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FINANCIAL RISK MANAGEMENT FIRST LECTURE
RISK
Risk is defined as the effect of uncertainty on objectives (whether
positive or negative).
Financial risk in an organization is the possibility that the outcome
of an action or event could bring up adverse impacts. Such
outcomes could either result in a direct loss of earnings / capital
or may result in imposition of constraints on an organizations
ability to meet its business objectives.
Risks are usually defined by the adverse impact on profitability of
several distinct sources of uncertainty. The types and degree of
risks an organization may be exposed to depends upon a number
of factors such as its size, complexity business activities and
volume.
RISK MANAGEMENT
Risk management can therefore be considered the identification,
assessment, and prioritization of risks followed by coordinated
and economical application of resources to minimize, monitor,
and control the probability and/or impact of unfortunate events or
to maximize the realization of opportunities.
It should address methodically all the risks surrounding the
organizations activities past, present and in particular, future.
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It must be integrated into the culture of the organization with an
effective policy and a programme led by the most senior
management. It must translate the strategy into tactical and
operational objectives, assigning responsibility throughout the
organization with each manager and employee responsible for the
management of risk as part of their job description. It supports
accountability, performance measurement and reward, thus
promoting operational efficiency at all levels.
Risk Management is a discipline at the core of every financial
institution and encompasses all the activities that affect its risk
profile. It involves identification, measurement, monitoring and
controlling risks to ensure that
a) The individuals who take or manage risks clearly understand it.
b) The organizations Risk exposure is within the limits
established by Board of Directors.
c) Risk taking Decisions are in line with the business strategy and
objectives set by BOD.
d) The expected payoffs compensate for the risks taken
e) Risk taking decisions are explicit and clear.
f) Sufficient capital as a buffer is available to take risk
Risk management as commonly perceived does not mean
minimizing risk; rather the goal of risk management is to optimize
risk-reward trade -off. Notwithstanding the fact that financial
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institutions are in the business of taking risk, it should be
recognized that an institution need not engage in business in a
manner that unnecessarily imposes risk upon it: nor it should
absorb risk that can be transferred to other participants. Rather it
should accept those risks that are uniquely part of the array of
banks services.
Risk management protects and adds value to the organisation
and its stakeholders through supporting the organisations
objectives by:
providing a framework for an organisation that enables
future activity to take place in a consistent and controlled
manner
improving decision making, planning and prioritisation by
comprehensive and structured understanding of business
activity, volatility and project opportunity/threat
contributing to more efficient use/allocation of capital and
resources within the organisation
reducing volatility in the non essential areas of the business
protecting and enhancing assets and company image
developing and supporting people and the organisations
knowledge base optimising operational efficiency
Risk Management Process
Organizations Strategic Objective
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Risk Assessment
Risk Analysis
o Identification
o Description
o Estimation
Risk Evaluation
Risk Reporting
o Threats
o Opportunities
Decision
Risk Treatment
Residual Risk Reporting
Monitoring
Risk Assessment
Risk Assessment is defined by the ISO/IEC Guide 73 as the overall
process of risk analysis and risk evaluation
Risk Analysis
Includes Identification, Description and Estimation
Identification
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Risk identification sets out to identify an organisations exposure
to uncertainty.
This requires an intimate knowledge of the organisation, the
market in which it operates, the legal, social, political and cultural
environment in which it exists, as well as the development of a
sound understanding of its strategic and operational objectives,
including factors critical to its success and the threats and
opportunities related to the achievement of these objectives.
Risk identification should be approached in a methodical way to
ensure that all significant activities within the organization have
been identified and all the risks flowing from these activities
defined. All associated volatility related to these activities should
be identified and categorized.
Risk Identification Techniques examples
Brainstorming
Questionnaires
Business studies which look at each business process and
describe both the internal processes and external factors
which can influence those processes
Industry benchmarking
Scenario analysis
Risk assessment workshops
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Incident investigation
Auditing and inspection
HAZOP (Hazard & Operability Studies)
Risk Description
The objective of risk description is to display the identified risks in
a structured format, for example, by using a table.
The risk description table overleaf can be used to facilitate the
description and assessment By considering the consequence andprobability of each of the risks set out in the table, it should be
possible to prioritise the key risks that need to be analysed in
more detail.
Identification of the risks associated with business activities and
decision making may be categorised as strategic, project/tactical,
operational. It is important to incorporate risk management at the
conceptual stage of projects as well as throughout the life of a
specific project.
Strategic level: It encompasses risk management functions
performed by senior management and BOD. For instance
definition of risks, ascertaining institutions risk appetite,
formulating strategy and policies for managing risks and establish
adequate systems and controls to ensure that overall risk remain
within acceptable level and the reward compensate for the risk
taken.
