fin risk management

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Financial Risk Management1 Introduction

Objectives

This module introduces the sources of risk, together with the methods used to measure it. It starts by looking

at the historical background before going on to define risk. It then examines the basic approaches used to

identify, measure and reduce risks. Managing risk is a key activity for firms and a range of different

approaches is outlined. Firms may either seek to examine the totality of the risks they face in the aggregate,

an approach known as top-down; or build up their exposures from the individual risks, a procedure referred

to as ground-up. In practice, many firms use both methods.

The function of risk management is to control the effects of uncertain and generally adverse externaldevelopments (or events) on firms activities and projects. Financial risk management is a more specific

activity which seeks to limit the effects of changes in financial variables such as interest rates, currencies and

commodity prices.

After reading this module you should be able to understand:

what financial risk management is designed to achieve; the difference between uncertainty and risk; the multidimensionality of risk; how different attitudes to risk lead to different decisions as to what amount of risk is acceptable; the basic approaches used to manage risks; the basic nature of the financial risks facing the firm; the three key steps used in risk management: risk awareness, risk measurement and risk adjustment.

1.1 Introduction

1.2 What Is Risk?

1.3 What Is Financial Risk?

1.4 Steps to Risk Identification

1.5 Top-Down and Building-Block Approaches to Risk Management

Appendix to Module 1: What Risks Are we Taking?

Summary

This module has introduced the concept of risk as an unavoidable consequence of human activity. The

increased risks facing firms from changes in economic variables has meant a greater focus on riskmanagement activities.

Risk can be variously defined, no two definitions being identical. Generally, we can define risk as the

variability of future outcomes. This variability is in some way measurable, rather than being pure uncertainty,

where measurement is not possible, or is inaccurate. Financial risk is that part of a wider risk-management

process concerned with managing changes in, among other areas, the business, social, economic, political,

technological and legal environment.

Corporate risk management is a natural response to an uncertain future. These risks can be measured in

different ways, using accounting information, future cash flows, contingent and economic exposures. The

risk-management process is simple to define and it follows a series of simple steps which involve the firm in:

(a) becoming aware of the risks; (b) measuring the risks; and (c) adjusting the risk, if necessary.

There are a number of different approaches that can be used to measure risk, either taking an equity view or

building up the relevant exposures from the basic unit level. Risk can also be related to the asset and liability

obligations of the organisation. In practice, organisations tend to use a combination of methods depending on

the quality and timeliness of the information available.

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2 Risk and the Management of the Firm

Objectives

This module explains why firms are willing to devote resources to risk management. As a general rule, firms

will be risk takers in areas where they have unique or specialised expertise, but seek to hedge or eliminate

those risks which do not form part of the firms core competencies.

There are a number of different reasons why managing risk is desirable. The two principal reasons are that,

first, firms have more information about the risks they face than investors possess and second, firms can

undertake risk management more efficiently than individuals. An added reason is that, for some types of

firm, financial difficulties can both jeopardise survival and, at the same time, lead to considerable loss of

value due to the nature of the firms business.

After studying this module you should be able to understand the impact of: firm-specific factors on the decision whether to hedge a risk or to leave it unhedged; asymmetric information on the risk-management decision; the interaction of financing and investment decisions; the impact of agency and other costs on the risk-management decision; the problem presented by financial distress; the effect of taxation; firm-specific risks and the undiversified investor in the firm.

2.1 Introduction

2.2 The Pervasiveness of Risk

2.3 Why Manage Risk?2.4 Taxes

2.5 Agency and Other Costs

2.6 Business Performance

2.7 Financial Risk and Financial Distress

2.8 The Costs of Risk Management

Summary

The rationale behind firms engaging in risk-management activity is that it adds value to the firm in ways that

investors cannot do for themselves. In particular, it addresses contracting problems between a well-informed

insider management and less well-informed providers of capital. It also allows investors to capture some, or

all, of the internal benefits of firm-specific assets, such as tax shields and positive net present valueinvestments, or to reduce contingent liabilities, such as the direct and indirect costs of financial distress.

