Paris – Institut Supérieur de Commerce

RISK MANAGEMENT

Paris - ISC

November 2007Hermin Hologan, CFA

PORTFOLIO MANAGEMENT & RISK

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ContentsRisk Management – PORTFOLIO

INVESTMENTS

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2

Risk Management Defintion and Process

3

Sources of Risks

Introduction – Learning Outcome Statements

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ContentsRisk Management – PORTFOLIO INVESTMENTS

4

5

Q & A

Enterprise wide Risk Management

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1Introduction – Learning Outcomes

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Learning Outcome Statements

Define Risk Management

Explain why risk should be managed, and describe the general process of risk management

Discuss risk governance and risk budgeting

Describe the source of financial risk, and distinguish between financial and non-inancial risks

Describe de sources of nonfinancial risk

Explain how liquidity is a source of financial risk

Discuss Market Risk

Explain how Risk Management relates to performances evaluation

Discuss the benefits of Enterprise-wide Risk Management (ERM)

Describe the main features of an ERM system

After completing this chapter, you will be able to do the following :

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2Risk Management Defintion and Process

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Executive Summary

Managing risk can increase the value of a firm by stabilizing income. The stabilization of income can lower taxes and cost of capital.

Risk management is important to governments and both profit and nonprofit firms.

Three important introductory concepts to all these entities are : – Defining risk management,– Understanding the sources of risk, and– Understanding why and how risk can be managed.

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Define Risk Management

For a firm, the process of risk management has several parts:

– Identify the desired level of risk – Determine the current level of risk – Bring the current level of risk in line with the desired level – Monitor the risk exposure to keep it in line with the desired level – After the process to reflect new information, policies and preferences.

The risk exposure of the firm can be broken into two main categories : – Financial risk – Non Financial risk

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Explain why risk should be managed and described the general processof risk management (cont’d)

Stable earnings streams are less likely to jump into higher tax brackets. The stable earnings :

– Make the company appear more attractive to potential creditors

– The firm can borrow at lower cost of capital

– Take on more projects with the positive NPV

– Increase its value

Risk Management is a journey and not a destination :

– The firm must continually watch over its risk management activities

– The general process of risk management include the 5 steps plus identifying and pricing the appropriate transactions.

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Discuss Risk governance and Risk budgeting

Risk governance is the process of setting policies and standards to manage risk. It is generally agreed that upper level management has this responsibility.

Risk governance begins with organizational structure. It can either be centralized or

decentralized.

Decentralized risk governance allows the individuals units to micro-manage their

respective risk exposures.

The centralized approach to risk management is also called firmwide risk management

or Entreprise Risk Management (ERM)

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Discuss Risk governance and Risk budgeting (cont”d)

Risk budgeting : Many firms have adopted Risk budgeting, which essentially means setting a maximum amount of risk for a given firm or unit within a firm.

The level of risk would be a function of the size of the operation (e.g. the amount of

capital under management)

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3Sources of Risks

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Describe the source of financial risk, and distinguish between financial and nonfinancial risks

Non financial risk are often related to unexpected operating problems.

They can also be associated with : – Financial assets, such as the market mechanisms through which financial

transactions take place

– The decision-making processes employed in making financial decisions

– Changes in local and federal government policies and regulations (e.g taxes, required accounting disclosures…)

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Describe the source of financial risk, and distinguish between financial and non-financial risks (cont’d)

Financial risk are usually associated with transactions with others parties. The six sources of financial risk are :

– Liquidity risk – Credit risk – Commodity risk – Equity prices– Exchanges rates – Interest rate

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Describe the sources of nonfinancial risk

As we have six sources of financial risk, we also have six sources of nonfinancial risk

– Operations risk : include employee errors and fraud, computer breakdowns, and “acts of God” such as fire. It’s can also include terrorist's acts. Managers can address those risk with a good internal controls, insurance contracts to cover risks that are outside a firm’s control.

– Model risk : arise from using wrong model or improperly using the correct model for pricing a derivative position for example

– Settlement risk : occurs when there are two-way cash flows between parties in an

agreement such as a swap, and one party defaults just as the other party is making a payment. Netting reduce settlement risk, so it is relatively low in the case of a plain-vanilla interest-rate swap.

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Describe the sources of nonfinancial risk (cont’d)

– Regulatory risk : refers to the risk that a loss that can occur from a change in regulation. There is a regulatory risk from owning land where the law concerning how the land may be used could change.

