PRELIMS - RISK MANAGEMENT - RAM.pdf

Risk Management - FM5617 2/3/2022 Side Notes about Risk Management - Became prominent 3-5 years ago with the promulgation of ISO 31000. It used to be under the Finance Department. For those entities who want to be recognized globally, they have...

Risk Management - FM5617 2/3/2022 Side Notes about Risk Management - Became prominent 3-5 years ago with the promulgation of ISO 31000. It used to be under the Finance Department. For those entities who want to be recognized globally, they have to at least adapt the standard certification by the international standard operating procedures under ISO 31000. For most Financial Institutions, they are obliged to follow the regulation set by BASEL. Specifically last November 2021, BASEL introduced and applied the premises and conditions from BASEL 4. Financial institutions such as banks, insurance, lending companies, investment firms established their own separate risk management unit or group in compliance with global standards. Risk Management - Art and science of creating strategies for the business Strategies has something to do with long-term; long term effect through thorough preparation - Ultimate objective of risk management: create and preserve the value or the worth of the firm Objective is done by securing (safety), protecting (protection), and handling all existing assets, liabilities, funds, capital through analysis and continuous monitoring and control of each process. - Commonly conceived as addressing the losses of the firm (pure risk). Addressing the losses of an institution means that you are dealing with only 1 type of risk. Pure risks tend to minimize or mitigate losses. - Based on our principle, we cannot simply avoid risk as we will be negating the principle of risk-return trade off. - As finance people, we cannot simply just be risk-averse individuals. There are instances that we should become risk takers as we want to realize better capital gains, improve cash flow, generate revenue, in a manner you create and preserve the value of the entity (ultimate objective of risk management). - It is not justifiable to just look at the potential losses once you come up with a decision. - In risk management, we consider more of the speculative risk, rather than just the pure risk. Speculative risk addresses both the positive and negative risks. Losses would be negative risks, gains would be positive risks. There may be a potential to have possible gains instead of only losses. - One of the very first steps you are to conduct is to identify the type of risk you are facing.  - In a scenario, we try to ask ourselves if there is still something that one can do when facing a problem. There are scenarios/conditions that can’t be solved anymore, but it does not mean that you won’t be doing anything. - We categorize risk as systematic risk or unsystematic risk. First step in addressing risk. - We may be looking into the possibility of resolving issues that are tactical. Tactical is short-lived but it requires immediate attention/resolution. This may be temporary, issues or concerns you may encounter on a routinary or daily basis. - Tactical Operation is short-term. Strategy is long-term. Systematic Risk 1. Uncontrollable Kahit uncontrollable ang risk, we still need to do a plan You succumb yourself to this risk. 2. There must be a contingency plan. Even if you can’t control it and you know it’s coming, you still need to have a plan. Backup plans. Has a plan for scenario A to Z, own set plan of actions — contingencies. 3. Also known as Systemic Risk. Part of the system. There is hardly anything you can do. 4. Primarily deals with Market Risk. Market risks are uncontrollable since we let economic forces prevail; demand and supply interaction. It is beyond an individual's control. Ex. We cannot control stock prices, demand and supply controls it. Just because we cannot control the stock market doesn't mean we won't do any plan. 5. Non-diversifiable You cannot revert, modify, or change the condition. If a risk is considered as systematic risk (has something to do with business or market), you have no choice but to prepare your backup or contingency plan. Unsystematic Risk 1. Controllable as it is initiated by internal activities However, there are internal activities that turn out to be uncontrollable, especially if the situation has worsened — unsystematic risk should not be associated/limited with Internal or External forces. There are times when systematic risk can become unsystematic risk when faced by a company (25:10 - 26:40). 