Part 8. Introduction to Risk Management Flashcards
Risk management process seeks to:
- Identify risk tolerance of the organisation.
- Identify and measure the risks that the organisations faces.
- Modify and monitor these risks.
Risk management framework
- Establishing processes and policies for risk governance.
- Determining the organisations risk tolerance.
- Identifying and measuring existing risks.
- Managing and mitigating risks to achieve the optimal bundle of risks.
- Monitoring risk exposures over time.
- Communicating across the organisation.
- Performing strategic risk analysis.
Risk governance
- Refers to senior managements determination of the risk tolerance of the organisation, the elements of its optimal risk exposure strategy and framework for oversight of risk management function.
- Seeks to manage risk that supports the overall goals of the organisation so it can achieve the best business outcome consistent with organisations overall risk tolerance.
- Provides organisation-wide guidance on risks that should be pursued in a efficient manner, subject to limits and reduced or avoided.
Factors determining risk tolerance:
- its expertise in its lines of business
- its skill at responding to negative outside events
- its regulatory environment
- its financial strength
- Its ability to withstand losses
Risk budgeting
The process of allocating firm resources at assets by considering their various risk characteristics and how they continue to meet organisations risk tolerance.
Goal: to allocate the overall amount of acceptable risk to mix of assets or investments that have greatest expected returns over time.
e.g. single metric, categories of investment, specific risk factors.
Financial risks
These arise from exposure to financial markets.
- Credit risk - uncertainty about whether counterparty to transaction will fulfil its contractual obligations.
- Liquidity risk - risk of loss when selling an asset at a time when market conditions make sales price < underlying fair value of asset.
- Market risk - uncertainty about market prices of assets (stocks, commodities, currencies) and interest rates.
Non-financial risks
This arises from the operations of the organisation and from sources external to the organisation.
- Operational risk - the risk of human error, faulty organisational processes, inadequate security, or business interruptions will result in losses, e.g. cyber risk.
- Solvency risk - the risk that the organisation will be unable to continue to operate as it has run out of cash.
- Regulatory risk - the risk the regulatory environment will change, imposing costs on the firm or restricting its activities.
- Governmental or political risk - the risk that political actions outside specific regulatory framework, such as increase in tax rates will impose significant costs to an organisation.
- Legal risk - the uncertainty about organisations exposure to future legal action.
- Model risk - the risk that asset valuations based on organisations analytical models are incorrect.
- Tail risk - the risk that extreme events (in tails of distribution outcome) are more likely than organisations analysis indicates, especially from incorrectly concluding the distribution of outcomes is normal.
- Accounting risk - the risk that organisations accounting policies and estimates are judged to be incorrect.
Mortality risk vs longevity risk
- risk of death to provide for families future needs, and risk of living longer than anticipated.
- MR is most often addressed with life insurance, and LR reduced by purchasing lifetime annuity.
- risks to bear, prevent/avoid and take in order to maximise the expected outcome in terms of personal utility or satisfaction.
Measures of risk for specific asset types:
Standard deviation = a measure of volatility of asset prices and interest rates, may not be appropriate measure of risk for non-normal probability distributions, especially negative skew or positive excess kurtosis (fat tails).
Beta = measures market risk of equity securities and portfolios of equity securities, considering risk reduction benefits of diversification, whereas standard deviation is a stand alone measure of risk.
Duration = measure of price sensitivity of debt securities to changes in interest rates.
Derivative risks include:
Delta = the sensitivity of derivatives values to price of underlying asset.
Gamma = sensitivity of delta to changes in the price of underlying asset.
Vega = the sensitivity of derivatives values to volatility of price of underlying asset.
Rho = sensitivity of derivatives values to changes in risk-free rate.
Tail risk (downside risk)
The uncertainty about the probability of extreme (negative) outcomes, measures of tail risk include Value at Risk VaR and conditional VaR.
Value at Risk (VaR)
The minimum loss over a period that will occur with a specific probability, used in establishing minimum capital requirements.
e.g. bank with 1 month VaR of $1m with probability of 5%, means 1 month loss of at least $1m is expected to occur 5% of the time.
limitations:
- inputs and models used will affect calculated value, and with estimates of risk, incorrect inputs or inappropriate distribution assumption lead to misleading results; so should be used in conjunction with other measures.
Conditional VaR
The expected value of loss, given the loss exceeds a minimum amount.
e. g. CVaR would be expected loss given that loss was at least $1m.
- calculated as the probability-weighted average loss for all losses expected to be at least $1m.
- similar to measure of loss given default that is used in estimating risk for debt securities.
2 methods of risk assessment used to supplement VaR measures are:
- Stress testing = examines the effects of a specific change in a key variable such as an interest rate or exchange rate.
- Scenario analysis = refers to similar what if analysis of expected loss, but incorporates changes in multiple inputs, e.g. combine interest rate change with significant change in oil prices or exchange rates.
Subjective risk
- risk of bankruptcy of a firm that has never experience financial distress, is subjective than data driven, estimates of risk based on market prices of insurance, derivatives or other securities can hedge those risks.
- operational risk is difficult to predict incurring large costs, but examining a large sample of firms to determine overall probability of significant losses, and average loss of firms who have experienced these losses.
- unexpected changes in tax laws or regulation imposes large costs, but political nature means difficulty predicting.
