FRM Lecture 1 Notes

7/31/2019 FRM Lecture 1 Notes

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FINANCIAL RISK MANAGEMENT FIRST LECTURE

RISK

Risk is defined as the effect of uncertainty on objectives (whether

positive or negative).

Financial risk in an organization is the possibility that the outcome

of an action or event could bring up adverse impacts. Such

outcomes could either result in a direct loss of earnings / capital

or may result in imposition of constraints on an organizations

ability to meet its business objectives.

Risks are usually defined by the adverse impact on profitability of

several distinct sources of uncertainty. The types and degree of

risks an organization may be exposed to depends upon a number

of factors such as its size, complexity business activities and

volume.

RISK MANAGEMENT

Risk management can therefore be considered the identification,

assessment, and prioritization of risks followed by coordinated

and economical application of resources to minimize, monitor,

and control the probability and/or impact of unfortunate events or

to maximize the realization of opportunities.

It should address methodically all the risks surrounding the

organizations activities past, present and in particular, future.


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It must be integrated into the culture of the organization with an

effective policy and a programme led by the most senior

management. It must translate the strategy into tactical and

operational objectives, assigning responsibility throughout the

organization with each manager and employee responsible for the

management of risk as part of their job description. It supports

accountability, performance measurement and reward, thus

promoting operational efficiency at all levels.

Risk Management is a discipline at the core of every financial

institution and encompasses all the activities that affect its risk

profile. It involves identification, measurement, monitoring and

controlling risks to ensure that

a) The individuals who take or manage risks clearly understand it.

b) The organizations Risk exposure is within the limits

established by Board of Directors.

c) Risk taking Decisions are in line with the business strategy and

objectives set by BOD.

d) The expected payoffs compensate for the risks taken

e) Risk taking decisions are explicit and clear.

f) Sufficient capital as a buffer is available to take risk

Risk management as commonly perceived does not mean

minimizing risk; rather the goal of risk management is to optimize

risk-reward trade -off. Notwithstanding the fact that financial


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institutions are in the business of taking risk, it should be

recognized that an institution need not engage in business in a

manner that unnecessarily imposes risk upon it: nor it should

absorb risk that can be transferred to other participants. Rather it

should accept those risks that are uniquely part of the array of

banks services.

Risk management protects and adds value to the organisation

and its stakeholders through supporting the organisations

objectives by:

providing a framework for an organisation that enables

future activity to take place in a consistent and controlled

manner

improving decision making, planning and prioritisation by

comprehensive and structured understanding of business

activity, volatility and project opportunity/threat

contributing to more efficient use/allocation of capital and

resources within the organisation

reducing volatility in the non essential areas of the business

protecting and enhancing assets and company image

developing and supporting people and the organisations

knowledge base optimising operational efficiency

Risk Management Process

Organizations Strategic Objective


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Risk Assessment

Risk Analysis

o Identification

o Description

o Estimation

Risk Evaluation

Risk Reporting

o Threats

o Opportunities

Decision

Risk Treatment

Residual Risk Reporting

Monitoring

Risk Assessment

Risk Assessment is defined by the ISO/IEC Guide 73 as the overall

process of risk analysis and risk evaluation

Risk Analysis

Includes Identification, Description and Estimation

Identification


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Risk identification sets out to identify an organisations exposure

to uncertainty.

This requires an intimate knowledge of the organisation, the

market in which it operates, the legal, social, political and cultural

environment in which it exists, as well as the development of a

sound understanding of its strategic and operational objectives,

including factors critical to its success and the threats and

opportunities related to the achievement of these objectives.

Risk identification should be approached in a methodical way to

ensure that all significant activities within the organization have

been identified and all the risks flowing from these activities

defined. All associated volatility related to these activities should

be identified and categorized.

Risk Identification Techniques examples

Brainstorming

Questionnaires

Business studies which look at each business process and

describe both the internal processes and external factors

which can influence those processes

Industry benchmarking

Scenario analysis

Risk assessment workshops


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Incident investigation

Auditing and inspection

HAZOP (Hazard & Operability Studies)

Risk Description

The objective of risk description is to display the identified risks in

a structured format, for example, by using a table.

The risk description table overleaf can be used to facilitate the

description and assessment By considering the consequence andprobability of each of the risks set out in the table, it should be

possible to prioritise the key risks that need to be analysed in

more detail.

Identification of the risks associated with business activities and

decision making may be categorised as strategic, project/tactical,

operational. It is important to incorporate risk management at the

conceptual stage of projects as well as throughout the life of a

specific project.

