Risk Categories Flashcards
Market risks affect a corporation’s financial position in what 3 ways?
1) Transaction exposure: the direct impact of market movements on revenue and expenses
2) Economic exposure: how market movements affect the competitive position, including buyer and supplier behaviour
3) Translation exposure: how market movements affect financial statements when converting to the home currency
Lam - ERM Textbook - pg. 319
What is stock price risk?
A type of market risk. The risks that a corporation faces due to its own stock price. High stock prices allow companies to pursue strategic initiatives.
Lam - ERM Textbook - pg. 319
What are some examples of operational risks faced by non-financial corporations?
1) Liability resulting from defective products
2) Failed mergers and acquisitions
3) R&D underperformance risk
4) Reliance on faulty financial models
5) Changes in tax laws and regulations
6) Organizational and technology risks too
Lam - ERM Textbook - pg. 321
What is cultural risk?
A form of operational risk. Ex: a company culture of inflexibility leaves the firm vulnerable to rapid business environment changes
Lam - ERM Textbook - pg. 324
Define outsourcing. Whats the risk?
The utilization of third parties to complete tasks that are normally performed internally. The risk is that the 3rd party is in charge of monitoring and regulating the process. The original firm has less control.
Lam - ERM Textbook - pg. 325
What are the steps to make a risk map?
- Establish a top-down framework & taxonomy
- Create a bottom-up list of specific risks
- Evaluate the probability and severity of each risk
- Identify existing controls and consider creating new controls
- Assign responsibilities for implementing controls, monitoring, and reporting on specific risks
- Aggregate individual risk maps into an enterprise level risk map
- Go back to step 1 in order to update and refine the risk mapping process
Lam - ERM Textbook - pg. 327
Why are risk maps popular? What are they for?
It is a popular risk identification and assessment tool because of its flexibility to incorporate both financial and non-financial risks.
Lam - ERM Textbook - pg. 328
What qualities should a risk map have?
1) Comprehensive: identifies and assesses all risks faced by the company
2) Consistency: uses a standard taxonomy to discuss and evaluate risks
3) Accountability: BUs are directly involved in identification, assessment, monitoring, and management
Lam - ERM Textbook - pg. 328
ERM process in general?
1) risk identification and assessment
2) quantification and reporting
3) management and control
Lam - ERM Textbook - pg. 326
VaR
A summary statistic that quantifies the worst decline in asset or portfolio value for a given level of confidence over a specified period of time.
Ex: Under normal market conditions, the most the portfolio can lose over a month is $X at the 99% confidence level.
Lam - ERM Textbook - pg. 329
What are the 3 approaches to estimating CFaR and EaR?
1) Pro Forma Analysis
2) Regression Analysis
3) Simulation Analysis
Lam - ERM Textbook - pg. 330
Summarize what a company should do about their risks
1) High frequency, low-med severity risks: implement control procedures
2) Low frequency, high severity: establish contingency plans and insurance
3) SPOFs: develop back up processes
4) For critical operations and core systems, have excess capacity
Lam - ERM Textbook - pg. 333
What is the difference between business and financial risks?
Business risks are willingly taken on to create a competitive advantage and add to shareholder value. Financial risks are the other risks, which relate to possible losses from financial market activities.
Jorion - Value at Risk - pg. 4
What does dollarization mean?
When a country adopts a foreign currency in place of or alongside its domestic currency. It can eliminate risk of sudden devaluation of the country’s exchange rate. However, “giving up fluctuations in currencies in exchange for greater fluctuations in output and employment may not be a bargain.”
Jorion - Value at Risk - pg. 10
Define derivative
Instruments designed to manage financial risks efficiently. A derivative contract is a private contract deriving its calue from some underlying asset price, reference rate, or index.
Jorion - Value at Risk - pg. 10
What is a notional amount?
Jorion - Value at Risk - pg. 10
What’s the difference between a security and a derivative?
Securities (like stocks and bonds) are issued to raise capital. Derivatives are contracts between 2 parties.