To summarise, maximum risk levels in the firm will be determined by:

1. investor appetite for volatility of equity value. In particular, this is likely where the firm is ownedby ill-diversified investors, that is private or closely-held firms;

2. the threat of bankruptcy or other restructuring costs. These can arise either because of highfinancial gearing and/or volatile net cash flows (income);

3. where a firm faces a significantly higher probability of a costly financial distress (or bankruptcy)situation;

4. management preferences as to the amount of risk they are willing to assume;5. the potential and/or actual conflicts between different classes of securities , in particular those

between shareholders and debt holders. These tend to be most severe when there is high

indebtedness and when there is a wide range of investment (growth) opportunities available to the

firm;

6. the nature of underlying assets or business activity. The greater the volatility of the underlying2008 Edinburgh Business School 2


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cash flow, the greater the benefits from risk management;

7. tax effects such as the ability to defer tax liabilities and the tax rate being related to profits.8. the ability to invest in positive net present value projects.3 Market Mechanisms and Efficiency

Objectives

The key learning objective of this module is to provide an understanding of the three main risk factors,

market risk, specific risk and credit risk, that make up the principal source of risk for financial instruments.

Other risks, for instance liquidity risk, are also discussed. The module ends with a brief overview of the role

of intermediaries in the transaction process.

The module starts with some general observations on markets and how they operate. The degree of

transparency or ability of market participants to see how the market is operating and how well the marketabsorbs new information are discussed. These will be critical if the risk management process is to use market

information for measuring and modelling the different risk factors.

Current financial theories about the nature and behaviour of risk are briefly covered, namely, interest rate

risk, currency risk, equity risk and commodity price risk and this forms a prelude to later modules which

look at the major asset classes in detail.

After reading this module, you should understand:

the diverse risks facing the firm; the concept of risk sensitivity; the nature of the different market mechanisms that underpin financial markets; the theoretical basis for risk as proposed by the capital asset pricing model and the arbitrage pricing

theory;

the source of major financial risks arising from changes in: interest rates, currency values,commodity prices and equity values; the effect of credit on risk valuations; the role of financial intermediaries in facilitating transactions in the different financial markets; the effect of credit risk on valuations.

3.1 Introduction

3.2 Market Efficiency

3.3 Market Liquidity

3.4 The Role of Financial Intermediaries

3.5 Systematic Risk and Non-Systematic Risk

3.6 Managing Market Risks3.7 Effect of Credit Risk

Summary

This module has considered market mechanisms and efficiency. Financial market risk can arise in a variety

of ways, from price risk, credit risk, liquidity risk and so on. The structure and behaviour of the market can

also have a bearing on these risks through the degree of market efficiency and transparency. The risk of a

position in the market is multidimensional, being a package of all the individual risk factors or elements that

are in the asset.

The direction of the exposure will depend on the sensitivity, whether the asset is owned (a long position) or

to be purchased (a short position).

The capital asset pricing model suggests that risk should be broken down into at least two elements, the

assets systematic risk which cannot be diversified, and its specific risk which can. The assets sensitivity can

then be measured by its beta to the market portfolio. Another approach, arbitrage pricing theory, proposes



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that risk is a function of a variety of independent factors. This latter theoretical model has more relevance to

the risk management approach which unbundles a particular exposure into its constituent risk factors.The major financial risk categories are: interest rates, foreign exchange rates, commodity price risk and

equity price risk. Each of these is subject to particular kinds of risk:

Market or price risk arises from changes in the demand and supply of an asset which move theequilibrium price.

Liquidity risk arises from (a) a lack of available buyers at a specific time, known as timing risk, and(b) changes in the market price due to delays in carrying out transactions. This can be either selling

price risk or purchasing price risk, or both if the transaction involves switching between two assets

which are illiquid.

Credit risk arises from a potential default by the issuer of the asset or the counterparty to atransaction.

