investment risk management

TLFeBOOK Investment Risk Management Yen Yee Chong TLFeBOOK TLFeBOOK Investment Risk Management TLFeBOOK Wiley Finance Series Investment Risk Management Yen Yee Chong Understanding International Bank Risk Andrew Fight Global Credit Management: An Executive Summary Ron Wells Currency Overlay Neil Record Fixed Income Strategy: A Practitioners Guide to Riding the Curve Tamara Mast Henderson Active Investment Management Charles Jackson Option Theory Peter James The Simple Rules of Risk: Revisiting the Art of Risk Management Erik Banks Capital Asset Investment: Strategy, Tactics and Tools Anthony F. Herbst Brand Assets Tony Tollington Swaps and other Derivatives Richard Flavell Currency Strategy: A Practitioner’s Guide to Currency Trading, Hedging and Forecasting Callum Henderson The Investor’s Guide to Economic Fundamentals John Calverley Measuring Market Risk Kevin Dowd An Introduction to Market Risk Management Kevin Dowd Behavioural Finance James Montier Asset Management: Equities Demystified Shanta Acharya An Introduction to Capital Markets: Products, Strategies, Participants Andrew M. Chisholm Hedge Funds: Myths and Limits Francois-Serge Lhabitant The Manager’s Concise Guide to Risk Jihad S. Nader Securities Operations: A guide to trade and position management Michael Simmons Modeling, Measuring and Hedging Operational Risk Marcelo Cruz Monte Carlo Methods in Finance Peter J¨ackel Building and Using Dynamic Interest Rate Models Ken Kortanek and Vladimir Medvedev Structured Equity Derivatives: The Definitive Guide to Exotic Options and Structured Notes Harry Kat Advanced Modelling in Finance Using Excel and VBA Mary Jackson and Mike Staunton Operational Risk: Measurement and Modelling Jack King Advanced Credit Risk Analysis: Financial Approaches and Mathematical Models to Assess, Price and Manage Credit Risk Didier Cossin and Hugues Pirotte Risk Management and Analysis vol. 1: Measuring and Modelling Financial Risk Carol Alexander (ed.) Risk Management and Analysis vol. 2: New Markets and Products Carol Alexander (ed.) TLFeBOOK Investment Risk Management Yen Yee Chong TLFeBOOK Copyright C  2004 John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England Telephone (+44) 1243 779777 Email (for orders and customer service enquiries): cs-books@wiley.co.uk Visit our Home Page on www.wileyeurope.com or www.wiley.com All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except under the terms of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP, UK, without the permission in writing of the Publisher. 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Other Wiley Editorial Offices John Wiley & Sons Inc., 111 River Street, Hoboken, NJ 07030, USA Jossey-Bass, 989 Market Street, San Francisco, CA 94103-1741, USA Wiley-VCH Verlag GmbH, Boschstr. 12, D-69469 Weinheim, Germany John Wiley & Sons Australia Ltd, 33 Park Road, Milton, Queensland 4064, Australia John Wiley & Sons (Asia) Pte Ltd, 2 Clementi Loop #02-01, Jin Xing Distripark, Singapore 129809 John Wiley & Sons Canada Ltd, 22 Worcester Road, Etobicoke, Ontario, Canada M9W 1L1 Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Library of Congress Cataloging-in-Publication Data Chong, Yen Yee. Investment risk management / Yen Yee Chong. p. cm. Includes bibliographical references and index. ISBN 0-470-84951-7 (cloth : alk. paper) 1. Investment analysis. 2. Risk management. I. Title. HG4529 .C47 2004 658.15 ′ 5–dc22 2003021828 British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN 0-470-84951-7 Typeset in 10/12pt Times by TechBooks, New Delhi, India Printed and bound in Great Britain by The Cromwell Press, Trowbridge, Wiltshire This book is printed on acid-free paper responsibly manufactured from sustainable forestry in which at least two trees are planted for each one used for paper production. TLFeBOOK Contents 1 Introduction to Investment Risk 1 Dream versus rude awakening 1 Book structure 3 2 The Beginning of Risk 5 Risk and business 5 Case study: The shark and its risk 5 Case study: The ruin of Cr´edit Lyonnais (CL) 7 Case study: ABB engineering 7 Investment scams 9 Banking risk and sharks 9 Risk management as a discipline 10 Humans and risk 11 Case study: High-street retail store losses 12 Case study: Allied Irish Bank (AIB) 12 The state of the investment game 13 Risk types 13 Reputation risk 14 Case study: Equitable Life 14 Credit risk 15 Market risk 15 Operational risk 16 Risk and damage 17 Viable alternatives 18 3 Investing under Risk 21 Human behaviour and investment choice 21 Portfolio management 22 Value-at-Risk (VaR) 25 Monte Carlo simulation 28 Collective use of mathematical tools 29 Position keeping 30 TLFeBOOK vi Contents Investment managerial control 31 The treasurer’s role 31 Trading and risk management 32 Investment risk experts 38 Case study: A large UK PLC defined benefits pension fund 39 Who controls whom 39 4 Investing under Attack 41 Investor disenchantment 41 Risk-bearers and risk-takers 41 Professional investor/shareholder 41 Investment companies/fund managers 42 Investment banks 43 Auditors 43 A look in the risk mirror 44 Risk-averse 44 Risk-neutral 45 Risk-takers 45 Investor analysis 46 Types of CEO – birds of a feather 47 The CEO eagle – The M&A addict 47 The CEO dodo – Risk-phobic 48 The CEO ostrich – Risk-ignorant 48 The CEO owl – Risk-acceptable 48 The CEO magpie – Risk-seeking 48 Company structure and risks 49 Case study: The executive background check 49 Risk vanities 51 Pensions mis-selling 52 Case study: Boo.com 53 Corporate misgovernance 53 Accuracy of corporate losses 54 Classes of instruments and their risk components 55 Derivatives 56 Bonds 57 Equities 60 Investment as a project 62 5 Investing under Investigation 63 Instinct versus ability 63 Checking corporate fundamentals 64 Formulate a business plan 64 Due diligence 67 Risk support and methodology 68 Investor cynicism 69 Case study: LTCM 70 TLFeBOOK Contents vii 6 Risk Warning Signs 73 Prevailing risk attitudes 73 Reputational risk 74 Case study: Enron 74 Airborne early warning (AEW) 76 International