MANM279 – Risk

Management
Introduction to Risk Management
Introduction to Risk Management
In this lecture, we’ll study:
1. Milestones of risk management
2. The definition of risk
3. The dimensions of risk management

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Milestones of Risk Management
• Risk Management is a relatively recent academic discipline.

World War II  Large companies began to develop self-insurance by creating a liquid reserve of funds to
cover losses resulting from accidents or negative market fluctuations.
1955  Wayne Snider gave a lecture entitled ‘The Risk Manager’ where he proposed creating an
integrated department responsible for risk prevention in the insurance industry.

1956  Gallagher published an article outlining the principles of risk management and proposing
hiring of a full-time risk manager in large companies.

1963  Mehr & Hedges and Williams & Heins published two academic books dedicated to the
field of insurance, excluding corporate financial risk.

1964  Arrow extended the Arrow-Debreu model of general equilibrium in an uncertain

environment to economics and finance, introducing hedging and the concept of payoff.

1973  Black and Scholes’ interconnection between hedging and pricing had a strong impact on
the development of equity, interest rates, currency and commodity derivatives.

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Milestones of Financial Risk Management
• There is evidence of Financial Risk Management practices going back 2000BC India.

1730 1973 1987 2001

Futures on currencies at the

First futures contracts First risk management
Chicago Mercantile Exchange
traded in Dōjima Rice department in Merrill Enron bankruptcy
Creation of the Chicago Board
Exchange in Japan 1971 – Collapse of Lynch
Bretton Woods Options Exchange

1973 – First Oil Shock

First futures on agricultural First OTC contracts in the First bankruptcies

Beginning of the
products at the Chicago form of currency and associated with
financial crisis
Board of Trade interest rate swaps misuse of derivatives

1864 1979 1994 2007

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 Financial Innovation
• Financial Risk Management is closely related to the development of innovation in
financial tools.
⎼ Increased price volatility and uncertainty since early 1970s drove changes in financial
management tools.

Value of the British Pound ($) Real Interest rate (%)

1967 – Devaluation of GBP due 1981 – Interest Rates Swaps
3
to a deficit in balance of trade. 10 1994 – Credit Default Swaps (CDS)
2.8

2.6 1980 – Currency Swaps 5

United States
2.4
1971 – US president 1987 – Coll. Debt
2.2ends
$ convertibility 0 Obligations (CDO)
2
to gold.
United Kingdom
1.8 -5
1.6

1.4 -10
1.2

1 -15
60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16 18 20 22
19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20 20

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 Financial Innovation
• Financial Risk Management is closely related to the development of innovation in
financial tools.
⎼ Market participants continuously seek better methods to manage the uncertainty.

Crude oil, average ($/bbl) Gold, average ($/troy oz)

120 2022 – Russia-Ukraine War 2500
2020 – Near-Zero Interest Rates
100 2008 – The Great Recession
2000
2011 – Recovery from the Great
80 Recession
1500
60

1979 – Iran-Iraq War 1000 1980 – Record high inflation

40 (US 13.5%)
1990 – Gulf War 2004/6 – Oil Glut
500
20 1973 – OPEC Embargo

0 0
60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16 18 20 22 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08 11 14 17 20 23
19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20 20 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20

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Definition of Risk and Risk Management
• Several definitions of risk are available in the literature.
⎼ A simple definition of risk is
The chance (or probability) of deviating from an anticipated
outcome

• The features of risk are:

⎼ Probabilities – risk can be quantified and expressed as a parameter.
⎼ Expected outcome – risk is a function of objectives and the extent to which
the actual results deviates from them.

• For risk to exists, there must be at least two possible outcomes, with at least one
outcome is undesirable and unexpected.

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Think Pair Share
THINK
 For 1 minute, write down your individual answer to this question:

Is the decrease in the value of your newly bought car with age and use a risk?

Pair
 For 2 minutes, compare your answer with your neighbour and come to a consensus

Share
 For 2 minutes, share your answer with the rest of the classroom

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Definition of Risk and Risk Management
• Brian Wynne (1992) proposes a four-level stratification risk is:
⎼ Risk – a set of outcomes of a decision whose probabilities could be quantified
⎼ Uncertainty – a set of outcomes that could be known but hard to quantify.
⎼ Indeterminacy – the inability to define causality relationship between a decision
and its outcomes
⎼ Ignorance – risks that have not been detected before.

