# Risk Management

Narintra Tinnarathsakulchai 494 55708 29
Outline
• Introduction to risk
– What is risk?
– Why manage risks?
– Types of risk
• Risk Management
• Policy tools for risk management
What is risk?
• The combination of the probability of an event
and its consequences
How does risk occur?
• State of the world = Uncertainty
• Asymmetric information
– Moral hazard
1. You think you would earn 10,000 baht
everyday for 1 month
= 300,000 baht per month
2. But, first 10 days you earn 12,000 baht.
Next 10 days you earn 10,000 baht.
Last 10 days you earn 5,000 baht.
= 270,000 baht at the end of the month
* Risk may lead to less actual income than that
you expect.
How does risk affect us?
1. Risk Neutral = Prefer fair game
Risk Preference
Probability Return
0.20 +50
0.60 0
0.20 -50
E(R) = 0.2×50 - 0.6×0 - 0.2×50 = 0
Utility
Outcome
2. Risk Lover = Prefer negative outcome game
Probability Return
0.20 +100
0.60 -20
0.20 -50
E(R) = 0.2×100 - 0.6×20 - 0.2×50 = -2
Utility
Outcome
3. Risk Averse = Prefer positive outcome game
Risk Preference
Probability Return
0.20 +60
0.60 +10
0.20 -40
E(R) = 0.2×60 + 0.6×10 - 0.2×40 = 1
Utility
Outcome
• This one is the assumption of all risk related theory.
• Since people are risk averse, riskier alternatives
should provide risk premium to draw community’s
interest.
Recall the interest parity;
See when risk premium (u) rises, given the
world interest rate constant, the interest rate in
the country must be higher. That means the
cost of borrowing in the country will rise, and
total income of the economy will decrease.
Example of risk
u ÷ + = +
-
) 1 ( 1 R
S
F
R
Objectives of risk management
• to integrate concerns for risk into an
organization's daily decision making and
implementation process
• to recognize resource allocation implications
• to understand the opportunity cost or
Why must we manage risk?
Types of Risk
Considering all the potential risks that a firm
may face, we can divide risks into 4 types
according to their features
1. Financial risk
2. Operational risk
3. Strategic risk
4. Hazard risk
Operational risk
• Risk arisen from execution of a company’s
• This can affect the firm’s decision for strategies
which may cause losses on credibility and
reputation.
• Ex. Human error
Fraud
Technical failure
• Risk arisen from the improper long-term
strategic objectives of the organization.
• This can affects firm’s capital
availability, sovereign and political risks,
legal and regulatory changes, reputation
and changes in the physical environment.
• Ex. Merging failure
Strategic risk
Hazard risk
• Risk arisen from unforeseen events partaken by
or associated with a company.
• This kind of risk may not occur frequently, but it
may severely ruin the firm’s value.
• Ex. Counterparty risk
Natural disaster
Bank panic
Financial risk
• Risk arisen from the dynamics of market
movement and changes in macroeconomic
factors.
• There are 2 major kinds of this risk
– Undiversifiable risk
• Market risk
• Credit risk
– Diversifiable risk
• Liquidity risk
Market risk
• Risk arisen from natural movements of interest
rate, foreign exchange rates and prices of
instruments in the money and capital markets.
• This affects the earnings and capital of the
financial institution.
• Classified into 3 types
• Interest rate risk
• Foreign exchange rate risk
• Price risk
Interest rate risk
• Risk arisen from changes in interest rates of
assets, debts, off-balance sheet items
- Repricing risk
- Basis risk
- Yield Curve risk
- Option risk
Foreign exchange risk
• Risk arisen from the fluctuation of exchange
rate, due to a transaction in a foreign currency or
from holding an asset or debt in a foreign
currency.
- Transaction risk
- Translation risk
Price risk
• Risk arisen from the changes in the price of
debt, equity instruments and commodity.
• This causes the value of the investment in the
trading portfolio and profit of the financial
institution to diminish.
Credit risk
• Risk arisen from a chance or probability that a
counterparty cannot fulfill the agreed obligation,
• This affects the credit extension both credits that
are assets and contingent liabilities of the
financial institutions.
- Default risk
Liquidity risk
• Risk arisen from FI’s failure to pay its debts
when due because of its inability to convert
assets into cash.
• Bank run because it doesn’t has enough liquidity
in their balance sheet
• Ex. Liquidity risk from asset side
Liquidity risk from liability side
Bank’s balance sheet
Source: http://finapps.forbes.com/finapps/jsp/finance/compinfo/FinancialIndustrial.jsp?tkr=AIG
Bank’s balance sheet
Source: http://finapps.forbes.com/finapps/jsp/finance/compinfo/FinancialIndustrial.jsp?tkr=AIG
Systemic risk
• Risk arisen from the collapse of an entire
financial system because each firm interlinks
with the others.
• The failure of a single entity or cluster of entities
bankrupt in the entire system or market.
Systemic risk
Risk Management
Principle of Risk Management
• create value
• be an integral part of organizational processes
• be part of decision making
• be systematic and structured
• be based on the best available information
• be tailored
• take into account human factors
• be transparent and inclusive
• be dynamic, iterative and responsive to changes
• be capable of continual improvement and enhancement
Source : International Organization of Standardization
is the action to deal with dissatisfying risks
occurred to a person or an organization.
Risk Management
Main Process of managing risks
1. Identification of risks
2. Risk measurement
3. Strategic planning
4. Policy implementation
Identification of Risk
