Management<br />BOI Domain Training<br />Date: 11 Jan 2010<br />
What is risk management?<br />RISK: Uncertainty regarding the value of the underlying asset<br />RISK MANAGEMENT: The proc...
Risk Management<br /><ul><li>It is a two-step process –
determining what risks exist in an investment and
handling those risks in a way best-suited to your investment objectives.
Risk management occurs everywhere in the financial world:
It occurs when an investor buys low-risk government bonds over more risky corporate debt, when a fund manager hedges their...
Risk Management Process<br />1<br />4<br />2<br />3<br />
Risk Assessment<br />The process of determining the likelihood that a specified negative event will occur. <br />Investors...
Risk Assessment<br />Examples of formal risk assessment techniques and measurements include <br />conditional value at ris...
Systematic Risk<br />The risk inherent to the entire market or entire market segment. <br />Also known as "un-diversifiabl...
Unsystematic Risk<br />Company or industry specific risk that is inherent in each investment. <br />The amount of unsystem...
DELAY / DEFAULT IN REALISATION – INVESTMENT</li></ul>Operational Risk<br /><ul><li>HUMAN FAILURE
SYSTEM DEFECTS  /    SYSTEM FAILURE
LAXITY IN INTERNAL RULES
LAXITY IN MONITORING </li></ul>Market Risk<br /><ul><li>INTEREST RATE VARIABLES
PRICE MOVEMENTS – ADVERSE DURING TENURE</li></ul>Other Risks<br /><ul><li>LIQUIDITY RISK
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Risk Management

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A primer on financial risk management for novice on banking & finance.

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Risk Management

  1. 1. Management<br />BOI Domain Training<br />Date: 11 Jan 2010<br />
  2. 2. What is risk management?<br />RISK: Uncertainty regarding the value of the underlying asset<br />RISK MANAGEMENT: The process of identification, analysis and either acceptance or mitigation of uncertainty in investment decision-making. <br />
  3. 3. Risk Management<br /><ul><li>It is a two-step process –
  4. 4. determining what risks exist in an investment and
  5. 5. handling those risks in a way best-suited to your investment objectives.
  6. 6. Risk management occurs everywhere in the financial world:
  7. 7. It occurs when an investor buys low-risk government bonds over more risky corporate debt, when a fund manager hedges their currency exposure with currency derivatives and when a bank performs a credit check on an individual before issuing them a personal line of credit. </li></li></ul><li>Risk Return Tradeoff<br />The principle that potential return rises with an increase in risk. <br />Low levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of uncertainty (high risk) are associated with high potential returns. <br />According to the risk-return tradeoff, invested money can render higher profits only if it is subject to the possibility of being lost.<br />
  8. 8. Risk Management Process<br />1<br />4<br />2<br />3<br />
  9. 9. Risk Assessment<br />The process of determining the likelihood that a specified negative event will occur. <br />Investors and business managers use risk assessments to determine things like <br />whether to undertake a particular venture, <br />what rate of return they require to make a particular investment <br />how to mitigate an activity’s potential losses. <br />
  10. 10. Risk Assessment<br />Examples of formal risk assessment techniques and measurements include <br />conditional value at risk- cVaR(used by portfolio managers to reduce the likelihood of incurring large losses); <br />loan-to-value ratios (used by mortgage lenders to evaluate the risk of lending funds to purchase a particular property); and <br />credit analysis (used by lenders to analyze a potential client’s financial data to determine whether to lend money and if so, how much and at what interest rate).<br />
  11. 11. Systematic Risk<br />The risk inherent to the entire market or entire market segment. <br />Also known as "un-diversifiable risk" or "market risk”<br />Interest rates, recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification. <br />
  12. 12. Unsystematic Risk<br />Company or industry specific risk that is inherent in each investment. <br />The amount of unsystematic risk can be reduced through appropriate diversification.  Also known as "specific risk", "diversifiable risk" or "residual risk". <br />For example, news that is specific to a small number of stocks, such as a sudden strike by the employees of a company you have shares in, is considered to be unsystematic risk. <br /><ul><li>Systematic risk affects a broad range of securities, unsystematic risk affects a very specific group of securities or an individual security. </li></li></ul><li>Risk Classification<br />Credit Risk<br /><ul><li>DEFAULT RISK – LOANS
  13. 13. DELAY / DEFAULT IN REALISATION – INVESTMENT</li></ul>Operational Risk<br /><ul><li>HUMAN FAILURE
  14. 14. SYSTEM DEFECTS / SYSTEM FAILURE
  15. 15. LAXITY IN INTERNAL RULES
  16. 16. LAXITY IN MONITORING </li></ul>Market Risk<br /><ul><li>INTEREST RATE VARIABLES
  17. 17. PRICE MOVEMENTS – ADVERSE DURING TENURE</li></ul>Other Risks<br /><ul><li>LIQUIDITY RISK
  18. 18. INTEREST RATE RISK
  19. 19. FOREX RISK
  20. 20. SOLVENCY RISK</li></li></ul><li>Beta<br />A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.<br />Beta is calculated using regression analysis, and you can think of beta as the tendency of a security's returns to respond to swings in the market. <br />A beta of 1 indicates that the security's price will move with the market. <br />A beta of less than 1 means that the security will be less volatile than the market. <br />A beta of greater than 1 indicates that the security's price will be more volatile than the market. <br />For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market. <br />
  21. 21. Diversification<br />A risk management technique that mixes a wide variety of investments within a portfolio. <br />The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. <br />Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. <br />
  22. 22. Hedging<br />“Hedge”: Take a position that offsets a risk<br />By hedging, one changes the risk inherent in owning the underlying asset.<br />The return distribution of the underlying asset is not changed<br />It’s a type of transaction that limits investment risk with the use of derivatives, such as options and futures contracts. <br />Hedging transactions purchase opposite positions in the market in order to ensure a certain amount of gain or loss on a trade. <br />They are employed by portfolio managers to reduce portfolio risk and volatility or lock in profits. <br />
  23. 23. VaR<br />VaR is defined as the predicted worst-case loss at a specific confidence level (e.g. 99%) over a certain period of time.<br />Value at Risk (VaR) is the most probable loss that we may incur in normal market conditions over a given period due to the volatility of a factor, exchange rates, interest rates or commodity prices. <br />The probability of loss is expressed as a percentage – VaR at 95% confidence level, implies a 5% probability of incurring the loss; at 99% confidence level the VaR implies 1% probability of the stated loss. <br />The loss is generally stated in absolute amounts for a given transaction value (or value of a investment portfolio).<br />
  24. 24. What is the Basel Committee?<br /><ul><li>Established at the end of 1974 by Central Bank Governors of G10 to address cross-border banking issues
  25. 25. Reports to G10 Governors/Heads of Supervision
  26. 26. Members are senior bank supervisors from G10, Luxembourg and Spain
  27. 27. Work undertaken through several working groups
  28. 28. Aims of Basel II:
  29. 29. To deliver a prudent amount of capital in relation to risk
  30. 30. To provide the right incentives for sound risk management
  31. 31. To maintain a reasonable level playing field </li></li></ul><li>Three pillars of the Basel II framework<br />Supervisory Review Process<br />Market Discipline<br />Minimum Capital Requirements<br /><ul><li> Credit risk
  32. 32. Operational risk
  33. 33. Market risk
  34. 34. Bank’s own capital strategy
  35. 35. Supervisor’s review
  36. 36. Enhanced disclosure </li></ul>All three pillars together are intended to achieve a level of capital commensurate with a bank’s overall risk profile<br />
  37. 37. Thank You<br />

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