PRELIM

Risk means the uncertainty that an investment will earn its expected rate of return.
Investment is a risky activity so we have to treat risk management as an important
component of the investment process. For both individual investments and portfolios,
we have to examine and compare the full extent of risks and expected returns to ensure
that the exposures we assume are justified by the rewards we expect to gain. The proper
identification, measurement, and control of risks are key to the process of investing.

Risk management therefore is a process involving the identification of exposure to risk,

the establishment of appropriate ranges for exposures with understanding of an entity’s
objectives and constraints, the continuous measurement of these exposures, and the
execution of appropriate adjustments whenever exposure levels fall outside of target
ranges. The process is continuous and may require alterations in any of these activities to
reflect new policies, preferences, and information.

An effective risk management identifies, assesses, and controls numerous sources of

risk, both financial and non-market related to achieve the highest possible level of
reward for the risks incurred.

Risk categories can be grouped into

1. Financial risks include liquidity risk, credit risk, commodity prices risk, equity prices
risk, exchange rate risk, and interest rate risk.
2. Non-financial risks include tax risk, accounting risk, legal risk, regulations risk,
settlement risk, model risk, and operations risk.

Identifying risks

1. Market risk is the risk associated with interest rate, exchange rates, stock prices,
and commodity prices and it links to supply and demand in various marketplaces.
Much of the evolution that has taken place in the field of risk management begun
from a desire to understand and control market risks.
2. Credit risk is the risk of loss caused by a counterparty or debtor’s failure to make a
promised payment.
3. Liquidity risk is the risk that a financial instrument cannot be purchased or sold
without a significant concession in price because of the market’s potential inability to
efficiently accommodate the desired trading size. Liquidity risk is present in both
initiating and liquidating transactions, for both long and short positions, but can be
particularly acute for liquidating transactions especially when such liquidation is
motivated by the need to reduce exposures in large losses. In trading securities, the
size of the bid-ask spread (the spread between bid and ask prices), stated as a
proportion of security price, is frequently used as an indicator of liquidity.
4. Operational risk is the risk of loss from failures in a computer’s systems and
procedures or from external events.
5. Model risk is the risk that a model is incorrect or misapplied. In investments, it often
refers to valuation models. Model risk exists to some extent in any model that
attempts to identify the fair value of financial instruments, but it is most prevalent in
models used in derivatives markets. Since the development s of the seminal Black-
Scholes-Merton option pricing model, both derivatives and derivative pricing models
have proliferated.
6. Settlement (Herstatt) risk is the risk that one party could be in the process of
paying the counterparty while the counterparty is declaring bankruptcy. Settlements
are the payments associated with the purchase and sale of cash securities such as
equities and bonds, along with cash transfers executed for swaps, forward, options
and other types of derivatives. The process of settling a contract involves on or both
parties making payments and /or transferring assets to the other. Most regulated
futures and options market exchanges are organized in such a way that they
themselves act as the central counterparty to all transactions.
7. Regulatory risk is the risk associated with the uncertainty of how transaction will be
regulated or with the potential regulations to change. Equities, bonds, futures, and
exchange-traded derivatives markets are usually regulated. Regulations is a source
of uncertainty, regulated markets are subject to the risk that the existing regulatory
regime will become more onerous, more restrictive, or more costly. In case of
derivatives, companies that are regulated in other ways may have their derivative
business indirectly regulated.
8. Legal/Contract risk is the possibility of loss arising from the legal systems failure to
enforce a contract in which an enterprise has a financial stake. Financial transaction
is subject to some form of contract law and contracts involve two parties. The
possibility of conflict can arise due to breach of contract, illegal contract, fraudulent
act and others.
9. Tax risk arises because of uncertainty associated with tax laws. Tax covering the
ownership and transaction of financial instruments can be extremely complex, and
the taxation of derivatives transactions is an area of even more confusion and
uncertainty. Tax rulings clarify these matters on occasion, but on other occasions,
they confuse them further. Also, tax policy often fails to keep pace with innovations
in financial instruments.
10. Accounting risk arises from uncertainty about how a transaction should be
recorded and the potential of accounting rules and regulations to change.
Accounting statements are a key, if not primary, source of information on publicly
traded firms. The international Accounting Standard Board (IASB) sets global
standards for accounting. The IASB together with different accounting standard
boards of other countries such US Financial Accounting Standards Board (FASB)
have been working together toward convergence of accounting standards
worldwide.
11. Sovereign and political risks- Sovereign risk is a form of credit risk in which the
borrower is the government of a sovereign nation. Its magnitude has two
components: likelihood of default and the estimated recovery rate. Political risk is
associated with changes in the political environment. It could be both overt (change
of economic system) or subtle (change political party control) and it exist in every
jurisdiction where financial instruments trade.

