Académique Documents
Professionnel Documents
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Classifications of Risks
Risk
Business Risks
Financial Risks
Market Risk
()
Absolute risk
Relative risk
Directional risks
Non-directional risks
Basis risk
Volatility risk
Measured by VAR
Credit Risk
()
Operational Risk
()
Probability of Default
Credit Exposure
Loss Given Default
Model risk
People risk
Legal risk
Liquidity Risk
()
Market Risk
Market risk is the risk that declining prices or volatility of prices in the
financial markets will result in a loss.
Types
Absolute Risk
Relative risk
Directional risks
Non-Directional
risks
Basis risk
Volatility risk
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Definition
Measured in terms of shortfall relative to the initial value of the
investment and focuses on the volatility of total returns.
Measured in terms of shortfall relative to a benchmark (e.g.
market index).
Involve exposures to the direction of movements in major
financial Market variables. These directional exposures are
measured by first order or linear approximations.
Are risks that have non-linear exposures or neutral exposures to
changes in economic or financial variables
The risk that the price of a hedging instrument and the price of
the asset being hedged are nor perfectly correlated.
Risk of loss from changes in actual or implied volatility of
market prices.
FRMFinancial Risk Manager
Credit Risk
Credit risk is the risk of an economic loss from the failure of a counterparty to
fulfill its contractual obligations.
Probability of Default
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Credit Exposure
Operational Risk
Operational risk is the risk of loss due to inadequate monitoring systems,
management failure, defective controls, fraud, and /or human errors.
Types
Definition
Model Risk The risk of loss due to the use of misspecified or misapplied models. For
example, an institution buying or selling collateralized mortgage
obligations (CMOs) may be exposed to model risk if the model used to
price the CMOs does not adequately account for the probability of
default in the underlying mortgages.
People Risk The risk associated with fraud perpetrated by internal employees and / or
external individuals. An example of people risk is a rogue trader.
Legal Risk
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The risk of a loss in value due to legal issues including lawsuits, fines,
penalties, and /or damages.
Liquidity Risk
The term liquidity has been defined in myriad ways that ultimately boil
down to two properties, asset liquidity risk, a property of assets or
markets, and funding liquidity, which is more closely related to creditworthiness.
Asset liquidity risk (also called market liquidity risk) results from a
large position size forcing transactions to influence the price of
securities.
Funding liquidity risk (also called cash-flow risk) refers to the risk
that a financial institution will be unable to raise the cash necessary to
roll over its debt; to fulfill the cash, margin, or collateral requirements
of counterparties; or to meet capital withdrawals.
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Risk Profile
Risk profile: the list, with all of the risks that a firm is potentially
exposed to and categorizing these risks into groups, is called a risk
profile.
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Risk Governance
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Example
B.
C.
D.
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Answer D
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CFt
NPV
t
(1
r)
t 0
where:
CFt: the expected net cash flow at time t
N: the estimated life of the investment
r: the discount rate (cost of capital)
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WACC
cos t of capital = cost of equtiy
equity
debt
cos t of debt
debt equity
debt equity
Where:
cost of equity = risk-free rate + beta equity market premium
cost of debt = cost of borrowing(1- marginal tax rate)
cost of borrowing = risk-free rate + default spread
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Example
Use the following information to answer the following Questions:
Reid, Inc. is embarking on a new 4-year project in a foreign country with a
country risk premium of 4%. Expected incremental annual cash flows from this
project (assuming all cash flows occur at the end of the year) are as follows:
Year
Cash Flow
0
-$2.0 million
1
-$1.75 million
2
-$0.5 million
3
+$0.4 million
4
+$2.6 million
The terminal value of the project in year 4 is $2 million. Reids relevant risk-free
rate is 3%, and the beta of the new project is 1.1. The market risk premium is 5%.
Reids credit rating lends itself to a 3.5% default spread, and its marginal
corporate tax rate is 32%. The firms capital structure consists of a 45% debt and
55% equity funding mix.
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Example
Example
2
3
4
1.0908 1.0908 1.0908 1.0908 1.09084
0.4671 million = - $467,100
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E ( Ri ) R f i E ( RM ) R f =2.25%+1.67 4.70%=10.1%
V
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About Beta
Debt
Levered(Equity) Beta = Unlevered Beta 1 1 tax rate
Equity
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risk
analysis
Step2: risk
assessment
AIRMIC
risk
manageme
nt process
risk estimation
purely
qualitative
semiquantitative
purely
quantitative
risk evaluation
scenario analysis
decision tree
simulation
Value at Risk (VaR)
risk avoidance
Step3: risk
treatment
risk transfer
risk reduction
risk retention
sensitivity analysis
Risk Estimation
1.
Purely Qualitative
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Risk Estimation
2.
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Semi-Quantitative
The semi-quantitative estimate method
transforms a series of qualitative
judgments into quantitative variables,
using numerical scoring systems to arrive
at a risk score a numerical synthetic
risk judgment.
For example The risk severity is
determined by multiplying the probability
score by the impact score.
An event that is probable and would have
severe impact on the corporation will
score 50 x 200 = 1000; so this risk score
is high.
Example
Risk avoidance.
B.
Risk transfer.
C.
Risk retention.
D.
Risk reduction.
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FRM
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