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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?Problems:
- 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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Voorbeelden van vragen in deze samenvatting
What is the concept of risk?
Is risk management the opposite of risk taking?
How does the risk management process look like?
What are the problems and challenges in the risk management process?