Jorion - Value at Risk - pg. 10
Use notional amount in an example
The simplest example of a derivative is a forward contract on a foreign currency, which is a promis to buy a fixed (notional) amount at a fixed price at a future date. Someone might buy this if they are importing foreign products because they could buy the foreign currency forward, eliminating the risk of subsequent exchange rate fluctuations.
Jorion - Value at Risk - pg. 10
How does mapping work?
Mapping replaces positions in instruments by exposures to fundamental risk factors. A position in a forward contract is equivalent to the same notional amount invested directly in the spot market, leveraged by cash so that there is no net initial investment.
Jorion - Value at Risk - pg. 11
What is leverage? Why is it a double-edged sword?
Leverage means using borrowed money. It makes derivatives efficient hedging instruments because of low transaction costs. However, the absence of an upfront cash payment makes it more difficult to assess the potential downside risk.
Jorion - Value at Risk - pg. 11
What is financial engineering?
A field of finance. The development and creative application of financial technology to solve financial problems and exploit financial opportunities.
Jorion - Value at Risk - pg. 11
What is financial risk management?
The design and implementation of procedures for identifying, measuring, and managing financial risks.
Jorion - Value at Risk - pg. 13
What do duration, beta, and delta measure?
(blank) is a linear sensitivity for exposure (blank).
1) Duration: to interest rates
2) Beta (or systematic risk): to stock-market movements
3) Delta: of options to the underlying asset price
Jorion - Value at Risk - pg. 15
Describe the differences between valuation and risk management approaches to derivatives
valuation vs risk management
1) Principle: expected discounted value vs dist. of future values
2) Focus: center of distribution vs tails
3) Horizon: current value vs future value
4) Precision: high needed for pricing vs less needed b/c errors cancel out
5) Distribution: risk neutral vs actual (physical)
Jorion - Value at Risk - pg. 22
What are the types of financial risks?
Market, liquidity, credit, and operational
Jorion - Value at Risk - pg. 22
What are the 2 forms of market risk?
1) Absolute risk (measured in the relevant currency) focuses on volatility of total returns
2) Relative risk (measured relative to a benchmark index) focuses on tracking error
Jorion - Value at Risk - pg. 22
What is tracking error?
Deviation from the index. Measured in relative risk.
Jorion - Value at Risk - pg. 22
What are the 2 classifications of market risks?
1) Directional: exposures to movements in financial variables (stock prices, interest rates, etc)
2) Nondirectional: the remaining risks. Nonlinear exposures and exposures to hedged positions or to volatilities.
Jorion - Value at Risk - pg. 22
What is basis risk?
Risk created from unanticipated movements in the relative prices of assets in a hedged position
Jorion - Value at Risk - pg. 22
What is volatility risk?
Exposure to movements in the actual or implied volatility
Jorion - Value at Risk - pg. 22
What are the 2 forms of liquidity risk?
1) asset liquidity risk (or maket/product liquidity risk)
2) funding liquidity risk (or cashflow risk)
Jorion - Value at Risk - pg. 23
What is asset liquidity risk and how can it be managed?
1) It’s the risk that a transaction can’t be conducted at prevailing market prices due to the asset illiquidity
2) Manage this risk by setting limits on certain markets and products and by diversification.
Jorion - Value at Risk - pg. 23
What is funding liquidity risk and how can it be managed?
1) It’s the risk that early liquidation of assets is required to meet payment obligations (resulting in realized losses)
2) Manage this risk by setting limits on cashflow gaps and by diversification
Jorion - Value at Risk - pg. 23
What is a credit event?
A credit event occurs when there is achange in the counterparty’s ability to perform its obligations
Jorion - Value at Risk - pg. 25
What is sovereign risk?
The risk that countries impose foreign exchange controls that make it impossible for counterparties to honour their obligations. Default risk is usually company specific, sovereign risk is country specific.
Jorion - Value at Risk - pg. 25
What is settlement risk?
A type of credit risk. The risk that obligations are fulfilled, but not at the agreed-upon time.
Jorion - Value at Risk - pg. 25
How can credit risk be managed?
