FinQuiz smart summary, study session 14, reading 34

1 2013, Study Session # 14, Reading # 34 “RISK MANAGEMENT” RG = Risk Governance ERM = Enterprise Risk Management CG = Corporate Governance DB = Defined Benefit ESG = Environmental, Social Governance INTRODUCTION
Identification, measurement & control of risk are key to the investment process
Risk management framework is applicable to the management of both enterprise & portfolio risk
Indentify which risks are worth taking on a regular or occasional basis & which should be avoided altogether VAR = Value at Risk EAR = Earning at Risk CR = Credit Risk IR = Information Ratios RAROC = Risk-Adjusted Return on Capital RISK MANAGEMENT AS A PROCESS
Risk management ⇒ a continuous process involving the identification of exposures to risk, establishing appropriate ranges for exposures, measurement of these exposures & the execution of appropriate adjustments when required
Risk management is a continuous processes (subject to evaluation & revisions) not just an activity
Risk management process to a hypothetical business enterprise: Nonfinancial Risk The Company Financial Risk Set Policies & Procedures Information/Data Define Risk Tolerance Information/Data Derivatives Identify Risks Execute Risk Mgmt Transactions Non-Derivatives Measure Risks Identify Appropriate Transactions Adjust Level of Risk Price Transactions Execute Transactions Measure Risks Identify Source(s) of Uncertainty Select Appropriate Model Determine Market Price or Value Determine Model Price or Value Compare Attractively Priced Not Attractively Priced Execute Transaction Seek Alternative Transaction Copyright © FinQuiz.com All rights reserved 2 2013, Study Session # 14, Reading # 34 RISK MANAGEMENT AS A PROCESS
Risk management process to portfolio management:
Companies hedge risk that arise from areas in which they have no expertise or comparative advantage &hedge tactically where they have an edge (e.g primary line of business)
Risk management involves risk modification RISK GOVERNANCE
RG ⇒process of setting overall policies & standards in risk management is called RG
RG is of good quality if it is transparent, effective, efficient & accountable Risk Governance Structure Centralized Decentralized
Single risk management group to monitor & control the risk
Also called ERM or firm wide risk management
Risk management by individual business unit managers Benefit Benefits People closer to actual risk taking are allowed to manage it
Economies of scale
Allows a company to recognize the offsetting nature of distinct exposures
Enterprise-level risk estimates may be
than individual units (risk-mitigating benefits of diversification)
Consider each risk factor to which a firm is exposed (in isolation & in terms of any interplay)
Effective RG is possible only if the organization has effective CG
Steps in effective ERM system:
Identify individual risk factors
Quantify exposure in monetary term
Use these inputs to a risk estimation model (e.g VAR)
Indentify overall risk exposures & contribution from each risk factor to overall risk
Process of risk reporting to senior management
Monitor compliance with policies & risk limits
Effective ERM systems have centralized data warehouses which may require a significant & continuing investment Copyright © FinQuiz.com All rights reserved 3 2013, Study Session # 14, Reading # 34 IDENTIFYING RISKS
Effective risk management requires the separation of risk exposures into specific categories that reflect their distinguishing characteristics
Financial risk ⇒ risk derived from events in the external financial markets
Nonfinancial risk ⇒ all other forms of risk Taxes Accounting Legal Regulations Liquidity Risk Nonfinancial Risks The Company Settlement Financial Risks Market Risk (interest rate, exchange rate, equity prices & commodity prices risk) Model Operations 4.1 Market Risk
Market risk ⇒ risk associated with IR, exchange rates, stock prices & commodity prices
Market risk is linked to supply & demand in various marketplaces
DB plan measures market exposure in asset/liability management context 4.2 Credit Risk
Credit risk ⇒ risk of loss caused by counterparty’s failure to make a promised payment
Development of credit derivatives has blurred the lines b/w credit risk & market risk
Before OTC credit derivative recognition, bond portfolio managers & bank officers were the primary credit risk managers 4.3 Liquidity Risk
