aon era cas Financial Risk Manager (FRM?®) Part | Foundations of Risk Management Third Custom Edition for Global Association of Risk Professionals 2013 Global Association © GARP | Saaseei.Copyright © 2013, 2012, 2011 by Pearson Learning Solutions All rights reserved. This copyright covers material written expressly for this volume by the editor/s as well as the compilation itself. It does not cover the individual selections herein that first appeared elsewhere. Permission to reprint these has been obtained by Pearson Learning Solutions for this edition only. Further reproduction by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval system, must be arranged with the individual copyright holders noted. Grateful acknowledgment is made to the following sources for permission to reprint material copyrighted or controlled by them: “Risk Taking: A Corporate Governance Perspective,” by Oliviero Rogai, Maxine Garvey, and Aswath Damodaran (une 2012), originally published by the International Finance Corporation (IFC), World Bank Group, Washington, D.C. Excerpts reprinted from Modern Portfolio Theory and Investment Analysis, by Edwin Elton et al., Eighth Edition (2010), by permission of John Wiley & Sons, Inc. “The Capital Asset Pricing Model and Its Application to Performance Measurement,” by Noel Amenc and Veronique Le Sourd, reprinted from Portfolio Theory and Performance Analysis (2003), by permission of John Wiley & Sons, Inc. “Information Risk and Data Quality Management,” by David Loshin, reprinted from Risk Management in Finance: Six Sigma and Other Next-Generation Techniques, edited by Anthony Tarantino and Deborah Cernauskas (2009), John Wiley & Sons, Inc. “Financial Disasters,” by Steve Allen, reprinted from Financial Risk Management: A Practitioner's Guide to Managing Market and Credit Risk (2003), by permission of John Wiley & Sons, Inc. “Risk Management Failures: What Are They and When Do They Happen?” by René Stultz, reprinted by permission of the author. All trademarks, service marks, registered trademarks, and registered service marks are the property of their respective owners and are used herein for identification purposes only. Pearson Learning Solutions, 501 Boylston Street, Suite 900, Boston, MA 02116 A Pearson Education Company www.pearsoned.com Printed in the United States of America 12345678910 VO31 171615141312 000200010271724054 RG/CM LAP USTO)NIM | ISBN 10: 1-256-93115-2 ISBN 13: 978-1-256-93115-7,Cuapter 1 Risk Takin: A Corporate GOVERNANCE PERSPECTIVE 3 Introduction 4 Objectives of IFC’s Risk Governance Program 4 Risk Taking as an Essential Activity of Enterprises IFC’s Risk Governance Program Target Reader: A Director's Perspective on Risk Taking Section Outlines What Is Risk? Speaking of Risk A Better Definition of Risk Where There Is Upside, There Is Downside and the Opposite Is True! 6. Classifying Risks Faced by aa oun as Organizations 6 What Is a Risk Profile? 7 Implications for Decision Makers 7 Risk Governance, Risk Management, and Value Creation 8 Corporate Governance 8 Risk Management 8 Enterprise Risk Management 10 Contents Measuring Value: Risk-Adjusted Value Approaches for Adjusting Value for Risk Risk-Adjusted Discount Rate Calculating Risk-Adjusted Rates: A Hypothetical Disney Theme Park in Rio Certainty Equivalents Certainty Equivalent Value: Rio Theme Park Example Implications for Decision Makers Managing Risk: Enterprise Approaches Risk Management and Enterprise value STEP 1: Identification of Risk and Enterprise Management Objectives STEP 2: Risk Assessment Risk Estimation Purely Qualitative Estimates Semi-Quantitative Estimates Pure Quantitative Estimates Risk Evaluation and Enterprise Value: The Value-Based Model STEP 3: Risk Treatment: Principal Strategies and Methods Risk Avoidance nN u 12 7 1B 19 19 20 20 22 22 23 23 24 24 25 25 25Risk Transfer, Also Known as Risk Hedging Risk Retention Risk Reduction, Diversification and Other Policies STEP 4: Monitoring Incurred Risks Implications for Decision Makers Tools for Better Risk Decision Making: Probabilistic Approaches Probabilistic Approaches Sensitivity Analysis Scenario Analysis Decision Trees Simulations Value at Risk (VaR) Creating Value from Risk Taking How Risk Management Affects Value Value from Risk Hedging The Costs of Hedging A Framework for Risk Hedging Approaches to Hedging Implications for Decision Makers Exploiting the Risk Upside: Contents Strategic Risk Taking and Building a Risk-Taking Organization Strategic Risk Taking and Value Taking Advantage of Taking Risks Organizing for Risk Taking Hiring the Right People Creating Incentives for Good Risk Taking Aligning Organizational Size and Culture with Risk Taking Understanding the Decision-Making Context Integrating Risk Analysis with the Strategy Process Monitoring and Responsiveness 38 25 Ensuring Adequate Capital 26 for Risks Retained 38 Preserving the Enterprise’s Options 38 26 Building the Optimal Risk Governance 26 and Management Structure 38 27 Balancing Quantitative and Qualitative Decision Making 39 Implications for Decision Makers 39 27 Summary 39 3, Appendix 42 27 About the Authors 47 28 29 29 CHAPTER 2 DELINEATING EFFICIENT PorTFo.ios 51 30 30 Combinations of Two Risky 30 Assets Revisited: Short Sales 31 Not Allowed 52 31 Case 1—Perfect Positive Correlation 3a (@=tD 53 33 Case 2—Perfect Negative Correlation (p= -1.0) 54 Case 3—No Relationship between Returns on the Assets (p = 0) 56 ae Case 4—Intermediate Risk (p = 0.5) 56 34 The Shape of the Portfolio 35 Possibilities Curve 57 35 The Efficient Frontier with No Short Sales 58 36 The Efficient Frontier with Short Sales Allowed 60 36 The Efficient Frontier with Bal Riskless Lending and Borrowing 62 37Contents Examples and Applications 64 Considerations in Determining Inputs 65 Three Examples 69 Conclusion n Cuapter 3 THE STANDARD CapiTAL Asset Pricinc MopeL 75 The Assumptions Underlying the Standard Capital Asset Pricing Model (CAPM) 76 The Capital Asset Pricing Model 77 Deriving the CAPM—A Simple Approach 7 Deriving the CAPM—A More Rigorous Approach 31 Prices and the CAPM 82 Conclusion 83 Cuapter 4 Nonstanparp Forms oF CapitaL Asset Pricinc Mopets 89 Short Sales Disallowed 90 Modifications of Riskless Lending and Borrowing 91 No Riskless Lending or Borrowing 91 Riskless Lending but No Riskless Borrowing 94 Other Lending and Borrowing Assumptions 96 Personal Taxes 7 Nonmarketable Assets Heterogeneous Expectations Non-Price-Taking Behavior Multiperiod CAPM The Consumption-Oriented CAPM Inflation Risk and Equilibrium The Multi-Beta CAPM Conclusion Cuapter 5 APPLYING THE CAPM to PERFORMANCE MEASUREMENT Applying the CAPM to Performance Measurement: Single-Index Performance Measurement Indicators The Treynor Measure The Sharpe Measure The Jensen Measure Relationships between the Different Indicators and Use of the Indicators Extensions to the Jensen Measure The Tracking-Error The Information Ratio The Sortino Ratio Recently Developed Risk-adjusted Return Measures 98 100 101 101 102 102 103 103 mM 12 n2 n2 13 ns ns 16 16 17 17vi Contents Cuapter 6 INFORMATION Risk Managing Information Risk Via AND Data Quatity a Data Quality Scorecard 13 MANAGEMENT 125 Data Quality Issues View 13 Business Process View 13 Business Impact View ar Introduction 126 Managing Scorecard Views B Organizational Risk, Business Summary 13: Impacts, and Data Quality 126 . Business Impacts of Poor Notes 13 Data Quality 126 Information Flaws 127 CHAPTER 7 FINANCIAL Examples 127 Disasters Employee Fraud and Abuse 127 Underbilling and Revenue Assurance 128 Disasters Due to Misleading Credit Risk 128 Reporting 13 Mitac bis teases ae Chase Manhattan Bank/Drysdale Development Risk 128 Securities B Compliance Risk 128 Kidder Peabody 3 Data Quality Expectations 128 Barings E aaeureet| 128 Allied Irish Bank (AIB) 14 echiieaee a3 Union Bank of Switzerland (UBS) 14 Consistency 129 Other Cases a Reasonableness 129 Disasters Due to Large Currency 129 Market Moves 14 Uniqueness 129 Long Term Capital Management Other Dimensions of Data Quality 129 acm) 14 Mapping Business Policies Metallgesellschaft (MG) 14 to Data Rules 129 Disasters Due to the Conduct Data Quality Inspection, Control, ct customer pusitiess o and Oversight: Operational Data parker eneuse oD hi Other Cases 15 Governance 130Contents Cuapter 8 Risk MANAGEMENT Cuapter 9 GARP Cope Faitures 153 oF Conpuct 167 Was the Collapse of Long-Term Introduction 168 Capital Management a Risk Management Failure? 154 Code of Conduct 13 Principles 168 A Typology of Risk Professional Standards 168 Management Failures 156 Mismeasurement of Known Risks 157. _—-Rules of Conduct 169 Mismeasurement Due to Ignored Professional Integrity Risks 158 and Ethical Conduct 169 Ignored Known Risks 1s8 Conflict of Interest 169 Mistakes in Information Collection 158 Ferree tee) gnaw cies 159 Fundamental Responsibilities 169 Et Rlitichte rented 160 General Accepted Practices 170 Failures in Monitoring Applicability and Enforcement 170 and Managing Risks 160 Risk Measures and Risk Management Failures 162 Sample Exam Questions— Foundations of Risk Management 171 Summary 164 Sample Exam Questions Answers & Explanations—Foundations of Risk Management Index 174 772013 FRM Committee MemBers Dr. René Stulz (Chairman) Ohio State University Richard Apostolik Global Association of Risk Professionals Richard Brandt Citibank Dr. Christopher Donohue Global Association of Risk Professionals Hervé Geny Thomson Reuters Kai Leifert, FRM® Northern Trust Global Investments Steve Lerit, CFA UBS Wealth Management William May Global Association of Risk Professionals Michelle McCarthy Nuveen Investments Ezra Uzi Moualem, FRM® The Financial Institute of Israel & ZRisk Dr. Victor Ng Goldman Sachs & Co Dr. Elliot Noma Garrett Asset Management Liu Ruixia: Industrial and Commercial Bank of China Robert Scanlon Standard Chartered Bank Dr. Til Schuermann, Oliver Wyman Serge Sverdlov Redmond Analytics Alan Weindort VisaPopper paterarataeceae gat Peaeenearaeeraearars Sareea ae eae EERE REDE SE SES PEPER Rarer as ean RnR ETE Seen ese ee sees PECEE EE heehee ete Pat raee ae aratamaaasaneteenenenes PELEPE EEE RHE p EERE Eee ssemeneae! 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Learning Objectives Candidates, after completing this reading, should be able to: + Define risk, identify the classifications of risks, and explain the role played by risk in value creation. + Describe a risk profile and explain how one is created, + Describe the role of risk governance in a corporation. + Identify Enterprise Risk Management (ERM) approaches and explain how they address risk management in an organization. * Describe how the value of a risky asset or project can be estimated through the development of a risk-adjusted discount rate, how such a risk-adjusted discount rate can be created, and strengths and weaknesses of this approach. * Describe problems which arise when using historical betas and equity risk premiums as inputs into a valuation model. + Construct a risk-adjusted discount rate for an asset or project and apply that rate to estimate the value of the asset or project. + Describe the certainty equivalent approach to estimating value and contrast it with the use of a risk-adjusted discount rate. Identify the four steps in the AIRMIC risk management process and summarize the approach used in each step. Identify the four risk treatment strategies a firm can use to manage its risks. Compare and contrast the different types of probabilistic approaches used to estimate value and contrast probabilistic approaches in general with risk-adjusted methods. Define hedging, explain the tradeoff between the costs and benefits of hedging, and assess whether it is appropriate for a firm to hedge in particular cases. Identify financial products a firm can use to reduce or eliminate exposure to specific risks. Identify the methods a firm can use to exploit risk better than its competitors, and explain how an organization can create a culture of prudent risk-taking among its employees. ‘Summarize the basic steps in building a good risk management system. Identify examples of acceptable, desirable, and best practices in corporate risk governance. Originally published by the International Finance Corporation (IFC), World Bank Group, Washington, D<.2 Financial Risk Manager Part I: Foundations of Risk Management INTRODUCTION Objectives of IFC’s Risk Governance Program In February 2008, the board of the French bank Société Générale learned that one of its traders had lost $7.2 billion dollars. Jerome Kerviel, the trader in question, had approval to risk up to $183 million. Since 2005, however, Kerviel had apparently ignored his limits and took on exposures as high as $73 billion—more than the market value of the entire firm. Société Générale’s board, managers, risk management systems, and internal controls failed to detect, much less halt, the reckless bets. When finally discovered, the fail- ure in risk governance and management had cost Société Générale and its shareholders clients, money, and reputa- tion. Similar failures of risk governance feature in scandals at UBS and Baring, with the latter failing to survive. In the 2008 economic crisis, several firms in emerging markets also suffered major losses due to failed risk man- agement and governance. Brazilian pulp producer Ara- cruz, and meat processor Sadia, had extensive losses on foreign exchange derivative contracts. Ceylon Petroleum Corporation (CPC) in Sri Lanka stood to lose hundreds of millions on commodity derivatives. In all of these cases, the chagrined boards (and, in the case of CPC, the state as the main shareholder) asserted that managers had acted without proper authorization. Losses and the collapse of firms due to failures in risk handling and risk governance hurt the wider community through loss of jobs, goods and services. These losses are felt particularly severely in emerging markets where the economies are vulnerable and jobs are scarce. Risk Taking as an Essen‘ of Enterprises I Activity Taking risks and dealing with uncertainty are essential Parts of doing business. Effective oversight of risk taking is a key responsibility of the board. Directors must protect profitable activities (“the golden goose") in the face of routine risks and improbable disasters (“the black swans"), ‘The word “enterprise” derives from the Latin “impresum,” meaning “taking upon oneself,” and describes the act, of carrying out actions with the intent to attain a preset objective. The purpose of the enterprise is the satisfaction of individual customer needs. This objective can be attained only if the enterprise prepares itself with the pro- ductive factors required for producing and delivering the products and services that can satisfy these needs. This circumstance, in which entrepreneurs must anticipate the needs of consumers, leads to a pervasive aspect of enter- prise management: dealing with the risks incurred as the entrepreneur organizes production. Hence, the enterprise is characterized by uncertainty in conducting its opera- tions: uncertainty is an inherent element of enterprise risk ‘The enterprise and the risk generated in operating it are inseparable, There is no enterprise without risk. Rewards earned by an enterprise compensate for such risk taking. IFC’s Risk Governance Program As part of IFC's response to the financial crisis of 2008, IFC's Corporate Governance Unit launched a risk gover- nance program. The program was intended to enhance the capability of boards of directors in emerging markets for improved risk management oversight. The aim was to provide directors with tools to enhance each board's risk oversight structures, processes, and competence. The program consisted of two elements: a series of training events across emerging markets and this chapter, By the end of 2011, the training team had conducted work= shops in 18 countries worldwide, working with directors and others in numerous emerging markets, drawing from mul- tiple industries, public and private sectors, real and financial sectors, small and large firms, and rich and poor countries, The discussions covered many topics on risk management, risk hedging, risk governance and strategic risk taking. This book reflects not only the content prepared by the core teaching faculty for these workshops but also the feedback and lessons shared by participants in these engagements. Target Reader: A Director’s Perspective on Risk Taking ‘The materials target decision makers, chiefly corporate directors to help them make sense of an increasingly com- plex and chaotic risk universe. Experienced directors with some finance training are the main audience for this book. ‘The approach takes the view that a director's