Topic 1: Risk Management: A Helicopter View

What is Hedging?

Hedging is a transfer of risk without buying insurance policies.

Economic Capital Definition?

Holding sufficient liquid reserves to cover a potential loss. Example: VaR is at 2.5 million, if the entity has 2.5 million liquid reserves, then it is more unlikely for it go bankrupt.

How are bonds like an IOU or a loan

holders = lenders issuers = borrowers coupon = interest bonds give advantages to the lender to have long-term investments with extra money. -bond lenders are creditor stakeholders

What is a bond?

instrument of indebtedness of the bond issuer to the holders. The most common type of bonds include municipal bonds and corporate bonds. essentially think of a bond as a security, which the issuer owes the holder

What happens if a bond payment is made at a later date than the maturity date

interest may be added to the bond payment

What is remuneration?

pay or other compensation provided in exchange for the services performed.

4 types of Market Risk:

- interest rate risk - equity price risk -foreign exchange risk -commodity risk

Example of Recovery Value and Loss Given Default (LGD)

-Ex: 500,000 is settlement amount -400,000 is expected for recovery -100,000 is the LGD -Recover Rate = 80% -LGD rate = 20%

What is concentration risk?

-Geographically speaking lenders should diversify areas of loans given across industries. - Concentration risk and correlation risk can be related with the overall economic health.

What is business risk?

-uncertainty in an entity income statement -unsure of market prices and the supply and demand of products, and unsure of returns -decreased revenues and/or increased costs may be significant enough that the entity suffers financial losses.

What is a financial instrument?

A monetary asset, that can be traded. They can be any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

What are the 5 steps in in risk management?

5 steps: 1. Identify the risk 2. Quantify and estimate the risk exposures or determine methods to transfer the risk. 3. Determine the collective effects of the risk exposures or perform a cost-benefit analysis on risk transfer methods. 4. Develop a risk mitigation strategy (avoid, transfer, mitigate, or assume risk) 5. Assess the performance and amend risk mitigation strategy as needed.

What is an irredeemable bond?

A bond that has no maturity date.

What is a subsidiary?

A company controlled by holding a company.

What is Stress Testing?

A form of scenario analysis, taking past scenarios and stressing them on current entities to see potential outcomes.

Example of expected loss

An entity knowing how many credit users paying late or never paying.

Local Bank, Inc., (LBI) has loaned funds to a private manufacturing company, named We Make It All (Make It). The current balance of the loan is $1 million and it is secured by a piece of land and the corresponding building owned by Make It. Due to an economic downturn, Make It suffered a loss for the first time in its 10- year operating history and is currently experiencing some cash flow difficulties. In addition, the land and building that is held as collateral has recently been appraised at only $800,000. Based only on the information provided, which of the following risks faced by LBI have increased? A.Bankruptcy risk and default risk. B.Bankruptcy risk and settlement risk. C.Default risk and downgrade risk. D.Default risk, downgrade risk, and settlement risk.

Answer = A The fact that the loan is secured by land and the building is now worth less than the amount of the loan outstanding subjects LBI to increased bankruptcy risk in the sense that the liquidation value of the collateral is insufficient to recover the loss if the loan defaults. The financial loss and the cash flow difficulties suggest that there is increased default risk for LBI as well. Downgrade risk does not apply here because Make It's loan is not publicly traded and is unlikely to be rated by a recognized rating agency. Settlement risk does not apply here either because there is no exchange of cash flows at the end of the transaction that would be required to incur such risk. In this case, the loan is settled when Make It fully repays the principal balance owed.

Which of the following items would be associated with unexpected losses? Loan defaults are increasing simultaneously while recovery rates are decreasing. Lending losses are covered by charging a spread between the cost of funds and the lending rate. A.I only. B.II only. C.Both I and II. D.Neither I nor II

Answer = A Loan defaults are increasing simultaneously while recovery rates are decreasing is an example of correlation risk. Correlation risk could drive up the potential losses to unexpected levels. In contrast, if lending losses are covered with a spread, given that there is sufficient information to compute such a spread, then the losses would likely be considered expected losses.