2. Primarily deals with Company Risk. Diversifiable Within your control Can set boundaries  Primarily deals with Market Risk. You can still do something about it. Your skill in strategizing would come out. Risk Managers in Risk Management - “Prevention is better than cure.” - Should not wait for the worst scenario, have to think in advance - Before anything worsens, it should be resolved/remedied. - Risk Management is distinguished from Auditing. - Risk managers only recommend, but not the ultimate decision makers. - After coming up with a decision, a risk manager would account for all deviations and if there is a problem, that is considered as an oversight. - Risk Managers do not cast a decision but rather observe, as he/she would anticipate exposures. - Risk management focuses on calculated risk — things that can be quantified or computed. - Risk managers should be able to compute the exposures. - Exposures are VaR or Values at Risk - Risk managers would always be asked on the potential exposures of a move by a company. Ex. ( 35:00 - 36:08). Risk Management - Course Description This is a competency-based course that introduces the college students to the multifaceted aspects of risk management and how it functions in an organization. Focus is on the various risks faced by corporate and financial institutions and how they deal, manage, mitigate and hedge those risks. The course covers market, credit, operational, model, enterprise and regulatory risks. The course also covers the phases of Basel and its recent development. - Risk management is different from each financial institution, but with the same objective of preserving the value of the firm by mitigating or reducing the implications of losses and aspiring for greater returns. Market Risk - Trading of securities - Sales and Expenses in trading the facility Credit Risk - Debts, structuring, financing, lending Operational Risk - Usual operation activities such as business risks - Regulations, standard operating procedures, quality of services Enterprise Risk - Broad type of risk - Business risks Model Risk - Tools or theories that would be applicable in realizing the VaR - If you use the wrong financial model, then you will succumb to model risk. - Wrong analysis. Ex. You used a wrong analysis since you used FCFE instead of FCFF. You already have a model risk. Regulatory Risk - Regulations that may affect the three major risks (market, credit, and operational) - If it deviates from the created procedures and policies of each type of risk, then you consider that as regulatory risk particularly if there is one institution that monitors or supervises your operation or compliance to such mandate. 02/08/2022 Risk Management Basics Objective Scenario - Foresights - risk man adapts the “prevention is better than cure”. So before any scenarios may happen you should have already anticipated the different possible risk exposures you may encounter. - Risk Managers need not develop paranoia. - Risk risk = the risk of having risk. Most, if not all, have the possibility of overthinking, it is not our objective. We might be coming up with potential solutions to the extent that you come up with recommendations, but one should not be overthinking. - When you overthink, you have a tendency to develop paralysis of analysis — you cannot think properly or appropriately. - The technique is to balance your risk appetite with your tolerance. - As a risk manager you are not managing your own resources, it is the organization’s resources. Risk Managers are not fault (?) finders. If there would be exemptions from the recommendations you have listed, you will report it as an oversight. Risk Management Process It is cyclical. IDENTIFY RISKS - The objective is to identify as many risk as possible based on the stated objectives, foreseen events, expected scenarios. MEASURE RISKS - It must be calculated, quantify your risk exposure. - Concern in knowing the Value at Risk (VAR) EXAMINE SOLUTIONS - Before you examine solutions you have to come up with your Alternative Courses of Actions (ACA) - short list of potential solutions to what you have addressed as problems or issues. - Pag nag recommend ng ACA, each ACA should stand alone. Treated independently and separately. Hindi mo icocombine yung ACA 1 and 2, kung 1. 1 lang. Assignment: 1. Continue researching different types of risks. 2. Be able to review or research the different measures of risk mathematically before applying it to a model. 3. What are the different tools that we could probably apply (?) 4. Risk Aggregation and Risk Decomposition. Be able to differentiate them and give your own example of how these are usually adapted. When is it beneficial to adapt risk aggregation and when is it appropriate for us to apply risk decomposition. - Answers:  4. Risk Decomposition - identify risks one by one and handle each one separately. Risk Aggregation - To reduce risks by being well diversified. are typically used by financial institutions. (page 18) Risk decomposition refers to a procedure where risks are handled one by one. Risk aggregation refers to a procedure where a portfolio of risks is considered. Risk decomposition requires an in-depth understanding of individual risks. Risk aggregation requires an understanding of the correlations between risks. IMPLEMENT SOLUTION - There would be certain treatments you need to apply. Apply different strategies. - Risk man is not problem solving. This is how the Risk Man process tries to handle issues and difficulty. - RECOMMENDATIONS MONITOR RESULTS - If there would be problems or difficulties brought by recommendations from the implement solutions ^. You monitor - And solicit feedbacks, to identify again the risks. Thus it is a cycle. It will only stop when — nag lag si sir. Assignment: - Be able to describe different risk treatments and give your own example - As for communication consultation and monitoring review there are also suggested presentation on how could you efficiently present your analysis (fishball?????? Diagram? - research kasi mag aask si sir - How come risk avoidance is generally not acceptable to fund managers. - In reality when we are trying to conduct risk treatments, our objective is that if this is a systematic risk more or less just to reduce its implications and then simply present significance. - It is not acceptable that you come up only with the status quo, not just recommend maintain, observe repost ~ - Mitigants - normally reduce the amount of exposure or the possibilities of attaining exposures based on uncertainties. 