measuring risk essentials of financial risk management

John Wiley & Sons, Inc. 1

Essentials of Financial Risk ManagementChapter 9: Measuring Risk

Lecture : Prof: Chheang Meng Hiek

Prepared by: PHET CHHO DIEP ROUM

Karen A. Horcher


Measuring Risk

I. What is Risk?II. Measures of ExposureIII. Value–at–RiskIV. Credit Risk MeasurementV. Operational Risk MeasurementVI. Summary

Karen A. Horcher


Chapter be able to

• Differentiate between measures of exposure and measures of risk.

• Consider the strengths and weaknesses of risk measurement Methodologies.

• Identify alternative strategies for estimating risks.

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I. What is Risk?

• Risk is the business of probabilities….can be defined as the chance of something happening that will impact upon objectives.

• The estimated chance - The chance that an investment's actual return will be different than expected.

• A probabilities or threat of a damage, Loss, or other negative occurrence that is caused by external or internal vulnerabilities.

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Category of Risk

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Category of Risk - Cont

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II. Measures of Exposure

• What is the exposure? A problem when you have a number of possible risks

is that it can be difficult to decide which risks are worth putting effort into addressing.

One component of risk management. Risk Exposure is a simple calculation that gives a

numeric value to a risk, enabling different risks to be compared.

Risk Exposure of any given risk = Probability of risk occurring x total loss if risk occurs

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Measures of Exposure – Cont There are two views of risk management.

The day to-day or tactical standpoint. High-level or strategic view.

To sum up: In order to manage risk, it is necessary to have the

capability to monitor risk from both standpoints in order to assess potential loss to the organization.

Risk management requires both quantitative and qualitative analysis.

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Measures of Exposure – Cont• Gap Analysis

Measures the sensitivity of an exposure, asset, or portfolio to market rate or price changes by considering the mismatch between assets and liabilities.

Currency exposure-arising from foreign currency - Cash flows For example, if an organization has more euro inflows than

outflows in a given period, but the mismatch reverses the following period, then the euro cash flows offset one another with only a timing difference. If over the course of a longer period, such as a fiscal cycle, there are more euros coming in than going out, the difference provides exposure to a falling euro.

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Measures of Exposure – Cont

• Leverage and Direction The use of leverage increases the potential for loss.

Therefore, the impact of any leverage or gearing strategy is important to consider when calculating the amount that an organization could potentially lose. The calculation of potential loss without considering the impact of leverage underestimates potential losses.

Direction is the nature of an exposure or trading position, either long or short. A long position will obviously benefit from a rise in prices, while a short position benefits from a price decline. Both leverage and direction are factors in the potential size of a loss given an adverse market move.

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Measures of Exposure – Cont• Instrument Sensitivity

Can be a useful way to measure potential for risk. Duration - Estimate of the sensitivity of fixed income securities’ prices to small

changes in interest rates. For assessing gaps between assets and liabilities. Convexity, Measures the rate of change of duration, Be used to further refine

the sensitivity of a fixed income security or exposure to interest rate changes. Option delta- the option’s value given a change in the price of the underlying.

• Scenario Analysis Commonly focuses on estimating what a portfolio's value would decrease to if

an unfavorable event, or the "worst-case scenario", were realized. involves computing different reinvestment rates for expected returns that are

reinvested during the investment horizon.

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Measures of Exposure – Cont• Stress Testing

A simulation technique used on asset and liability portfolios to determine their reactions to different financial situations. Stress tests are also used to gauge how certain stressors will affect a company or industry. They are usually computer-generated simulation models that test hypothetical scenarios.

• Financial Crises A situation in which the value of financial institutions or assets drops rapidly. A

financial crisis is often associated with a panic or a run on the banks, in which investors sell off assets or withdraw money from savings accounts with the expectation that the value of those assets will drop if they remain at a financial institution.

Not Predictable. Correlations between markets and instruments, may break down entirely.

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III. Value–at–Risk

• Used measure of market risk. It is the maximum loss which can occur with X% confidence over a holding period of n days.

• Used to estimate the probability of portfolio losses based on the statistical analysis of historical price trends and volatilities.

• Systematic methodology to quantify potential financial loss based on statistical estimates of probability.

• Can be used by any entity to measure its risk exposure.

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Value-at-Risk – Cont

• Methods to Calculate Using historical data Using stochastic simulation, random or Monte Carlo

scenario generation. Monte Carlo simulation is based on randomly generated market moves. Volatilities and correlations are calculated directly from underlying time-series data, assuming a normal distribution.

Value-at-risk using the variance/covariance (parametric) approach. Volatilities and correlations are calculated directly from the underlying time series, assuming a normal distribution.

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• Variance-Covariance Method Normally Distributed – Correlations Historical data on investment returns Simple historic volatility: this is the most straight forward method but the

effects of a large one-off market move can significantly distort volatilities over the required forecasting period.

Example:An IBM stock is trading at $115 with a 1-year standard deviation of 20%. In the normal distribution, 95% confidence level is 1.645 standard deviations away from the mean.