A range of other risks, such as legal risk, regulatory risk and tax risk may also need to be considered.4 Interest-Rate Risk

Objectives

Module 4 discusses the risks that arise from changes in interest rates. It looks at the different theories that

have been advanced to explain the behaviour of interest rates. The nature, cause and effect of the key sources

of interest-rate risk are also detailed. The similarities and differences in interest-rate risks are brought out as

well as the source and nature of the different risks. Interest-rate risk is a major component of any financial

risk. In particular, the value of rate-sensitive assets depends directly, or indirectly, on the interest rate (or the

discount rate) used to present-value the cash flows.

After studying this module you should be able to understand:

the sources of interest-rate risk; the impact of the different types of interest-rate risk on a given exposure; how interest-rate price risk is inversely related to the level of interest rates and the maturity of the set

of fixed cash flows;

how reinvestment risk is directly related to interest rates; the problems and attractions of the right to early repayment of a set of fixed cash flows; the causation of extension risk in some fixed-interest securities; the nature of and theories used to explain, the term structure of interest rates: expectations theory; liquidity preference theory; market-segmentation theory; volatility theory of the term structure;

how different securities are affected by the various components of interest rate risk.4.1 Introduction

4.2 Interest-Rate Risk

4.3 The Term Structure of Interest Rates

4.4 Analysing Yield Curve Behaviour

4.5 The Money Markets

4.6 Term Instruments

Appendix 1 to Module 4: A Note on Early Redemption

Appendix 2 to Module 4: Relationship of Spot Rates and Par Yields

Summary

This module has looked at the effects of interest-rate risk on cash flows. There are a number of different risks



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within the definition of interest-rate risk and which depend on the exact nature of the cash flows:

The term structure of interest rates, or the yield curve, is a depiction of the relationship of interest rates totime. It embodies the markets best guess as to what interest rates are likely to be in the future. A number of

different theories have been put forward to explain the observed shapes of the yield curve.

We can analyse changes in the yield curve through two principal effects: a parallel shift, when the rate for all

maturities changes equally, and a rotational shift, when the curve pivots around a particular maturity to either

steepen or flatten. When changes to the yield curve are observed, it is likely that both effects take place at the

same time, leading to twisting effects.

Financial instruments, whose values are directly related to interest rates, either can be characterised by a

simple pair of cash flows and a short maturity, as is the case with the money markets, or are complex bundles

of simple cash flows, as are the instruments traded in the term debt markets. The characteristics of the

instruments cash flows will dictate their exposure to the different types of interest rate risk.

5 Currency Risk

Objectives

This module looks at currency risk, one of the major types of financial risk. Foreign exchange rate risk can

arise in a variety of different ways, from transactions and, through financial statements and competition. The

module also looks at the different theories that have been advanced to explain the behaviour of currencies.

The nature, cause and effect of the key sources of currency risk are also detailed.

After completing this module, you should know:

how foreign exchange rates are determined; the sources of currency risk: transaction exposure; translation exposure; economic exposure;

the complexities involved in managing economic exposures arising from currency movements; the role of interest rates in setting forward exchange rates; the different theories advanced to explain the behaviour of currencies.

5.1 Introduction

5.2 Foreign Exchange Rate Risk

5.3 Foreign Exchange Exposure

SummaryThe changes in the value of currencies over time are a major source of risk. Foreign exchange rate risk arises

whenever the value of one currency against another changes in an unexpected way. In a world of floating

exchange rates, market forces and participants expectations determine the value of one currency against

another.

A number of different theories have been advanced to explain the relationship of the current market rate for a

currency and the forward exchange rate. These models, purchasing power parity, interest rate parity,

expectations and the international Fisher effect, are based on economic or arbitrage arguments. These

theories provide alternative explanations for the paths that currencies may pursue over time. The fact that a

number of theories exist indicates that we do not really understand how exchange rates are determined at any

time.