Liquidity risk ⇒ risk of concession in financial instruments price because of the market’s potential inability to efficiently accommodate the desired trading size
In case of short squeezing, liquidity may completely dry up in the market
For illiquid underlying, derivatives market may also be illiquid
Size of the bid-ask spread is an imprecise measure of liquidity risk (because it is suitable only for small trade size)
Complex liquidity measures are available to address the issue of trading volume
Liquidity risk is difficult to observe & quantify Copyright © FinQuiz.com All rights reserved Credit Risk 2013, Study Session # 14, Reading # 34 4.4 Operational Risk
Operational risk ⇒ risk of loss in a company’s internal (systems & procedures) or from external events
The risk can arise from:
Human errors (unintentional errors or willful misconduct)
Computer breakdown (hardware, software problems)
Act of God (only cash compensation for losses can be covered through insurance)
Rogue trader ⇒ trader that assumes irresponsibly  level of risk or engaged in unauthorized transactions or some combination of both
Companies manage operational risk by monitoring their systems, taking preventive actions & having a plan in place to respond if such events occur 4.5 Model Risk
Model risk ⇒ risk that model is incorrect or misapplied (often valuation models)
Inappropriate model ⇒ chances of loss  & control over risk is impaired
Investors must scrutinize & validate all models they use 4.6 Settlement (Herstatt) Risk
Settlement risk ⇒ risk that one party could be in process of paying the counterparty while the counterparty is announcing bankruptcy
Transactions b/w exchange members & clearing house removes settlement risk
Netting arrangement reduces settlement risk
Transactions with foreign exchange component:
Don’t lend themselves to netting
Parties are unaware to each other
The risk is called Herstatt risk (bank Herstatt default)
Risk can be mitigated through continuously linked settlement (simultaneous payments) 4.7 Regulatory Risk
Risk associated with the uncertainty of how a transaction will be regulated or potential for regulation change
Regulation is a source of uncertainty (risk that existing regulatory regime will ∆ or unregulated market will become regulated)
Regulatory risk is difficult to estimate due to ∆ in political parties & regulatory personnel
Equivalent combinations of cash & derivative securities are not regulated by same way or by same regulator 4.8 Legal/Contract Risk
Legal/contract risk ⇒ possibility of loss arising from failure of legal system to enforce a contract in which an enterprise has a financial stake
Dealers should be very careful when writing contracts with their counterparties (due to their advisory nature)
Contract law is often federally or nationally governed 4.9 Tax Risk
Uncertainty associated with tax laws
Tax policy often fails to keep pace with innovations in financial instruments
Equivalent combination of financial instruments may be subject to different tax treatments Copyright © FinQuiz.com All rights reserved 2013, Study Session # 14, Reading # 34 4.10 Accounting Risk
Uncertainty about transaction recording & potential for accounting rules & regulations to ∆
Historically accounting standards varied from country to country (more disclosure requirements in some countries than others)
Accounting risk can be reduced by hiring personnel with latest accounting knowledge (accounting risk will always remain) 4.11 Sovereign and Political Risks
Sovereign risk;
Form of credit risk involving sovereign nation’s borrowing
Current credit risk & potential credit risk
Its magnitude involves likelihood of default & the estimated recovery rate
Willingness & ability to repay
Political risk ⇒ risk of ∆ in the political environment 4.12 Other Risks ESG Risk Performance Netting Risk
Performance netting risk;
Applies to firms that fund more than one strategy
Firm will receive fee only if net +ve performance
Firm will pay its portfolio managers on basis of individual performance
Asymmetric incentive fee arrangements with portfolio managers
Firms may have to pay to its portfolio managers when firm’s revenue is zero
Environmental risk ⇒ leads to variety of –ve financial & other consequences
Social risk ⇒ risk regarding policies & practices of human resources, contractual arrangements & work-place
Governance risk ⇒ flaws in CG policies & procedures Settlement Netting Risk
