Topic 1:
Introduction to Risk Management in
Finance
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1.1 What is Risk?
• In the Concise Oxford English Dictionary:
– Risk is hazard dangerous to your health, safety, wealth, plan
or reputation.
– A chance of bad consequences
– Loss or exposure to mischance
• McNeil et al. (2005): “Risk is any event or action that
may adversely affect (negative impact) an
organization’s ability to achieve its objectives and
execute its strategies (how to increase sales/profit)”.
• Anyway, no single one-sentence definition captures all
aspects of risk.
• Risk =Chance of Loss ⇒ Randomness (no direction) /
Uncertainty  not sure
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1.1 What is Risk? (cont’d)
• Distinguishing between “Uncertainty” and “Risk”
– Uncertainty exists whenever one does not know for sure
what will occur in the future. (do not know what happen in
future)
– Risk is the uncertainty that matters if it affects
people's welfare. (life/ monetary)
• Thus, uncertainty is a necessary but not a sufficient
condition for risk.
• Every risky situation is uncertainty, but there can be
uncertainty without risk (no change in profit).
– For example, the uncertainties happening in a project’s daily
operations are not a risk, as long as the uncertainties are
not developing into a risk that affects the project profits.
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1.1 What is Risk? (cont’d)
• In many risky situations, the possible outcomes can be
classified either as losses or gains in a simple and
direct way.
• For example, suppose that you invest in the stock
market. If the value of your stock portfolio goes down, it
is a loss; and if it goes up, it is a gain.
• The issue is people normally consider the "downside"
possibility of losses to be the risk, not the "upside"
potential for a gain (investors respond to risk
differently).
• But, there are some situations in which there is no
obvious downside or upside in the short run, if the
upside gain is not substantial and long enough, we can’t
say it is definite upside risk.
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1.1 What is Risk? (cont’d)
Economists use three categories to describe how
investors respond to risk:
• Risk averse is the attitude toward risk in which
investors would require an increased return as
compensation for an increase in risk.
• Risk neutral is the attitude toward risk in which
investors choose the investment with the higher
return regardless of its risk.
• Risk seeking is the attitude toward risk in which
investors prefer investments with greater risk even
if they have lower expected returns.
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1.1 What is Risk? (cont’d)
• Risk aversion is also a measure of willingness to
pay to reduce one's exposure to risk.
• In evaluating trade-offs between the costs and
benefits of reducing risk, risk averse people prefer
lower-risk alternatives for the same cost or
expected rate of return.
• For example, if you are generally willing to accept a
lower expected rate of return on an investment
because it offers a more predictable rate of
return (i.e. less risk), you are risk averse.
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1.2 Risk Exposure
• If you face a particular type of risk because of your job,
the nature of your business, or your pattern of
consumption, you are said to have a particular risk
exposure.
• For example,
– If you are a farmer, you are exposed both to the risk of a
crop failure[operating risk because crop is part of the
supply chain of the farmer] and to the risk of a decline in
the price at which you can sell your crops[commodity price
risk].
– If your business significantly involves imports or exports of
goods, you are exposed to the risk of an adverse change in
currency exchange rates. [currency risk / foreign exchange
risk]
– If you own a house, you are exposed to the risks of fire,
theft, storm damage, earthquake damage, as well as the
risk of a decline in its market value. [market risk]
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1.2 Risk Exposure (cont’d)
• On one hand, a purchase or sale of a particular asset may
be risk increasing, and on the other hand, may be risk
reducing.
• For example, if a farmer with wheat ready to be harvested
enters a contract to sell wheat at a fixed price in the
future, the contract is risk reducing. (The farmer is a
hedger)
• But, if a speculator who has no wheat to sell, entering
into that same contract to speculate that wheat prices
will fall, the contract is risk increasing.
• This is because the speculator gets profit only when the
market price at the contract delivery date is below the
future’s contractual, fixed price (i.e. the speculator can
buy at low market price and sell high with the contract).
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1.2 Risk Exposure (cont’d)
• Speculators (risk seeking) are defined as investors
who take positions that increase their risk
exposure to certain risks in the hope of increasing
their wealth.
• In contrast, hedgers (risk adverse) take positions
to reduce their risk exposures.
• The same person or trader in the stock market can
be a speculator on some risk exposures and a
hedger on others.