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Macro Level: It encompasses risk management within a business
area or across business lines. Generally the risk management
activities performed by middle management or units devoted to
risk reviews fall into this category.
Micro Level: It involves On-the-line risk management where
risks are actually created. This is the risk management activities
performed by individuals who take risk on organizations behalf
such as front office and loan origination functions. The risk
management in those areas is confined to following operational
procedures and guidelines set by management.
Risk Estimation
Risk estimation can be quantitative, semiquantitative or
qualitative in terms of the probability of occurrence and the
possible consequence. For example, consequences both in terms
of threats (downside risks) and opportunities (upside risks) may
be high, medium or low (see table 4.3.1). Probability may be high,
medium or low but requires different definitions in respect of
threats and opportunities.
Different organisations will find that different measures of
consequence and probability will suit their needs best.
Risk Analysis methods and techniques
A range of techniques can be used to analyse risks. These can be
specific to upside or downside risk or be capable of dealing with
both.
Risk Analysis Methods and Techniques examples
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Upside risk
Market survey
Prospecting
Test marketing
Research and Development
Business impact analysis
Both
Dependency modelling
SWOT analysis (Strengths,Weaknesses, Opportunities,Threats)
Event tree analysis
Business continuity planning
BPEST (Business, Political, Economic, Social,Technological)
analysis
Real Option Modelling
Decision taking under conditions of risk and uncertainty
Statistical inference
Measures of central tendency and dispersion
PESTLE (Political Economic Social Technical Legal
Environmental)
Downside risk Threat analysis
Fault tree analysis
FMEA (Failure Mode & Effect Analysis)
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Risk Profile
The result of the risk analysis process can be used to produce a
risk profile which gives a significance rating to each risk and
provides a tool for prioritising risk treatment efforts. This ranks
each identified risk so as to give a view of the relative
importance.
This process allows the risk to be mapped to the business area
affected, describes the primary control procedures in place and
indicates areas where the level of risk control investment might
be increased, decreased or reapportioned.
Accountability helps to ensure that ownership of the risk is
recognised and the appropriate management resource allocated.
Risk Evaluation
When the risk analysis process has been completed, it is
necessary to compare the estimated risks against risk criteria
which the organisation has established.The risk criteria may
include associated costs and benefits, legal requirements,
socioeconomic and environmental factors, concerns of
stakeholders, etc. Risk evaluation therefore, is used to make
decisions about the significance of risks to the organisation and
whether each specific risk should be accepted or treated.
Risk Reporting and Communication
Internal Reporting
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Different levels within an organisation need different information
from the risk management process.
The Board of Directors should:
know about the most significant risks facing the organisation
know the possible effects on shareholder value of deviations to
expected performance ranges
ensure appropriate levels of awareness throughout the
organisation
know how the organisation will manage a crisis
know the importance of stakeholder confidence in the
organisation
know how to manage communications with the investment
community where applicable
be assured that the risk management process is working
effectively
publish a clear risk management policy covering risk
management philosophy and responsibilities
Business Units should: be aware of risks which fall into their area of responsibility, the
possible impacts these may have on other areas and the
consequences other areas may have on them
have performance indicators which allow them to monitor the
key business and financial activities, progress towards objectives
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and identify developments which require intervention (e.g.
forecasts and budgets)
have systems which communicate variances in budgets and
forecasts at appropriate frequency to allow action to be taken
report systematically and promptly to senior management any
perceived new risks or failures of existing control measures
Individuals should: understand their accountability for individual risks
understand how they can enable continuous improvement of
risk management response
understand that risk management and risk awareness are a key
part of the organisations culture
report systematically and promptly to senior management any
perceived new risks or failures of existing control measures
External ReportingA company needs to report to its stakeholders on a regular basis
setting out its risk management policies and the effectiveness in
achieving its objectives. Increasingly stakeholders look to
organisations to provide evidence of effective management of the
organisations non-financial performance in such areas as
community affairs, human rights, employment practices, health
and safety and the environment.
Risk Treatment
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Risk treatment is the process of selecting and implementing
measures to modify the risk. Risk treatment includes as its major
element, risk control/mitigation, but extends further to, for
example, risk avoidance, risk transfer, risk financing, etc.
Any system of risk treatment should provide as a minimum:
effective and efficient operation of the organisation
effective internal controls
compliance with laws and regulations.
The risk analysis process assists the effective and efficient
operation of the organization by identifying those risks which
require attention by management. They will need to prioritise risk
control actions in terms of their potential to benefit the
organisation.
