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Lesson 04 Risk Management Process & Risk Identification
What are the Elements of a Risk Management System?1
A risk management system must respond to a number of
questions:
What is the objective of risk management?
How can the company determine if risk management is
effective?
How much risk does the company want to take?
Which specific risks should the company assume and which should
it
eliminate or reduce?
What are the underlying factors that determine the risks
faced?
What are the exposures within a company?
What areas of the company have exposures that are related to
each other?
Who is authorized to make risk-taking decisions?
How should the company obtain and train risk management
personnel?
An effective risk management system includes the following
specific elements:
1) Statement of the policy and philosophy of the organization
toward
risk management.
2) Statement of the objective of the risk management system.
3) A list of the instruments that can be used.
4) Description of how risk will be analyzed, measured, and
managed.
5) Specification of the accounting and control measures.
6) Risk limits, if any.7) Statements about the types of
counterparties that can be used.
8) Description of how transactions will be documented.
9) Description of how reporting and disclosure will be
accomplished.
10) Prescribed frequency and method of review and evaluation of
the
risk management system.
A risk management system should also address the qualitative
concept of a risk
culture = an organization in which everyone is:
Alert to the risks they and others in close proximity have to
deal with.
Capable of responding to risks quickly. Communicating and
working well with others.
Aware that some risks must be taken but with proper
controls.
This section is based extensively on Don Chances FIN 7400
Teaching Note IVB1
Implementing a Risk Management Program: Corporate Governance and
Risk Management.
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Crouhy, Galai, and Mark (Essentials of Risk Management)
illustrate the risk
management process in their Figure 1-1 (p. 2):
Risk Identification output: (1) a register/list and description
of risks and (2) an
initial assessment of the severity of the risk (e.g., using a
risk-matrix that maps
risks according to two dimensions probability of occurrence and
impact)
Risk Measurementoutput: (1) quantitative (and calibrated)
measures of identified
exposures and (2) a listing of potential mechanisms to shift or
trade those risks.
Risk Analysis output: (1) quantitative measures of the impact of
potential risk
management techniques (i.e., the benefits); and (2) costs of
those techniques.
Costs of risk management include explicit costs (e.g., insurance
and
options premiums, margin requirements) and implicit costs (e.g.,
differential
borrowing costs if debt structure is chosen for its hedging
rather thanminimum cost, opportunity costs of foregone upside
potential).
Note: explicit and implicit costs have different accounting
implications
since explicit costs reduce earnings in the period during which
the
protection is acquired, while implicit costs manifest themselves
only
indirectly in future earnings.
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Risk Management Implementation includes: (1) setting strategy
for use of risk
management tools/techniques to avoid, transfer, mitigate, or
retain identified
risks; (2) a process for evaluation of chosen strategies.
Risk Avoidance = eliminating the source of risk within an
investment
or avoiding projects/businesses that generate that risk
exposure.
Risk Transfer = using contracts, insurance, or hedging
instruments to
transfer risk exposure to another party.
Risk Mitigation = lowering the probability of occurrence of a
risk or
lessening its impact (or both).
Risk Retention = retained risk can be intentional or
unintentional;
ideally, retained risks should be those with which the
organizationss
core value-adding activities are associated (consequently
those
which the organization is most able to manage).
How are Risks Classified?
The possible risk classification schemes are almost limitless
and every author
presents his or her own variations. A comprehensive typology of
sources of risk
is presented by Crouhy, Galai, and Mark (Essentials of Risk
Management) their
Figure 1A-1 and Figure 1A-2 (p. 26):
In the first figure, they present the major categories: Market
risk, Credit risk,
Liquidity risk, Operational risk, Legal & Regulatory risk,
Business risk,
Strategic risk, and Reputation risk. The first two categories
(collectively
referred to as Financial Risks) are further divided in the
second figure.
We might also categorize risks by some shared feature, such
as:
Emerging risks = risks that materialize rapidly, seemingly out
of
nowhere (black swans)
Event versus continuous risks
Catastrophic versus smaller risks
Risk cascades = multiple paths through which a particular source
of risk
can impact the firms productivity, product/service market
performance,
cost structure and/or financing.
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How are Risks Identified?
Risk identification strategies include:
Brainstorming a good technique for generating lists of sources
of risk; but
may not be appropriate for all aspects of risk management.
Groups have a
tendency to make riskier decisions than individuals due to the
dispersed
responsibilities and the tendency for members with more extreme
views to
speak out while more moderate members remain silent.
Assumptions Analysis the assumptions underlying a model or
forecast
are identified and then assessed as to what impact their proving
false will
have on the outcomes.
Delphi individual forecasts are aggregated and individuals are
asked to
revise their predictions in light of the collective/consensus
view. In this
approach, individuals are separated and interact only through
the chair
(moderator) of the group which avoids the over-reliance on
extreme views
that can occur with brainstorming.
Interviews detailed questioning of product/area experts can help
to
identify sources of risk.
Process Flow Diagrams tracking risks from their root cause and
drivers
through their economic consequences.
In-class Exercise: Midwestern US aluminum producer
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