Risk Management

ByNiken Iwani Surya Putri. S.E.MSc.

Agenda For Today

• 1. Introduction• 2. chairman, class rules• 3. expectation• 4. Introduction to subjects (14 class),

– Textbook: (Kit Sadgrove)

• 5. Meeting 1: – Introduction (Scale and Scope of Risk Management)

Syllabi for 14 meeting

• 1. Risk Management Introduction• 2. Why are Financial Institution Special?• 3. Depository Institutions• 4. Non depository Institutions (Insurance, Finance

Companies)• 5. Non depository Institutions (Mutual Fund, Hedge

Fund)• 6. Risks Faced By Financial Institutions• 7. Measuring Risks of Financial Institutions• MIDTERM EXAM

Syllabi for 14 meeting

• 8. Interest Rate Risk • 9. Market Risk• 10. Credit Risk• 11. Liquidity Risk• 12. Operational Risk• 13. Managing Risk 1: ALMA,deposit insurance, capital

Adequacy• 14. Managing Risk 2: Hedging tools, loan sales, securitization

• Final EXAM

• Risk definition The Australian Standard 4360 on Risk Management :

“… the chance of something happening that will have an impact upon objectives. It is measured in terms of likelihood and consequences”

What is Risk?What is Risk?

Kids, don’t try this without properly know what risk is....

Am not a reckless person just a very confident person,

with insurance…

1) A logical and systematic step

2) Steps in decision making, comprehensive

3) Opportunity Identification

4) Avoiding or Minimizingloss

5) Good management practice

What is risk Management?What is risk Management?

A logical and systematic method in

to identify, analyze, treat, and monitoring potential risk in every

business activities.

What is RiskManagement?What is RiskManagement?

A method for managers in using the best possible

source to manage resources.

What is risk management?What is risk management?

Risk management develop responses from any identified events such below:– Prevention– Impact mitigation– Risk transfer– Risk acceptance

How to handle riskHow to handle risk

“Assist company in identifying potential risk that might threat the company,

by analyzing its type, source, occurrence, and severity levels.

Management may act promptly in order to minimize the risks”

What are the benefits?What are the benefits?

The user?The user?

• Finance and Investment

• Insurance

• Health Care

• Public Institutions

• Governments

• International Corporation/M

NC

• Finance and Investment

• Insurance

• Health Care

• Public Institutions

• Governments

• International Corporation/M

NC

• Effective Risk Management Skill

• Standardized process (International Risk Management process standards).

• An integral part in finance and banking

• An integral part of business and daily life

Risk Management’s Knowledge AreRisk Management’s Knowledge Are

Failure of a project to reach its objectives Client dissatisfaction Unfavorable publicity Threat to physical safety Mismanagement Fraud and deficiencies in financial

control Failure of equipment Breach of legal responsibility

Type of risksType of risks

Risk Management ModelsRisk Management Models

Establish Board’s Philosophy on RiskManagement

Determine Key Risk Areas

Stakeholder’s Risk Acceptance Expectations

What Events can Create UnfavourableConsequences in Key Risk Areas

What Unfavourable Consequences can Occur

What are the Impacts of these

Assess Risk

Determine & Apply Risk ManagementTechniques

Monitor & Adapt Continuously

1. Determine Strategic Elements

2. Determine Exposure

3. Determine Risks & Apply Techniques

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Steps in the Risk Management Process

- Property loss exposures- Liability loss exposures- Business income loss exposures- Human resources loss exposures- Crime loss exposures- Employee benefits loss exposures- Foreign loss exposures

Type of Losses

Major loss exposures and techniques for handling the loss exposure include the following:

Physical damage to a bus in an accident

(can be handled by a commercial auto policy, by retention of part of all of the loss exposure, and by loss control activities to reduce the possibility of an accident)

Sues arising out of injuries to children in a bus accident

(can be handled by a commercial auto policy, by loss control such as a defensive driving course, and by avoiding hiring

drivers with poor driving records)

Suits arising out of bodily injury or property damage to other motorists or pedestrians

(can be handled by a commercial auto policy, by loss control such as a defensive driving course, and by avoiding hiring drivers with poor driving records)

Physical damage losses to the three garages from natural disasters or

other perils

(can be handled by a commercial property insurance policy and by retention of part of the exposure by a sizable deductible)

Loss of business income if the firm is unable to operate (can be handled by business income insurance that covers the loss of business income

and extra expenses that continue during the shutdown period and by loss control activities to reduce the

possibility of a loss)

Workers compensation claims if a bus driver or other employees are injured in a work-related accident

(can be handled by workers compensation insurance and by self-insurance)

Death or disability of a key executive

(can be handled by loss control, such as an annual physical exam, and by having other employees trained to take over the duties of the key executive)

Tools for recognizing loss exposures:

- Risk analysis questionnaires- Physical inspection- Flow charts (standard operating procedure)- Financial statements- Historical loss data

Sources of Risk s(Internal dan External):Commercial and StrategicEconomicContractualFinancialEnvironmentalPoliticalSocialProject InitiationProcurement Planning

