5 1 reading 42 risk management an introduction pdf

LOS Portfolio Management • • • • • • Portfolio Management – An Overview Portfolio Risk and Return – Part I Portfolio Risk and Return – Part II Basics of Portfolio Planning and Construction Risk Management – An Introduction Fintech in Investment Management LOS LOS Define risk management • What’s risk?  Exposure to uncertainty  Chance of loss or adverse outcome • What’s risk management?  Decisions taken to achieve maximum risk-adjusted return;  The overall goal is to maximize firm value;  Risk managers follow the “Doctrine of No Surprises”  It’s not about avoiding risks; it’s more about establishing possible future scenarios and putting in place measures to mitigate unfavorable outcomes LOS LOS Define risk management Risk management can be institutionalized (enterprise-wide) or individualized (silo-based): Financial risk Credit risk Enterprise risk management Inflation risk Operation al risk Interest rate risk Institutionalized: a holistic approach Silo-based: each risk is managed individually Describe features of a risk management framework Risk Drivers Board Establish risk management infrastructure Management MODIFY Risk Governance LOS LOS Goals Strategies Risk Tolerance (Allocate to) Risky Activities Risk Budgeting Risk Exposures Policies and processes Risk Mitigation and Management Identify Risks NO Measure risks Risks in line? Monitor risks Yes Reports Strategic Analysis LOS LOS Describe features of a risk management framework • • • Governance is the top-level system of structures and policies and risk governance ensures risk management activities align and support the overall enterprise It is often driven by regulatory concerns as well as the fiduciary role of the governing body For best results, governance should take an enterprise-wide view LOS Describe LOS features of a risk management framework Risk identification and measurement • Environment is analyzed to identify the relevant risk factors • Portfolio is analyzed to ascertain whether it is indeed exposed to the risks identified • Risk metrics are calculated to size these risks under various scenarios and stresses LOS LOS Describe features of a risk management framework Risk Infrastructure • • Refers to people and systems that carry out the risk management process May include technology solutions capable of capturing, storing, computing and reporting the necessary data as well as skilled personnel to run this process LOS LOS Describe features of a risk management framework Policies and Processes • Encompass day-to-day operation and decisionmaking processes • May entail:  Controlling cash flows in line with risk assessments  Conducting due diligence of potential investments  Ensuring decisions made include important checklists  Ensuring data is updated and protected LOS LOS Describe features of a risk management framework Risk Monitoring, Mitigation, and Management • Entails continuous assessment as to whether the existing exposure is in line with the established risk tolerance level  If not, action must be taken to realign the exposure LOS LOS Describe features of a risk management framework Communication/Reports • • A communication loop must be put in place to ensure that:  Governance parameters can be clearly communicated to managers  Reporting of risk metrics to decision makers is done in a clear and timely manner Reports must be written in a clear, easy to understand language LOS LOS Describe features of a risk management framework Strategic Analysis or Integration • • These help turn risk management into an offensive weapon to improve performance Rigorous analysis supports better investment decisions and improves strategy and risk-adjusted returns LOS LOS Explain how risk tolerance affects risk management Risk tolerance identifies the extent to which the organization is prepared to experience losses or opportunity costs in the effort to achieve organizational objectives • The risk tolerance decision requires the integration of internal shortfalls in the organization which may cause failure as well as the external and sometimes uncertain risk drivers • Determination of the risk tolerance level depends on:  The ability to respond dynamically to changing events;  The ability to withstand losses and remain a going concern;  The competitive landscape; and  The regulatory environment • Personal motivations and beliefs, agendas of board members, and management compensation should not factor into the risk tolerance determination LOS LOS Explain how risk tolerance affects risk management Risk budgeting is focused on implementing the risk tolerance decisions taken at a strategic or governance level in the day-to-day management decision making • The risk budget will quantify risk by specific metrics and allocate risk across the organization • A risk budget may:  Use simple risk measures such as the standard deviation, VAR, Beta, and scenario loss  Use more complex risk measures such as evaluating risks by their underlying risk classes, such as equity, fixed income, commodity risk, and so on, and then allocates investments by their risk class LOS LOS Explain how risk tolerance affects risk management Benefits of Risk Budgeting • By implementing a risk budget, a risk culture is created in which all decisions are evaluated with a risk-return tradeoff in mind • Management is, therefore, focused on adding value to the overall enterprise when taking decisions while simultaneously remaining within the desired risk tolerance level LOS LOS Identify financial and non-financial sources of risk and describe how they may interact • Financial risks originate from financial markets They include: i Market risk: which arises from movements within the financial