• Risk exposure refers to the vulnerability to a certain outcome, determining the maximum
loss that could be suffered.
• Downside risk refers to an assessment of risk that looks only at adverse events

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Risk Management Process
• Risk management can be defined as
The identification, assessment, and decisions made to
treat a particular risk.
• The risk management process proposed by the Australian Standard for Risk Management

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Risk Management Process

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Establishing Context
• This first step is necessary:
⎼ to define the basic parameters within which risks must be managed
⎼ to provide guidance for decisions within more detailed risk analysis

Strategic analysis Objectives

 Identify the internal and  Understand the company’s  Understand the company’s
external stakeholders. capabilities, objectives, and operational, technical,
exciting strategies. financial, legal, social, and
 Determine the crucial humanitarian criteria.
elements in the company’s  Understand the nature of the
environment which could company’s cash flows and  Decide the criteria against
impair/support risk exciting exposures. which risk is to be evaluated.
management.

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Establishing Context
• As a result of this analysis, the following key characteristics are defined:
⎼ Risk profile – a complete description of risks faces by the company, including
potential future risks affecting current operations.
⎼ Risk capacity – the maximum volume of risk that the company can endure.
⎼ Risk appetite – the targets and limits of risk that the company is willing to
pursue or retain.
⎼ Risk tolerance – the acceptable level of variation that management is willing to
allow for any particular risk as the company pursues its objectives.
⎼ Risk thresholds – the level of risk exposure above which risks are addressed
and below which risks may be accepted.

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Establishing Context
• Company’s risk context:
Risk Threshold Risk Exposure Risk Threshold

Treatment Risk Tolerance Treatment

Risk Appetite
Risk Capacity

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Risk Management Process

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Identifying Financial Risk
• Financial Risk is the probability that the actual outcome of investment decision is
different from excepted.

Market Risk The possibility that fluctuations in interest rates, foreign exchange rates, share prices, or other
market prices will change the market value of financial products, leading to a loss.
Financial Risk

Credit Risk The possibility of a loss arising from a credit event, such as deterioration in the financial condition
of a borrower, that causes an asset to lose value or become worthless.

Liquidity Risk Difficulties in raising funds needed for settlements, as a result of the mismatching of uses of funds
and sources of funds or unexpected outflows of funds.

Operational The possibility of losses arising from inadequate or failed internal processes, people, and systems
Risk or from external events.

Other Risks Geopolitical risk, regulatory and legislative risk, reputation risk, climate risk

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 Identifying Financial Risk
Bank of England survey (2023) of risks most likely to materialise Deloitte global survey (2023) of most important risks
– as mentioned by respondents – over the next two years

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Risk Management Process

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Analysing Risk
• The objectives of risk analysis are to determine whether:
⎼ The risk event is worth further analysis.
⎼ The risk event information can be acquired through quantitative or qualitative means.

• Risk is measured using two parameters:

⎼ Probability – the likelihood or chance of a risk event occurring.
⎼ Consequence – the severity or impact generated from the risk event.

Risk magnitude is the product of risk probability and consequence.

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Analysing Risk
• The risk quantities can be determined using:
⎼ Qualitative analysis – descriptive scales to describe the magnitude of potential
consequences and their likelihood of occurrence. It is used:
 as an initial screening activity to identify risks which require more detailed
analysis
 where the numerical data are inadequate for a quantitative analysis.

⎼ Quantitative analysis – numerical estimations by modelling the outcomes of an event,

or by extrapolation from experimental studies or past data.

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Analysing Risk – Qualitative Analysis
• Risk Rating Matrix – a grid consisting of probabilities on one axis and impacts on another,
which represents events based on experience or organisational procedures.

Legend
E extreme risk; immediate action
required
H high risk; senior management
attention needed
M moderate risk; management
responsibility must be specified
L low risk; manage by routine
procedures

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Analysing Risk – Quantitative Analysis
• Decision Tree – a flowchart visually outlining the potential outcomes, costs, and
consequences of a complex decision.
Decision nodes – represent critical points where choices are made, leading to
different paths.

Alternative branches – show two outcomes that stem from the initial node.

A B Chance nodes – show multiple possible outcomes.

𝜌 1−𝜌 Probabilities – quantify the likelihood of specific outcomes at each

branch.

𝒗𝟏 𝒗𝟐 𝒗𝟑 End nodes – depict the potential outcomes resulting from decisions made at nodes. c
𝐸𝑉 ( 𝐵 ) =𝜌 𝑣 2 + ( 1− 𝜌 ) 𝑣 3 Expected Value – provide a measure of the potential value or risk associated with a
particular decision path.

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Analysing Risk – Quantitative Analysis
• Decision Tree Example – A company is considering whether to expand its operations by
building a new factory.

Choice: Expansion Cost $3m Choice: No Expansion Cost $0

Chance Event Probability Profits ($m) Chance Event Probability Profits ($m)
High Demand 0.60 10 High Demand 0.70 3.6
Low Demand 0.40 1 Low Demand 0.30 1.8

Requirement: Analyse the alternative expected values to choose a course of action.

