BBA FN415 (18) Lect 01 Introduction.pptx

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Introduction to Risk Management

tio

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to

R

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M

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t

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The ability to learn faster than your

competitors is the only

sustainable competitive advantage.

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

_{Improved resource allocation and decision}

making.



_{Increased compliance with regulatory}

requirements.



_{Improved corporate governance.}



_{Improved communication with}

stakeholders.



_{Reduced financial losses.}

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$0.00

A

B

You Ch

_oose

$0.00

C

A

B

C

D

E

F

G

H

I

J

You Ch_oose

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1/3

A

B

C

B

C

Placement of Prize Door Chosen by player

Door open by hosts

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Conditional Probability can be confusing

• Consider a family with two

children.

• You are told that one of the

children is a girl.

• What is the probability that

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Seating Problem

Jane was first to arrive at a 100 seat theater.

She forgot her seat number and picks a random

seat for herself.

After this, every single person who get to the

theater sits on his seat if its available else

chooses any available seat at random.

Peter is last to enter the theater and 99 seats

were occupied.

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What is so important

about risk management?

What is so important

about risk management?

Risk management is one of the most

important processes within any

organisation. It is crucial for future

long term success. Managing your

enterprise risk wisely means that you

are in control of risk and not the other

way round.

Risk management is one of the most

important processes within any

organisation. It is crucial for future

long term success. Managing your

enterprise risk wisely means that you

are in control of risk and not the other

way round.

What benefits will it

bring to my organisation?

What benefits will it

bring to my organisation?

• _{Enhanced understanding of risk}

• _{Better understanding of how risks}

interact.

• _{Clearer views of risk that have to be}

managed, monitored and controlled.

• _{Better decision making.}

• _{Risk is viewed as opportunity rather}

than threat.

• _{Enhanced understanding of risk}

• _{Better understanding of how risks}

interact.

• _{Clearer views of risk that have to be}

managed, monitored and controlled.

• _{Better decision making.}

• _{Risk is viewed as opportunity rather}

than threat.

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Risk Management is all about eliminating risks!

Risk Management is just another term for

compliance.

Risk Management is part of insurance.

My company already has risk management dept

so I don’t need to worry about risks.

Risk Management is concerns only risk.

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FATALIST

Willing to react to any events

without any prior thinking or

activity.

Willing to react to any events

without any prior thinking or

activity.

FANATIC

Believing there are no risk

to manage. Have faith in your

abilities.

Believing there are no risk

to manage. Have faith in your

abilities.

PESSIMIST

Never willing to take on any

risks because of a strong

fear of failure.

Never willing to take on any

risks because of a strong

fear of failure.

PRAGMATIST

Understanding that there is

balance between risk and

reward and that risks have

to be identified and managed.

Understanding that there is

balance between risk and

reward and that risks have

to be identified and managed.

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Financial

Strategic

_Strategic

Project

_Project

Operational

Environmental

_{Environmental}

Technological

_{Technological}

Reputational

Talent

_Talent

Personal

_Personal

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Our risk appetite defines how much risk we want to take and

hence how much of a loss we are prepared to suffer it the risk

matures.

• _{Defined at the senior management / board level}

• _{Companies often fail to articulate the risk appetite}

well enough. This leads to two problem:

(1) Excess Risk-Aversion

(2) Excess Risk-Loving

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M

an

ag

em

en

t

o

f

ri

sk

Attitude to risk

Adverse

Seeking

Good

Poor

Ostrich

Owl

_Owl

Dodo

Lemming

_Lemming

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Define risk framework

Establish risk

governance

Articulate risk appetite

Create risk culture

Identify

Respond

Quantify

Manage

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Firm’s Risk

Investment

Risk

Investment

Risk

Insurance

_Risk

Insurance

Risk

Operational

_Risk

Operational

Risk

Credit

Risk

Credit

Risk

ALM

Risk

ALM

Risk

Life & Health

Risk

Life & Health

Risk

Business

_Risk

Business

Risk

Market

Risk

Market

Risk

Trading

Risk

Trading

Risk

Event

Risk

Event

Risk

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• _{Affects virtually all business on varying degree.}

• _{With increasing volatility in the market, regulators are becoming more concerned.}

• _{Institution are strongly encourage to actively manage their market risk.}

• _{It’s crucial that risk as well as return is used to measure performance.}

• _{What are the types of market risk faced by different firms?}

Market risk is defined most simply as the chance of loss

caused by an unfavorable movements in market prices.

