P1.T1.

Foundations of Risk Management

Introduction to Foundations “Domain”

Bionic Turtle FRM Video Tutorials

By David Harper, CFA FRM

1
Foundations

• Helicopter view
•
Misleading Unexpected market Conduct of
Case studies Reporting moves Customer Business

• Crisis (2007-08) •Chase/Drysdale

•Kidder Peabody
•LTCM
•Metallgesellschaft
•Banker’s Trust

•Barings
• CAPM (RAPM) •Allied Irish Bank

• GARP’s Code of
Conduct
Portfolio Possibilities Curve
Concave
Each line is different correlation (A, B)
15%
Expected Return -1.00
-0.50
10%
0.00
0.50
5%
1.00

0%
0.0% 10.0% 20.0%
Standard Deviation 2
Definition of risk

• Risk is volatility of unexpected

outcomes
 change in value of assets,
equity or earnings

• Risk is the potential for the

occurrence of a loss,
but cannot be separated from
growth opportunities.

• Uncertainty → (Quantifiable) Risk

3
Origins of risk

Human Human Natural Economic

(Accident) (Deliberate) disaster Growth
• Regulatory • Terrorism • Earthquake • Technological
policy: • War • Hurricane innovation
unintended
consequence

4
 Business versus Financial Risk
Business Risks
• Deliberate, necessary
– Competitive advantage
– To create shareholder value
• For example
– Business decisions (investments,
products) & Business environment
(competition & economy)
Shareholders pay for and expect
firms to assume business risk!
Financial Risks
• Losses due to financial
market activities
• For example
– Interest rate exposure
– Defaults on financial obligations
– Accounts receivables
To a non-financial firm, not core &
firm should (probably) hedge
5
Financial risk management

• Is the design and implementation of procedures for …

identifying,

measuring, and

managing financial risks

6
Major financial risk types (typology)

Market Credit Operational Investment

Market Risk Risk Risk Risk Risk

“Price level risk”

• Absolute vs. Relative Liquidity Counterparty Basel II/III

• Directional vs. Non Risk Risk

• Basis
• Volatility

7
Major financial risk types (typology)

Market Credit Operational Investment

Market Risk > Liquidity Risk Risk Risk Risk Risk

• Asset-liquidity
(market liquidity) Liquidity Counterparty Basel II/III

• Funding-liquidity Risk Risk

(cash-flow)

Liquidity risk
is often a
lack of time

8
Major financial risk types (typology)

Market Credit Operational Investment

Credit Risk Risk Risk Risk Risk

• Default
• Credit deterioration Liquidity Counterparty Basel II/III
Risk Risk
(downgrade)
• M2M loss in value

9
Major financial risk types (typology)

Market Credit Operational Investment

Operational Risk Risk Risk Risk Risk

“Almost everything else”

• Internal processes Liquidity Counterparty Basel II/III

• Model risk Risk Risk

• People risk
• Legal risk

10
Value at Risk (VaR)

• VaR summarizes the worst loss over a target horizon that will not be
exceeded with a given level of confidence

“Under normal conditions, the most the portfolio can lose over
[given horizon] is $X/%X at with (1 – α) % confidence”

“Under normal conditions, the most the portfolio can lose over a
month is about $3.6 million at the 99% confidence level”

Specify confidence
= 1 – significance (α)

Specify horizon

VaR is always one-tail

11
Value at Risk (VaR)

“Under normal conditions, we expect the portfolio to lose [over given

horizon] at least $X/%X at the selected significance (1 – confidence)
level.”

“Under normal conditions, over a one month horizon the portfolio

should lose at least $3.6 million about 1% of the time”

Specify confidence
= 1 – significance (α)

Specify horizon

VaR is always one-tail

12
Value at Risk (VaR)

• Nonparametric VaR: Quantile of an empirical distribution

90
80
70
60
50
40
30
20
10
0
-4 -3.5 -3 -2.5 -2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5 3 3.5 4
13
Value at Risk (VaR)

• Parametric VaR: quantile of an statistical distribution

4.0%

3.0% -1.645
2.0%

1.0%
VaR%95%  (1.645)
0.0%

100.0
100.3
100.6
100.9
101.2
97.0
97.3
97.6
97.9
98.2
98.5
98.8
99.1
99.4
99.7

14
Value at Risk (VaR)

• VaR is the worst expected (i.e., with selected confidence) loss over a
target horizon

P( L  VaR)  1  c
The FRM exam tends to only use c = 95% or 99%:

P( L  VaR)  5%
P( L  VaR)  1%
15
The End

• P1.T1. Foundations of Risk Management

Introduction to Foundations “Domain”

16