Enterprise Risk Management and Future Trends.

ERM Introduction

• Risk management is the process of identifying, assessing, and prioritising potential risks and taking actions to mitigate or avoid them. There are two ways to handle this situation:
• Traditional
• Silo Based: 
• Risk assessment, management and mitigation will be performed separately for each division within the firm.
• Advantages:
• Adequate in a less volatile market environment.
• Disadvantages:
• Ignores the dynamic nature of risks and their interdependencies.
• Costly overhedging of risks at the firm level.
• Different risk measurement methodologies and formats across units may result in fragmented information for senior management and the board.
• Risk management decisions are often made independently, without a comprehensive and strategic approach to enterprise-wide risk.
• Modern
• ERM
• Risk assessment, management and mitigation will be performed in an integrated and centralized framework for the firm.
• It's essential to keep in mind that risks are interconnected, and one type of risk can have a ripple effect on other areas of the company. However, when risks are evaluated from a company-wide perspective, they can sometimes offset each other. Therefore, it's crucial to consider risks holistically to create a robust risk management strategy.
• Advantages:
• Optimizing the total cost of risk expenses is better managed by avoiding overhedging and scaling various risks in a single umbrella (credit, regulatory, market, and so on).
• Understand the correlation risks between specific risk types and the crossover risks where one risk creates additional risks.
• Serves as a foundation for incorporating risk into business model selection and strategic decision-making, helping banks achieve their objectives while managing risks effectively.
• Helps risk managers define risk appetite to the entire company and can put constraints on enterprise-level risk.
• Managers and the board of directors can focus on the largest risk faced by the firm and not focus on day-to-day business divisions.
• Identifies threats to the entire operation that arise from individual business lines.
• Manage emerging risks such as cyber threats, reputation risks and anti-money laundering (AML) risks at the enterprise level.
• Regulatory compliance.
• Reassure stakeholders, stockholders and debtholders. 
• Saving capital by incorporating stress testing into pricing and decision-making.
• Disadvantages:
• Limited foresight, might struggle to predict entirely new or unforeseen risks, especially those arising from rapid technological advancements or significant economic shifts.
• The effectiveness of ERM can be challenging to measure quantitatively.
• Silo-Based Risk Management VS ERM
• Visualization

Credits: https://analystprep.com/study-notes/wp-content/uploads/2020/01/Enterprise_Risk_Management_ERM-1536x1273.jpg

• Silo-Based
1. Managing risks within the line of business
2. Isolated risk managers
3. Multiple risk metrics that cannot be compared
4. Difficult to see enterprise-wide risk
5. Hedging risk with specific risk transfer tools
6. Risk management and risk transfer are not integrated with balance sheet management and financing strategies
• ERM
1. Risk managers review all business lines, functional areas, and risk types for diversification and concentration to avoid overhandling costs.
2. Integrated risk managers and a chief risk officer.
3. Integrated risk metrics can be compared.
4. Aggregate risk across business lines and potentially across types of risk.
5. Could lead to potential cost savings.
6. Risk management is integrated with the bank's capital management strategy, balance sheet management strategy, and financing strategies.