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25 .1

0.

05

14 .1

2.

05

2.

06

24 .3

.0

6

13 .5

.0

6

2.

7.

06

21 .8

.0

6

10 .1

0.

06

29 .1

1.

06

18 .1

.0

7 -15.0%

-13.0%

-11.0%

-9.0%

-7.0%

-5.0%

-3.0%

-1.0%

1.0%

3.0%

5.0%

Daily Returns in 2006

• What happened was a 14.97 standard deviation event i.e. the model

predicts that the probability of this event occurring is 6.4 x 10

-52

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1 M 3 M 6 M 1 Y 2 Y 3 Y 4 Y 5 Y 6 Y 7 Y 8 Y 9 Y₁₀ Y₁₁ Y₁₂ Y₁₃ Y₁₄ Y₁₅ Y₁₆ Y₁₇ Y₁₈ Y₁₉ Y₂₀ Y₂₁ Y₂₂ Y₂₃ Y₂₄ Y₂₅ Y₂₆ Y₂₇ Y₂₈ Y₂₉ Y

2.50 3.00 3.50 4.00 4.50 5.00 5.50 6.00 6.50 7.00 7.50

Yield (%)

Thai Gov Bond Yield Curve

Q1/08

Q2/08

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Case-Schiller Home Price Index

0 25 50 75 100 125 150 175 200 225

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Bank

Relatively short term position, Aggregation of market risk

from various instruments, VaR, and Stress test.

Relatively short term position, Aggregation of market risk

from various instruments, VaR, and Stress test.

Insurance

Subject to market as investors, complex liabilities,

Asset-Liability risk.

Subject to market as investors, complex liabilities,

Asset-Liability risk.

Investment Managers

Asset allocation for equities and fixed income. Risk

measure is tracking error. VaR. Longer time horizon.

Asset allocation for equities and fixed income. Risk

measure is tracking error. VaR. Longer time horizon.

Brokerage Firm

Main risk – margin requirement. Insufficient margin to

cover true exposure. Indirect exposure to risk. VaR.

Main risk – margin requirement. Insufficient margin to

cover true exposure. Indirect exposure to risk. VaR.

Corporation

IR and FX exposures. Commodity/Energy prices. Longer

time horizon. Derivatives for hedging. VaR

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VaR is defined to be the level that losses may

exceed with a given probability.

Example:

A one day, 99% VaR of $10 million means that there is only 1% chance that

losses exceed the $10 million in one day.

x

1% Chance

Probability

σ

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-2

%

<

r

≤

0 %

<

r

≤

2 %

<

r

≤

4 %

<

r

≤

6 %

<

r

≤

8 %

<

r

≤

1

0 %

1

0 %

<

r

≤

1

2 %

1

2 %

<

r

≤

1

4 %

1

4 %

<

r

≤

1

6 %

-4

%

<

r

≤

-2

%

-6

%

<

r

≤

-4

%

-8

%

<

r

≤

-6

%

-1

0 %

<

r

≤

-8

-1

2 %

<

r

≤

-1

Number of trials = 94

Number of trials with

Returns below -8%

is four, so the

probability

of an event of a return

being

less than -8% is simply

= 4/94 = 4.26%

statement and we have

that there’s a 95.74%

the return will be

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• _{VaR is only useful in normal market conditions.}

• _{Short time frame.}

• _{Underlying assumptions break down in turbulent market conditions.}

• _{Liquidity not taken into account for the first generation of VaR models.}

• _{Beyond VaR – Stress Test, Scenario testing, and sensitivity analysis.}

• _{Asian Crisis 1997-1998 made stress testing an essential tool in market risk}

management.