There are three major sources of exchange rate risk for most organisations: transaction risk, when a cash flow in one currency has to be converted at the prevailing market rate

into another currency;



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translation risk oraccounting risk, when a reported item in one currency is converted into anothercurrency;

economic orcompetitive risk, when changes in the value of a currency against other currencies leadto increased or decreased competitiveness and alter the future cash flows from its operations. This

form of exchange rate risk is both direct, as it affects the firm itself and its subsidiaries and indirect

when it affects the position of its competitors and domestic and foreign suppliers.

6 Equity and Commodity Price Risk

Objectives

This module continues the analysis of risk in the main financial asset classes and covers equities and

commodities.

The overall objective of the analysis is to provide an understanding of the three main risk factors, marketrisk, specific risk and credit risk that make up the principal sources of risk for financial instruments.

Equity risk is, in effect, the risks from asset ownership since the equity holder has a residual claim on the

cash flows and by implication the value of the firms assets after prior charges have been met. Ownership

brings both gains and losses. The nature of the risks is detailed these can be either market-wide effects,

which affect all equities to a greater or lesser extent, or firm-specific factors.

The second section looks at commodities. These are both consumption assets, in that firms use commodities

as the raw material for their processes and agricultural commodities are eaten and used for investment

purposes. As a result, commodity price risk is a significant problem for some firms if the produce is used in

the manufacturing process and for consumers in general.

After completing this module, you should understand:

the sources and types of risk relating to equity; problems in analysing future cash flows relating to equity; the difference between systematic and stock specific risks; the difference between commodities, which are consumption assets and other financial assets, which

are held for investment purposes;

the factors that determine commodity prices, including the existence of a convenience yield forcommodities.

6.1 Equity Market Risks

6.2 Commodity Price Risk

SummaryThis module has looked at two different kinds of market risk: those in equity and commodities. Equity risk

relates to the ability of firms to manage the future economic performance of real assets. Problems arise in

two areas. One relates to how the market discounts the future cash flows and the covariance of these cash

flows to the market factor. The second area is firm- or sector-specific shocks which affect the value of

individual firms. Complex analysis, often of a heuristic nature, is required to understand the interrelated and

complex package of the many different kinds of risk that are included in equity ownership. These risks are

far more wide ranging than just economic factors, including political risk, regulatory risk, legal risk,

environmental risks and so on.

Commodity risk is important since such risk often forms part of the inputs or outputs for many firms, either

directly as raw materials or indirectly as a component of intermediate or finished goods or services. As such

the risk has two sides. For consuming firms in which such raw materials are an important factor of

production, their price risk has to be carefully managed. For producing firms, the revenues from selling

commodities can be subject to significant price swings, affecting profitability and cash flows.

Equally, to investors they are potentially a separate investment asset class. Regardless of the reasons for



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having exposures to commodities, there are a number of special idiosyncratic factors which have to be

considered when managing commodity price risk. These include potential shortages of supply, the lack ofclose substitutes leading at times to hoarding by consumers which manifests itself through the convenience

yield and various kinds of official intervention to support or depress the price.

7 The Behaviour of Asset Prices

Objectives

This module looks at the behaviour of asset prices over time. How asset prices change is an important

consideration in managing financial market risks.

After studying this module you should be able to understand the essential features of asset price behaviour,

namely that:

asset price changes are random, that is, they cannot be predicted;

the price-generating process or distribution of price changes follows what is known as a lognormaldistribution;

the process and nature of asset price volatility.

7.1 Introduction

7.2 The Price-Generating Process for Financial Assets

7.3 Understanding Volatility

7.4 Describing the Price-Generating Process

Appendix to Module 7: Statistical Measures of a Probability Distribution

Summary

This module has examined the nature of the price behaviour of assets. The important relationship from a

modelling point of view is not the change in price, but the periodic return. From a conceptual perspective, the

natural logarithm of price relatives provides a measure of the continuous rate of change in the asset price.

Changes in prices lead to differences in return. The dispersion of such changes is generally known in

financial markets as volatility. Specifically, volatility is the annualised standard deviation of daily returns.

