Risk Management

INTRODUCTION TO
RISK MANAGEMENT

Dr. Ika Pratiwi Simbolon

References:
Hull, John C. 2012. Risk Management and Financial Institutions
Levine, D. M., Stevan , D. F., and Szabat, K. A. 2014. Statistics for Managers . Seventh Edition
Before we begin …
• Introduce your self, please.

• Password: SMILE & CHARACTER BUILDING & then

skill will follow itself.

• Volunteer for team leader.

• Make groups and team leader for each group.

 Learning Method

Student-Centered-Learning:

 Information Sharing
 Brainstorming LIFE-LONG-
 Group Discussion LEARNING
 Problem Solving Based

 Everything based on YOU

Valuation
• Attendance 10%  Max time to be late: 30
minutes, after that, there’s no presence in
attendance list. More than (>) 3 times absence: E

• Nine Values 10%

• Mid Exam 40%

• Final Exam 40%

Learning Outcomes
• To distinguish Risk vs Return for investors.

• To define the Efficient Frontier, the Capital Assets

Pricing Model, and Arbitrage Pricing Theory.

• To describe Risk Management by final institutions.

• To distinguish Risk vs Return for companies.

Introduction
• Companies must take risks to survive and prosper.

• The risk management function’s primary responsibility is

to understand the portfolio of risks that the company is
currently taking and the risks it plans to take in the future.

• It must decide whether the risks are acceptable and, if

they are not acceptable, what action should be taken.
Risk/Return Tradeoff
Return

Standard deviation (risk)

Risk vs Return for investors

• There is a trade off between risk and return when money

is invested.

HIGH RISK, HIGH RETURN

LOW RISK, LOW RETURN
• Low levels of uncertainty (low risk) are associated with
low potential returns. High levels of uncertainty (high risk)
are associated with high potential returns.

• The risk/return tradeoff is the balance between the desire

for the lowest possible risk and the highest possible
return. This is demonstrated graphically in the chart
below. A higher standard deviation means a higher risk
and higher possible return.
Portfolio Return and Risk
Covariance
The covariance of a probability distribution (σxy) measures
the strength of the relationship between two numerical
variables, X and Y.
A positive covariance indicates a positive relationship. A
negative covariance indicates a negative relationship. A
covariance of 0 indicates that two variables are
independent.

Because the covariance can have any value, you cannot

use it to determine the relative strength of the relationship.
Covariance between two variables:
• cov(X,Y) > 0 X and Y tend to move in the same direction
• cov(X,Y) < 0 X and Y tend to move in opposite directions
• cov(X,Y) = 0 X and Y are independent
Coefficient of Correlation
Measures the relative strength of the linear relationship between
two numerical variables.

• The population coefficient of correlation is referred as ρ.

• The sample coefficient of correlation is referred to as r.

ρ or r have the following features:

• Ranges between –1 and 1.

• The closer to –1, the stronger the negative linear relationship.
• The closer to 1, the stronger the positive linear relationship.
• The closer to 0, the weaker the linear relationship.
Portfolio Return and Risk
Portfolio Return

E(P) = wE (x) + (1-w)E(y)

Where:
E(P) = portfolio expected return
W = portion of the portfolio value assigned to asset X
(1-w) = portion of the portfolio value assigned to asset Y
E(X) = expected return of asset X
E(Y) = expected return of asset Y
Portfolio Risk
σp  w 2σ 2 x  (1  w)2 σ 2 y  2 ρw(1 w)σ x σ y

or:

σp  w 2σ 2 x  (1  w)2 σ 2 y  2w(1 w)σ xy

Where:
σ2x = variance x
σ2y = variance y
σx = standard deviation x
σy = standard deviation y

σxy = covariance xy
ρ = correlation
 n

i 1
(Xi  X) 2
σx  σx2 
n 1

Where:
x = mean
n = sample size
Xi = ith value of the variable X
 Coefficient of Correlation
cov (X, Y)
ρ
σxσ y

Where:

N n n
 (X i  X)(Yi  Y)
 (Xi  X) 2  (Yi  Y) 2
cov (X, Y) or σ xy  i 1 i 1 i 1
n -1 σx  σy 
n 1 n 1
Case
Example:
w=0.50
E(X)=$65
E(Y)=$35
σ2x=37,525
σ2y=11,025;
σxy= -19,275

Calculate the portfolio expected return and portfolio

risk.
Example:
w=0.50; E(X)=$65; E(Y)=$35; σ2x=37,525; σ2y=11,025;
and σxy= -19,275

E(P) = (0.5)(65) + (1-0.5)(35) = $50

 p  (0.5) 2 (37,525)  (1  0.5) 2 (11,025)  2(0.5)(1  0.5)(19,275)

2,500  $50
Alternative Risky Investments
Efficient Frontier
Return

Standard deviation (risk)

Portfolio below the curve are not efficient, because for the
same risk one could achieve a greater return.