Other risks
1. ESG risks- is the risks to a company’s market valuation resulting from
environmental, social and governance factors.
a. Environmental risk is created by the operational decisions made by the company
managers, including decisions concerning product and services to offer and the
processes to use in producing those products and services.
b. Social risk derives from the company’s various policies and practices regarding
human resources, contractual arrangement, and the work place.
c. Governance risk is the flaws in corporate governance policies and procedures
with direct and material effects on a company’s value in the market place.
 2. Performance netting risk or netting risk, which applies to entities that fund more
than one strategy, is the potential for loss resulting from the failure of fees based on
net performance to fully cover contractual payout obligations to individual portfolio
managers that have positive performance when other portfolio managers have
losses and when there are asymmetric incentive fee arrangements with the portfolio
managers.

3. Settlement netting risk- refers to the risk that a liquidator of a counterparty in

default could challenge a netting arrangement so that profitable transactions are
realized for the benefit of creditors.

The practice of Risk Management

Risk management should be a process, not just an activity. A process is continuous and
subject to evaluation and revision. Effective risk management requires the constant and
consistent monitoring of exposures, with an eye toward making an adjustment, whenever
and wherever the situation calls for them. Risk management in its totality is all at once a
proactive, anticipative, and reactive process that continuously monitors and control risk.

Practical application of the process

The company faces a range of financial and nonfinancial risks and response to these
challenges by establishing a series of risk management policies and procedures. It defines
its risk tolerance, which is the level of risk it is willing and able to bear. It then identifies the
risks, drawing on all sources of information, and attempts to measure these risks using
information or data related to all of its identified exposures. After having an effective risk
identification and measurement mechanisms, it is now in a position to adjust its risk
exposures, whenever and wherever exposures diverge from previously identified target
ranges. These adjustments take the form of risk-modifying transactions (including risk
transfer). The execution of risk management transactions is itself a distinct process; for
portfolios, this step consists of trade identification, pricing, and execution. The process
then loops around to the measurement of risk and continues in that manner, and to the
constant monitoring and adjustments of the risk, to bring it into or maintain it within the
desired range.
Risk Management Process: practice of risk management

Nonfinancial the company Financial

risks risks

Set policies and procedures

Information Define risk and tolerance Information/data

data
Identify risk

Measure risk derivatives

Execute risk
Adjust level of Mgt. transactions
risk non-derivatives
identify appropriate transactions

price transactions

execute transactions

In applying risk management process to portfolio management, managers must devote

considerable amount of attention to measuring and pricing the risks of financial
transactions or positions particularly those involving derivatives.

Risk Management Process: pricing and measuring of risk

Identify the sources of risks

Measure risks
Select appropriate model

Determine determined
Market price or value model price or value

Compare

Attractively priced not attractively priced

Execute transaction Seek alternative transaction

Risk management involves adjusting levels of risk to appropriate levels, not necessarily
eliminating risk altogether. Risk management is a general practice that involves risk
modification (risk reduction or risk expansion) as deemed necessary and appropriate by
the custodians of capital and its beneficial owners.
Risk Governance: management responsibility
Risk governance is a process of setting overall policies and standards in risk
management. It involves choices of governance structure, infrastructure, reporting, and
methodology. The quality of risk governance can be judged by its transparency,
accountability, effectiveness (achieving objectives), and efficiency (economy in the use of
resources).

Governance Structure: centralized or decentralized risk management system

1. Centralized risk management system approach- company has a single risk
management group that monitors and ultimately controls all of the organization’s
risk-taking activities.
2. Decentralized risk management system approach- places risk management
responsibility on individual business unit managers. Thus, each unit calculates and
reports its exposure independently.

