1. PBBF 303: FIN RISK MANAGEMENT AND INSURANCE
LECTURE EIGHT
ADVANCED TOPICS IN RISK MANAGEMENT

2. The Changing Scope of Risk Management
Traditionally, risk management was limited in scope to pure loss exposures, including property risks, liability risks, and personnel risks.
An interesting trend emerged in the 1990s, as many businesses began to expand the scope of risk management to include speculative financial risks.
Recently, some businesses have gone a step further, expanding their risk management programs to consider all risks faced by the organization. (enterprise risk mgt)

3. Financial Risk Management
Financial risk management refers to the identification, analysis, and treatments of speculative financial risk. These risk include the following:
Commodity price risk
Interest rate risk and
Currency exchange rate risk

4. Commodity Price Risk
It is the risk of losing money if the price of a commodity changes. Producers and users of commodities face commodity price risks.
e.g. Consider an agricultural operation that will have thousands of bags of maize at harvest time. At harvest time the price of the commodity may have increased or decreased, depending on the supply and demand for grain.
Because little storage is available for the crops, the grain must be sold at the current market prices, even if that price is low.

5. Cont.
In a similar fashion, users and distributors of commodities face commodity price risks. Consider a cereal company that has promised to deliver 500,000 boxes of cereal at an agreed- upon prices (GHc50) in six months. Worth GHc25million
In the meantime, the price of grain-commodity needed to produce the cereal may increase or decrease, altering the profitability of the transactions.
If price increase to GHc55 the farmer will produce the maize at a cost of GHc27.5million an extra cost of 2.5million, whilst if price decrease to GHc45 the farmer will produce the maize at cost of 22.5million and make a gain of 2.5million

6. Interest Rate Risk
Financial institutions are especially susceptible to interest rate risk. Interest rate risk is the risk of loss caused by adverse interest rate movements.
e.g. Consider a bank that has loaned money at fixed interest rates (10%) to home purchasers under 15 to 30 years mortgages.
If interest rate increases, (15%) the bank must pay higher interest rates (15%) on deposits while the mortgages are locked in at lower interest rates (10%). This affects the ALM

7. Cont.
Similarly, a corporation might issue bonds at a time when interest rates are high. Coupon rate 15% and interest rate on market 15%
For the bonds to sell at their face value when issued, the coupon interest rate must equal the investor- required rate of return.
If interest rates later decline (10%), the company must still pay the higher coupon interest rate (15%) on the bond.

8. Currency Exchange Rate Risk
The currency exchange rate is the value for which one nation’s currency may be converted to another nation’s currency. Currency exchange rate risk is the risk of loss of value caused by changes in the rate at which one nation’s currency may be converted to another nation’s currency.
Most multinational companies who have subsidiaries in other countries are susceptible to currency exchange rate risk.
e.g. A Ghanaian company faces currency exchange rate risk when it agrees to accept a specified amount of foreign currency in the future as payment for goods sold or work performed.

9. Cont.
Likewise, a Ghanaian company with significant foreign operations face an earning risk because of fluctuating exchange rates.
When the company generates profits abroad, those gains must be translated back into the national’s currency (cedis). When the cedis is strong (that is, when it has a high value relative to a foreign currency) the foreign currency purchases fewer cedis and the company’s earnings therefore are lower. (e.g. GHc0.9 /$1 therefore $100 =GHc90)
A weak cedis (that is, when it has a low value relative to a foreign currency) means that foreign profits can be exchanged for a larger number of cedis and consequently the firm’s earnings are higher. (e.g. GHc1.45/$1 therefore $100 = GHc145)

10. Enterprise Risk Management
Encouraged by the success of financial risk management, some organizations are taking the next logical step.
Enterprise risk management is a comprehensive risk management program that addresses an organization’s pure risks, speculative risks, Strategic risks, and operational risks.
Strategic risks refers to uncertainty regarding the organization’s goals and objectives, and the strengths and weaknesses, opportunities, and threats.
Operational risks are risks that develop out of business operations, including such things as manufacturing products and providing services to customers.

11. Securitization of Risk
Another important development in insurance and risk management is the accelerating use of securitization of risk.
Securitization of risk means that insurable risk is transferred to the capital markets through creation of a financial instrument, such as a catastrophe bond, futures contract, options contract, or other financial instruments.
The impact of securitizations upon the insurance market place is an immediate increase in capacity for insurers and reinsurers. Rather than relying upon the capacity of insurers only, securitization provides access to the capital of many investors.