chief responsibility is to attend to the stakeholders’ value, par- ticularly shareholders’ value. Thus, the risk-taking issues are discussed in terms of their impact on value. TheChapter 1 Risk Taking: A Corporate Governance Perspect approach also takes the view that decision makers/ directors should understand the analytical tools used WHAT IS RISK? in the “typical” corporation. Understanding these tools makes oversight more effective because directors can Thane use their judgment to decide when to act and what tools to apply in their enterprise. The contents are written with a broad scope to apply to as many industries as pos- sible. The material covers traditional corporate finance Concepts and enterprise approaches. Bankers, actuaries, and risk managers (particularly those with a quantitative bent), will need resources beyond the coverage of this chapter as they execute their specific tasks. Section Outlines In the first two sections the chapter lays out the scope of risk management by defining risk and exploring risk governance. The next few sections look at measuring and dealing with risk and the different tools used to incor- orate risk into decision making. The final portion of the manual advocates for a broader view of risk management, demonstrates its impact on the value of a business and suggests a template for building a good risk-taking orga- nization. Sections are tied to simple steps in the general- ized risk management process. Sections start with a theme, followed by an examination of the key issues relating to the theme. Sections conclude with a set of tasks that can be used to convert the abstrac- tions and theories proposed to real world corporate gover- nance tests/measures for any organization. To manage risk, we first have to define risk. In this section, we look at how risk has been defined in both theory and practice. The section explores different risk classifications and introduces the use of a risk profile for enterprises as a starting point for analyzing their isk-taking activities. Speaking of Risk ‘There is no consensus on a single formal definition of risk. Given this lack of consensus, a definition from common usage serves to start our discussion: Risk is a concept linked to human expectations. It indicates a potential negative effect on an asset that may derive from given processes in progress or given future events. In the common language, risk is often used as a synonym of probability of a loss or of a danger. In the assessment of professional risk, the concept of risk combines the probability of an event occurring with the impact that event may have and with its various circumstances of happening! However useful this layman's start, it does not fully lay out the risk concept. For example, this definition does * Source: http:wwwwikipedia.com. Risk Management Steps Sections in Chapter Step Make an inventory of all of the risks that the firm is | Section I: What Is Risk? : faced with—firm specific, sector, and market. Section Ill: Risk Governance, Risk Management, and Value Creation i Step 2 Measure and decide which risks to hedge, avoid, Section IV: Measuring Value: Risk-Adjusted Value or retain based on impact on the value of the Section V: Managing Risk: Enterprise Approaches enterprise, Section Vi: Tools for Better Risk Decision Making: Probabilistic Approaches ‘ Step 3. For the risks being hedged, select the risk-hedging | Section Vil: Creating Value from Risk Taking products and decide how to manage and monitor Step 4 Determine the risk dimensions in which you have {ction Vill: Exploiting the Risk Upside: Strategic an advantage over your competitors and select an organizational structure suitable for risktaking. Risk Taking and Building a Risk-Teking Organization6 Financial Risk Manager Part |: Foundations of Risk Management not clearly distinguish between the concepts of risk and uncertainty, It focuses only on negative implications of risk taking, A Better Definition of Risk Risk, in traditional terms, is viewed as a negative. The dic- jonary defines risk as “exposing to danger or hazard.” The Chinese symbol for “crisis,” reproduced in Figure 11, offers a better description of risk. ‘The first symbol is the symbol for “danger.” while the sec- ond is the symbol for “opportunity,” making risk a mix of danger and opportunity. By linking the two, the definition ‘emphasizes that you cannot have one (opportunity) with- ‘out the other and that offers that look too good to be true (offering opportunity with little or no risk) are generally not true. By emphasizing the upside potential as well as, the downside dangers, this definition also serves the useful purpose of reminding us of an important truth about risk. Where There Is Upside, There Is Downside and the Opposite Is True! It should come as no surprise that managers become interested in risk management during or just after a crisis, and pay it little heed in good times. The Chinese definition of risk/crisis points to the fact that good risk-taking orga- nizations not only approach risk with equanimity, but also manage risk actively in good times and in bad times. Thus, they plan for coming crises, which are inevitable, in good times and look for opportunities during bad times. Classifying Risks Faced by Organizations Identifying risk (making it tangible) can help managers or directors in their decision making. The two lists of risks provided here are not intended to be exhaustive, because it is not possible to cover the full gamut of potential risks. Instead, the idea is to help organizational decision makers w GISUSSEEI the Chinese symbol for “cris (managers or directors) begin to think more clearly about the risks faced by their organization, Note that there are many equally valid classifications, and firms can develop their own lists suitable to their particu- lar circumstances. The most important thing is that deci- sion makers must understand the risks relevant to their enterprises as they are making decisions. Classification Example 1 Using the the Basel Ii framework and adapting the classi- fications to non-financial firms, this example divides orga- nizational risks into three categories: operational, financial and market-based. 1. Operating Risk a. Operating and verification (accuracy) b. Business risk 2. Financial Risk a. Internal risks I. Insolvency |. Counterparty Financial structure planning b, External risks i, Interest rate fi, Currency exchange rate tii, Inflation 3. Market-Based Risk Classification Example 2 1. Financial Risk a. Credit (default, downgrade) 'b. Price (commodity, interest rate, exchange rate) c. Liquidity (cash flow) 2. Operational Risk a. Business operations (efficiency, supply chain, busi- ness cycles) . Information technology 3. Strategic Risk a. Reputational (ie., bad publicity) b. Demographic and social/cultural trends . Regulatory and political trends 4. Hazard Risk a. Fire and other property damage b. Theft and other crime, personal injury . DiseasesChapter 1 Risk Taking: A Corporate Governance Perspective 7 Operational Risks Aircraft crash and aircraft breakdowns Strikes Telephone, IT failure, utility outages Failure of sub-contractors Employee turnover ‘Changes in code-share agreements Crime and social unrest Fire Pollution Theft and fraud Damage to the brand ‘Developed by risk workshop participant What Is a Risk Profile? ‘A major step in appropriate oversight of risk taking by a firm is listing out all of the risks that a firm is potentially exposed to and categorizing these risks into groups. This list is called a risk profile. Do most firms create risk profiles? Not necessarily. In many firms, it is taken for granted that most everyone in the firm (particularly those with experience) is already aware of the risks that the firm faces. This can be a mistake and more so with risks that are uncommon, since many managers may never have experienced that risk. For boards and across firms as a whole itis useful to be clear and explicit about the risk faced. Instead of assuming awareness, make sure that everyone understands by spelling out the potential risks. ‘Once you have created your risk profile, acknowledging the risk that your company is facing, the next step is to divide the various risks into three groups: + Risk that should be allowed to pass through the firm to its owners + Risk that should be hedged + Risk that should be exploited This phase is part of the broader process, known as risk treatment. Later in this manual, we will present various, ways to conduct a risk treatment process. Implications for Decision Makers ‘To manage risk correctly, we must acknowledge its posi- tive and negative effects. Risk management has to look Emerging Market Example: Risk Profile of an Airline Company in Brazil* Financial and Market Risks Oil prices changes Inflation Interest rate changes Exchange rate fluctuations Tax changes in Brazil Changes in world's aviation laws New trade agreements Cash flow difficulties Bankruptcy Stock price collapse Debt covenant violations at both the downside of risk and the potential upside. In other words, risk management is not just about minimiz- ing exposure to the wrong risks. It also is about increasing ‘exposure to good risks. It is important that a firm's decision makers build a com- mon understanding of the risks they face by developing a risk profile, an explicit listing of potential risks. While classifications and categorizations as suggested above are useful, the discussion itself is more important, because it helps establish a common language and understanding of the risks faced by the enterprise. Risk profiles are an enterprise's starting point for risk analysis. Most firms will need to go beyond risk profiles, and conduct risk assessments, treatment, and monitoring, However, for small, simple firms without the interest or capacity to deepen the risk management process, a well- developed, thoroughly-discussed, and strongly- internalized risk profile is a good start. This is a better ‘option than completely ignoring the risk situation. Section Task: Define Risk 1. How would you define risk? 2. Ask a fellow director or manager to list the top five risks facing your enterprise. Is this list different from, the one you would make? How and why?8 Financial Risk Manager Part |: Foundations of Risk Management RISK GOVERNANCE, RISK MANAGEMENT, AND VALUE CREATION Theme The section addresses the fiduciary duties of a board member focusing on risk oversight. It starts by defining corporate governance, draws on the Organization for Economic Cooperation and Development's Principles of Corporate Governance in discussing the role of directors, and presents ideas on the role and structure of risk committees. It closes by linking the value of the enterprise to risk management, Corporate Governance IFC's Corporate Governance Unit defines corporate gov- ernance as the structures and processes for the direction and control of companies. Corporate governance con- cerns the relationships among the management, board of directors, controlling shareholders, minority shareholders, and other stakeholders. Good corporate governance con- tributes to sustainable economic development by enhanc- ing the performance of companies and increasing their access to outside capital. Risk Governance Risk governance is a relatively new term. In the corpo- rate governance arena, there is no consensus defini- tion, although in the information technology field, risk governance is a more developed concept. However, for the purposes of discussion in this book, we define risk governance in firms as the ways in which directors autho- rize, optimize, and monitor risk taking in an enterprise. It includes the skills, infrastructure (je., organization structure, controls and information systems), and cul- ture deployed as directors exercise their oversight. Good risk governance provides clearly defined accountability, authority, and communication/reporting mechanisms. Risk oversight is the responsibility of the entire board. How- ever, some boards use risk committees to help fulfil responsi- bilities. The risk committee might be independent, or the work might be combined with audit tasks and assigned to an audit and risk committee. For further details on proposed structure and functioning of risk committees, see the appendix, Corporate Governance Perspectives There are a number of predominant theoretical perspectives on corporate governance: + Agency theory—align the interests of internal agents (executives/managers) who display strong self- interest with those of the shareholders (owners). In effect this represents a double agency dilemma (see figure) + Transaction cost theory—reduce costs of transac- nal hazards through internal corporate gover- nance mechanisms, which cannot be handled by ‘external market mechanisms ‘+ Stewardship theory—general human motives of achievement, altruism and meaningfulness should be managed and guided in the most opportune manner + Resource dependence theory—highlights corporate ‘dependence on external relations and sees gover- nance as a vehicle to ensure continued access to essential resources, + Stakeholder theory—acknowledges agreements with multiple stakeholders that can create incremen- tal value and/or lead to subsequent risk events if, neglected or abused ‘Shareholders (ublic company) Managers Risk Management Risk Taking and Value Creation: Risk-Adjusted Valuation Ultimately, the objective of managing risk is to make the firm more valuable. For directors and managers, this is the primary objective, regardless of whether they view this as value to shareholders or value to a wider group of stakeholders. Fortunately, classical finance provides robust techniques for valuing enterprises. The most fre- quently used method is the discounting of future cashChapter 1 Risk Taking: A Corporate Governance Perspective 9 Responsibilities of Board Members The OECD Principles of Corporate Governance provide 7. Ensuring the integrity of the corporation's uidance on the responsibilities of directors: accounting and financial reporting systems, ‘A. Board members should act on a fully informed basis, including the independent audit, and that appro- in good faith, with due diligence and care, and in the priate systems of control are in place, in particu- best interest of the company and the shareholders. TnL SUETC ler ak thanaderienk Thtanclal and 8. Where board decisions may affect different operational control, and compliance with the law shareholder groups differently, the board should and relevant standards. treat all shareholders fairly. C._ The board should apply high ethical standards. It should take into account the interests of 8. Overseeing the process of disclosure and ‘communications. stakeholders, E. The board should be able to exercise objective inde- . The board should fulfil certain key functions, including: pendent judgment on corporate affair 1. Reviewing and guiding corporate strategy, major 1. Boards should consider assigning a sufficient plans of action, risk policy, annual budgets and inlinibeliof Hion:ekecutive Goard members capa business plans; setting performance objectives: monitoring implementation and corporate performance; and overseeing major capital ‘expenditures, acquisitions and divestitures. Examples of such key responsibil 2. Monitoring the Ehectiveriess oF the company's ing the integrity of financial and non-financial governance practices and making changes as reporting, the review of related party transac- needed. tions, nomination of board members and key_ executives, and board remuneration. ble of exercising independent judgment to tasks where there is a potential for conflict of interest. jes are ensur- 3. Selecting, compensating, monitoring and, when necessary, replacing key executives and 2. When committees of the board are established, overepelial successor Renan: their mandate, composition and working proce- 4. Aligning key executive and board remuneration dures should be well defined and disclosed by with the longer term interests of the company the naa and its shareholders. 5. Ensuring a formal and transparent board nomination and election process. 3. Board members should be able to commit them- selves effectively to their responsibilities. 