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Risk management FIN 404/BBA

Risk management is a structured approach to managing uncertainty related to a threat, a sequence of human activities including: risk assessment, strategies development to manage it, and mitigation of risk using managerial resources. The strategies include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a particular risk. Some traditional risk managements are focused on risks stemming from physical or legal causes (e.g. natural disasters or fires, accidents, ergonomics, death and lawsuits). Financial risk management, on the other hand, focuses on risks that can be managed using traded financial instruments. Principles of Risk Management: The International Standards Organization identifies the following principles of risk management:

Risk management should create value. Risk management should be an integral part of organizational processes. Risk management should be part of decision making. Risk management should explicitly address uncertainty. Risk management should be systematic and structured. Risk management should be based on the best available information. Risk management should be tailored. Risk management should take into account human factors. Risk management should be transparent and inclusive. Risk management should be dynamic, iterative and responsive to change. Risk Management should be capable of continual improvement and enhancement

The Process: The process of risk management consists of several steps as follows: Establish the context: Establishing the context involves 1. Identification of risk in a selected domain of interest 2. Planning the remainder of the process. 3. Mapping out the following: o the social scope of risk management o the identity and objectives of stakeholders o the basis upon which risks will be evaluated, constraints.

4. Defining a framework for the activity and an agenda for identification. 5. Developing an analysis of risks involved in the process. 6. Mitigation of risks using available technological, human and organizational resources. Identification: After establishing the context, the next step in the process of managing risk is to identify potential risks. Risks are about events that, when triggered, cause problems. Hence, risk identification can start with the source of problems, or with the problem itself.

Source analysis Risk sources may be internal or external to the system that is the target of risk management. Examples of risk sources are: stakeholders of a project, employees of a company or the weather over an airport. Problem analysis Risks are related to identified threats. For example: the threat of losing money, the threat of abuse of privacy information or the threat of accidents and casualties. The threats may exist with various entities, most important with shareholders, customers and legislative bodies such as the government.

Risk management plan: Most critically, risk management plans include a risk strategy. Broadly, there are four potential strategies, with numerous variations. Projects may choose to:

Accept risk; simply take the chance that the negative impact will be incurred Avoid risk; changing plans in order to prevent the problem from arising Mitigate risk; lessening its impact through intermediate steps Transfer risk; outsource risk to a capable third party that can manage the outcome

Financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly Credit risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc. Similar to general risk management, financial risk management requires identifying its sources, measuring it, and plans to address them. As a specialization of risk management, financial risk management focuses on when and how to hedge using financial instruments to manage costly exposures to risk. a) Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit (either the principal or interest (coupon) or both)

b) Market risk is the risk that the value of an investment will decrease due to moves in market factors. The five standard market risk factors are:

Equity risk, the risk that stock prices will change. Interest rate risk, the risk that interest rates will change. Currency risk, the risk that foreign exchange rates will change. Commodity risk, the risk that commodity prices (e.g. grains, metals) will change. Credit risk, the risk that a loan will not be paid back.

Insurance and finance risk modeling We introduce some techniques that have been developed in insurance and finance risk modelling. Insurance and finance analysts have placed a lot of emphasis on finding numerical solutions to stochastic problems - something that is highly desirable because it gives more immediate and accurate answers than Monte Carlo simulation. We show some modelling techniques to give you a flavour of what can be done. Notice that the insurance and finance domains frequently share common principles in modeling. Two other types of risk are noteworthy but not covered in separate topics: a) market risk and b) liquidity risk. So we'll touch upon them only briefly. Market risk Market risk concerns equity, interest rate, currency and commodity risks. Liquidity risk Liquidity risk concerns a party who is an owner, or is considering becoming an owner, of an asset, and is unable to trade the asset at its proper value (or at all) because nobody in the market is interested.

Measures of risk - Value at Risk


Value at Risk (VaR) is defined as the amount which, over a predefined amount of time, losses won't exceed at a specified confidence level. As such,

VaR represents a worst-case scenario at a particular confidence level. It does not include the time value of money, as there is no discount rate applied to each period's cashflows. VaR is very easy to calculate using Monte Carlo simulation on a cashflow model.

The main problem with VaR is that it is not subadditive (Embrechts, 2000) meaning that it is possible to design two portfolios, X and Y, in such a way that VaR (X + Y) > VaR(X) + VaR(Y). For example: Consider a defaultable corporate bond. A bond is a contract of debt: the corporation owes to the bond holder an amount called the face value of the bond and has to pay at a certain time - unless they go bust in which case they default and the bond holder gets nothing. Let's say that the probability of default is 1%, the face value is $100 and the current price of the bond is $98.5. If you buy this bond, the total cashflow at exercise can be modelled using a Bernoulli distribution: Bernoulli (99%)*$100 - $98.5 i.e. a 1% chance of -$98.5 and a 99% chance of $1.50: a mean of $0.50. You could buy 50 such bonds for the same company which means that you will either get 50*$100 or nothing, i.e. a cashflow of: (Bernoulli (99%)*$100 - $98.5) * 50 With a mean of $25. Alternatively, perhaps you could buy 50 bonds with the same face value and default probability but each with different companies that have no connection between them so the default events are completely independent, in which case your cashflow is: Binomial (50, 99%)*$100 - $98.5*50 But has the same mean of $25. Obviously the latter is less risky since one would expect most bonds to be honoured. This figure plots the two cumulative distributions of revenue together.

