Samenvatting Class notes - Part 1: Foundations of Risk Management

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Samenvatting - Class notes - Part 1: Foundations of Risk Management

  • 1470780000 Reading 1 - The Essentials of Risk Management

  • What is the concept of risk?
    Risk exists in how variable our costs and revenues really are. Risk management is really about how firms actively select the type and level of risk that it is appropriate for them to assume. 

    Risk an uncertainty are different; variability that can be quantified in terms of probabilities is best thought of as risk, while variability that cannot be quantified is best thought of as uncertainty.  

    Risk management is not the process of controlling and reducing expected losses (that is just budgeting, pricing and efficiency), but the process of UNDERSTANDING, costing and efficiently managing UNEXPECTED levels of variability.
  • Is risk management the opposite of risk taking?
    Certainly not. Risk is not solely a defensive term alone. They are two sides of the same coin. Risk management aims to support deliberate risky activities that it founds to be risk-rewarding. In that sense risk management prevents risk taking to become speculative.
  • How does the risk management process look like?
    Identify risk exposures
    Then, what to do with them:
    - Measure and estimate risk exposures (assess the effects of these)
    - Find instruments and facilities to shift or trade risks (assess cost and benefits)
    Form a risk (mitigation) strategy:
    - Transfer (shift/trade risks)
    - Eliminate/avoid (don't do it)
    - Accept/keep (go for it)
    - Mitigate (prevention)
  • What are the problems and challenges in the risk management process?
    - Not all uncertainty/risk factors can be measured (acknowledging this is important)
    - Over reliance on historical-statistical data 
    - Silos that are build are risk types: potential for missed risk and gaps in responsibility.

    - Stochastic covariance (correlation/dispersion between risk factors changes over time)
    - Understand risk factors
    - Create transparency
    - Create enterprise-wide acceptance of risks (DEEPER roots)
    - Relation risk and business, close but not too close
    - Extensive interaction risk and business, but not dominance
    - Understanding, but not collusion (complot)
    - Not to be seen as risk avoidance (averse)
    - Risk does not (or only to some extent) generate revenue, i.e. lower status
  • What about quantitative measures, assessments  and ERM?
    Most important to keep in mind that human psychology interferes with risk assessment. People tend to misassess extreme probabilities (D. Kahneman).

    ERM, concerns taking risk into consideration in business decisions much more explicitly than has been done in the past. Making risk an integral part of the business, to create a culture for risk.

    Quantitative measures, like VaR and stress-testing have been developed over the recent years. Challenge on VaR is that it analyses primarily business-as-usual and not the more extreme worst-case scenarios. Moreover, rogue traders try to find ways to circumvent controls.
    Defining risk types is important to quantify/measure and manage risk. But be aware of gaps.
  • What is the difference between expected and unexpected loss?
    Expected (credit) loss refers to how much the bank expects to lose on average over a period of time. Because it is by definition PREDICTABLE, it is just considered to be a cost of doing business and priced accordingly.

    Unexpected losses concern estimates with risk factors and statistical analysis, which may correlate more in times of high unexpected losses. This has led to two key concepts: VaR and economic capital. So managing, costing and understanding unexpected levels of variability in financial outcomes of businesses.
  • What is the relation between risk and reward? And conflict of interest?
    In general, if is sounds to good to be true it usually is (W. Buffet). If one wants to achieve a higher rate of return on average, one often has to assume more risk. However the transparency between this risk-reward trade-off is highly variable. There are many other factors that can influence the price:
    - Fundamental difference
    - Investors appetite

    Rewards should be properly adjusted for economic risk, if not it's tempting for the self-interested to play down the potential for unexpected losses to spike somewhere in the economic cycle and to willfully understand how risk factors sometimes come together to give rise to severe correlation risks. Conflicts on trading, but also strategic decisions. Especially incentive schemes can be very bad for this; bonuses today for profits in the future.
  • What are the key risk classes?
    Market risk: the risk of losses arising from changes in market risk factors (e.g. interest rates, equity, commodity, FX). 

    Credit risk: the risk of loss following a change in the factors that dive the credit quality of an asset.

    Operational risk: refers to financial loss resulting from a host of potential operational breakdowns that we can think in terms of risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
  • What about market risk?
    Many different underlying market risk factors. Cornerstone is open, unhedged or imperfectly correlations between positions. Also called basis risk, chance of a breakdown between price of product on one hand and the price of an instrument.

    Interest rate risk consist of two risks:
    - Trading risk is general sensitivity to IR 
    - Gap risk as a result of the different sensitivities of assets and liabilities to changes of interest rates. Curve risk, special case, arises in portfolios 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: volatility in stock prices (idiosyncratic should be diversified)

    FX risk: open or imperfectly hedged positions may lead to fluctuations in profits

    Commodity price risk: different as supply/concentration is the primary driver and in addition the ease and cost of storage
  • What about credit risk?
    Economic loss from the failure of a counterparty to fulfill its contractual obligations, or from increased risk of default during the term of the transaction. Credit risk only place a role in case of an asset.

    Default risk: debtor's incapacity or refusal to meet its debt obligations
    Bankruptcy risk: risk of actually taking over collateralized assets from the counterparty.
    Downgrade risk: risk of deterioration in the perceived creditworthiness of the borrower
    Settlement risk: risk due to the exchange of cash flows when a transaction is settled. Caused by: default, liquidity constraints or operational issue. Mitigate risk by net settlements, instead of gross.      

