Risk Management Lecture Notes PDF

DISCLAIMER: Every reasonable effort is made to ensure the accuracy of the information used in the creation of this reference material, without prejudice to the existing copyrights of the authors. As an offshoot of the innumerable difficulties encountered during these trying times, the authors endeav...

DISCLAIMER: Every reasonable effort is made to ensure the accuracy of the information used in the creation of this reference material, without prejudice to the existing copyrights of the authors. As an offshoot of the innumerable difficulties encountered during these trying times, the authors endeavored to ensure proper attribution of the esteemed original works, by way of footnotes or bibliography, to their best abilities and based on available resources, despite the limited access and mobility due to quarantine restrictions imposed by the duly constituted authorities. We make no warranties, guarantees or representations concerning the accuracy or suitability of the information contained in this material or any references and links provided here. Links to other materials in our CPOD and CAM was made in good faith, for non-commercial teaching purposes only to the extent justified for the purpose, and consistent with fair use under Sec. GD185 of Republic Act No. 8293, otherwise known as the Intellectual Property Code of the Philippines. PRELIM Lecture notes #01 Risk means the uncertainty that an investment will earn its expected rate of return. Investment is a risky activity so we have to treat risk management as an important component of the investment process. For both individual investments and portfolios, we have to examine and compare the full extent of risks and expected returns to ensure that the exposures we assume are justified by the rewards we expect to gain. The proper identification, measurement, and control of risks are key to the process of investing. Risk management therefore is a process involving the identification of exposure to risk, the establishment of appropriate ranges for exposures with understanding of an entity’s objectives and constraints, the continuous measurement of these exposures, and the execution of appropriate adjustments whenever exposure levels fall outside of target ranges. The process is continuous and may require alterations in any of these activities to reflect new policies, preferences, and information. An effective risk management identifies, assesses, and controls numerous sources of risk, both financial and non-market related to achieve the highest possible level of reward for the risks incurred. Risk categories can be grouped into 1. Financial risks include liquidity risk, credit risk, commodity prices risk, equity prices risk, exchange rate risk, and interest rate risk. 2. Non-financial risks include tax risk, accounting risk, legal risk, regulations risk, settlement risk, model risk, and operations risk. Identifying risks 1. Market risk is the risk associated with interest rate, exchange rates, stock prices, and commodity prices and it links to supply and demand in various marketplaces. Much of the evolution that has taken place in the field of risk management begun from a desire to understand and control market risks. 2. Credit risk is the risk of loss caused by a counterparty or debtor’s failure to make a promised payment. 3. Liquidity risk is the risk that a financial instrument cannot be purchased or sold without a significant concession in price because of the market’s potential inability to efficiently accommodate the desired trading size. Liquidity risk is present in both initiating and liquidating transactions, for both long and short positions, but can be particularly acute for liquidating transactions especially when such liquidation is motivated by the need to reduce exposures in large losses. In trading securities, the size of the bid-ask spread (the spread between bid and ask prices), stated as a proportion of security price, is frequently used as an indicator of liquidity. 4. Operational risk is the risk of loss from failures in a computer’s systems and procedures or from external events. 5. Model risk is the risk that a model is incorrect or misapplied. In investments, it often refers to valuation models. Model risk exists to some extent in any model that attempts to identify the fair value of financial instruments, but it is most prevalent in models used in derivatives markets. Since the development s of the seminal Black-Scholes-Merton option pricing model, both derivatives and derivative pricing models have proliferated. 6. Settlement (Herstatt) risk is the risk that one party could be in the process of paying the counterparty while the counterparty is declaring bankruptcy. Settlements are the payments associated with the purchase and sale of cash securities such as equities and bonds, along with cash transfers executed for swaps, forward, options and other types of derivatives. The process of settling a contract involves on or both parties making payments and /or transferring assets to the other. Most regulated futures and options market exchanges are organized in such a way that they themselves act as the central counterparty to all transactions.  7. Regulatory risk is the risk associated with the uncertainty of how transaction will be regulated or with the potential regulations to change. Equities, bonds, futures, and exchange-traded derivatives markets are usually regulated. Regulations is a source of uncertainty, regulated markets are subject to the risk that the existing regulatory regime will become more onerous, more restrictive, or more costly. In case of derivatives, companies that are regulated in other ways may have their derivative business indirectly regulated. 8. Legal/Contract risk is the possibility of loss arising from the legal systems failure to enforce a contract in which an enterprise has a financial stake. Financial transaction is subject to some form of contract law and contracts involve two parties. The possibility of conflict can arise due to breach of contract, illegal contract, fraudulent act and others. 9. Tax risk arises because of uncertainty associated with tax laws. Tax covering the ownership and transaction of financial instruments can be extremely complex, and the taxation of derivatives transactions is an area of even more confusion and uncertainty. Tax rulings clarify these matters on occasion, but on other occasions, they confuse them further. Also, tax policy often fails to keep pace with innovations in financial instruments. 10. Accounting risk arises from uncertainty about how a transaction should be recorded and the potential of accounting rules and regulations to change. Accounting statements are a key, if not primary, source of information on publicly traded firms. The international Accounting Standard Board (IASB) sets global standards for accounting. The IASB together with different accounting standard boards of other countries such US Financial Accounting Standards Board (FASB) have been working together toward convergence of accounting standards worldwide. 11. Sovereign and political risks- Sovereign risk is a form of credit risk in which the borrower is the government of a sovereign nation. Its magnitude has two components: likelihood of default and the estimated recovery rate. Political risk is associated with changes in the political environment. It could be both overt (change of economic system) or subtle (change political party control) and it exist in every jurisdiction where financial instruments trade. Other risks 1. ESG risks- is the risks to a company’s market valuation resulting from environmental, social and governance factors. a. Environmental risk is created by the operational decisions made by the company managers, including decisions concerning product and services to offer and the processes to use in producing those products and services. b. Social risk derives from the company’s various policies and practices regarding human resources, contractual arrangement, and the work place. c. Governance risk is the flaws in corporate governance policies and procedures with direct and material effects on a company’s value in the market place. 