Part 1: Foundations of risk management

Chapter 1
The Building Blocks of Risk Management

Nguyen Thi Lien

Faculty of Mathematical Economics, NEU
Email: [email protected]

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Learning objectives
✓ Explain the concept of risk and compare risk management with risk taking.
✓ Describe the risk management process and identify problems and challenges that
can arise in the risk management process
✓ Evaluate and apply tools and procedures used to measure and manage risk, including
quantitative measures, qualitative assessment, and enterprise risk management.
✓ Distinguish between expected loss and unexpected loss.
✓ Describe and differentiate between the key classes of risks.
✓ Interpret the relationship between risk and reward

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Learning objectives
✓ Explain the concept of risk and compare risk management with risk taking.
✓ Describe the risk management process and identify problems and challenges that
can arise in the risk management process
✓ Evaluate and apply tools and procedures used to measure and manage risk, including
quantitative measures, qualitative assessment, and enterprise risk management.
✓ Distinguish between expected loss and unexpected loss.
✓ Describe and differentiate between the key classes of risks.

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The concept of risk
✓ 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.
✓ Enterprise risk management (ERM) is the process of planning, organizing, leading,
and controlling the activities of an organization in order to minimize the effects of
risk on an organization’s capital and earnings as a whole.

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Exercise 1.1:
You are having lunch with a client who suddenly asks you, “I noticed that you
studied risk. To me, risk is when bad stuff can happen. Can you tell me, what is
your definition of risk?” As far as the financial risk manager (FRM) is concerned-
at least among the following potential responses to your client’s question-which
of the following definitions of risk is BEST?
a. Risk is the source or cause of a financial loss or cost
b. Risk is a condition that increases the probability of a loss
c. Risk the size of a loss or cost: if a cost is greater, its risk is greater
d. Risk is the variability of adverse outcomes that are unexpected

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Risk management process
1. Identify the risks.

2. Quantify and estimate the risk exposures or determine appropriate methods

to transfer the risks.

3. Determine the collective effects of the risk exposures or perform a cost-

benefit analysis on risk transfer methods.

4. Develop a risk mitigation strategy (avoid, transfer, mitigate, or assume risk).

5. Assess performance and amend risk mitigation strategy as needed.

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Risk management process

• Name • Rank
• Categorize • Score
• Understand • Measure
1.IDENTIFY 2. ANALYZE • Quantify
Assess
performance
• Avoid 3.ASSESS
• Retain 4. MANAGE
IMPACT
• Effects
• Mitigate
• Knock-Ons
• Transfer
• Repercussions

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 Identify the risks
Market Risk Equity risk, Interest rate risk, Price movements
Currency risk, Commodity risk

Credit Risk Downgrade risk, Failure of one party

bankruptcy risk
Funding Liquidity risk, Liquid cash
Liquidity risk
market Liquidity risk

Operational Risk Anti-money laundering risk, Failed internal process

Cyber risk, legal Risk…

Business Risk Demand, pricing, cost, rev…. Worries of firms

Strategic Risk Investment, capital, Long term decisions

human resoures,….
Reputation Risks Market standing or brand Sudden fall in market

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Exercise 1.2: Typology of risks
In considering the major classes of risks, which risk would best describe an
entity with weak internal controls that could easily be circumvented with a
lack of segregation of duties?
A. Business risk.
B. Legal and regulatory risk.
C. Operational risk.
D. Strategic risk

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Exercise 1.3: Typology of risks
Operational risk includes
A. legal risk.
B. business risk.
C. reputation risk.
D. currency risk
E. counterparty risk.
F. cyber risk.

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Exercise 1.4: Typology of risks
Reputation risk

A. is easy to quantify.
B. is the responsibility of the chief market risk officer.
C. cannot be managed at all.
D. should be monitored by the board.

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Quantitative Risk Metrics
▪ Expected loss (EL) is the average loss a
position taker might expect to incur

▪ Unexpected Loss (UL): The extent to

which losses depart from the average.

▪ Value-at-Risk (VaR): Value at Risk

predicts the maximum loss which will
not be exceeded with a certain level
of confidence
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Quantitative Risk Metrics

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Quantitative Risk Metrics
Expected shortfall helps to quantify the losses in the extreme tail

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Exercise 1.5: Quantitative Risk Metrics
EL for a loan is based on

A. probability of default (PD).

B. exposure at default (EAD).

C. loss given default (LGD).

D. all of the above

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Quantitative Risk Metrics
The EL of a portfolio can be calculated by :
1) the probability of the risk event occurring;
2) the firm's exposure to the risk event;
3) the severity of the loss if the risk event occurs.
Example: In case the credit risk: EL = EAD X LGD X PD
PD: the borrower’s Probability of Default
EAD: the bank’s Exposure At Default
LGD the severity of Loss Given Default
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Exercise 1.6: Quantitative Risk Metrics
Tail risk techniques are dealt by

A. Extreme Value Theory.

B. VaR Theory.

C. Probably of Default Theory.

D. standard deviation.

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Exercise 1.7:
The purpose of economic capital is to absorb

A. expected loss.

B. unexpected loss.

C. tail loss.

D. all of the above.

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The relationship between risk and reward

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The relationship between risk and reward
• Sharpe ratio (SR), which is the ratio of the average rate of return, 𝜇 𝑅𝑃 , in excess
of the risk-free rate 𝑅𝑓 , to the absolute risk:

𝜇 𝑅𝑃 − 𝑅𝑓
SR =
𝜎 𝑅𝑃
• Information Ratio (IR) is the ratio of the average rate of return of portfolio 𝑃 in
excess of the benchmark portfolio :

𝜇 𝑅𝑃 − 𝜇 𝑅𝐵
IR =
𝜎 𝑅𝑃 − 𝑅𝐵

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Exercise 1.8:
The risk-free interest rate is 𝑅𝑓 = 3% and the portfolio average return is −6%, with
volatility of 25%.
1. What is the Sharpe ratio of the portfolio?
2. Assume now that the benchmark returned −10% over the same period and that the
tracking error volatility was 8%. What is the information ratio?

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