    Within portfolios risk managers should care about:
    - Credit standing (rating, perceived creditworthiness)
    - Concentration/correlation risk (diversification of borrowers)
    - State of the economy
    - Maturities of the loan (lengthier is more riskier), also time diversification. Which also helps to decrease liquidity risk.
  • What about liquidity risk?
    Consists of two factors:
    - Funding liquidity risk, which relates to a firm's ability to raise necessary cash to roll over its debt; meet cash, margin or collateral requirements; satisfy withdrawals.
    - Trading liquidity risk, relates to the risk that a transaction cannot be executed at the prevailing market price because there is (temporarily) NO APPETITE for the deal on the other side of the market. SIZE and IMMEDIACY are the most important factors.
  • What about operational risk?
    Potential loss from a range of operational weaknesses (also fraud, terrorism, other catastrophes). Derivative trading is prone to operational risk because of its complexity and high amount of leverage.

    Human factor risk: human errors like wrong button, typos, etc.
    Technology risk: failure of systems.

    Legal and regulatory risk (part of OR under Basel II). Legal, lacking authority. Regulatory, like tax reform/change.
  • What about business risk?
    Easily forgotten. But refers to the classic risks of the world of business, such as uncertainty about the demand, price or cost. Even though important to assess it is not obvious how to do this that complements the classic market and credit risk. It was removed from Basel II agenda, but plans are up to get it in again.

    Important components are:
    - Strategic risk, risk of significant investments for which there is high uncertainty about the success (quality) and profitability. Also think about cannibalization of its own products (Nokia).
    - Reputation risk, two classes:
    1) Belief that an enterprise can and will fulfill its promises 
    2) Belief that an enterprise is a fair dealer and follows ethical principles (ESR, fraud)
    Most managers belief that reputation risk is even bigger than market/credit risk. Especially with the rise of social media, that can badly hurt a company. TRUST and CONFIDENCE are vital to remain in business.
  • What about systemic risk?
    Concerns the potential or 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. PANIC about the soundness of an institution. FLIGHT to QUALITY/SAFETY. Fire-sale prices. There should be a fair price for firms that made themselves systemic, but costs will just be allocated to customers.
  • What about Marked-to-Market?
    Three accounting classifications:
    - Amortized cost, by effective interest method less allowances (bad loans)
    - AFS, available for sale, go through equity, but only upon realization through P&L.
    - MtM, fair value, daily valuation through P&L.

    - Market prices may deviate from fundamental value
    - Market illiquidity may reder fair value difficult to measure (unreliable losses)
    - Unrealized losses may trigger unhelpful feedback effects, with more margin calls and further deterioration (destabilizing in a downward spiral)
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How about applicability and enforcement?
All GARP members should know and abide to the code, local laws and regulations have precedence in conflicts.

Violation may result in:
- temporary suspension
- permanent removal
To roles, right to use FRM designation or any other GARP designation. In case a violation is confirmed by a formal determination of occurance.
Rules of Conduct - General accepted practices
Members shall:
- execute all services with diligence and perform all work in a manner that is independent from interested parties (highest level of objectivity)
- be familiar with current generally accepted risk management practices
- ensure that communications include factual data and do not contain false information
- make a clear distinction between fact and opinion in their work
Rules of Conduct - Fundamental Responsbilities
Members shall:
- comply with all applicable laws, rules and regulations (including this code) for GARP members and shall not knowingly participate or assist in any violation.
- have ethical responsibilities that cannot be delegated
- understand the needs and complexity of their employer or client, and should provide appropriate and suitable advice and services
- be diligent about not overstating the accuracy or certainty of results or conclusions
- clearly disclose relevant limits of their specific knowledge and expertise concerning risk assessment, practices and applicable laws and regulation
Rules of Conduct - Confidentiality
Members shall:
- not make use of confidential information for inappropriate purposes and unless having received prior consent shall maintain confidentiality of their work/client or employer.
- not use confidential information to benefit personally
Rules of Conduct - Conflict of interest
Members shall:
- act fairly in all situations and must fully disclose any actual or potential conflict to all affected parties.
- make full and fair disclosure of all matters that could reasonably be expected to impair their independence and objectivity or interfere with their duties to any stakeholder.
Rules of Conduct -  Professional integrity and ethical conduct
Members shall:
- act professionally, ethically and with integrity in all dealings with stakeholders
- exercise reasonable judgment in provision of risk services while maintaining independence of thought and direction
- not offer, solicit or accept any gift, benefit or compensation that could reasonably compromise their or someone's independence and objectivity
- take reasonable precautions to ensure that the members services are not used for improper, fraudulent or illegal purposes
- not knowingly misrepresent details on activities
- not engage in any professional conduct involving dishonesty or deception, or engage in any act that reflect negatively on his integrity/trustworthiness or on the profession
- not engage in any conduct or commit any act that compromises the integrity of Global Association of Risk Professional (GARP), FRM designation, or examination.
- endeavor to be mindful of cultural differences regarding ethical behavior and customs, any protect ethical appearance.
What Rules of Conduct?
- Professional integrity and ethical conduct
- Conflict of interest
- Confidentiality
- Fundamental responsibilities
- General accepted practices
Prof. standards - Best practices
Members must:
- Promote and adhere to applicable best practice standards, and will ensure that activities performed under supervision satisfy this
- Recognize that risk management does not exist in a vacuum (has connections)
- Commit to considering the wider impact of their assessments and actions on colleagues and wider community
Prof. standards - Fundamental responsibilities
Members must:
- Endeavor and encourage others to operate at the highest level of professional skill
- Continue to perfect expertise
- Have a personal responsibility that is not out-sourced or delegated to others
What professional standards?
- Fundamental responsibilities
- Best practices
- Communication and disclosure