is a process of monitoring and defining all
risks that involves in the organization value.
Risk monitoring
is the procedure to search and list all potential
risks that an organization is facing.
Risk defining
is the procedure to indicate which types and
magnitude of risks the firm concerns.
Risk measurement
is a process of evaluating risk which is
defined by the firm. It can be either qualitative
approach or statistical approach.
Risk scoring
is a qualitative approach of risk management.
It’s conducted by rating each aspect in the list
and weight them for individual preference.
Quantifying risk
is the way to define risk in statistical approach.
Duration
• a measure of sensitivity of the asset’s price to
interest rate movements or elasticity of asset or
liability’s value
• weighted-average time to maturity on the loan
with present value of cashflows
• equal to ratio of percentage reduction in the
bond’s price to the percentage increase in the
redemption yield of the bond
• Basic model :
( )
2
0
1
1
) ( 2 R V
V V
PV
t PV
D
n
t
t
n
t
t
A
÷
=
×
=
+ ÷
=
=
¯
¯
Immunization
• a strategy ensuring that a change in interest rate
will not affect the value of a portfolio by duration
• foreign exchange risk or stock market risk, can
be immunized using similar strategies
• incomplete immunization called “hedging”
complete immunization called “arbitrage”
Duration matching
• match duration of asset with duration of liability
• to protect against losses from interest rate volatility
Duration gap
• is the difference in sensitivity of interest-yielding
assets and the sensitivity of liabilities to a change
in market interest rate
| |
A
L
k
R
R
A k D D E
L A
=
+
A
× × ÷ ÷ = A ;
1
Problem of duration analysis
• Duration matching can be costly
• Immunization is a dynamic problem
• Large interest rate changes and convexity
Mean – Variance Approach
Expected return :
Variance :
Standard Deviation :
¯
=
=
n
i
i i
r w r E
1
) (
( )
¯
=
÷ =
n
i
i i i
r E r w r Var
1
2
) ( ) (
( )
¯
=
÷ = =
n
i
i i i i
r E r w r Var D S
1
2
) ( ) ( . .
E(r)
E(r)+S.D. E(r)-S.D.
return
Extreme Value Theory
• A branch of statistics dealing with the extreme
deviations from the median of probability
distributions
• There are 2 approaches
– Basic theory approach
– Peak-Over-Threshold model
• Extreme value distributions are the limiting
distributions for the minimum or the maximum of
a very large collection of independent random
variables from the same arbitrary distribution.
Value at Risk (VaR)
• is used to measure a bank’s market risk, also
has been adapted to measure credit risk
• emphasizes on losses arising as a result of the
volatility of assets, as opposed to the volatility
of earnings
• Downsize risk measurement
• “What is my worst-cased scenario?”
• consists of a time period, a confidence level
and a loss amount
• Basic model :
t x x
P
dP
dV
V Var A × × =
Value at Risk (VaR)
• Definition :
• Basic model :
t x x
P
dP
dV
V VaR A × × =
} 1 ) Pr( { o ÷ s < e = l L R l VaR
Level Confidence V VaR % 95 ; 65 . 1 o × =
Level Confidence V VaR % 99 ; 33 . 2 o × =
Value at Risk (VaR)
1. Non-Parametric Method (Historical method)
• full valuation model
• requires at least one year historical data (Basel)
• assumes historical data will repeat itself
Source : http://www.investopedia.com/articles/04/092904.asp
Value at Risk (VaR)
2. Parametric Method (Variance-Covariance)
• delta normal approach (usually multivarate)
• partial valuation model (only linear combination)
• requires at least one year historical data
Source : http://www.investopedia.com/articles/04/092904.asp
Value at Risk (VaR)
3. Monte – Carlo approach
• full valuation approach by multiple “black box”
generators to generate a distribution of returns
• uses hypothetical trials instead of historical data
Source : http://www.investopedia.com/articles/04/092904.asp
|
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.
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÷
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.
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\
|
÷ + =
÷
1 ) 1 (
c
c
|
p
N
n
u VaR
u
p
Conditional Value at Risk (CVaR)
• often used to reduce the probability of
incurring large losses
• derived by taking a weighted average between
the value at risk and losses exceeding the
value at risk.
• known as Expected Excess Loss, Expected
Shortfall, or Tail VaR
Value
5% worst-cased value
VaR 5% CVaR 5%
) (
p p p p
VaR X VaR X E VaR ES > ÷ + =
Scenario Analysis
• a process of analyzing possible future events
by considering alternative possible outcomes
• There are 3 steps in the process
1. Scenario building
2. Extraction of issues from the scenarios
3. Synthesis of results
High Impact
F
r
e
q
u
e
n
c
y
High
Low
Low
Scenario 1
Scenario 2
Scenario 3
Scenario 4
Stress Testing
• a simple form of scenario analysis
• takes into account extreme events that are
virtually impossible according to the probability
distributions
• Vary input parameters in a financial model and
• This is an extension of VaR.
When there’s an extreme loss
exceeding the VaR, stress test
can be applied to indicate the
approximated value of loss.
Time
VaR
Return
Stress Testing
• Example of stress test : Liquidity stress test
Bank A’s balance sheet (unit = \$ million)
CAR = (Legal capital adequacy ratio)
If bank A faces \$5 million capital deficit,
“What should bank A do?”
Asset Liability
100
Debt 90
Capital 10
% 10 10 . 0
100
10
= =
Gaussian Copula Model
• constructed from the bivariate normal distribution
• Basic model :
• widely used in financial risk
assessment and actuarial
analysis (ex. pricing of CDOs)