Scenario Analysis and Stress Testing

• Definitions
• Sensitivity Analysis involves in changing one variable at a time to assess the impact on the model. The resulting impact is the net income for that variable.
• Scenario Analysis examines multiple variables to understand their impact and the developing narrative to explain why they changed and their effects.
• Advantages:
• The frequency of a risk occurrence is not as important as its plausibility.
• Scenarios can be intuitive and transparent.
• Firms should anticipate the worst-case scenario and evaluate its potential consequences.
• Helps firms focus on key risk types and their exposures.
• Firms can see potential warning signals and develop contingency plans to manage risk events.
• Scenarios can be created either by imagining hypothetical events or by using historical data.
• Scenarios analysis is utilized to establish the firm's risk appetite, define risk limits, and inform capital adequacy planning.
• Disadvantages
• Probabilities of the adverse events are difficult to estimate.
• Scenario analysis cannot quantify risk because it is qualitative.
• It is possible to underestimate the occurrence of possible events and the potential impact they may have.
• It is important to develop the right scenario, as only a limited number can be fully developed.
• Most scenarios are based on past crises, not future possibilities.
• The effectiveness of scenario analysis relies on its accuracy and comprehensiveness, which should encompass both past and future risks. 
• Could be challenging to determine the credibility of a situation since the scenarios can vary in their complexity.
• Scenarios may be intuitive and transparent which are advantage but are necessarily complex which is a disadvantage.
• Stress testing is a crucial evaluation method to ensure a firm's sustainability. It assesses extreme scenarios that may occur rarely but can have a significant impact on losses. On the other hand, probabilistic risk metrics, such as VaR, ES, or Standard Deviation, are suitable when the frequency of losses is high, and the severity of losses is low.
• Reverse stress tests, banks can identify worst-case outcomes on the key performance indicators and do the reverse engineering to see which scenarios could lead to these outcomes.
• History
• Before the 2007-2009 financial crisis, banks used to create historical scenarios based on actual past events. However, this approach failed to predict the crisis. 
• Banks didn't understand the risk interaction and market behaviour changes during the crisis, as the correlation between assets and asset classes increased.
• Bank stress test scenarios were mild, regulators demanded banks demonstrate the ability to withstand more realistic stress test scenarios. Hence multiple regulatory changes were announced, as noted below.
• Regulatory Requirement
• SCAP: Supervisory Capital Assessment Program
• Stress testing is performed to review whether there is sufficient capital available or not.
• DFAST: Dodd-Frank Act Stress Tests
• A mid-year review will be conducted for all banks with assets of $10 Billion or more. 
• Devised by supervisors.
• The approach is more prescriptive, involves less reporting, and requires fewer assumptions about capital action.
• CCAR: Comprehensive Capital Analysis and Review
• A year-end review will be conducted for all banks with assets of $50 Billion or more.
• Complex than SCAP.
• Encompassed of 28 scenarios, considering all the factors that might affect their portfolio (allowing interlinking factors).
• Mandated by regulators.
• Requires projections over 9-quarters i.e. 2.25yrs.
• Requires banks to dynamically forecast balance sheets and income sheets.
• Forecast must include:
• Actual loss
• Revenues
• Loan loss provisions
• Credit losses related to defaulting loans and downgrades on debt scenarios
• Rules for making new loans
• Regulatory ratios
• Capital plans based on each scenario/stress tests:
• Forecast expected capital sources
• Capital use over 9 quarter horizon
• Describe methodologies that will be used to determine capital adequacy
• Minimum capital standards required
• How to raise capital if necessary
• Plans for dividend payments, share repurchases and other factors that will affect the bank's capital
• In the CCAR report about capital planning example:
• CoCos - Contingent convertible bonds, in the event of trouble, bonds could be converted to equity and ease the bank's cash outflows in times of stress.
• These bonds have the characteristic of being convertible into equity shares of the issuing company under certain conditions, typically triggered by predefined events related to the financial health of the issuer.
• One of the key features of CoCos is that they come with contingent conversion triggers. These triggers are often tied to the issuer's capital levels or financial health.
• The bonds act as insurance for banks thus a risk transfer from ERM perspective.
• Tier 1
• Tier 1 typically refers to the highest level of risk within an organization.
• Organizations prioritize these risks due to their potential to cause substantial harm or disruption. 
• Examples of Tier 1 risks may include major regulatory changes, economic downturns, catastrophic events, or severe cybersecurity breaches.
• The capital ratio is like a measure of how safe a bank is. The higher the ratio, the safer the bank; the lower the ratio, the riskier it might be and may face regulatory scrutiny to improve its capital adequacy.
• Stress test cannot dip below it:
• Minimum common equity capital ratio is 4.5%.
• Minimum capital requirement is 6%.
• Total risk-based capital ratio is 8% and Tier 1 leverage ratio is 4%.
• If banks fail to meet minimum capital standards under stress testing, the bank must lower its risk appetite.
• CCAR requires banks to engage in exercises that require business line managers to come together and discuss risks, which is the key to the ERM process.
• Different banks are testing the same scenarios, for regulators have a better sense of systematic risks and can compare bank risk exposures, which would be impossible if each bank had its own scenarios.
• Federal Reserve Annual Stress Tests
• Mandated by regulators.
• Below are three macroeconomic scenarios that need to be considered:
• Baseline: Normal
• Adverse: Moderately declining economy
• Severely Adverse: Global recession or depression with the corresponding decline in demand for fixed-income investments.
• While all these are used for compliance issues, it is also used for below:
• Develop warning signals
• Specify risk appetites and risk limits
• Check the reasonableness of capital plans
• Put in contingency plans to manage different risks such as liquidity, and credit.
• Stress tests focus on macroeconomics and can be used in day-to-day business planning.
• Scenarios analysis can be in strategic decision-making.

