Risk Management Flashcards
What is the VaR (Value-at-Risk) measure and why is it used?
The Concept of Value at Risk (VaR) is a maximum potential loss measured in currency, under normal market condition for given investment period with certain level of confidence. It is developed to help investors operationalise risk, in other words whether investor is comfortable or not for given level of risk in one of their investment. ( for instance JP Morgan reported daily earning at risk from their trading activities averaged 15 million at 95% confidence)
VAR measures and quantifies and expresses risk.
What is the purpose of a risk management policy?
A risk policy provides guidelines for management. It has two purposes (see Figure 11.5 as an example):
- to protect the shareholders of the firm from the management of the firm.
- protect the managers from themselves by outlining the specific actions that may or may not be taken. The policies force managers to work together within a unified framework toward a common goal.
Why risk management is so important?
Explain a firm’s reasons for managing risk
- it reduces the volatility of earnings (risk premium falls=> value of the firm goes up)
- reduces the volatility of cash flow (bank willingness to lend up=>easy cash access)
- Control of earnings volatility increases (increases competitiveness)
- Reduces the likelihood of financial institutions failure. it lowers volatility hence consumers are safer and their confidence increases.
- Financial system as a whole will much safer and less prone to any disruption
All firms face business risk and market risk. Explain the difference between them and list their components.
Market risk - this is systematic risk
- Interest rate risk
- FX risk
- Commodity price risk
Business risk
1. Model risk - as financial models got increasingly complex to at point where it is diffcult to determine underlying assumption and other between now and future features casuing to use it incorrectly
- Liquidity risk - is a need to sell an asset at an unfavourable price to cover up the short term liquidity needs.
3. Credit risk - is a failure to meet the obligation for required payments of a financial contract
4. Legal risk - is the risk of legal contracts are not being enforced.
5. Operational Risk- is a risk of failure of internal system that manages the business the risk of direct or indirect loss as a result of inadequate internal process, people and system, or from external events
Discuss Operational Risk, making reference to its four components, causes of operational risk, and managing it.
Operational Risk is a common problem and it often arises because firm is successful and growthing, it is a risk that is relatively harder to manage. It has 4 components
- Operations Risk - is a risk that results from consequences of breakdown in a core operating , manufacturing, processing capacity. In case of investment responsibility organisation, the risk is associated with manager, marketing, sales and technology
- Asset impairment risk - risk that asset loses its value because of reduction in likelihood of receiving future cash flows. This risk is at the center of organisation’s ability to safeguard its assets.
- Competitive risk - as a result of competitive environment failure of business’s ability to create valur. In finance organisations failure to deliver superior performance is often linked to market downturn or managerial failure.
- Franchise risk - it is a consequence of excessive risk in 3 previous risk classes. It occurs when value of the entire firm erodes due to loss in confidence of critical constituents.
Example of operational risk failure : Joseph Jett and Kidder, Peabody. Kidder, Peabody is owned by GE and the chairman of GE demanded each business owned by GE be number 1 or 2 in their market. Kidder, Peabody chose to be a leader in mortgage-backed securities. However, Kidder, Peabody did not have the people nor computer systems to do this. In this environment, Joseph Jett became the head of Kidder, Peabody’s government trading desk. Jett found weaknesses in the computer system that allowed him to book profits and hide losses and thus create a pyramid scheme.
‘An inadequate risk management function can lead to disaster.’ Discuss this statement with reference to a company you have studied. (read LTCM and Barings)
What lessons can be learned from the many well-documented examples of risk management failures?
Calssic example of Operating risk is Barings Bank. Summarising what went wrong in this case
- Barings didn’t realise the importance of segregation of front, middle, back office roles. Nick Leeson was effectively in charge of dealing desk and the back office hence he was perfectly placed to play false information to head office.
- the importance of Senior management involvement.Every major report on managing derivative risk has stressed the need for management understanding the risks of the business and to draft strategies and control procedures to achieve these objectives.
- The importance of proper internal control procedures. - as … Not only should there be separation of operational duties between the front and back offices, but also a risk management unit independent of both to provide an additional layer of checks and balances. Barings did not require Leeson to distinguish margin needed to cover in house trades and customer trades.