Risk AnalysisRisk Analysis

Risk AnalysisRisk Analysis

Operational Risk Jurisdiction Risk Settlement Risk Systems Risk

Employee Risk Strategic Decision Risk

Purchasing Risk

Operational Risk Jurisdiction Risk Settlement Risk Systems Risk

Employee Risk Strategic Decision Risk

Purchasing Risk

Strategic Risk Regulatory Risk

Tax Risk Catastrophe Risk Currency Policy

Strategic Risk Regulatory Risk

Tax Risk Catastrophe Risk Currency Policy

Sales Risk Competition Risk

Elasticity Risk Predictive Risk

Sales Risk Competition Risk

Elasticity Risk Predictive Risk

Physical Risk Physical Assets

Real Estate Manufacturing Process

Supply Chain

Physical Risk Physical Assets

Real Estate Manufacturing Process

Supply Chain

Liquidity Risk Funding Risk

Market Liquidity

Liquidity Risk Funding Risk

Market Liquidity

Cpty/Credit Risk Default risk

Downgrading

Cpty/Credit Risk Default risk

Downgrading

Market Risk Price risk (int. rate, ccy,

equity, commodity) Curve risk Basis risk

Correlation risk Option specific risk

Market Risk Price risk (int. rate, ccy,

equity, commodity) Curve risk Basis risk

Correlation risk Option specific risk

FinancialRisks

FinancialRisks

ENTERPRISE RISK PLATFORM ENTERPRISE RISK PLATFORM

Risk AnalysisRisk Analysis

SEVERITY

Catastrophic

IV

HAZARD PROBABILITY

Critical

Moderate

Negligible

I

II

III

Frequent Likely Occasional Seldom Unlikely

A B C D E

ExtremelyHigh

High

Medium Low

Risk AnalysisRisk Analysis

HighImpact

LowImpact

LowLikelihood

HighLikelihood

Moderate RiskMinor Risk

Major RiskModerate Risk

Lifecycle of Risk ManagementLifecycle of Risk Management

Adoption MaturityRelatively

Slower Advancement

Operational Risk

Credit Risk

Market Risk

Liquidity Risk Asset/Liability Management

Level of Develop

ment

Evolution of Risk Decision MakingEvolution of Risk Decision Making

Focus on Revenue and Cost Management

Mark-to-market

Activity-basedcosting

Transferpricing

1980s

Value atRisk

Risk-adjustedperformance

PortfolioManagement

1990s

Focus on Risk Control (historical focus)

Shareholder ValueIntegrated Risk & Profitability

2000+

Fully integratedprofitability andrisk information

Forward-looking,not just static,

management tools

Beware of Risks,

but don’t be

phobia toward

Risks…

Competency needed: Business Risk Modelling Risk Analysis tools such as: Value

at Risk (VaR), Risk Simulation, RAROC.

Career choiceCareer choice

Risk Management in Finance and Banking

This is it, class.. For those who love math and stat.

You’ll be watching clip movie Inside Job (10 min)

• This movie is about the subprime mortgage (credit default swap)

• In risk management perspective, what might go wrong?

Famous Notation in

Finance and Banking Risk Management

Famous Notation in

Finance and Banking Risk ManagementNotation List

Rev = Revenue C () = Probability of loss occurence(1 – C) = Confidence level = Normal Standard DeviationR = ReturnZ = Normal Distribution

i j = Coefficient correlation i and j

39

Different Types of Risk

• Speculative risks: Those that offer the chance of a gain as well as a loss.

• Pure risks: Those that offer only the prospect of a loss.

• Demand risks: Those associated with the demand for a firm’s products or services.

• Input risks: Those associated with a firm’s input costs.

• Financial risks: Those that result from financial transactions.

• Property risks: Those associated with loss of a firm’s productive assets.

• Personnel risk: Risks that result from human actions.

• Environmental risk: Risk associated with polluting the environment.

• Liability risks: Connected with product, service, or employee liability.

• Insurable risks: Those which typically can be covered by insurance.

40

An Approach to Risk Management

• Corporate risk management is the management of unpredictable events that would have adverse consequences for the firm.

• Firms often use the following process for managing risks.Step 1. Identify the risks faced by the firm.Step 2. Measure the potential impact of

the identified risks.Step 3. Decide how each relevant risk

should be dealt with.

41

Techniques to Minimize Risk

• Transfer risk to an insurance company by paying periodic premiums.

• Transfer functions which produce risk to third parties.• Purchase derivatives contracts to reduce input and financial

risks.• Take actions to reduce the probability of occurrence of

adverse events.• Take actions to reduce the magnitude of the loss associated

with adverse events.• Avoid the activities that give rise to risk.

42

Nature and Purpose of Trading in Financial Derivatives

• Financial risk exposure refers to the risk inherent in the financial markets due to price fluctuations.