Risk Culture

• Risk culture
• It is the heart of the ERM
• It defines the behaviour and response towards risk.
• It is the firm's goals, customs, values and beliefs both implicit and explicit that influence the behaviour of employees.
• Corporate norms guide individuals in their understanding and responses to risk and were identified as primary contributors to bank failures in the 2007-2009 financial crisis.
• Risk culture happens at the enterprise level, group level and individual level.
• Measure risk culture
• Measuring risk culture is a problem because it is multi-layered and complex. Individuals have their own risk attitudes because they come from different backgrounds and the risk behavior is as well influenced by peers and management.
• Measures of risk culture help the firm to understand the changes in the risk culture but they do not quantify the losses associated with failures related to the firm's risk culture.
• To measure progress in terms of risk culture there are different methods, one such method is to identify key risk culture indicators of the firm. The Financial Stability Board (FSB) has specified four risk indicators:
• Tone of top management
• Actions of management conflict with stated risk appetite or goals.
• Board of directors communicate the fit between risk appetite and firm strategies and goals.
• Effective communication and challenge
• Firm is valuing whistleblower
• Opposing views are valued
• Right to disagree
• Incentives
• Compensation plans supportive of and in alignment with risk appetite and risk culture.
• Accountability
• Expectations are clear
• Escalation process used
• Survey and other data can be used to develop a risk culture score.
• Factors that can be used to build a robust risk culture.
• Knowledge of the firm's risk appetite and ability to answer questions about its application in day-to-day business operations.
• Risk literacy through training programs and knowledge of the language used to describe risks and the consequences of risk-taking.
• The flow of risk information, and the details about risk flow across the firm with clarity on the discussions of risk and decisions made.
• Risk/reward decisions of managers.
• Risk management stature typically refers to the level of maturity or sophistication of an organization's risk management practices. It reflects how effectively an organization identifies, assesses, mitigates, and monitors risks to achieve its objectives and protect its interests.
• Whistleblowing and escalation, to report enterprise risks and methods in place to blow the whistle.
• Priorities of the board.
• Action against offenders.
• Identification of risk culture concerns and incidents, that were taken in response to violations.
• Factors that prevent firms from developing robust risk cultures that can withstand fluctuations and recover from setbacks relatively quickly.
• Risk education
• Throughout the organization risk education should be provided including the board of directors.
• The board must be able to list key enterprise risks and relate key risks to the firm's risk appetite.
• Having common risk language across the organization would be useful.
• Risk indicators become risk levers
• Firms identify risk indicators, but in many cases, it is easier to manage the risk indicator than to actually improve the firm's risk culture.
• Curse of data
• Growing amount of data available for analyzing risk.
• Culture cycle
• During a crisis behaviour towards risk will be very low due to the feelings and fear, but that fades away over time.
• Risk across the organization and across time
• Risks are generally established in business lines and often develop an internal risk culture rather than at the enterprise level.
• By proactively identifying and managing risks that span multiple business lines, enterprises can strengthen their resilience and enhance their ability to achieve their strategic objectives despite potential challenges and uncertainties.
• External factors also influence risk culture, a few factors are the economic cycle, industry and professional norms, changing industry practices, professional and regulatory standards, country risk and corruption indices.

ERM Best Practices

• Corporate governance (CG) refers to the system of rules, practices, and processes by which a company is directed and controlled. 
• It encompasses the relationships and responsibilities among a company's management, its board of directors, its shareholders, and other stakeholders.
• Effective corporate governance is essential for the success of Enterprise Risk Management (ERM) initiatives
• CG ensures senior management and the board have the requisite organizational practices and processes to adequately control risks.
• CG practices have evolved considerably through recent regulatory initiatives including the Turnbull Report and the Sarbanes-Oxley Act.
• A successful corporate governance framework requires the senior management and the board to adequately define the firm's risk appetite and risk and loss tolerance.
• The firm should have the required management skills and organization structure to successfully implement the ERM program.
• All key risks are successfully integrated into the ERM program.
• Risk roles and responsibilities should be clearly defined including the role of the chief risk officer (CRO).
• Audit and monitoring targets are crucial components of the ERM governance process.

ERM Program Dimensions

ERM programs typically encompass several dimensions that collectively contribute to effective risk management across an organization. The following are five important dimensions.

• Targets
• Set correct risk targets.
• Targets should be in sync with strategic goals.
• Targets includes:
• Risk appetite operational mechanism and global risk limits are linked to the risk appetite of the firm.
• Strategic goals are linked to the firm's risk appetite.
• Structure
• The roles along with a description of the firm's governance structure needs to be defined for chief risk officer, global risk committee and other risk committees.
• Ensure enterprise wide risks are identified contributing to direct or indirect losses.
• Establish reporting lines and frequency.
• Identification and metrics
• Identification of risks
• impact on the firm
• severity of the risks
• frequency of the occurrence
• concentration
• Right metrics used to capture whole firm's risks
• scenario analysis
• stress testing
• sensitivity analysis
• standard deviation
• value at risk (VaR)
• total cost of risk approaches
• enterprise-wide risk mapping
• risk specific metrics
• risk flagging tools
• ERM Strategies
• Communicate risk to the entire organization
• Decisions must be made at the enterprise level regarding accept, avoid, mitigate or transfer.
• Culture
• Strong risk culture is the heart and soul of ERM
• Top-down approach in instilling the importance of risk through goals, practices and behaviours.

Credits and References

• https://st4.depositphotos.com/2547605/40711/v/450/depositphotos_407115488-stock-illustration-erm-enterprise-risk-management-business.jpg
• FRM Book 1 - Chapter 8
• https://gemini.google.com/
• https://chatgpt.com/

Memcached - An Overview - InDraft

 

Cache and Session Store

A cache is a type of high-speed data storage layer in computing that temporarily stores a portion of data. This allows subsequent requests for that data to be delivered faster than if it had to be accessed from the data's primary storage location. Caching is a technique that helps you to use previously received or calculated data more effectively. The main objective of a cache is to enhance data retrieval performance by minimizing the need to contact the slower storage layer beneath. Cache data is usually stored in fast-access hardware such as RAM (Random-access memory) and may also be used with a software component.    