The module also looks at the sources of volatility. Volatility occurs as a result of changes in the factors

affecting asset value. This arises from macro- and microeconomic factors, such as changes in exchange rates,

interest rates, commodity prices and cash flows. It also is due to news which affects the current and future

prospects for individual assets, sectors or whole markets. Changes in volatility arise from a revaluation of the

range of outcomes that are expected in the future together with the probabilities that are attached to these.

The wider the range, the greater the volatility.Although it is convenient to assume that asset returns follow a normal or lognormal distribution, there is

considerable empirical evidence that asset returns may be non-normal. A number of alternative formulations

for asset price-generating processes have been put forward, including, inter alia, infinite variance, mixed-

diffusion jump, compound normal and stochastic volatility models. The implications of non-normal

behaviour are that standard statistical techniques must be used with care and that adjustments must be made

to take account of observed price behaviour.

8 Controlling Risk

Objectives

Undertaking risk management requires some thought. Risk management and the control of risk, as with mostother aspects of commercial decision making, are not without cost. In order to control risk, information has

to be gathered and processed and management time devoted to analysing the result. Firms also need to set



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objectives in relation to the right decisions to be made once the analysis has been completed.

This module looks at some of the managerial issues and methods that are used by firms in analysing andcontrolling risks. There are two basic approaches, one involving a top-down analysis of the firms

activities; the other starting with individual risk factors makes use of a building-block approach.

The module then goes on to examine different approaches to risk control using the firms accounting records.

The first method is based on limits and this is expanded to introduce the forward-looking value at risk

approach that is the current, best practice, method. This latter approach attempts to predict the expected loss

from a given exposure at any particular time during some predetermined time period. To ensure a complete

risk profile, this approach is usually coupled with a stress test scenario to provide a worst-case loss.

After reading this module, you should be able to:

see how and why firms set relevant exposure limits to different risks; understand how different assessment methods work; differentiate between macro-based and micro-based assessment methods as to the quality of the

analysis and insights into the different risks; understand the differences in approach of and the insights provided by accounting data, management

information and the value at risk methodology which is based on statistical and worst-case scenario

analysis;

the problems of and limitations to any risk-management activity.

8.1 Introduction

8.2 The Top-Down Approach to Risk Assessment

8.3 The Building-Block Approach to Risk Assessment

8.4 Reporting and Controlling Risk

8.5 A Note of Warning

Summary

We can summarise the process of controlling and managing risks as a series of evaluation and decision steps.

Be aware that, although the approach appears simple, in practice the actual task is quite difficult. The control

steps then follow a logical sequence:

1. Identifying risksThis requires a risk audit of the firms activities. Each risk can be broken down into its component

parts to derive the individual risk factors that form the fundamental building blocks of the risk-

management process.

2. Analysing the impact of each riskFor risks to be managed, their effects on the firms activities have to be measured. The resultantexposures will determine whether the risks are material or not. Note that the question of materiality

is a subjective one: what is acceptable to one firm may be totally inappropriate to another.

3. Assessing the effect of the exposures on the firms business and strategy The key question is how vulnerable the firm may be to changes in its financial risk exposures and the

degree to which the firm needs to respond to the problem. Firms will need to set a policy for

managing such financial risks. The exact mix will depend on the firms objectives, its appetite for, or

dislike of, risk and other operational considerations.

4. Assessing the firms internal capability for risk managementThe initial stage of risk reduction will seek to look for internal ways of managing risk. The

availability of information and the costs of putting in place such systems, together with other

management resources, will determine how much of the firms financial risks can be managed

internally. Natural offsets will reduce the cost of hedging and insurance to the firm.5. Selecting the most appropriate risk-management strategies and/or products

Once the firm has set a policy for the amount and types of risk it wants to bear, the unwanted or



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unacceptable risks can be reduced through the appropriate strategy or the purchase of appropriate

risk management products.6. Keeping the programme under constant review

Any business situation is dynamic and the degree of exposure needs to be kept under constant review

as the variables that go into the risk-management process can, and are likely to change over time.

