Lecture 1: introduction to risk management
Risk management
“There is no such thing as a return without risk”
Risks: necessary to generate return.
ð True in business, in investing, when buying a house, etc
ð Through risk management, try to understand the risk involved in running a business, identify the amount
of risk you are willing to take and manage the risk.
ð Trying to understand how much risk you’re running, and if you’re okay with it (risk appetite) → doesn’t
eliminate risk
Rely on a fixed process → identify, measure, manage, monitor, and report on risks.
1. Risk management process
Risk appetite: something banks needs to do, how much risk are they willing
to take.
ð Translate yes-or-no questions in numbers.
ð Identifying the risks you’re taking & how to manage them.
2. Identifying risks
Financial risk: from financial markets, changes in prices and interest rates.
ð Comes from participating in the financial markets.
ð If everybody behaves like they should then you can still have financial risk.
ð Market risk: risk of losses due to adverse movements in stock prices, interest rates, exchange rates,
commodities prices, etc.
ð Credit risk: risk of losses due to counterparty not being able to pay back.
ð Liquidity risk: risk unable to buy or sell assets due to lack of market participants.
Non-financial risk:
ð Everything else, can still have major financial consquences.
ð People/ prophesis are not sure.
ð Deals with imperfect humans, ex. internal fraud.
ð Residual risk: can still have major financial consequences.
ð Operational risk: risk of losses due to inadequate internal processes, people and systems, or from
external events.
o Internal/external fraud
o Cyber risk
1
, o Legal risk
o Country risk
o Model risk
ð Reputation risk: risk of losses due to damages in reputation.
From Deloitte Global Risk Management Survey:
ð Most financial institutions now have proper risk management framework in place for financial risks.
ð Nonfinancial risks are becoming more important.
ð How many of you take this type of risk in account?
3. Measuring financial risks
What exactly is risk? → Not the same as uncertainty
ð Risk means that your outcome is uncertain.
ð Uncertainty and risk aren’t necessarily the same.
ð No known knowns.
ð Known unkowns = things that we don’t know that we don’t know.
Donald Rumsfeld: (former Secretary of Defense in the U.S.).
“There are known knowns. These are things we know that we know. There are known unknowns. That is to say,
there are things that we know we don’t know. But there are also unknown unknowns. These are things we don’t
know we don’t know.”
ð Example:
o You own shares in AB-Inbev currently worth €49.94.
o Tomorrow, there are two states of the world, each with 50% probability:
o The risk in owning this share is that tomorrow it is worth either €30.00 or €80.00, and your
investment might lose value.
Uncertainty is an unknown unknown:
ð Don’t know how many states there are.
ð Their probability (attached to each of these states).
ð Their pay-off.
ð Uncertainty is a fact of life, something we can’t do anything about it, is much more consequential than
risk (because you can’t manage it).
Or, as Frank Knight (UChicago) put it:
“Uncertainty must be taken in a sense radically distinct from the familiar notion of risk, from which it has never
been properly separated.... The essential fact is that 'risk' means in some cases a quantity susceptible of
measurement, while at other times it is something distinctly not of this character; and there are far- reaching and
2
,crucial differences in the bearings of the phenomena depending on which of the two is really present and
operating.... It will appear that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far
different from an unmeasurable one that it is not in effect an uncertainty at all.”
Risk measurement:
ð Shed some light on the unknown unknowns, to potentially make them known unknowns.
ð Quantify the known unknowns.
ð Using statistical and econometric methods.
4. Managing risks
Once financial risks are quantified, need tools to manage risks:
ð Derivative instruments:
o Contracts whose value is derived from an underlying asset.
o Futures, forwards, swaps, options, credit default swaps, etc.
o Outstanding (notional) derivatives market is >730 trillion dollar, roughly 3 times larger than the
bond (145 trillion dollar) and equity market (126 trillion dollar) combined!
o Mainly interest rate and foreign exchange rate derivatives.
5. Monitor risks
3 lines of defense:
ð 1st line: front office → internal risk limits.
ð 2nd line: risk management → central risk controls.
ð 3rd line: internal audits.
Senior management sets the risk appetite that they feel comfortable with.
6. Reporting risks
Monitoring and measuring of risks need to be reported to the board of directors.
Most Financial Institutions have a Chief Risk Officer in the board.
Dual purpose:
1) Board of directors need a risk appetite framework in place before taking the risks.
2) Board of directors need to be informed on the current risks (and risk exceedances).
3
, Firms have become more skilled at managing financial risks:
ð Challenges for risk management in the future:
o Incorporating non-financial risks
o Hiring and developing talent
o New ‘uncertainties’ in the world
o Geopolitical risk
o Trade uncertainties
o Climate
o Changing business models
o …
ð But there is always a trade-off between risk and return.
Interest rates
1. Valuing financial assets
Valuing financial assets is important in risk management:
ð To know value of your investment
ð To know how expensive it would be to hedge/manage risks
ð Etc.
2 ways to determine fair value of any financial asset:
1) Discounted cash flow approach
a. Bonds
b. Stocks
c. Derivatives
2) Arbitrage price / replicating portfolio approach
Discounted cash flow approach estimates value of asset/investment as the present value of expected future
cash flows using a discount (interest) rate.
2. Interest rates
Interest rate: the price to convert future money to today’s money, and the other way around.
ð “Time value of money”
ð Moving money across time
o €100 today is not same €100 as next year!
o If we deposit €100 today, it is worth more next year
ð Why?
o Can obtain a (risk-free) interest on it!
