Foundations of Risk Manageinent

1.1 The Building Blocks of Risk Management

• Most risk management disasters are caused by the failure to properly recognize and/or deal with
one or more of these fundamental building blocks, rather than the failure of some sophisticated risk
management technique.
1.1 TYPOLOGY OF RISKS AND RISK INTERACTIONS

• Typology has many uses.

• It can help organizations drill down into the risk-specific factors within
each risk type,
• map risk management processes to avoid gaps,
• and hold staff accountable for specific risk domains
1.1 TYPOLOGY OF RISKS AND RISK INTERACTIONS
1.1 TYPOLOGY OF RISKS AND RISK INTERACTIONS

• Corporate Risk
• Market Risk
• Equity Risk
• Interest Rate Risk
• Trading Risk
• Market Risk
• Specific Risk
• Gap Risk
• Currency Risk
• Commodity Risk
1.1 TYPOLOGY OF RISKS AND RISK INTERACTIONS

• Corporate Risk
• Credit Risk
• Downgrade Risk
• Bankruptcy Risk
• Operational Risk
• AML Risk
• Cyber Risk
• Model Risk
• Data Privacy Risk
• Business, Strategic & Reputation Risks
1.1 TYPOLOGY OF RISKS AND RISK
INTERACTIONS
• Furthermore, the risk types interact with one another so that risk flows.
• During a severe crisis, for example, risk can flow from credit risk to liquidity risk to market risk,
(which was the case during the global financial crisis of 2007-2009).
• The same can occur within an individual firm:
• the "fat finger" of an unlucky trader (operational risk) creates a
• dangerous market position (market risk) and
• potentially ruins the standing of the firm (reputational risk)
Market Risk

• Market risk takes many forms depending on the underlying asset.

• From a financial institution's perspective, the key forms are equity risk, interest rate risk, currency risk,
and commodity price risk.
• Across all the markets, market risk is driven by the following.
• General market risk: Risk that an asset class will fall in value, leading to a fall in the value of an
individual asset or portfolio.
• asset class will fall in value leading to a fall in value of an individual asset or portfolio.

• Specific market risk: Risk that an individual asset will fall in value more than the general asset class.
• fall in value of individual asset > fall in value of general asset class
Market Risk

• basis risk - a position intended to balance out, or hedge, another position or market price behavior
might do so imperfectly- a form of market risk
Credit Risk

• Credit risk arises from failure of one party to fulfill its financial obligations to another party. Ex
• A debtor fails to pay interest or principal on a loan (bankruptcy risk or default risk);
• An obliger or counterparty is downgraded (downgrade risk), indicating an increase in risk that may
lead to an immediate loss in value of a credit-linked security; and
• A counterparty to a market trade fails to perform (counterparty risk), including settlement or Herstatt
risk. (Named after the failure of Herstatt bank in Germany. The bank, a participant in the foreign exchange
markets, was closed by regulators in 1974. The timing of closure caused a settlement failure because Herstatt's
counterparties had already paid their leg of foreign currency transactions (in Deutsche Marks) only to find
defunct Herstatt unable to pay its leg (in US dollars)).
Credit Risk

• Credit risk is driven by

• probability of default of the obliger or counterparty,
• exposure amount at the time of default, and
• amount that can be recovered in the event of a default.
• These levers can all be altered by a firm's approach to risk
management through factors such as
• quality of its borrowers,
• structure of the credit instrument,
• The structure of credit instrument involves whether the credit instrument is collatera lized or not,
• type of collateral if it is collateralized,
• priority of the creditor in case of bankruptcy, and inclusion of protective covenants in the loan agreement that impose
restrictions on the borrower so as to protect the lender
• and controls on exposure.
Credit Risk

• The exposure amount is clear with most loans but can be volatile with other kinds of transactions.
Ex: derivatives
• The portfolio will be a lot riskier if:
• It has a small number of large loans rather than many smaller loans;
• The returns or default probabilities of the loans are positively correlated (e.g., borrowers are in the same industry or
region);
• The exposure amount, probability of default, and loss given default amounts are positively correlated (e.g., when defaults
rise, recovery amounts fall).
Liquidity Risk
• Liquidity risk is used to describe two quite separate kinds of risk: funding liquidity risk and
market liquidity risk
• Funding liquidity risk: risk that covers the risk that a firm cannot access enough liquid cash and
assets to meet its obligations.
• Funding liquidity risk threatens all kinds of firms. For example, many small and fast-growing firms find
it difficult to pay their bills quickly enough while still having sufficient funds to invest for the future.
• Banks have a special form of funding liquidity risk because their business involves creating maturity
and funding mismatches. One example of a mismatch is that banks aim to take in short-term
deposits and lend the money out for the longer term at a higher rate of interest. Sound
asset/liability management (ALM), therefore, lies at the heartening of the banking business to help
reduce the risk. There are various techniques involved in ALM, including gap and duration analyses.
• Market liquidity risk (trading liquidity risk): risk of a loss in asset value when markets
temporarily seize up. If market participants cannot, or will not, take part in market, this may force a
seller to accept an abnormally low price, or take away the seller's ability to turn an asset into cash and
funding at any price. Market liquidity risk can translate into funding liquidity risk overnight in the case
of banking institutions too dependent on raising funds in fragile wholesale markets.
Operational Risk
• Risk of loss resulting from inadequate or failed internal processes, people, and systems or
from external events.
• It includes legal risk, but excludes business, strategic, and reputational risk.
• physical operational mishaps and corporate governance scandals

•
Business and Strategic Risk

• Business risks lie at the heart of any business and includes all the usual worries of firms, such as customer
demand, pricing decisions, supplier negotiations, competition, and managing product innovation

• Strategic risk involves making large, long-term decisions about the firm's
direction
• For example, today banks and other financial institutions are facing competition from so-called financial
technology [FinTech] companies

• Role of risk managers

• Define risk appetite for risk in holistic manner
• Quantify aspects of business and strategic risks
• Be involved at the start of business planning
Reputation Risk

• Reputation risk is the danger that a firm will suffer a sudden fall in its
market standing or brand with economic consequences (e.g., through
losing customers or counterparties).
1.2 The Risk Management Process
Assess the
effects of any
Identify the risk risk event

Analyse and Manage the risk

measure risk

I – Identify
A – Analyze
M – Manage
AI – Assess Impact
• Brainstorming
• Structure Interviews
• Industry resources
• Loss data analysis
• Basic Risk triage
• Hypothetical what-if
• Front line observation
• Following the trail
The risk management process culminates in a series of choices that both manage risk and help to

define the identity and purpose of the firm.

• Avoid Risk: risks that can be sidestepped by discontinuing the business or pursuing it using a different
strategy. For example, selling into certain markets, or off-shoring production, might be avoided to
minimize political or foreign exchange risks.
• Retain Risk: retained within the firm's risk appetite. Large risks can be retained through mechanisms
such as risk capital allocation, self-insurance, and captive insurance.
• Mitigate Risk: There are risks that can be mitigated by reducing exposure, frequency, and severity
• Transfer Risk: There are risks that can be transferred to a third party using derivative products,
structured products, or by paying a premium (e.g., to an insurer or derivatives provider).