Risk of netting arrangement on profitable transactions for the benefit of creditors challenged by liquidator of counterparty in default
Risk is mitigated by netting agreements that can survive legal challenge MEASURING RISK 5.1 Measuring Market Risk
Exposure of actively traded financial instruments prices to ∆ in IR, exchange rates, equity prices & commodity prices
Volatility (S.D) is a statistical tool to describe market risk
Adequate description of portfolio risk
Suitable for instruments with linear payoffs
Portfolio’s exposure to losses due to market risk:
Primary or 1st order measures of risk ⇒ adverse movement in a key variable (linear)
2nd order measures ⇒ ∆ in sensitivities (curvature)
Examples of primary risk measures are β (for stocks), duration (for bonds) & delta, vega & theta (for options)
Examples of 2nd order measures are convexity & Gamma Copyright © FinQuiz.com All rights reserved 6 2013, Study Session # 14, Reading # 34 5.2 Value at Risk
VAR:
Probability-based measure of loss potential for a company, fund, portfolio, strategy or transactions
Expressed either in % or in units of currency
Easily & widely used to measure loss from market risk but can also be used to measure credit & other exposures (subject to greater complexity)
Can be described as a minimum or maximum VAR
VAR implication:
It measures a minimum loss

The probability,  the VAR in magnitude
VAR has a time element (the period,  the VAR) 5.2.1 Elements of Measuring Value at Risk Establishing an appropriate VAR measure requires a no of decisions about the calculation structure Three Important Decisions in VAR Picking a Probability Level Choosing the Time Period

The probability, more conservative the VAR estimate is
Linear risk characteristics portfolios, two probability level (e.g 5% & 1%) will provide identical information
Optionality or nonlinear risks, select the more conservative probability threshold Selecting a Specific Approach
VAR magnitude is directly related to time interval selected
Relationship is nonlinear Three standardized methods for estimating VARs (discussed below) 5.2.2 The Analytical or Variance-Covariance Method
Assumptions ⇒ portfolio returns are normally distributed
Standard normal distribution ⇒ expected value of zero & a SD of
Conversion of a nonstandard normal distribution to a standard normal distribution:
    −   
 = 
^ − 


Estimation of expected returns & SD of returns is key to using analytical method
If we are comfortable with normal distribution assumption & accuracy of our estimates, we can confidently use the analytical method for a different time period by adjusting the avg returns & SD accordingly (e.g annual VAR can be converted to daily VAR by dividing avg return & SD to 250 (trading days))
VAR (usually daily VAR) can also be estimated by assuming an expected return of zero Two advantages:
No need to estimate E(R) which is harder to estimate than volatility
Easier to adjust VAR for a different time period(     =  √250) Advantage/Disadvantage of Analytical Method Advantage Simple method Disadvantage Normal distribution assumption often does not hold (e.g.in options) Copyright © FinQuiz.com All rights reserved 7 2013, Study Session # 14, Reading # 34 5.2.3 The Historical Method
Collect the historical return & indentify the return below which 5% or 1% of returns fall
No constraint to use normal distribution
If different portfolio composition than what actually had in the past to calculate historical VAR, it is more appropriate to call the method a historical simulation
Advantage ⇒ non parametric
Disadvantage ⇒ relies completely on past data (also a problem with other methods but not so acute) 5.2.4 The Monte Carlo Simulation Method
MCS produce random portfolio returns which are assembled into a summary distribution from which we can determine at which level the lower 5% (or 1%) of return outcomes occur
MCS does not require a normal distribution
MCS is more flexible approach & even suitable for portfolios containing options
As sample size  sample VAR converge to population VAR
MCS require extensive commitments of computer resources 5.2.5 Surplus at Risk": VAR as It Applies to Pension Fund Portfolios
Pension fund managers apply VAR methodologies to the surplus (rather their asset portfolio)
Managers express their liability portfolio as a set of short securities & calculate VAR on net position (any VAR methodology can apply) 5.3 The Advantages and Limitations of VAR VAR’s Imperfections VAR’s Attractions
