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Risk Variability of adverse outcomes that are unexpected
Financial Risk Volatility of unexpected losses
Value at risk (VaR) Statistical measure that defines a particular level of loss in terms of its chances of occurrence, i.e. "the confidence level" of occurrence
Economic capital is the financial cushion that a bank employs to absorb unexpected losses
Steps of Risk Management process 1. Identify risk exposures; 2. Measure and estimate risk exposures; 3. Assess effects of exposures; 4. Form a risk mitigation strategy (avoid, transfer, mitigate, keep) 5. Evaluate performance
What is Risk Management Is the process of understanding, costing and efficiently managing unexpected levels of variability of the financial outcomes for a business.
Correlation risk Is the tendency for things to go wrong together.
What is the role of the Risk manager His role is to uncover the sources of risk and make them visible to key decision makers and stakeholders in terms of probability (not to read a crystal ball). His role is not just defensive.
Market Risk Is the risk of losses arising from changes in market risk factors. Market risk can arise from changes in interest rates, foreign exchange rates, or equity and commodity price factors
Credit Risk Is the risk of loss following a change in the factors that drive the credit quality of an asset. These include adverse effects arising from credit grade migration, including default, and the dynamics of recovery rates.
Operational Risk Is the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events (e.g., frauds, inadequate computer systems...)
What is the purpose of ERM To break silos and facilitate enterprise wide risk measurement, risk identification,
When is VaR efficient ? Works well only for markets operation under normal condition
Role of Risk Management 1. Asset all risks faced by the firm; 2. Communicate these risk to risk-taking decision makers; 3. monitor and manage these risk
Objective of risk management Recognize that large losses are possible and develop contingency plans that deal with such losses. The purpose is NOT to control or reduce expected losses but to allow the firm to balance risk and reward.
ERM consist of 1. Identification of risk management and enterprise objectives; 2. Risk assessment (risk identification, risk estimation, risk evaluation; 3. Risk treatment (risk avoidance, risk transfer, risk reduction, risk retention; 4. Risk monitoring
Challenge in risk management process 1. it is hard anticipate correlation in risk; 2. it is hard not to over depend on historical dat during the crisis;
Tools and procedures to measure and manage risk 1. Risk classification makes it easier to control and manage risk but can create silos 2. Quantitative measures such as VaR but only works well in normal conditions
Advantage and disadvantages of hiding risk
The role of the board of directors in risk governance the board should ensure that business and risk management strategies are directed at economic rather than accounting performance. The board has a duty to shareholders but must also be sensitive to debt holders
Methods to hedge operational risk
Methods to hedge financial risk
Business objective of risk appetite statement
Market Risk risk that changes in financial market prices and rates will reduce the value of a security or a portfolio: 1. Interest rate risk; 2. Equity price risk 3. Foreign exchange risk 4. Commodity price risk
Credit Risk 1. Default risk; 2. Bankruptcy risk; 3. Downgrade risk; 4. Settlement ris
Liquidity Risk funding liquidity risk and trading liquidity risk
Operational Risk Operational risk refers to potential losses resulting from a range of operational weaknesses including inadequate systems, management failure, faulty controls, fraud, and human errors
Legal and Regulatory Risk are classified as operational risks.
Sytemic Risk concerns the potential for the failure of one institution to create a chain reaction or domino effect on other institutions and consequently threaten the stability of financial markets and even the global economy. Doo=dd-Frank Act focus on this risk
The role and responsibilities of audit provide an independent assessment of the design and implementation of the bank’s risk management
Expected loss How much an entity expects to lose in the normal course of business
Unexpected loss More difficult to predict. it increases with correlation. If correlation is less than a perfect 1.0, the portfolio UL is less than the sum of individual ULs; if toward 1.0, the portfolio UL increases and approaches the sum of individual ULs.
Risk and uncertainty 1. Risk is the portion of variability that is measurable as a probability function 2. Uncertainty is the portion of variability that is NOT measurable
Tradeoff between risk and reward Potential returns can be overstated because they are not adjusted for risk
Peril is the cause of a loss
Hazard is a condition that increases the probability (and/or frequency and/or severity)
Market risk value at risk (MVaR) can be expressed as either relative MVaR or absolute MVaR but it is "relative MVaR" that matches (better captures) unexpected losses (UL)
The risk Manager's role is not to try to read a crystal ball, but to uncover the sources of risk and make them visible to key decision makers and stakeholders in terms of probability
Advantages of hedging 1) reduces the chance of default which can have high fixed costs 2) gives management better economic control 3) has the potential to reduce the firm's cost of capital, reduce its cash flow volatility, and enhance its ability to grow;
Arguments AGAINST hedging an exposure at a non-financial firm 2) markets are perfect, hedging is a theoretically a zero-sum game 3) risk management requires specialized skills; and can incur high compliance costs
Static hedge A static strategy is relatively easy to implement and monitor
Dynamic hedge dynamic strategy calls for much greater managerial effort in implementing and monitoring the positions, and may incur higher transaction costs.