Setting limits on notionals, current and potential exposures, and using credit enhancement features like requiring collateral or marking to market
Jorion - Value at Risk - pg. 25
What is legal risk and how can it be managed?
1) The risk of fines, penalties, and punitive damages from supervisory actions, lawsuits, or private settlements.
2) Manage it by having the legal counsel, risk management, and senior management work together to create company policies, and make sure agreements with counterparties can be enforced.
Jorion - Value at Risk - pg. 26
What does risk mean?
In a nontechnical context, it means a danger of loss. In a financial context, risk refers to the dispersion of possible outcomes, positive or negative.
Jorion - Value at Risk - pg. 75
What are the 4 types of market risk?
interest rate risk, exchange rate risk, equity risk, and commodity risk
Jorion - Value at Risk - pg. 76
How can volatility be measured?
Standard deviation of unexpected outcomes
Jorion - Value at Risk - pg. 76
What 2 factors cause financial losses?
Volatility in the underlying financial variable and exposure to it. Firms can only control the latter.
Jorion - Value at Risk - pg. 76
What do convexity and gamma measure?
Both are second-order exposures. Convexity is for the fixed-income market and gamma is for the options market.
Jorion - Value at Risk - pg. 76
What is skewness? Kurtosis?
1) Skewness describes a distribution’s departure from symmetry
2) Kurtosis describes the degree of flatness of a distribution
Jorion - Value at Risk - pg. 86
What does ETL mean?
Expected tail loss, expected shortfall, conditional loss, or conditional tail expectation. The average of X given X exceeds a given value.
Jorion - Value at Risk - pg. 91
What does stationary mean?
If a distribution is stationary, it means the parameters are stable over time
Jorion - Value at Risk - pg. 93
Why might someone use a geometric rate of return instead of arithmetic (or discrete)?
1) If geometric returns are distributed normally, then the dist can never lead to a negative price (unlike arithmetic)
2) Geometric returns easily allowable extensions into multiple periods. Ex: the 2-month geometric return is the sum of the 2 monthly returns. This is not true for arithmetic.
Jorion - Value at Risk - pg. 94
What is the time aggregation problem? How do we solve it?
The problem of transforming risk measures from one time horizon to another. To do this, we assume that returns are uncorrelated (independent) over successive time intervals. We assume prices follow a random walk because we assume markets are efficient, and all prices reflect all relevant public information.
Jorion - Value at Risk - pg. 97
Why might markets have trends in the returns?
This may happen because of illiquidity in the underlying market. The price impact of new can be felt over many periods, creating trends.
Jorion - Value at Risk - pg. 99
What is IAIS’ holistic framework?
1) A framework to assess and mitigate systemic risk in the global insurance market.
2) Created to support the mission of effective and globally consistent supervision to protect policyholders and contribute to global financial stability.
IAIS Holistic Framework - pg. 4
What is included in the IAIS holistic framework?
1) Supervisory material. A set of policy measures used to prevent exposures from developing into systemic risks, and corrective measures to respond to a concern.
2) Global monitoring exercise. To detect a global systemic risk and ensure a consistent response to the risk.
3) Implementation assessment. To ensure consistent application of the supervisory material.
IAIS Holistic Framework - pg. 4
Where does systemic risk come from?
Risk that arises from:
1) the distress of a globally important financial institution
2) the collective exposures of organizations
IAIS Holistic Framework - pg. 7
What is systemic risk?
The risk of disruption to financial services that is caused by an impairment of all or parts of the financial system and has the
potential to have serious negative consequences for the real economy.
IAIS Holistic Framework - pg. 9
What does a cross-sector assessment mean?
IAIS’ holistic framework focuses on a cross-sectoral dimension of systemic risk because the assessment of risk in an isolated sector would be incomplete. Insurers are an integral part of the financial system, so they need to be addressed in the broader context.
IAIS Holistic Framework - pg. 9
What are the key exposures the IAIS has identified in the insurance sector that may lead to a systemic impact?
1) Liquidity risk
2) Interconnectedness
3) Limited substitutability
4) Emerging risks that require more investigation: cyber risk, climate risk, and wide-spread under reserving without ability to reprice
IAIS Holistic Framework - pg. 10
What does interconnectedness mean in the holistic framework?