Effectiveness of internal control is the degree to which the risk
will either be eliminated or reduced by the proposed control
measures.
Cost effectiveness of internal control relates to the cost of
implementing the control compared to the risk reduction benefits
expected.
Compliance with laws and regulations is not an option. Anorganisation must understand the applicable laws and must
implement a system of controls to achieve compliance.There is
only occasionally some flexibility where the cost of reducing a risk
may be totally disproportionate to that risk. (Example is SOX and
BASEL)
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Residual Risk Reporting
The level of risk faced by an organisation after internal controls
have been applied is known as the net or residual risk. Controls
will not eliminate the risk but help to manage it; therefore this is
also known as the organisation's "exposure to risk".
Monitoring and Review of the Risk Management Process
Effective risk management requires a reporting and review
structure to ensure that risks are effectively identified and
assessed and that appropriate controls and responses are in
place. Regular audits of policy and standards compliance should
be carried out and standards performance reviewed to identify
opportunities for improvement. It should be remembered that
organisations are dynamic and operate in dynamic environments.
Changes in the organisation and the environment in which it
operates must be identified and appropriate modifications made
to systems.
The monitoring process should provide assurance that there are
appropriate controls in place for the organisations activities and
that the procedures are understood and followed.
Changes in the organisation and the environment in which it
operates must be identified and appropriate changes made tosystems.
Any monitoring and review process should also determine
whether:
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the measures adopted resulted in what was intended
the procedures adopted and information gathered for
undertaking the assessment were appropriate
improved knowledge would have helped to reach betterdecisions and identify what lessons could be learned for future
assessments and management of risks
Financial risk management
is a process of evaluating and managing current and possible
financial risk at a firm as a method of decreasing the firm'sexposure to the risk. Financial risk managers must identify the
risk, evaluate all possible remedies, and then implement the
steps necessary to alleviate the risk.
These risks are typically remedied by using certain financial
instruments as a method of counteracting possible ramifications.
Financial risk management cannot prevent a firm from all possible
risks because some are unexpected and cannot be addressedquickly enough.
Similar to general risk management, financial risk management
requires identifying its sources, measuring it, and plans to
address them.
How does financial risk arises
Pressure from shareholders
Management working for bonuses
Good ratings from moodys etc
Better share prices
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Credit Risk
The risk of loss of principal or loss of a financial reward stemming
from a borrower's failure to repay a loan or otherwise meet a
contractual obligation. Credit risk arises whenever a borrower isexpecting to use future cash flows to pay a current debt.
Investors are compensated for assuming credit risk by way of
interest payments from the borrower or issuer of a debt
obligation.
Credit risk is closely tied to the potential return of an investment,
the most notable being that the yields on bonds correlate strongly
to their perceived credit risk.
The higher the perceived credit risk, the higher the rate of
interest that investors will demand for lending their capital. Credit
risks are calculated based on the borrowers' overall ability to
repay. This calculation includes the borrowers' collateral assets,
revenue-generating ability and taxing authority (such as for
government and municipal bonds).
Credit risks are a vital component of fixed-income investing,which is why ratings agencies such as S&P, Moody's and Fitch
evaluate the credit risks of thousands of corporate issuers and
municipalities on an ongoing basis.
Market Risk
The day-to-day potential for an investor to experience losses from
fluctuations in securities prices. This risk cannot be diversified
away. Also referred to as "systematic risk".
The beta of a stock is a measure of how much market risk a stock
faces
Risk which is common to an entire class ofassets or liabilities. The
value ofinvestments may decline over a given time period simply
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because ofeconomicchanges or other events that impact large
portions of the market. Asset allocation and diversification can
protect against market risk because different portions of the
market tend to underperform at different times. also called
systematic risk.
Market risk is exposure to the uncertain market value of a
portfolio. A trader holds a portfolio of commodity forwards. She
knows what its market value is today, but she is uncertain as to
its market value a week from today. She faces market risk.A
forward contractor forwardis an OTCderivative. In its simplest
form, it is a trade that is agreed to at one point in time but will
take place at some later time. For example, two parties might
agree today to exchange 500,000 barrels of crude oil for USD
42.08 a barrel three months from today.
Some financial or commodities instruments are traded on
established exchanges. Examples include most highly-capitalized
stocks, which trade on exchanges such as the New York Stock
Exchange, and futures, which trade on futures exchanges such as
the Chicago Board of Trade. These instruments are called
exchange traded.