– Legal risk : is a major concern of dealers who write many OTC derivatives contracts. It is usually associated with the possibility of a counterparty in an agreement repudiating its obligation based upon some legal technicality (i.e that the counterparty did not have the right to enter into the agreement in the first place)

– Accounting risk : arises from the misrepresentation of the true economic information in the

accounting statements. Accounting risk is high in the case of derivatives because there is currently some controversy about how to report changes in derivatives positions.

An other source of accounting risk is from the fact that accounting standards vary from country to country.

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Explain how liquidity is a source of financial risk

Liquidity refers to loss in revenue from selling illiquid asset. Sellers usually face the most liquidity risk because potential buyers who desire a given asset can often find a substitute if the specific asset is not available.

Derivatives may not be able to help protect against liquidity risk because if the market for the asset is illiquid, then the derivative market for the asset is likely to be illiquid as well.

Asset bid/ask spreads are a good measure of liquidity risk, which can change over time to reflect relative interest in the asset.

An option with a long maturity that is well out of the money, for example, might have a very wide spread. As time passes and/or the option becomes in the money, the spread could fall dramatically. Spread can widen, too, and this can catch a risk manager off-guard if liquidity risk is not monitored.

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Discuss Market risk

Market risk is usually associated with the potential change of value in an asset or derivative in response to a change in some basic source of uncertainty.

Three of the six sources of risk mentioned earlier fall under the category of market risk :

– Interest rate risk– Exchange rate risk– Equity prices

Obviously, the value of a portfolio will change as the prices of the stocks in the portfolio Change and changes in stock prices also affect the values of derivatives. Interest rates are a basic source of uncertainty for bonds and other fixed-income assets. Changes in exchange rates can affect the values of equity, bond, and derivatives positions.

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4Enterprise wide Risk Management

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Explain how risk management relates to performance evaluation

It is generally agreed that any performance measure must have an adjustment of the risk assumed.

– This might be as simple as imposing a penalty on the return such as subtracting

from the return an amount that is commensurate with the risk assumed in

achieving the return.

– Such an approach is now being applied to the performance of nonfinancial firms and activities.

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Discuss the benefits of Entreprise-wide Risk Management (ERM)

ERM is an attempt to manage all types of risk across all business units of the firm.

The benefits of an ERM system are directly proportional to the complexity of the firm. Some of the benefits are :

– Major enhancement to risk-return analysis

With the improvement in risk reporting associated with an ERM system, the quality of risk return analysis is greatly improved.

– Improved decision making at all levels

With an ERM system, all decision makers are better-informed regarding risk across other business units and at the firm level. Thus, coordination across all levels of management is more efficient.

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Discuss the benefits of Entreprise-wide Risk Management (cont”d)

– Improved allocation of capital

With an ERM system, the computation of risk, and therefore the computation of expected risk-adjusted marginal returns is improved, thus providing for better allocation decisions.

– Enhanced data collection and analysis An ERM system imposes discipline on the firm with the respect to data

collection

– Ensures consistency in measurement and processing,

– Highlights gaps and other data problems

– Facilitates auditing and monitoring

– Reduces the likelihood of human error or fraud

– Enhances marginal control over business units with the respect to risk.

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Discuss the benefits of Entreprise-wide Risk Management (cont”d)

– Enhanced information available to market participants

With an ERM system, firms are better able to communicate to the market their

risk exposure and hedging status to the investing public.

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Describe the main features of an ERM System

The 4 main features of an ERM system are :

– Centralized Data Storage

– The first step in creating an ERM system is the creation on “one-stop” shopping, i.e a centralized storage system that allows access to all position, credit, and transactions data. Once the data has been centralized it needs to be standardized and cleaned.

– Data Analysis

– Once the data has been centralized, the next step is to put it to work. Management needs to be able to properly analyze the data through several value at risk (VaR) methodologies, for example.

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Describe the main features of an ERM System (cont’d)

– Continual Monitoring and Updating

– The third step is to ensure that the system output gets to the proper monitors who continually evaluate it as well as look for new or different data necessary for successful monitoring. This would include the ability to easily identify data problems, identify position limit violation, perform diagnostics on pricing….

– Dissemination of the Analysis

– The system must provide the means for disseminating the analysis to the appropriate personnel. This allows the decision makers to take corrective actions where necessary or to allocate resources for efficiently.

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5

Q & A