Decentralization has the advantage of allowing the people closer to the actual risk
taking to more directly manage it.
Centralization permits economies of scale and allows the company to recognize the
offsetting nature of distinct exposure that an enterprise might assume in a day-to-
day operation.

Example: Assuming one subsidiary of Corporation Kwekwek buys from Japan and another
subsidiary sells to Japan, with both engaged in yen-denominated transaction, each
subsidiary has some foreign exchange exposure, from centralized viewpoint these risks
have offsetting effects that reduces the overall need to hedge.

Centralized risk management gives an overall picture of the company’s risk position, and
ultimately overall is what counts. The centralized risk management is known as
Enterprise Risk Management (ERM). Its distinguishing feature is a firmwide or across-
enterprise perspective that is sometimes called firmwide risk management.

In ERM, the organization must consider each risk factor to which it is exposed – both in
isolation and in terms of any interplay among them. For risk taking entities, it is
contradictory to suggest that an organization has sound corporate governance without
maintain a clear and continuously updated understanding of its exposure as an enterprise
level.

In case of decentralized risk management approach, it will require a mechanism by

which senior managers can inform themselves about the enterprise’s overall risks
exposures.

At enterprise level, companies should control not only the sensitivity of their earnings to
fluctuations in the stock market, interest rate foreign exchange rate, and commodity prices
but also their exposure to credit spreads and default risk, to gaps in the timing match of
their assets and liabilities and to operational/system failures, financial fraud, and other
factors that can affect corporate profitability and survival.
An effective Enterprise Risk Management (ERM) system usually incorporates the
following steps:

1. Identify each risk factor to which the company is exposed

2. Quantify each exposure’ size in money term.
3. Map these inputs into a risk estimation calculation.
4. Identify overall risk exposures as well as the contribution to overall risk deriving from
each risk factor.
5. Set up a process to report on these risks periodically to senior management, who
will set up a committee of division heads and executives determine capital
allocations, risk limits, and risk management policies.
6. Monitor compliance with policies and risk limits.

Step 5 and 6 allows the organization to quantify the magnitude and distribution of its
exposures and enabling it to use the ERM system’s output to more actively align its risk
profile with its opportunities and constraints on a routine, periodic basis. Effective ERM
system feature centralized data warehouse, where a company stores all pertinent risk
information, including position and market data, in a technologically efficient manner. The
process of identifying and correcting errors in a technologically efficient manner can be
resource intensive especially when effort requires storing historical information on complex
financial instruments.

Measures of Risk
Market risk refers to the exposure associated with actively traded financial instrument
whose prices are exposed to the changes in interest rate, exchange rates, equity prices,
commodity prices or a combination of them. The most widely used statistical tools to
describe market risk is the standard deviation of price outcomes associated with an
underlying asset, this measure is referred to as assets’ volatility. Volatility is an adequate
description of portfolio risk, particularly for those portfolios composed of instruments with
linear payoffs. In some applications, such as indexing, volatility relative to a benchmark is
paramount. In those cases, the focus should be on the volatility of the deviation of a
portfolio’s returns in excess of a stated benchmark portfolio’s returns known as active risks,
tracking risk, tracking error volatility or simply as tracking error. Volatility associated with
individual position beside being a useful risk management metric can be combined with
other simple statistics such as correlations to form the building blocks for the portfolio-
based risk management system that has become an industry standard.

A portfolio’s exposure to losses because of market risk takes one of two forms:
(1) sensitivity to adverse movements in the value of a key variable in valuation (primary or
first-order measures of risk); and
(2) risks measures associated with changes in sensitivities (secondary or second-order of
measures of risk).

Primary measures of risk often reflect linear elements in valuation relationship;

secondary measures often take account of curvature in valuation relationships. Each
asset class (e.g., bonds, foreign exchange, equities) has specific first and second-order
measures.
Considering measures of primary sources of risks, for a stock or stock portfolio,
 Beta (a measure of the sensitivity of a given investment or portfolio to movements
in the overall market) measures sensitivity to market movements and is linear risk
measure. For bonds,
 Duration (a measure of the approximate sensitivity of a security to a change in
interest rate i.e., a measure of interest rate risk) measures the sensitivity of a
bond or bond portfolio to a small parallel shift in the yield curve and is a linear
measure.
 Delta (ratio change in the option price to a small change in the price of underlying
asset) for options, and is a linear measure, which measures an option’s
sensitivity into small change in price of its underlying. These measures all reflect
the expected change in price for a financial instrument for a unit change in the value
of another instrument.