12. Cont.
Insurers were among the first organizations to experiment with securitization. USSA insurance company, through a subsidiary issued a catastrophe bond in 1997 to protect the company against catastrophic hurricane losses.
Catastrophe bonds are corporate bonds that permit the issuer to skip or defer scheduled payments if a catastrophic loss occurs.

13. Cont. From the banking aspect
Securitization is defined by (Sinkey, 2002) to be the process in which financial intermediaries pool and package loans (e.g. Mortgages) for sale as securities.
A major financial innovation in the last quarter of the twentieth century asset securitization, has fundamentally changed the process of financial intermediation.
It involves pooling of loans and repackaging them as securities backed by the cash flows of the underlying loans. Residential mortgages were the first asset to be securitized and they are the major asset subject to such processing.

14. Cont.
Today, however, just about any loan that a bank makes has the potential to be securitized. Besides mortgages, the most popular other loans banks securitize are automobile loans and credit card receivables.
As a technique of ALM, securitization does its job by removing risk from the balance sheet.
Moreover, assuming no recourse (i.e. the right to put securitized assets back to the originator) It removes all the risks associated with the loan.

15. Cont.
The key to understanding securitization as a major financial innovations is to distinguish between indirect finance and pass-through finance.
The traditional function of a bank is to originate and fund loans.
Securitization has led to pass-through finance in which a bank either
(1)originates or sells loans, or
(2) originates, sells and services loans.

16. Cont.
Servicing means collecting payments of interest and principal and passing them through to investors hence the term pass-through finance. Servicers earn fees, of course, for performing this function. Securitization has permitted banks to sell large volumes of loans.
If lenders, who underwrite or originate the loans also service them, then they collect interest and principal payments for a price, called servicing fees, and pass the proceeds onto investors hence the terms pass-through finance and mortgage backed securities.

17. Other Risk Management Tools
Risk Management Information Systems (RMIS)
Risk Maps
Value at Risk (VAR) Analysis
Stress Testing

18. Risk Management Information Systems (RMIS)
A key concern for risk managers is accurate and accessible risk management data.
A Risk Management Information System (RMIS) is a computerized database that permits the risk manager to store and analyze risk management data and to use such data to predict and attempt to control future loss levels.
RMIS may be of great assistance to risk managers in decision making. Such systems are marketed by a number of vendors, or they may be developed in-house.

19. Risk Maps
Some organizations have developed or are developing sophisticated risk maps. Risk maps are grids (network or framework) detailing the potential frequency and severity of risk faced by the organization.
Construction of these maps require risk managers to analyze each risk that the organization faces before plotting it on the map. Use of risk maps varies from simply graphing the exposure to employing simulation analysis to estimate likely loss scenarios.
In addition to property, liability, and personnel exposures, financial risk and other risks that fall under the broad umbrella of enterprise risk, may be included on the risk map.

20. Value at Risk (VAR) Analysis
A popular risk assessment technique in financial risk management is value at risk (VAR) analysis.
Value at risk (VAR) is the worst probable loss likely to occur in a given time period under regular market conditions at some level of confidence.
The concept is often applied to a portfolio of assets, such as a mutual fund or a pension fund, and is similar to the concept of maximum probable loss (is the worst loss that is likely to happen GHc8 million) in traditional property and liability risk management.

21. Cont.
e.g. a mutual fund may have the following VAR characteristics: there is a 5% probability that the value of the portfolio may decline by GHc50,000 in any single trading day.
In this case, the worst probable loss is GHc50,000, the time period is one trading day, and the level of confidence is 95%. (95% sure that the loss will fall in this range)
Based on the VAR estimate, the risk level could be increased or decreased, depending on risk tolerance.

22. Cont.
Value at risk can also be employed to examine the risks of insolvency for insurers.
VAR can be determined in a number of ways, including using historical data and running a computer simulation.
While VAR is used in financial risk management, a growing number of organizations are considering financial risk under the broadened scope of risk management.

23. Stress Testing
In addition to requiring that a model for market risk be backed tested, the Basel Committee requires market risk VAR calculations be accompanied by a “rigorous and comprehensive” stress-testing program.
Stress testing involves estimating how the portfolio would have performed under extreme market moves. These extreme market moves typically have a very low (virtually zero) probability under most VAR models- but they do happen!
Stress testing is a way of taking into account extreme events that are virtually impossible according to the probability distributions assumed for market variables, but do occur from time to time.