FRM Part 1

Book 1 – Foundations of Risk Management

HOW DO FIRMS MANAGE FINANCIAL RISK?

 Learning Objectives
After completing this reading you should be able to:
 Compare different strategies a firm can use to manage its risk
exposures and explain situations in which a firm would want to use each
strategy.
 Explain the relationship between risk appetite and a firm's risk
management decisions.
 Evaluate some advantages and disadvantages of hedging risk
exposures, and explain challenges that can arise when implementing a
hedging strategy.
 Apply appropriate methods to hedge operational and financial risks,
including pricing, foreign currency, and interest rate risk.
 Assess the impact of risk management tools and instruments, including
risk limits and derivatives.
 Managing Risk Exposures
 At the most basic level, a business can choose from four different risk management
strategies:

1. Accept the risk

 Entails acknowledging and retaining a given risk.
 No attempt to mitigate or eliminate the risk.
 Desirable when:
 Risk mitigation is more costly than the risk itself.
 Exposure yields positive rewards, e.g., an oil field owner may want direct exposure
to oil price movement.
 It’s possible to pass on the costs associated with the risk to consumers.

2. Avoid the risk

 Eliminates the risk by eliminating the cause
 Firm may decide not to perform the activity or do it differently.
 Desirable when a business risk is not a normal part of operations.
 Managing Risk Exposures
 At the most basic level, a business can choose from four different risk management
strategies:

3. Mitigate the risk

 Entails reducing the probability of the occurrence of a risk or taking
steps to minimize the potential impact.
 Informed by the view that taking mitigating actions costs much less
than repairing damages after the risk has occurred.
 E.g., a lender may ask for additional collateral to mitigate credit risk.

4. Transfer the risk

 Shifts the risk to a third party via legally binding contracts such as derivatives and
securitizations.
 Ownership, as well as the impact of the risk, is borne by that third party.
 Relationship between Risk Appetite and a
Firm's Risk Management Decisions

 Risk appetite is the type and amount of risk that

an organization is prepared to pursue, retain or
take.
 It should not be confused with risk capacity
(maximum amount of risk that an organization is
able to take on) and risk profile (a firm's current
risk exposure).
 In practical terms, a firm's risk appetite is comprised of two key things:
I. A formal written document called the risk appetite statement which
outlines the aggregate level and types of risk that a financial institution is
willing to accept or avoid to achieve its business objectives; and
II. Mechanisms that link the risk appetite statement to the firm's day-to-day
risk management operations. These include risk-specific statements, a
detailed firm risk policy, and risk limit determination tools.
 Relationship between Risk Appetite and a
Firm's Risk Management Decisions
 Financial institutions work with an elaborate risk appetite statement to pursue
their business objectives.
 All risk management decisions are made in line with the firm’s risk appetite.
 Risk appetite should be below total risk capacity but above risk profile.
 The dotted lines are upper and lower trigger points for reporting purposes.

Risk capacity

Risk appetite

Risk
profile
 The Risk Management Process
 To achieve its objectives, every firm must have a working risk management
framework that guides all operations.
 First, the firm should define and identify its risk appetite.
 Next, the firm should map all known risks and then put the risk appetite into
practice.
 What follows should be adequate planning to ensure the firm sticks to its risk
appetite. The plan should be monitored closely and adjusted as needed

Monitor and adjust Identify risk appetite

Risk management
process

Implement a plan Map known risks

Activate risk appetite

 Role of the Board of
Directors
 The firm's senior management and the board of directors must define the firm's
appetite for risk and communicate that to stakeholders in a quantitative and/or
qualitative manner. That includes:
 Using the value at risk (VaR) to specify the maximum loss the firm is
prepared to tolerate at a given level of confidence for a given period of
time;
 Stating how the firm treats each risk: which ones to accept, reject,
mitigate, or transfer, and the tools used in risk management; and
 Constantly evaluating the plausible scenarios the firm might find itself in
through stress testing.
 Right-Sizing Risk
Management
 Concerns itself with a firm’s efforts that ensure it does not under- or over-
manage risk and that it has the capability needed to adopt certain risk
management tools.
 Firm has to select and develop – but not over-engineer – risk management
functions that are right-sized for the firms’ size and complexity.