Which of the following statements regarding risk and risk management is correct? A.Risk management is more concerned with unexpected losses versus expected losses. B.There is a relationship between the amount of risk taken and the size of the potential loss. C.The final step of the risk management process involves developing a risk mitigation strategy. D.If executed properly, the risk management process may allow for risk elimination within an economy.

Answer = A Risk management is more concerned with the variability of losses, especially ones that could rise to unexpectedly high levels or ones that suddenly occur that were not anticipated (unexpected losses). Choice B is not correct because risk is not necessarily related to the size of the potential loss. For example, many potential losses are large but are quite predictable and can be provided for using risk management techniques. Choice C is not correct because the final step of the risk management process involves assessing performance and amending the risk mitigation strategy as needed. Choice D is not correct because the risk management process only involves risk transferring by one party and risk assumption by another counter-party. It is a zero-sum game so it does not result in overall risk elimination

In considering the major classes of risks, which risk would best describe an entity with weak internal controls that could easily be circumvented with a lack of segregation of duties? A.Business risk. B.Legal and regulatory risk. C.Operational risk. D.Strategic risk.

Answer = c Weak internal controls and lack of segregation of duties would represent a non-financial risk and be best described as an operational risk. Choice A is not correct because business risk focuses on the income statement (i.e., revenues too low and expenses too high). Choice B is not correct because legal and regulatory risk focuses on the risk of an entity being sued or the risk of unfavorable changes in the rules and laws that the entity must follow. Choice D is not correct because strategic risk focuses on significant new business investments or significant changes in an entity's business strategy.

Examining the impact of a dramatic increase in interest rates on the value of a bond investment portfolio could be performed using which of the following tools? I. Stress Testing II.Enterprise risk management. A. I only B. II only C. Both I and II. D. Neither I nor II.

Answer: C Examining the impact of a dramatic increase in interest rates is an example of stress testing. Enterprise risk management makes use of measures such as stress testing.

What is specific risk?

Changes of a stock due to unique factors of the entity. (you can avoid specific risk but not market risk)

What is income smoothing?

Deceptive accounting techniques to level out fluctuations in net income from one period to the next. Companies want this practice because investors will pay premium for stocks with steady and predictable streams.

What is Strategic Risk?

Developing new products and there success in markets not being as successful as anticipated. Incurring a loss with the millions of dollars of investment. Or in a financial specific lending strategy chasing to riskier firms, but they may end up defaulting.

What is Enterprise Risk Management?

Entity wide managing risk within each department or division of an entity.

How can Risk Management cause market disruptions?

Example would be selling risky assets during a market crisis, and increase the markets volatility.

What types of liquidity risk are there?

Funding Liquidity Risk and Trading Liquidity Risk

What is downgrade risk?

If an entity has some financial instability or recent transaction that is decreasing its creditworthiness This leads to the lending party charing a higher lending rate, and it could also cause the entity to default due to the downgrade risk.

What is interest rate risk?

If interest rates rise, then bond values decrease.

What other than credit risk is involved in risk and return?

Liquidity risks and taxation impacts. Risk takers/ participants can also vary.

What is trading liquidity risk?

This is when you are unable to buy or sell a security at the market price because other sides (a counterpart) is not complying

What is operational risk?

Inadequate computer systems (having tech risks), insufficient internal controls, management issues, fraud, human error, natural disasters are a few to state.

Collateral definition?

It is a security that a lender will keep from the borrower incase the borrower defaults or can't repay the loan.

What is a position?

It is the amount of a security, commodity, or currency which is owned by an individual, dealer, instituion, or other fiscal entity.

What is a lien?

It is the claim on the security for the lender.

What is Refinancing?

It is the process of replacing an existing loan with a new loan. The new loan will pay off the current debt, so the debt is not eliminated when you refinance.

What is interest rate?

It is the proportion of the loan that the borrower pays the loaner, usually a percentage.

What is the zero sum game in risk management?

It means when one wins the other loses. There is no in between with risk management to satisfy both parties.

How can credit risk be considered for portfolio of loans?

Lenders should charge rates of interest to borrowers that will size the risk taken.

What else should be diversified with loans?

Maturity Dates should be

What is foreign exchange risk?