2/10/2022 RISK MANAGEMENT PROCESS CONT. Difference between strategy and tactics Strategy - long-term effect as well as its preparation Tactics - short-lived but requires immediate attention and its effects are short-term. Who’s in charge of the strategy? Top Management, long term effect and concerns the board usually strategic risk. Who’s in charge of tactics? Supervisors, because it concerns daily operations — routinary. Needs immediate supervision. Ex. Monitoring stock prices (realizing the spread) Compliance Risk - process of identifying risks to your enterprise’s conformity with regulations and industry standards. Looking at the policies set by the regulating bodies (PSE, SEC, PDEX. BIR, Insurance Commissions) Unconformity to such would result in risk — suspension of activities, fines and penalties. May attain losses on a company. Strategic Risk is often interchange with Business Risk because strategic risk tends to cover very critical and crucial decision making that would normally affect the entirety of the business aspect. It may overlap. It depends on what perspective you are taking, important is you could explain how this was connected to this type of risk and to justify the nature of this risk. Compliance risk often overlaps with Legal risk. Legal Risks - an exposure to any gain or loss incurred to a business due to negligence and compliance with the laws — directly related or relevant to loss. Example: 1. Non conformity to Bank Secrecy Act - LEGAL RISK 2. Reserve Requirement - COMPLIANCE RISK (subject to fines and penalties and continuous actions to such will lead you to suspension) 3. Anti-money laundering - LEGAL RISK LEGAL RISK - batas, laws COMPLIANCE RISKS - governing bodies only SYSTEMATIC RISKS Business Risk - loosely associated with Strategic Risk because it is inherent in the organization. ○ It should be treated as a whole. The implications may be normally aggregated as a whole. ○ Include physical risk - effect would be tangible assets.  Ex. Purchasing new machinery or investing on capital activities is a business risk, it requires strategy that may be exposed with strategic risk. But the moment it is facilitated with credit financing and talk about leveraging it now becomes a financial risk. Entrepreneurial Risk - business starters. Smaller than a corporate entity. (not included, example lang ni sir for comparison) Liquidity Risk - concerns the ability of a company to pay its short-term obligations – CASH FLOW. Ideally your inflow should always be bigger than your outflow. Solvency Risk - much bigger risk than liquidity risk; that the business cannot meet its financial obligations as they come due for full value even after disposal of its assets. Long-Term financing. (not included also, for comparison only) Country Risk - entirety of a whole nation. ○ Ex. Territorial Dispute Papasok business risk don if it may hinder the production of our agricultural products or fisheries. May impact on or more countries. Business risk although it may be strategic by nature it may actually be limited to an industry or sector. Unlike country risk, impact is on the entire nation. Exchange Rate Risk - caused by the fluctuations in countries’ currencies, concerns two or more currencies. ○ Dual/ partner currencies. ○ Ex. When a company owns a subsidiary in another country. Either you’re investing in another company from another country or another country is investing in you. ○ Foreign Investors in your company. ○ Business is engaged with international trade – import or export. ○ Global partners, usually suppliers. (refer picture next page) Legal and Compliance Risk fall under Operational Risks. Why do you think Reputational Risk falls under Business/ Strategic Risk Reputational risk could affect the credibility and integrity of a company. It may affect the overall profits of a company. Protect your trust and confidence, build your integrity and credibility. Exposure - measurement of potential future loss or gain due to a specific event. Calculate risk through Value at Risk. By computing the VaR it may help LEVEL the exposures of risk. LEVELS OF RISK EXPOSURE Macro level - Cover a broad scope, if the impact would be greater to the entire state. ○ Total/Aggregated market. LAHAT apektado. ○ market risk - anything that would regard economic issues. ○ Ex. stock prices, wala kang control because it is brought by market/economic forces (demand and supply) ○ Inflation ○ Country risk Industrial level - specific sectors. One specific sector would carry the burden. ○ Ex. Real estate - discovery or alignment of faultline. Tendency na bababa ang worth ng value ng properties nila at pwede ring yung competitors mas tumaas values. ○ Food estate - ex. Low agricultural products, swine flu. Exterior Level - mix of external and internal level. ○ Ex. Credit risk - inherent to both parties (borrower and