Key Goals
 Understand the business, for that’s the only way to understand the underlying
risks.
 Focus on key risks but also keep an eye on the little ones.
 Clarify roles and responsibilities.
 Firm must decide whether to allocate risk management costs proportionally to
the different areas that risk management serves.
 An annual gap analysis should be conducted to ensure that the firms'
sophistication matches the conservative nature of their hedging strategies.
 Risk Mapping
 Refers to a graphic representation of risks to summarize the threats and risks
posed to an organization, presenting them in a hierarchical format.
 Each risk is categorized into two dimensions: cash impact and probability of
occurrence.
 Management can use the location of the risks in the representation to
determine which risks should be assumed and which ones should be hedged.
 Can occur at the aggregate level. i.e., credit risk, market risk, etc., or at the
individual level, e.g., a map of foreign exchange risk.
A company exposed to foreign exchange risk, for example may begin the risk management
process by mapping out existing positions, contracts, and other upcoming transactions.
Afterward, the company must establish a policy that dictates which exposures should be
hedged (e.g., is hedging necessary for probable but not yet guaranteed sales?)

Benefits of Mapping
 Prompts top management to take a closer look at risks they usually don't consider until it is
too late.
 Process that ends with the risk map helps everyone gain a thorough understanding of all
the relevant risks.
 Fosters enterprise risk management where risks are managed holistically rather than
individually.
 Hedging
 A hedge is an investment position that is meant to negate/offset losses or gains
caused by a companion investment.
 Primarily motivated by enhancing financial stability and reducing the risk of
financial distress (e.g., bankruptcy risks or reputational risks).
Examples of Hedging Instruments
Swaps
 Two economic positions (or values) are swapped over-the-counter (OTC) until
(or when) the contract matures.
Forwards

 Customized contract that involves the exchange of a predetermined quantity of

an asset at a predetermined price at some future point in time.
Futures

 Standardized contract that involves the exchange of a predetermined quantity

of an asset at a predetermined price at some future point in time.
 Advantages of Hedging
Reduced Capital Costs
 With a working hedging framework, a firm is able to reduce volatility of earnings, attracting
investors.
Capital Protection
 In the event of a “black swan event,” a hedge can help keep a firm afloat.
 Example: Some interest rate trades, such as interest rate swaps, proved to be very good
hedges for the equity market downturn following the outbreak of the Covid-19 pandemic.
Cash Flow Benefit
 Example: An airline that hedges the price of jet fuel is able to smooth out revenues.
Predictability
 Example: A multinational organizational can use FX swaps to lock down the price of future
foreign operating expenses affecting its international subsidiaries/affiliates.
Better Governance
 Hedging gives senior management ample time to find solutions to a permanent change in
market or credit conditions.
 Disadvantages of Hedging
Costs
 Hedging comes with transaction costs as well as adequate investment in relevant controls,
accounting, and disclosures.
Insufficient Flexibility
 Investment risk and reward are directly proportional; by minimizing your risks, you also
reduce your potential profits.
Complexity
 Risks arising from derivatives contracts may be too complicated to analyze due to the built-in
leverage.
 There's a real risk of not pricing derivatives correctly such that not all relevant risk factors
are taken into account
Unintended Risks
 Example: A firm might hedge credit risk using a credit default swap contract that may
introduce an unexpected wrong-way risk.
 Challenges That Can Arise
When Implementing a Hedging
Strategy
A lot can go wrong during the implementation of a hedging strategy:
1) A company might misunderstand the type of risk to which it is exposed, fail to
map or measure risk correctly or overlook changes in the market structure.
 Result? Notional values that either "overhedge“ or “underhedge” the risk.
2) Model risk.
 Biased internal/external models may lead to erronerous decisions that
bring about loss.
3) Without a robust corporate governance system, any risk management
program and hedging strategy is likely to fail.
 Poor monitoring, for example, may lead to overly complex hedging
positions or excessive leverage.
4) Poor communication or inadequate disclosures can be financially disastrous.
 In 1993, the U.S. subsidiary of Metallgesellschaft AG, MGRM, lost 1.3
billion dollars suffering from flawed long hedge strategy in near term futures
contracts that was meant to protect against forward sales commitments.
 Since senior management was not fully briefed about the potential liquidity
impact of hedging with futures, MGRM did not set aside enough capital
to meet margin calls and maintain the hedge. (More on this later in the curriculum)
 Methods Used to Hedge Operational
and Financial Risks
Pricing Risk
 For producers, selling forwards and futures contracts can help them lock in a favorable
selling price for their output.
 A corn farmer expecting a bumper harvest in three months can sell a series of forwards
or futures. That way, they are guaranteed a minimum return.
 For consumers, buying forwards and futures can help protect them from possible price
hikes.
 For example, airlines often go long in the jet fuel market to lock in a favorable price for
the fuel and therefore protect their profit margins.
Foreign Currency Risk

