Introduction to Risk

Dr. P.K. Gupta

Some questions to think!

Are organizations adequately insured? Why RBI extended the time for BASEL II implementation? What is the status of loss control strategy in operating offices? Do

HR

departments

have

sophisticated

HR

transition

strategies?

Some questions to think!

Do we know what is VaR? What is the status of implementation

of VaR?
Why

corporate reporting now started talking of risk

management?
Have you earlier heard of dedicated risk management positions

in organizations?

Some questions to think!

Can we think of BASEL III? Corporate Governance-still a long way to go! How may companies actually do project risk analysis?

Business Models of Companies solely based on returns!!

Level of ERM in insurance, Government etc..

We Know?
Insurance Derivatives Loss Control Hold-harmless agreements Corporatization Diversification Innovation Balance Sheet Provisioning

Risk - Basics

What is Risk ?

Risk refers to the deviation from the standard- it refers

to the possibility that actual outcomes shall be different

from the standard ones.

Chinese Expression of Risk

Danger + Opportunity

Uncertainty Defined
Uncertainty is said to exist in situations where decisionmakers lack complete knowledge, information or understanding concerning the proposed decision and its possible consequences.

Risk is an implication of a phenomenon being uncertain- that may be wanted or unwanted.

Uncertainties and their implications need to be understood to be managed properly.

Types of Uncertainty
Aleatory uncertainty- uncertainty arising from a situation of
pure chance, which is known.

Epistemic uncertainty- uncertainty arising from a problem

situation where the resolution will depend upon the exercise of judgment.

Risk vs. Uncertainty

A decision is said to be subject to risk when there is a range of
possible outcomes and when known probabilities can be attached to the outcome.

Uncertainty exists when there is more than one possible

outcome to a course of action but the probability of each outcome is not known.

Riskuncertainty continuum

Susceptibility to Change or External Influences: opportunity upside or downside result

Degree of Interdependency with other Factors of Risk

Severity of Impact (high/low): threat intensity (damage potential) continuously varying in terms of cost & time

Probability of Occurrence (high/low): Varying probability (0-1) Frequency (high/low) potential)

Risk Level & Risk-Adjusted Returns

Risk-Aversion (Sub-optimal)
Matching Risk (Optimal) Excessive Risk (Sub-optimal)

Risk

Shimpi(2001)

Why Risk?
Risk reduces Value
What is Value?

Value is measurable variable that depicts ones desire or state of affairs in a given set of circumstances. Since circumstances never remain same for any identity, what ever value is perceived or created is always at risk (Value-at-risk).

Some Proxies for value

Economic Value Added (EVA) Risk-adjusted return Market capitalisation

What is VaR?
VaR measures the worst expected loss over a given
horizon under the normal market conditions at a given confidence level.

VaR Methodologies

Historical Simulations Approach Variance-Covariance Approach Monte-Carlo Simulation

Supplementing VaR
Stress Testing
Hypothetical estimation of various market scenarios, valuation of the impact, development of contingency plans

Sensitivity Analysis
Hypothetical changes in the value of the individual market factor, use of pricing models to compute the overall value, formulating strategies for the

combined impact.

Drivers of Stakeholders Value

Discounted Value of the Current Business Model Value of the future growth Options

Enterprise Value

Enterprise Value ~ Stakeholders Value

(Shareholders, Employees, Customers, Suppliers, Outside agencies etc.)

The value of the enterprise is the utility or the importance of the entity
Gupta(2004)

Risk Classifications

Generic Classification
Risks
Degree of Occurence
Static Dynamic

Measurability
Financial

Association
Particular

Chance of Loss
Speculative Pure

Non-Financial Fundamental

Risks for Banks &Financial Institutions

Market Risk Foreign Exchange Risk Deviations to the mark-to-market value of trading portfolio Variation in earnings/assets from forex exposures Default Risk, Portfolio Risk Inability to absorb losses generated by all risks, with the available capital Changes in Interest rates Malfunctioning in the IS, Internal controls/risk-monitoring rules, reporting systems

Credit Risk Solvency Risk

Interest Rate Risk Operational risk

Risk for Individuals

Personal Risks Premature Death Dependent old Age Sickness/Disability Unemployment Loss of Property Loss of use of property Legal liability arising out of intentional/ unintentional torts Failure to meet obligations

Property Risks Liability Risks

Risks arising from failure of others

Risk for Businesses

Market Risk Price Risk (I/O Prices Commodities, exchange rates, Interest rates) Credit Risk Non-market Risk Pure Risk(Damage to assets, legal liability, worker injury, employee benefits) Process related risks Structured Risks

Basel Type Classification

Credit - a customer, counter party, or supplier will fail to meet its obligations. It includes every thing from a borrower default to supplier missing deadlines because of credit problems. Market - Market risk is the risk that process will move in a way that has negative consequences for a company.

Basel Type Classification

Operational - risk that people, processes, or systems will fail or that an external event will negatively affect the company. Other - extensions of the above categories viz. Business risk is that future operating results may not meet expectations ; organisational risk arises from a badly designed organisational structure or lack of sufficient human resources.

