Rate in Cash Flows
- Time Period
- Financing Choices
Strategic Risk- Taking Affects
4 Key Inputs to Firm Value:
- Efficient Operations
- More Reinvestment and Higher Returns
- Competitive Risk- Taking
- Exploit Upside- Risk and Reduce Downside- Risk
Taking Advantage of Taking Risks
- Information Advantage
- Speed Advantage
- Experience/ Knowledge Advantage
- Flexibility
- Resource Advantage
Information Advantage
Better Information and Early
Speed Advantage
Act Quickly and Appropriately
Flexibility
Capacity to Change Course Quickly
Resource Advantage
- Capital Access
2. Debt Capacity
Organizing for
Risk- Taking
Most- Important Ingredient in RM
Luck
3 Propositions
- Today’s Hero will be Tomorrow’s Goat
- Luck is not a Skill
- Life is not Fair
