5 1 reading 42 risk management an introduction pdf

: Los Define risk management Risk management can be institutionalized enterprise-wide or individualized silo-based: Credit risk Enterprise risk management Inflation risk Interest r

y

Portfolio Management

¢ Portfolio Management — An Overview

¢ Portfolio Risk and Return — Part |

¢ Portfolio Risk and Return — Part II

¢ Basics of Portfolio Planning and Construction

¢ Risk Management — An Introduction

¢ Fintech in Investment Management

yy

: Los Define risk management

¢ What’s risk?

> Exposure to uncertainty

> Chance of loss or adverse outcome

¢ What’s risk management?

> Decisions taken to achieve maximum risk-adjusted return;

>» The overall goal is to maximize firm value;

> Risk managers follow the “Doctrine of No Surprises”

v It’s not about avoiding risks; it’s more about establishing possible future scenarios and putting in place measures to mitigate unfavorable outcomes

: Los Define risk management

Risk management can be institutionalized (enterprise-wide) or

individualized (silo-based):

Credit risk

Enterprise risk

management

Inflation risk

Interest rate risk

Silo-based: each risk is managed

.osDescribe features of a risk management framework

Establish risk management

Policies and processes

tosDescribe features of a risk management framework

Governance is the top-level system of structures and policies and risk governance ensures risk management activities align and support the overall

enterprise

It is often driven by regulatory concerns as well as the fiduciary role of the governing body

For best results, governance should take an enterprise-wide view

yy

LOS Describe features of a risk management framework

Risk identification and

measurement

¢ Environment is analyzed to identify the relevant risk factors

¢ Portfolio is analyzed to ascertain whether it is indeed exposed to the risks identified

¢ Risk metrics are calculated to size these risks under various

scenarios and stresses

tosDescribe features of a risk management framework

TH €—— Risk Infrastructure

¢ Refers to people and systems that carry out the risk management process

e May include technology solutions capable of capturing, storing, computing and reporting the necessary data as well

as skilled personnel to run this process

tosDescribe features of a risk management framework

Policies and Processes

¢ Encompass day-to-day operation and decision- making processes

tosDescribe features of a risk management framework

Risk Monitoring, Mitigation, and Management

¢ Entails continuous assessment as to whether

the existing exposure is in

line with the established risk tolerance level

> If not, action must be

taken to realign the

tosDescribe features of a risk management framework

Communication/Reports

put in place to ensure that:

> Governance parameters can be clearly

communicated to managers

> Reporting of risk metrics

to decision makers is done in a clear and timely manner

Reports must be written ina clear, easy to understand

tosDescribe features of a risk management framework

Strategic Analysis or Integration

¢ These help turn risk management into an offensive weapon to improve

performance

¢ Rigorous analysis supports better investment decisions and improves strategy and risk-adjusted returns

LosExplain how risk tolerance affects risk management

Risk tolerance identifies the extent to which the organization is

prepared to experience losses or opportunity costs in the effort to

achieve organizational objectives

¢ The risk tolerance decision requires the integration of internal

shortfalls in the organization which may cause failure as well as the external and sometimes uncertain risk drivers

¢ Determination of the risk tolerance level depends on:

> The ability to respond dynamically to changing events;

> The ability to withstand losses and remain a going concern;

> The competitive landscape; and

> The regulatory environment

¢ Personal motivations and beliefs, agendas of board members, and management compensation should not factor into the risk tolerance

determination.

