Lecture notes Risk Management
Week 1: Identification of risk and risk management
Lecture 1 10-11-2020
Chapter 1: Introduction to the importance of risk management
Risk plays a key role in the economy, because it is the basic ingredient of the business model.
Banks finance companies depending on their risk. Insurance companies absorb risk from
companies.
Important questions:
- Which parties absorb risk?
- What is the role of banks and insurance companies in the economy?
- What is the role of financial markets (bonds, equity, options, futures)?
- Is there a Law of Constant Risk in the universe (risk doesn’t disappear, it just transfers
to other parties)?
Risk management aims for:
- To identify, assess and prioritize risks.
- To minimize (not completely, because it will also
minimize profit), monitor and control the
probability of unfortunate events (very hard to
predict).
- To maximize business opportunities.
Risk management cycle shows the strategy of the
company. Risk strategy = senior management is involved;
they want certain risks and don’t want other risks. For
example, banks like credit risks. Risk taxonomy = all types
of risks that can be identified and which are relevant for
that certain company. Risk response = hedging or other
responses. Control risk = measuring how much risk you are exposed to and setting risk limits.
Types of risk: 1) credit risk (when people don’t pay back loans); 2) interest rate risk; 3) equity
risk; 4) foreign currency exchange (FX) risk; 5) underwriting risk; 6) operational risk; 7)
liquidity risk (difficult to hedge); 8) strategic/event risk (difficult to hedge as well); 9) conduct
risk (fail to comply to rules and regulations).
Organisation/financial institution risk is organized in the
3-line model. First line = business targets for volumes
and profit and losses. Second line = risk management
department: compliance role: rules and regulations,
write policies for risk types, setting risk limits, creating
models for measuring risk, insurance company: actuaries
check whether provisions on balance sheet are adequate
to cover liabilities(?). Third line = internal audit check
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,whether processes are sound. Fourth line = only big 4 companies have this. Fifth line =
another check for compliance to rules and regulations, AFM = autoriteit financiele markten
(Netherlands) check conduct risk (do financial institutions sell products that are clear to the
clients).
Bank roles:
- Transformation function: short-term money for individual clients and long-term
money (loans) for big companies. The bank transforms short-term to long-term
money: interest rate risk and liquidity risk.
- Providing credit to individuals, SMEs and corporations: credit risk. They create a large
portfolio, so the risk is manageable. Other companies (Klarna Amazon) become
competitors for credit cards to individuals.
- Helping clients to transfer risks to financial markets (for example banks help with
placing bonds in the market).
Insurance companies and reinsurance companies:
- Pooling risks: life, non-life, health.
- Transferring insurance risks to the financial markets, for example CAT bond = a
company or individual has exposure to certain risk event (earthquake) and you can
buy their CAT bond, so when this event doesn’t happen you get your money back.
- Provider of long-term capital and debt in financial markets (also for pension funds):
investing money they get from insurance and pension back into the market to
provide capital.
Risk vs. return
Without risk there is no return. The more risk you take, the higher the expected return.
What is the risk profile of shares in relation to the market, because if the stock price moves
closer to the market or even better share price increases. CAP model is used.
The capital asset pricing model: relies on the efficient frontier. The formula’s for the
expected return and volatility of a portfolio of assets are shown below. From these
formula’s, you measure the return and volatility (= standard deviation = measure of risk) of
the portfolio with different risk weights for the assets. Then you can compare what return
you want from your portfolio and what risk you are willing to take. The portfolio with only
one asset has a certain volatility and return, when adding the other asset the risk usually
goes down and the return goes up,
because the assets don’t have a
perfect correlation.
Volatility is a measure of risk: you measure the movements of the returns in terms of
standard deviation. One of the simplest risk measures on earth.
Simulating returns of a certain stock in Excel: =return+stdev*NORM.S.INV(RAND()). The
return * standard deviation of a standard normal distribution. You can also download
returns of equity stakes (Bloomberg terminal). Then we can calculate the average return and
the standard deviation of the stocks and use these in the capital asset pricing model to find
the efficient frontier.
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,The minimal variance (minimal risk) portfolio = portfolio with the lowest risk and an
acceptable return still.
Now we add a risk-free asset (bank account) with Rf = risk free interest rate. We have a linear
line in which people can invest with their risk preference in the market portfolio (M) and the
risk-free asset (F) and receive the highest possible return.
This is the linear equation of the expected return of the market portfolio and the risk-free
asset:
From there we can ‘remove’ the expectation of the returns and setting ,
we find the equation: ; which can be used to compare an
instrument R that you want to observe and the market. This equation tells us that the risk in
the investments return is given by the systemic risk SR ( β R M ) and the non-systemic or
idiosyncratic risk IR (ϵ ). Systemic risk can be controlled with diversification of risk, so that the
portfolio doesn’t have more risk than the market. But it still has some errors due to the
idiosyncratic risk, because this is specific to the stock under consideration.
If we rearrange the terms in the linear equation of the CAPM, we see that the expected
return of the stock – risk-free rate = the risk premium (= the premium that investors demand
for investing in a stock above the risk-free rate to cover the volatility). Also the expected
return of the market – the risk-free rate = market premium (= the premium you get from an
equity market portfolio). The relationship between the risk premium and the market
premium is proportional to each other with beta.
Beta = when the beta is 1, the risk premium of a stock moves the same as the market.
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, Alpha = not dependent on the market return. It can be
expressed in the following equations. If the stock has a
positive alpha, it can generate a higher return than the
market can. A lot of hedge- and private equity funds claim
they can generate a positive alpha independent on what the
global market is doing.
Assumptions of the CAP model:
- Investors only care about expected return and standard deviation of the return
not true, because investors also care about behavior of returns, specific sectors they
want to invest in etc.
- The standard errors ϵ of different investments are independent not true, there are
some correlations, because of economic cycles (time series models).
- Investors focus on returns over one period not true, they usually focus on returns
over a long period of time.
- All investors can borrow or lend at the same risk-free rate not true, because banks
can borrow money at the central bank at almost the risk-free rate, but other
investors can’t do this.
- Tax doesn’t influence investment decisions not true, especially with financial risks
investments you think about taxes.
- Every investor makes the same estimations for μ , σ and ρ not true.
So, the CAPM doesn’t really work in practice, but it is a good model because it is easy to
understand.
If shareholder only care about systemic risk, is this the same for company managers? No,
because the company managers are concerned about the overall risk profile. Also, they care
about earnings stability of the company and company survival. Systemic risk is only
measured through the stock, which is not the most important thing for company managers.
Investors also look at total risk of the company, not only SR.
Banks and insurance companies use both risk aggregation and decomposition:
Risk aggregation = aims to get rid of non-systematic risks with diversification. Banks and
insurance companies try to aggregate a lot of good risks on their balance sheet. For example,
a huge portfolio of loans (or insurance contracts of life insurance) diversificate each other in
which they won’t materialize at the same time.
Risk decomposition = tackles risk one by one.
Risk measures: 1) value at risk; 2) solvency or capital at risk; 3) volatility of solvency or capital
ratio; 4) earnings at risk; etc.
Chapter 2: Banks
Two types of banking = commercial banking and investment banking.
Commercial banking: taking deposits (managing savings from public), creating loans (for
large corporations and small businesses), market maker (provide financial instruments to the
market), funding themselves by borrowing (issuing bonds). Commercial banks business
model is manly driven by the difference in interest rate they pay and the rate they receive,
which creates income.
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