lender) ○ Credit facility (features of loans) is designed by the organization – it is internal, corporate level. Credit investigation to a client is still internal. The moment the credit is released to a client it is external, you cannot control the loan applicant anymore, particularly the defaults on payments. If the borrower defaults on payment it is beyond the control of the banks (kung pigang-piga na yan wala na talaga pambayad hindi mo siya pwede maipakulong). Pag ganon kukunin mo properties ni borrower, internal arrangement na. Restructuring the financial scheme, internal. External kapag mag aaggree si client sa restructuring ng financial scheme. Corporate Level - the company can manage their liquidity risk exposure. ○ Ex. Model Risk - occurs when a financial model/quantitative tool is used/misused. ○ Kapag maling quantitative tool ginamit mo mali na yung valuation mo sa company. (refer picture next page) Risk Matrix - should not rely on instinct. Measures on corresponding value. This is essential to know which risk should be prioritized. Impact - exposures Probability - the chance of occurring. If high yung probability it should be prioritized. So dapat na quantify mo yung risk and may standard ka to determine what level of risk impact meron ang company. If wala kang standard, it would be better to formulate your risk radar. Risk Radar - Gusto mong makita dito ano bang relationship ng risk na ito sa iba pang risk na operational. Based sa picture, pag malapit yung risk sa red (middle) yun yung  uunahin kasi yun yung core/center. Kaya mong i-justify yung hindi mo pa gawa ng values (computations) kasi pag sa risk matrix need ng values, dito sa illustration at least napakita mo yung relationship between risks. Risk Treatments - Paikot ang process. - There is a process in facing risk. Risk Avoidance - Can risk be avoided? It depends on the situation. - In finance, we do not advotave avoidance of risk as there is a principle whereas the higher risk, the higher returns. - Forfeiting risks would mean forfeiting the chance of realizing positive risks which would yield returns, profits, additional cash flows etc. - The risks that you can avoid are unsystematic risks or pure risks (negative risk). - The risk involved in risk avoidance is unsystematic risk since you can control it. - At an early stage, you avoid the risks already. In the first step, you divert the resolution on a more general perspective. - Risk avoidance is impractical in finance. You are not considering its positive implication. - Practical Example: Did not buy an item on shopee that is already in the cart, but found out there are many negative comments/reviews. So, risk avoidance happens when you choose to not buy the item anymore. - Practical Example: My objective is to not get heartbroken. Don’t get a jowa. - Finance Example: Did not invest in the oil industry since there is a political problem involving oil. - Risk Management aims to create value for an organization. Adding value means realizing better profits, returns, improving these returns, and protecting the firm from incurring any losses. Risk Acceptance - Type of risk involved is systematic risk. You can’t avoid systematic risk. - Systematic risk can be market risk. - Tanggap mula simula pa lang. You cannot do anything about it. You submit to the risk. - Practical Example: Your lover doesn’t want you anymore. You cannot do anything about it. - Tanggap mo na posibleng mangyari sa’yo. - Kung wala ka nang ginawa at tinanggap ‘yung risk, then risk acceptance. Kung may steps ka to mitigate, then risk reduction. Risk Reduction - Reducing and diverting impact of risk. - Mitigating risk. - Do something about the risk. - Applying reducing effects to the risk. - Kung gagawa ka ng mga paraan from the start in diverting the impact of risk, that is already risk reduction. Risk Transfer - Complete transfer of risk. - Most aggressive form of risk treatment. You’re not exposed anymore on the identified risk. - Win or take all. - There should be another party to absorb or have the capability of acquiring the risk. - Practical Example: When your car is already almost destroyed, then you sold it to another person. - Finance Example: Derivatives. There is no division or sharing of exposures. Risk Sharing - Sharing the exposure of risk to another party. - Partnership. Relationship. Ex. 50/50. - Financial Example: Loan syndication. BDO will have to contact other banks to grant a loan tos a specific applicant applying for a high loan of 100 million pesos. Will contact, for example, 4 banks to grant the loan; they will share 25 million pesos each. But, risk exposure is lower since the risk is shared. - Insurance is risk sharing since not all the amount will be covered by the insurance company. The first 5,000 pesos will be covered by you. The rest by the insurance company. Approaches to Risk Management Risk aggregation: aims to get rid of non-systematic risks with diversification Risk decomposition: tackles risks one by one In practice banks use both approaches Risk Decomposition - Break down. Iniisa-isa. Hinihimay. Kinikilatis yung subcategory ng subcategory. - Practical Example: Mental stress — financial, work, career etc. - - Fish bone diagram. - You know what causes specific risks. - Top down approach is often applied in risk decomposition. Start from the