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PORTFOLIO

MANAGEMENT & RISK

RISK MANAGEMENT

Paris - ISC
November 2007
Hermin Hologan, CFA

Paris – Institut Supérieur de Commerce


Risk Management –
PORTFOLIO INVESTMENTS

Contents
1
Introduction – Learning Outcome Statements

2
Risk Management Defintion and
Process
3
Sources of Risks

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Risk Management – PORTFOLIO
INVESTMENTS

Contents
4
Enterprise wide Risk Management

5
Q&A

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1
Introduction –
Learning Outcomes

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Learning Outcome
Statements
After completing this chapter, you will be able to do the
following :
 Define Risk Management  Explain how liquidity is a
source of financial risk
 Explain why risk should be
managed, and describe the  Discuss Market Risk
general process of risk  Explain how Risk Management
management relates to performances
 Discuss risk governance and evaluation
risk budgeting  Discuss the benefits of
 Describe the source of Enterprise-wide Risk
financial risk, and distinguish Management (ERM)
between financial and  Describe the main features of
non-inancial risks an ERM system

 Describe de sources of
nonfinancial
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2
Risk Management
Defintion and
Process

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Executive Summary

Managing risk can increase the value of a firm


by stabilizing income.
 The stabilization of income can lower taxes and cost of
capital.

Risk management is important to governments and both


profit and nonprofit firms.

Three important introductory concepts to all these entities are :


– Defining risk management,
– Understanding the sources of risk, and
– Understanding why and how risk can be managed.

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Define Risk Management

For a firm, the process of risk management has


several parts:

– Identify the desired level of risk


– Determine the current level of risk
– Bring the current level of risk in line with the desired level
– Monitor the risk exposure to keep it in line with the desired
level
– After the process to reflect new information, policies and
preferences.

The risk exposure of the firm can be broken into two


main categories :
– Financial risk
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– Non Financial risk
Explain why risk should be managed and described the
general process
of risk management (cont’d)
Stable earnings streams are less likely to jump into higher tax
brackets. The stable
earnings :

– Make the company appear more attractive to potential


creditors
– The firm can borrow at lower cost of capital
– Take on more projects with the positive NPV
– Increase its value
 Risk Management is a journey and not a destination :
– The firm must continually watch over its risk management
activities
– The general process of risk management include the 5
steps plus identifying and
pricing the appropriate transactions.
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Discuss Risk governance and Risk budgeting

 Risk governance is the process of setting policies and


standards to manage risk. It
is generally agreed that upper level management has this
responsibility.

Risk governance begins with organizational structure. It can


either be centralized or
decentralized.

Decentralized risk governance allows the individuals units to


micro-manage their
respective risk exposures.

The centralized approach to risk management is also called


firmwide risk management
or Entreprise Risk Management (ERM)

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Discuss Risk governance and Risk budgeting (cont”d)

 Risk budgeting : Many firms have adopted Risk budgeting,


which essentially means
setting a maximum amount of risk for a given firm or unit
within a firm.

The level of risk would be a function of the size of the operation


(e.g. the amount of
capital under management)

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3
Sources of Risks

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Describe the source of financial risk, and distinguish between
financial and
nonfinancial risks
Non financial risk are often related to unexpected
operating problems.

They can also be associated with :


– Financial assets, such as the market mechanisms through
which financial transactions take place

– The decision-making processes employed in making


financial decisions

– Changes in local and federal government policies and


regulations (e.g taxes, required accounting disclosures…)

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Describe the source of financial risk, and distinguish between
financial and
non-financial risks (cont’d)
Financial risk are usually associated with transactions with
others parties. The six sources of financial risk are :

– Liquidity risk
– Credit risk
– Commodity risk
– Equity prices
– Exchanges rates
– Interest rate

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Describe the sources of nonfinancial risk

 As we have six sources of financial risk, we also have six


sources of nonfinancial risk

– Operations risk : include employee errors and fraud, computer


breakdowns, and “acts of God” such as fire. It’s can also include
terrorist's acts. Managers can address those risk with a good
internal controls, insurance contracts to cover risks that are
outside a firm’s control.

– Model risk : arise from using wrong model or improperly using


the correct model for pricing a derivative position for example

– Settlement risk : occurs when there are two-way cash flows


between parties in an agreement such as a swap, and one party
defaults just as the other party is making a payment. Netting
reduce settlement risk, so it is relatively low in the case of a plain-
vanilla interest-rate swap.
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Describe the sources of nonfinancial risk (cont’d)

– Regulatory risk : refers to the risk that a loss that can occur
from a change in regulation. There is a regulatory risk from
owning land where the law concerning how the land may be used
could change.