6. Monitoring and managing potential conflicts of In order to fulfil their responsibilities, board members interest of management, board members and. should have access to accurate, relevant and timely. shareholders, including misuse of corporate information: assets and abuse in related party transactions. Source: OECD Principles of Corporate Governance, 2004 flow to the firm at a risk-adjusted cost of capital. For diversification, it does not add value for the board or risk management purposes, many would point out that managers to concern themselves with these types of using the capital asset pricing model (CAPM) for cal- risks. From this viewpoint, using CAPM in assessing culating risk-adjusted capital has a double benefit of projects, investments, and in valuation provides a ready- already accounting for all the risk that a firm's decision to-use approach for guiding risk-taking in firms. Firms makers need concern themselves about—the market risk, without any formal risk management functions are well All other risks are firm risks and can be diversified away _ served by using the capital asset pricing models in guid- by the individual investor in the firm's shares. As the ing their investment decisions as they reap its double shareholders can handle firm risk by their own portfolio _benefit—valuation and risk management.10 Financial Risk Manager Part |: Foundations of Risk Management Enterprise approaches also use valuation techniques at various points in the process to ensure that any deci- sions taken will maximize value. These valuation efforts also deploy the discounted cash flows, often using the capital asset pricing models as well. Whatever the valua- tion method used, the risk analyst needs to estimate the effect of each risk on firm value and determine the cost of reducing each risk. If risk reduction is costly, the decision makers must decide whether the benefit to firm value jus- tifies the costs. Each firm must seek a value-maximizing risk management strategy. Enterprise Risk Management Enterprise Risk Management (ERM) emphasizes a compre- hensive, holistic approach to managing risk, shifting away from a "silo-ed" approach of separately handling each organizational risk. ERM also views risk management as a value-creating activity, and not just a mitigation activity. ERM is still an evolving concept. Before its emergence, organizations tended to isolate the management of risks. For example, the treasurer managed currency exposures, the sales or credit manager managed credit risk, and com- modity traders and purchasing officers managed com- modity price risks. Insurance risk managers handled the hazard risks. The personnel department managed the human resources risks. Quality and production managers were responsible for containing production risk. Market- ing and strategy departments attended to the competi- tive risks. There was limited effort to coordinate across the enterprise, to understand where risks could multiply, where they cancel each other out, or where they could be exploited for profit. ERM addresses these issues, focusing on coordination and value addition. For example, in a conglomerate in which one division is long in currency A and another division is short in the same sum in the same currency, responsible division managers might decide to purchase separate currency hedges. This represents a silo-ed approach, which does not enhance value. Taking an enterprise-wide approach instead, using ERM, renders such actions unnec- essary, because the conglomerate already has a natural hedge. ERM's coordinated function is often vested in a chief risk officer and in increased risk governance, including board oversight. This evolving portfolio approach is aided by Improved tools for risk measurement, pricing and trading. ‘Today, there are two widely-disseminated ERM approaches: + COSO II ERM: Risk framework from the Committee of Sponsoring Organizations of the Treadway Commis- sion that is geared to achieving strategic, operational, reporting, and compliance objectives. + CAS ERM Framework: Developed by the Casualty Actu- arial Society, the framework focuses on hazard, finan- cial, strategic, and operational risks. Regardless of the framework used it is important that risk decisions always tie in to the value of the enterprise to its stakeholders, particularly to its shareholders. Risk Aversion, Risk Policy, Risk Tolerance and Risk Appetite ‘The development of a risk policy is an important task for boards. This activity is related to the board's corporate strategy work, and involves specifying the types and Emerging Market Example: Tea and Coffee Plantation in Kenya A.commercial Kenyan farm producing tea and coffee for the European, Asian, and American markets faces a rarige of risks. These risks include the vagaries of weather, particularly drought, changes in government policy, ethnic strife affecting the workforce, commodity price fluctuations, and exchange rate fluctuations. The farm is owned and operated by the second generation of the founding family. The board consists of the three siblings running the business, their accountant, and the export sales manager. The directors have made a decision that they will not retain any foreign exchange risks, because the siblings believe that they lack the expertise to cope with foreign exchange fluctuations. ‘They are confident that their knowledge of Kenya enables them to assess, evaluate, and treat the weather and political risks. As a result of their aversion to foreign currency risk, their risk policy is to avoid or hedge this risk almost completely. They sell their produce to a middleman, a trading company that sets the contracts in Kenyan shillings. In addition, non-deliverable forwards and forwards are used to limit exposure on any inputs that need to be purchased in foreign currency and ‘on the occasional sales that are not sold through the trading company.Chapter 1 Risk Taking: A Corporate Governance Perspective u degree of risk that a company is willing to accept in pur- suit of its goals. It is @ crucial management guideline in managing risks to meet the company's desired risk profile. An enterprise's risk policy reflects the aggregate risk aver- sion of its decision makers. In the enterprise approach detailed later in the chapter, we will look at various mana- gerial decision points, when decision makers’ attitudes toward risk will drive action. This attitude toward risk may or may not be codified in a formal risk policy. Risk appetite and risk tolerance are newer terms in the risk management lexicon. In recent years, these terms have been used with increased frequency, particularly in the corporate governance and accounting community, The precise meaning and metrics of the two terms are still evolving and considerable inconsistency in their use remains. In contrast, the term risk aversion has the ben- efit of long use in the corporate finance community, with consensus on the concept, its measurement, and its impli- cations for behavior. Fortunately, risk appetite and risk tol- erance concepts appear to be rooted in the more robust concepts of risk aversion and risk policy, Recently, the Institute of Risk Management attempted to produce a clear definition of the terms “risk appetite” and “risk tolerance” as follows: + Risk appetite: The amount of risk an organization is, willing to seek or accept in pursuit of its long-term. objectives. + Risk tolerance: The boundaries of risk taking outside of which the organization is not prepared to venture in the pursuit of long-term objectives. Risk tolerance can be stated in absolutes, for example: “We will not deal with a certain type of customer” or “We will not expose more than X percent of our capital to losses in a certain line of business.” + Risk universe: The full range of risks that could impact either positively or negatively on the ability of the orga- nization to achieve its long term objectives. Section Task: Risk Governance, Risk Management, and Value Creation 1. How does your board define its responsibilities on risk-taking? 2. How often does your board discuss risk issues? MEASURING VALUE: RISK-ADJUSTED VALUE Theme Pursuing value- maximizing risk strategies requires that decision makers assess risk-taking within the context of a valuation methodology. For the discussion in this section, we use discounted cash flows methodology, ‘and two practical ways of adjusting risky asset values. In the first, we adjust the discount rates upwards for risky assets and reduce the present value of expected ‘cash flows. in the second, we replace the expected cash flows with “certainty equivalent” cash flows, which, when discounted back at the risk-free rate, yields a risk- adjusted value. Approaches for Adjusting Value for Risk ‘The value of an asset that generates cash flows can be written as the present value of the expected cash flows from that asset, discounted back at a discount rate that reflects the risk. The value of a risky asset can be esti- mated by discounting the expected cash flows on the asset over its life at a risk-adjusted discount rate: ECCR) , ECR) , CCR), ECCED tn" Gen Gt Oey where the asset has a n-year life, E(CF,) is the expected cash flow in period t and r is a discount rate that reflects the risk of the cash flows. In this approach, the numera- tor is the expected cash flow, with no adjustment paid for risk, whereas the discount rate bears the burden of risk adjustments, Value of asset = Alternatively, we can replace the expected cash flows with the guaranteed cash flows we would have accepted as an alternative (certainty equivalents) and discount these at the risk-free rate: CECCR) , CECCR) , CELE), CEKCE) ; 4 SECA), CECE) Value of asset = any Gan Gan dene? where CE(CF,) Is the certainty equivalent of E(CF,) and r, is the risk-free rate, Note that the key sets of inputs are the certainty equiva- lent cash flows, which bear the burden of risk adjustment. The discount rate is the risk-free rate.2 Financial Risk Manager Part I: Foundations of Risk Management Risk-Adjusted Value Definition: The value of a risky asset can be estimated by discounting the expected cash flows on the asset over its life at a risk-adjusted discount rate: 2 [Eccr | (vate ofaset =]S f Sa+[p}- where the asset has a n-year life, E(CF,) is the expected cash flow in period t and r is a discount rate that reflects the risk of the cash flows. PROCESS TO ESTIMATE RaV Step 1: Estimate the expected cash flows from a project/asset/business. For a risky asset, consider/ estimate cash flows under different scenarios, attach probabilities to these scenarios and estimate an expected value across scenarios. - Step 2: Estimate a risk-adjusted discount rate, comprised ‘of two components, the risk-free rate and the risk premium. Risk-adjusted rate = Risk-free rate + Risk premium Rf + Beta (Rm-RA ‘Step 3: Take the present value of the cash flows at the risk-adjusted discount rate. With both approaches, the present value of the cash flows will be the risk-adjusted value for the asset. Risk-Adjusted Discount Rate To adjust discount rates for risk, we must use a risk and return model. In this section, we will examine how best to estimate the inputs for the simplest of these mod- els (the CAPM) but much of what we say about these inputs can be replicated for more complex risk and return models. Three Steps in Estimating Value There are three steps in estimating value, using risk- adjusted discount rates: 1. Estimate the expected cash flows from a project/asset/ business. If there is risk in the asset, this will require us to, consider/estimate cash flows under different scenarios, attach probabilities to these scenarios, and estimate an expected value across scenarios. In most cases, though, it takes the form of a base case set of estimates that captures the range of possible outcomes. 2. Estimate a risk-adjusted discount rate. While there are 2 number of details that go into this estimate, consider that a risk-adjusted discount rate has two components: Risk-Adjusted Rate = Risk-Free Rate + Risk Premium 3. Take the present value of the cash flows at the risk- adjusted discount rate. The resulting value will be the risk-adjusted rate. In the sections that follow, we focus on Step 2, and then use an example to illustrate all three steps. Adjusting Discount Rates for Risk If we start with the presumption that a business can raise funds for investments from one of two sources (borrowed money (debt) or owners’ money (equity)) we can boil down the process for adjusting discount rates for risk into several inputs, as shown in Figure 1-2. With cost of equity, we need three inputs to estimate the risk-adjusted rate: a risk-free rate, an equity risk premium, and a beta. With the cost of debt, we need three inputs as well: the risk-free rate, a default spread for the debt, and a tax rate to use in adjusting the cost of debt for its tax advantages. Input 1: The Risk-Free Rate On a risk-free asset, the actual return is equal to the expected return. Therefore, there is no variance around the expected return. For an investment to be risk free, it must come with: + No default risk: Since there can be no uncertainty about the return on the investment, the entity promising the cash flows can have no default risk. + No reinvestment risk: A six-month Treasury bill rate is not risk free for an investor looking at a ten-year time horizon, even if we assume that there is no default risk in the U.S. government. This is because the returns are guaranteed only for six months and there is uncer- tainty about the rate at which you can invest beyond that period. With these two criteria in place, two propositions follow about risk-free rates,Chapter 1 Risk Taking: A Corporate Governance Perspective B Cost of Equity: Rate of Return demanded by equity invstors same currency as cash flows, and defined in same terms {real of nominal) asthe cash flow | historical Premivm | 1. Mature Equity Market Premium: Average premium earned by stocks over | MBonds in US. today and a | 2. Countey risk premium= Country Default | | simple valuation | Spread* (Equity/Country bond) model | [imptie Premium | | bored on now | or | saute ced | Cost of Capital: Weighted rate of return demanded by all investors Cost of borrowing should be based upon 1. synthetic or actual bond rating 2 default spread Cost of Borrowin Marginal tax rate, reflecting iskfree + Default spread | | t2* benefits of debt Cost of Capital = Cost of Equity (equityDebt + Equity)) + Cost of Borrowing (74) (DebulDebt + Equity)) | cost of equity based upon bottom-up beta t Weights should be market value weights Cost of equity: Rate of return demanded by equity investors. Proposition 1: Time horizon matters. The risk-free rates in valuation will depend upon when the cash flow is expected to occur and will vary across time. Thus, a six-month risk-free rate can be very different from a ten-year risk-free rate in the same currency at the same point in time, Proposition 2: Not all government securities are risk free. Most practitioners use government security rates as risk-free rates, making the implicit assumption that gov- ernments do not default on local currency bonds. Some governments face default risk, so the rates on the bonds they issue will not be risk free, In Figure 1-3, we illustrate this principle by estimating risk- free rates in various currencies. While we assume that the government bond rates in Japan, Switzerland, and the United States are the risk-free rates for the currencies in these countries (the Japanese yen, the Swiss franc and the U.S. dollar), we adjust the government bond rates in Colombia and Peru for the default risk embedded in them. With the euro, we use the German euro bond rate as the risk-free rate, since it is the lowest of the ten-year euro- denominated government bond rates. It also is worth noting that risk-free rates vary across currencies because of differences in expected inflation; currencies with high expected inflation will exhibit high risk-free rates. Input 2: Beta(s) Given that beta is a measure of relative risk, what is the best way to estimate it? In conventional corporate finance and valuation, the answer is to run a regression of returns on the stock of the company in question against the mar- ket index. ‘The slope of the regression is the beta. This is illustrated for a Peruvian construction company, Grana Montero, in Figure 1-4, Regressing weekly returns on Grana Montero from August 2008 to July 2010 against the Peruvian Lima General Index, the beta for the company is 0.549. We should be skeptical about this number for three reasons: + It looks backward. Since a regression is based on returns earned by owning the stock, it has to be historical and does not reflect the current business mix and financialFinancial Risk Manager Part I: Foundations of Risk Management 1% Default Spread 6% suf Bb Rsidree Rate 496 3% 2% Colombian Peruvian dolar Peso So! Japanese Swiss Euro US Yen Francs (EUR Estimating risk-free currency rates. leverage of the company. Thus, the regression above, run in August 2010, uses data from 2008 to 2010 to estimate the beta for the company. Even ifit is accurate, it gives