Second order measures of risks deal with the change in the price sensitivity of a
financial instrument. They include:
Convexity (a measure of how interest rate sensitivity changes with a change in interest
rate) for fixed-income portfolios and;
Gamma (a numerical measure for sensitivity of delta to a change in underlying ‘s value)
options.

For options,
TWO MAJOR FACTORS DETERMINE PRICE:
(1) volatility and
(2) time to expiration,

both first order or primary effects. Sensitivity to volatility is reflected in

 Vega (a measure of the sensitivity of an option’s price to a change in the underlying
assets’s volatility).
Option prices are also sensitive to changes in time to expiration as measured by
 Theta (the rate at which an option’s time value decays)
which the change in price of an option associated with a one-day reduction in its
time to expiration.
 Theta and Vega are risks associated exclusively with options.

VALUE AT RISK (VAR)

is an estimate of the loss (in money terms) that we expect to be exceeded with a given
level of probability over a specified time period. It is a probability-based measure of loss
potential for a company, a fund, a portfolio, a transaction, or a in units of currency. Any
position that exposes one to loss is potentially candidate for VAR measurement.
VAR is widely and easily used to measure the loss from market risk and to measure the
loss from credit risk and other types of exposure subject to more complexity.

VAR has important elements which are

(1) estimate of the loss that we expect to be exceeded,
(2) VAR is associated with a given probability,
(3) VAR has a time element and that as such, VARs cannot be compared directly unless
they share the same time interval.

Example of VAR for an investment portfolio:

The VAR for a portfolio is 1.5 million for one day with a probability of 0.05 which means
there is 5 percent chance that the portfolio will lose at least 1.5 million in a single day. The
1.5 million loss is a minimum. To describe VAR as a maximum: The probability is 95
percent that the portfolio will lose no more than 1.5 million in a single day. This perspective
states that VAR uses confidence level that says, with 95 percent confidence (or for 95
percent confidence level), the VAR for a portfolio is 1.5 million for a single day.

Elements of Measuring Value at Risk

Appropriate VAR requires the user to make a number of decisions about the calculation’s
structure such as

(1) picking a probability level,

(2) selecting the time period over which to measure VAR, and
(3) choosing the specific approach to modeling the loss distribution.

The probability chosen is typically either .05 or .01 that corresponds to 95 percent and 99
percent confidence level, respectively. The use of .01 leads to a more conservative VAR
estimate, since it sets the figure at the level where there should be a 1 percent chance that
a given loss will be worse than the calculated VAR.

The trade-off is that the VAR risk estimate will be much larger with a 0.01 probability than
it will be for a .05 probability. There is no definitive rule exists preferring one probability
from the other. For portfolios with largely linear risk characteristics, the two probability
levels will provide essentially identical information. However, the tails of loss distribution
may contain a wealth of information for portfolios that have a good deal of optionality or
non-linear risks, and in this case risk managers may need to select the conservative
probability threshold.

The SECOND IMPORTANT DECISION for VAR users is choosing the time period. VAR
is often measured over a day, but others, the common are longer time periods. Regardless
of the time interval selected, the longer the period the greater the VAR number will be
because of the magnitude of potential losses varies directly with the time span over which
they are measured.

Once these primary paremeters are set, one can proceed to actually obtain the VAR
estimate, the THIRD DECISION will be the choice of technique. The basic idea behind
estimating VAR is to identify the probability distribution characteristics of portfolio returns.