The module has discussed a number of issues relating to the management of risks, in particular how they are

to be evaluated in terms of the firms own assessments and the steps required to implement such a

programme. The various approaches, using either macro data or building up from the individual risk factors,

are discussed. The nature of the analysis requires that any assessment must look to the future this is the

intention of the value-at-risk methodology. To complement the expected-value framework of the value-at-

risk analysis, the worst-case scenario or stress test is required to provide an indication of the maximum

potential exposure.

9 Quantifying Financial Risks

Objectives

This module looks at measuring and modelling financial risks and the use of portfolio effects. The initial part

concentrates on the financial approach used for measuring risk and then focuses on how these can be

extended with portfolio techniques. The key building blocks of the financial risk-analysis framework relate

to measuring the mean, variance and probability of outcomes and the interdependency or covariance between

different stochastic risk factors.

The module then extends the analysis to look at risk in a portfolio context.

After completing this module you should be able to:

calculate the average value, the variance and the standard deviation of a financial series; calculate the correlation between two different risks; construct a portfolio to show the combined effect of different risks on a position. apply the model to estimating the value-at-risk of a portfolio.

9.1 Introduction

9.2 Statistical Analysis of Financial Risk

9.3 The Significance of the Normal Distribution

9.4 Understanding the Risk Measures

9.5 Measuring the Relationship between Assets

9.6 Portfolio Expected Return and Risk

9.7 Practical Considerations in Measuring Risk

9.8 Estimating Value at RiskAppendix to Module 9: Example of the Statistical Analysis of Risk

Summary

This module has looked at quantifying risk and, in particular, at the portfolio approach to assessing risk.

Assets can be evaluated in terms of the uncertain return (or future values) which are quantified by a

probability distribution of returns. Risk is the dispersion or spread of the possible returns around the (ex ante)

expected return. The expected return on an asset is a probability-weighted average return from the possible

range of future outcomes.

The spread of return (which leads to risk) is summarised by its variance. An equivalent measure of dispersion

is the standard deviation (which is the square root of the variance). This is an easier measure to understand

since it is denominated in units of return.

We can characterise the normal probability distribution uniquely by its mean and standard deviation. With a

normal distribution, the standard deviation provides a measure of the probability of a given set of outcomes



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away from the mean. About two-thirds of the distribution is accounted for by observations falling between

1 and +1 standard deviation; about 95 per cent of the distribution is within

2 and +2 standard deviations.

And 99 per cent is accounted for by observations within three standard deviations of the mean.

When looking at two assets, their covariance or their correlation is an important measure of their

interdependence. The covariance measures the tendency of two assets to move together. The correlation

coefficient is a standardised measure of this tendency that allows comparisons between several assets. The

correlation coefficient can take a value between 1 (perfect negative correlation) and +1 (perfect positive

correlation); a value of zero means the returns on the two assets are independent. Two assets will be

positively correlated if, on average, their returns move in the same direction; two assets will be negatively

correlated if, on average, their returns move in the opposite direction.

The benefits of risk reduction from creating portfolios result from the correlation effect. The diversification

effect arises from creating portfolios with assets which are less than perfectly correlated. As a result, by

selecting efficient portfolios, less risk per unit of expected return can be had or higher return for a given risk

can be had due to the risk-reducing benefits of diversification. The lower the correlation (to a minimum of1, or perfect negative correlation), the greater the risk reduction obtained.

Diversification is beneficial because, for imperfectly correlated asset returns, the risk (standard deviation of

the portfolio) is less than the weighted-average risk of the individual assets.

10 Financial Methods for Measuring Risk

Objectives

This module describes the use of discounted cash flow techniques used to measure risks. It starts by outlining

the methods used to create a zero-coupon or spot-rate yield curve from observed securities prices and its use

for calculating the present value of future cash flows. It then shows how the present-value method can be

applied to future cash flows in order to determine their sensitivity to changes in the discount rate. Thisdiscussion is then extended to show how a given risk position can be simulated using the known statistical

relationships between the different elements of risk in the term structure of interest rates.