Can be difficult to estimate
Different estimation methods can provide different results
If assumptions are not accurate, VAR often underestimate magnitude or frequency of worst returns
Portfolio VAR is not simply the sum of individual position’s VAR
VAR provide incomplete picture of overall exposure (ignore +ve results)
Back testing should be applied to check method’s accuracy
VAR estimate is not suitable for organization with complex structure





Quantify loss in simple terms Easily understood by senior management May be a requirement of regulatory body VAR is a verstyle measure VAR is often paired with stress testing VAR results are input dependent Copyright © FinQuiz.com All rights reserved 8 2013, Study Session # 14, Reading # 34 5.4 Extensions and Supplements to VAR
Incremental VAR ⇒ effect on portfolio VAR by including & excluding an asset
Provide extremely limited picture of the asset’s or portfolio’s contribution to risk
Cash flow at risk & EAR ⇒ with a given probability & over a specified time period, the minimum CF (earnings) that we expect to be exceeded
Useful for companies that generate CF or earnings but not readily valued in a publicly traded market
Tail VAR ⇒ VAR plus the expected loss in excess of VAR, when such additional loss occurs 5.5 Stress Testing
Stress testing is used to supplement VAR as a risk measure
VAR assumes potential losses under normal market conditions while stress testing identifies additional losses due to unusual circumstances Approaches in Stress Testing 5.5.1 Scenario Analysis 5.5.2 Stressing Models
Evaluating a portfolio under different scenarios
Effect of large movements in a key variable on portfolio’s value
Stylized scenarios ⇒ simulating a movement in at least one primary market force (e.g IR, exchange rate etc.)
Problem ⇒it assumes that shocks tend to be applied to variables in a sequential fashion (in reality shocks often happen simultaneously)
Actual extreme events ⇒ put the portfolio through price movements resulting from the events that occurred in the past
Hypothetical events ⇒ that have never happened in the markets (difficult to analyze & confusing outcomes)
When a series of appropriate scenarios is established, the next step is to apply them to the portfolio (consider assets’ sensitivities to the underlying risk factors)
Use an existing model & apply shocks to the model inputs in some mechanical way
Range of possibilities rather than a single set of scenarios
Computationally demanding
Factor push ⇒ push risk factors & prices of a model in most disadvantageous way & to work out the combined effect on the portfolio value
Model risk is present
Max Loss optimizations ⇒ mathematically optimizing the risk variable that will produce the maximum loss
Worst-case scenario analysis ⇒ examines the expected worst case 5.6 Measuring Credit Risk
Credit risk ⇒ risk that the party owing money to another will renege on the obligation
CR has two dimensions:
Probability of loss
Amount of loss
Empirical data set on credit losses is quite limited with respect to time perspective, credit losses can be current or potential credit losses
Cross-default provision ⇒ borrower’s default on any outstanding credit obligation is considered default on all outstanding credit obligations
Credit or default VAR ⇒ reflects the probability of minimum loss during certain time period
Credit VAR can’t be separated from market VAR & focus on upper tail of the distribution of market returns
More accurate measures of default probability & recovery rate ⇒
& more accurate credit VAR
Estimating credit VAR is complicated because:
Credit events are rare & harder to estimate
CR is less easily aggregated than market risk
Correlations b/w CR of counterparties must be considered Copyright © FinQuiz.com All rights reserved 2013, Study Session # 14, Reading # 34 5.6.1 Option-Pricing Theory and Credit Risk
A bond with CR can be viewed as:
Default free bond plus
Short put option written by bondholders for shareholders (this put option reflects shareholders right of limited liability)
Traditional put-call parity with a little bit changes can beand used to draw 5.6.1 option-Pricing Theory Credit Risk value of implicit put option
Value of put option is the difference b/w default-free bond & bond subject to default 5.6.2 The Credit Risk of Forward Contracts