you a beta for that period rather than for the future. + Ibis estimated with error. The standard error of the beta is 0.083, suggesting that the true beta for Grana Mon- tero can be much higher or lower than the reported value; the range on the beta from this regression, with 99 percent confidence, would be 0,09-0.60. + Itis dependent on how the regression is structured and whether the stock is publicly traded in the first place. The beta we would obtain for Grana Montero would be very different if we used a different time period (five years instead of two), a different return interval (daily instead of weekly) or a different market index (a dif- ferent Peruvian Index or a broader Latin American or global index), As an alternative, it is worth thinking about the determi- nants of betas, the fundamental factors that cause some companies to have high betas and others to have low betas. The beta for a company measures its exposure to macroeconomic risk and should reflect: + Products and services it provides and how discretion- ary these goods and services are: Firms that produce products or services that customers can live without ‘or can hold off on purchasing should have higher betas than firms that produce products and services that are necessities, * Coefficients on regressions are normally distributed. A 99 percent confidence interval is plus or minus three standard deviations. GHEY Measuring relative risk for Grana Montero. + Fixed cost structure: Firms that have high fixed costs (high operating leverage) should have more volatile Income and higher betas than firms with low fixed, costs. + Financial leverage: As firms borrow money, they cre- ate fixed costs (interest expenses) that make their equity earnings more volatile and their equity betas higher. In fact, the beta for equity in a firm can be written as a function of the beta of the businesses that the firm operates in and the debt to equity ratio for the firm: Levered (Equity) Beta = Unlevered Beta (1+ (1 = tax rate) (Debt/Equity)) A better estimate of beta for a firm can be obtained by looking at the average betas for the businesses that the firm operates in, corrected for financial leverage. For example, Grana Montero, the Peruvian company, is in three businesses: software and software consulting, construction, and oil extraction. Using estimated betas for each of these businesses and the revenues that Grana Montero derives from each one as weights, we obtain the unlevered beta for the firm: Revenues %of Unlevered Beta Firm __ for Business Construction 453—(77.58% 0.75 Oil Extraction 225 12.01% 0.90 Software Consulting 195 10.41% 1.20 1873 O81Chapter 1 Risk Taking: A Corporate Governance Perspective 6 In August 2008, the firm had outstanding debt of 433 mil- lion Peruvian soles and equity market value of 2.4 billion soles. Using Peru’s 30 percent corporate tax rate, we can estimate the beta for the equity in the company: 81.(I + (1 ~ 30) (433/2400)) = 0.92 Levered Beta Given such a situation, when a firm is in multiple busi- nesses with differing risk profiles, it should hold each busi- ness up to a different standard, or hurdle rate. In the case of Grana Montero, for instance, the hurdle rates for invest- ments will be much higher in software consulting than in construction. Input 3: Equity Risk Premiums ‘The equity risk premium is the collective additional pre- ium that investors demand for investing in any equities or risky assets. Two approaches can be used to estimate the number. The first approach looks at the past and esti- mates how much of a premium you would have earned investing in stocks as opposed to treasury bonds or bills over long time periods. in Table 1-1 we estimate for premi ums ranging from 10 to 80 years. The problem with using historical risk premiums is illus~ trated in the numbers in brackets in the table; these are standard errors in the risk premium estimates. Thus, even with an 80-year period (1928-2009), the estimated risk premium for stocks over treasury bonds comes with a standard error of 2.4 percent. With ten years of data, the standard errors drown out the estimates. An alternative is to estimate a forward-looking premium, using current stock prices and expected future cash flows. In Figure 1-5, for instance, we estimate an implied equity risk premium for the Standard & Poor's 500 stock index ‘on January 1, 2010. EZEVGEEE Estimated Equity Risk Premiums Arithmetic Geometric Average ‘Average Stocks- | Stocks- | Stocks~ | Stocks- T.Bills |. Bonds| T. Bills |T. Bonds 1928-2009 | 753% | 603% | 5.56% | 429% (228%) | 2.40%) 1960-2009 | 5.48% | 378% | 4.09% | 2.74% (2.42%) | 2.71%) 2000-2009| =150% |-s.47% | -36a% | -722% (6.73%) | (9.22%) In January 2010, the equity risk premium for the United States, and, by extension, other mature equity markets, was 4.36 percent. This number has been volatile, particu- larly in the last few years, going from 4.37 percent at the start of 2008 to 6.43 percent in January 2009, and back to 4.36 percent in 2010. Based on the previous number, it seems reasonable to use a 4.5 percent equity risk pre- mium for mature markets, at least for 2010. An Adjustment for Country Risk ‘When a company operates in an emerging market, it is exposed to significantly more economic risk, arising from both political instability and the nature of the underly- ing economy. Even if we accept the proposition that an ‘equity risk premium of about 4.5 percent is reasonable for a mature market, one might expect a larger risk premium when investing in an emerging market. One simple way to adjust for this additional risk is to add on the default spread for the country in question to the In 2010, the actual Analysts expect earings to grow 21% in 2010, resulting in a Alter , we wil assume that (2h returned 10 ‘compounded annual growth rate of 7.2% over the next 5 year. fearnings on the index wil grow stockholders was We will assume that dividends & buybacks will keep pace. 231 3.84%, the same rate at the 40.38. That was 43.2 49.74 3.32 S716 entire economy (ariskfree rate) foal thet earl 3.29 46.40 9. 53.3 vt ) om Zoe bet sg 1908229, 4640 | 4974 | 53.32 | 5716 | 5716010380) Tan Cant ae Can Tan ose January 1, 2010 S&P 500 Expected Return on Stocks (V1 =8.20% iat 1115.10 Adjusted Tondrateon VWI Shae Dividends & Buybacks for Equity Rsk Premiu=8.20%-3.84% =4.36% 2008 =40.38 GIUEEEY Estimated equity risk premium for the Standard & Poor's 500, January 2010.16 Financial Risk Manager Part I: Foundations of Risk Management BEETEEEA Equity Risk Premiums, January 2010 mas 5 cision iy [ase] (RRR Equity Risk Premiums Bessa lil [43s oo January 2010 ernest caso) = oe Frajeer[—¥Pas0=] owl sn emaanige canada, 4 i 450% [Bulgarig-s? a snes — |" sso Germny 1] gf 4.505] a oR Te ted Sates ot rsc0_* | oss) /” agra BOTY llceland Ag = Gf tous el ‘soo [Atiay rg sp dn we He yee rn Tas : ome TI 2 8esn aioe a P Vrosusat i ea fssainfi) Tesi ede iceland 9 eae fine [esi = lex = [Botivie 12.46% My pope | Sr 7 al (oie a sai 0a] slontia a sla [ssl = fe oY sador es [salvador [Lebanon codes ar ficou [aut Ponams [United Arab Enis | sa onus frneries mature market premium. Thus, the total equity risk pre- mium for Peru, which has a sovereian rating of Baa3 and default spread of 2 percent, would be 6.5 percent. A slightly more involved way of adjusting for country risk is to start with the default spread and adjust this default spread for the higher risk borne by equities in that market. Using Peru as the example again, the standard deviation in weekly returns over the last two years for Peruvian equities is 26 percent and the standard deviation in the bond is 13 percent. ‘Additional risk premium for Peru = 2% (26/13) Total equity risk premium for Peru 45% + 4% = 8.5% 4% While neither one of these measures is perfect, they offer simple solutions to the country risk issue. Input 4: Default Spreads To calculate the cost of borrowing for a firm, we must assess the amount banks will charge to lend, over and above the risk-free rate, This “default spread” can be assessed in several ways + For the few companies that have bonds rated by a rat ing agency, we can use the bond rating as a measure of default risk and estimate the spread based upon, the rating. For example, the Walt Disney Company, the large American entertainment conglomerate, has an A rating from rating agency Standard & Poor's. Based on this rating, the default spread in September 2010 was roughly 0.85 percent. Adding this to the ten-year bond rate at the time (2.5 percent) would have yielded a 3.35 percent pre-tax cost to borrow.Chapter 1 Risk Taking: A Corporate Governance Perspective ” + For firms with no bonds and no ratings, estimate the interest rate that they likely would have to pay on a long-term bank loan today. This rate would be the pre- tax cost to borrow debt. + In some cases, it is possible to estimate a synthet bond rating for a company, based on its financial ratios. This rating can be used to estimate a pre-tax cost of borrowing, Default spreads change over time and reflect both eco- nomic uncertainty and investor risk aversion. Table 1-3 shows September 2010 default spreads for bonds in dif- ferent ratings classes. Since default spreads can and often do change over time, such information must be updated on a frequent basis to reflect current levels. Input 5: Tax Rates and Weights for Debt and Equity Two additional inputs are needed to calculate the cost of capital. The first is a tax rate to use in computing the after-tax cost of borrowing: After-tax cost of borrowing Pre-tax cost of debt (1 ~ tax rate) Since interest expenses save taxes on last dollars of, income, the tax rate that should be used is a marginal tax rate. The best source for this rate is the tax code (and not the financial statements of the firm). To illustrate, the mar- ginal tax rate in the United States is a cumulative value, based on a 35 percent federal corporate tax rate plus vari ous state and local taxes. In 2010, the cumulative rate was estimated at approximately 40 percent. The weights for computing the risk-adjusted cost of capital should be market value weights, since the busi- ness has to raise debt and equity in the market to fund its projects at market rates. It also is worth noting that the risk-adjusted discount rate for an individual project may be based on target weights for the entire business, instead of a reflection of the actual funding mix for the project. Calculating Risk-Adjusted Rates: A Hypothetical Disney Theme Park in Rio In this example, we conduct an analysis for a hypothetical theme park that The Walt Disney Company would build Default Spreads, September 2010 Default Spread Rating Moody’s/S&P on Ten-Year Bond Aaa/AAA 0.45% AaV/AAt 0.50% Aa2/Aa 0.55% Aas/AA- 0.60% VAY 0.75% A2/A 0.85% ASA 105% Baal/aBe+ “150% Baa2/BBB 1.75% 003/BBB- 2.25% Bal/BB+ 3.50% Ba2/BB. oe es 4.50% Ba3/BB— 4.75% Bee 5.00% 82/B 5.75% 83/8 6.25% caa/ccct 775% in Rio De Janeiro, Brazil in early 2009. Table 1-4 estimates expected cash flows from the theme park to the company, based on projections of revenues, operating expenses and taxes. To calculate risk-adjusted discount rates, we follow these steps: 1. Since the cash flows were estimated in dollars, the risk-free rate is the U.S. treasury bond rate at the time, 3.5 percent. 2. The beta for the theme park business is 0.7829. This was estimated by looking at publicly-traded theme, park companies. 3. The risk premium was composed of two parts, & 6 percent mature market premium (the premium used8 Financial Risk Manager Part |: Foundations of Risk Management EEGEEERY Expected Theme Park Cash Flows ° 1 2 3 a [ose seo] 38 |e: | 10 Operating Income so | —ss0| -sis0 | —sea | sios | s3is | $309 | s467 | $551 | sea | sese Taxes $0 =si9| -$57 | -$32 | $40 | $120 | si4a| $178 | $209 | $244 | $250 Operating Income $0 -s3i| -$93 | -$52 | $66 | si96 | $241 | $290 | $341 | $397 | $408 after Taxes +Depreciation & $0 350] $425 | $469 | $444 | $372 | $367 | s364 | $364 | ssee | $368 Amortization Capital Expenditures | $2500 | $1,000] sites | $752 | $276 | $25e | $285 | $314 | $330 | $347 | $350 =Change in Working $0 go| ses} $25 | $38 | s31| sie] siz} si9|] $2]. $5 Capital Cash Flow to Firm $2500 | —soai| -so18 |-s360 | sige | $279 | $307 | $323 | $357 | $395 | $422 “+Pre-Project $500 so] so| $0] so| so] so} so| so] so|. so Investment =Pre-project $0 sia] sia] so | si] so] so] sil sie] sia] sio Depreciation +Fixed G&A d=) $0 so| s78 | sioo | siss | sia | sas | $234 | $258 | s2ea | $289 Incremental Cash Flow | -$2,000 | $1,000 | -$859 | $270 | $332 | $44 | $501 | s53e | $596 | seco | $692 to Firm I In 2009) and an additional 3.9 percent risk premium. for Brazil. Country risk premium for Brazil = 3.95% Cost of equity in US$ = 3.5% + 0.7829 (6% + 3.95%) = 129% 4. In early 2009, the company had a 6 percent pre-tax cost of debt, based on its A rating, a 2.5 percent default spread, and a 38 percent marginal tax rate: After-tax cost of debt = (3.5% + 25%) (I~ 38) = 372% 5. The company uses a mix of 35.32 percent debt and 64.68 percent equity to fund its existing theme parks. Using these inputs, we can estimate the cost of capital for the hypothetical Rio project: Cost of capital in US$ = 11.29% (0.6468) + 3.72% (0.3532) = 8.62% 6. We discount the expected cash flows back at the 8.62 percent risk-adjusted discount rate to arrive at a value for the theme park, net of costs, shown in Table 1-5. The risk-adjusted value for the Rio theme park is $2.877 bllion. Certainty Equivalents In the certainty equivalent approach, we adjust the expected cash flows for risk, rather than the discount rate, and use the risk-free rate as the discount rate. Adjust- ing the risk of expected cash flows is the most important aspect of this approach. This adjustment can be calcu- lated using several methodologies, including: + Compute certainty equivalents, using utility functions. This is very difficult to do and not worth exploring in most cases. + Subjectively estimate a “haircut”—decrease—to the expected cash flows. This is arbitrary and can lead to different analysts making different judgments of value, based on their risk aversion. + Convert expected cash flow to a certainty equiva lent. This approach is the most straightforward, but it requires an estimate of the risk-adjusted cash flows as a first step. ‘Once we have determined the risk-adjusted cash flows, we can discount them at the risk-free rate.Chapter 1 Risk Taking: A Corporate Governance Perspective x EZEIEEEY Values for Hypothetical Rio Theme Park Risk-Adjusted Value for Hypothetical ‘Annual Terminal Present iperliedi Park (in millions of U.S. é _ Near. ‘Cash Flow Value Value — OF [2582000 =#2000 “Cash | Terminal | Certainty | Present 1 —$1,000 $921 Year Flow Value Equivalent | Value 2 oe -$860 —$729 = ° $2,000 | a $2,000 $2,000 3 =$270 =s2n 1 | -si000 -s053_ | —soz1 4 Ie $332 $239 2 -$860 ~$780 ~$729 5 $453, $300 3 $270 —$234 ~$2n 6 $502_| $505 4 $532 $274 Pee: $538 $502 s |. $453 | sss | $300 8 $596 $3076 $502 $375 | $305 rc) $660 $313 7 $538. $384 $302 10 seoz_ | sioeea $4,970 a | $596 $405 | $307 Net Present Value $2,877 9 $660 $427 $313 10 $692 | $10,669 $7,011 | "$4,970 | i $2,877 | Certainty Equivalent Value: Rio Theme Park Example To estimate the certainty equivalent cash flows, we used. the 8.62 percent risk-adjusted discount rate that we obtained for the company’s Rio project in conjunction with the 3.5 percent risk-free rate to adjust each cash flow. To illustrate, the certainty equivalent for the $332 million expected cash flow in Year 4 can be computed as follows: 035* 10862 Repeating this process with each cash flow yields the cer- tainty equivalent cash flows for each year. Discounting all of the cash flows back at the risk-free rate of 3.5 percent yields a risk-adjusted value for the theme park, as shown, in Table 1-6, Cerny Eashalnt tor Yord = $30 sara ‘The risk-adjusted value for the theme park is $2,877 mil- lion, identical to the value that we obtained with the risk- adjusted discount rate approach Implications for Decision Makers Any firm involved in risky activities has to make a good faith effort to estimate the amount of risk exposure for every part of the business, as well as how this exposure translates into a risk-adjusted discount rate. Thus, differ- ‘ent components of the same business, with different risk exposures, can have different risk-adjusted rates. These rates can be used in risk-adjusting value, either as dis- count rates for expected cash flows, or as adjustment fac- tors in deriving certainty equivalents. ‘While managers might believe that risk and return models are flawed or that the estimates used in the models are incorrect, this skepticism cannot be viewed as a reason for not