- The need for clear lines of responsibility and accountability. - all institutions should maintain an up to date organisational chart that shows clearly all the reports inlines and who is accountable to whom and for what. ( nb job descriptions)
Briefly outline some frameworks you have looked at to assess operational risk.
R.L. Simon developed a framework for assessing operational risk. Thw framework looks into 3 area Growth Culture and Information Management. You assign each reference a score from 1 (low risk) to 5 (high risk) and then calculate the total score
Describe the steps for creating a risk policy.
- This statement starts with identification of the company’s investment philosophy, which is based on the company’s level of risk aversion. The statement will clearly differentiate between operational aspects of risk and investment risk
- The next step is to identify the objective of the risk management policy. For instance: a) preserving the value of the firm in the long term regardless of the variation in underlying economic variables b)ensuring orderly recognition of income without undue variation due to changes in underlying economic variables
3.Now we must identify the parties responsible for risk management and the limitations the company wants to place on risk managers.
A treasurer must know:
How risk management tools work in both rising and falling markets, and how to quantify the dollar value of potential gains and losses. While the treasurer must understand various techniques, the Board of Directors may choose to limit the tools that the treasurer may use in attempting to manage risk.
Discuss the evaluation of risk management performance.
Creating a risk management philosophy and a risk management policy statement is that these provide reference for evaluating the effectiveness of the company’s risk management efforts.
One possible measure of effectiveness of risk management is degree of hedging efficiency. Regardless of the hedging objective, the implementation must have the following characteristics.
- Acceptability - the strategies must make sense to professionals who will implement the strategy.
- Consistency - the strategies make sense in the context of management’s stated values and objectives and the strategies have a logical flow from period to period.
- Quality - the strategies can be seen to improve management decision-making, i.e. management’s beliefs align with market realities.
What is Stress testing?
def: It is a procedure to expose vulnerability of firm/portfolio in a hypothetical event. It tells us what stands to lose but does not tell us how likely it is. ie not looking at proability of happening, but posibility of consequences.
Example: break-even analysis and scenario analysis
2 Major approaches:
SCENARIO (focuses particular scenario)
MECHANICAL APPROACHES (focus range of scenario, hence computaionally intensive)
Discuss the concept of bankruptcy and outline its advantages and disadvantages.
Generally speaking, bankruptcy is triggered when a company can no longer meet its short term commitments and thus faces a liquidity crisis. Bankruptcy is caused by
1. ill conceived strategy
2. Badly implemented strategy
3. Market Changes
4. Cost problems
Two different types of bankruptcy procedures:
Creditor (Lender) friendly
Debtor (Company) friendly
Disadvantage is voluntary or court-mandated reorganisation or liquidation, which is often costly, lengthy and sometimes ineffective.
Discuss the implications of bankruptcy for financial theory.
Every economic system needs mechanisms to ensure the optimal use of resources. Bankruptcy is the primary instrument for reallocating means of production from inefficient to efficient firms. A bankruptcy process can allow a company to reorganise, often requiring asset sales, a change in ownership and partial debt forgiveness on the part of creditors.
In other cases, bankruptcy leads to liquidation-the death of the company.
Generally speaking, bankruptcy is triggered when a company can no longer meet its short term commitments and thus faces a liquidity crisis.
Nevertheless, the exact definition of the financial distress leading the company to file for bankruptcy may differ from one jurisdiction to another.
How should ‘Stress Testing’ be used in risk management?
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What is a risk management?
Risk management is defined as management of risk over specified time period in situations where volatility existsand managers have the opportunity to change the expected cash flows.
To the extent that if managers cannot change the expected cash flows, then no opportunity for managing risk exists.
Causes of operational risk
Growth - This can occur when senior managers pressure employees a very high level of performance, when the rate of expansion is so high that existing employees do not have enough time to perform their jobs well or when the company is forced to use untrained or inexperienced employees in important positions.
Culture - This problems here usually steam from incomplete managerial information, for example when managers provide high year end bonuses directly linked to performance (this leads to employees taking greater risks) linked to this incentives can cause excessive competitive work environment that encourages employees to compete with one another
Information management - As a company grows, the nature and extend of the transactions in which it is involved often become much more complex. If employees are forced to do this more complicated functions without adequate training or preparations disasters can occur.