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Analysing Risk – Quantitative Analysis
• Decision Tree Example – A company is considering whether to expand its operations by
building a new factory.

1.8 m3.6 m 1m 10 m
0.6
Expan
Cost
d = $3m 0.4

Decision
node
0.7
Do not
Cost = $0
expand 0.3

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Risk Management Process

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Evaluating Risk
• Risk evaluation consists of identifying risk events that need to be prioritised so that risk
mitigation plans are determined:
⎼ This proves involves comparing the level of risk found during the analysis process
with previously established risk criteria.

• Financial criteria are usually determined against financial regulations and standards.
⎼ Four international authorities have primary responsibility of financial regulation:
 The Basel Committee on Banking Supervision (BCBS)

 The Financial Stability Board (FSB)

 The International Organization of Securities Commissions (IOSCO)

 The International Association of Insurance Supervisors (IAIS)

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Evaluating Risk
• The Basel Committee on Banking Supervision (BCBS) provides frameworks to control the
riskiness of individual banks and to increase the stability of the financial system

1988  Basel I sets a framework to classify banks depending on their credit risk
exposure.
⎼ Introduction of Cooke Ratio to measure the minimum amount of
capital a bank should maintain in case of unexpected losses.
2004
 Basel II consists of three pillars:
⎼ Pillar 1 – Minimum Capital Requirements to compute the capital charge for
credit risk, market risk and operational risk.
⎼ Pillar 2 – Supervisory Review Process to explains the role of the
supervisor and gives the guidelines to compute additional capital
charges for other risks
⎼ Pillar 3 – Market Disciple to explains the to detail the disclosure
2010 requirement regarding the capital structure and the risk exposures
of the bank

 Basel III introduces of liquidity risk and leverage ratio. 27

Evaluating Risk
• The 2008 financial crisis was responsible for Basel III, Dodd-Frank, Volcker rule, and the
the creation of the Financial Stability Board (FSB) in 2009.
• The FSB:
⎼ Develops assessment methodologies for defining systemically important financial
institutions.
⎼ Makes policy recommendations for mitigating the systemic risk of the financial
system.
⎼ Provides a scoring system based on five categories:
Size – Interconnectedness – Substitutability/financial
institution infrastructure – Complexity – Cross-jurisdictional
activity

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Evaluating Risk
• Other Supervisory Authorities
European Union
EBA European Banking Authority; www.eba.europa.eu
ECB/SSM European Central Bank/Single Supervisory Mechanism; www.bankingsupervision.europa.eu
ESMA European Securities and Markets Authority; www.esma.europa.eu
ESRB European Systemic Risk Board; www.esrb.europa.eu

United States of America

CFTC Commodity Futures Trading Commission; www.cftc.gov
FRB Federal Reserve Board; www.federalreserve.gov/supervisionreg.htm
FDIC Federal Deposit Insurance Corporation; www.fdic.gov
FSOC Financial Stability Oversight Council; home.treasury.gov/policy-issues/financial-markets-financial-institutions-and-fiscal-service/fsoc
OCC Office of the Comptroller of the Currency; www.occ.gov
SEC Securities and Exchange Commission; www.sec.gov

United Kingdom
FCA Financial Conduct Authority; www.fca.org.uk
PRA Prudential Regulation Authority; www.bankofengland.co.uk/prudential-regulation

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Risk Management Process

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Treating Risk
• At an aggregate level, the total amount of risk cannot be reduced.
⎼ The economic consequences can be modified through:
 Risk avoiding – an informed decision not to proceed with the activity likely to
generate risk
 Risk pooling – the effects of risks are spread among all market participants.
Diversification, insurance pools
 Risk shifting – risk is transferred partially or fully from one party to another.
Hedging, insurance
 Risk retaining – residual risks can also be retained when there is a failure to
identify and/or appropriately transfer or otherwise treat risks.

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 Risk Management Process

• Monitoring risk consists of:

⎼ Assessing the effectiveness of the risk
treatment plan.
• Communication and consultation at each ⎼ Managing systems set up to control
step of the process involve: their implementations
⎼ Developing a two-way dialogue with ⎼ Ensuring that changing circumstances
internal and external stakeholders. do not alter risk priorities.
⎼ Establishing perceptions of risks.
⎼ Identifying responsibilities for • Ongoing review to:
implementing risk management. ⎼ Ensure that the management plan
remains relevant.
⎼ Update the plan as factors affecting
the likelihood and consequences of
outcomes change.

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Introduction to Risk Management
In this lecture, we covered:
1. The development of risk management
2. Some financial innovation
3. The definition of risk, uncertainty and exposure
4. The risk management process

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