estimating risk-adjusted discount rates or using arbi- trary numbers. Section Task: Risk-Adjusted Value Risk-Adjusted Discount Rates 1. Does your firm have a hurdle rate for assessing invest- ments? If so, do yo know (roughly) what it is right now? 2. Has this hurdle rate changed over time? Why?20 Financial Risk Manager Part ‘oundations of Risk Management 3. Is there only one hurdle rate for all investments or do you have different hurdle rates for different invest- ments? If you use different hurdle rates for different investments, what is the reason? Risk-Adjusted Cash Flows Do you adjust your cash flows for risk? If so, how are they adjusted for risk? + “Haircut” cash flows on risky investments + No established approach but it gets done by individual decision-makers It happens and | have no idea how it happens Other (please describe) MANAGING RISK: ENTERPRISE APPROACHES Theme In this section we link enterprise approaches, also known as ERM, with the more established, classical risk-adjusted value approach covered in the previous section and explain how this new approach can cohtribute to value creation. The section details the steps of a typical ERM process, with specific directions ‘on how to apply these techniques. Risk Management and Enterprise Value ERM (or Corporate Risk Management) is a strategic sup- port activity. It creates business value through an inte- grated process of identification, estimation, assessment, handling, and controlling of risk. Classical finance assumes market efficiency when assess- ing the value of the firm. It only focuses on the “beta” to estimate the risk embedded in the company, as we saw the discussion of the CAPM. In contrast, ERM recognizes the imperfection of markets, imperfect diversification of the investment portfolio, and bankruptcy costs. It allows an enterprise to create value by managing risks. ERM takes a much broader perspective on risk. It introduces a way to think about the enterprise processes that involves a proactive approach to management by directors, man- agers and employees. Despite differences in view about the beta, ERM techniques use discontinued cash flow val- uations to aid decision making on risk treatment. Enterprise Risk Management (ERM) “A comprehensive and integrated framework for managing credit risk, market risk, operational risk and ‘economic capital and risk transfer in order to maximize firm value” (Lam 2003) “Dealing with uncertainty for the organization. (Monhanan 2008) “RM is the identification, assessment, and handling of risks enacted through (coordinated) corporate actions ‘to monitor, control, and minimize the adverse effect of unfortunate events or maximize the realization of ‘opportunities.” (Andersen 2010) "Risk management is a central part of any organization's strategic management. It is the process whereby organizations methodically address the risks attaching to their activities with the goal of achieving sustained benefit within each activity and across the portfolio of, all activities” AIRMIC 2010 (Risk Management Standard) Corporate Finance and ERM Objectives Converge “BEHOLDER VALUE MaXiMzATION MAXIMIZE EXPECTED CASH ROWS trough though ACTIVE ous ACTIVE RM to generate incremental positive cash fad ower) incemental postive Costof capita flow, mainly through tax optimization and smoothing of earings ———, and default risk > cefauit spread é a —_,— ACTIVE RM AIMS TO MAXIMIZE SHAREHOLDERS’ VALUE ‘The corporate decisions targeted by ERM analysts are all relevant in terms of value generation. ERM is an active approach to risk governance that leads to better invest- ments (maximization of cash flow generated by invest- ments) and aims to reduce the cost of capital. In doing so it helps maximize the company value. ‘As with the definition of risk there is no universal agree- ment on the process to be followed in the implementa- tion of ERM. For the purposes of this section we useChapter 1 Risk Taking: A Corporate Governance Perspective 2 the AIRMIC? approach as a starting point and add a few refinements of our own. Others may wish to use frame- works such as COSO* Regardless of the approach taken, whether AIRMIC, COSO 3. Risk treatment 4. Risk monitoring or another emerging standard, a good risk management The AIRMIC Enterprise Risk Management process must help the enterprise to: Process + Define risks acceptable to the enterprise as a whole— ir risk policy [?_stratesic Objectives |] + Develop a list of actual and potential risks pom eer, : Tik Assesoment + Assess both likelihood and consequences impact) o 01 quences (impact) AL ARIRS the previously identified risks fea + Build a value-based model that can estimate the impact, P|. Rak Desrption. (7 of risks on firm value through impacts on cash flows and/or cost of capital § by] {tisk evatuation ke} + Determine risks the company should retain, transfer, or Duby See eg | 3 | [__ BistReporting evel) SPP threats and: | Opportunities: ‘The process certified by AIRMIC requires the analysis to be carried out in four sequential staves: tal 1. Identification of risk management and enterprise ie] | at objectives : 2. Risk assessment {>| Residual Risk Reporting aaanaain Monitoring 3 Association of Insurance and Risk Managers. http/www.airmic.com + committee of Sponsoring Organizations ofthe Treadway oes Commission The Risk Management Process 1 2 3 4 setting firs ik fk sessment Ask weatment Ask monitoring ‘management goals and implementation fon the CG structure ie 2A. Risk Analysis Risk Idenification/Descriptin > Rsk Estimation, 28, Rsk Evaluation i22 Financial Risk Manager Part I: Foundations of Risk Management STEP ation of Risk and Enterprise Management Objectives This is primarily a managerial phase. It begins with determining the enterprise's approach to risks, includ- ing planning for the resources made available for risk management and selecting the general criteria for treat- ing risks. The enterprise selects a risk strategy compat- ible with the degree of risk aversion that prevails. The directors and managers define strategic objectives and operational goals compatible with the risk aversion of the shareholders who are looking to maximize enter- prise value. In this context, all ERM decisions should be made after responding to this simple question: “What impact do top managers’ decisions (hedging or reten- tion action) have on the value of the enterprise for shareholders?” STEP 2: Risk Assessment ‘The second, largely technical, phase of the ERM process is, divided into two sub-phases: + Risk analysis + Risk evaluation The risk analysis consists of risk identification and esti- mation. In the identification of enterprise risks we must identify the potential sources of negative events that are capable of compromising achievement of strate- gic and operational objectives. Due to the potential Risk Identification: Definition and Tools Risk identification sets out to identify an organization's ‘exposure to uncertainty. Risk identification requires intimate knowledge of the firm, the market in which it operates, the legal, social, political, and cultural environment, and sound understanding of its strategic and operational ‘objectives, including factors critical to its success and the threats and opportunities related to achieving of its objectives. AVAILABLE TECHNIQUES INCLUDE: + Brainstorming + Questionnaires + Business studies on business processes describ- ing both the internal processes and external factor determinants + Industry benchmarking + Scenario analysis + Risk assessment workshops * Incident investigation + Auditing and inspection + HAZOP (Hazard & Operability Studies) losses that might arise, the emphasis will be on identi- fying downside risk, but the process should also elicit the upside risk and its beneficial effects on enterprise performance. Emerging Market Participants Exampl by Workshop Participants) : Major Risks (Risk Identification Contributed Rebel insurgency Flooding Political instability Regulatory changes Electrical power fluctuations ‘Competition Skilled labor Reputation Nigeria Vietnam India Government policy changes Inflation Regulatory changes Physical security Foreign exchange changes Tox rates Exchange rate fluctuations Regulatory changes Project failure IT breakclown Flooding Unions Electrical power fluctuations Operational disruptions Environmental issues Customer receivables Access to resources Receivables from state Zambia i Corruption Fee Electrical power fluctuations Copper price changes Uzbekistan Nepal IT Failures, Earthquakes. Regional political instability Regulatory changes Cotton price changes Gold prices Political restrictionsChapter 1 Risk Taking: A Corporate Governance Perspective 23 Useful qualitative analytical tools for risk identification include brainstorming, questionnaires and risk assessment ‘workshops. Additional tools include review of publicly available documents for industry benchmarks, as well as investigation of previous incidents and auditing and, Inspection documents, Business studies focused on inter- nal and external procedures and scenario analysis also can be useful in gaining a better understanding of the poten- tial risk factors. ‘Once the risks are identified, they need to be described. In this second part of the identification phase, the ERM team creates risk maps in which the failure events are described using the following characteristics: + Name + Qualitative description of risk + Principal up/downside scenarios + Probability of occurrence + Identity of person in charge of managing identified risks + Measurement techniques to monitor identified risks + Preliminary evaluation of the economic impact of the scenarios presented ‘Such a risk map is more detailed than the risk profile. However, it should be noted that there is no single best practice for mapping risks. Many firms can simply list risks related strategic and operational objectives as part of a risk profile. Risk Estimation ‘Once the risk map is known, the enterprise must auantify the probability of the event as well as its impact on cash flows, estimating expected and unexpected losses and/or upsides. Based on the nature of tools used, the estimation methods are divided into three main groups: + Purely qualitative estimates + Semi-quantitative estimates + Purely quantitative estimates Purely Qualitative Estimates Qualitative methods use descriptive words or scales of value to illustrate the impact and the probabilities of an event. Among the various methods used for qualitative estimates, the Probability-Impact Matrix is among the most common, The Estimation Phase Risk estimation can be quantitative, semi-quantitative or qualitative in terms of the probability of occurrence and the possible consequence. + Qualitative methods: Probabilities and conse- quences of events (catastrophic to insignificant) are estimated according to qualitative scaling (analysts’ bias). + Semi-quantitative methods: Qualitative scaling is weighted and transformed into a quantitive scale ‘and a P-I risk synthetic score is computed, + Quantitive methods: Risk is estimated through uantitive methods as such Scenario Analysis, Dec sion Tree, Monte Carlo Simulation or according to the Value-at-Risk Models. These methods rely on ‘causal distribution estimation (subjective and/or objective methods). Using the P-I Matrix for risk management involves creating ‘a matrix in which risks are identified and classifying the identified risks. Creating a P-I Matrix requires defining the following: + Aqualitative scale that indicates the probability of the ‘occurrence of a given event. Generally, these observa- tions are grouped into five probability classes: almost certain, very frequent, moderate, improbable, and rare. + A qualitative scale representing the impact, that is, the possible economic consequences from the occurrence of the event. Generally, there are five impact classes: insignificant, low, moderate, severe, and catastrophic. + A qualitative scale that assigns a risk rating to every combination of elements (probability-impact). This can take on four different values: extreme, high, moderate, and low. + Appropriate criteria for a risk rating assessment, In Table 1-7, we provide an example of a P-I Matrix. ‘The next step is to assign all previously identified risks to one class of probability and impact. The quality of the results depends on how carefully this step is carried out. It is important to note that the outcome will be affected by the subjective approach of the analyst. ‘The P-I Matrix is simple to prepare and use. However, itis, ‘a screening tool only for pure downside risks. This method ‘overlooks potential beneficial upside effects.24 Financial Risk Manager Part I: Foundations of Risk Management Probl ity-Impact Matrix Structure Probability Impact I z Insignificant | Low Moderate | Severe _| Catastrophic ‘Almost certain (50%) High [iigh | extreme Extreme _ | Extreme Very frequent @0%-50%) Moderate High | High Extreme | Extreme | Moderate (69%-20%) Low Moderate | High Extreme — | Extreme Improbable (%-5%) Low Moderate | High Extreme Rare (<1%) Low Moderate _ | High High Legend: Insignificant: Very low impact events of marginal consequence Low: Management of event risks using routine procedures and controls ‘Moderate: Requires the identification of an individual responsible for its management and monitoring ‘Severe: Caroful risk evaluation by the officer at the highest hierarchical level ‘Catastrophle: Requires a moximum lovel of attention and an immediate intervention for risk treatment Semi-Quantitative Estimates ‘The semi-quantitative estimate method transforms a series of qualitative judgments into quantitative variables, using numerical scoring systems to arrive at a risk score— ‘a numerical synthetic risk judgment. The transformation takes place when the analyst attaches a score to each qualitative probability and impact class on the P-1 Matrix. This yields two set of scores: one for probability and one for impact. ‘The risk severity is determined by multiplying the prob- ability score by the impact score. For example, an event that is probable and would have severe impact on the cor- poration will score 50 x 200 = 1000. The sum of all risk scores yields the company's cumulative risk score. This ‘cumulative risk score fs called the Severity Risk Index—or Risk Score—as shown in Table 1-8 The principal goal of quantitative methodologies is to estimate the distribution of probability of risky events. The ‘most frequently used quantitative methods are “proba- bilistic approaches” such as sensitivity analysis, scenario analysis, decision tree methodology, and simulation. In addition, the Value at Risk (VaR) technique is typically based on the Monte Carlo simulation that is often used in financial calculations. The VaR technique is mainly used in the financial industry. Calculating the Risk Score obo [Sa il Feu [oscoe |s'wer | Se00 500 A quantitative estimation process involves estimating the potential losses from a particular risk. There are four steps required to perform this analysis. 1. Build a causal model on event probability 2. Estimate individual input distributions using historical data or simulations.Chapter 1 Risk Taking: A Corporate Governance Perspective 25 3. Estimate the outcome distribution according to the inputs. 