Risk Taking: A Corporate Governance Perspective
1-25
FRMFinancial Risk Manager
Classifications of Risks
Risk
Business Risks
Financial Risks
Market Risk
()
Absolute risk
Relative risk
Directional risks
Non-directional risks
Basis risk
Volatility risk
Measured by VAR
Credit Risk
()
Operational Risk
()
Probability of Default
Credit Exposure
Loss Given Default
Model risk
People risk
Legal risk
Liquidity Risk
()
Asset liquidity risk
Funding liquidity risk
Create Value with Risk Management
2-25
FRMFinancial Risk Manager
Market Risk
Market risk is the risk that declining prices or volatility of prices in the
financial markets will result in a loss.
Types
Absolute Risk
Relative risk
Directional risks
Non-Directional
risks
Basis risk
Volatility risk
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Definition
Measured in terms of shortfall relative to the initial value of the
investment and focuses on the volatility of total returns.
Measured in terms of shortfall relative to a benchmark (e.g.
market index).
Involve exposures to the direction of movements in major
financial Market variables. These directional exposures are
measured by first order or linear approximations.
Are risks that have non-linear exposures or neutral exposures to
changes in economic or financial variables
The risk that the price of a hedging instrument and the price of
the asset being hedged are nor perfectly correlated.
Risk of loss from changes in actual or implied volatility of
market prices.
FRMFinancial Risk Manager
Credit Risk
Credit risk is the risk of an economic loss from the failure of a counterparty to
fulfill its contractual obligations.
Expected credit loss PD CE LGD
Probability of Default
4-25
Credit Exposure
Loss Given Default
=1-Recovery Rate
FRMFinancial Risk Manager
Operational Risk
Operational risk is the risk of loss due to inadequate monitoring systems,
management failure, defective controls, fraud, and /or human errors.
Types
Definition
Model Risk The risk of loss due to the use of misspecified or misapplied models. For
example, an institution buying or selling collateralized mortgage
obligations (CMOs) may be exposed to model risk if the model used to
price the CMOs does not adequately account for the probability of
default in the underlying mortgages.
People Risk The risk associated with fraud perpetrated by internal employees and / or
external individuals. An example of people risk is a rogue trader.
Legal Risk
5-25
The risk of a loss in value due to legal issues including lawsuits, fines,
penalties, and /or damages.
FRMFinancial Risk Manager
Liquidity Risk
The term liquidity has been defined in myriad ways that ultimately boil
down to two properties, asset liquidity risk, a property of assets or
markets, and funding liquidity, which is more closely related to creditworthiness.
Asset liquidity risk (also called market liquidity risk) results from a
large position size forcing transactions to influence the price of
securities.
Funding liquidity risk (also called cash-flow risk) refers to the risk
that a financial institution will be unable to raise the cash necessary to
roll over its debt; to fulfill the cash, margin, or collateral requirements
of counterparties; or to meet capital withdrawals.
6-25
FRMFinancial Risk Manager
Risk Profile and Risk Governance
Risk Profile
Risk profile: the list, with all of the risks that a firm is potentially
exposed to and categorizing these risks into groups, is called a risk
profile.
These risk can be divide into three groups:
Risks that are un-hedged.
Risks that are hedged.
Risks that exploited.
The risk profile should be created by company management and
reviewed by the Board of Directors.
A combination of brainstorming activities and the companys past
experiences is a starting point creating a companys risk profile.
7-25
FRMFinancial Risk Manager
Risk Profile and Risk Governance
Risk Governance
Risk governance can be thought of as the methods in which risk-taking
is permitted, optimized, and monitored within an organization.
Good risk governance provides clearly defined accountability,
authority, and communication/reporting mechanisms.
Risk oversight is the responsibility of the entire board. However, some
boards use risk committees to help fulfill responsibilities.
The point of risk governance is to increase the value of the
organization from the perspective of shareholders and/or stakeholders.
8-25
FRMFinancial Risk Manager
Example
Which of the following statements regarding corporate risk governance
is correct?
A.
Management of the organization is ultimately responsible for risk
oversight.
B.
A risk committee is useful for enforcing the firms risk governance
principles.
C.
Effective risk governance requires multiple levels of accountability
and authority.
D.
The point of risk governance is to minimize the amount of risk taken
by the organization.
9-25
FRMFinancial Risk Manager
Answer D
10-25
FRMFinancial Risk Manager
Valuation Using a Risk-Adjusted Discount Rate
NPV (Net Present Value)
N
CFt
NPV
t
(1
r)
t 0
where:
CFt: the expected net cash flow at time t
N: the estimated life of the investment
r: the discount rate (cost of capital)
11-25
FRMFinancial Risk Manager
Valuation Using a Risk-Adjusted Discount Rate
The risk-adjusted discount rate is equal to the weighted average cost of
capital (WACC) based on a combination of the cost of equity and the cost
of debt.