• lack of dependence dynamics
and poor representation of extreme events
( )
( ) ( ) ) ( ) (
) ( ), (
) , (
1 1
1 1
, ,
v u
v u
v u c
Y X
÷ ÷
÷ ÷
u u
u u
=
m m
m
p
p
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|
÷ +
÷
÷
÷
= xy y x y x
Y X
p
p
p t
m
p
2
) 1 ( 2
1
exp
1 2
1
) , (
2 2
2
2
, ,
RAROC
capital (amount of money needed to secure the
survival in a worst case scenario)
• Economic capital is a function of market risk,
credit risk, and operational risk, and is often
calculated by VaR.
• Basic formula :
or
capital economic
return expected
= RAROC
VaR
return expected
= RAROC
Strategies in Managing Risk
1. Controlling (limit)
2. Avoidance (eliminate)
3. Reduction (mitigate)
4. Sharing (transfer)
5. Pooling (diversify)
6. Retention (accept and budget)
Managing Risk
After risk monitoring and measurement, we
will understand feature and magnitude of risk.
This will lead to strategic planning and then the
implementation.
Risk Control
Risk control is the action of accepting an
exact level of risk. The maximum level of risk
tolerance is determined. When risk level exceeds
the limit, some reactions have to be held in order
to manage it.
Example : Loss control, Credit limit
risk
time
take actions
Risk Avoidance
is the action of not performing an activity that
could carry risk. This helps reduce risk, however, it
also reduce the potential gain from accepting risk.
By applying this strategy, the firm will face less
uncertainties than others, but firm may lose the
large number of income in a competitive market.
Example : Corporate downsizing or shutdown
Taken over
Risk Reduction
is the action of reducing the severity of loss
or likelihood of loss from occurring.
Example : Computer-based information system
Human capital development
Hiring specialists and professional
consultants
Risk Sharing
is the action of transferring risk to the third
party. The exact size of risk still exists, but it would
be push away from one person to another.
Outsourcing
Hedging
CDS
Risk Pooling
is the action of diversifying risk by contributing
capital in more various types of assets. When there
is a dramatic adverse change to one security, the
opposite effect from another could rise and offset
loss. This helps reducing the severity of loss, but
reduces magnitude of abnormal gain.
Example : Composing efficient portfolio
Conglomerate merger
risk
number of securities
Risk Retention
is the action of accepting loss when it
occurred, by taking some policy changes to
increase the capacity of risk tolerance.
Example : Raising capital to cover more losses
risk
time
risk bearing capacity
Central bank, Government and risk
management in financial system
CB
Gov.
Macro economy
FI
Consumers
Investors
policy
control
risk risk
Disclosure
“The Bank reaffirms its recognition and
endorsement of the fundamental importance of
transparency and accountability to the development
process. Accordingly, it is the Bank’s policy to be
open about its activities and to welcome and seek
out opportunities to explain its work to the widest
possible audience.”
From : “The World Bank Policy on Disclosure of
Information” 2002
Basel II
Objective :The final version aims at:
• Ensuring that capital allocation is more risk
sensitive.
• Separating operational risk from credit risk, and
quantifying both;
• Attempting to align economic and regulatory
capital more closely to reduce the scope for
regulatory arbitrage.
• While the final accord has largely addressed the
regulatory arbitrage issue, there are still areas
where regulatory capital requirements will
diverge from the economic.
• Basel II has largely left unchanged the question
of how to actually define bank capital, which
diverges from accounting equity in important
respects. The Basel I definition, as modified up
to the present, remains in place.
Basel II
CAR is a ratio of a bank's capital to its risk,
National Regulator track a bank's CAR to ensure
that it can absorb a reasonable amount of loss
and are complying with their statutory Capital
requirements.
10% in this case is a common requirement
for regulators conforming to the Basel Accords
>10%
Good risk management process for
market risk
• Appropriateness of the role of Board of
Directors and Senior Management and
suitability of organizational structure
• The financial institution should clearly state
the policy and practical guidelines in
managing market risks
• Appropriateness of Risk Specification,
Measurement, Monitor, Report and Control
• Effective internal control and audit
independence
Risk control and monitoring for
credit risk
• Setting the target and acceptable risk level
• FI should have a good management
information system
• Operating under a sound credit granting
process
• Proper credit administration and Monitoring
• Monitoring the structure and quality of credit
• Good management of problem credits
Risk controlling for liquidity risk
• Competent the Board of Directors of financial
institution and senior executives
• Sound management policy of assets and
liabilities
• Flexible management structure
• Up-to-date and accurate information system
• Determining risk limits
• Well managing market access
• Contingency funding plans
Risk management and Financial crisis
Leverage ratio of financial companies in the US
Source : SNL
Risk management and Financial crisis
• The Hamburger crisis derived from the lack of
• The roots of crisis are “Lack of accountability”,
“Leverage” and “Liquidity”.
• Is it enough to rely on just a single simple model?
• Risk modeling guideline
1. Use data-driven assumptions
2. Transparent stress test key assumptions
3. Understand the limit of data