– Legal risk : is a major concern of dealers who write many OTC


derivatives contracts. It is usually associated with the possibility of
a counterparty in an agreement repudiating its obligation based
upon some legal technicality (i.e that the counterparty did not
have the right to enter into the agreement in the first place)

– Accounting risk : arises from the misrepresentation of the true


economic information in the accounting statements. Accounting
risk is high in the case of derivatives because there is currently
some controversy about how to report changes in derivatives
positions.
16 An other source of accounting Paris
risk is– from
Institutthe fact that
Supérieur de accounting
Commerce
standards vary from country to country.
Explain how liquidity is a source of financial risk

Liquidity refers to loss in revenue from selling illiquid asset. Sellers


usually face the most
liquidity risk because potential buyers who desire a given asset can
often find a substitute
if the specific asset is not available.

 Derivatives may not be able to help protect against liquidity risk


because if the market
for the asset is illiquid, then the derivative market for the asset is
likely to be illiquid as
well.

 Asset bid/ask spreads are a good measure of liquidity risk, which


can change over
time to reflect relative interest in the asset.

 An option with a long maturity that is well out of the money, for
example, might have a
very wide spread. As time passes and/or the option becomes in
the money, the spread
could fall dramatically.
Spread can widen, too, and this can catch a risk manager off-
guard if liquidity risk is not Paris – Institut Supérieur de Commerce
17
monitored.
Discuss Market risk

Market risk is usually associated with the potential change of


value in an asset or
derivative in response to a change in some basic source of
uncertainty.

Three of the six sources of risk mentioned earlier fall under the
category of market
risk :

– Interest rate risk


– Exchange rate risk
– Equity prices

Obviously, the value of a portfolio will change as the prices of


the stocks in the portfolio
Change and changes in stock prices also affect the values of
derivatives. Interest rates
are a basic source of uncertainty for bonds and other fixed-
income assets. Changes in
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exchange rates can affect the values of equity, bond, and
derivatives positions.
4
Enterprise wide Risk
Management

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Explain how risk management relates to performance
evaluation
It is generally agreed that any performance measure must have
an adjustment of the
risk assumed.

– This might be as simple as imposing a penalty on the


return such as subtracting
from the return an amount that is commensurate with the
risk assumed in
achieving the return.

– Such an approach is now being applied to the performance


of nonfinancial firms
and activities.

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Discuss the benefits of Entreprise-wide Risk Management
(ERM)
ERM is an attempt to manage all types of risk across all
business units of the firm.

The benefits of an ERM system are directly proportional to the


complexity of the firm.
Some of the benefits are :

– Major enhancement to risk-return analysis


With the improvement in risk reporting associated with
an ERM system, the
quality of risk return analysis is greatly improved.

– Improved decision making at all levels


With an ERM system, all decision makers are better-
informed regarding risk
across other business units and at the firm level. Thus,
coordination across all
21 levels of management is more
Paris –efficient.
Institut Supérieur de Commerce
Discuss the benefits of Entreprise-wide Risk Management
(cont”d)
– Improved allocation of capital
With an ERM system, the computation of risk, and
therefore the computation of
expected risk-adjusted marginal returns is improved,
thus providing for better
allocation decisions.
– Enhanced data collection and analysis
An ERM system imposes discipline on the firm with the
respect to data
collection
– Ensures consistency in measurement and processing,
– Highlights gaps and other data problems
– Facilitates auditing and monitoring
– Reduces the likelihood of human error or fraud
– Enhances marginal control over business units with the
respect to risk.
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Discuss the benefits of Entreprise-wide Risk Management
(cont”d)
– Enhanced information available to market
participants

With an ERM system, firms are better able to


communicate to the market their
risk exposure and hedging status to the investing public.

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Describe the main features of an ERM System

The 4 main features of an ERM system are :

– Centralized Data Storage

– The first step in creating an ERM system is the creation on


“one-stop” shopping, i.e a centralized storage system that
allows access to all position, credit, and transactions data.
Once the data has been centralized it needs to be
standardized and cleaned.

– Data Analysis

– Once the data has been centralized, the next step is to put it
to work. Management needs to be able to properly analyze
the data through several value at risk (VaR) methodologies,
for example.

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Describe the main features of an ERM System (cont’d)

– Continual Monitoring and Updating

– The third step is to ensure that the system output gets to the
proper monitors who continually evaluate it as well as look
for new or different data necessary for successful
monitoring.
This would include the ability to easily identify data
problems, identify position limit violation, perform
diagnostics on pricing….

– Dissemination of the Analysis

– The system must provide the means for disseminating the


analysis to the appropriate personnel.
This allows the decision makers to take corrective actions
where necessary or to allocate resources for efficiently.

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5
Q&A

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