A session store is a server-side location where user session data is stored. In web applications, this is usually done through a cookie stored in the client's web browser. This allows your application to identify the user and keep them logged in, for example. Storing session data is crucial for the proper functioning of web applications. In-memory databases can ensure high-speed access, horizontal scalability, and high-fidelity data storage. These features improve the overall performance and user experience of web applications.

Memcached is a commonly used in-memory data store by application developers to manage session data for internet-scale applications. It is an excellent choice for implementing a high performance in-memory cache to reduce data access latency, improve throughput, and reduce the load on your back-end systems. Persistence is not critical when using Memcached.

Memcached

Memcached is an open-source distributed, high-performance in-memory system that caches memory objects in key-value storing short bits of random data (strings, objects) returned by databases queries, API requests or page rendering. It was initially designed to speed up dynamic web apps and reduce database load by Brad Fitzpatrick from Danga Interactive for LiveJournal in 2003. It was written is Perl, but is rewritten in C by Anatoly Vorobey. Memcached is now used by all the major websites having huge data, for example, YouTube, Wikipedia, Twitter etc.

Memcached enables to allocation of memory from the parts of the system where it’s surplus, and makes it accessible to the areas that need more memory. When you use memcached, all the servers in the cluster access the same virtual pool of memory. As a result, every item is stored and retrieved from the same location across the entire server cluster. Since Memcached is decentralized or distributed system, it can be easily scaled by adding more nodes. Additionally, Memcached’s multithreaded nature enables users to quickly increase computational capabilities by utilizing several cores in the given node.

Architecture of Memcache

Memcached is a type of in-memory key-value store that stores its data in RAM instead of on disks. This helps to eliminate delays caused by disk access and enables data to be accessed in microseconds. 

Memcached is a software that consists of three main components. 

• The first component is the client software, which provides a list of available Memcached servers. 
• The second component is a client-based hashing algorithm, which chooses a server to store based on the key - this helps to distribute the load.
• The third component is the server software, which stores values and their keys into an internal hash table.  

The architecture of Memcached is straightforward. 

• When a client requests a piece of data, Memcached checks to see if it is stored in the cache.
• There are two possible outcomes. 
• If the data is stored in the cache, Memcached returns the data without checking the database. 
• However, if the data is not stored in the cache, Memcached queries the database, retrieves the data, and stores it in the cache. 
• It is important to note that data is only sent to one server, and servers do not share data. 
• Servers keep the values in RAM, and if RAM runs out, the oldest value is discarded. Memcached uses LRU caching algorithm(Least Recently Used (LRU) – discards the least recently used items first).
• Whenever information is modified or the expiry value of an item has expired, Memcached updates its cache to ensure fresh content is delivered to the client.
• Clients use a hashing algorithm to determine which memcached storage server to use, helping to distribute the load efficiently.
• When the server receives a key, it computes a second hash to determine where to store the corresponding value in an internal hash table.
• The name, expiration date, and raw data are included in every object. Whenever data is updated, or an object has an expiry value expired, it updates its cache to provide the client with fresh content.

A few important points about Memcached architecture include:  

• Data is only sent to one server. 
• Servers do not share data.
• Servers store data in the Random Access Memory (RAM) of the system, it is not persistence. 

Benefits of Memcache

• Response times in milliseconds
• Server Client program can run in both TCP and UDP 
• Open source
• Data is saved in the server
• Supports multiple OS
• Provides APIs for major languages like Perl, Python, Java, Ruby, C, C++ and so on.
• Scalability, easily by adding or removing nodes
• Community support

Limitations of Memcached

• Datastore is not persistent
• As the data package is located in only one place, multiple users have limited access to it.
• Also when the data is too rapidly changing, memcached is not preferred to use.

Credits and References

https://spin.atomicobject.com/wp-content/uploads/brain-forget.jpg

https://www.javatpoint.com/memcached-tutorial

https://www.keycdn.com/support/what-is-memcached

https://www.cs.cmu.edu/~dga/papers/memc3-nsdi2013.pdf

https://github.com/couchbase/Memcached/blob/master/docs/Architecture.md

https://acquia.my.site.com/s/article/360005256114-Memcached-in-detail

https://www.dragonflydb.io/guides/memcached

https://www.ijert.org/research/a-brief-introduction-to-memcached-with-its-limitation-IJERTV3IS21081.pdf

https://en.wikipedia.org/wiki/Memcached

Firms Manage Financial Risk

 

Strategies for Risk Management

After identification of the risk, at a high level a firm can pick from below four different risk management strategies. More than one of the below could be used to manage the risk.