Outline
• Introduction to risk – What is risk? – Why manage risks? – Types of risk • Risk Management • Policy tools for risk management

What is risk?
• The combination of the probability of an event and its consequences

How does risk occur?
• State of the world = Uncertainty • Asymmetric information – Adverse selection – Moral hazard

000 baht. Next 10 days you earn 10.000 baht everyday for 1 month = 300. But.000 baht at the end of the month * Risk may lead to less actual income than that you expect.000 baht.How does risk affect us? 1.000 baht. first 10 days you earn 12. = 270. Last 10 days you earn 5. .000 baht per month 2. You think you would earn 10.

2×50 = -2 Outcome .60 0.0.20 Return +50 0 -50 Utility E(R) = 0.2×50 .6×0 .20 Return +100 -20 -50 Utility E(R) = 0.6×20 .0.0.Risk Preference 1.2×50 = 0 Outcome 2. Risk Neutral = Prefer fair game Probability 0.60 0.0. Risk Lover = Prefer negative outcome game Probability 0.2×100 .20 0.20 0.

2×60 + 0.20 Return +60 +10 -40 Outcome Utility E(R) = 0.60 0.2×40 = 1 • • This one is the assumption of all risk related theory. Since people are risk averse. Risk Averse = Prefer positive outcome game Probability 0. riskier alternatives should provide risk premium to draw community’s interest.6×10 .20 0. .0.Risk Preference 3.

