LM06 Introduction to Risk Management

Part 4

9. Measuring and Modifying Risk – Drivers and Metrics

9.1 Drivers  

Basic drivers of risk arise from:

• Global macroeconomics: The economic policies adopted by foreign governments and central banks have a significant impact on domestic companies.
• Domestic macroeconomics: Economic activity in a country is affected by the taxes, regulations, laws, monetary and fiscal policy introduced by government and quasi-government agencies in a country.
• Industries: Government’s policies expose industries to risk. For example, the government may exempt taxes on the textile industry to encourage growth in the sector, while it may levy additional taxes on the tobacco industry.
• Individual companies: There could be an issue that is specific to the company that you have invested in. For example, a lawsuit.

Using proper risk management, some of the risk can be managed, but not all of it. For risks that cannot be controlled, an entity must ensure that its risk exposure is aligned with its objective and risk tolerance.

9.2 Metrics

Risk exposure is often expressed in terms of quantitative measures. The basic metrics used to measure market risk are as follows:

• Probability: It is a measure of the relative frequency with which an outcome is expected to occur. For instance, the probability of a loss of 25% implies the likelihood of incurring loss, but it does not say how much the loss would be.
• Standard deviation: It is a measure of the dispersion in a probability distribution. That is, it gives us a range over which a certain percentage of outcomes are likely to occur. The underlying assumption is that the returns are normally distributed. Hence, it is not an appropriate risk measure for non-normal distributions. Standard deviation and variance are measures of total risk, that is, both unsystematic and systematic risk.
• Beta or duration: It is a measure of the sensitivity of a security’s returns to the returns on the market portfolio. For instance, if beta is 1.5, then it implies that the stock is expected to go up by 1.5% when the market goes up by 1%. Beta is generally used for stock portfolios, while duration is used to measure the sensitivity of fixed-income portfolios to changes in interest rates.
• Derivative measures: Delta, gamma, vega, and rho are often used measures of derivative risk. Delta is the sensitivity of the derivative price to a small change in the value of the underlying asset. Gamma measures the sensitivity of the derivative to changes in delta. Vega measures the sensitivity of the derivative to changes in the volatility of the underlying. Rho measures the sensitivity of the derivative to changes in interest rates.
• Value at risk or VaR: VaR measures and quantifies the risk of loss in a portfolio over a specific time period. A VaR measure comprises three elements: an amount stated in units of currency, a time period, and a probability. Let us take an example of a bank with a portfolio value of $200 million. A VaR of $3 million at 5% for one day implies that the bank is expected to lose a minimum of $3 million in one day 5% of the time. Note that VaR only tells us the minimum expected loss; it does not state the maximum loss.
• Conditional VaR or CVaR: Conditional VaR is the weighted average of all loss outcomes in the statistical distribution that exceed the VaR loss.
• Expected loss given default: This is equivalent to CVaR for a debt security.
• Scenario analysis and stress testing: Scenario analysts evaluate what would happen to a portfolio if a set of conditions or market movements occur. For example, what would be the impact on a portfolio if the Fed increases interest rates and there is a significant decline in the value of the US dollar?

10. Risk Modification – Prevention, Avoidance and Acceptance

The objective of the risk manager in the risk modification stage is to align the actual risk with pre-defined levels of risk tolerance. Different approaches to manage and modify risk are discussed below.

Risk Prevention and Avoidance

The simplest approach to manage risk may be to avoid it altogether. But, it is not as simple as it appears. For example, consider an individual who invests all his retirement savings in cash to avoid the risk of volatility in equities. By doing so, he gives up any upside return potential that equities offer and protection against inflation. Sometimes, boards may take a strategic decision to avoid risks in certain business areas altogether after analyzing the risk-return trade-off, and rather focus on areas with a higher likelihood of adding value. In reality, it is difficult to take a calculated risk by offsetting the risk of loss with the benefit of gain.

When actual risk exceeds the acceptable level, the following approaches are used to manage risk.

Risk Acceptance: Self-Insurance and Diversification

Self-insurance is simply bearing the risk because the external means to eliminate the risk are costly. For business, self-insurance means setting aside sufficient capital to cover losses. An example of self-insurance is capital and loan loss reserves set aside by a bank.

Diversification: According to modern portfolio theory, diversification is an efficient way of mitigating risk.

11. Risk Modification: Transferring, Shifting, and How to Choose

Next, we will look at two approaches to transfer or sell the undesired risk to another party.

Risk Transfer

Risk transfer is the process of passing on a risk to another party, often in the form of an insurance policy. When a corporation buys fire insurance for its office building it pays a standard premium and in return the insurance company covers the damage if the office building catches fire. Hence through the insurance policy the risk of fire damage is transferred from the corporation to the insurance company.

Risk Shifting

Unlike risk transfer where the risk is transferred from one party to another, risk shifting refers to actions that change the distribution of risk outcomes. Risk shifting typically involves the use of derivatives. Derivatives are classified into two categories:

• Forward commitments. Examples of forward commitments are forward contracts, futures contracts, and swaps.
• Contingent claims. Examples of contingent claims are call options and put options.

How to Choose Which Method for Modifying Risk

Choosing which risk mitigation method to use is an important step in the risk management process. The risk-mitigation methods discussed above are not exclusive of each other. Often, companies use all methods. Some important points to consider how to choose a method are discussed below:

• Consider the cost and benefit of each option in light of the risk tolerance of the entity.
• Organizations should avoid the risks that provide few benefits at extremely high costs.
• Organizations with large free cash flow may self-insure and diversify to the extent possible.
• Insure when risks can be pooled effectively and when the cost of insurance is less than the expected benefit.
• Risk shifting is an appropriate choice for mitigating financial risks that exceed risk appetite.

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