Risk Management

Managers should exploit familiar risk but avoid unfamiliar risk.

Risk Management Process:

1. Identify risks
2. Setting tolerance levels
3. Reporting risk exposure
4. Monitoring and take necessary actions

Risk governance: centralized (enterprise risk management (ERM) or decentralized.

Financial or non-financial risks

Market risk (F) (not necessarily systematic)

Liquidity risk (F) (not able to liquidize at fair price)

Settlement risk (NF) (one side paying the other side not)

Credit risk (F) (default of counterpart)

Operation (NF) risk

Model (NF) risk

Sovereign (NF) risk

Regulatory (NF) risk

Responding to risk problem:

Aberration? Long-term/fundamental/ERM? New risk? Wrong model? (e.g. changes of sensitivities)

Active risk = tracking risk = tracking error volatility = track error (see information ratio)

Financial Risk: changes of asset values due to changes in interest rates, exchange rates, equity prices and commodity prices.

Non-financial risk: difficult to measure so buy insurance

Value at risk (VAR) – minimum loss amount with confident

level over a time period

e.g. 5% VAR of $100 next month, 95% confidence will not loss more than $100 over next month

analytical VAR: remember daily sigma = annual_sigma/sqrt(250) = monthly/sqrt(22) (only true if assume zero expected return)

Historical VAR: no need to assume normality; assume history repeats

Monte Carlo VAR

Other measurements:

Incremental VAR – differences of adding a new asset

Cash flow at risk (CFAR), Earning at risk (EAR)

Tail value at risk (TVAR) – expected return in the tail part

Stress Testing:

Scenario Analysis

Stressing Models (Factor Push Analysis, Worst Case Scenarios, Maximum Loss optimization)