Strategic level: It encompasses risk management functions

performed by senior management and BOD. For instance

definition of risks, ascertaining institutions risk appetite,

formulating strategy and policies for managing risks and establish

adequate systems and controls to ensure that overall risk remain

within acceptable level and the reward compensate for the risk

taken.


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Macro Level: It encompasses risk management within a business

area or across business lines. Generally the risk management

activities performed by middle management or units devoted to

risk reviews fall into this category.

Micro Level: It involves On-the-line risk management where

risks are actually created. This is the risk management activities

performed by individuals who take risk on organizations behalf

such as front office and loan origination functions. The risk

management in those areas is confined to following operational

procedures and guidelines set by management.

Risk Estimation

Risk estimation can be quantitative, semiquantitative or

qualitative in terms of the probability of occurrence and the

possible consequence. For example, consequences both in terms

of threats (downside risks) and opportunities (upside risks) may

be high, medium or low (see table 4.3.1). Probability may be high,

medium or low but requires different definitions in respect of

threats and opportunities.

Different organisations will find that different measures of

consequence and probability will suit their needs best.

Risk Analysis methods and techniques

A range of techniques can be used to analyse risks. These can be

specific to upside or downside risk or be capable of dealing with

both.

Risk Analysis Methods and Techniques examples


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Upside risk

Market survey

Prospecting

Test marketing

Research and Development

Business impact analysis

Both

Dependency modelling

SWOT analysis (Strengths,Weaknesses, Opportunities,Threats)

Event tree analysis

Business continuity planning

BPEST (Business, Political, Economic, Social,Technological)

analysis

Real Option Modelling

Decision taking under conditions of risk and uncertainty

Statistical inference

Measures of central tendency and dispersion

PESTLE (Political Economic Social Technical Legal

Environmental)

Downside risk Threat analysis

Fault tree analysis

FMEA (Failure Mode & Effect Analysis)


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Risk Profile

The result of the risk analysis process can be used to produce a

risk profile which gives a significance rating to each risk and

provides a tool for prioritising risk treatment efforts. This ranks

each identified risk so as to give a view of the relative

importance.

This process allows the risk to be mapped to the business area

affected, describes the primary control procedures in place and

indicates areas where the level of risk control investment might

be increased, decreased or reapportioned.

Accountability helps to ensure that ownership of the risk is

recognised and the appropriate management resource allocated.

Risk Evaluation

When the risk analysis process has been completed, it is

necessary to compare the estimated risks against risk criteria

which the organisation has established.The risk criteria may

include associated costs and benefits, legal requirements,

socioeconomic and environmental factors, concerns of

stakeholders, etc. Risk evaluation therefore, is used to make

decisions about the significance of risks to the organisation and

whether each specific risk should be accepted or treated.

Risk Reporting and Communication

Internal Reporting


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Different levels within an organisation need different information

from the risk management process.

The Board of Directors should:

know about the most significant risks facing the organisation

know the possible effects on shareholder value of deviations to

expected performance ranges

ensure appropriate levels of awareness throughout the

organisation

know how the organisation will manage a crisis

know the importance of stakeholder confidence in the

organisation

know how to manage communications with the investment

community where applicable

be assured that the risk management process is working

effectively

publish a clear risk management policy covering risk

management philosophy and responsibilities

Business Units should: be aware of risks which fall into their area of responsibility, the

possible impacts these may have on other areas and the

consequences other areas may have on them

have performance indicators which allow them to monitor the

key business and financial activities, progress towards objectives


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and identify developments which require intervention (e.g.

forecasts and budgets)

have systems which communicate variances in budgets and

forecasts at appropriate frequency to allow action to be taken

report systematically and promptly to senior management any

perceived new risks or failures of existing control measures

Individuals should: understand their accountability for individual risks

understand how they can enable continuous improvement of

risk management response

understand that risk management and risk awareness are a key

part of the organisations culture

report systematically and promptly to senior management any

perceived new risks or failures of existing control measures

External ReportingA company needs to report to its stakeholders on a regular basis

setting out its risk management policies and the effectiveness in

achieving its objectives. Increasingly stakeholders look to

organisations to provide evidence of effective management of the

organisations non-financial performance in such areas as

community affairs, human rights, employment practices, health

and safety and the environment.

Risk Treatment


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Risk treatment is the process of selecting and implementing

measures to modify the risk. Risk treatment includes as its major

element, risk control/mitigation, but extends further to, for

example, risk avoidance, risk transfer, risk financing, etc.

Any system of risk treatment should provide as a minimum:

effective and efficient operation of the organisation

effective internal controls

compliance with laws and regulations.

The risk analysis process assists the effective and efficient

operation of the organization by identifying those risks which

require attention by management. They will need to prioritise risk

control actions in terms of their potential to benefit the

organisation.

