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Enterprise Risk Management

BU9227
Lecture 1
Dr. Yeo Keng Leong
Lecturer
Nanyang Business School
Division of Banking and Finance
S3-B1A-26
67905648
15
th
January 2014
Enterprise Risk Management Course Outline
Risk
Frameworks
Identification
Risk Management Process
Risk Management Function
Measurement
Control
Financial
Market
Risk
Credit
Operational
Insurance
Capital
Lecture 1 Risk
Readings :
Lam (Chapter 3, pgs 23-27)
ST9 (Chapter 1)
Wikipedia entries for Risk and Uncertainty
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Risk
- Exposure to chance of loss or gain
- Downside and upside risk
- Usually refer to chance of loss only, i.e. downside risk
- This course will follow this standard
- Variability of outcome
Risk vs Uncertainty
- Two different concepts!
Uncertainty (common definition)
- Lack of certainty
Risk (common definition)
- Uncertainty where some possible outcomes results in loss
- Different definitions of each exist
- Inability to describe exactly future outcome
Risk (Knightian)
- quantifiable variability
Uncertainty (Knightian)
- unquantifiable variability
- e.g. weather one month from now
Knightian definitions by Frank Knight
- Economist from University of Chicago (1921)
- e.g. outcome of a throw of 1 die
- unknowns are unknown
- unknowns are known
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Risk Concepts
- Concepts linked to one another
- Analogy: driving and traffic accident
1) Exposure
- e.g. cost of totally wrecked car
- Maximum loss possible
2) Probability
- e.g. high probability of safe journey, small probability of minor
accidents, very small probability of serious accidents and
fatalities
- Quantification of chance of each outcome
3) Severity
- e.g. replacement of bumper
- Likely/expected loss
- Analogous to concept of expected value in statistics, E(X)
4) Volatility
- Analogous to concept of variance and standard
deviation in statistics, Var(X) and SD(X)
- e.g. zero cost (safe journey), moderate cost (minor accidents),
high cost (serious accidents and fatalities)
- Variability or spread of outcomes
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E(X), Var(X) and SD(X) Explained
For example, X is the outcome of throw of 1 fair die.
P(X = 1) = P(X = 2) = = P(X = 6) = 1/6.
E(X)
= [x * P(X=x)]
all x
= 1/6 * 1 + + 1/6 * 6
= 3.5
Then X has a probability distribution described by:
E(X), Var(X) and SD(X) Explained (cont.)
Var(X)
= {[x E(X)]
2
* P(X=x)}
all x
= 1/6 * (1 3.5)
2
+ + 1/6 * (6 3.5)
2
= 2.9167
SD(X)
= Var(X)
= 1.7078
5) Time Horizon
- e.g. occupation of driver
- Period of exposure
6) Correlation
- Systematic risk vs non-systematic risk
- e.g. driving with passengers
- Tendency of risks to move together
- Concentration vs diversification
- e.g. taking different forms of transport
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7) Capital
- e.g. savings or buying insurance
- Amount of money set aside for unexpected losses
- Economic vs accounting capital
Risk Management
- Objective: maximise return for given level of risk
- Steps
- Identify
- Measure
- Understand
- Respond
- Avoidance/removal
- Transfer
- Reduction
- Retention
Risk management is
not risk reduction!
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Enterprise Risk Management
- Integrated approach by enterprises to risk management
- Apply risk management techniques consistently throughout
enterprise
- Contrasts with the traditional silo approach
- Reason?
Business decision likely to impact on various aspects
of business simultaneously
Enterprise Risk Management (cont.)
- Benefits
- Increased effectiveness of enterprise due to better coordination of risk
management activities
- Increased risk transparency to stakeholders
- Improved business performance due to better informed management
decisions
Enterprise Risk Management (cont.)
- Stakeholders
- Shareholders
- Directors
- Employees
- Customers
- Government
- Regulators
- Business partners
- Others
e.g. professional advisors, credit rating agencies,
creditors, subcontractors and suppliers, public, etc.