• Accept the Risk : 
• The firm could decide to retain or accept the known risk.
• Reasons
• Cost of mitigating the risk is higher than the actual risk impact
• Cost can be of priced into the firms products and passed along to customers.  Here the business risk is accepted.
• Investors / Owners desire exposure to this risk factor
• Eg: When we talk about investors, like owners of a gold mine, desiring exposure to a risk factor such as the market price movements of gold, it means they want their investment returns to be influenced by changes in the price of gold. While it might seem counterintuitive for owners of gold mines to desire exposure to the market price movements of gold since they already have exposure through their business operations, there are several reasons why they might choose to do so. It aligns with their core business interests, provides a natural hedge, reflects their belief in gold as an investment, and allows them to leverage their expertise in the industry.
• Avoid the Risk
• Not to take an action or avoid selling the units of business to avoid risks to their core business units
• Mitigate the Risk
• After accepting risk, may seek ways to strategically mitigate known risks.
• Different techniques are used to handle different types of risk.
• Transfer the Risk
• To the third party the risk is transferred
• Insurance
• Derivatives Contract
• This introduces counterparty risk because the firm is relying on the third party to make good if a risk event arises.

Risk Appetite

Risk Appetite is how much risk the firm is willing to retain. After discussing the above high-level strategies of the risk, here are five steps process to manage the risk.

• Identify the risk appetite
• Map the known risks
• Operationalise the risk
• Operationalizing risk involves taking a theoretical risk identified through risk assessment and turning it into a practical approach for managing that risk within your organization. 
• Implement the plan
• Monitor and adjust continuously 

The risk appetite can be further divided into two sub-parts:

• Risk Willing
• Desire to accept the risk in pursuit of business goals
• Risk Ability
• Based on the factors risk ability can cap risk willingness.
• Less than risk willing
• Controlled by internal risk controls and also regulatory constraints

In layman's terms, assume the car has been driven on a highway:

• Risks Appetite - Highway speed limit for cars
• Risk Willing - Personal preference to drive at a certain speed, but not exceeding the limit
• Risk Ability - Capability of the car to be able to reach a certain speed, less than risk willing

It is important to distinguish between Industry Risk Appetite vs Internal Risk Appetite as both vary, one is based on the current general market sentiments and another is based on the internal firm's control.

There is always potential for errors in the risk estimation process, hence below allowing margin room for errors. For example:

• Max of 200 Crore - After this firm will go bankrupt
• 150 Crore - Internal risk appetite
• 100 Crore - Actual risk accepted

Role of the Board of Directors

• Communication: 
• It is important for senior management and the board of directors to clearly define the company's risk tolerance and communicate it to stakeholders in a quantitative and/or qualitative manner.
• Quantitative:
• VAR: To convey maximum loss for a given confidence level for a given period.
• Notional Principal: Notional principal amount refers to a predetermined dollar value used in various financial contracts, but it's important to understand that it's not actual money that gets exchanged.
• Eg: Imagine a contract between two friends where they agree to split the cost of a movie rental (the notional principal). However, they only exchange the difference between what each owes based on their preferred snacks (the interest payments). The total cost of the movie (notional principal) doesn't physically change hands.
• Stress Testing: Take the possible input to extreme negatives to determine the level of the losses.
• Qualitative
• List of risks that are retained (unhedged), avoided, mitigated (hedged) or transferred.
• External communication, for example, government or media.
• In detailed communication with the employees, the line managers and the risk managers to understand the enterprise-level expectations. Enabling the below:
• Decision making
• Identify trouble spots
• Business planning cycles
• Determine risk appetite between two major stakeholders - Debt holders vs Stakeholders
• Debt holders are less inclined to take risks and instead prioritize receiving principal and interest payments.
• Stakeholders prefer taking calculated risks that are unlikely to generate more profits/equity returns.
• Time Horizon
• Needs to decide either on taking short-term or long-term risks.
• Reputational Risk
• Ensure any risk impacting the brand of the firm
• Entrepreneurial opportunities
• Characterized by the taking of financial risks in the hope of profit, that could also provide a competitive edge if more risk is assumed.
• Limit Based Risk
• Allowing managers to operate with flexibility but given limits that cannot be exceeded, while also clearly communicating the expectations.
• Risk measurement
• It is difficult to reduce risk management to a single value at the firm level.
• VaR, notional limits, and stress testing are useful tools, but the firm should determine the most relevant metric based on their unique business model.
• Measure the risk at the enterprise level and division level.
• Unity of risk appetite
• Different risk types have different appetites.
• Layers of correlated risk
• Taking one risk might lead to other correlated risks.
• The company need to decide which risks to hedge and which to accept or avoid or transfer.
• Note: Notional Limits Vs Notional Principal

• Both notional principal and notional limits deal with theoretical values in finance, but they serve different purposes:  

• Notional Principal: A predetermined dollar value used as a reference point in various financial contracts. It represents the underlying value of an asset or obligation in the contract. Not actual money that gets exchanged.

• Notional Limits:

   Predefined maximum amounts set for specific types of risk exposure. They act as boundaries to control risk within a portfolio or activity. Used to establish a limit on how much risk can be taken for a particular asset class, strategy, or counterparty.
• Here's an analogy to understand the difference: Imagine a baking recipe (the financial contract).
• The notional principal is like the total amount of flour required (the underlying value). You don't necessarily use all the flour at once, but the recipe uses it as a reference for other ingredients.
• The notional limit is like the maximum amount of sugar you should add (the risk boundary). You can use some sugar, but exceeding the limit can ruin the recipe (excessive risk exposure).