Effectiveness of internal control is the degree to which the risk

will either be eliminated or reduced by the proposed control

measures.

Cost effectiveness of internal control relates to the cost of

implementing the control compared to the risk reduction benefits

expected.

Compliance with laws and regulations is not an option. Anorganisation must understand the applicable laws and must

implement a system of controls to achieve compliance.There is

only occasionally some flexibility where the cost of reducing a risk

may be totally disproportionate to that risk. (Example is SOX and

BASEL)


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Residual Risk Reporting

The level of risk faced by an organisation after internal controls

have been applied is known as the net or residual risk. Controls

will not eliminate the risk but help to manage it; therefore this is

also known as the organisation's "exposure to risk".

Monitoring and Review of the Risk Management Process

Effective risk management requires a reporting and review

structure to ensure that risks are effectively identified and

assessed and that appropriate controls and responses are in

place. Regular audits of policy and standards compliance should

be carried out and standards performance reviewed to identify

opportunities for improvement. It should be remembered that

organisations are dynamic and operate in dynamic environments.

Changes in the organisation and the environment in which it

operates must be identified and appropriate modifications made

to systems.

The monitoring process should provide assurance that there are

appropriate controls in place for the organisations activities and

that the procedures are understood and followed.

Changes in the organisation and the environment in which it

operates must be identified and appropriate changes made tosystems.

Any monitoring and review process should also determine

whether:


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the measures adopted resulted in what was intended

the procedures adopted and information gathered for

undertaking the assessment were appropriate

improved knowledge would have helped to reach betterdecisions and identify what lessons could be learned for future

assessments and management of risks

Financial risk management

is a process of evaluating and managing current and possible

financial risk at a firm as a method of decreasing the firm'sexposure to the risk. Financial risk managers must identify the

risk, evaluate all possible remedies, and then implement the

steps necessary to alleviate the risk.

These risks are typically remedied by using certain financial

instruments as a method of counteracting possible ramifications.

Financial risk management cannot prevent a firm from all possible

risks because some are unexpected and cannot be addressedquickly enough.

Similar to general risk management, financial risk management

requires identifying its sources, measuring it, and plans to

address them.

How does financial risk arises

Pressure from shareholders

Management working for bonuses

Good ratings from moodys etc

Better share prices


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Credit Risk

The risk of loss of principal or loss of a financial reward stemming

from a borrower's failure to repay a loan or otherwise meet a

contractual obligation. Credit risk arises whenever a borrower isexpecting to use future cash flows to pay a current debt.

Investors are compensated for assuming credit risk by way of

interest payments from the borrower or issuer of a debt

obligation.

Credit risk is closely tied to the potential return of an investment,

the most notable being that the yields on bonds correlate strongly

to their perceived credit risk.

The higher the perceived credit risk, the higher the rate of

interest that investors will demand for lending their capital. Credit

risks are calculated based on the borrowers' overall ability to

repay. This calculation includes the borrowers' collateral assets,

revenue-generating ability and taxing authority (such as for

government and municipal bonds).

Credit risks are a vital component of fixed-income investing,which is why ratings agencies such as S&P, Moody's and Fitch

evaluate the credit risks of thousands of corporate issuers and

municipalities on an ongoing basis.

Market Risk

The day-to-day potential for an investor to experience losses from

fluctuations in securities prices. This risk cannot be diversified

away. Also referred to as "systematic risk".

The beta of a stock is a measure of how much market risk a stock

faces

Risk which is common to an entire class ofassets or liabilities. The

value ofinvestments may decline over a given time period simply
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because ofeconomicchanges or other events that impact large

portions of the market. Asset allocation and diversification can

protect against market risk because different portions of the

market tend to underperform at different times. also called

systematic risk.

Market risk is exposure to the uncertain market value of a

portfolio. A trader holds a portfolio of commodity forwards. She

knows what its market value is today, but she is uncertain as to

its market value a week from today. She faces market risk.A

forward contractor forwardis an OTCderivative. In its simplest

form, it is a trade that is agreed to at one point in time but will

take place at some later time. For example, two parties might

agree today to exchange 500,000 barrels of crude oil for USD

42.08 a barrel three months from today.

Some financial or commodities instruments are traded on

established exchanges. Examples include most highly-capitalized

stocks, which trade on exchanges such as the New York Stock

Exchange, and futures, which trade on futures exchanges such as

the Chicago Board of Trade. These instruments are called

exchange traded.

An instrument is traded over-the-counter (OTC) if it trades in

some context other than a formal exchange. Most debt

instruments are traded OTC with investment banks making

markets in specific issues. If someone wants to buy or sell a bond,

they call the bank that makes a market in that bond and ask for

quotes. Many derivative instruments, including forwards, swaps

and most exotic derivatives are also traded OTC. In these

markets, large financial institutions serve as derivatives dealers,customizing derivatives for the needs of clients.