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• _{Risen to top agenda for most financial institution}

• _{Still No. 1 source of serious banking problem}

• _{Problems are caused by}

• _{Insufficiently stringent credit standards for burrowers and counterparties}

• _{Poor credit risk management of entire credit portfolio}

• _{Lack of attention to economic condition that affects a counterparty’s}

credit standing.

• _{There are a few factors driving this wave of credit risk management}

• _Regulators

• _{Greater Industry Competition}

Credit risk refers to the risk that a borrower or counterparty

will fail to meet its obligations. Lending - from credit

cards to corporate loans - is the largest and most obvious

source of credit risk.

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• _{Interest rate risk arises from the possibility that profits will change if interest}

rates change.

• _{The liquidity risk arises from the possibility of losses due to the bank having}

insufficient

cash on hand to pay customers.

• _{Both risks are due to the difference between the bank’s assets and liabilities.}

• _{ALM is distinct from the management of market risk in trading operations.}

ALM deals with the management of the market risks that arise

from an organisation’s structural position. The two primary

risks are interest rate and liquidity risk.

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• _{US savings and loan crisis.}

• _{Local banks mandated to take retail deposits and make retail loans.}

• _{For years the Feds kept interest rate stable.}

• _{Took deposits that paid 4% and}

• _{lent 30 ys mortgages paying about 8% fixed rates.}

• _{4% profit before noninterest expenses.}

• _{In late 1980’s, Feds let the rate float.}

• _{Short term rate rose to 16%.}

• _{Depositors withdrew funds and demanded the new higher rates.}

• _{S&L’s were locked into receiving 8% from the long term fixed mortgages}

and paying 16% to the

short term, floating rate deposits.

• _{This forced many S&L’s into bankruptcy.}

• _{This crisis could have been avoided if the S&L had practiced better ALM}

and not exposed themselves so badly to this risk.

• _{US savings and loan crisis.}

• _{Local banks mandated to take retail deposits and make retail loans.}

• _{For years the Feds kept interest rate stable.}

• _{Took deposits that paid 4% and}

• _{lent 30 ys mortgages paying about 8% fixed rates.}

• _{4% profit before noninterest expenses.}

• _{In late 1980’s, Feds let the rate float.}

• _{Short term rate rose to 16%.}

• _{Depositors withdrew funds and demanded the new higher rates.}

• _{S&L’s were locked into receiving 8% from the long term fixed mortgages}

and paying 16% to the

short term, floating rate deposits.

• _{This forced many S&L’s into bankruptcy.}

• _{This crisis could have been avoided if the S&L had practiced better ALM}

and not exposed themselves so badly to this risk.

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1) Allen, S. (2003)

Financial Risk Management,

John Wiley & Sons.

2) Bessis, J. (2002)

Risk Management in Banking

, John Wiley & Sons.

3) Crouhy, M., Galai, D. and Mark, R. (2001)

Risk Management

, New York:

McGraw-Hill.

4) Gaeta, G. (2003)

Frontiers in Credit Risk,

John Wiley & Sons.

5) Holmes, A. (2004)

Smart Risk,

Capstone Publishing.

6) Laster, D. (2000) Asset-liability management for insurers.

Sigma No.6,

Swiss

Reinsurance Co.

7) Marrison, C. (2002)

The Fundamentals of Risk Measurement

, New York:

McGraw-Hill.

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Good risk management enables a company

to operate in an environment in control and

not a controlled environment.

Risk management should be used to

encourage the taking of appropriate risk.

Risk management is synonymous to

Risk-reward optimisation.

Risk and Rewards are two sides of the same coin.

You only find out who is swimming naked

when the tide goes out.

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Maths can also be useful in calculating personal risks!

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How to optimise your choice of husbands?

• _{Suppose when you are young (18-25) you can date with 30 guys}

• _{Once you date and dump Rain you cannot return to him.}

• _{If you date all 30 buys, you’ll end up with number 30.}

• _{The optimal strategy is to date and dump the first 5 guys}

• _{Remember the best man out of the 5, call him Mr. Best}

• _{Date number 6, if number 6 is not as good as Mr. Best move to no 7.}

• _{If date number 6 is better then Mr. Best , choose number 6.}