Types of risk and their measurements Flashcards
What are the 6 types of risk?
Credit, Market, Liquidity, Interest, Country and Solvency Risk
Why do banks have to take on risks?
Their main business is to use principles of mismatching to generate profits. They aim to control risk with risk management processes while balancing it to generate profits.
What are the approaches to risk management processes?
Top-down: Sets risk limits based on banks earnings as a whole and let limits trickle down into specific business units risk and finally into individual customer risks.
Bottom-up: Exact opposite. Monitoring and reporting of risks from transactions and customers through upwards to aggregate risks.
What are the 4 stages of risk management process?
Identification of risk
Measurement of risk
Optimise tradeoff between risk and potential returns
Set exposure risk limit and control procedures. Undergo monitoring and ensure regulations met.
What are the 3 Lines of Defence?
Business Lines: Identify evaluate risk as have direct involvement with clients
Compliance and Risk Functions: Independent oversight over Business lines, Monitor risk management and develop risk management policies and procedures
Internal Audit: Independent and objective assurance on effectiveness of risk management and control processes.
Overall entire framework provides good structure to strengthen banks ability to identify, evaluate and reduce risk effectively and promotes risk-awareness culture within bank.
What are the 3 types of quantitative risk measures?
Sensitivity, Volatility and Downside risk
What is downside risk measurement?
Focus on adverse deviations and measures worst case scenario of banks’ losses and probability of it occurring.
Explain VAR.
Estimates maximum potential losses that can occur within specific time horizon based off a preset confidence level.
What are the 3 types of VAR approaches?
RiskMetrics, Historic Simulation and Monte Carlo Simulation.
Explain the 3 types of VAR approaches.
RiskMetrics: Assumes returns follow normal distribution to calculate VAR.
Historic: Uses historical data to estimate future performance. Easy to calculate. No need statistical methods and
Monte Carlo: Uses Historic data but uses statistics to generate large number of possible scenarios to estimate potential losses
What is economic capital?
It is the amount of capital required for absorbing unexpected losses at preset confidence level determined based on the banks’ risk appetite.
Can be measured by both VAR or EAR. A better way of computing risk-based capital compared to regulatory capital as it encompasses diversification effects and also includes various other types of risk which diverges from the inherent in calculation of regulatory capital.
Explain EAR.
Measures volatility of earnings about mean for given confidence level.
Similarities between EAR and VAR
Both dependent on historical data. Both can measure economic capital.
Differences between EAR and VAR
EAR is simpler to calculate than VAR. EAR measures using earnings while VAR measures using expected loss. EAR is a top down approach which does not identify sources of risk while VAR is bottom up approach which identify risk sources. VAR can used to measure risk while EAR cannot.
