Risk Analytics

three major forms of risk control analytics

1. Scenario Analysis  A scenario analysis is a top-down, what-if analysis
that measures the impact that a certain event (or combination of
events) will have on the enterprise.
A stress test
 form of scenario analysis focused on specific risk factor(s).
implemented in combination with regularly performed risk assessments,
as well as on an as-needed basis.
tailored to the institution’s unique combination of size, business model,
and risk/return characteristics,
regularly evaluated to ensure its effectiveness and relevance.
stress testing
The important of stress testing :
help institutions to identify underestimated or previously unconsidered areas of
vulnerability and risk.
The impact for enterprise :
1. The effects of interest rate movements
2. Changes in the default rates in a portfolio
3. A decrease in liquidity
4. Changes in unemployment
5. Credit downgrade
6. The effects of movements in commodity prices
7. Changes in gross domestic product
stress testing
Benefit of stress testing
provide transparent information regarding the capital and liquidity resources of each
institution to assess their ability to weather harsh macroeconomic shocks
shortcomings of stress testing
focuses on extreme, adverse events and does not capture the impact of less
extreme, but more probable, adverse events.
Use Monte Carlo simulation for do stress testing.
A computer performing Monte Carlo simulation is basically a machine for generating
what-if scenarios—random scenarios based on parameters specified by the user.
Monte Carlo simulation has been used in the measurement of a variety of different
types of risk, including credit, market, insurance, and operational risks.
three major forms of risk control analytics
2. Economic Capital
the amount of financial resources that the institution must
theoretically hold to ensure the solvency of the organization at a
given confidence level and given its enterprise risk profile.
Economic capital called solvency standard and risk
solvency standard
desired creditworthiness of an organization and can be inferred from
its (desired) debt ratings
A higher solvency standard implies that more economic capital is
held for a given level of risk
the greater the risk that an institution bears, the greater the financial
resources it must have in order to maintain a given solvency standard
solvency standard
the amount of capital a financial institution needs to hold against a
given level of risk is based on Robert Merton’s model of default :
a. A company’s shareholders own the right to default on payments to
debt-holders, and will do so if the value of the firm’s equity (net
assets) drops to zero
b. Debt holders charge shareholders for default risk by demanding a
spread over the risk-free rate on the funds they provide; and
c. The probability of default is a function of the current level and
potential variability (the probability distribution) of a firm’s net
asset value.
solvency standard
The process of calculation of an organization’s economic capital :
a. Generate stand-alone distributions of changes in the enterprise’s
value due to each source of risk;
b. Combine the stand-alone distributions, incorporating diversification
effects;
c. Calculate the total economic capital for the combined distribution
at the desired target solvency standard; and finally
d. Attribute economic capital to each activity based on the amount of
risk generated by the activity
Risk indicator or early warning systems
to give timely information about changes in risk conditions to allow
management to take appropriate action to mitigate risk.
Early warning systems can use either :
- external market data  use of market and economic data to indicate
changes in the amount of risk to which an institution is exposed.
Eternal Data : interest rates, foreign exchange rates, credit spreads,
unemployment rates, changes in GDP, the volatilities of these factors,
and so on. This information can be monitored in levels and trends,
also translated into the economic impact on an organization, such as
increases in funding costs.
Risk indicator or early warning systems
- Internal systems  institution-specific data to indicate
changes in risk levels. measured by directly to the bottom
line (e.g., credit card default rates) or associated less directly
with an increase in risk levels (e.g., increased concentration
in the lending book, or increased line utilization which may
indicate higher probability of customer default). advance
warning will allow to establish policies and procedures to
reduce exposure to the specific risks.
Risk Optimization Analytics

The goal of risk management is not to reduce an institution’s risk to

zero, or even to minimize risk. Without risk, there is no return. Rather,
it is to ensure that the enterprise is well compensated for the risk that
it takes, subject to the constraint that the risks taken fall within the
institution’s overall risk appetite.
 Method for maximize returns relative to risks
1. Risk-Adjusted Return on Capital
calculated for an institution as a whole, or separately for each of its business activities (e.g., by
product, customer, or business unit)
RAROC = Risk adjusted return / economic capital
disadvantage of RAROC as a performance metric is that it does not capture the quantity of
return that an activity generates.
RAROC apply for :
- credit risk related activities, since expected losses are often used in the calculation of return,
rather than actual losses.
- compare the risk/return of different, and potentially quite diverse, business activities.
- RAROC against its cost of equity capital (Ke), to identify business activities that are adding
shareholder value (RAROC is greater than Ke) and those that are destroying shareholder value
(RAROC is less than Ke).
Method for maximize returns relative to risks

2. Economic Income Created (EIC)

EIC = Risk−adjusted return − (Hurdle rate × economic capital)
EIC is better mechanism for setting performance targets and
executive compensation payouts, as it clearly encourages
business managers to pursue all above-hurdle, marginal
growth opportunities (whereas RAROC targets can have the
adverse effect of discouraging growth in businesses with high
historical RAROC performance).
Method for maximize returns relative to risks
3. Shareholder Value and Shareholder Value-Added RAROC and EIC
provides the translation from these annual measures to measures of
the intrinsic economic value of a business as an ongoing concern
Shareholder Value SHV : - capture the full economic value of a
transaction or business activity, which is to say the present value of all
future cash flows. - -
- measures the degree to which shareholder value exceeds the value of
the capital invested
- SHV = Discounted Value of Cash Flows
 Method for maximize returns relative to risks
• Share holder value added SVA = Discounted Value of EVAs
- measurement of the future growth prospects of a business, g.
- inherently difficult to estimate, particularly for time horizons well into the future.
- more useful, and accurate, to use detailed cash flow projections for each unit, most
organizations employ a medium-term horizon of three to five years in determining the growth
rate.
- the ratio involving RAROC, hurdle, and growth (g) in the SHV equation is conceptually similar
to a market-to-book ratio and can thus be benchmarked externally.
- SVA is designed as a decision-support metric.
- SVA analyses are generally used to support decisions about internal resource allocation, as
well as decisions on acquisitions, divestitures, and joint ventures.
- SVA employs many of the same conceptual factors that are used in the construction of the
performance metrics described above, but differs from them in that it captures both tangible
and intangible changes in value.
Market Risk Analytics
Interest Rate Models  useful in predicting the dynamics of cash flows
that are contingent on interest rates.
uses for interest rate or term structure models:
1. pricing interest rate-dependent instruments
2. interest rate risk management.
Value-at-Risk Models
Value-at-Risk (VAR) Models  common forms of measurement market
risk
There are 3 way to calculate VAR :
1. the parametric approach uses volatilities and correlations of risk
factors;
2. the Monte Carlo simulation method uses a simulation model to
generate many possible outcomes;
3. the historical simulation technique uses previously observed price
and rate movements.
Value-at-Risk Models
advantage of parametric VaR is that it can be calculated quickly and is
computationally simple, which makes it useful when analyzing
portfolios with many different assets and risk factors.
it assumes that asset returns are linearly related to risk factor returns,
and that the risk factor returns are normally distributed.
parametric VaR ignores non-linear price sensitivities, such as gamma for
options and convexity for bonds. In
parametric VaR models (usually) assume that price movements are
normal. Both of these factors cause underestimations of the potential
future volatility of portfolios