LosExplain how risk tolerance affects risk management

Risk budgeting is focused on implementing the risk tolerance

decisions taken at a strategic or governance level in the day-to-day

management decision making

¢ The risk budget will quantify risk by specific metrics and allocate risk

across the organization

¢ Arisk budget may:

> Use simple risk measures such as the standard deviation, VAR,

Beta, and scenario loss

>» Use more complex risk measures such as evaluating risks by their

underlying risk classes, such as equity, fixed income, commodity risk, and so on, and then allocates investments by their risk class

yy

LosExplain how risk tolerance affects risk management

Benefits of Risk Budgeting

¢ By implementing a risk budget, a risk culture is created in which all

decisions are evaluated with a risk-return tradeoff in mind

¢ Management is, therefore, focused on adding value to the overall

enterprise when taking decisions while simultaneously remaining

within the desired risk tolerance level

Losidentify financial and non-financial sources of risk and

describe how they may interact

¢ Financial risks originate from financial markets They include:

| Market risk: which arises from movements within the financial market environment like share prices, interest rates, exchange rates, commodity prices and other economic or industry market factors

li Credit risk: the risk of loss due to the failure of one party to pay another an outstanding obligation

iti Liquidity risk: the inability to convert assets into cash without incurring significant costs

> In stressed market conditions, the seller may have to accept a price well below their perception of value

Losidentify financial and non-financial sources of risk and

describe how they may interact

Non-financial risks are from outside of the financial market

environment and could be as a result of environmental or regulatory

changes or an issue with customers or suppliers

li Legal risk: risk of suits/ litigation

ili Compliance risk: failure to adhere to laid down rules/obligations

iv Model risk: use of inappropriate models or inputs

` y

Losidentify financial and non-financial sources of risk and

describe how they may interact

v Tail risk: the likelihood or probability of a material negative

phenomena like floods and wild brazes

vil Solvency risk: risk that the company may run out of cash to

fund its operations

Losidentify financial and non-financial sources of risk and

describe how they may interact

Do financial risks and nonfinancial risks interact?

v The answer is yes

¢ In times of market stress, the correlation among financial and

nonfinancial risks increases

¢ The result? The combined risk is often far more than the "sum-of-

the-parts."

Example:

Suppose a key counterparty fails to settle an obligation in a timely

manner Settlement risk creates a solvency risk for the company

which was due to receive the proceeds In turn, they may not be able to

pay their suppliers which leads to legal risk Or, they may not meet

regulatory solvency requirements which creates compliance risk

They may need to rapidly sell assets to raise the cash creating a

liquidity risk

yy

tosDescribe methods for measuring and modifying risk

exposures and factors to consider in choosing among the

methods

Commonly used risk metrics are as follows:

Standard deviation

¢ Standard deviation (also referred to as volatility) provides a measure

of the range of potential outcomes

¢ It has limitations as a measure for financial markets as it presumes a

normal distribution of returns which is inappropriate

Beta

¢ Beta is a measure of the sensitivity of a security’s returns to the

overall market portfolio

¢ It provides an indication of systematic risk and is particularly

appropriate for equity portfolios

yy

: tosDescribe methods for measuring and modiifying risk

exposures and factors to consider in choosing among the methods

Greeks (Delta, Gamma, Vega, Rho)

¢ Commonly referred to as "the Greeks", these metrics are

appropriate for measuring the risk associated with derivative positions

> Delta measures the sensitivity to changes in the underlying price

of the asset

> Gamma measures sensitivity to changes in the delta

> Vega measures sensitivity to changes in volatility

> Rho measures sensitivity to changes in interest rates

Duration

¢ Duration is a measure of sensitivity to interest rates used for fixed-

income instruments.

tosDescribe methods for measuring and modifying risk

exposures and factors to consider in choosing among the

methods

VaR (Value at Risk)

« VaR specifies the maximum loss that could possibly be incurred at a

given level of confidence

¢ For instance, if the annual 95% VaR of a portfolio is $100 million, the

firm is said to be 95% confident that the loss incurred, if any, will not

exceed $100 million In other words, there is a 5% chance that if a

loss is experienced over the next year, it will exceed $100 million

Conditional VaR, CVaR

¢ Also called the expected shortfall, CVAR is the expected loss

beyond the VAR

¢ It's analogous to the “loss given default.”

yy

tosDescribe methods for measuring and modifying risk

exposures and factors to consider in choosing among the

> The firm accepts and attempts to mitigate the risk, usually

through the use of derivatives

yy

> Fintech in Investment Management

yy