Each party assumes the other’s CR
No current CR exists prior to expiration (no payments are due)
If the counterparty with –ve value declares bankruptcy before the contract expiration, the claim of non-defaulting counterparty is market value of forward contract at the time of bankruptcy 5.6.3 The Credit Risk of Swaps



CR is present at a series of points during the contract’s life MV of contract can be calculated at any time to reflect potential CR CR of IR & equity swaps is largest during middle of swap’s life In case of currency swaps, the CR is greatest b/w midpoint to end of swap’s life 5.6.4 The Credit Risk of options
Options have unilateral CR (after paying premium credit risk accrues entirely to the buyer)
European options ⇒ no current CR until expiration ⇒ significant potential CR
American option ⇒ current CR if holders decide to exercise option early
Credit risk on derivative transaction tends to be quite small relative to that on loan 5.7 Liquidity Risk
Cost of an illiquid instrument can be measured through bid-risk spread
Instruments that trade very infrequently at any price give illusion of
volatility)
Practitioners often liquidity-adjust the VAR estimates 5.8 Measuring Non-Financial Risks
These risks are very difficult to measure ⇒ usually lack of observable distribution of losses related to these factors
Techniques like extreme value theory is used if possible to model sources of risk but these techniques are input dependent 5.8.1 Operational Risk
Well publicized losses at financial institutions (e.g rogue employees theft) have put operational risk justifiable into the forefront
Banks can measure their operational risk through Basel II Copyright © FinQuiz.com All rights reserved 2013, Study Session # 14, Reading # 34 MANAGING RISK
Key components:
Effective risk governance model
Systems & technology to provide timely & accurate risk information decision makers
Trained personnel to evaluate risk information
Risk management is just a good common business sense 6.1 Managing Market Risk
ERM system identifies appropriate risk tolerance levels
Taking too little risk is as much problematic as taking too much risk (e.g
possible rewards) 6.1.1 Risk Budgeting Risk budgeting ⇒ efficient allocation of capital risk across various units of an organization or portfolio managers Risk Budgeting Organization Perspective Portfolio Management Context
Allocation of an acceptable level of risk to various departments of an organization
In addition to VAR, risk can also be allocated based on individual transaction size, amount of working capital needed etc
If correlation among departments is < 1, the sum of risk budgets for individual units > than organizational risk budget
Assets class correlation adjusted IR can determine the optimal tracking risk allocation
Investment manager’s allocation is positively related to his correlation adjusted IR
Risk budget allocation should be measured in relation to risk to surplus (assets – liabilities) 6.2 Managing Credit Risk
Estimating default probability is difficult
Credit risk is not symmetric & normally distributed (downside only) thus not easily measured & controlled using SD & VAR 6.2.1 Reducing Credit Risk by Limiting Exposure
Not lend too much money to one entity
Not engage in too many derivative transactions with one counterparty 6.2.2 Reducing Credit Risk by Marking to Market
Credit risk can be reduced through marking to market an OTC derivative contract
OTC options are not marked to market (one sided +ve value)
Credit risk of option is normally handled by collateral Copyright © FinQuiz.com All rights reserved 10 11 2013, Study Session # 14, Reading # 34 6.2.3 Reducing Credit Risk with Collateral
Collateral posting is widely accepted as credit exposure mitigant
Collateral requirements are based on market values & participants credit ratings 6.2.4 Reducing Credit Risk with Netting
Payment netting
credit risk by
the amount of money that must be paid
Netting in the event surrounding a bankruptcy referred to as closeout netting
Cherry picking ⇒ bankrupt company attempting to enforce contracts that are favorable to it while walking away from those that are unprofitable 6.2.5 Reducing Credit Risk with Minimum Credit Standards and Enhanced Derivative Product Companies
Companies will not business with organization of low credit quality