accounting standards (IAS) 77 Credit ratings 78 The ratings procedure 79 Business lines 80 Law and risk management 81 Case study: the UK Football League 81 What the law covers 82 Completeness of contract 82 Case study: Merrill Lynch versus Unilever pension fund 83 Sarbanes–Oxley Act for audit control 84 Insurance 85 Risk retention: self-insurance 87 Case study: Insuring big oil projects 88 Case study: the Names and Lloyds, London 89 Sharing, transferring or mitigating risk 89 Search for risk management 92 Alternative theories 92 Causality and managing investment risk 92 Value-added chain 93 Risk management to pick up the pieces 94 Scenario analysis 94 Case study: Business Continuity, lessons from September 11 th 94 Case study: Guaranteed annuity payments 96 Stress testing 96 Bayesian probability 97 Artificial intelligence (AI) and expert systems 97 Case study: Anti-money laundering 97 Risk maps 99 7 The Promise of Risk Management Systems 101 Current state of systems 101 Risk management methodology – RAMP 102 Activity A: Analysis and project launch 102 Activity B: Risk review 102 Activity C: Risk management 102 Activity D: Project close down 103 Financial IT system support 103 The Basel II Loss Database project 103 Case study: Algorithmics systems in a bank 105 Integration and straight-through processing (STP) 106 IT systems project failure 107 TLFeBOOK [...]... various conditions Risk management Devise risk management plan Assign key staff for completion of project Allocate risk management budget Implement risk management IT systems Run investment risk model Execute risk management decisions: ignore risks (prepare to bear all burden yourself) mitigate risks (lessen damage e.g write a hedging contract) transfer risk to insurer sell off risk operation to an... Forensic accounting Appropriate risk management structure Case study: BCCI bank Facts, not figures New risk focus 159 159 160 161 163 163 164 164 166 167 168 169 170 171 174 175 11 Integrated Risk Management Developments in the finance sector Organic risk management Separating reputation from risk management Case study: Enron Future for risk management The case for organic risk management Case study: Hunting... Beginning of Risk We look at what risk entails at the beginning These hazards are linked to the actual result, but humans tend to focus on the danger only when it materialises The fear of investment failure has led to risk management emerging as a more visible business skill and discipline We introduce risk management within an investment project management methodology The three investment risks: credit,... – the risk of an outcome or event; r danger or risk catalyst that allowed this risk to occur; r impact of the event upon your group; r risk management – the process in which you can limit or avoid the potential damage There are four risk types that we wish to examine in depth within this book 1 2 3 4 Reputation risk Market risk Credit risk Operational risk These last three are the same major risk types... look at risk management is required This book targets those risk factors that threaten a loss in our portfolio value or investment We adopt a view of business investment as a closed project This enables us to use a more disciplined analysis of what governs enterprise success, and that involves project management We focus upon what constitutes investment risk; how organisations handle investment risk; ... banking risks are outlined in Chapter 9 Risk- managed Banking and Basel II” The evolving paradigms on investment risk have led to new ideas on modelling risk These are summarised in Chapter 10 “Future-Proofing against Risk Visiting the past has shown us the potential graveyard of many previous, proud companies and investment dreams Even a current examination of the current state of investment risk management. .. more like living beings requiring “organic” risk management These can, and should be, joined up by integrated risk management detailed in Chapter 11 “Integrated Risk Management Whether we engage in simple personal investments, or much larger and more complex corporate business decisions, we can all benefit from risk management to preserve the value of our investments These are summarised in Chapter... cultural risk appetites Others prefer just to avoid the fatal risk completely 1 The potential death from a shark attack is a “hazard” phenomenon in the first line of risk analysis 2 The intrusion into its path is the second element or risk catalyst” in a shark attack Within the process, the victim is open to injury through risk exposure” TLFeBOOK 6 Investment Risk Management 3 The third element is the risk. .. and r being punished RISK MANAGEMENT AS A DISCIPLINE The idea of risk management is certainly not a new one; it is certainly as old as that great risk mitigation practice – building an ark The business theme is the same, believe that the risk event can strike us, act constructively to mitigate or lessen the damage when it strikes us 1 There is the first school of investment risk management – the fatalistic... to be hit by a risk event, so better be covered Bear the load yourself – retaining the risk under self-insurance Risk management means keeping a contingency fund for your company 2 This is can be the second paradigm of investment risk management – the technological school We are mathematically and technically developed in our understanding of risk event, so we can avoid or mitigate risk through smart . TLFeBOOK Investment Risk Management Yen Yee Chong TLFeBOOK TLFeBOOK Investment Risk Management TLFeBOOK Wiley Finance Series Investment Risk Management Yen Yee Chong Understanding International Bank Risk Andrew. 115 Project life cycle 116 Risk management project plan 117 A – Our risk strategy 117 B – Risk review 117 C – Risk management 117 D – Project close down 119 8 Realistic Risk Management 121 Intentional. Integrated Risk Management 177 Developments in the finance sector 177 Organic risk management 178 Separating reputation from risk management 180 Case study: Enron 181 Future for risk management