management level. - Budgeting is also used in risk decomposition. You allocate/decompose the budget by cascading it to respective departments. - In risk, you identify the major risk then you try to break it down. Risk Aggregation - Bottom up approach. Start from the lowest level. - Top management has no idea what is happening. They only know that there is a problem. Risk aggregation is applied to know what this risk is. - (45:05) - Lower department may be losing money. - Hindi kasali ang unsystematic risks. - When you identify the risks, it is possible to use only one strategy since you have aggregated the risk exposures into one. -  - - HEHE DI KO SURE KUNG RISK AGGREGATION ;YAN OR DECOMPOSITION HINDI SINABI NI SIR. -  - Scattered Plot - Correlation of one variable to another. - Each dot represents an expected return. - In a scattered plot, we correlate each expected return until such time that we realize the efficient frontier. HOMEWORK: - Explain the efficient frontier - How to calculate the SNL and CNL - How to calculate the beta, standard deviation Efficient Frontier The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal because they do not provide enough return for the level of risk. Portfolios that cluster to the right of the efficient frontier are sub-optimal because they have a higher level of risk for the defined rate of return. The efficient frontier comprises investment portfolios that offer the highest expected return for a specific level of risk. Returns depend on which investments make up the portfolio. The standard deviation of a security is synonymous with risk. Lower covariance between portfolio securities results in lower portfolio standard deviation. Successful optimization of the return versus risk paradigm should place a portfolio along the efficient frontier line. Optimal portfolios that comprise the efficient frontier usually exhibit a higher degree of diversification. Security Market Line (SML) The security market line (SML) is a line drawn on a chart that serves as a graphical representation of the capital asset pricing model (CAPM)—which shows different levels of systematic, or market risk, of various marketable securities, plotted against the expected return of the entire market at any given time. Also known as the "characteristic line," the SML is a visualization of the CAPM, where the x-axis of the chart represents risk (in terms of beta), and the y-axis of the chart represents expected return. The market risk premium of a given security is determined by where it is plotted on the chart relative to the SML. Capital Market Line (CML) The capital market line (CML) represents portfolios that optimally combine risk and return. It is a theoretical concept that represents all the portfolios that optimally combine the risk-free rate of return and the market portfolio of risky assets. Under the capital asset pricing model (CAPM), all investors will choose a position on the capital market line, in equilibrium, by borrowing or lending at the risk-free rate, since this maximizes return for a given level of risk. The capital market line (CML) represents portfolios that optimally combine risk and return. CML is a special case of the capital allocation line (CAL) where the risk portfolio is the market portfolio. Thus, the slope of the CML is the Sharpe ratio of the market portfolio. The intercept point of CML and efficient frontier would result in the most efficient portfolio called the tangency portfolio. As a generalization, buy assets if Sharpe ratio is above CML and sell if Sharpe ratio is below CML. Beta Beta is a measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a whole. Beta is used in the capital asset pricing model (CAPM), which describes the relationship between systematic risk and expected return for assets (usually stocks). CAPM is widely used as a method for pricing risky securities and for generating estimates of the expected returns of assets, considering both the risk of those assets and the cost of capital. Beta, primarily used in the capital asset pricing model (CAPM), is a measure of the volatility–or systematic risk–of a security or portfolio compared to the market as a whole. Beta data about an individual stock can only provide an investor with an approximation of how much risk the stock will add to a (presumably) diversified portfolio. For beta to be meaningful, the stock should be related to the benchmark that is used in the calculation. Standard Deviation The standard deviation is a statistic that measures the dispersion of a dataset relative to its mean and is calculated as the square root of the variance. The standard deviation is calculated as the square root of variance by determining each data point's deviation relative to the mean. If the data points are further from the mean, there is a higher deviation within the data set; thus, the more spread out the data, the higher the standard deviation. Standard deviation measures the dispersion of a dataset relative to its mean. It is calculated as the square root of the variance. Standard deviation, in finance, is often used as a measure of a relative riskiness of an asset. A volatile stock has a high standard deviation, while the deviation of a stable blue-chip stock is usually rather low. As a downside, the standard deviation calculates all uncertainty as risk, even when it’s in the investor's favor—such as above-average returns. 