READING 1---RISK MANAGEMENT: A HELICOPTER VIEW

READING 1---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.
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 (I.e., avoid, transfer, mitigate, or assume risk).
5. Assess performance and amend risk mitigation strategy as needed.

Quantitative Risk Measures:

Value at risk (VaR) states a certain loss amount and its probability of occurring. And it’s useful for liquid positions operating under normal market circumstances over a short period of time.
Economic capital refers to holding sufficient liquid reserves to cover a potential loss.

Qualitative Risk Assessment:

Scenario analysis takes into account potential risk factors with uncertainties that are often non-quantifiable. (adverse scenario or worst-case scenario)
Stress testing is a form of scenario analysis that examines a financial outcome based on a given “stress” on the entity.

Enterprise Risk Management (ERM)

ERM 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.
Trade-off between risk and reward
       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.
Class of risk

• Market risk

(1) interest rate risk,
(2) equity price risk,
(3) foreign exchange risk,
(4) commodity price risk.

• Credit risk

(1) default risk,
(2) bankruptcy risk,
(3) downgrade risk,
(4) settlement risk.

• Liquidity risk

(1) funding liquidity risk,
(2) trading liquidity risk.

• Operational risk       

        Wide range of non-financial problems such as inadequate computer systems, insufficient internal controls, incompetent management, fraud, human
error, and natural disasters.

• Legal risk

        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.

• Strategic risk

        In the context of large new business investments, which carry a high degree of uncertainty as to ultimate success and profitability.

• Reputation risk

       (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),
       (2) the general perception that the entity engages in fair dealing and conducts business in an ethical manner.