2. Performance netting risk or netting risk, which applies to entities that fund more than one strategy, is the potential for loss resulting from the failure of fees based on net performance to fully cover contractual payout obligations to individual portfolio managers that have positive performance when other portfolio managers have losses and when there are asymmetric incentive fee arrangements with the portfolio managers. 3. Settlement netting risk- refers to the risk that a liquidator of a counterparty in default could challenge a netting arrangement so that profitable transactions are realized for the benefit of creditors. The practice of Risk Management Risk management should be a process, not just an activity. A process is continuous and subject to evaluation and revision. Effective risk management requires the constant and consistent monitoring of exposures, with an eye toward making an adjustment, whenever and wherever the situation calls for them. Risk management in its totality is all at once a proactive, anticipative, and reactive process that continuously monitors and control risk. Practical application of the process The company faces a range of financial and nonfinancial risks and response to these challenges by establishing a series of risk management policies and procedures. It defines its risk tolerance, which is the level of risk it is willing and able to bear. It then identifies the risks, drawing on all sources of information, and attempts to measure these risks using information or data related to all of its identified exposures. After having an effective risk identification and measurement mechanisms, it is now in a position to adjust its risk exposures, whenever and wherever exposures diverge from previously identified target ranges. These adjustments take the form of risk- modifying transactions (including risk transfer). The execution of risk management transactions is itself a distinct process; for portfolios, this step consists of trade identification, pricing, and execution. The process then loops around to the measurement of risk and continues in that manner, and to the constant monitoring and adjustments of the risk, to bring it into or maintain it within the desired range. Risk Management Process: practice of risk management Nonfinancial the company Financial risks risks Set policies and procedures Information Define risk and tolerance Information/data data Identify risk Measure risk derivatives Execute risk Adjust level of Mgt. transactions risk non-derivatives identify appropriate transactions price transactions execute transactions In applying risk management process to portfolio management, managers must devote considerable amount of attention to measuring and pricing the risks of financial transactions or positions particularly those involving derivatives. Risk Management Process: pricing and measuring of risk Identify the sources of risks Measure risks Select appropriate model Determine determined Market price or value model price or value Compare Attractively priced not attractively priced Execute transaction Seek alternative transaction Risk management involves adjusting levels of risk to appropriate levels, not necessarily eliminating risk altogether. Risk management is a general practice that involves risk modification (risk reduction or risk expansion) as deemed necessary and appropriate by the custodians of capital and its beneficial owners. Risk Governance: management responsibility Risk governance is a process of setting overall policies and standards in risk management. It involves choices of governance structure, infrastructure, reporting, and methodology. The quality of risk governance can be judged by its transparency, accountability, effectiveness (achieving objectives), and efficiency (economy in the use of resources). Governance Structure: centralized or decentralized risk management system 1. Centralized risk management system approach- company has a single risk management group that monitors and ultimately controls all of the organization’s risk-taking activities. 2. Decentralized risk management system approach- places risk management responsibility on individual business unit managers. Thus, each unit calculates and reports its exposure independently. Decentralization has the advantage of allowing the people closer to the actual risk taking to more directly manage it. Centralization permits economies of scale and allows the company to recognize the offsetting nature of distinct exposure that an enterprise might assume in a day-to-day operation. Example: Assuming one subsidiary of Corporation Kwekwek buys from Japan and another subsidiary sells to Japan, with both engaged in yen-denominated transaction, each subsidiary has some foreign exchange exposure, from centralized viewpoint these risks have offsetting effects that reduces the overall need to hedge. Centralized risk management gives an overall picture of the company’s risk position, and ultimately overall is what counts. The centralized risk management is known as Enterprise Risk Management (ERM). Its distinguishing feature is a firmwide or across-enterprise perspective that is sometimes called firmwide risk management. In ERM, the organization must consider each risk factor to which it is exposed – both in isolation and in terms of any interplay among them. For risk taking entities, it is contradictory to suggest that an organization has sound corporate governance without maintain a clear and continuously updated understanding of its exposure as an enterprise level. In case of decentralized risk management approach, it will require a mechanism by which senior managers can inform themselves about the enterprise’s overall risks exposures. At enterprise level, companies should control not only the sensitivity of their earnings to fluctuations in the stock market, interest rate foreign exchange rate, and commodity prices but also their exposure to credit spreads and default risk, to gaps in the timing match of their assets and liabilities and to operational/system failures, financial fraud, and other factors that can affect corporate profitability and survival. An effective ERM system usually incorporates the following steps: 1. Identify each risk factor to which the company is exposed 2. Quantify each exposure’ size in money term. 3. Map these inputs into a risk estimation calculation. 4. Identify overall risk exposures as well as the contribution to overall risk deriving from each risk factor. 5. Set up a process to report on these risks periodically to senior management, who will set up a committee of division heads and executives determine capital allocations, risk limits, and risk management policies. 6. Monitor compliance with policies and risk limits. Step 5 and 6 allows the organization to quantify the magnitude and distribution of its exposures and enabling it to use the ERM system’s output to more actively align its risk profile with its opportunities and constraints on a routine, periodic basis. Effective ERM system feature centralized data warehouse, where a company stores all pertinent risk information, including position and market data, in a technologically efficient manner. The process of identifying and correcting errors in a technologically efficient manner can be resource intensive especially when effort requires storing historical information on complex financial instruments. 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