Monetary losses due to unhedged or not fully hedged currency positions. Imperfect correlation with currency price movements and changes in international interest rates.

What is settlement risk?

Net gain vs net loss (winning vs losing) - the losing position may choose to not pay and fulfill transaction.

What is basis risk?

Offsetting with partially hedged positions.

Example of VaR

Picture for example of VaR attached in notes Explanation - 2.5 million dollars are at the 95 percent confidence level. Meaning there is a 5 percent chance of having a loss greater than 2.5 million, and a 95 percent chance of a loss being 2.5 or less.

What is Risk more or less about?

Risk is not necessarily about how large or small the loss is, but more about how volatile and predictable that loss is.

What is bankruptcy risk?

Risk that the liquidation of the collateral by a counterpart is not sufficient to cover the loss on the default.

What are the 3 types of qualitative assessments?

Scenario Analysis, Stress Testing, and Enterprise Risk Management

Difference between short and long positions?

Short positions are borrowed and then sold, where as long positions are owned and then sold.

What is confidence level versus significance level?

So, if your significance level is 0.05, the corresponding confidence level is 95%. If the P value is less than your significance (alpha) level, the hypothesis test is statistically significant. If the confidence interval does not contain the null hypothesis value, the results are statistically significant.

Example of hedging against investment risk?

Strategically using instruments in the market to offset the risk of any adverse price movements. Or in other words investors hedge one investment by making another. Technically to hedge you would invest in two securities with negative correlations.

What is commodity price risk?

This is an example of volatility of commodities such as precious metals, base metals, agricultural products, and energy. The lack of trading liquidity leads to increase of price volatility. price jumps will happen a lot.

What are publicly traded securities?

This is ownership with a stock or bond in a public companie's shares.

What is Mark to Market?

That means that the markets assets/fair value accounts/ current financial situations are marked to the market.

What is General Market risk?

This is the sensitivity of the price of a stock to changes in market.

Why is OCC an example of having heavy operational risk?

The nature of derivative transactions make it susceptible to operational risk. OCC also derives complicated transactions making it more susceptible.

Which position always remains in credit risk?

The net gain position always risks losing due to the counterpart defaulting or not paying all of the settlement amount.

what is par value?

The nominal value of a bond, share of stock, or a coupon as indicated in writing on the document or specified by the character.

What are non public traded securities even riskier?

There is no market price validation.

What is a cash instrument?

These are securities that can be transferred. They can also be deposits and loans agreed upon by borrowers and lenders.

What is legal and regulatory risk?

These type of risks correspond with operational, repetition risk. Suing can occur due to the termination of a transaction or nullifying it.

What is Equity?

Think of it as one's degree of ownership in any asset after subtracting all debts associated with that asset.

What is Reputation Risk?

Trust, Ethics, Fairness, Public Reputation.

Derivative instrument?

Underlying components like assets, interest rates or indices. These can be over the counter derivatives or exchange traded derivatives.

What is correlation risk?

Unfavorable events happening together, like loan defaults in a recession. or Probability of loss from a disparity between the estimated and actual correlation between two assets, currencies, derivatives, instruments or markets.

In what conditions is VaR useful?

Useful for liquid positions, and under normal market conditions and for short periods of time.

What is VaR

Value at Risk is certain amount of loss and that probability of it occurring. .

What is default risk?

When a borrower does not pay a lender for an interest or principal on a loan.

What is funding liquidity risk?

When an entity is unable to refinance its debt, pay down debt, or satisfy cash obligations.

What is Credit Risk?

When counterparts don't pay their financial obligations under a contract then a party will endure loss. A part can be affected if this is increased risk of default by a counter-party.

Example of correlation risk with interest rate risk?

Where the price of a bond and the price of the vehicle for hedging were changed unfavorably.

What is equity price risk?

Where there is volatility of stock prices.

What is Scenario Analysis?

Worst Case Scenarios/ Adverse scenarios Macroeconomic scenarios on entities and various divisions, several categories, or risk considered.

Example of a bad mark to market with correlation risk

company bonuses for management may be based off of mark to market but those may be overstated and therefore overstating the bonuses.