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MIS 4500 (31)

Chapter 39.docx

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Management Info. Systems
MIS 4500
Pourang Irani

Chapter 39: Risk Management: Risk Management Process:  1. Set Policies & Procedures  2. Define Risk Tolerance  3. Identify Risks  4. Measure Risks  5. Adjust Level of Risk  6. Execute Risk Management Transactions  7. Identify Appropriate Transactions  8. Price Transactions  9. Execute Transactions Risk Governance:  Enterprise risk management (ERM): centralized risk management for overall company at level close to senior management. Steps: o 1. Identify each risk factor exposed to o 2. quantify each exposure’s size in money terms o 3. map inputs into risk estimation calculation o 4. identify overall risk exposures as well as contribution from each factor o 5. set reporting process to senior mgmt: committee o 6. monitor compliance Identifying Risks: market risk (interest rate risk, exchange rate risk, equity price risk, commodity price risk); credit risk; liquidity risk; operational risk; model risk; settlement risk; regulator risk; legal/contract risk; tax risk; accounting risk; sovereign/political risk  Market risk: interest rate risk, exchange rate risk, equity price risk, commodity price risk  Credit risk: counterparty risk  Liquidity risk: that financial instrument cannot be purchased or sold w/o significant concession in price o Size of Bid-ask spread: a measure of liquidity risk o Volume  Operational Risk: risk from failure in co’s systems and procedures or from external events  Model Risk:  Settlement (Herstatt) Risk: paying counterparty while counterparty is declaring bankruptcy o May net to reduce  Regulatory Risk: how transactions will be regulated or that regulation will change  Legal/Contract Risk: say fraud or illegal contract, or otherwise unenforceability of K  Tax Risk: uncertainty associated w/ tax laws  Accounting Risk: uncertainty about how transaction should be recorded and potential for accounting rules and regulations to change  Sovereign and Political Risks: changing political conditions in countries o Sovereign risk: where borrower is gov’t o Political risk: changes in political environment  Other risks: o ESG risk: environmental, social and governance o Performance netting risk: potential for loss resulting from failure of fees based on net performance to fully cover contractual payout obligations to individual portfolio managers that have positive performance when other portfolio managers have losses and when there are asymmetric incentive fee arrangements w/ the portfolio managers o Settlement netting risk: that liquidator of a counterparty in default could challenge netting arrangement so that profitable transactions are realized for benefit of creditors Measuring Risk  Measuring Market risk: o standard deviation / volatility o active risk / tracking risk / tracking error volatility o beta, duration, delta o convexity, gamma o vega, theta  Value at Risk (VAR): probability-based measure of loss potential, expressed as % or units of currency; “estimate of loss (in money terms) that we expect to be exceeded with a given level of probabiliby over a specified time period.” o requires: 1. probability level; 2. time period; 3. model o analytical or variance-covariance method: infer VAR from standard deviation and normal distribution  delta-normal method: assume that change in option price is assumed to equal change in underlying price multiplied by delta (avoids non normality of options) o Historical Method (historical simulation method): set VAR according to actual historical experience / historical distribution  nonparametric o diversification effect: difference b/w sum of individual VARs (say for different divisions) and total VAR o Monte Carlo Simulation Method: o “Surplus at Risk”: VAR as it applies to pension funds o backtesting: process of comparing number of violations of VAR thresholds w/ figure implied by user-selected probability level  Extensions and Supplements to VAR: o Incremental VAR (IVAR): measures incremental effect of an asset on VAR o cash flow at risk (CFAR) o earnings at risk (EAR) o tail value at risk (TVAR): VAR plus the expected loss in excess of VAR, when such excess loss occurs  Stress Testing: identify unusual circumstances that could lead to losses in excess of typical o Scenario analysis: under different states of the world  actual extreme events
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