Return on portfolio probability

Less than -40% .01
-40% to -30% .01
-30% to -20% .03
-20% to -10% .05
-10% to -5 % .100
-5% to – 2.5% .125
-2.5% to 0% .175
0% to 2.5% .175
2.5% to 5% .125
5% to 10% .100
10% to 20% .01
20% to 30% .01
30% to 40% .03
Greater than 40% .01

Three standardized methods for estimating VAR

1. Analytical or Variance-Covariance Method
2. The Historical Method or Historical Simulation Method
3. Monte Carlo Simulation Method

The Advantage and Limitations of Value at Risk (VAR)

Although Value at risk has become the industry standard for risk assessment, it also
has documented imperfections:

1. VAR can be difficult to estimate, and different estimation methods can give quite
different values;
2. VAR can also lull one into a false sense of security by giving the impression that the
risk is properly measured and under control;
3. VAR often underestimates the magnitude and frequency of the worst returns,
although this problem often derives from erroneous assumptions and models;
4. VAR for individual positions does not generally aggregate in a simple way to
portfolio VAR;
5. VAR fails to incorporate positive results into its risk profile, and as such, it arguably
provides an incomplete picture of overall exposures.

The process of comparing the number of violations of VAR thresholds with the figure
implied by the user-selected probability level is part of a process known as Back-testing. It
is important to go through this exercise, ideally across multiple time intervals, to ensure
that the VAR estimation method adopted is reasonably accurate.

Example: if the VAR estimate is based on daily observations and targets a 0.05 probability, then in
addition to ensuring that approximately a dozen threshold violation occur during given year, it is
also useful to check other, shorter time intervals, including the most recent quarter (for which, given
60-odd trading days, we would expect approximately three VAR exceptions – i.e., losses greater
than the calculated VAR), and the most recent month (20 observations, implying a single VAR
exception). The results should not be expected to precisely match the probability level predictions
but should be at a minimum of similar magnitude. If the results vary much from those that the
model predicts, then users must examine the reasons and make appropriate adjustments.
An accurate VAR estimate can also be extremely difficult to obtain for complex
organizations. Consolidating the effects of risk exposures into a single risk measure can be
difficult. However, most large bank, though expose to thousands of risks, manage to do so,
and do an excellent job of managing their risk.

Advantages of VAR
1. VAR has the attraction of quantifying the potential loss in simple terms and can be
easily understood by senior management.
2. Regulatory bodies have taken note of VAR as a risk measure, and some require
that institutions provide it in their reports;
3. VAR is one acceptable method of reporting how companies manage their financial
risk;
4. VAR is versatile: companies use VAR as a measure of their capital at risk, they
estimate VAR associated with a particular activity such as a line of business, a
subsidiary, or a division. They evaluate performance, taking into account the VAR
associated with this risky activity, and companies allocate capital based on VAR.

Surplus at risk: VAR as it applies to pension funds

The DIFFERENCE BETWEEN THE VALUE OF THE pension fund’s assets and
liabilities is referred to as the surplus. It is the value that pension fund managers seek to
enhance and protect. If this surplus falls into negative territory, the plan sponsor must
contribute funds to make up the deficit over a period of time that is specified as a part of
the fund’s plan. Pension fund managers apply VAR methodologies not to their portfolio of
assets but to the surplus. They express their liability portfolio as a set of short securities
and calculate VAR on the net position, once this adjustment is made the three VAR
methodologies can be applied to the task.

Extensions and supplements to VAR

In the evaluation of the portfolio effect of a given risk, isolating the effect of a risk,
particularly in complex portfolios with high correlation effects is important. Incremental VAR
(IVAR) is used to investigate the effect.

1. IVAR measures the incremental effect of an asset on the VAR of a portfolio by

measuring the difference between the portfolio’s VAR while including a specified
asset and the portfolio’s VAR with that asset eliminated. IVAR is also use to assess
the incremental effect of a subdivision on an enterprise’s overall VAR. Although
IVAR gives a limited picture of the asset or portfolio’s contribution to risk, however it
provides useful information about how adding the asset will affect the portfolio’s
overall risk as reflected in its VAR.
2. Cash flow at risk (CFAR) – measures the risk to a company’s cash flow instead of
its market value as in the case of VAR. CFAR is the minimum cash flow loss that
we expect to be exceeded with a given probability over a specified period of time. It
can be used when a company (or portfolio of assets) generates cash flows but
cannot readily valued in a publicly traded market, or when the analyst’s focus is on
the risk to cash flow in a valuation.