Optimal portfolio should lie on this curve (known as efficient

frontier).
Beta vs. standard deviation
• Standard deviation includes systematic and unsystematic
risk; not used because unsystematic risk diversified away

• Beta: A standardized measure of the risk of an individual

asset, one that captures only the systematic component of
its volatility; measures how sensitive an individual security
is to market movements; measure of market risk
Unsystematic vs. systematic risk
Unsystematic risk:
risk that can be eliminated through diversification.
The unsystematic risk is the element of risk
that does not contribute to the risk of the
market.

This component is diversified away when the

investment is combined with other investments.

For example: Change of management,

bankruptcy.
Systematic risk
risk that cannot be eliminated through
diversification. The systematic risk
component measures the contribution of the
investment to the risk of the market.

For example: War, inflation.

Total risk = systematic risk + unsystematic risk

Portfolio Risk & the Number of Stocks in
Portfolio
The Capital Assets Pricing Model
Systematic risk is measured by beta coefficient, which estimates the
extent to which a particular investment’s returns vary with the returns
on the market portfolio.

CAPM also describes how the betas relate to the expected rates of
return that investors require on their investments.

The key insight of CAPM is that investors will require a higher rate of
return on investments with higher betas.

The CAPM therefore states that in equilibrium, only the systematic

(market) risk is priced, and not the total risk; investors do not require to
be compensated for unique risk.

Risk premium on an individual security is a function of its systematic

risk, measured by the covariance with the market
Assumptions
• Investors care only about expected return and standard
deviation of return.
• The ε’s of different investments are independent.
• Investors focus on returns over one period and the length
of this period is the same for all investors.
• All investors can borrow or lend at the same risk-free rate.
• Tax does not influence investment decisions.
• All investors make the same estimates of expected
returns, standard deviations of returns and correlations
between returns for available investments.
Equations of the CAPM can be estimated:

E(Ri )  R f  βi (E(Rm )  R f )

Where:
E(Ri) = the expected return on security i over
some number of periods
Rf = risk free rate
βi = the estimated beta for security I
E(Rm) = market risk
Beta Illustration
Provides a convenient measure of systematic risk of the volatility of an asset
relative to the markets volatility.

 is this measure--gauges the tendency of a security’s return to move in

tandem with the overall market’s return.

 1 Average systematic risk

 1 High systematic risk, more volatile than the market

 1 Low systematic risk, less volatile than the market

How to calculate beta
A common procedure is to use historical data and
regression analysis to determine a best-fit linear
relationship between returns from an investment and
returns from the market portfolio.

This relationship has the form:

R i  βi R m  e
Security Market Line
Line representing the relationship between expected return
and market risk; shows expected return of an overall
market as a function of systematic risk

Graphical representation of CAPM

Compare a single asset to the SML (and see if it falls below,

above, or on the line)
Overpricing/Underpricing and the SML
Assets above the SML are underpriced relative to the
CAPM. Why? Because the assets’ “too” high expected
return means their price is “too” low compared to the “fair”
CAPM value.

Assets below the SML are overpriced relative to the CAPM.

Why? Because the assets’ “too” low expected return means
their price is “too” high compared to the “fair” CAPM value.
Arbitrage Pricing Theory
• Unlike CAPM that is a one-factor model, APT is a multifactor
pricing model.
• However, unlike CAPM that identifies the market portfolio
return as the factor, APT model does not specifically identify
these risk factors in application.

These multiple factors include:

• Inflation
• Gross National Product
• Changes in interest rates

In practice, APT testing is difficult (as CAPM) since theory does

not provide any guidance regarding the risk factors
Risk vs Return for Companies

In practice companies are concerned about total risk.

Companies have to ensure that the expected returns on
new ventures are consistent with the risk-return trade-offs
of their shareholders.

• Earnings stability and company survival are important

managerial objectives.
• “Bankruptcy costs” arguments show that that managers
are acting in the best interests of shareholders when they
consider total risk.
What Are Bankruptcy Costs?
• By the time company reaches the point of bankruptcy, it is
likely that its assets have lost some value. This further
reduction in value is referred to bankruptcy costs.
• Lost sales.
• Key employees leave.
• Legal and accounting costs.
Regulation
• Governments throughout the world want a stable financial
sector.
• The regulations are designed to ensure that the
probability of bank or insurance company experiencing
severe financial difficulties is low.
• Regulated financial institutions are forced to consider total
risks (systematic plus nonsystematic).
Risk Management by Financial Institutions

Approaches to Bank Risk Management

• Risk aggregation: aims to get rid of risks with
diversification.
• Risk decomposition: tackles risks one by one
• In practice banks use both approaches
“Don’t forget to SMILE …”

Thank you fellas

God bless, Good Luck and With Love,

Dr. Ika Pratiwi Simbolon