market environment like share prices, interest rates, exchange rates, commodity prices and other economic or industry market factors ii Credit risk: the risk of loss due to the failure of one party to pay another an outstanding obligation iii Liquidity risk: the inability to convert assets into cash without incurring significant costs  In stressed market conditions, the seller may have to accept a price well below their perception of value LOS LOS Identify financial and non-financial sources of risk and describe how they may interact Non-financial risks are from outside of the financial market environment and could be as a result of environmental or regulatory changes or an issue with customers or suppliers • They include: i Settlement risk: arises when payments are not exchanged simultaneously  The simplest case is when a bank makes a payment to a counterparty but will not be recompensed until some time later; the risk is that the counterparty may default before making the counterpayment ii Legal risk: risk of suits/ litigation iii Compliance risk: failure to adhere to laid down rules/obligations iv Model risk: use of inappropriate models or inputs >> LOS LOS Identify financial and non-financial sources of risk and describe how they may interact v Tail risk: the likelihood or probability of a material negative outcome vi Operational risk: related to the people and processes of an organization  Examples: fraud on the part of employees/management, operational errors, and interruption due to natural phenomena like floods and wild brazes vii Solvency risk: risk that the company may run out of cash to fund its operations LOS LOS Identify financial and non-financial sources of risk and describe how they may interact Do financial risks and nonfinancial risks interact?  The answer is yes • In times of market stress, the correlation among financial and nonfinancial risks increases • The result? The combined risk is often far more than the "sum-ofthe-parts." Example: Suppose a key counterparty fails to settle an obligation in a timely manner Settlement risk creates a solvency risk for the company which was due to receive the proceeds In turn, they may not be able to pay their suppliers which leads to legal risk Or, they may not meet regulatory solvency requirements which creates compliance risk They may need to rapidly sell assets to raise the cash creating a liquidity risk LOS LOS Describe methods for measuring and modifying risk exposures and factors to consider in choosing among the methods Commonly used risk metrics are as follows: Standard deviation • Standard deviation (also referred to as volatility) provides a measure of the range of potential outcomes • It has limitations as a measure for financial markets as it presumes a normal distribution of returns which is inappropriate Beta • Beta is a measure of the sensitivity of a security’s returns to the overall market portfolio • It provides an indication of systematic risk and is particularly appropriate for equity portfolios LOS LOS Describe methods for measuring and modifying risk exposures and factors to consider in choosing among the methods Greeks (Delta, Gamma, Vega, Rho) • Commonly referred to as "the Greeks", these metrics are appropriate for measuring the risk associated with derivative positions  Delta measures the sensitivity to changes in the underlying price of the asset  Gamma measures sensitivity to changes in the delta  Vega measures sensitivity to changes in volatility  Rho measures sensitivity to changes in interest rates Duration • Duration is a measure of sensitivity to interest rates used for fixedincome instruments LOS LOS Describe methods for measuring and modifying risk exposures and factors to consider in choosing among the methods VaR (Value at Risk) • VaR specifies the maximum loss that could possibly be incurred at a given level of confidence • For instance, if the annual 95% VaR of a portfolio is $100 million, the firm is said to be 95% confident that the loss incurred, if any, will not exceed $100 million In other words, there is a 5% chance that if a loss is experienced over the next year, it will exceed $100 million Conditional VaR, CVaR • Also called the expected shortfall, CVAR is the expected loss beyond the VAR • It’s analogous to the “loss given default.” LOS LOS Describe methods for measuring and modifying risk exposures and factors to consider in choosing among the methods Risk modification What options does a firm have on matters risk? 1) Risk avoidance  The firm effectively shelves investment plans or discontinues the existing exposure 2) Risk acceptance  The firm accepts a risk and proceeds to make an investment 3) Risk transfer  The firm accepts the risk but then transfers it to a third party, e.g., an insurer 4) Risk shifting  The firm accepts and attempts to mitigate the risk, usually through the use of derivatives LOS Portfolio Management • Portfolio Management – An Overview • Portfolio Risk and Return – Part I • Portfolio Risk and Return – Part II • Basics of Portfolio Planning and Construction • Risk Management – An Introduction  Fintech in Investment Management ... Define risk management Risk management can be institutionalized (enterprise-wide) or individualized (silo-based): Financial risk Credit risk Enterprise risk management Inflation risk Operation al risk. .. infrastructure Management MODIFY Risk Governance LOS LOS Goals Strategies Risk Tolerance (Allocate to) Risky Activities Risk Budgeting Risk Exposures Policies and processes Risk Mitigation and Management. .. Portfolio Risk and Return – Part I • Portfolio Risk and Return – Part II • Basics of Portfolio Planning and Construction • Risk Management – An Introduction  Fintech in Investment Management