Risk Assessment

Risk is said to come from the Arabic word risq (‘anything that has been given to you (by God) and from which you draw profit’) or the Latin word risicum (originally referring to challenges to seafarers, potentially with a negative outcome). The concept of risk brought foreward in the book talks about something that has an uncertain outcome possibly improving or worsening one’s position. It has a probability, can be good or bad (ex credit risk, which can only be bad) and involves something changing. The question is how to assess this.

Risk mapping is one potential solution, being an aid to increase the knowledge of risk exposure within the organisation. It is both an idea and a technique. Different risks to look at might be foreign exchange or interest rate risk and actually other internal audits, aimed at potentially suggesting improvements. There are three steps in this:

1\. find involved risk categories

2\. estimate size and degree of exposure

3\. rank risks for prioritisation

You should always look back to the strategy when doing this.

_Risk categories_ (suggestion):

\- financial: monetary changes due to balances and resource changes, e.g. gearing of different operations and he business

\- organisational: industrial relations, labour costs, skill requirements, price/quality, processes, R&D,

\- market: Market share, distribution, demand, product range

\- Environmental: STEEP

To estimate risk you can take the formula:

Expected return = Sum over all (probability of outcome * value of outcome)

Also keep in mind avoidable risk, which should only be taken if the expected return is positive. In the end, choose the options with the highest expected return.This gives you necessary conditions but not necessarily sufficient ones. There might be catastrophic outcomes attached that you need to avoid, outweighing any potential positive return. As a reminder, in the NPV valuation, you would put the risk into the discount rate. A decision tree will help in finding out about linkages between choices and their implications. At the end, after all your analysis you should be able to answer about your risks:

\- Why are you exposed

\- What is the size of the exposure

\- What are warning signs

\- What is the cost of risk

\- What are correlations of risks

Then you _allocate your risk capacity_ , ranking your different risks. The OUBS suggests:

\- Unavoidable risk in relation to core activities

\- Risk only avoidable by ceasing non-core activities

\- Avoidable risk, core activities

\- Avoidable risk, non-core activities

\- Selectable risk

In a sense you are moving further out of the region of your core capabilities and you must link this ranking to your strategy and appetite for risk.

In the end, while you will never be able to say what your risk is, the market will give a clear indication of what it thinks. It is important to note that strategy still drives the business, while risk mapping allows you to make sure you do not overstep your stated boundaries.

The book then includes a template and some questions to ask for financial risk analysis. The template has the different stakeholder groups on the y-achsis and the different risks on the x-achsis (e.g. forex rate, interest rate, commodity price, equity&funding, …)

**Interest rate risk is something that can be managed specifically and also applies for equity investors. This should first bring us to bonds. These can be said to be a _securitised evidence of indebtedness_. They normally have maturities between 5 and 15 years and mostly a fixed-rate or floating-rate. As it is securities, it is freely transferable. There are registered bonds, in which the issuer has a registry of who currently owns the bonds and bearer bonds, meaning that they are anonymous and whoever shows up with the paper gets the interest. Bonds normally repay the principal at the end of the period and interest once or at different times of the year. They might be quoted as “Bond1 11/2 2010” being a bond with 5.5% interest maturing 2010. Bonds are normally quoted at prices in relation to 100%, meanign that a bond valued at 95 is traded at 95% of face value.

Duration

To quantify interest rate risk, you can use the measure of duration, introduced by F.R. Macaulay in 1938. In general you already have a coupon rate and mixed with the price and that coupon rate you get a yield to maturity which gives us the IRR of the bond. If the interest rates move, the fair return or YTM changes though and how much it changes depends on the sensitivty of the bond towards interest rates. This is what duration measures. If your assets equal those of your liabilities and the duration of the both are the same, then your portfolio is immunised. This method can be applied to any know series of cash flows.

The duration is actually the weighted average maturity. That means that the formula is as follows:

D= (1/Price of the bond) (t_1 (CF_1 / (1+r)^(t_1)) + … + t_n * (CF_n / (1+r)^(t_n)))

An easy calculation would be to calculate the present value of the cash flows of a bond over the entire timeframe. Then you multiply each of those results by the time and add that up too. Deviding the later by the former will give your the duration in years. The discount rate should be the yield to maturity of the bond(s).

The rule is:

\- The longer the duration, the higher the exposure to interest rate risk

\- If the duration is the same, the exposure is the same, independant of sequence of cash flows.

Due to compound interest, the further away a cash flow is, the more exposed it is to interest rate changes. With zero coupon bonds, duration equals maturity. You can also adabt the formula to reflect the changes in value of a portfolio with interest rate changes.

Delta(P) = -D x P x 1/(1+r) x Delte(r)

For a percentage change, simply devide by P. For bigger changes this can be wrong though as it assumes a straight line relationship between price and yield, which is a curve. An immunised portfolio will be good for changes of +/- 1%, which leaves enough time to rebalance your portfolio.**