That means the cost of borrowing in the country will rise. F 1  R  (1  R)   S  See when risk premium () rises.Example of risk Recall the interest parity. given the world interest rate constant. . and total income of the economy will decrease. the interest rate in the country must be higher.

Why must we manage risk? Objectives of risk management • to integrate concerns for risk into an organization's daily decision making and implementation process • to recognize resource allocation implications • to understand the opportunity cost or trade-offs with any decision .

4.Types of Risk Considering all the potential risks that a firm may face. 2. 3. we can divide risks into 4 types according to their features 1. Financial risk Operational risk Strategic risk Hazard risk .

• This can affect the firm’s decision for strategies which may cause losses on credibility and reputation.Operational risk • Risk arisen from execution of a company’s business functions. Human error Fraud Technical failure . • Ex.

reputation and changes in the physical environment.Strategic risk • Risk arisen from the improper long-term strategic objectives of the organization. Merging failure Misleading research . sovereign and political risks. • This can affects firm’s capital availability. legal and regulatory changes. • Ex.

• This kind of risk may not occur frequently. Counterparty risk Natural disaster Bank panic . • Ex. but it may severely ruin the firm’s value.Hazard risk • Risk arisen from unforeseen events partaken by or associated with a company.

• There are 2 major kinds of this risk – Undiversifiable risk • Market risk • Credit risk – Diversifiable risk • Liquidity risk .Financial risk • Risk arisen from the dynamics of market movement and changes in macroeconomic factors.

• Classified into 3 types • Interest rate risk • Foreign exchange rate risk • Price risk .Market risk • Risk arisen from natural movements of interest rate. foreign exchange rates and prices of instruments in the money and capital markets. • This affects the earnings and capital of the financial institution.

debts.Repricing risk .Option risk .Basis risk . off-balance sheet items .Yield Curve risk .Interest rate risk • Risk arisen from changes in interest rates of assets.

Foreign exchange risk • Risk arisen from the fluctuation of exchange rate. .Translation risk . due to a transaction in a foreign currency or from holding an asset or debt in a foreign currency.Transaction risk .

Price risk
• Risk arisen from the changes in the price of debt, equity instruments and commodity. • This causes the value of the investment in the trading portfolio and profit of the financial institution to diminish.

Credit risk
• Risk arisen from a chance or probability that a counterparty cannot fulfill the agreed obligation, • This affects the credit extension both credits that are assets and contingent liabilities of the financial institutions. - Default risk - Credit spread risk - Downgrade risk

Liquidity risk
• Risk arisen from FI’s failure to pay its debts when due because of its inability to convert assets into cash. • Bank run because it doesn’t has enough liquidity in their balance sheet • Ex. Liquidity risk from asset side Liquidity risk from liability side

jsp?tkr=AIG .com/finapps/jsp/finance/compinfo/FinancialIndustrial.Bank’s balance sheet Source: http://finapps.forbes.

jsp?tkr=AIG .forbes.Bank’s balance sheet Source: http://finapps.com/finapps/jsp/finance/compinfo/FinancialIndustrial.

Systemic risk • Risk arisen from the collapse of an entire financial system because each firm interlinks with the others. . • The failure of a single entity or cluster of entities can cause a cascading failure which leads to bankrupt in the entire system or market.

Systemic risk .

iterative and responsive to changes be capable of continual improvement and enhancement Source : International Organization of Standardization .Risk Management is the action to deal with dissatisfying risks occurred to a person or an organization. Principle of Risk Management • • • • • • • • • • • create value be an integral part of organizational processes be part of decision making explicitly address uncertainty be systematic and structured be based on the best available information be tailored take into account human factors be transparent and inclusive be dynamic.

Risk Management Main Process of managing risks 1. Strategic planning 4. Risk measurement 3. Identification of risks 2. Policy implementation .

Identification of Risk is a process of monitoring and defining all risks that involves in the organization value. Risk defining is the procedure to indicate which types and magnitude of risks the firm concerns. . Risk monitoring is the procedure to search and list all potential risks that an organization is facing.

Risk measurement is a process of evaluating risk which is defined by the firm. It’s conducted by rating each aspect in the list and weight them for individual preference. . It can be either qualitative approach or statistical approach. Risk scoring is a qualitative approach of risk management. Quantifying risk is the way to define risk in statistical approach.

