Summary: Part 1: Foundations Of Risk Management
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Read the summary and the most important questions on Part 1: Foundations of Risk Management
Reading 1 - The Essentials of Risk Management
This is a preview. There are 6 more flashcards available for chapter 10/08/2016
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What is the concept of risk?Risk exists in how variable our costs and revenues really are. Risk management is really about how firms actively select the type and level of risk that it is appropriate for them to assume.
Risk an uncertainty are different; variability that can be quantified in terms of probabilities is best thought of as risk, while variability that cannot be quantified is best thought of as uncertainty.
Risk management is not the process of controlling and reducing expected losses (that is just budgeting, pricing and efficiency), but the process of UNDERSTANDING, costing and efficiently managing UNEXPECTED levels of variability.
Is risk management the opposite of risk taking?Certainly not. Risk is not solely a defensive term alone. They are two sides of the same coin. Risk management aims to support deliberate risky activities that it founds to be risk-rewarding. In that sense risk management prevents risk taking to become speculative.
How does the risk management process look like?Identify risk exposures
Then, what to do with them:
- Measure and estimate risk exposures (assess the effects of these)
- Find instruments and facilities to shift or trade risks (assess cost and benefits)
Form a risk (mitigation) strategy:
- Transfer (shift/trade risks)
- Eliminate/avoid (don't do it)
- Accept/keep (go for it)
- Mitigate (prevention)
What is the difference between expected and unexpected loss?Expected (credit) loss refers to how much the bank expects to lose on average over a period of time. Because it is by definition PREDICTABLE, it is just considered to be a cost of doing business and priced accordingly.
Unexpected losses concern estimates with risk factors and statistical analysis, which may correlate more in times of high unexpected losses. This has led to two key concepts: VaR and economic capital. So managing, costing and understanding unexpected levels of variability in financial outcomes of businesses.
What are the key risk classes?Market risk: the risk of losses arising from changes in market risk factors (e.g. interest rates, equity, commodity, FX).
Credit risk: the risk of loss following a change in the factors that dive the credit quality of an asset.
Operational risk: refers to financial loss resulting from a host of potential operational breakdowns that we can think in terms of risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
What about liquidity risk?Consists of two factors:
- Funding liquidity risk, which relates to a firm's ability to raise necessary cash to roll over its debt; meet cash, margin or collateral requirements; satisfy withdrawals.
- Trading liquidity risk, relates to the risk that a transaction cannot be executed at the prevailing market price because there is (temporarily) NO APPETITE for the deal on the other side of the market. SIZE and IMMEDIACY are the most important factors.
What about operational risk?Potential loss from a range of operational weaknesses (also fraud, terrorism, other catastrophes). Derivative trading is prone to operational risk because of its complexity and high amount of leverage.
Human factor risk: human errors like wrong button, typos, etc.
Technology risk: failure of systems.
Legal and regulatory risk (part of OR under Basel II). Legal, lacking authority. Regulatory, like tax reform/change.
What about systemic risk?Concerns the potential or failure of one institution to create a chain reaction or domino effect on other institutions and consequently threaten the stability of financial markets and even the global economy. PANIC about the soundness of an institution. FLIGHT to QUALITY/SAFETY. Fire-sale prices. There should be a fair price for firms that made themselves systemic, but costs will just be allocated to customers.
What about Marked-to-Market?Three accounting classifications:
- Amortized cost, by effective interest method less allowances (bad loans)
- AFS, available for sale, go through equity, but only upon realization through P&L.
- MtM, fair value, daily valuation through P&L.
- Market prices may deviate from fundamental value
- Market illiquidity may reder fair value difficult to measure (unreliable losses)
- Unrealized losses may trigger unhelpful feedback effects, with more margin calls and further deterioration (destabilizing in a downward spiral)
Reading 2 - Corporate Risk Management: A Primer
This is a preview. There are 6 more flashcards available for chapter 11/08/2016
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What are the disadvantages of hedging risk exposures?- Active hedging may distract management from its core business (e.g. SME)
- Compliance costs (disclosure)
- Protected confidential information becomes public
- Gap between accounting earnings and economic cash flows.
- Zero-sum game and cannot increase earnings or cash flows
- Reducing volatility through hedging simply moves earnings and cash flows from one year to another.
- Managers may act in their self-interest (agency risk, by reduce share volatility)
- According to the most fundamental understanding of the interest of shareholders, executives should not actively manage the risks of their corporation at all.
- Individual investors can replicate themselves.
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