Premium calculations
Imagine that we are insuring a policyholder against the total damage X that might be accrued in automobile accidents over a year. The number of accidents the policyholder might have is modelled as Plya(0.26,0.73). The damages incurred in any one accident is $Lognormal(300, 50). The insurer has to determine the premium to be charged. The premium must be at least greater than the expected payout E[X] otherwise, according to the law of large numbers; in the long run the insurer will be ruined. The expected payout is the product of the expected values of the Plya and Lognormal distributions: in this case = 0.1898 * $300 = $56.94. The question is then: how much more should the premium be over the expected value? Actuaries have a variety of methods to determine the premium. Four of the most common methods are listed below.

Expected value principle


This calculates the premium in excess of E[X] as some fraction of E[X]:
Premium =

>0

Ignoring administration costs represents the return the insurer is getting over the expected capital required E[X] to cover the risk. This method is implemented in Model Risk with the VosePrincipleEV function.

Integrated Risk Management


Increasingly, firms are finding that the simultaneous use of tools and techniques from insurance and the finance can greatly enhance the value of their risk management efforts. A number of books have been written about the subject of integrated risk management, including Doherty's 'Integrated Risk Management' (2000, McGraw-Hill).

Example 1
You are CRO (Chief Risk Officer) of a non-financial firm that is exposed to two types of risk: 1. 2. Price and volume risk (market risk) - depending on average temperature during the year. Risk for accidents (operational risk)

Currently, your company does not hedge for the market risk, nor has insurance against the operational risk. You are asked to evaluate the following options: 1. 2. 3. 4. Do nothing; Hedge against all the price risk; Take insurance against all accidents; Combine both.

As the goal of this example is to illustrate some of the methods used in integrated risk management and their value added, the examples are kept fairly simple. However, even though a real world example would be more complicated and likely involve more factors, the same techniques, methods and tools would apply. Input Weather Average temperature Warm 25 Average sales 125000 Market risk Average price/unit $50 Average cost/unit $20 Fire risk Average per year 12.0 Average loss per event $200,000

year Cool year Sales Volume The expected sales volume is 125,000 with a standard deviation of 10%, which we can model as lognormal(125000, 12500). Market risk - Price and Cost per unit of product Both sales price and costs per unit of product depend on the average temperature of the year, which is assumed to be minimum 15, most likely 20 and maximum 25 Celsius. The related sales price and costs per unit are shown in the figure above. A linear relationship is assumed between the average temperature during the year and the sales price and costs per unit of product (in reality, there would be uncertainty about this relationship which, for simplicity reasons, we ignore here). Fire risk Recent independent research has revealed that the expected number of fires occurring per year is an increasing function of the average temperature for that year. In addition, the losses per fire (event) increase with the average temperature during the year. Again, a linear relationship is assumed between the average temperature during the year and the number and size of the fires. Decision option You are asked to evaluate whether the company should hedge against the price risk, obtain insurance against the fire risk or do both. Your bank has quoted a price of $25,000 to hedge against the price risk. In addition, you can assume that the yearly cost of insurance is equal to the expected losses per year, and that the coverage is 90% of you losses. . Discussion Example model Integrated Risk Management provides a solution to the problem. There are several issues in this model that require special attention: The expected number of fires per year (lambda) is a rate. The actual number of fires in any one year can therefore be modelled with a Poisson distribution, with lambda equal to the expected number of fires given a certain average temperature over the year. From the input data we can see that both risks have actually some correlated effect. In other words, with high temperatures we have bigger margins on our products, but we also have on average more fires that are also on average larger. In this example, we assume that the risk premium is equal to the expected losses (i.e. the insurance company makes an expected 10% profit, as they only pay out 90% of the losses). To do this, a simulation is run on Cell C31 15 125000 $33 $20 2.4 $100,000

which calculates the total cost of fires; the mean value is then placed in Cell F16 and the model run again.

Weather Average Temp C 25.00 C 15.00 minimum C 15.00 Av. Price/unit $50 $33 most likely C 20.00

Market Risk Av. Costs/unit $20 Same maximum C 25.00 INSURANCE ONLY Premium Coverage Paid by insurance Net profits HEDGING ONLY Costs hedging Price hedged # units hedged Revenues hedge Net profits

Fire Risk Average/yr 12.0 2.4 Av Loss/event $200,000 $100,000

Warmest summer Coolest summer

Weather

GENERAL CALCULATIONS

Average sales Mea = 125,000 Stdev = 10%

Average Temperature Sales (units) Price/unit Costs/unit Revenues Costs Profits excl. loss

#NAME? #NAME? #VALUE! $20.00 #NAME? #NAME? #NAME?

$1,113,811 90% #NAME? Mean #NAME?

NO INSURANCE OR HEDGE Average Nr Accidents Average Loss/event Fires Cost of fires Net profits Fire # 1 2 3 4 5 6 7 8 #VALUE! #VALUE! #NAME? #NAME? #NAME? Cost #NAME? #NAME? #NAME? #NAME? #NAME? #NAME? #NAME? #NAME?

$25,000 $42 125000 #VALUE! #NAME?

BOTH INSURANCE AND HEDGE Net profits #NAME?

LIMITED INSURANCE Insurance against losses > Premium ** = Paid by insurance Net profits

$1,000,000 $309,000 #NAME? #NAME? (expected losses) Mean

LIMITED INSURANCE + HEDGE

9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

#NAME? #NAME? #NAME? #NAME? #NAME? #NAME? #NAME? #NAME? #NAME? #NAME? #NAME? #NAME? #NAME? #NAME? #NAME? #NAME? #NAME?

Net profits

#NAME?

** Calculating premium limited insurance Losses Expected payout #NAME? Mean(F48)

Given Lambda, the number of fires/yr will not likely exceed 25

In conclusion, this very simplified example shows that it is important to consider all risks related to a company in an integrated way. Ignoring the relationships between risks can result in making wrong decisions as shown above with the hedging strategy. Finally, there are addition ways to determine the optimal insurance and hedging scenario, but these go beyond the scope of this illustrative example.