4, Validate the model. In the first step the analyst builds a causal model linking ‘event and loss, The second step involves estimating the individual components of the model using historical data, such as the historical probability of fire in a particular, neighborhood. In the third phase the analyst estimates the ‘conseauence of the event once the causal model is known and the distribution of probability of the individual model components is determined. The final step tests the model. Risk Evaluation and Enterprise Value: The Value-Based Model In this managerial phase, the analyst compares the output from the previous risk estimation phase to the risk policy limits that the board establishes. The objective is to deter ‘mine whether the hedging decisions generate or destroy enterprise value based on the assumption that only deci- sions that affect cash flows or cost of capital are relevant. Active risk management can increase the firm value if the costs generated in hedging a risk are lower than the loss suffered by the company in case of an incident. In Fig ure 1-6 we suggest an analytical approach to value gener- ated by a hedging decision, STEP 3: Risk Treatment: Principal Strat- egies and Methods Allrrisks that are identified, estimated, and evaluated are subject to a risk treatment decision. There are four poten- tial outcomes of the decision: The Risk Evaluation Phase + Managerial risk management phase + Compares estimated risks against risk criteria iden tified by the organization upon completion of risk analysis phase + Risk criteria include associated costs and benefits, legal requirements, socioeconomic and environmen- tal factors, stakeholders’ concerns among others + Evaluation used to make decisions about the signifi: ‘cance of risks to the organization, whether to accept each risk, or whether to treat according to DCF model Risk avoidance Risk transfer Risk reduction 4. Risk retention ‘The risks are alternatively avoided or accepted. If accepted, they can be retained by the firm, reduced through diversification (risk reduction) or transferred to third parties (risk transfer), The risk treatment decision should be consistent with the guidance criteria of value maximization, Risk Avoidance Whenever a risk generated by a project is not consis- tent with the company risk policy, the decision maker should avoid this particular risk. The enterprises should avoid investing in projects if the cost of hedging is. greater than the value generated by the project, result- ing in destruction of value. Risk Transfer, Also Known as Risk Hedging Instead of avoiding risk altogether, management may decide to assume the risk generated by a project and pass along this risk to a third party through risk hedg- ing. Typically, this is done through purchase of insur- ance policies or financial derivatives that can reduce variability of cash flows and/or lower the cost of capital, ‘The DCF frameworks useful to rank preferences and to select Fisk to avoid, mitigate or retain, r EHC CH ie aM Hedging decision valu i Where: + EDHC,) are the expected incremental postive cashflows generated by the hedging decison (Le, tax advantage, ‘greater efficiency in investing) 1 Bjis the cost of equity =k tee + Btequity premium (i Beta =1, R= Rn) + HC are the negative cash lows associated with the hedging decision (ie, cost of insurance) 4 AMI market imperfections (ie, asymmetry of information, regulation, rsk spectc assets) ‘The individual hedging decision value.26 Financial Risk Manager Part I: Foundations of Risk Management Tools for Risk Retention and Risk Transfer ai 4 + Coppel tuurtuns/eini ofyheicer 6 23 important to mitigate both market and BE | Gimrapectte aks BE |. + iewonceneen secures esved by the firm, ‘+ Insurance is good for almost all types of risk but insurance cannot protect against core business risk. No risk, no return! + Forwards, futures, and options are impor- tant primarily to mitigate commodities and currency risk + Swaps, such as interest rate swap, credit default swap, and currency swap address. market risks + Contingent capital ‘Out-Balance: Sheet Tools Risk Monitoring Risk monitoring and control includes the following: + Identify, analyze, and plan for new risks + Track identified risks and monitor trigger conditions + Review project performance information such as progress/status reports, issues, and corrective actions + Re-analyze existing risks to see if the probability, impact, or proper response plan has changed + Review the execution of risk responses and analyze their effectiveness: + Ensure proper risk management policies and proce: dures are being utilized Useful tools to transfer risks to third parties include futures and options, swaps, insurance, and other more innovative financial products, such as risk-linked securities and contingent capital. Risk Retention Retention is the decision to maintain the risk in the enter- prise. Typically, risks are retained in two different ways. Either they can be expressly retained according to the firm’s risk strategy or they are retained simply because they have not been identified and evaluated in the ERM process. Hence, as Shimpi notes, “A risk neglected isa risk retained."> * Shimpi, P.A, Integrating Corporate Risk Management, Texere, New York, New York, 2001, ‘The size and relevance of risk retained should guide the decision on how much equity to raise to sustain potential losses generated by the projects. The capital raised on the market should be proportionate to the risk retained by the firm. Inadequate capital can bring the firm into financial distress and might end in bankruptcy. Risk Reduction, Diversification and Other Policies ‘The risk manager also can pursue a risk reduction behavior by engaging in a policy of investment portfolio diversification. Diversification is a useful tool for risk reduction when the decision maker can split investments into diversified activities. In emerging markets, where conglomerates are a common organizational structure, conglomerate firms operating in these markets can reduce risk by investing in assets with uncorrelated returns. STEP 4: Monitoring Incurred Risks ‘The last phase of the integrated risk management pro- cess is monitoring. This phase Is both technical and managerial. Senior decision makers, including board members, must identify the risks to be monitored and, middle managers need to ensure that these risks are reported. Regardless of who is responsible for which tasks, it should be noted that retained risks require monitoring. This monitoring is a check on the business variables identified as potential sources of risk that management has voluntarily decided to assume. Many boards review their P-1 Matrix regularly or review their risk score as a way to monitor such risks. Among the considerations: + Obsolescence of outcomes from the risk analysis: Deci- sion makers must be aware of when key assumptions in their risk analyses no longer apply and when the envi= ronment changes drastically. In the 2008 crisis, many risk models failed because the normal distribution embedded in many models to estimate market risks was no longer applicable, + Quality and effectiveness of the risk process: Firms must monitor and audit the risk management pro- cess itself. Board members and senior managers need to ensure the process remains appropriate and updated.Chapter 1 Risk Taking: A Corporate Governance Perspective 27 Implications for Decision Makers ‘This section provides a series of useful steps that can guide a decision maker in implementing ERM. Not all firms are able to implement a comprehensive ERM framework due to lack of resources. Still, itis important for all com= Panies to identify and map their risks, including small- and medium-sized companies and early stage start-ups. AS firms gain confidence and develop their risk management capacity, the full ERM process can be deployed. Section Task: Implementing ERM What are the five main risks faced by companies in your country? What are the five risks that affect your company the most? Work with ancther director/manager to design a P-| Matrix. TOOLS FOR BETTER RISK. DECISION MAKING: PROBABILISTIC APPROACHES Theme ‘One probiem with risk-adjusted value approaches is ‘that analysts are required to condense their uncertainty about future outcomes into a set of expected cash flows. Probabilistic approaches take a richer and more ata-intensive view of uncertainty, allowing for extreme ‘outcomes, both good and bad. In the process, a better Sense of how risk can affect a venture Is developed, and enables consideration of appropriate ways to Manage this risk. This section looks at such tools. Probabilistic Approaches ‘There are many ways to make uncertainty explicit in an ‘analysis. The simplest way is to ask “what if?” questions about key inputs and look at the impact on value. This is called sensitivity analysis. It allows analysts to examine extreme outcomes and evaluate the sensitivity of the out ‘come to changes in individual assumptions. Another approach is to estimate the outcomes and value under viable scenarios in the future, ranging from very good scenarios to very bad ones. Attaching probabilities to these scenarios yields a result. A third approach—and arguably the most robust—is to use probability distributions for key inputs rather than ‘expected values and run simulations in which a single out- ‘come from each distribution is selected and the value is calculated. This simulation process is repeated many times and the resulting outcomes for the investment are pre- sented to decision makers. Sensitivity Analysis ‘The value of an investment and its outcome will change as the values ascribed to different variables change. One way of analyzing uncertainty is to assess the sensitivity of decision outcomes to changes in key assumptions. With the advent of more powerful computers and more data this process has become easier. The analysis should focus on the two or three most important variables. The sensi tivity analysis output should be presented succinctly, in a way that helps decision makers. Scenai Analysis Scenario analysis is best employed when the outcomes of a project are a function of the macroeconomic environ- ment and/or competitive responses. As an example, sup- pose that Boeing, a leading global aircraft manufacturer, is considering the introduction of a new, large capacity airplane, capable of carrying 650 passengers, called the Super Jumbo, to replace the Boeing 747. Cash flows will depend on two major, uncontrollable factors: + The growth in the long-haul, international market, relative to the domestic market. Arguably, a strong Asian economy will play a significant role in fueling this growth, since a large proportion of it will have to ‘come from an increase in flights from Europe and North America to Asia. + The likelihood that the company’s primary competitor— 1us—will come out with a larger version of its largest capacity airplane over the period of the analysis. In Table 1-9, we look at three possible outcomes for each of these factors and the number of planes the company might expect to sell under each outcome. ‘The probabilities for each scenario are included in brack- ets below the number of planes. To illustrate, the best sce- nario for this manufacturer is high growth in Asia and that the competitor abandons the large capacity aircraft mar- ket. Under this scenario, the company could expect to sell 200 planes a year. Still, the probability of such a scenario28 Financial Risk Manager Part I: Foundations of Risk Management Hypothetical Scenario Analysis for Aircraft Manufacturer in Asio Airbus Abandons Alrbus | Airbus | Large Capacity | Large Jet | a-300 Airplane High 120 150 200 Growth | 02.5%) + | 42.5%) ) Average | 100 335 160 Growth 15%). (25%) 0%), Low 75] 10 120 Growth ow) 10%) 10%) is marginal at best. The worst scenario is if Asian growth slows and the competitor introduces its own version of the Super Jumbo. In this case, the company would be able to sell only 75 aircraft each year. There is a § percent ‘chance that this scenario will unfold. The expected value of going ahead with the Super Jumbo can be assessed under each scenario and the expected value can be com- puted across the scenarios, using the probabilities. Types 182 Succeed Test GIS De development. Decision Trees ‘Some firms face sequential risks, a situation in which it is necessary to move through one stage successfully before proceeding to the next stage. Decision trees are useful for such risks. A classic example is the drug develop- ‘ment process in the United States. The new drug must be developed and tested. Then, it must pass through various stages in the Federal Drug Administration’s approval pro- cess before it can be produced. At each stage, the drug could be rejected. The information gathered at each of, the stages can help refine estimates of what will happen in subsequent periods. In Figure 14, we use a decision tree to examine whether ‘a diabetes drug should be tested by a firm. The firm is unsure about whether the drug will work and, if it does, ‘whether it will work only on Type 1 diabetes, only on Type 2 diabetes or on both. ‘Thus, the firm will have to spend $50 million to test the drug. Ifthe initia! drug test is successful, with an estimated 70 percent probability, more extensive tests will help determine the type of diabetes it can treat. Probability -§50-$100/1 1.30071 -$600-5400 (PVA, 10%, 1Syears." -$50-$100/1.1-250/1.P413500-5125, (VA, 10%, 1S years." -$50-$100/.1.30001.P-1$500-$300 (PVA, 10%, 1S year. -$50-510071..2501." -$50-$100/141 ion tree for pharmaceutical company with diabetes drug inChapter 1 Risk Taking: A Corporate Governance Perspective 29 estimates suggest a 10 percent chance that the drug will treat both diabetes types, a 10 percent chance that it will treat only Type 2, a 30 percent chance that it will treat only Type 1, and a 50 percent chance that it will not ‘work at all, We then estimate how much value the firm is expected to extract from the drug in each of the paths. Simulations A simuiation allows for the deepest assessment of uncer tainty because it lets analysts specify distributions of values rather than a single expected value for each input about which they feel uncertain. Thus, if you are uncer- tain about operating margins, you can allow the margins to be normally distributed, for example, with an 8 per cent expected value and a 2 percent standard deviation. After specifying distributions and parameters for the key inputs, a value picked from each distribution is extracted and the outcomes are computed. This single simulation is repeated multiple times and the computed values are plotted as a distribution of possible outcomes. Value at Risk (VaR) Value at Risk, oF VaR, measures the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval. Thus, if the VaR on an asset is, $1CO million in a one-week period at the 95 percent con- fidence level, there is a 5 percent chance that the value of the asset will drop more than $100 million over a given week, VaR is comprised of: + Specified level of loss in value + Fixed time period over which risk is assessed + Confidence interval ‘The VaR can be specified for an individual asset, portfolio of assets, or for an entire firm. For an individual asset, the VaR is a simple extension of the probabilistic approaches. VaR has been used most widely at financial service firms, where the risk profile is constantly shifting and a big loss over a short period can be catastrophic. This is partly because these firms have comparatively small amounts of equity, relative to the bets that they make. It also is due, in Part, to regulatory constraints. Thus, an investment bank will compute the VaR at the end of each trading period by aggregating the risks of all of the open positions in which the bank has capital at risk, including long and short positions. To manage risk and keep it at levels that do not imperil survival, the investment bank will set a limit on the VaR. Typically, this limit is set by looking at the amount of the bank's capital and how close the bank is operating to regulatory limits. Other things remaining equal, the more capital reserves a bank has, the greater its capital buffer in excess of the regulatory limit. If the internal VaR limit Is exceeded, trading positions should be closed or modified to bring the VaR back within prudent limits. The collapse of Bear Stearns and Lehman Brothers in 2008, ‘as well as the near-death experiences of many other invest- ‘ment banks, is clear evidence that VaR, at least as practiced today, falls to do an adequate job in measuring risk in crisis periods. In fact, focusing on VaR as the central risk measure ina firm comes with several limitations: + Focus is too narrow and the VaR can be wrong: Regardless of approach used to estimate VaR, it remains an estimate and can be wrong. In statistical terms, this means that the VaR estimate contains a large standard error. ‘+ The "Black Swan": No matter how they are framed, ‘VaR approaches have their roots in the past. As long as ‘markets are mean-reverting and stay close te historical norms, VaR will work. If there is a structural break, VaR may provide litle or no protection against calamity. This, is the "black swan” event that Nassim Nicholas Taleb popularized in his books Fooled by Randomness and The Black Swan. In his books, Taleb suggests that the focus ‘on normal distributions and historical data leaves firms ‘exposed to new risks that can potentially wipe them out. Section Task: Probabilistic Approaches 1. Do you use probabilistic approaches in your firm? 2. Ifyes, which approach do you use? ‘What if?" analysis b. Scenario analysis . Decision trees Simulation 3. Ifno, do you think that there is potential for a proba- bilistic approach? Do you use the Value at Risk ‘approach in your firm? 4. IF itis used, how often it is computed? 