4
Risk management
“There is no such thing as a return without risk”
Risks: necessary to generate return.
ð True in business, in investing, when buying a house, etc
ð Through risk management, try to understand the risk involved in running a business, identify the amount
of risk you are willing to take and manage the risk.
ð Trying to understand how much risk you’re running, and if you’re okay with it (risk appetite) → doesn’t
eliminate risk
Rely on a fixed process → identify, measure, manage, monitor, and report on risks.
1. Risk management process
Risk appetite: something banks needs to do, how much risk are they willing
to take.
ð Translate yes-or-no questions in numbers.
ð Identifying the risks you’re taking & how to manage them.
2. Identifying risks
Financial risk: from financial markets, changes in prices and interest rates.
ð Comes from participating in the financial markets.
ð If everybody behaves like they should then you can still have financial risk.
ð Market risk: risk of losses due to adverse movements in stock prices, interest rates, exchange rates,
commodities prices, etc.
ð Credit risk: risk of losses due to counterparty not being able to pay back.
ð Liquidity risk: risk unable to buy or sell assets due to lack of market participants.
Non-financial risk:
ð Everything else, can still have major financial consquences.
ð People/ prophesis are not sure.
ð Deals with imperfect humans, ex. internal fraud.
ð Residual risk: can still have major financial consequences.
ð Operational risk: risk of losses due to inadequate internal processes, people and systems, or from
external events.
o Internal/external fraud
o Cyber risk
1
, o Legal risk
o Country risk
o Model risk
ð Reputation risk: risk of losses due to damages in reputation.
From Deloitte Global Risk Management Survey:
ð Most financial institutions now have proper risk management framework in place for financial risks.
ð Nonfinancial risks are becoming more important.
ð How many of you take this type of risk in account?
3. Measuring financial risks
What exactly is risk? → Not the same as uncertainty
ð Risk means that your outcome is uncertain.
ð Uncertainty and risk aren’t necessarily the same.
ð No known knowns.
ð Known unkowns = things that we don’t know that we don’t know.
Donald Rumsfeld: (former Secretary of Defense in the U.S.).
“There are known knowns. These are things we know that we know. There are known unknowns. That is to say,
there are things that we know we don’t know. But there are also unknown unknowns. These are things we don’t
know we don’t know.”
ð Example:
o You own shares in AB-Inbev currently worth €49.94.
o Tomorrow, there are two states of the world, each with 50% probability:
o The risk in owning this share is that tomorrow it is worth either €30.00 or €80.00, and your
investment might lose value.
Uncertainty is an unknown unknown:
ð Don’t know how many states there are.
ð Their probability (attached to each of these states).
ð Their pay-off.
ð Uncertainty is a fact of life, something we can’t do anything about it, is much more consequential than
risk (because you can’t manage it).
Or, as Frank Knight (UChicago) put it:
“Uncertainty must be taken in a sense radically distinct from the familiar notion of risk, from which it has never
been properly separated.... The essential fact is that 'risk' means in some cases a quantity susceptible of
measurement, while at other times it is something distinctly not of this character; and there are far- reaching and
2
,crucial differences in the bearings of the phenomena depending on which of the two is really present and
operating.... It will appear that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far
different from an unmeasurable one that it is not in effect an uncertainty at all.”
Risk measurement:
ð Shed some light on the unknown unknowns, to potentially make them known unknowns.
ð Quantify the known unknowns.
ð Using statistical and econometric methods.
4. Managing risks
Once financial risks are quantified, need tools to manage risks:
ð Derivative instruments:
o Contracts whose value is derived from an underlying asset.
o Futures, forwards, swaps, options, credit default swaps, etc.
o Outstanding (notional) derivatives market is >730 trillion dollar, roughly 3 times larger than the
bond (145 trillion dollar) and equity market (126 trillion dollar) combined!
o Mainly interest rate and foreign exchange rate derivatives.
5. Monitor risks
3 lines of defense:
ð 1st line: front office → internal risk limits.
ð 2nd line: risk management → central risk controls.
ð 3rd line: internal audits.
Senior management sets the risk appetite that they feel comfortable with.
6. Reporting risks
Monitoring and measuring of risks need to be reported to the board of directors.
Most Financial Institutions have a Chief Risk Officer in the board.
Dual purpose:
1) Board of directors need a risk appetite framework in place before taking the risks.
2) Board of directors need to be informed on the current risks (and risk exceedances).
3
, Firms have become more skilled at managing financial risks:
ð Challenges for risk management in the future:
o Incorporating non-financial risks
o Hiring and developing talent
o New ‘uncertainties’ in the world
o Geopolitical risk
o Trade uncertainties
o Climate
o Changing business models
o …
ð But there is always a trade-off between risk and return.
Interest rates
1. Valuing financial assets
Valuing financial assets is important in risk management:
ð To know value of your investment
ð To know how expensive it would be to hedge/manage risks
ð Etc.
2 ways to determine fair value of any financial asset:
1) Discounted cash flow approach
a. Bonds
b. Stocks
c. Derivatives
2) Arbitrage price / replicating portfolio approach
Discounted cash flow approach estimates value of asset/investment as the present value of expected future
cash flows using a discount (interest) rate.
2. Interest rates
Interest rate: the price to convert future money to today’s money, and the other way around.
ð “Time value of money”
ð Moving money across time
o €100 today is not same €100 as next year!
o If we deposit €100 today, it is worth more next year
ð Why?
o Can obtain a (risk-free) interest on it!
4