Risk Mapping

• Risk mapping involves the next logical step of the risk management process.
• All the factors related to risk or that can go bad should be taken into consideration by the risk managers:
• Factors including all the types of risk:
• Market Risk
• Equity Risk
• Interest Rate Risk
• Foreign Exchange Risk
• Commodity Risk
• Credit Risk
• Default Risk
• Downgrade Risk
• Settlement Risk
• Bankruptcy Risk
• Liquidity Risk
• Funding Liquidity Risk
• Market Liquidity Risk
• Operational Risk
• Business Risk
• Strategy Risk
• Legal and Regulatory Risk
• Reputational Risk
• Correlation Risk
• Cross out risk factors
• Granular information should be recorded for each type of risk. 
• It is ideal to conduct a risk assessment for all known risks. If that is not possible, at least the top 10 risks should be thoroughly assessed and all granular information should be provided to the board of directors or senior management. This will enable them to make informed decisions on how to handle the risks, such as accepting, avoiding, mitigating, or transferring them.
• Employees should be informed of all the risks if not then at least the top 10.

Hedging Risk Exposures

• Hedge means to protect, hedging risk means providing financial stability for the organization and mitigating the known risks preventing financial stress.
• Many risks can be hedged, but not all the risks are hedged.
• Some investors would intentionally want the risks unhedged.

Hedging Types

• Static Hedging
• Involves creating an initial hedge position using derivatives (usually options) and then leaving it unchanged throughout the life of the underlying asset.
• May not be as effective in highly volatile markets where the underlying asset price fluctuates significantly.
• Dynamic Hedging
• Involves continuously adjusting the hedge position based on changes in the price of the underlying asset and other relevant factors (volatility, time decay). 
• Incurring frequent adjustments to the hedge can result in additional transaction costs.
• It is important to allocate sufficient time for continuous monitoring and analysis of market conditions, which includes the addition of new data and information to the analysis.
• Here's an analogy to understand the difference:
• Static Hedging: Imagine buying an umbrella before a weather forecast with a 30% chance of rain. You have basic protection but might get caught in unexpected downpours.
• Dynamic Hedging: Think of checking the live weather radar and constantly adjusting your umbrella position (or bringing a raincoat) based on the rain intensity and direction. This offers more tailored protection but requires constant monitoring.

Hedging Tools

Hedging tools are financial instruments used to manage risk by offsetting potential losses in one investment with gains from another.  These tools are particularly valuable when dealing with volatile markets or when you want to protect the value of an existing asset.

Below are two channels for trading various financial instruments:

• Over The Counter (OTC) refers to a direct trade between two parties without involving any intermediaries.
• Direct transaction
• Privacy
• Costomizable
• Involves counterparty risk 
• Can be expensive 
• Not easily liquidate
• Exchange refers a centralized marketplace where investors and other participants can buy and sell various financial instruments such as NSE,  BSE.
• Easily liquidate
• Transparency
• Less transaction costs
• Reduces counterparty risk
• Due to standardization, this may not be flexible and meet the specific security, timing, or location needs of risk managers.

Below are some of the available derivative contracts:

• Forward Contracts
• Forward contracts are customizable OTC products traded between two counterparties in the form of price or physical assets.
• Used to lock in a price for buying or selling an asset at a future date and can be used to hedge against price fluctuations, aiming to profit if the price goes in the desired direction.
• Future Contracts
• Future contracts are standardized exchange products that involve an intermediary unit and eliminate counterparty risk.
• Same as forward contracts but standardized.
• Swap Contracts
• Counterparties exchange swap contracts to trade their economic position. For instance, they can exchange a fixed interest rate with a variable interest rate with the assumption of obtaining benefits from it.
• Swaps can be a valuable tool to hedge against fluctuations in interest rates, currency exchange rates, or commodity prices.
• In layman's terms: Imagine you and a friend are both going on vacation, but you have different preferences for dealing with the weather:
• You: You hate surprises and prefer predictable weather, so you pack for sunshine every day (fixed rate).
• Your Friend: They love adventure and don't mind the occasional rain shower, so they pack for whatever comes (variable rate).
• Let's say halfway through packing, you realize you might miss some exciting rainforests if you're stuck in all sunshine. Your friend, on the other hand, starts to worry about getting caught in a downpour without proper gear.
• This is where a swap contract comes in:
• The Swap: You agree to exchange some of your sunshine days (fixed payments) with your friend's chance of rain showers (variable payments) for a certain period (duration of the swap).
• The Benefit: Now you both get some of what you desire! You still have some sunny days (guaranteed fixed income), but you also have the possibility of experiencing exciting adventures (potential for higher returns with variable payments). Your friend gets some predictability (fixed income from you) while keeping some room for surprises (variable income they keep).
• Key Points in this Analogy:
• Exchange of Cash Flows: The swap is about exchanging streams of payments, just like you exchange sunshine days for rain shower possibilities.
• Customization: The swap agreement can be designed to fit your specific needs, just like you agree on how many sunshine days to exchange.
• Risk Management: The swap helps you manage risk by getting some exposure to what you desire (rainforests for your friend, sunshine for you) while keeping some predictability (fixed income).
• This is a simplified analogy, and swap contracts can be much more complex.
• Options Contracts: Contracts that give you the right, but not the obligation, to buy or sell an asset at a certain price by a certain date. They offer more flexibility than futures contracts and can be used for various hedging strategies depending on your risk tolerance and market expectations.
• Call Option Contract
• In a call option, the buyer has the right to buy shares at a specified strike rate either at or before the maturity date.
• Put Option Contract
• In a put option, the seller has the right to sell shares at a specified strike rate either at or before the maturity date.
• Exotic Option Contracts
• Exotic option contracts are derivatives that differ from standard (vanilla) options like calls and puts by having unique features or payoffs tied to the underlying asset. These features add complexity but can also provide investors with more flexibility and potentially higher returns compared to vanilla options. 
• Swaption Contracts
• Combination of Swaps and Option Contracts, here it has the right to swap but is not obliged to enter into a swap contract at some future date.
• When a swaption contract is initiated, the key terms of the underlying swap are indeed established. These terms would be similar to the terms of a regular swap agreement, but with the crucial difference that the swaption only grants the right, not the obligation, to enter into the swap.