 Example: An oil producer based in Canada but selling oil to buyers in the U.S. may want to
hedge the risk that the Canadian dollar (domestic currency) will strengthen against the U.S.
dollar (foreign currency), translating to lower cash flows.
 A currency put option would give the company the right but not the obligation to sell
euros for rubles at a specified rate.
 A currency forward contract would help sell a specified amount of euros at a pre-
specified price at the maturity of the contract
 Methods Used to Hedge Operational
and Financial Risks
Balance Sheet Hedging
 Balance sheet hedging refers to hedging programs that protect foreign currency-
denominated assets and liabilities from fluctuating exchange rates.
 If an entity has a foreign payment to make or a foreign receipt, a forward allows it to
fix the exchange rate at which it will buy and sell the foreign currency, respectively.
 Currency swaps would be suitable for a company with foreign debt. In a typical
agreement, the two parties would exchange the principal amount of a loan and the
interest in one currency for the principal and interest in another currency

Interest Rate Risk

 Interest rate swaps enable two parties to counter their interest rate exposure by trading one
set of future interest payments for another based on a specified principal.
 A forward rate agreement can help a party to lock in the rate of interest that will be
applicable for a period of time in the future.
 The owner of an interest rate futures contract is either entitled to earn interest at a given
rate or is obligated to pay interest at a given rate.
 The Impact of Risk Management Tools and
Instruments, Including Risk Limits and
Derivatives
 Risk limits refer to a broad set of constraints risk managers have to deal with in
their efforts to nurture a strong risk management system that fits well into the
firm's overall goals.
Risk Limit Description Potential Weaknesses
An offsetting order that exits your
Will not prevent future exposure,
Stop Loss Limits trade once a certain price level is
only limit realized losses
reached
Notional amount may not be
Specify notional exposure
Notional Limits strongly related to the economic
parameters
risk assumed
Not easy to aggregate at the
Focus on a very specific risk such as enterprise level and may require the
Risk Specific Limits
credit risk or interest rate risk recruitment of individuals with very
specific skills
Put a cap on the number of contracts Succeed in smoothing operational
Maturity/Gap
or transactions that can mature/reset and liquidity risks but do not address
Limits
in each time period price risk
Designed to reduce concentrations of
Concentration May not capture correlation risks in
various kinds, e.g., too much business
Limits stressed markets
with the same counterparty
 The Impact of Risk Management Tools and
Instruments, Including Risk Limits and
Derivatives
 Risk limits refer to a broad set of constraints risk managers have to deal with in
their efforts to nurture a strong risk management system that fits well into the
firm's overall goals.
Risk Limit Description Potential Weaknesses
Prone to classic model
Address option-specific
risks and calculation may be
Greek Limits limits with respect to the Greek
compromised by poor governance,
quartet (delta, gamma, theta, or vega)
such as a lack of controls
Prone to classic model risks and does
Attempts to set an aggregate risk
Value-at-Risk (VaR) not indicate how bad a loss might
threshold
get in an unusually stressed market
Based on how bad things might get in
a plausible worst-case scenario. Stress
tests examine specific stresses. Level of sophistication varies.
Stress, Sensitivity, Sensitivity tests assess a position or Dependent upon in-depth
and Scenario portfolio's sensitivity to changes in key knowledge of the firm's exposures
Analysis variables. Scenario modeling simulates and market behavior. Very difficult to
the consequences of real-world cover all possible scenarios
scenarios (either hypothetical or
historical).
 The Impact of Risk Management Tools and
Instruments, Including Risk Limits and
Derivatives
 Derivatives too have their limits
 A hedging strategy, for example, can involve offsetting investments, which might
not experience totally opposite price changes. This is known as basis risk.
Example
There are no exchange-traded products for jet fuel, a situation that forces airlines to
hedge the price of jet fuel using products linked to crude oil. However, jet fuel prices
and crude oil prices do not move in lockstep, and therefore the hedge positions
taken by the airlines do not fully insulate them from changes in the price of jet fuel.

 Derivatives come with further constraints

 For example,
 Exchange-traded offer standardized contracts and have lower credit risk
than OTC derivatives. However, they can’t quite be customized to meet the
needs of individual traders.
 OTC derivatives can be customized, but they do not carry the same level of
security guarantees as exchange-traded derivatives.
 Book 1 – Foundations of Risk Management

HOW DO FIRMS MANAGE FINANCIAL RISK?

Learning Objectives Recap:
 Compare different strategies a firm can use to manage its risk exposures and
explain situations in which a firm would want to use each strategy.
 Explain the relationship between risk appetite and a firm's risk management
decisions.
 Evaluate some advantages and disadvantages of hedging risk exposures, and
explain challenges that can arise when implementing a hedging strategy.
 Apply appropriate methods to hedge operational and financial risks, including
pricing, foreign currency, and interest rate risk.
 Assess the impact of risk management tools and instruments, including risk
limits and derivatives.

ANALYST