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Introduction to Risk managementBlackwell, Griffiths and Winters, Chapter 11

Introduction

What is risk?

When does it occur?

Why should we be concerned?

How do we measure it?

How should we manage it?

These questions are asked frequently by business and financial managers.

In Chapter 7 systematic (market) risk and unsystematic (business) risk is introduced

It discussed how it can be reduced through diversification.

However, this tells us little about how to operationalize the management of risk.

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Introduction

Value-at-Risk (VaR) is a recent development to help investors operationalize risk.

VaR is the maximum expected loss over a given investment period under normal market conditions at a pre-determined level of confidence. This is a measure of the potential downside in an investment.

An example of VaR comes from the 1994 annual report for J.P. Morgan which stated the daily earnings at risk for our combined trading activities averaged approximately $15 million … at the 95% percent level.

Then investors can determine if they are comfortable with this level of risk in one of their investments.

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General Definition of Risk

Risk is a measure of the potential changes in value that will be experienced in a managed portfolio as a result of differences in the economic environment between now and some specific point in the future.

Note that if managers cannot change the expected cash flows, then no opportunity for managing risk exists.

Areas of risk management:

Business Risk

Market Risk

Operational Risk

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Risk Landscape Business Risk

Business Risk

Operational Risk

CreditRisk

LiquidityRisk

ModelRisk

LegalRisk

Risk Landscape Business Risk

Operational Risk is the risk of the failure of the internal systems that manage a business.

Legal Risk is the risk that contracts are not enforced.

Credit Risk is when a party to a financial transaction does not have the ability to make the required payments under the contract.

Liquidity Risk is the need to sell (unwind) an asset at an unfavorable price because of a very near-term need for cash.

Model Risk is that financial models may not do what a person excepts or needs them to do.

Financial models have gotten increasingly complex to the point where it is often difficult to determine underlying assumptions and other features of a model causing the models to be used incorrectly.

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Risk Landscape Market Risk

Like business risk, market risk has various component parts.

CommodityPriceRisks

ForeignExchangeRisks

InterestRateRisks

MarketRisks

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Risk Landscape Separating Out Operational Risk

Operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems or from external events.

Note that this definition includes people interacting with the business and the business interacting with the outside world.

Separating Out Operational Risk

Operations risk results from the consequences of a breakdown in a core operating, manufacturing, or processing capability. In an organization charged with investment responsibilities, this risk is associated with the manager, marketing and sales behavior, as well as technology-related transactions.Asset impairment risk occurs when an asset loses a significant portion of its current value because of a reduction in the likelihood of receiving future cash flows. Points where transactions are processed or where data can be manipulated are important for maintaining the integrity of the financial system and the value of the assets.

Competitive risks result from changes in the competitive environment that could impair the business’ ability to create value and differentiate its products and services. In financial terms, this often means the organization has failed to deliver superior performance as a result of a market downturn or from managerial failures.

Franchise risk is a consequence of excessive risk in one of the three other risk categories. It occurs when the value of the entire business erodes due to a loss in confidence by critical constituents such as shareholders, investors or customers.

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Operational Risk and Weak Procedures Barings Bank

Barings Bank failed due to trading activities of Nicholas Lesson in its Singapore office.In 1995 Barings reported equity of £440 million. A Bank of England review found losses of £927 million directly attributable to Lesson’s trading.The failure of Barings actually occurred because the bank was unable to meet the margin calls on the trading positions created by Lesson.

On August 8, 1991, suspended the two executives in charge of trading these issues and admitted to violating Government rules. in three Treasury securities auctions, in December 1990 and February and May of 1991.

Saved from failure by a capital infision by Warren Buffet

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Operational Risk and Technology Porblems: Goldman Sachs, CBOT, BATS

A programming error at Goldman Sachs Group Inc. caused unintended stock-option orders to flood American exchanges this morning, roiling markets and shaking confidence in electronic trading infrastructure on August 19, 2013

Four months earlier the Chicago Board Options Exchange was shut down for 3 1/2 hours by a computer malfunction.

On August 2, 2012, Knight Capital Group announced it is being forced to raise money after an erroneous trading position wiped out $440 million of its capital

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BATS IPO was halted (March 25, 2012) as software glitch sent shares plunging

BATS Global Markets, the third-largest US stock exchange operator by volume, has alerted traders that computers (January 13, 2013) on its two equity exchanges and one options exchange allowed certain trades beginning in October 2008 to be processed at prices that may have not been the best available.

