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Reading 55: Risk Management - Introduction (Risk management framework…
Reading 55: Risk Management - Introduction
Risk Management
For organization
Is the process of
Identify and measure risks
Modify and monitor risks
Determine organization's risk tolerance
Goal:
not to avoid or minimize risk, but to identify which best able risk to take on
For individual
how to maximize utility while bearing a tolerable level of risk
Investor can control risk
Risk management framework features
Identify and measure existing risks
Determine the organization's overall risk tolerance
Establish the processes and policies for risk tolerance
Manage and mitigate risks to achieve the optimal bundle of risk
Monitor risk exposure over time
Communicate across the organization
Perform strategic risk analysis
Risk Governance
Definition:
Managing risk to support organization's goals within its risk tolerance
Should be done at enterprise level by senior management
Risk management committee identifies specific risks that should be pursued, limited or avoided
Sequences
Risk tolerance
is determined by top management.
Factors
Expertise in specific business lines
Ability to respond to external events
Financial strength
Regulatory environment
Weigh risk exposure against their expected benefits
Risk tolerance is the overall amount of risk that an organization will take in pursuing its goals.
Risk budgeting
Risk budgeting is the process of allocating the total risk the firm will take among assets or investments, based on
Organization's goal and risk tolerance
Risk characteristics of assets or investments
Risk budgeting consider the risk characteristics of each assets and how they can be combined to best meet the organization's goals.
Risk budget may be a single metric such as VaR, portfolio beta, or portfolio duration
Risk exposures
Sources of risk
Financial sources
arise from exposure to financial markets
Credit risk: Counterparties might not fulfill their obligations
Liquidity risk: May receive less than fair value when selling an asset
Market risk: Uncertainty about asset prices and interest rates
Non-financial sources
risks from the operation of the organization and from external sources.
Operational risk: Human error, faulty processes, business interruptions, IT security (cyber risk)
Solvency risk: running out of cash
Regulatory risk: Regulations impose costs of restrict activities
Political/ governmental/ tax risk: Government actions beside regulations
Legal risk: exposure to lawsuits
Model risk: Incorrect asset valuations
Tail risk: Underestimating probability of extreme outcome (e.g., incorrectly assuming normality)
Accounting risk: policies and estimates may be judged to be incorrect
Interaction among risks are frequent and can be especially significant during period of stress in financial market.
Measures of Risk Exposure
Derivative risk measures
Delta: Sensitivity of derivative value to price of underlying asset
Gamma: Sensitivity of delta to price of underlying asset
Vega: Sensitivity of derivative value to volatility of underlying asset
Rho: Sensitivity of derivative value to risk-free rate
Tail risk is measured with (VaR) or conditional VaR
Value-at-risk (VAR): Minimum loss over a period with a specific probability
Conditional VaR: Expected value of loss, given that loss exceeds a specific amount
Risk of assets is measure by standard deviation, beta, or duration.
Some risks must be valued subjectively
Risk Exposure Modification
Management may choose to
Accept a risk (i.e., self-insurance) and bear it efficiently, for example through diversification
Avoid a risk: by not engaging in activities that expose the organization to it
Prevent a risk, with stronger security for example
Transfer the risk: to another party, via
Insurance
Surety bond (third-party obligations)
Fidelity bond (employee dishonesty)
Shift a risk: change the distribution of outcomes, typically with derivatives contracts
Organization may use multiple methods of risk modification after considering the cost and benefit of the various methods.
The end result is a risk profile that match the organization's risk tolerance and includes the risks that top management has determined match the organization goal
Risk management infrastructure:
is the people or system required to track risk exposure, and perform quantitative risk analysis to allow assessment of risk profile
activities
Risk identification
Risk measurement
Risk monitoring