Basis risk refers to the mismatch that occurs between the actual risk and the hedge. It is important to note that the hedge is not always perfect, as in the case of an airline industry that is heavily exposed to volatile jet fuel prices. Unfortunately, there is no exchange-traded product for jet fuel, and due to heavy industry competition, airlines cannot pass on the fuel price risk to customers. As a result, airlines have considered using products linked to crude oil as an alternative. Here it brings in basis risk, due to mismatch.

Hedging Operational and Financial Risks

Hedging operational risks covers a firm's expenses(production) and revenues(sales), which are reflected in the income statement.

Hedging financial risks covers a firm's assets and liabilities, which are reflected in the balance sheet.

Pricing Risk

• Input costs significantly impact a firm's ability to compete.
• Hedging such pricing risk by purchasing a forward or futures contract to buy a specific quantity of the input at a fixed cost, which can be determined in advance.

Foreign Currency Risk

• Hedging foreign currency risk is to control exposure to exchange rate fluctuations that impact both future cash flows and the fair value of assets and liabilities.
• Hedging should consider the cost of hedging, as well as revenue, exchange rate volatilities, and correlations.

Interest Rate Risk

• Hedging interest rate risk is managing the firm's exposure to unfavorable interest rate fluctuations.

Hedging Strategies Challenges

• Misunderstand their risk exposure during the risk mapping process
• Selecting the wrong risks, missing relevant risks, or misestimating risks can result in notional values on derivatives that are either too high or too low. 
• The remains of unhedged during a period when it could create a substantial risk event.
• Market trends are constantly changing
• Affects variables such as commodity prices, foreign exchange rates, and interest rates. These changes impact a company's exposure to risk. 
• To manage risk effectively, the risk management process must be as adaptable as the risk variables themselves. 
• However, the rapid pace of change can make it challenging for some firms to actively monitor and keep up with these variables. 
• Attempting to hedge using a flawed hedging strategy may result in greater losses for a firm than the risks they are trying to mitigate.
• Amplified by poor communication
• Communication of strategy is ineffective and decision makers are not adequately informed about potential consequences.
• Knowledge gaps
• Hedging often requires very specific skills, knowledge, research and time.
• Firms may not have the necessary internal human capital, but they can outsource to trusted third-party risk managers.
• Time horizons
• Relevant time horizons for hedging and ensure the performance evaluations are matched with the time horizons
• Taxation
• Taxation of derivatives is a key issue because of its impact on the firm's cash flow as well as the differing laws between countries.
• Significant effort and cost may required to decipher the complex surrounding derivatives.

Some of these challenges could be overcome by training and education, regular communications about risk, awareness of company goals, articulate the firm's top 10 risks.

Risk Limits

Risk limits are a cornerstone of sound financial risk management. As part of the risk mapping process, it is crucial to understand and potentially control various risk limits. They establish thresholds for various types of risk exposure, helping investors and institutions stay within their risk tolerance.  Here's a breakdown of different types of risk limits, their purposes, and potential limitations:

1. Stop-Loss Limits:

   • Purpose: Set a maximum acceptable loss for a particular position or portfolio. Once the loss reaches the limit, the position is automatically liquidated (sold) to prevent further losses.
   • Weakness: Can lead to unnecessary selling during temporary price fluctuations. Misses out on potential recovery if the price rebounds.

2. Notional Limits:

   • Purpose: Set a maximum total dollar value of exposure to a particular asset class or sector. Helps prevent excessive concentration in any single area.
   • Weakness: Doesn't consider the underlying risk of the assets themselves. A high-risk asset with a low notional value could still pose significant risk.

3. Risk-Specific Limits:

   • Purpose: Set limits for specific types of risk, such as market risk (volatility), credit risk (default), or liquidity risk (difficulty selling an asset). Provides a more nuanced approach to risk management.
   • Weakness: Requires a good understanding of different risk measures and how they interact. Can be complex to implement and monitor, may require hiring someone with very specific skills.