02/27/22 MARKET LINE Security Market Line - Interrelate returns with risk. Correlate your portfolio of securities whether these are bonds or stocks into the market index. To compare it you utilize beta. Capital Market Line - Interrelate returns with risk. It tends to analyze the performance of the securities in your own portfolio. Apply Standard Deviation. Normally, all market lines would have to start with the value of the risk free rate, why? It is one of the factors to consider when you need to continue the investment. You need to beat/surpass the risk free rate. It is the first point of comparison, kailangan mas mataas palagi doon. Investing on a non-risk free rate investment outlet you are only adding more risk. Adding risk would have a risk premium. You only add a risk premium if you have compromised additional return. For some, if you anticipate additional returns, you add more risk, higher the risk higher the return. However, there are instances that no matter how you add up more risks there will be a point of saturation, expected return is no longer increasing — Law of Diminishing Marginal Returns. (Mark Howitz) Efficient Frontier - optimal point, most reasonable that you need to consider as potential return.  Above the SML is undervalued Below the SML is overvalued Before you could realize the efficient frontier, you should suffice the requirement of the risk-free rate. Housekeeping - Try to substitute investments that are overvalued, constant checking of your investments whether it still complies to its correct values. - As a portfolio manager ginagawa mo to kasi lahat ng overvalued securities mo, whether stocks or bonds syempre papalitan mo yan to the extend na ma improve mo ulit yung efficient frontier. BASIC MEASURES OF RISK  Standard Deviation - it is the difference. You calculate the square root of your variance. Often interchange with volatility - changes in the movement from one value to another, in terms of pricing. Standard deviation is only one component of volatility, pinakamalaking impact sa volatility. ○ Bell curve - if the MU is in the center of the curve it is a normal distribution of data. ○ Skewness - left and right skew. Determination of your Loss and Gains ○ Presented as plus or mine (positive or negative) ○ Presented by symbol of sigma ○ As you increase the value of your standard deviation the value becomes more dispersed, the higher the standard deviation the higher the risk of an investment. Same thing is true, the higher the standard deviation, the higher the volatility. ○ Volatility is a factor of risk measurement. POSITIVE OR NEGATIVE RISK. End with mr. uy @31:02 - Beta - Correlations - copula - Value at Risk (VaR) - MVar - CVar - OVar Basic Measures of Risk Standard deviation - Square root of variance. Steps: 1. Add all recorded profits. 2. Divide by 8 (number of profits). 3. *Gumagamit tayo ng N-1 sa solution kapag randomly selected ang population or malaki ang population. 8 yung ginamit sa solution dahil actual na yung record at maliit lang yung 8.  4. 9.5 is the arithmetic mean. 5. Apply Square root of variance. 23.75 is the variance. 6. The final answer is the square root of the variance which is ± 4.87. 7. Standard deviation is ±4.87 million. You will add or subtract the 4.87 million from the arithmetic mean which is the 9.5. The range of values are: 14.37 to 4.63. It is possible that profit may increase to 14.37, or reach the lowest which is 4.63. Standard deviation is not always in percent. Depende sa pinag-uusapan. In this case, yung range pinag-uusapan. Probability is the chance of an occurrence of an event. In the standard deviation, we give way to other possible outcomes. The highest probability is still not the best since pwede pang mangyari yung iba/ Probability should always equal 1 or 100. Steps: 1. Get expected rate of return — 6%. 2. Get the standard deviation — 6.25%. 3. We can use standard deviation, 6.25%, to find the range by adding or subtracting it from 6%. 12.25% to -.25%. 4. The coefficient of variation is 1.04, by dividing the standard deviation to the expected return. 5. The coefficient of variation tends to equate the value of your risk against the value of your return. If standard deviation lang ang hahanapin mo, the information could still be insignificant, even if you arrive with these ranges. You consider returns; higher risk, higher returns. But, we have the law of diminishing marginal return; we have to consider this in the selection of a good investment. Problem: Investment A (Example above) Investment B - 7% standard deviation, 6% expected return. 1.16 coefficient of variation. Investment C - very low standard deviation, 4% expected return. 