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1.3 Common Risks Faced by Individuals
Five common major categories of risk exposures for
individuals:
1) Sickness, disability, and death (purchase health
and life insurance) [nonfinancial risk]
– Unexpected sickness or accidental injuries can impose
large costs on people because of the need for treatment
and care and loss of income caused by inability to work.
2) Unemployment risk (savings, unemployment
insurance)
– This is the risk of losing one's job.
3) Consumer-durable asset risk (purchase car
insurance, fire insurance)
– This is the risk of loss arising from ownership of a house,
car or other consumer-durable assets. Losses can occur
due to hazards such as fire or theft, or due to
obsolescence arising from technological change.
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1.3 Common Risks Faced by Individuals
(cont’d)
4) Liability risk / legal risk(purchase car insurance)
– This is the risk that others will have a financial claim against
you because they suffer a loss for which you can be held
responsible.
– For example, you cause a car accident through reckless driving
and are required to cover the cost to others of personal injury
and property damage.
– If you are a guarantee, you are responsible for the financial
claim, hence, facing liability risk.
5) Financial-asset risk (diversification, options, futures)
– This is the risk arising from holding different kinds of
financial assets such as equities or fixed-income securities
that denominated in one or more currencies.
– The underlying sources of financial-asset risk are the
uncertainties faced by the firms, governments, or other
economic organizations that have issued these securities.
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1.4 Risks Faced by Firms
• Business risks of the firm are borne by its
stakeholders (including shareholders, creditors,
customers, suppliers, employees and government).
• The financial system in the market can be used to
transfer risks faced by firms to other parties.
Specialized financial firms such as insurance
companies perform the service of pooling and
transferring risks (not to reduce the risks).
• Ultimately, however, all risks faced by firms are
borne by the people (as in 2008 world financial
crisis). [this can happened if the counterparty do
not fulfil their commitment]
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1.5 Risk Management Process
• Risk Management Process:
– The process of formulating the benefit and
cost trade-off of risk reduction, and deciding
on the course of action to take for managing
the risk (including the decision of taking no
action at all).
• By definition, risk-management decisions are made
under conditions of uncertainty, and therefore
multiple outcomes are possible.
• After the fact, only one of these outcomes will occur.
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1.5 Risk Management Process (cont’d)
• It is difficult in practice to distinguish between the skill
and luck of a decision maker.
• Neither recriminations nor congratulations for a decision
seem warranted, when such action are based on
information not available at the time the decision
was made. [not at the time the decision’s outcome is
produce] [Ex: if a manager compare marginal cost and
benefit and make a decision, we say that this manager
made a rational decision even the decision will not
necessarily produce positive outcome, but as long as the
decision is made after considering all aspects, it is a
rational decision]
• Thus, the appropriateness of a risk-management
decision should be judged, in the light of the
information availability at the time the decision is
made.
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1.5 Risk Management Process (cont’d)
The risk management process can be broken down
into five steps:
1. Risk identification
– Risk identification consists of figuring out what
the most important risk exposures are for
the unit of analysis, be it a household, a firm or
some other entity.
2. Risk assessment
– Risk assessment is the quantification of the
costs associated with the risks that have
been identified in the first step of risk
management.
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1.5 Risk Management Process (cont’d)
3. Selection of risk-management techniques.
– There are four basic techniques available for reducing risk:
• Risk avoidance - A conscious decision not to be exposed
to a particular risk.
• Loss prevention and control - Actions taken to reduce
the likelihood or the severity of losses (impact).
• Risk retention - Absorbing the risk and covering losses
out of one's own resources.
• Risk transfer - Transferring the risk to others. [got three
types of risk transfer techniques]
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1.5 Risk Management Process (cont’d)
4. Implementation
– Following a decision about how to handle the risks identified,
one must implement the techniques selected.
– The underlying principle in this step of the risk-management
process is to minimize the costs of implementation.
5. Review
– Risk management is a dynamic feedback process in which
decisions are periodically reviewed and revised.
– As time passes and circumstances change, new exposures
may arise, information about the likelihood and severity of
risks may become more readily available, and techniques
for managing them may become less costly.
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1.6 Three Dimensions[techniques] of Risk
Transfer
1) Hedging
– One hedges a risk when the action taken to reduce
one's exposure to a loss, also causes one to give up
of the possibility of a profit. [gain some part of
certainty profit while giving up potential gain]
– For example, farmers who sell their future crops before the
harvest at a fixed price to eliminate the risk of a low price
at harvest time, also give up the possibility of profiting
from high prices at harvest time. They are hedging their
exposure to the price risk of their crops.