Liquidity Risk
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The risk that arises from the difficulty ofselling an asset. An

investment may sometimes need to be sold quickly.

Unfortunately, an insufficient secondary market may prevent the

liquidation or limit the funds that can be generated from the

asset. Some assets are highly liquid and have lowliquidity risk

(such as stock of a publicly tradedcompany), while other assets

are highly illiquid and have high liquidity risk (such as a house).

Operational Risk

the risk of direct or indirect loss resulting from inadequate or

failed internal processes, people and systems or from external

events.

A form of risk that summarizes the risks a company or firm

undertakes when it attempts to operate within a given field or

industry. Operational risk is the risk that is not inherent in

financial, systematic or market-wide risk. It is the risk remainingafter determining financing and systematic risk, and includes risks

resulting from breakdowns in internal procedures, people and

systems.

Operational risk can be summarized as human risk; it is the risk of

business operations failing due to human error. Operational risk

will change from industry to industry, and is an importantconsideration to make when looking at potential investment

decisions. Industries with lower human interaction are likely to

have lower operational risk.
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Compliance Risk

Compliance risk is the current and prospective risk to earnings or

capital arising from violations of, or nonconformance with, laws,

rules, regulations, prescribed practices, internal policies, and

procedures, or ethical standards. Compliance risk also arises in

situations where the laws or rules governing certain bank

products or activities of the Banks clients may be ambiguous or

untested. This risk exposes the institution to fines, civil money

penalties, payment of damages, and the voiding of contracts.

Compliance risk can lead to diminished reputation, reduced

franchise value, limited business opportunities, reduced

expansion potential, and an inability to enforce contracts.

Regulatory Risk

The risk associated with the potential for laws related to a given

industry, country, or type ofsecurity to change and impact

relevantinvestments.

The risk that a change in laws and regulations will materially

impact a security, business, sector or market. A change in laws or

regulations made by the government or a regulatory body can

increase the costs of operating a business, reduce the

attractiveness of investment and/or change the competitive

landscape.

For example, utilities face a significant amount of regulation in

the way they operate, including the quality of infrastructure and

the amount that can be charged to customers. For this reason,
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these companies face regulatory risk that can arise from events

- such as a change in the fees they can charge - that may make

operating the business more difficult.

Another type of regulatory risk would be a change by the

government in the amount of margin that investment accounts

are able to have. While this is an unlikely change, if it were to be

changed, the impact on the stock market would be material as

this would force investors to either meet the new margin

requirements or sell off their margined positions.

Legal Risk

A description of the potential for loss arising from the uncertainty

oflegal proceedings, such as bankruptcy, and potential legal

proceedings.

Reputational Risk

What Is Reputation?

The reputation of any individual or organization of any size is

complex. It exists in the minds of both those with whom we

interact directly, and in the minds of those who become aware of

us as word of our actions circulates. It changes all the time,

reflecting both the things we say and do an the trends and events

that change the way our words and actions are interpreted

It takes twenty years to build a reputation and five minutes to

destroy it. (W. Buffet)
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If you lose dollars for the firm, I will be understanding. If you

lose reputation, I will be ruthless. (W. Buffet)

Our assets are our people, capital and reputation. If any of

these are ever diminished, the last is the most difficult to

restore. (Goldman Sachs Business Principles)

What Does Risk-Return Tradeoff Mean?

The principle that potential return rises with an increase in risk.

Low levels of uncertainty (low risk) are associated with low

potential returns, whereas high levels of uncertainty (high risk)

are associated with high potential returns. According to the risk-

return tradeoff, invested money can render higher profits only if it

is subject to the possibility of being lost.

Because of the risk-return tradeoff, you must be aware of your

personal risk tolerance when choosing investments for your

portfolio. Taking on some risk is the price of achieving returns;therefore, if you want to make money, you can't cut out all risk.

The goal instead is to find an appropriate balance - one

that generates some profit, but still allows you to sleep at night.

Systematic Risk- Systematic risk influences a large number of

assets. A significant political event, for example, could

affect several of the assets in your portfolio. It is virtuallyimpossible to protect yourself against this type of risk.

Unsystematic Risk- Unsystematic risk is sometimes referred to

as "specific risk". This kind of risk affects a very small number of

assets. An example is news that affects a specific stock such as a
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sudden strike by employees. Diversification is the only way to

protect yourself from unsystematic risk. (We will discuss

diversification later in this tutorial).
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FRM Lecture 1 Notes

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