EDPCs are SPVs which are used by banks to control their exposure to rating downgrades 6.2.6 Transferring Credit Risk with Credit Derivatives
Credit default swap ⇒ protection buyer pays the protection seller in return for the right to receive a payment from the seller in case of specific credit event
Total return swap ⇒ protection buyer pays the total return in return for floating rate payments
Protection seller exposed to credit & IR risk
Credit spread option ⇒ yield spread of a reference obligation & over a referenced benchmark
Credit spread forward ⇒ forward contract on yield spread
Credit derivatives are used to eliminate as well as to assume credit risk 6.3 Performance Evaluation Risk adjusted performance is a critically important capital allocation tool (homogenous units of exposure assumption) as measured against sensible benchmarks Methodologies for Risk-Adjusted Performance Sharpe Ratio
This ratio measures excess mean return over Rf per unit of total risk
SD assumes normal distribution so not suitable for portfolios containing options RAROC
      
Capital at risk can be calculated in a variety of ways & can take a no of different forms Copyright © FinQuiz.com All rights reserved 12 2013, Study Session # 14, Reading # 34 Methodologies for Risk-Adjusted Performance Return over Maximum Drawdown Sortino Ratio
Max drawdown ⇒ largest difference b/w a high watermark & subsequent low

 =   %  
 the ratio, the better it is
Portfolio managers should not be penalized for +ve volatility (as in Sharpe ratio)
Downside deviation ⇒ rate of return volatility below the minimum acceptable return (MAR)
  = (     )     
If MAR is Rf then the only difference b/w Sharpe ratio & Sortino ratio is due to denominator
If non-normal distribution = Sharpe ratio & Sortino ratio behave much in similar way
Sharpe ratio is preferred in finance theory 6.4 Capital Allocation
In addition to capital preservation, risk management has become a vital component for risk taking enterprises
Risk management is a vital input into a capital allocation process
Most effective approach to capital allocation ⇒ appropriate combination of these methodologies: Methodologies for Capital Allocation Nominal, Notional, or Monetary Position Limits VAR-Based Position Limits
Capital that a portfolio or business unit can use in specified activity
Advantages:
Easy to understand & calculate
Nominal position can be taken by using other assets (e.g derivatives)
Disadvantages:
Ignore effects of correlation & offsetting risks
Not suitable in risk-control perspective Maximum Loss Limits
Determine a maximum loss limit
Max loss limit should be determined carefully (preserve capital & not constrained in meeting investment objectives)
In notional limits a VAR limit serves as a proxy for capital allocation
Advantage ⇒ appropriate for risk control process
Problem ⇒ dependent on VAR’s effectiveness Internal Capital Requirements
Capital, the management believes to be appropriate for the firm
If regulatory capital requirement is, overrule internal requirements
Traditionally, capital ratio was used to specify internal capital requirements
Modern approach ⇒ firm will be insolvent if
in asset is  than value of capital
VAR based capital requirement has an advantage over regulatory capital requirement ⇒ it consider correlations Regulatory Capital Requirements
May be inconsistent with rational capital allocation scheme
Part of overall allocation process whenever demanded by overall allocation process Copyright © FinQuiz.com All rights reserved 2013, Study Session # 14, Reading # 34 6.5 Psychological and Behavioral Considerations
Behavioral aspects have two implication of risk management:
At different points in portfolio management cycle, risk takers may behave differently
Risk management can be better implemented if these dynamics could be modeled Copyright © FinQuiz.com All rights reserved 13 ... may require a significant & continuing investment Copyright © FinQuiz. com All rights reserved 3 2013, Study Session # 14, Reading # 34 IDENTIFYING RISKS
Effective risk management requires the... Liquidity risk is difficult to observe & quantify Copyright © FinQuiz. com All rights reserved Credit Risk 2013, Study Session # 14, Reading # 34 4.4 Operational Risk
Operational risk ⇒ risk of loss... instruments may be subject to different tax treatments Copyright © FinQuiz. com All rights reserved 2013, Study Session # 14, Reading # 34 4.10 Accounting Risk
Uncertainty about transaction recording