4. Maturity Limits:

   • Purpose: Set limits on the maximum maturity (time to expiry) of an investment. Helps manage interest rate risk and ensures investments align with investment goals.
   • Weakness: May limit access to certain investment opportunities with longer maturities that could offer higher potential returns.

5. Concentration Limits:

   • Purpose: Set limits on the maximum exposure to a single issuer (company), industry, or asset class. Prevents overdependence on any single entity or sector.
   • Weakness: May limit diversification opportunities in smaller markets or asset classes. Outcomes may be correlated even if they are not concentrated.

6. Greek Limits:

   • Purpose: Set limits on exposure to specific risk measures derived from options pricing models (Delta, Gamma, Vega, Theta). Helps manage the risk profile of options positions.
   • Weakness: Greek measures are based on assumptions and can be volatile with market changes. Requires a sophisticated understanding of options pricing.
7. Value at Risk
• Purpose: 
  • Quantitative Measure: VAR provides a single numerical value to represent overall portfolio risk, simplifying communication and risk management processes.
  • Customizable: VAR calculations can be customized to include various risk factors relevant to the portfolio, offering a more tailored approach.
• Weakness: 
• Does not provide a measure of magnitude beyond the threshold. Subject to model risk and input variables can be adjusted to yield desired results.

8. Stress Testing and Scenario Analysis:

   • Purpose: Evaluate how a portfolio would perform under extreme but plausible market conditions (stress testing) or specific hypothetical scenarios. Helps identify potential vulnerabilities and assess risk tolerance.
   • Weakness: Effectiveness depends on the accuracy of chosen scenarios and assumptions. Doesn't guarantee future outcomes.

Hedging Trade-Off

• Advantages
• Cost reduction
• Lowering the cost of capital, whether through debt or equity, can lead to economic growth.
• Debt: When a company is seen as less risky, lenders are more likely to offer them loans with lower interest rates. This makes borrowing cheaper, freeing up more capital for investment and growth.
• Equity: Reduced risk also makes a company's stock more attractive to investors. This can lead to a lower cost of equity, meaning the company can raise capital by issuing new shares at a lower price dilution to existing shareholders.
• Increase in debt capacity by reducing the volatility of its earnings/cash flows.
• Imagine a company's earnings as a bumpy rollercoaster ride. Lenders are hesitant to lend money on such a risky journey. The company smooths out the ride by using hedging as safety rails, making it a more predictable and reliable borrower. This entices lenders to offer more favourable loan terms, allowing the company to take on more debt for growth.
• Borrowing arrangements for firms with less volatile earnings/cash flows usually contain fewer conditions and restrictions imposed by the lenders.
• Possible cash flow impact could be tax reduction
• Hedging strategies can generate tax-deductible losses that can be used to offset taxable income. This can be particularly relevant for companies that hedge against certain risks.
• Imagine a company uses futures contracts to hedge against a potential decline in oil prices (if they're a heavy oil consumer). If oil prices do fall, the company might experience a loss on the futures contract. This loss can be deducted from their taxable income, potentially lowering their overall tax burden.
• Beyond risk transfer, there is also the potential for a cash flow advantage.
• Positive cash flow, though only when hedging is done through options
• Imagine with the effort to hedge commodity prices and end up with a large profit position in future contracts.
• Signal to stabilize income
• Stability in a firm's income operations signals strength to its stakeholders.
• Reputational message could impact lenders, customers, suppliers, employees and as well reflected in the firm's stock price.
• Communicate the risk appetite to the firm's board of directors.
• Makes business easier
• Firms can make better decisions for the future if they demonstrate stability.
• As risks are controlled.
• Lock in strong margins
• Hedging can serve as a crutch to meet short-term performance goals. However, it can also help lock in solid performance when it arises organically.
• Cheaper than purchasing insurance policy.
• Disadvantages
• The assumption of no transaction cost or taxes is highly unrealistic in real world.
• In addition to systematic risk, which affects all market participants, unsystematic or idiosyncratic risk pertains to the inherent uncertainty or potential loss associated with an individual investment or a small group of assets. However, diversification efforts may lead to transaction costs.
• Unplanned cost involved to hedge
• Cost involved to hedge, like talent and expertise, software, transaction cost, legal and compliance, market data, training and education, and some more.
• Hidden cost involved, when management can get distracted, and lose focus on the core business activities of the firm.
• Hedging as a "zero-sum game" might not be entirely accurate. In a zero-sum game, one participant's gain is exactly balanced by another participant's loss. Hedging is a risk management strategy used to offset potential losses in one investment with potential gains from another.
• Extremely complex and not as accurate as equity or bond pricing, reflect all of its relevant risk factors.
• The goal is to achieve a more predictable outcome, rather than a win-lose scenario.
• Hence hedging with derivatives may not be a zero-sum game of transferring risk between periods or between participants.

Credits and References

https://blog.deltafx.com/en/what-does-hedging-mean/

https://gemini.google.com/

https://chat.openai.com/

SchweserNotes and BionicTurtle Notes

#Chapter2