WACC
cos t of capital = cost of equtiy
equity
debt
cos t of debt
debt equity
debt equity
Where:
cost of equity = risk-free rate + beta equity market premium
cost of debt = cost of borrowing(1- marginal tax rate)
cost of borrowing = risk-free rate + default spread
12-25
FRMFinancial Risk Manager
Example
Use the following information to answer the following Questions:
Reid, Inc. is embarking on a new 4-year project in a foreign country with a
country risk premium of 4%. Expected incremental annual cash flows from this
project (assuming all cash flows occur at the end of the year) are as follows:
Year
Cash Flow
0
-$2.0 million
1
-$1.75 million
2
-$0.5 million
3
+$0.4 million
4
+$2.6 million
The terminal value of the project in year 4 is $2 million. Reids relevant risk-free
rate is 3%, and the beta of the new project is 1.1. The market risk premium is 5%.
Reids credit rating lends itself to a 3.5% default spread, and its marginal
corporate tax rate is 32%. The firms capital structure consists of a 45% debt and
55% equity funding mix.
13-25
FRMFinancial Risk Manager
Example
1. Which of the following amounts is closest to Reids discount
rate (i.e., its cost of capital)?
A. 7.43%
B. 8.86%
C. 9.08%
D. 10.0%
Answer: C
The cost of equity is computed as: 0.03 + 1.1(0.05 + 0.04) = 12.99%
The cost of debt is computed as: (0.03 + 0.035)(1 0.32) = 4.42%
The cost of capital is computed as: (12.9%0.55) + (4.42%0.45) = 9.08%
14-25
FRMFinancial Risk Manager
Example
2. Which of the following amounts is closest to the risk-adjusted
value of the new project (i.e., the net present value)?
A. -$561,700
B. -$467,100
C. +$120,200
D. +$177,300
Answer: B
The risk-adjusted value of the project using the 9.08% discount rate is:
1.75
0.5
0.4
2.6
2.0
NPV 2
2
3
4
1.0908 1.0908 1.0908 1.0908 1.09084
0.4671 million = - $467,100
15-25
FRMFinancial Risk Manager
E ( Ri ) R f i E ( RM ) R f =2.25%+1.67 4.70%=10.1%
V
16-25
1, 400, 000 1,800, 000
800, 000
3,355,889 3,356, 000
2
3
(1 10.1%) (1 10.1%) (1 10.1%)
FRMFinancial Risk Manager
About Beta
Financial leverage: as firms borrow money, they create fixed
costs (interest expenses) that make their equity earnings more
volatile and their equity betas higher. The beta for equity in a
firm can be written as a function of the beta of the business
that the firm operates in and the debt to equity ratio for the
firm:
Debt
Levered(Equity) Beta = Unlevered Beta 1 1 tax rate
Equity
17-25
FRMFinancial Risk Manager
Unlevered Beta =1.75 / (1 + (1 25%)100million/100million)=1
Levered Beta = Unlevered Beta(1 + (1 15%)200million/100million)=2.7
2.50 3.25
18-25
FRMFinancial Risk Manager
Enterprise Risk Management
Enterprise Risk Management (ERM) emphasizes a comprehensive,
holistic approach to managing risk, shifting away from an approach of
separately handling each organizational risk.
ERM also views risk management as a value-creating activity, and not
just a mitigation activity.
Regardless of the framework used, it is important that risk decisions
always tie in to the value of the enterprise to its stakeholders, particularly
to its shareholders.
19-25
FRMFinancial Risk Manager
Four Steps in AIRMIC Risk Management Process
Step1: identification of risk management and enterprise objectives
risk
identification
risk
analysis
Step2: risk
assessment
AIRMIC
risk
manageme
nt process
risk estimation
purely
qualitative
semiquantitative
purely
quantitative
risk evaluation
scenario analysis
decision tree
simulation
Value at Risk (VaR)
risk avoidance
Step3: risk
treatment
risk transfer
risk reduction
risk retention
Step4: risk monitoring
20-25
sensitivity analysis
FRMFinancial Risk Manager
Risk Estimation
1.
Purely Qualitative
21-25
FRMFinancial Risk Manager
Risk Estimation
2.
22-25
Semi-Quantitative
The semi-quantitative estimate method
transforms a series of qualitative
judgments into quantitative variables,
using numerical scoring systems to arrive
at a risk score a numerical synthetic
risk judgment.
For example The risk severity is
determined by multiplying the probability
score by the impact score.
An event that is probable and would have
severe impact on the corporation will
score 50 x 200 = 1000; so this risk score
is high.
FRMFinancial Risk Manager
Example
Krista Skujins, FRM, is the CFO of a manufacturing firm. She is
currently in the process of diversifying the firms investment
portfolio by varying the correlations and asset classes among
securities. Diversification is best characterized as which of the
following risk treatments?
A.
Risk avoidance.
B.
Risk transfer.
C.
Risk retention.
D.
Risk reduction.
23-25
FRMFinancial Risk Manager
24-25
FRMFinancial Risk Manager
FRM
25-25
FRMFinancial Risk Manager