1.25 coefficient of variation. Answer: (55:34 - ang hirap explain nung sinabi ni sir) You will choose investment A as the higher coefficient of variation means the greater level of dispersion from the mean. The lower coefficient of variation means that it is the more precise estimate. You also consider all variables. If you were risk averse, you would go after the one with the lower standard deviation. Lower coefficient of variation is better as with a lower standard deviation, you arrive with the same return. Beta - Performance of portfolio in relation to an index. - Computed as Covariance divided by Variance. - Classified in three: Positive, Negative, and Zero beta. (‘Yung zero, hindi talaga siya classification. It just looks at how positive or negative a beta is. Ex. Close to zero beta.) Correlations Value at Risk (VaR) Assignment: 1. Define beta. Beta measures the sensitivity of the return on the investment to the return on the market portfolio.We can define the beta of any investment portfolio by regressing its returns against the returns on the market portfolio. Beta is a measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a whole. Beta is used in the capital asset pricing model (CAPM), which describes the relationship between systematic risk and expected return for assets (usually stocks). CAPM is widely used as a method for pricing risky securities and for generating estimates of the expected returns of assets, considering both the risk of those assets and the cost of capital. 2. Review how we calculate beta. https://www.youtube.com/watch?v=nDcZJcxOwVI 3. How we will derive beta from the photo. https://corporatefinanceinstitute.com/resources/knowledge/valuation/what-is-beta-guide/  4. Research on the significance of the treynor ratio and the sharpe ratio. When do you think this would be best applied? Compare both ratios. https://www.investopedia.com/terms/t/treynorratio.asp https://www.investopedia.com/terms/s/sharperatio.asp Treynor Ratio Also known as the reward-to-volatility ratio, is a performance metric for determining how much excess return was generated for each unit of risk taken on by a portfolio. Excess return in this sense refers to the return earned above the return that could have been earned in a risk-free investment. Although there is no true risk-free investment, treasury s are often used to represent the risk-free return in the Treynor ratio. Risk in the Treynor ratio refers to systematic risk as measured by a portfolio's beta. Beta measures the tendency of a portfolio's return to change in response to changes in return for the overall market.   Sharpe Ratio developed by Nobel laureate William F. Sharpe and is used to help investors understand the return of an investment compared to its risk. The ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. Volatility is a measure of the price fluctuations of an asset or portfolio. The Sharpe ratio adjusts a portfolio’s past performance—or expected future performance—for the excess risk that was taken by the investor.  DIFFERENCE https://www.investopedia.com/ask/answers/010815/what-difference-between-sharpe-ratio-and-tr aynor-ratio.asp#:~:text=The%20Sharpe%20ratio%20helps%20investors,of%20risk%20in%20a %20portfolio. 5. Read chapter 2. Regulations of Basel Regulations. Basel 1 to 4. A 3/3/2022 Homework: Reaction Paper 1. One page only. 2. Synopsis of the talk. 3. Relating the talk to the subject matter. 4. Assessment, personal views, suggestions, recommendations, or insights. Treynor Ratio - Also known as the reward-to-volatility ratio, is a performance metric for determining how much excess return was generated for each unit of risk taken on by a portfolio. - Used and applied in evaluating and assessing excess returns (alpha in greeks — excess market returns; alpha over beta). a. Beta - Beta here is the beta of the whole portfolio. Since stocks and bonds have different beta, you will get the beta of the portfolio with the assigned weight. - You should be able to compute the beta of the whole portfolio on your own. b. Average Portfolio Return - Computed as one. - “Average”, because you consider several periods of time. - Averaging is normally done on a monthly basis. - Daily returns are computed and arithmetic mean is used in average portfolio returns. c. Average Risk-Free Rate - Base rate. - Government securities. - Composed of the average of T-s and T-Bonds. Sharpe Ratio - Standard deviation of the particular investment or portfolio. What is the difference between Treynor and Sharpe Ratio? - Difference in formula. - Treynor has a divisor of Beta. - Sharpe has a divisor of Standard Deviation. When is it applicable to use Treynor Ratio? - When your portfolio of assets are greatly indexed in the market. - If the majority of your portfolio is from the stock and bond indices, you will use Treynor Ratio. When is it applicable to use Sharpe Ratio? - If you want to compare your portfolio from one period to another period. - Focuses on your own portfolio. Bank Risk - Banks tend to affect the economy. - Government policies protect the performances of banking institutions because it could have a great impact on the economy. - When the banking sector collapses, they need immediate assistance since they are a reflection of the economy. Different Types of Corporate Planning for Banks - Presents the causes and effects. - Present in-detail other consequences and indications of an event until you reach the point of the most detailed aspect.  1. Scenario (Di ko talaga maintindihan - 23:00 to 24:30) - This is different from sensitivity analysis. Sensitivity analysis deals with one or two variables on a specified test if there would be changes. In a scenario analysis, you can combine all significant effects of all variables, but the value should be pre-computed. It is pre-computed because you have to describe the situation and it is already designed. You will come up with different scenarios because when you describe the situation, it should be in conformity with the conditions. When one doesn’t match, you will treat that as another scenario. 