Therefore, our VaR at 95% confidence level will be:

VaR (95%) = 115* 0.20 * 1.645 = 37.835

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• VaR of a PortfolioGenerally VaR will not be calculated for a single position, but a portfolio of

positions. In such a case will require the portfolio volatility.The portfolio volatility of a two-asset portfolio is given by:

• W1 is the weighting of the first asset• W2 is the weighting of the second asset• Q1 is the standard deviation or volatility of the first asset• Q2 is the standard deviation or volatility of the second asset• P is the correlation coefficient between the two assets

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Value–at–Risk - Cont

• Historical Simulation Method Finance's VaR analysis-Procedure for predicting VaR for many portfolio Determined on the basis of the information about potential profit and loss

gained from the simulation scenarios. Avoids some of the pitfalls of the correlation method (normally distributed

returns, constant correlations, constant deltas)

• VaR (1 – ) is the estimated VaR at the confidence level 100 × (1 – )%.• (R) is the mean of the series of simulated returns or P&Ls of the portfolio• R is the worst return of the series of simulated P&Ls of the portfolio or, in

other words, the return of the series of simulated P&Ls that corresponds to the level of significance

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Value-at-Risk – Cont• Monte Carlo Simulation

Analyze (complex) instrument, Portfolios and investment by simulating the various sources of uncertainty affecting their value, and then determining their average value over the range of resultant outcomes.

To calculate VaR using M.C. simulation we

Value portfolio today Sample once from the multivariate distributions of the Dxi Use the Dxi to determine market variables at end of one day Revalue the portfolio at the end of day Calculate DP Repeat many times to build up a probability distribution for DP VaR is the appropriate fracted of the distribution times square root of N For example, with 1,000 trial the 1 percentile is the 10th worst case. Use the quadratic approximation to calculate DP

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IV. Credit Risk MeasurementDefinition

One of the most fundamental types of risk. it represents the chance the investor will lose his or her investment.

The probability of loss as a result of the failure or unwillingness of a counterparty or borrower to fulfill a financial obligation.

Issue: Exposure to credit risk increases with the market value of outstanding financial

instruments with other counterparties, all else being equal. Whenever a borrower is expecting to use future cash flows to pay a current

debt. Investors are compensated for assuming credit risk by way of interest

payments from the borrower or issuer of a debt obligation. Lender's risk that borrower will not repay or The total amount of credit

extended to a borrower by a lender.

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Credit Risk Measurement - Cont• Counterparty Ratings

The risk to each party of a contract that the counterparty will not live up to its contractual obligations. Counterparty risk as a risk to both parties and should be considered when evaluating a contract.

The other party that participates in a financial transaction. Every transaction must have a counterparty in order for the transaction to go through. More specifically, every buyer of an asset must be paired up with a seller that is willing to sell and vice versa.

In most financial contracts, counterparty risk is also known as "default risk".• Notional Exposure

In an interest rate swap, the predetermined dollar amounts on which the exchanged interest payments are based. Notional principal never changes hands in the transaction, which is why it is considered notional, or theoretical. Neither party pays or receives the notional principal amount at any time; only interest rate payments change hands.

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Credit Risk Measurement - Cont• Aggregate Exposure

The exposure of a bank, financial institution, or any type of major investor to foreign exchange contracts - both spot and forward - from a single counterparty or client.

Aggregate risk in forex may also be defined as the total exposure of an entity to changes or fluctuations in currency rates.

• Replacement Cost The cost to replace the assets of a company or a property of the same

or equal value. The replacement cost asset of a company could be a building, stocks, accounts receivable or liens. This cost can change depending on changes in market value.

Also referred to as the price that will have to be paid to replace an existing asset with a similar asset.

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Credit Risk Measurement - Cont

• Credit Risk Measures Probability of counterparty default, which is an assessment

of the likelihood of the counterparty defaulting. Exposure at counterparty default, which takes into account

an organization’s exposure to a defaulting counterparty at the time of default.

Loss given counterparty default, which considers recovery of amounts that reduces the loss otherwise resulting from a default.

• Future of Credit Risk Measurement

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V. Operational Risk Measurement

Overview of Operational Risk• Inadequate or failed internal processes: Marketing material can be mailed to the

wrong customers, account opening documentation can turn out not to be robust, transactions can be processed incorrectly, etc.

• People: violation of employee health and safety rules, organized labor activities and discrimination claims. inadequate training and management, human error, lack of segregation, reliance on key individuals, lack of integrity, honesty, etc.

• Systems: The growing dependence of financial institutions on IT systems is a key source of operational risk. Data corruption problems, whether accidental or deliberate, are regular sources of embarrassing and costly operational mistakes.

• External events: This source of operational risk has at least two discernible dimensions to it, firstly the extent to which a chosen business strategy pursued by a bank may expose it to adverse external events, and secondly external events that impact it independently, emanating from the business environment in which it operates.

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Operational Risk Measurement - Cont

Some methods that have been used to measure or indicate potential for operational risk in financial institutions and other organizations include:

Number of deviations from policy or stated procedure Comments and notes from internal or external audits Volume of derivatives trades (gross, not netted) Levels of staff turnover Volatility of earnings Unusual complaints from customers or vendors

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VI. Summary• The concept of probability is the central tenet of risk, and the

business of risk measurement involves estimating the probability of loss.

• Scenario analysis involves using a set of predetermined changes in market prices or scenarios to test the performance of the current portfolio or exposure.

• The most commonly used measure of market risk is value at risk, a systematic methodology based on statistical estimates.

• As the costs of computation decline and user sophistication increases, the number and variety of risk management tools has increased substantially. More rigorous measurements of risk will likely become commonplace.

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DiscussionThank You.

Karen A. Horcher

measuring risk essentials of financial risk management

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