2) Insuring
– Insuring means paying a premium (for example, the
price paid for the insurance) to avoid losses and retain
the potential for gain. [only claim insurance when we
incur loss]
– For example, by buying insurance, you substitute a sure
loss (the premium you pay for the policy) for the possibility
of a larger loss if you do not insure.
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1.6 Three Dimensions of Risk Transfer
(cont’d)
• The fundamental difference between insuring and
hedging:
– When you hedge, you eliminate the risk of loss by
giving up the potential for gain.
– When you insure, you pay a premium to eliminate the
risk of loss, and retain the potential for gain.
3) Diversifying
– Diversifying means holding similar amounts of many
risky assets instead of concentrating all of your
investment in only one. “Do not put all eggs in a basket”
– Diversification thereby reduces your exposure to the
risk of any single asset (non-systematic risk).
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1.7 Risk Management “in Finance”
• Financial Risk Management is the process by
which the financial risks are identified, assessed,
measured and managed in order to create economic
value (purpose).
• Some risks can be measured reasonably well. For
those, risk can be quantified using statistical tools
to generate a probability distribution of profits and
losses.
• Some other risks are not applicable to formal
measurement but are nonetheless important.
• The function of the risk manager is to evaluate
financial risks using both quantitative tools and
judgment (qualitative tools).
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1.8 A Brief History of Financial Risk
Management
1) Academic innovation in the 20th century
• Markowitz (1952): Theory of portfolio selection;
Desirability of an investment was decided upon a
risk-return diagram.
– An efficient frontier determined the optimal return for a
given risk level (x-axis: standard deviation; y-axis:
expected return). (for a given same level of risk, choose the
best return portfolio; for a given same level of return,
choose the lower risk portfolio)
• Capital Asset Pricing Model (CAPM) developed in the
early 1960s by William Sharpe, Jack Treynor, John
Lintner and Jan Mossin.
– Expected asset return and systematic (market) risk
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1) Academic innovation in the 20th century
• Late 20th century: Theory of valuation for
derivatives
– Black and Scholes (1973): Black–Scholes–Merton formula
for the price of a European call option (hedging risk of
financial asset) (Scholes and Merton received Nobel Prize in
1997)
Fischer Black
Myron Scholes
Robert Merton
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2) Disasters of the 1990s
1995 Barings Bank ruin
• Growing volume of derivatives in banks’ trading
books (which often not appearing as assets or
liabilities in the bank’s balance sheet do not have
proper record).
• 1995 Barings Bank’s operational risk loss.
– Straddle position on the Nikkei and Kobe earthquake had
incurred a total loss of $1.3 billion
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3) 1996–2000: Dot-com bubble
• Technology-dominated
Nasdaq index climbed
from around 1000 to
around 5400.
• Many firms that
contributed to this rise
belonged to the internet
sector.
• Within one year, the
Nasdaq fell by 50%.
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4) The World Financial Crisis of 2008
• US house prices began to decline in 2006 and 2007.
• Subprime mortgage holders (loan borrowers) having
difficulties in refinancing their loans due to higher
interest rates had defaulted on their payments
to banks.
• In 2007, this led to a rapid reassessment of the
riskiness of securitization and losses in the value
of the Collateralized Debt Obligation (CDOs).
• Banks were forced into write downs the value of
these assets on their balance sheets.
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Securitization and CDOs - Destructive
financial innovation in the century
• An asset-backed security (ABS) is a security created from
the cash flows of underlying financial assets such as mortgage
loans, bonds, credit card receivables, auto loans and aircraft
leases. [financial security backed by the income-generating
asset]
• A particular type of ABS is called Collateralized Debt
Obligation (CDO). It is a financial tool that banks use to
repackage individual mortgage and loan into a product and
sold to investors in the secondary market. Many mortgage
loans were given to borrowers with low credit ratings
(subprime mortgage borrowers). CDO issuance volume by
2008 was around $3 trillion.
• Credit Default Swaps (CDS) is a type of insurance
protection against CDO’s default used by investors to speculate
on the credit risk. CDS was issued with huge volume around
$30 trillion. [usually sold by insurance companies(AIG)]
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The Financial Crisis of 2008 (cont'd)
• World financial crisis in 2008 is the most serious
financial crisis since 1920s and it had caused
some of the big financial companies collapsed.