3. Earnings at risk (EAR) measures the risk to a company’s earning instead of its
market value as in the case of VAR. EAR is the minimum earning loss that we
 expect to be exceeded with a given probability over a specified period of time. It can
be used when a company (or portfolio of assets) generates earnings but cannot
readily valued in a publicly traded market, or when the analyst’s focus is on the risk
to earnings in a valuation.
4. Tail value at risk (TVAR) also known as conditional tail expectation – TVAR is
VAR plus the expected loss in excess of VAR, when such loss occurs.

Stress Testing

VAR analysis is to quantify potential losses under normal conditions. Stress testing, by
comparison, seeks to identify unusual circumstances that could lead to losses in excess of
those typically expected. Different scenarios will have attached probabilities of occurring
that vary from the highly likely to the almost totally improbable.

Broad approaches in stress testing

1. Scenario analysis – the process of evaluating a portfolio under different states of
the world. It involves designing scenarios with deliberately large movements in the
key variables that affect the values of a portfolio’s assets and derivatives.
a. Stylized scenarios analysis – involves simulating a movement in at least one
interest rate, exchange rate, stock price, or commodity price relevant to the
portfolio. These movement might range from fairly modest changes to quite
extremes shifts.
b. Recommended scenarios from derivative policy group
a. Parallel yield curve shifting by +-100 basis points (1 percentage point
b. Yield curve twisting by +-25 basis points
c. Each of the four combinations of the above shifts and twists
d. Implied volatilities changing by +-20 percent from current levels
e. Equity index levels changing by +-10 percent
f. Major currencies moving by +-6 percent and other currencies by +-20 percent
g. Swap spread changing by +-20 basis points
c. Another approach to scenario analysis involves using actual extreme events that
occurred in the past and Hypothetical events that have never happened in the
markets or market outcomes to which we attached a small probability.
2. Stressing models
Another approach might to use an existing model and apply shocks and
perturbations to the model inputs in some mechanical way. This approach might
be considered more scientific because it emphasizes a range of possibilities
rather than a single set of scenarios, but it will be more computationally
demanding.
a. Factor push – a form of stressing model which is the idea of pushing prices and
risk factors of an underlying model in the most disadvantageous way and to work
out the combined effect on the portfolio’s value. This exercise might be
appropriate for a wide range of models, including option-pricing models such as
Black-Scholes-Merton, multifactor equity risk models, and term structure factor
models.
b. Maximum loss optimization, which is to optimize mathematically the risk
variable that will produce the maximum loss.
c. Worst-case scenario analysis, which is to examine the worst case that we
actually expect to occur.
Measuring Credit Risk
Credit risk is present when there is a positive probability that one party owing money to
another wiil renege on the obligation, that is the counterparty could default. If the defaulting
party has insufficient resources to cover the loss or the creditor cannot impose a claim on
any assets the debtor has that are unrelated to the line of business in which the credit
extended, the creditor can suffer a loss. A creditor might be able to recover some of the
loss, perhaps by having the debtor sell assets and pay the creditors a portion of their claim.

Credit losses have two dimensions.

a. The likelihood of loss – the likelihood of loss is a probabilistic concept. In every
credit-based transaction, a given probability exists that the debtor will default.
b. Associated amount of loss (reflects the amount of credit outstanding and the
associatd recovery date)

In the risk management business, exposure must often be viewed from two different
time perspectives. We must assess first the (1) risk associated with immediate credit
events and second the (2) risk associated with events that may happen later.

Elements of credit risk

1. Current credit risk (jump-to-default risk) – the risk of events happening in the
immediate future
2. Potential credit risk – Though the counterparty can pay on time, still the risk
remains that the entity will default at the later date.
3. Cross-default provisions – which blends current and potential credit risk, is the
possibility that a counterparty will default on a current payment to a different
creditor, and in direct lending or derivative-based credit contracts stipulate that if the
borrower defaults on any outstanding credit obligations, the borrower is in default on
them all. Creditors stipulate this condition as one means of controlling credit
exposure.

VAR is also used to measure credit risk known as credit VAR or default VAR or credit
at risk and it reflects the minimum loss with a given probability during a period of
time.

Example: A company might quote a credit VAR of 10 million for one year at a probability of
0.05 (or a confidence level of 95 percent. That means the company has a 5 percent
chance of incurring default-related losses of at least 10 million in one year.