2. Fault Tree - - Effective if you tend to discover the entirety up to the most detailed pababa. - Concentrated on one major issue. - Continuous flow (unlike fishbone na maraming sanga/tinik). 3. Bow Tie - You can present different events simultaneously to compare. - If you’re not sure of the major issue because there are many of them, you apply bowtie. - If you think that all issues are equally important and you cannot pinpoint which among these is the most major effect, you apply the bowtie analysis. 4. Incident 5. Ishikawa / Fishbone Diagram - Present the cause and effect. - Ultimate goal is to extract in detail the root cause. Types of Data Analysis 1. Descriptive Analysis 2. Exploratory Data Analysis 3. Predictive Analysis - Applicable to risk management when you are creating your own scenario.  4. Inferential Analysis - Applicable to risk management when you are creating your own scenario. Basel - Series of regulations issued by a knowledgeable body about how a bank operates. - A guide or procedures for banking activities as set by the Basel committee. - Adopted and complied by the different banks in the world. - Based on the experiences prior to this formulation, there was a history of bankruptcy from banks. Banks should be protected from bankruptcy as it would have a significant effect on the economy. - Set by the Basel committee, because Basel is a set of regulations that would be considered as the guiding rules or procedures for the banks that would have global trade utilizing these financial institutions. Bank for International Settlements (BIS) They aim to support central banks Tagged as central banks of all central banks. They support central banks probably in the formulation of their own monetary policy and when they create monetary policy it should also be aligned with international standards. Tend to supervise the performance of the central bank of every country; dapat compliant din sila sa international standards. Otherwise, they will not be allowed to facilitate transactions with other countries. BASEL Located in Basel, Switzerland Original purpose - mag set ng minimum capital for banks How was it organized? The BIS called for representatives from G10 - (11) countries – nagkaroon kasi ng financial crisis kaya sila sila nag set ng regulations.  It is composed of tier 1 and tier 2 to account for the total capital ratio Tier 1 - ○ basic na dapat ma-comply. ○ Based sa capital portion ng bangko (okay ba yung retained earnings, sources of capital etc.) — RESERVES, a certain percentage should be retained in the equity of the bank kasi hindi pwedeng lahat ipa-utang. Tier 2 ○ adds up value to the capitalization of the bank but it is not the primary, supplementary only. ○ Undisclosed/off balance sheet - one of the contributors of the 2008 financial crisis. Accounts that are not reflected on the balance sheet but have a separate record. Banks have 2 sets of books: Trading Books - transactions activities that are not reflected in the financial statements of the bank. These are derivatives, securities, foreign currencies, and commodities. Banking Books - financial statements. Accounts that are expected to be held for the whole of their life or operation. Bakit may derivative accounts sa banking book? - you wait for the expiration date. Only recognize the transactions once it is done. Capital Requirement for the bank TIER 1 Ideal requirement should be 10% Based on BASEL 1 = 6% (mababa kasi have not yet recognized the off balance sheet accounts) Based on BASEL 3 = 8% TIER 2 >2% - mababa lang required capitalization kasi not all banks facilitate this transaction. Risk Weighted Asset (RWA) Used to determine the minimum amount of capital that must be held by banks. In terms of VAR - To substantiate the value of assets that are exposed to risk. DIFFERENCES: BASEL 1 ○ Highlight credit risks kasi galing sa credit crisis; to prevent defaulting of banks. ○ Introduced RWA as proposed by?? ○ McDonough ratio  example: get the percentage depending on the account of risk associated to come up with RWA BASEL 2 ○ 3 pillars - Minimum Capital Requirements, Supervisory Review, Market Discipline & Disclosure ○ credit risk, market risk, operational risk — risk concerns in BASELS BASEL 2.5 ○ search ko BASEL 3 ○ Geared to liquidity risk - focused about liquidity coverage ratio and net stable funding ratio.  - From the Current Assets you still have to select the high quality - Total net cash flow is your Ending Cash balance - Stable Funding - All deposits/funds that are easily withdrawn by their clients should be excluded. (exclude checking accounts, savings account na may ATM kasi walang control yung bangko dun, Hot Money - temporarily part (?) funds it means short-term) BASEL 4 “Step-in risk” is the risk that a bank decides to provide financial support to an unconsolidated entity that is facing stress, in the absence of, or in excess of, any contractual obligations to provide such support. The main reason for step-in risk might be to avoid the reputational risk that a bank might suffer were it not to provide support to an entity facing a stress situation. - https://www.bis.org/bcbs/publ/d423.pdf