Interconnectedness refers to interlinkages with other parts of the financial system and the real economy, of which two types can be identified: macroeconomic exposure and counterparty exposure
IAIS Holistic Framework - pg. 10
What does macroeconomic exposure mean?
When an insurer has high exposure to macroeconomic risk factors, its financial position is highly correlated with the overall economy, limiting the potential to diversify through the pooling of idiosyncratic risks. Macroeconomic exposure can accumulate from insurance liabilities.
IAIS Holistic Framework - pg. 10
What does counterparty exposure mean?
Mutual exposure of an individual insurer to counterparties in
the broader financial system and real economy resulting from asset-side interconnectedness and liability-side exposures, which leads to both parties being vulnerable to distress or failure of the other
IAIS Holistic Framework - pg. 10
What does limited substitutability mean?
The difficulty for other organizations in the financial system to ensure the continuation of supply of insurance coverage after a failure or distress of an individual insurer. The risk of this is higher when a small number of organizations dominate the market.
IAIS Holistic Framework - pg. 10
In the holistic framework, what are transmission channels? What are they?
For an exposure to have a systemic impact, it must spread to other market participants through transmission channels.
1) Asset liquidation
2) Exposure channel
3) Critical functions
IAIS Holistic Framework - pg. 11
How does the asset liquidation transmission channel work?
1) Asset liquidation refers to the sudden sale of assets on a large scale, by a large insurer or a sufficiently large number of smaller insurers,
2) which could trigger a decrease in asset prices and significantly disrupt trading or funding in key financial markets
3) or cause significant losses or funding problems for other firms with similar holdings.
IAIS Holistic Framework - pg. 11
How does the exposure channel work as a transmission channel?
1) Indirect exposure stemming from macroeconomic exposures, because institutions are exposed to the same or similar asset classes or because their exposures are highly correlated with the financial market
2) Direct exposure, in case of direct interlinkages between institutions. Distress at the level of an individual insurer may then propagate through transferring directly or indirectly losses to the rest of the financial system.
IAIS Holistic Framework - pg. 11
How do critical functions work as a transmission channel?
Interruption of services of an individual insurer may have a systemic impact if two conditions are met:
1) the insurer provides services that are important for the functioning of the financial sector and real economy
2) there are few, if any, readily available substitutes
IAIS Holistic Framework - pg. 11
Why is a large asset liquidation a concern?
1) It can exacerbate market movements
2) It can increase asset price volatility
IAIS Holistic Framework - pg. 12
Why is the exposure channel a concern?
1) transferring losses to other market participants
2) constraining funding or liquidity to financial institutions
IAIS Holistic Framework - pg. 12
What are the sections of the supervisory material in the holistic framework?
1) On-going supervisory policy measures
a) macroprudential supervision
b) requirements on insurers
c) crisis management and planning
2) Powers of intervention for supervisors (preventive and corrective)
IAIS Holistic Framework - pg. 13
What does the macroprudential supervision section of the supervisory material in the holistic framework contain?
General processes for supervisors to conduct their review. Ex: macroprudential analysis is required to be quantitative and qualitative, to consider historic and current risk environments, and to consider inward and outward risks.
IAIS Holistic Framework - pg. 15
What does the requirements on insurers section of the supervisory material in the holistic framework contain?
1) ERM requirements related to the key exposures that the IAIS has identified as potential systemic impacts. Stress tests are a main focus.
2) Public disclosure requirement for liquidity risk
IAIS Holistic Framework - pg. 16
What does the crisis management and planning section of the supervisory material in the holistic framework contain?
Requirements on
1) recovery planning
2) resolution planning
3) establishment of crisis management groups
IAIS Holistic Framework - pg. 17
What elements are included in the global monitoring exercise?
1) sector-wide monitoring
2) individual insurer monitoring
3) Data analysis by the IAIS
4) Collective discussion of the results within the IAIS
5) Reporting to participating insurers, IAIS members, the FSB, and the public
IAIS Holistic Framework - pg. 19
