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Risk Management:: A Helicopter View

This document discusses risk management and the various types of risk. It defines risk management as activities aimed at reducing expected losses. The basic risk management process involves identifying risks, quantifying exposures, developing mitigation strategies, and assessing performance. Various quantitative and qualitative tools are used to measure and manage risk, including value at risk, economic capital, scenario analysis, and stress testing. The document also outlines different types of risk such as market risk, credit risk, liquidity risk, operational risk, and strategic risk.

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Tony Nasr
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179 views2 pages

Risk Management:: A Helicopter View

This document discusses risk management and the various types of risk. It defines risk management as activities aimed at reducing expected losses. The basic risk management process involves identifying risks, quantifying exposures, developing mitigation strategies, and assessing performance. Various quantitative and qualitative tools are used to measure and manage risk, including value at risk, economic capital, scenario analysis, and stress testing. The document also outlines different types of risk such as market risk, credit risk, liquidity risk, operational risk, and strategic risk.

Uploaded by

Tony Nasr
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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RISK MANAGEMENT: A HELICOPTER VIEW

Risk arises from the uncertainty regarding an entity's future losses as well as future gains.
Risk management includes the sequence of activities aimed to reduce or eliminate an entity's
potential to incur expected losses. Risk taking refers specifically to the active assumption of
incremental risk in order to generate incremental gains.

In its basic format, the risk management process is as follows:


Step 1: Identify the risks.
Step 2: Quantify and estimate the risk exposures or determine appropriate methods to transfer
the risks.
Step 3: Determine the collective effects of the risk exposures or perform a cost-benefit
analysis on risk transfer methods.
Step 4: Develop a risk mitigation strategy (i.e., avoid, transfer, mitigate, or assume risk).
Step 5: Assess performance and amend risk mitigation strategy as needed.

Challenges: Identify correct risk – Find efficient technique

Tools and procedures used to measure and manage risk:


Quantitative Measures
Value at risk (VaR) states a certain loss amount and its probability of occurring. For example,
a financial institution may have a one-day VaR of $2.5 million at the 950% confidence level.
That would be interpreted as having a 5o/o chance that there will be a loss greater than $2.5
million on any given day.
VaR is a useful measure for liquid positions operating under normal market circumstances
over a short period of time. It is less useful and potentially dangerous when attempting to
measure risk in non-normal circumstances, in illiquid positions, and over a long period of
time.
Economic capital refers to holding sufficient liquid reserves to cover a potential loss.

Qualitative Assessment
Scenario analysis takes into account potential risk factors with uncertainties that are often
non-quantifiable.
Stress testing is a form of scenario analysis that examines a financial outcome based on a
given "stress" on the entity.

Enterprise risk management takes an integrative approach to risk management within an


entire entity, dispensing of the traditional approach of independently managing risk within
each department or division of an entity.

Expected loss considers how much an entity expects to lose in the normal course of business.
It can often be computed in advance (and provided for) with relative ease because of the
certainty involved.
Unexpected loss considers how much an entity could lose usually outside of the normal
course of business. Compared to expected loss, it is generally more difficult to predict,
compute, and provide for in advance because of the uncertainty involved.

There is a trade-off between risk and reward. In very general and simplified terms, the greater
the risk taken, the greater the potential reward. However, one must consider the variability of
the potential reward. The portion of the variability that is measurable as a probability function
could be thought of as risk whereas the portion that is not measurable could be thought of as
uncertainty.

Market risk considers how changes in market prices and rates will result in investment losses.
There are four subtypes of market risk: (1) interest rate risk, (2) equity price risk, (3) foreign
exchange risk, and (4) commodity price risk.

Credit risk refers to a loss suffered by a party whereby the counterparty fails to meet its
financial obligations to the party under the contract. Credit risk may also arise if there is an
increasing risk of default by the counterparty throughout the duration of the contract.
There are four subtypes of credit risk: (1) default risk, (2) bankruptcy risk, (3) downgrade
risk, and (4) settlement risk.

Liquidity risk is subdivided into two parts: (1) funding liquidity risk and (2) trading liquidity
risk. Funding liquidity risk occurs when an entity is unable to pay down or refinance its debt,
satisfy any cash obligations to counterparties, or fund any capital withdrawals. Trading
liquidity risk occurs when an entity is unable to buy or sell a security at the market price due
to a temporary inability to find a counterparty to transact on the other side of the trade.

Operational risk considers a wide range of non-financial problems such as inadequate


computer systems, insufficient internal controls, incompetent management, fraud, human
error, and natural disasters.

Legal risk could arise when one party sues the other party in an attempt to nullify or
terminate the transaction. Regulatory risk could arise from changes in laws and regulations
that are unfavorable to the entity (e.g., higher tax rates, higher compliance costs).

Business risk revolves around uncertainty regarding the entity's income statement. Revenues
may be uncertain because of the uncertainty surrounding the demand for the products and/ or
the price that should be set. Production and administration costs may also be uncertain.

Strategic risk can be thought of in the context of large new business investments, which carry
a high degree of uncertainty as to ultimate success and profitability. Alternatively, it could be
thought of from the perspective of an entity changing its business strategy compared to its
competitors.

Reputation risk consists of two parts: (1) the general perceived trustworthiness of an entity
(i.e., that the entity is able and willing to meet its obligations to its creditors and
counterparties) and (2) the general perception that the entity engages in fair dealing and
conducts business in an ethical manner.

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