Duration • a measure of sensitivity of the asset’s price to interest rate movements or elasticity of asset or liability’s value • weighted-average time to maturity on the loan with present value of cashflows • equal to ratio of percentage reduction in the bond’s price to the percentage increase in the redemption yield of the bond n • Basic model : D  PV  t  t 1 t  PV t 1 n  V  V 2V0 (R) 2 t .

can be immunized using similar strategies • incomplete immunization called “hedging” complete immunization called “arbitrage” Duration matching • match duration of asset with duration of liability • to protect against losses from interest rate volatility .Immunization • a strategy ensuring that a change in interest rate will not affect the value of a portfolio by duration matching or trading derivatives • foreign exchange risk or stock market risk.

Duration gap • is the difference in sensitivity of interest-yielding assets and the sensitivity of liabilities to a change in market interest rate R L E  DA  DL k  A  . k 1 R A Problem of duration analysis • Duration matching can be costly • Immunization is a dynamic problem • Large interest rate changes and convexity .

D. Standard Deviation : S .Mean – Variance Approach Expected return : E (r )   wi ri i 1 n Variance : Var (r )   wi ri  E (ri )  i 1 n 2 return E(r)-S.D.D. E(r) E(r)+S.  Var (ri )   wi ri  E (ri ) i 1 n 2 .

.Extreme Value Theory • A branch of statistics dealing with the extreme deviations from the median of probability distributions • There are 2 approaches – Basic theory approach – Peak-Over-Threshold model • Extreme value distributions are the limiting distributions for the minimum or the maximum of a very large collection of independent random variables from the same arbitrary distribution.

a confidence level and a loss amount dV Basic model : Varx  Vx   Pt dP . as opposed to the volatility of earnings Downsize risk measurement “What is my worst-cased scenario?” consists of a time period. also has been adapted to measure credit risk emphasizes on losses arising as a result of the volatility of assets.Value at Risk (VaR) • • • • • • is used to measure a bank’s market risk.

65 VaR  V  2.33 .Value at Risk (VaR) • Definition : VaR  {l  R Pr(L  l )  1   } • Basic model : dV VaRx  Vx   Pt dP VaR  V 1. 95% Confidence Level . 99% Confidence Level .

Value at Risk (VaR) 1.asp .com/articles/04/092904. • • • Non-Parametric Method (Historical method) full valuation model requires at least one year historical data (Basel) assumes historical data will repeat itself Source : http://www.investopedia.

asp .com/articles/04/092904.investopedia.Value at Risk (VaR) 2. • • • Parametric Method (Variance-Covariance) delta normal approach (usually multivarate) partial valuation model (only linear combination) requires at least one year historical data Source : http://www.

Value at Risk (VaR) 3.investopedia. Monte – Carlo approach • full valuation approach by multiple “black box” generators to generate a distribution of returns • uses hypothetical trials instead of historical data   n     VaR p  u  (1  p)   1      Nu     Source : http://www.asp .com/articles/04/092904.

Expected Shortfall. or Tail VaR ES p  VaR p  E ( X  VaR p X  VaR p ) 5% worst-cased value Value CVaR 5% VaR 5% . known as Expected Excess Loss.Conditional Value at Risk (CVaR) • • • often used to reduce the probability of incurring large losses derived by taking a weighted average between the value at risk and losses exceeding the value at risk.

Synthesis of results High Frequency Scenario 1 Scenario 2 Scenario 3 Impact High Low Low Scenario 4 . Scenario building 2. Extraction of issues from the scenarios 3.Scenario Analysis • • a process of analyzing possible future events by considering alternative possible outcomes There are 3 steps in the process 1.

Stress Testing • a simple form of scenario analysis • takes into account extreme events that are virtually impossible according to the probability distributions • Vary input parameters in a financial model and see how much your answer changes Return • This is an extension of VaR. When there’s an extreme loss exceeding the VaR. stress test can be applied to indicate the approximated value of loss. VaR Time .

10  10% (Legal capital adequacy ratio) 100 If bank A faces \$5 million capital deficit. “What should bank A do?” .Stress Testing • Example of stress test : Liquidity stress test Bank A’s balance sheet (unit = \$ million) Asset 100 Liability Debt 90 Capital 10 10 CAR =  0.