230 Financial Risk Manager Pat : Foundations of Risk Management 5. How is it computed? a. Variance Covariance Matrix b. Historical simulation ‘¢. Monte Carlo simulation IF your firm uses VaR, does it also use other risk mea- sures? Which ones? 6. ‘CREATING VALUE FROM RISK TAKING Four sets of inputs determine the value of a business. These include: + Cash flow generation from assets in place and invest ments already made + Expected growth rate in the cash flows during periods of high growth and excess returns, when the firm earns more than its cost of capital on its investments ‘Time period elapsing before the firm becomes a stable Theme When managing a firm's risk, the ultimate objective is to make the firm more valuable. Thus, itis important to consider how risk management affects the value of a firm. The most straight-forward way to do this is to start with the conventional drivers of firm value and look at how individual risk management actions affect these drivers. In this section, we also look at the costs and benefits of hedging and whether the firm should hedge, even if the benefits exceed the costs, What is the rationale for hedging? How can it increase the value of a business? ‘We examine choices on hedging risk and address how, to identify optimal hedging approaches. growth firm + Discount rate that reflects the risk of the investments made by the firm and the financing mix used to fund them These factors are illustrater Figure 1-8. Value from Risk Hedging Given that the value of the firm is a function of the cash flows from existing assets, the growth rates, the length of the competitive advantage period, and the cost of capital, a risk management action can affect the value of the firm if it alters one or more of these inputs. How Risk Management Affects Value ‘Since our definition of risk encompasses both the upside and the downside, we can categorize risk management actions into those that are designed primarily to reduce exposure to downside risk (risk-hedging actions) and. Creating Value from Risk Management Exploit upside potential~reduce downside risk 1. Pursue the potential of sew opporunies | improve he iret 1 2. cone aa fost || fentaltor || fownide | = looses Effective risk management can increase the average return and reduce the variance in return. The Value of Risk Management Does it pay to avold potential losses and take advantage of new opportunities? The high performers con handle al types ofrisk mcluding hazards, econamic ks, operational rks and strategie asks ‘The tow performers Sreoften unable tohanaleany ‘Analyses of corporate data show positwe relationships between Etfectve risk management and average performance, ater controlling for Industry and see effects Performance (ROA). 50, the empirical ov nce favorablet ‘Effective isk management (ERM "ERM = the ability to handle external market volatilities and generate smooth net cash inflows or earnings over time ‘Source: Andersen, TJ, 2008, The Performance Relationship of Effective Risk Management: Exploring the Firm-Specific Investment Rationale, Long Range Planning, 412).Chapter 1 Risk Taking: A Corporate Governance Perspective an Cash flows from existing assets | Operating income (-tax rate) + Depreciation’ ‘Maintenance Cap B« = Cashflow from exsting assets Function of both quality of past investments ‘and efficiency with which they are managed Discount Rate of investments and funding mix used ‘Weighted average ofthe cost of equity and cost of debt. Feflect the rbkiness Growth Rate during Excess Return Phase Reinvestment Rate * Return on Capital on new investments Depends upon compete advantages & constraints on growth GIEUSEEEE Factors influencing the value of a business. those that are more generally focused on increasing exposure to upside risk (risk-taking actions). Thus, buying insurance or entering into forward or options contracts to cover foreign exchange exposure in the future would be classified as risk-hedging actions whereas introducing a new product or service or entering a new market would be categorized as risk-taking action The Costs of Hedging The benefits of hedging must be weighed against the cost to do so. Costs can range from small to large, depend- ing on the type of risk being hedged and the product, used to hedge the risk. In general, the costs of hedging can be broken down into explicit costs, which show up as expenses in financial statements and implicit costs, which may not show up as expenses but can affect earnings in dramatic ways. + Explicit costs: When companies hedge against risk by purchasing insurance or put options, the cost of hedg- ing Is the cost of buying the protection against risk. It increases costs and reduces income. + Implicit costs: When buying or selling futures or forward contracts, there is no upfront explicit cost. However, there is an implicit cost. This process means forfeiting upside for downside protection. Thus, a gold mining company that buys futures contracts to lock in the price of gold might not face explicit costs at the time it enters into these agreements. In the future, though, the company could report sharply lower ‘earnings in future periods, if gold prices exceed the futures price. A Framework for Risk Hedging Fundamentally, it makes sense for firms to hedge a risk if both of the following conditions hold: + The benefits of hedging the risk exceed the costs: Bringing together the tax benefits, the reduced dis- tress costs, and improved investment decisions, do the benefits exceed the costs? If the answer is no, the firm should not hedge that risk. + It is less expensive for the firm to take responsibility for hedging the risk: Even if the benefits exceed the costs, the firm has to follow up by examining whether itis less expensive for the firm to hedge this risk or whether it makes more sense for investers to hedge on their own. For example, firms facing exchange rate risk can. choose to hedge this risk, but it might be less expen- sive for institutional investors to do so on their own, since some portion of the risk could be eliminated by the portfolio, Figure 1-9 provides a flow chart for determining when It makes sense to hedge risk and when it does not. Approaches to Hedging ‘Assuming that a firm has reached the conclusion that hedging risk makes sense, there are several ways in which it can reduce or eliminate its exposure to a specific risk,32 Financial Risk Manager Part I: Foundations of Risk Management Whats the cost tothe fm of hedging this rik? Negligible High I I is ere a sigafcant benefit in Tether a signicant benfitin texms of higher cashflows ora terms of higher cash flows or@ lower discount ate? lower discount rate? fe NO (ves [ho v v Tv Hedge this risk, The | _tnaiferentt0 {Can investors hedge this risk (De nok beds ts rea. Se ey hedge a | contemses igs ak | Tete ore small enced the cost, relative to costs Ye no] [wate bene bess esto | v aie as Fe | fi risk instead ofthe fi? ledge his risk. The Ide the risk instead of the f cir: Te ve = exceed the costs v Let the risk passthrough Hedge ths risk. The to investors and let them bnetis tthe frm hedge the risk, vil exceed the casts When is it appropriate to hedge risk? + Investment cholces: A firm might achieve a partial hedge against some types of risk by investing in many projects across geographical regions or businesses. + Financing choices: Matching the cash flows on financ- ing to the cash flows on assets can also mitigate expo- sure to risk. Thus, using peso debt to fund peso assets, can reduce peso risk exposure. + Insurance: Buying insurance can provide protection against some types of risk. In effect, the firm shifts the risk to the insurance company in return for a payment. ‘+ Derivatives: In the last few decades, options, futures, forward contracts, and swaps have all been used to good effect to reduce risk exposure, ‘Which choice is best? The answer will depend on the type of risk being hedged and on what the firm wants to accomplish through the hedge. + For complete, customized risk exposure, forward con- tracts can be designed to a firm's specific needs, but only if the firm knows these needs. The costs are likely to be higher and this could increase exposure to credit from the other party to the contract. + Futures contracts offer a lower cost alternative to for- ward contracts, since they are traded on the exchanges ‘and not customized. Plus, there is no credit risk. Types of Derivatives ‘Over-the-Counter (OTC) Derivatives Forward foreign exchange Non-deliverable forwards Currency swaps Interest rate swaps Exchange-Traded Derivatives ‘Currency options Interest rate futures ‘Commodity futures ‘Options on futures ‘Securltizations Collateralized debt obligations Mortgage-backed securities Exotic Options, Structured Products and Non- ‘Traditional Derivatives Weather, oil, natural gas and electricity derivatives Asian options, barrier options, basket options, ‘compound options, look back options, binary options However, they may not provide complete protection. against risk + Options contracts provide protection only against downside risk while preserving upside potential. This benefit has to be weighed against the cost of buyingChapter 1 Risk Taking: A Corporate Governance Perspective 35 the options, which will vary depending on the amount of protection desired + In combating event risk, a firm can either self insure or use a third party insurance product. Self insurance makes sense if the firm can achieve the benefits of risk pooling on its own, does not need the services or sup- ort offered by insurance companies, and can provide the insurance more economically than the third party. Implications for Decision Makers ‘The objective in risk management is to increase the value of a business. To accomplish this objective, itis important to consider the way in which a given risk management action will translate into one of the business value inputs: cash flows from existing assets, value-adding growth, length of the competitive advantage period, and cost of capital. Actions that do not affect any of these inputs are value neutral, so time spent on them is time wasted. Actions that reduce value are perverse and should be eliminated from the risk management list. Hedging decisions should not be based on inertia (we have always hedged that risk) or on fear. They have to be based on an assessment of the risks the firm faces and ‘whether it makes economic sense to hedge some or all of, these risks. Hedging risks can create more stable earnings {and cash flows while at the same time reduce the value of the firm, because the costs exceed the benefits. Section Task: Value and Risk at Your Firm Do you have a risk manager or someone responsible for risk management at your firm? + Ifyes, what is the job description? Is it to measure risk and report to top management, monitor risk taking, hedge risks or something else? + If'no, how is risk managed in your organization? Do you hedge risks at your firm? a. Yes b. No c. Not sure It you hedge risk, what types of risks do you hedge? a. Input cost risk: cost of raw materials used for operations b. Output price risk: price of products sold «. Exchange rate risk EXPLOITING THE RISK UPSIDE: STRATEGIC RISK TAKING AND BUILDING A RISK-TAKING ORGANIZATION Theme Risk management is more than just risk hedging. In fact, successful firms, over time, can attribute their successes not to avoiding risk but to seeking out and taking the “right risks.” Success in risk taking is as much a result of design as of luck. A key choice for firms is the design of the organization to optimize the benefits from risk taking. Risk taking occurs within a context that includes the firm's leadership and culture, systems, ‘and capabilities. in this section, we examine risks to exploit and organizational designs to help convert these risks into value increases. Strategic Risk Taking and Value Returning to the framework that related value to funda- mental inputs, there are four basic inputs that drive valu cash flows from existing assets, the expected growth rate during the high growth period, the length of the competi- tive advantage period, and the cost of capital. Exploiting risk well can affect each of these inputs: + Cash flows from existing assets: Better risk taking can lead to more efficient operations and higher cash flows from existing assets. + Higher expected growth rate: More efficient risk taking can lead to more reinvestment and higher returns on. capital, both of which can translate into higher value- adding growth. + Length of competitive advantage growth period: Good risk taking can be a significant competitive advantage by itself, but exploiting risks better than the rest of your competitors requires bringing something to the table that is unique and different, + Discount rate: Risk taking that increases potential upside, while minimizing or reducing downside risk, can provide the best of both worlds—higher cash flows and. lower discount rates.34 Financial Risk Manager Part |: Foundations of Risk Management ‘The impact of risk taking on each of the valuation inputs is captured in Figure 110. Taking Advantage of Taking Risks ‘To exploit risk better than your competitors, you need to bring something to the table. Successful risk-taking firms can exploit several advantages, including: Strategic Risks within the Risk Profile Risk categories Risk factors Competitor moves New regulations Paokcial events Social changes Changing taste New technologies Strategic rks: Exogenous | i ‘Malfunction Process disruptions ‘Aaminsrative e015 Technology breakdown Compliance failure Legal exposures Operational rks: Endogenous sant General demand Price relations Foteign exchange Incest rates Commodity prices ERM Economic rks: Natural catastrophes Man-made disasters Terrorsm events Catton Mostly Exogenous Hazards ‘Source: Andersen, TJ. and P. W. Schrader, 2010, Strategic Fisk Management Practice, Cambridge University Press. + Information advantage: In a crisis, getting better infor- mation and getting it early can be a huge benefit. + Speed advantage: Being able to act quickly and appro- priately can allow a firm tc exploit opportunities that ‘open up in the midst of risk. + Experience/knowledge advantage: Firms and their managers that have been through similar crises in the past can use what they have learned, + Flexibility: Building in the capacity to change course quickly can be an advantage when faced with risk, Emerging Market Example: An Indian Conglomerate Exploits Its Superior Access to Capital” During the international economic crisis of 2008, Tata, {an Indian conglomerate, was flush with cash. Prior to tthe crisis, the conglomerate had been building its cash resources as it foresaw future market instability. Once the crisis was fully upon the international financial market, Tata found that its sterling reputation and. strong balance sheet allowed it to access capital despite the severe credit squeeze. Due to this foresight, Tata gained a liquidity advantage over its rivals. In this period, the conglomerate was able to exploit this competitive advantage by negotiating several ‘acquisitions at favorable prices. In fact, Tata was, frequently the only buyer during such negotiations, because potential rivals could not finance the deal, due. to lack of comparable access to cash. “This example was provided by @ workshop participant. Cash Flows from existing asets Focused rik taking con lead to beter resource allocation and more efficient operation, thus higher ‘cashflow from existing assets, Excess returns during high growah period: The compesive edge you have on some ‘ypes of risk can be expboited to generate higher excess returns on investments during high growth period. Length of patod of excess returns: Explltng rss beter than your competitor can give you a longer high growth period. ‘Value today can be higher as a result of tisk taking Discount Rate sk taking can minimize this impact. SaaS SSE | SEE iil sk faking is general viewed as pushing up discount rates, selective CHETEEEEY impact of risk taking on valuation inputs.Chapter 1 Risk Taking: A Corporate Governance Perspective 35, + Resource advantage: Having superior resources can allow a firm to withstand a crisis that devastates its ‘competition, All crises put firms to the test, and while itis not fait, firms that have access to more resources, such as capital and personnel, are better positioned to survive than firms. lacking these resources. Firms can gain a resource advan- tage through: + Capital access: Being able to access capital markets allows firms to raise funds in the midst of a crisis. Firms ‘that operate in more accessible capital markets should have an advantage over firms that operate in less accessible capital markets. + Debt capacity: Preserving debt capacity is an advan tage because this capacity can be accessed in times of crisis. Firms that operate in risky businesses should hold less debt than they can afford. In some cases, this