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Operational Risk and the Five BBA Stages

1. Companies know that operational risk exists.

2. Recognize that operational risk can have a significant impact on the profitability of the company. Company works to understand and assess operational risk.

3. Measure current levels of operational risk and effectiveness of management function.

4. Quantify relative risks and predict possible outcomes. Company usually develops empirical models and test their validity.

5. Recognize the pervasive nature of operational risk. The objective is to integrate and implement processes and solutions that recognize the different needs of different levels of management. At this stage operational risk becomes an integral part of strategic planning.

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Why are we so concerned about risk?

The goal of management is to maximize present shareholder wealth. That is, management is to create value for the shareholders.

The goal of operational risk management is to protect the firm value for shareholders.

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Implementing Risk Management

To implement a risk management procedure, we need to establish a risk management philosophy that incorporates:

1. a knowledge of the effect of risk on the performance of the company,

2. the amount risk [potential losses] the company can tolerate and,

3. the impact of volatility on financial performance.

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Operational Risk in the Risk Management Function

There are three parts to operational risk in the risk management function.

1. Why a business should have a risk management policy,2. How to create a risk management policy, and3. How to measure the effectiveness of the risk

management operation.

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Why a business should have a risk management policy

A risk policy provides guidelines for management. It has two purposes (see Figure 11.5 as an example):1. to protect the shareholders of the firm from the management of the firm.2. protect the managers from themselves by outlining the specific actions that may or may not be taken. The policies force managers to work together within a unified framework toward a common goal.

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ING Bank, fsbAuthority and Responsibility

The Board of Directors has ultimate authority and responsibility for the management of investment portfolios and financial risk. All new proposals and amendments on limits, products and other parts of the investment policy are also subject to approval by the ING Direct Market & Credit Risk Management Committee (DMC).

In order to ensure accountability, authority to act is delegated to individuals (defined in Delegation of Authority Section below) in the Company, and to ensure maximum control, responsibility for monitoring limits is delegated to Risk Management and the Asset-Liability Committee (ALCO).

In order to ensure an efficient and effective process, authority for the management of investment portfolios and authority for the management of financial risk is delegated to the same individuals.

Delegation of AuthorityThe authority to manage ING Bank, fsb’s investment portfolios and its financial risk, within the limits specified, is delegated from the Board to the President who shall delegate all these authorities of a portion thereof to the Treasurer.

The Treasurer may further delegate all or a portion of these authorities with the approval of the President.

All delegations of the President’s and Treasurer’s authorities shall be confirmed in writing.

Why a business should have a risk management policy

The policy statement is designed so a well-informed independent reviewer can understand why something was done and the way it was done.

The policy should be developed by senior management under the

supervision of the Board of Directors.

The policy could try to eliminate risk, but eliminating risk also eliminates gain. Instead, most risk policies are designed to trade-off upside benefits against downside losses.

Most businesses prefer to avoid losses at the expense of realizing large upside gains.

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Creating a Risk Management Policy Statement

This statement starts with identification of the company’s investment philosophy, which is based on the company’s level of risk aversion.

The statement will clearly differentiate between operational aspects of risk and investment risk (see Figure 11-6 in Chapter 11).The next step is to identify the objective of the risk management policy. Some standard policy objectives are:preserving the value of the firm in the long term regardless of the variation in underlying economic variablesensuring orderly recognition of income without undue variation due to changes in underlying economic variables

ensuring the total risk position of the firm is managed in a prudent fashion through the imposition of reasonable and stringently enforceable limitsensuring that within the limits imposed, the firm receives a reasonable return for the risk it does takepursuing a non-concentration strategy (including but not limited to issuer, industry and maturity), the selection of solvent counter-parties, issuers and an adequate control of market risk

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Creating a Risk Management Policy Statement

Now we must identify the parties responsible for risk management and the limitations the company wants to place on risk managers.

For example, a treasurer must know:1. How risk management tools work in

both rising and falling markets, and2. How to quantify the dollar value of

potential gains and losses.

While the treasurer must understand various techniques, the Board of Directors may choose to limit the tools that the treasurer may use in attempting to manage risk.

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Evaluating Risk Management Performance

One major benefit from creating a risk management philosophy and a risk management policy statement is that these provide reference for evaluating the effectiveness of the company’s risk management efforts.