Risk Management An Introduction

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Define Risk Management
❖Risk management does not mean to
eliminate risk altogether but to identify
and respond to it to manage it.
Identify and ❖The process can be done in many ways
Identify risk measure the risks Modify and monitor by either purchasing insurance or even
tolerance of the that the hedging.
organisation risk
organisation faces ❖As we all know that returns cannot be
made by not taking risk altogether, any
return above the risk free rate to be
earned has an element of risk which
needs to be taken and managed.

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The Risk Management Cycle

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The basic process steps are:
Establishing processes and policies of risk governance

Determining the organisations risk tolerance

•Identify and measure existing risks

Managing and mitigating risks to achieve optimal risk
Monitoring risk
Communicating risk to the organisation
Perform strategic risk analysis

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Risk Governance and Elements of effective Risk Governance
Refers to the institutions, rules conventions, processes and mechanisms by
which decisions about risks are taken and implemented. It can be both
normative and positive, because it analyses and formulates risk
Risk governance management strategies to avoid and/or reduce the human and economic
Meaning costs caused by disasters.

• Putting the right structures in place –all the pieces of framework need to
be in
place & operating. It starts with board and senior management.
• Getting the culture right- If the highest level of organisation see
benefits in managing risk, then they are likely to establish a positive
Elements of risk risk culture.
governance • Effective monitoring and reporting of risk- The board and senior
management ensure risks are being responded to appropriately in order
to mitigate threats & pursue opportunities.

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Risk Budgeting and Its Role
Risk budgeting is the process of allocating
firms resources to assets by considering
their various risk characteristics and how
they combine to meet the risk tolerance of
the organisation
The budget may be a single metric like:

Value at Duration
Risk

Beta Returns
Variance

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Financial and Non Financial Sources of Risk
Credit Risk-Uncertainty of counterparty fulfilling its obligation

Liquidity risk- The risk of not able to transact due to lower

Financial Risks counter party participants

Market risk-The uncertainty of prices of assets

Operational risk-The risk of human error or process

Solvency risk- Organisation running out of cash to manage operations

Non Regulatory Risk-Regulatory changes imposing restrictions to the firm
Financial
Risks Political risk- Political changes which could be harmful to the firm

Legal Risk- Uncertainty of the organisation exposure to future legal

action

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Financial and Non Financial Sources of Risk-Continued…
Non-Financial
Risks

Model risk- Assets

valuations error due to
model error

Tail risk- The risk of extreme

events which are not thought of
assuming a normal distribution

Accounting risk- Risk that

the accounting estimates of
the firm are misjudged
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Methods of Measuring and Modifying Risk exposures

Measures of Risk Derivatives Risks

Delta: Sensitivity of derivative Value at Risk (Var):
Standard Deviation: A measure
values relative to the price of VAR is the minimum loss over a
of the volatility of asset prices assets
and interest rates. It may not period that will occur with a
Gamma: Sensitivity of specific probability. Example
be the right measure for
assets following non normal derivative values relative to the A bank with a 5 % probability
price of delta loss of 200 million over a
distribution
Vega: Sensitivity of week. This is not the maximum
Beta: It measures the risk of derivative values relative one week loss but the
equity relative to the risk of to the volatility price of minimum loss 5% of the time
market assets
Duration: Measure of price Rho: Sensitivity of derivative
sensitivity relative to change values relative to the risk free
in interest rates rate

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Methods of Measuring and Modifying Risk exposures

Modifying Risk Exposures:

Diversification: The organisation
Conditional Var( CVar): can use diversification for the
Expected value of loss given the Subjective and Market Based kinds of risk the organisation has
Estimates of Risk: decided to take
loss exceeds a minimum
amount. Relating this to the Var, Two methods to Self Insurance: This means the
supplements risk measures organisation has decided to take
Cvar would be the expected loss like Var are:
given that the loss was at least the risk given the loss
Stress Testing: Use of an Risk Transfer: The organisation
200 million. extreme situation and see has decided not to bear the risk
the results and transfer the risk to other
Scenario Analysis: Changing of party
scenarios to see the results. For Surety Bond: an insurance
e.g. interest rate change and oil company has agreed to make the
price change payment if a third party fails to
perform the obligation

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Risk Assessment Matrix

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Practice Question
1.Risk management in the case of individuals is best described as concerned with:
A. hedging risk exposures.
B. maximizing utility while bearing a tolerable level of risk.
C. maximizing utility while avoiding exposure to undesirable risks.

2. Which of the following may be controlled by an investor?

A. Risk
B. Raw returns
C. Risk-adjusted returns

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Practice Question
3. The process of risk management includes:
A. minimizing risk.
B. maximizing returns.
C. defining and measuring risks being taken.

4. Risk governance:
A. aligns risk management activities with the goals of the overall enterprise.
B. defines the qualitative assessment and evaluation of potential sources of risk in an organization.
C. delegates responsibility for risk management to all levels of the organization’s hierarchy.

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Practice Question
5. The factors a risk management framework should address include all of the following except:
A. communications.
B. policies and processes.
C. names of responsible individuals.

6. Which of the following is the correct sequence of events for risk governance and management that focuses on the entire
enterprise? Establishing:
A. risk tolerance, then risk budgeting, and then risk exposures.
B. risk exposures, then risk tolerance, and then risk budgeting.
C. risk budgeting, then risk exposures, and then risk tolerance

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Solution
1. B is correct. For individuals, risk management concerns maximizing utility while taking risk consistent with
individual’s level of risk tolerance.

2. A is correct. Many decision makers focus on return, which is not something that is easily controlled, as
opposed to risk, or exposure to risk, which may actually be managed or controlled
3. C is correct. Risks need to be defined and measured so as to be consistent with the entity’s chosen level of
risk tolerance and target for returns or other outcomes.

4. A is correct. Risk governance is the top-down process that defines risk tolerance, provides risk oversight and guidance
to align risk with enterprise goals.
5. C is correct. While risk infrastructure, which a risk management framework must address, refers to the people
and systems required to track risk exposures, there is no requirement to actually name the responsible
individuals.
6. A is correct. In establishing a risk management system, determining risk tolerance must happen before specific risks
can be accepted or reduced. Risk tolerance defines the appetite for risk. Risk budgeting determine how or where the
risk is taken and quantifies the tolerable risk by specific metrics. Risk exposures can then be measured and compared
against the acceptable risk.
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