Y .  1 (v)  c (u.Y .Gaussian Copula Model • constructed from the bivariate normal distribution • Basic model :  X .   1 (u ). pricing of CDOs) • lack of dependence dynamics and poor representation of extreme events . y)  exp  x 2  y 2  2 xy 2 2(1   2 ) 2 1    1       • widely used in financial risk assessment and actuarial analysis (ex. v)    1 (u )   1 (v)   1   X .  ( x.

and is often calculated by VaR. • Basic formula : expected return RAROC  economic capital expected return RAROC  VaR or .RAROC • the ratio of risk adjusted return to economic capital (amount of money needed to secure the survival in a worst case scenario) • Economic capital is a function of market risk. and operational risk. credit risk.

6. we will understand feature and magnitude of risk. Strategies in Managing Risk 1. 5. Controlling (limit) Avoidance (eliminate) Reduction (mitigate) Sharing (transfer) Pooling (diversify) Retention (accept and budget) . This will lead to strategic planning and then the implementation. 2.Managing Risk After risk monitoring and measurement. 4. 3.

When risk level exceeds the limit. Credit limit risk take actions time . some reactions have to be held in order to manage it. Example : Loss control.Risk Control Risk control is the action of accepting an exact level of risk. The maximum level of risk tolerance is determined.

Example : Corporate downsizing or shutdown Taken over . This helps reduce risk. it also reduce the potential gain from accepting risk.Risk Avoidance is the action of not performing an activity that could carry risk. By applying this strategy. however. the firm will face less uncertainties than others. but firm may lose the large number of income in a competitive market.

Risk Reduction is the action of reducing the severity of loss or likelihood of loss from occurring. Example : Computer-based information system Human capital development Hiring specialists and professional consultants .

Example : Buying an insurance Outsourcing Hedging CDS . but it would be push away from one person to another.Risk Sharing is the action of transferring risk to the third party. The exact size of risk still exists.

Risk Pooling is the action of diversifying risk by contributing capital in more various types of assets. When there is a dramatic adverse change to one security. but reduces magnitude of abnormal gain. Example : Composing efficient portfolio Conglomerate merger risk number of securities . the opposite effect from another could rise and offset loss. This helps reducing the severity of loss.

Risk Retention is the action of accepting loss when it occurred. Example : Raising capital to cover more losses risk risk bearing capacity time . by taking some policy changes to increase the capacity of risk tolerance.

Government and risk management in financial system control CB risk Consumers FI risk Investors policy Macro economy Gov. .Central bank.

” From : “The World Bank Policy on Disclosure of Information” 2002 . it is the Bank’s policy to be open about its activities and to welcome and seek out opportunities to explain its work to the widest possible audience. Accordingly.Disclosure “The Bank reaffirms its recognition and endorsement of the fundamental importance of transparency and accountability to the development process.

• Separating operational risk from credit risk. . • Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage. and quantifying both.Basel II Objective :The final version aims at: • Ensuring that capital allocation is more risk sensitive.

which diverges from accounting equity in important respects.Basel II • While the final accord has largely addressed the regulatory arbitrage issue. as modified up to the present. . The Basel I definition. there are still areas where regulatory capital requirements will diverge from the economic. • Basel II has largely left unchanged the question of how to actually define bank capital. remains in place.

>10% 10% in this case is a common requirement for regulators conforming to the Basel Accords . National Regulator track a bank's CAR to ensure that it can absorb a reasonable amount of loss and are complying with their statutory Capital requirements.Capital adequacy ratio (CAR) CAR is a ratio of a bank's capital to its risk.

Measurement.Good risk management process for market risk • Appropriateness of the role of Board of Directors and Senior Management and suitability of organizational structure • The financial institution should clearly state the policy and practical guidelines in managing market risks • Appropriateness of Risk Specification. Monitor. Report and Control • Effective internal control and audit independence .

Risk control and monitoring for credit risk • Setting the target and acceptable risk level • FI should have a good management information system • Operating under a sound credit granting process • Proper credit administration and Monitoring • Monitoring the structure and quality of credit • Good management of problem credits .

Risk controlling for liquidity risk • Competent the Board of Directors of financial institution and senior executives • Sound management policy of assets and liabilities • Flexible management structure • Up-to-date and accurate information system • Determining risk limits • Well managing market access • Contingency funding plans .

Risk management and Financial crisis Leverage ratio of financial companies in the US Source : SNL .

Understand the limit of data . • Is it enough to rely on just a single simple model? • Risk modeling guideline 1. • The roots of crisis are “Lack of accountability”. Transparent stress test key assumptions 3. “Leverage” and “Liquidity”. Use data-driven assumptions 2.Risk management and Financial crisis • The Hamburger crisis derived from the lack of “risk adjustment” when reporting profit.