• Hedging– Protect Value of Securities Held– Protect the Rate of Return on a Security Investment– Reduce Risk of Fluctuations in Borrowed Costs

• Speculating

43

Using Derivatives to Reduce Risk

• Commodity Price Exposure– The purchase of a commodity futures contract will allow a

firm to make a future purchase of the input at today’s price, even if the market price on the item has risen substantially in the interim.

• Security Price Exposure– The purchase of a financial futures contract will allow a

firm to make a future purchase of the security at today’s price, even if the market price on the asset has risen substantially in the interim.

44

Using Derivatives to Reduce Risk

• Foreign Exchange Exposure– The purchase of a currency futures or options contract will

allow a firm to make a future purchase of the currency at today’s price, even if the market price on the currency has risen substantially in the interim.

45

Risks to Corporations from Financial Derivatives

• Increases financial leverage

• Derivative instruments are too complex

• Risk of financial distress

Basics of VaRBasics of VaR

• Static VaR, Uncoditional variance

If FX is a random variable, observed in T period, expected FX is:

•Assuming FX is normally distributed, ( Z )

E (FX) =T

Σt =1

FX t

T

σ (FX) = Σ (FX – E(FX) 2

T - 1

( 1 )

( 2 )

Z = FX – E (FX)

σ (FX)

whichE ( Z ) = 0, σ ( Z ) = 1with P ( Z ) = 5%, maka Z = – 1,65

47

Derivative Securities

• Derivative: Security whose value stems or is derived from the value of other assets.

• Types of Derivatives– Forward– Futures– Options– Swaps

48

Forward Contracts

• An agreement where one party agrees to buy (or sell) the underlying asset at a specific future date and a price is set at the time the contract is entered into.

• Characteristics– Flexibility– Default risk– Liquidity risk

• Positions in Forwards– Long position– Short position

49

Futures Contracts

• A standardized agreement to buy or sell a specified amount of a specific asset at a fixed price in the future.

• Characteristics– Margin Deposits

• Initial margin• Maintenance margin

– Marking-To-Market– Floor Trading– Clearinghouse

50

Hedging with Futures

• Hedging: Generally conducted where a price change could negatively affect a firm’s profits.– Long hedge: Involves the purchase of a futures contract

to guard against a price increase.– Short hedge: Involves the sale of a futures contract to

protect against a price decline in commodities or financial securities.

– Perfect hedge: Occurs when gain/loss on hedge transaction exactly offsets loss/gain on unhedged position.

51

Option Contracts

• The right, but not the obligation, to buy or sell a specified asset at a specified price within a specified period of time.

• Option Terminology– Call option versus put option– Holder versus writer or grantor– Exercise or strike price– Option premium– American versus European option

• Market Arrangements

52

Swap Contracts

• Financial contracts obligating one party to exchange a set of payments it owns for another set of payments owed by another party.– Currency swaps– Interest rate swaps

• Usually used because each party prefers the terms of the other’s debt contract.

• Reduces interest rate risk or currency risk for both parties involved.

VaRVaR

•The problem is, E(FX) and σ (FX) as other financial data, most likely is not normally distributed.

• Covariance and Correlation If X1 and X2 is two random variable, the joint distribution could show correlated activity between FX, and for example interest rate (i).

Kovariance = E ( X1 – E (X1) (X2 – E (X2) ) ( 3 )

σ12 =

1T - 1

ΣT

T = 1( X1t – E (X1) ) ( X2t – E (X2) ) ( 4 )

Correlation = , ( 5 )σ12

σ1 σ2

1 1

VAR PORTOFOLIO

( 6a )VARP = - P W

σ() = Σ 2iW σ +

21

Z Σ Σ Wi Wj σiσj ij (6b)

Security risk, Daily EARSecurity risk, Daily EAR

DEaR = σ2 (Δ)

= σ2 δ σA1

ΔA1 +δ

σA2

ΔA2

1

2

= ( W Ω W1)

1

2

( 7 )

W = δ δA1

δ δA2

: ( 8 )

Ω = Var (ΔA1) Cov (ΔA1ΔA2)

Cov (ΔA1ΔA2) Var (ΔA2) ( 9 )

1

2

EWMAEWMA

This approach assumes that today’s return is affected by yesterday’s return (or some prior certain period) . The model is been used by JP Morgan by assuming mean of historical series is considered as 0 . So the model below only represent variances.

Ft+1\t = Ft\t – 1 + (1 - ) Xt (1 - ) =

Ft+1\t = (Ft-1\t – 2 + Xt-1) + Xt = 2Ft-1\t – 2 + Xt-1) + Xt = 2 (Ft-2\t – 3 + Xt-2) + Xt-1 + Xt = 3 Ft-2\t – 3 + 2Xt-2 + Xt-1 + Xt

Ft+1\t = q Xt – q + q - 1 Xt – (q – 1) + ......... 3Xt – 3 + 2 Xt – 2 + Xt – 1 + Xt

Ft+1\t = i Xt-i

q

i = 0

2 = ( 1 - ) t-1 ( rt – E (r) ) T

t = 1

"It is not the strongest species that survive,nor the most intelligent,

but the ones most responsive to change…" Charles Darwin

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