An instrument is traded over-the-counter (OTC) if it trades in
some context other than a formal exchange. Most debt
instruments are traded OTC with investment banks making
markets in specific issues. If someone wants to buy or sell a bond,
they call the bank that makes a market in that bond and ask for
quotes. Many derivative instruments, including forwards, swaps
and most exotic derivatives are also traded OTC. In these
markets, large financial institutions serve as derivatives dealers,customizing derivatives for the needs of clients.
Liquidity Risk
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The risk that arises from the difficulty ofselling an asset. An
investment may sometimes need to be sold quickly.
Unfortunately, an insufficient secondary market may prevent the
liquidation or limit the funds that can be generated from the
asset. Some assets are highly liquid and have lowliquidity risk
(such as stock of a publicly tradedcompany), while other assets
are highly illiquid and have high liquidity risk (such as a house).
Operational Risk
the risk of direct or indirect loss resulting from inadequate or
failed internal processes, people and systems or from external
events.
A form of risk that summarizes the risks a company or firm
undertakes when it attempts to operate within a given field or
industry. Operational risk is the risk that is not inherent in
financial, systematic or market-wide risk. It is the risk remainingafter determining financing and systematic risk, and includes risks
resulting from breakdowns in internal procedures, people and
systems.
Operational risk can be summarized as human risk; it is the risk of
business operations failing due to human error. Operational risk
will change from industry to industry, and is an importantconsideration to make when looking at potential investment
decisions. Industries with lower human interaction are likely to
have lower operational risk.
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Compliance Risk
Compliance risk is the current and prospective risk to earnings or
capital arising from violations of, or nonconformance with, laws,
rules, regulations, prescribed practices, internal policies, and
procedures, or ethical standards. Compliance risk also arises in
situations where the laws or rules governing certain bank
products or activities of the Banks clients may be ambiguous or
untested. This risk exposes the institution to fines, civil money
penalties, payment of damages, and the voiding of contracts.
Compliance risk can lead to diminished reputation, reduced
franchise value, limited business opportunities, reduced
expansion potential, and an inability to enforce contracts.
Regulatory Risk
The risk associated with the potential for laws related to a given
industry, country, or type ofsecurity to change and impact
relevantinvestments.
The risk that a change in laws and regulations will materially
impact a security, business, sector or market. A change in laws or
regulations made by the government or a regulatory body can
increase the costs of operating a business, reduce the
attractiveness of investment and/or change the competitive
landscape.
For example, utilities face a significant amount of regulation in
the way they operate, including the quality of infrastructure and
the amount that can be charged to customers. For this reason,
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these companies face regulatory risk that can arise from events
- such as a change in the fees they can charge - that may make
operating the business more difficult.
Another type of regulatory risk would be a change by the
government in the amount of margin that investment accounts
are able to have. While this is an unlikely change, if it were to be
changed, the impact on the stock market would be material as
this would force investors to either meet the new margin
requirements or sell off their margined positions.
Legal Risk
A description of the potential for loss arising from the uncertainty
oflegal proceedings, such as bankruptcy, and potential legal
proceedings.
Reputational Risk
What Is Reputation?
The reputation of any individual or organization of any size is
complex. It exists in the minds of both those with whom we
interact directly, and in the minds of those who become aware of
us as word of our actions circulates. It changes all the time,
reflecting both the things we say and do an the trends and events
that change the way our words and actions are interpreted
It takes twenty years to build a reputation and five minutes to
destroy it. (W. Buffet)
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If you lose dollars for the firm, I will be understanding. If you
lose reputation, I will be ruthless. (W. Buffet)
Our assets are our people, capital and reputation. If any of
these are ever diminished, the last is the most difficult to
restore. (Goldman Sachs Business Principles)
What Does Risk-Return Tradeoff Mean?
The principle that potential return rises with an increase in risk.
Low levels of uncertainty (low risk) are associated with low
potential returns, whereas high levels of uncertainty (high risk)
are associated with high potential returns. According to the risk-
return tradeoff, invested money can render higher profits only if it
is subject to the possibility of being lost.
Because of the risk-return tradeoff, you must be aware of your
personal risk tolerance when choosing investments for your
portfolio. Taking on some risk is the price of achieving returns;therefore, if you want to make money, you can't cut out all risk.
The goal instead is to find an appropriate balance - one
that generates some profit, but still allows you to sleep at night.
Systematic Risk- Systematic risk influences a large number of
assets. A significant political event, for example, could
affect several of the assets in your portfolio. It is virtuallyimpossible to protect yourself against this type of risk.
Unsystematic Risk- Unsystematic risk is sometimes referred to
as "specific risk". This kind of risk affects a very small number of
assets. An example is news that affects a specific stock such as a
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sudden strike by employees. Diversification is the only way to
protect yourself from unsystematic risk. (We will discuss
diversification later in this tutorial).
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