Risk to Corporations
Credit Risk-failure of counter party

Market Risk Deviations due to adverse movement of market value of assets

Model Risk- emanating due to use of inappropriate models and analytical tools

Suitability Riskarising from client transaction suitability issues Liquidity Riskmismatches of cash flows

Process Risk-arising from failure of business and control processes

Legal Risk- - legal process failures

Market Risk Types

Directional Risk-deviations due to adverse movement in the direction of the underlying reference asset Curve Risk-deviation due to adverse change in the maturity structure of a reference asset Volatility risk unexpected volatility of financial variable

Market Risk Types

Time decay risk risk due to passage of time Spread risk-adverse change in two reference assets that are unrelated Basis risk - adverse change in two reference assets that are related Correlation risk risk due to adverse correlations

Credit Risk Types

Direct Credit Risk- due to counter party default on a direct, unilateral extension of credit Trading credit risk-counter party default on a bilateral obligation(repos) Contingent credit-counter party default on a possible future extension of credit

Credit Risk Types

Correlated credit risk magnified effect Settlement risk-failure of the settlement conditions

Sovereign risk- due to government policies(exchange controls)

Misconceptions
Risk can be eliminated Risk Management is always better Risk set is finite Risk management is implied/automatic Top valued(rated) organizations have best risk management practices

Perception of Risk

Different people will respond to seemingly similar risky situations in very different ways. Empirical evidence concerning individual risk response is often ignored in the risk analysis process.

Perception of Risk
Experience, subjectivity and the way risk is framed all play a major role in decision making. Risk perception has a crucial influence on risk-taking behavior. The perceived importance attached to decisions influences team behavior and the consequent implementation methods.

Psychological Risk Dimensions

People use heuristics to evaluate information that may lead to inaccurate judgments in some situations become cognitive biases. Representativeness - usually employed when people are asked to judge the probability that an object or event belongs to a class or processes by its similarity implying - insensitivity to prior probability, sample size, misconception of chance, insensitivity to predictability, illusion of validity, misconception of regression

Psychological Risk Dimensions

Availability heuristic: events that can be more easily brought to mind or imagined are judged to be more likely than events that could not easily be imagined: - biases due to retrievability of instances - biases due to the effectiveness of research set - biases of imaginability - illusory correlation

Psychological Risk Dimensions

Anchoring and Adjustment heuristic: people will often start with one piece of known information and then adjust it to create an estimate of an unknown risk but the adjustment will usually not be big enough: - insufficient adjustment - biases in the evaluation of conjunctive and disjunctive event - anchoring in the assessment of subjective probability distributions

Psychological Risk Dimensions

Cognitive Psychology Factors that are common and generic are more expressed. Psychometric Paradigm People perceive risks to be high in general . Perceived risk is quantifiable and predictable.

Psychometric research
Broad domain of characteristics that may be condensed into three high order factors: # the degree to which a risk is understood #the degree to which it evokes a feeling of dread and #the number of people exposed to the risk.

Case Lets
Daimler and Chrysler Business Risk & Its Impact Webvan- What ERM does? Global Petroleum Hazard Risk Management Response World Trade Center- Catastrophic Risk Philips, Nokia and Ericsson- Quantum of Risk

Risk Cultures & Business Models

Classical Risk Controllers Efficiency Enhancers Risk Transformers

Classical Risk Controllers

Firms that allocate resources to a RM process exclusively in order to avoid losses in excess of a shareholders risk tolerance.

Risk management as a cost center - more focused on minimizing

the gaps between actual risk exposures and target risk exposures (examples: gap reports, exposure norms)

These firms significantly emphasis on VaR policy measures, hedge

ratios, collateral management etc..

Third party services on risk management and risk transformation products, and services often meet the risk management needs.

Suppliers of risk transformation solutions are swap dealers, clearing

houses, exchanges, derivative instruments etc.. Significant amount is spend on consulting services and on consulting firms.

Efficiency Enhancers
Firms that leverage their risk management process into efficiency enhancement in other non-risk related business lines. Focus on strategy of risk management rather than on tactical implementation issues. Use of risk control tools not just for classical risk control but rather to operate their businesses more effectively. Paramount importance on strategic consulting services rather than pre-canned software solutions and over used policy and procedure templates.

Risk Transformers
Risk management is viewed primarily as a business opportunity. Conventionally emerged from demanders of risk products to suppliers of financial innovations.

Special Facets of Risk

Risk without owners

Strategic Risk-possible deviations from adopting an identified risk or failure to recognize problems(strategic failure) Subculture risk- problems that occur because unit cultures vary in terms of their ability to operate effectively within a larger structure. Leadership risk- leadership misbehaviors

Life cycle risk- failure to respond to the various stages of life cycle

Horizon Risk

An external exposure that arises when the organization is not actively scanning its external environment for the development and changing trends that could affect business and operations.

Horizon Risk - Broad Goals

Vision Risk- Do we have a compelling business model that is consistent with changes that are occurring outside our controller current risk mitigation strategies? Resources Risk- Have we linked and will we continue to be linked proactively so that resources expended will not be wasted as a result of changing external conditions? Market Risk- When we assess capabilities and likely actions of customers and competitors, are we considering new developments and trends that could destroy our business?

Thank You You