ERM

ERM: Enterprise Risk management

Centralized risk management

To:

Meet business obj, minimize unexpected earning volatility and maximize firm value

CRO： may report to board or CEO/cfo, BUT A DOTTED relation should be between CEO/CRO to avoid conflicts.

Risk management should be transparent to outside

Corporate Governance And Risk Management

Best  practices:


• Independent board member
• Take care of stakeholder and debt holder
• CEO not the head and introduce CRO
• Agency risk
• Focus on economic performance instead of accounting performance
• Compensation based on risk adjusted return

Board of directors oversee:

• Policies, reports, strategy, control , audit, practics

Risk appetite -> tolerance/willingness a firm can take risk.

Transmitted by risk director and audit committee

Audit main role: make sure financial statement and regulatory report correct. Also oversee risk and so on

Hedging Risk Exposure:

Disadvantage: 

In theory:

1. assume no tax and has same transaction cost, then the value dos not change…..Too fake
2.  CPAM suggests focusing on  systematic risk (common for player) while non-systematic ones can be diversified (no perfect market)
3. Derivative fully reflect underlying. Of course no, partial correlation, even no related derivative available

They do not consider bankruptcy.

In practice:

1.  lose focus on making money
2. Lack of knowledge
3. Reduce volatility of value may result in reduce of earning cash flow

Advantage:

1. Stable earning make fund raising easy
2. Achieve board of director's goal
3. Stable operation cost (put on consuming materials)
4. Chance to get low tax

Hedging  Decision

 

Hedging  Decisions

The role of board of director

Decide firm's risk appetite with

1. Decision on appetite  (accounting or economic, eg. Fx, short or long term heding eg. Put maturity, hard limit on quantities )
2. With Quantative
3. And qualitive method

Map risks

Analyze top 10 risk exposures according to market risk, credit risk, operation, business and so on. Give it dollar value. Ready for next step, hedge

Hedging risks

Pricing risk: fwd or call

FX: FX fwd, swap

Interest rate:  irs

Static vs Dynamic

Static, once decided, does not change

Dynamic, changing  but more transaction cost

Others:

1. Time horizon goad matches
2. If hedging position matches the goad
3. Tax

Hedging instrument

OTC: difficult to price, less info, credit risk and so on…but I think it is cheaper most of time and designed for purchaser.

Exchange Traded : standard, clear price, enough info 

Risk Management: A Helicopter View

1.     Concept of Risk

Risk  -> volatility of uncertain risk and uncertain gains -> risk take, profit gain. 
        -> 1. expected, can be well expected 2. unexpected (focus)
Risk Management :
A) manage expected risk
B) manage unexpected risk


Ultimately, determine the risk taking (take risk to gain)

 2.   Risk Management steps:

Identify-> evaluate exposure->propose method->develop strat -> reevaluate/readjust
Not perfect:
A)  fail to identify risk B) no proper method
3. Quantative measure:
VaR95 -> %95 confidence level of min loss or 95% significance level of max loss
Economic reserve:  ER =  ED*EP*ER , expected default rate* exposure*expected loss rate
To keep liquidity and avoid from bankruptcy


4. Qualitative measure:
Scenario analysis: eg. Worst case scenario analysis looking at macroeconomic scenarios on entity
Stress testing: stress on entity (shock factors etc)



 5.   ERM

Look at risk overall firm, apply quant and quality analysis, board of director decide risk appetite, review, audit and so on


6. Expected Loss vs Unexpected Loss
EL: normal course, single factor with statistics collected from history and can be mitigated with increasing charge, spread over
UL: unormal course, multi correlated factors, can be studied with hist data to gain some certainty


7. Risk And Reward
The more risk taken the more reward have, but reward has volatility.



 8.  Risks

  Market Risk:  market price/rate changes

  Interest rate risk, bond, unhedged, basis risk ( hedge not favorable)
  Equity Price risk , all market, secpecific ( diversify)
  FX Risk,  international interest rate
  commodity risk, sudden jump, black box
 

Credit Risk:  counterparty cannot settle

 Default risk: fail to pay, bond
Bankruptcy risk
 Downgrade risk： downgraded ->default
Settlement Risk:  in derivative (eg swap) losing party fail to pay


To mitigate:
Rate consider the risk taken, avoid concentration, avoid maturity concentration.



Liquidity risk

Funding risk: no money to pay, repurchase and etc
Liquidity risk: cannot buy/sell with lack of counterparty


Operation risk:
Internal process and unexpected and unavoidable external factors.



Legal and Regulatory Risk

Tax, orders laws and etc



Business Risk

Things with specific product ( eg, production-consumption relation）

 

Strategic Risk

Stupid board/management made stupid decision



Reputation Risk



Eg. Sanlu milk powder