After completing this module, you should be able to:

use the present-value (PV) method to calculate the value sensitivity of assets and liabilities tochanges in interest rates;

construct spot or zero-coupon rates from the yield curve as the appropriate periodic interest rate usedin discounting future cash flows;

apply sensitivity analysis to a given risk position; undertake the simulation of a risk position.

10.1 Introduction10.2 Using the Present-Value Approach to Determine Risk

10.3 Calculating Spot Discount Rates for Specific Maturities

10.4 The Term-Structure Approach to Risk Measurement

10.5 Simulation

Appendix to Module 10: Bootstrapping Zero-Coupon Rates from the Par Yield Curve

Summary

This module uses the key concept of the time value of money and applies present-value analysis to the

valuation of future cash flows. The aim of such an analysis is to measure the sensitivity of future cash flows

to changes in the discount rates being used to value them.

In order to be able to value cash flows correctly, it is first necessary to calculate the appropriate zero-coupon

rates for the relevant time periods. These spot interest rates can be derived from standard, coupon-paying

instruments via an iterative bootstrapping process in order to create a synthetic zero-coupon yield curve.



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Once the valuation has been made, the positions sensitivity to changes in the discount rates can be

measured. Various approaches can be used, including:1. modelling a small change in the discount rate. This involves making a very small change to the

discount rate to see how much the present value is altered. The value is then grossed up by some

estimate of the likely change over the horizon period;

2. changing the discount rate according to some predetermined view on the likely course of interestrates. This entails making some forecast about how interest rates are likely to change over the

planning horizon and making suitable adjustments to the present value of the cash flows;

3. applying a statistical assessment of past rate changes to the discount rate in order to derive aprobable change in valuation.

A more sophisticated approach might involve simulation of the different risk factors in the term structure of

interest rates. For instance, the behaviour of the term structure can be characterised by two principal risk

factors, one representing a parallel shift in interest rates that affects all maturities, the other a rotational shift

around some pivotal point in time. Depending on prior analysis of the nature of the term structure, simulationinvolves concurrently changing all the parameters of the model to obtain an overall assessment of the nature

of the valuing risk in the exposed set of cash flows.

To summarise: financial assessments aim to provide an appraisal of the current market value of a set of future

cash flows. The financial methods used for risk assessment apply the established net present value technique

in combination with elements of statistical analysis and sensitivity analysis to establish the potential range of

values over a given management horizon.

11 Qualitative Approaches to Risk Assessment

Objectives

This module looks at how qualitative models can be prepared for risk-management purposes. Such modelsare used for complex situations that cannot be modelled in formal ways, or as a way of adding a directional

or a considered view of the likely evolution of the risk factors.

After completing this module, you should be able to:

understand the steps required to prepare a qualitative forecast; understand the different methods used to create a qualitative forecast; know the problems that can arise from such an approach; see how the different approaches are integrated into decision making.

11.1 Introduction

11.2 Qualitative Forecasting Methods

11.3 Qualitative Forecasts11.4 A Practical Example of a Forecast

11.5 Assessing Qualitative Accuracy

Summary

This module has looked at some qualitative approaches to forecasting as tools to help risk managers develop

appropriate strategies for the future. Quantitative or causal models rely on the assumption that the variables

being forecast will be generally similar over the forecasting horizon. In contrast, qualitative models can be

used when there is little or no prior, historical data on which to build a quantitative forecast. The approach

may also be considered to be more appropriate when there is a strong belief that past behaviour is not

expected to continue into the future. A number of methods have been developed to make best use of intuitive

judgements in providing forecasts and in reducing the subjective bias of the forecaster.

In practice, most organisations rely on a combination of quantitative and qualitative forecasts to guide their

decisions, the weights attached to the different approaches by decision makers varying over time.

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