The function of a risk advisor director is to improve the overall efficiency and effectiveness of the senior risk committees and the audit committee, as well as the independence and quality of risk oversight by the main board.
Risk Appetite statement a corporation must be able to tie its board-approved risk appetite and risk tolerances to particular business strategies
Limits Limits should be expressed in normal markets (e.g., VaR) but should also be expressed in worst-case scenarios, probably by scenario analysis and/or stress testing. They must take into account an assessment of the business unit’s historical usage of limits
Limit types tier 1) limits might include a single overall limit for each asset class, as well as a single overall stress test limit and a cumulative loss from peak limit. tier 2) limits are more general and cover authorized business and concentration limits.
relationship between risk and reward trade-off between risk and return= what is the return demanded by investors for assuming risk
interest rate risk: gap risk relates to the risk that arises in the balance sheet of an institution as a result of the different sensitivities of assets and liabilities to changes of interest rates
Interest rate risk: curve risk can arise in portfolios in which long and short positions of different maturities are effectively hedged against a parallel shift in yields, but not against a change in the shape of the yield curve
equity price risk is the risk associated with volatility in stock prices
Foreign exchange risk risk that arises from open or imperfectly hedged positions in particular foreign currency denominated assets and liabilities leading to fluctuations in profits or values as measured in a local currency
Commodity Price Risk commodity prices generally have higher volatilities and larger price discontinuities than most traded financial securities due to ease and cost of storage
Default risk corresponds to the debtor’s incapacity or refusal to meet his/her debt obligations by more than a reasonable relief period from the due date.
Bankruptcy risk is the risk of taking over the collateralized assets of a defaulted borrower or counterparty. In the case of a bankrupt company, debt holders are taking over the control of the company from the shareholders.
Downgrade risk is the risk that the perceived creditworthiness of the borrower or counterparty might deteriorate
Settlement risk is the risk due to the exchange of cash flows when a transaction is settled
recovery value The value it is likely to recover in case of the counterpart defaults
Loss given default (LGD) the amount it is expected to lose in case the counterpart defaults
Funding liquidity risk relates to a firm’s ability to raise the necessary cash to roll over its debt; to meet the cash, margin, and collateral requirements of counterparties; and to satisfy capital withdrawals
Trading liquidity risk, is the risk that an institution will not be able to execute a transaction at the prevailing market price because there is, temporarily, no appetite for the deal on the other side of the market.
Strategic risk risk of significant investments for which there is a high uncertainty about success and profitability
Reputation risk 1. The belief that an enterprise can and will fulfill its promises to counterparties 2. The belief that the enterprise is a fair dealer and follows ethical practices.
Risk appetite statement sets out the types of risk that the firm is willing to tolerate and, which risks should be hedged and which risks the company should assume as part of its business strategy. It can be expressed in quantitative and qualitative statements
Exchange-traded instruments are based on a limited number of underlying assets and are much more standardized than OTC contracts
OTC products are issued by commercial and investment banks and thus can be tailored to customers’ needs. they tend to lack the price transparency and liquidity advantages of exchange products.
Responsibilities of the board needs to make sure that risk are made transparent Develop /approve the firm's risk appetite statement and assit management in developing the strategic plan
RAS and business strategy the risk appetite statement should be connected to its overall business strategy and capital plan. It is approved by the board
Mapping risk requires clarification as to which risk are insurable, headgeable, non insurable or non hedge able and involves a detailed analysis of the impacts of such risk on the firm's balance sheet and income statement
The CRO (1) responsible for the bank's risk management strategy. (2) responsible for risk policies, methodologies and governance (3) setting the overall risk appetite (4) measuring and quantifying risk (5) setting limits and monitoring limits
CRO reporting reports to the CEO and is independent from the business Line.
uncertainty vs risk the portion of the variability of the potential reward that is not measurable vs measurable
Created by: npk144a