• Bear Stearns collapsed in March 2008 and it was
sold to JP Morgan Chase.
• Lehman Brothers filed for bankruptcy in
September 2008 which had caused worldwide
panic, markets tumbled, liquidity vanished and
many banks nearly collapse.
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The Financial Crisis of 2008 (cont'd)
• AIG (who offer insurance for the default risk in the
securitized products by selling CDS protection) got
into difficulty when many of the underlying
securities defaulted in 2008.
• AIG called for an emergency loan of $85 billion from
the Federal Reserve Bank of New York.
• Governments had to bail out some companies by
injecting capital, or acquiring their distressed
assets.
• US-TARP (Troubled Asset Relief Program) was
executed.
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The Financial Crisis of 2008 (cont'd)
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Costs of the Financial Crisis 2008
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Evolution of Global Financial Crisis: Mid 2007- 2010
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The Financial Crisis of 2008 (cont'd)
- Failure of Asset Pricing Models?
• Mathematicians/financial engineers were also blamed
due to the failure of pricing models used to design
the complex securitized products.
• Some experts criticise the failure of pricing models
are caused by the formula of “Gauss copula model”
which its application to credit risk was attributed to
David Li.
– Read “Recipe for disaster: the formula that killed Wall
Street”. https://www.wired.com/2009/02/wp-quant/
• Mathematicians had also warned about securitization.
Political short-sightedness, the greed of market
participants and the slow reaction of regulators had
all contributed to the financial crisis.
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5) Recent developments and concerns
Algorithms Trading Errors
• High Frequency Trading (HFT) has raised
concerns among the regulators.
• The high frequency trades are executed by
computer (algorithms) in fractions of a second
(no testing), and normally the computer centres are
build near stock markets for faster trading.
• Algorithms trading error events was triggered:
1) Flash Crash of 06-May, 2010 wiped off
trillions of dollars in equity.
2) Knight Capital Group lost $460 million due to
trading errors on 01-August, 2012.
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1.9 Road to Regulation – Basel Accords
• Systematic risk (or undiversifiable-risk) of the
collapse of the entire financial system due to the
propagation of financial stress through a network of
participants. The networks are complex.
• Besides banks and insurance companies, the
financial system contains largely unregulated
hedge funds and structured investment
vehicles (for example, the “shadow banking
system”).
• Regulation in bank risk management is to ensure
that financial institutions have enough capital
to remain solvent.[absorb loss, this technique is
called risk retention technique]
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1.9 The Road to Regulation – Basel
Accords (cont’d)
• Basel Committee of Banking Supervision
(BCBS)[Basel Standard] - Committee established
by the Central-Bank Governors of the Group of Ten
(G10) in 1974.
• Basel Accords drafted by BCBS is the worldwide
regulation for bank risk management.
• The Basel Committee does not have legal force, but
it formulates standards, best practices and
guidelines.
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1.10 Why manage financial risk?
- A societal view
• Society relies on the stability of the banking and
insurance system for optimal consumption and
resource allocation of individuals.
• The reduction of systemic risk has become an
important focus of banking regulation (from which Basel
Accords) since the 2007–2009 crisis.
• Most would agree that the protection of customers
and the promotion of financial stability are vital.
• But, it is not always clear whether the two aims are well
aligned (for example, it might be good to let a company
go bankrupt to teach others a lesson).
• Considering some systematically important firms as
“too big to fail” creates a moral hazard (which
actually should be avoided), because the firm’s
management board may take more risk knowing
that it would be bailed out in a crisis.
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1.10 Why manage financial risk?
- A shareholder’s view
• Individual investors are typically risk averse and they
should therefore manage the risk in their portfolios.
• But it is not clear whether the risk management at
the corporate level (e.g. hedging a foreign-currency
exposure or holding a certain amount of risk capital)
can increase the value of a corporation and thus
enhance shareholder value. [but need to beware of
the agency theory: incentive of managers may be
different with shareholders’]
• The rationale behind is simple: If investors have
access to perfect capital markets, they can
incorporate risk management via their own trading
and diversification. But in real, it is seem impossible.
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Quotes on Pessimistic and Optimistic..
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Comic on Pessimistic and Optimistic..
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The End
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