debt capacity can be made explicit by arranging lines of credit in advance of a crisis. Organizing for Risk Taking ‘There are several keys to becoming a strong risk-taking firm, including: + Hiring the right people + Creating incentives for good risk taking + Aligning organizational size and structure with risk taking + Understanding the decision-making context + Integrating risk analysis with the strategy process, + Monitoring and responsiveness + Ensuring adequate capital for risks retained + Preserving the enterprise's options + Building the optimal risk governance and management structures + Balancing quantitative and qualitative decision making Here, we discuss each of these factors in tum. Hiring the Right People Good risk taking requires good risk-taking personnel, but what are the characteristics of a good risk taker? Research in the last few decades suggests that good risk takers have the following characteristics: + They are realists who still manage to be upbeat. + They allow for the possibility of losses but are not over~ \wheimed or scared by the potential for losses. + They keep their perspective and see the big picture, ‘even in the midst of a crisis. + They make decisions with limited and often incomplete informati How can a firm hire and retain good risk takers? + Have a hiring process that looks beyond technical skills to consider crisis management skills. The hiring pro- cess should look at how people react when exposed to change and instability, in addition to considering back- ‘ground and technical skils. + Accept that good risk takers will not be mode! employ- 05 in stable environments. People who seen most attuned to risk can be disruptive in more placid times. + Keep risk takers challenged, interested, and invelved. Boredom will drive them away. + Surround them with kindred spirits. Enterprise Risk Management Framework Leadership and Culture There are.a number of formal ERM standards, including AIRMIC, AS/NZS 4360, COSO, FERMA, IRM, ISO 31000 ‘Source: Andersen, 7 and P, W. Schredar, 2010, Strategic Risk Management Practice, Cambridge University Press.36 Financial Risk Manager Part I: Foundations of Risk Management Creating Incentives for Good Risk Taking Self interest is the strongest force driving the way in which individuals make decisions. In risk management terms, the biggest factor determining risk taking and whether it Is good or bad is the incentive system in place. In a per- fect world, we would reward managers who expose the firm to the right risks and punish those who expose it to the wrong risks. In practice, though, we often reward or punish decision makers based on outcome rather than process. Thus, a trader who takes an imprudent risk but succeeds might earn millions of dollars in compensation, while one who takes a prudent risk and fails might lose his job. In recent years, firms have started to offer mangers equity ‘options as compensation, or they have instituted bonus systems or compensation tied to profits earned based on decisions these managers made. It can be argued that, both systems are asymmetric—they reward upside risk taking too much while punishing downside risk taking too little—teading to too much risk taking. Finding the appropriate compensation system is not a simple task. Key to success here is balance, for a sym- ‘metrical system that punishes downsides about as much as it rewards upsides, and rewards process as much as outcome. Aligning Organizational Size and Culture with Risk Taking Organizations can encourage or discourage risk based on how big they are and how they are structured. Large, layered organizations tend to be better at avoiding risk whereas smaller, flatter organizations tend to be better at risk taking, Each type of organization has to be kept from Fixed Compensation (Galan) Equity in company ‘A Reasonable compromise? Its own excesses. Bureaucratic, multi-level organizations err on the side of too little risk and have a difficult time dealing with change and risk. Flatter organizations tend to be much more agile and flexible in the face of change, but the absence of checks and balances also makes them more susceptible to lone rangers undercutting their objectives. ‘The culture of a firm also can act as an engine for or as a brake on sensible risk taking. Some firms are more open to risk taking and its positive and negative consequences. How the firm deals with failure Is another indicator of the ‘company’s risk culture: risk takers are seldom punished for succeeding. Understanding the Decision-Making Context Directors often are required to make high-stakes deci- sions under less than ideal conditions. They often have inadequate information and time to engage in exhaus- tive analysis. Even if they had time, the cost of collecting Information could be a deterrent. And even with sufficient information and enough time, managers are hindered, by their own cognitive limitations, including bounded rationality, Not only do directors have to face individual constraints, they act in a group and are subject to the dys function inherent in group decision making. An average deci steps, including: + Setting objectives + Searching for alternatives jon process can be divided into several + Evaluating alternatives + Choosing alternatives + Implementing decisions Bonsues ted to proitabiity Equity Options “oo litle isk taking, since you do not share the upside “Too litle rik taking if ‘managers end up over invested in company Risk taking focused on investments with short-term earings payofts Too much risk taking, because risk increases option valve Finding the balance: rewarding risk takers.Chapter 1 Risk Taking: A Corporate Governance Perspective Cognitive Biases Decision makers may repress uncertainty and act on simplified models they construct. 1, Formulate goals and identify problems Prior hypothesis: problem identification is affected by erroneous beliefs. ‘Adjustment and anchorin judgments and values Reasoning by analogy: impose simpler analogies to ‘complex situations Escalating commitment: increase commitment when {a project is failing 2. Generate alternatives Single outcome: focus on a single goal or preferred alternative Impossibility: discard non-preforred alternatives by Inferring that itis impossible to implement Denying value trade offs: over-valuation of a preferred alternative Problem sets: imposing an often-used problem _ solution. 3, Evaluate alternatives and choice Insensitivity to predictability: ignoring the reliability ‘of information Illusion of validity: observations may reflect a different concept or data can be confounded Influence of previous ‘small data sample or a limited set of examples Devaluation of partial description: discounting alternatives that are only partially described Cognitive biases can arise at all stages of the decision-making process They can all lead to bad decision outcomes! Source: Charles Schwenk, Cognitive Simplifications Processes in Strategic Decision-Making, 1984. 7 Cognitive biases can distort the outcomes by acting at various points in this flow. These cognitive biases lead to bbad decisions as alternatives are not properly defined, the appropriate information is not collected, and costs and. benefits are not weighted accurately. Awareness of these decision-making dysfunctions will help alert directors and their risk managers to these potential failures. Directors can try to alleviate the problems by viewing a problem from different perspectives, seeking opinions from differ- tent sources, and thinking through their positions clearly before negotiating, Integrating Risk Analysis with the Strategy Process The strategy planning process and the risk management process can be combined into a single framework. If they are not combined, at minimum the two should be linked and opportunities taken to exploit efficiencies by under taking joint data collection and analysis. Further, risks can be defined in terms of their potential influence on the abil ity of the enterprise to meet its strategic objectives. During the strategy planning process, risk analysis is an implicit part of the process, even if itis not addressed specifically, as the desirability of various strategic alterna- tives are assessed for thelr risk and reward offering. Addi- tional effective risk mitigation might be needed to realize the benefits of strategic initiatives pursued. Risk analysis is also implicit in many standard strategy planning tools. For example, analysis of the strengths, weaknesses, threats, and opportunities imply discussions about risks. Internal and external analyses are inherently environmental risk assessments at the strategic level and Example: LEGO Group Active Risk and Opportunity Planning (AROP) The process applies to all new corporate projects Searching (direction) Identification (assessment) ‘Source: LEGO Systems A/S ‘Managing (moniton) Robust plan and oo38 Financial Risk Manager Part strategic planning generally proposes ways to deal with the identified strategic risks. Monitoring and Responsiveness Great risk-taking firms also have mastered the monitor- Ing and responsiveness phases. Organizationally, this means each risk is “owned” by specific managers who are accountable for their monitoring and for initiating responses where needed. Prioritization of risks helps the board decide at which level the risk will be “owned” and the frequency of follow-up and reporting, Adequate resources, including information technology and person- nel, are needed to ensure that the required level of moni- toring and responsiveness is achieved. Ensuring Adequate Capital for Risks Retained ‘The 2008 crisis highlighted the importance of capital adequacy to preserve the business continuity of firms, Long an issue for financial firms, capital adequacy has become important for non-financial firms as well, because of the Basel II regulations aimed at maintaining financial stability. Risk management tools and techniques allow for ‘expansion of potential financing sources with the intent of minimizing the cost of capital and maximizing the value of the enterprise. Preserving the Enterprise’s Options Even if you are a sensible risk taker and measure risks well, you will be wrong a substantial portion of the time. ‘Sometimes, you will be wrong on the upside—you under- estimate the potential for profit—and sometimes, you will be wrong on the downside. ‘Successful firms preserve their options to take advantage of both scenarios: + To expand an investment, if faced with the potential for more upside than expected + To abandon an investment, if faced with more down- side than expected Real options give firms flexibility to take advantage of scenarios such as these. “oundations of Risk Management Building the Optimal Risk Governance and Management Structure Directors who take the time to uncerstand risks, risk tools, ‘and modern approaches to risk taking have taken a criti- cal step towards providing appropriate risk oversight for their firm, Some boards delegate detailed risk-taking tasks to a risk committee or audit and risk committee, Some firms have a risk committee and an audit committee. Firms with both committees might want to ensure a mem- bership overlap, perhaps at the chairperson level, with the chair of one committee sitting as @ member of the other. There is no single correct way to organize a risk function to suit every firm. Financial sector firms, particularly those engaged in trading, are challenged to have risk managers ‘who are independent from trading but who have sufficient market focus to understand the trades. The essential issue here is the balance of power and know-how between the back office and the front office. Some financial firms use a decentralized or distributed model in which risk managers report to the business head or chief financial officer of the trading business unit. In this structure, the risk manager is ‘embedded in the business. ‘Other firms prefer a centralized model, with a risk depart- ment headed by a chief risk officer reporting directly to the chief executive officer. The structure tends to elevate the authority of the risk officers within the enterprise. ‘Some firms use hybrid structures, balancing between cen- tralized and decentralized models depending on the com- plexity of the business. Regardless of the structure used, financial institutions must recruit individuals with signifi- cant business/trading experience who hold advanced degrees to assume positions as senior risk managers. In the real sector, the issues focus more heavily on the relationships between chief risk officer, internal auditor, and the board, Here, too, there is no consensus on a right or a wrong approach. Increasingly, however, the chief risk officer has @ matrix reporting relationship to the board, or risk committee as well as a daily administrative report- ing line to the chief financial officer or the chief execu- tive. Some firms have combined their risk and internat audit functions; the most senior officer assumes the dual reporting position.Chapter 1 Emerging Market Example: Bank in Colombia ‘Ata retail commercial bank in Colombia, the board has a joint audit and risk committee chaired by an’ independent director~a qualified economist formerly. employed in the supervision unit of the central bank. The board committee is supported by a risk ‘committee with a membership of senior executives including the CEO and chief risk officer~CRO. The CRO reports to the CEO and meets monthly with the chair of the joint audit and risk committee. The risk committee coordinates the work of its three supporting committees: credit risk, operating and security risk, and asset and liability management committee. In keeping with Basel ll requirements, capital adequacy is monitored daily using VaR and stress testing. However, most of the bank's risk policy focuses on credit risk. Thore are detailed approval limits, credit scoring, and credit concentration limits by client and sector. The bank also prioritizes security issues, relying on external consultants for assistance. Balancing Quantitative and Qualitative Decision Making Recent increased interest in behavioral finance has reminded us that despite the numbers, understanding the human element is an important part of risk decision mak- ing. Becoming too dependent on numerical risk measures can also lead managers to ignore risks that do not have a ‘quantitative basis. Good risk takers are the managers who can balance quantitative and qualitative factors in thelr decision making, Implications for Decision Makers Building a successful risk-taking organization requires sev- ‘eral components, To become a better risk taker than the competition, a firm has to have competitive advantages. It has to act faster than everyone else, with better informa- tion, and to better effect. Good risk takers gain their status by design, both in strat- egy and organization structure. First, the right people are required; good risk takers are not always good orga- nizational people. Second, they must have a stake in the Risk Taking: A Corporate Governance Perspective 39 outcome that makes them think like the owner. Com- pensation systems should reward the right processes for dealing with risk, rather than outcomes. Third, a corporate structure and culture compatible with good risk taking must be built. Section Task: Assess the Risk-Taking Capabilities in Your Organization/Firm Your Organization’s Dimension Standing 1. Are the interests of managers aligned with the interests of capital providers? Aligned with stockholders Aligned with bondholders Aligned with their own interests 2, Do you have the right people in place to deal ‘with risk? Too many risk takers Too many risk avoiders Right balance 3. [s the incentive process designed to ‘encourage good risk Discourages all risk taking Encourages too much risk taking taking? Right balance 4. What is the risk Risk seeking culture in your Risk avoiding ‘organization? No risk culture 5, How much flexibility do you have to exploit upside risk and protect against downside risk? Good on exploiting upside risk Good in protecting against downside Good on both SUMMARY Basic Steps in Building a Good ‘isk Management System ‘The steps in building a good risk management system are outlined below: 11. Make an inventory of possible risks. The process has to begin with an inventory of all the potential risks to which a firm could be exposed. This will include firm-specific risks, risks that affect the entire sector, and macroeco- nomic risks that have an influence on the value.40 Financial Risk Manager Part I: Foundations of Risk Management Main Propositions about Risk 1. Risk is everywhere. 2. Risk is threat and opportunity. 3. People are ambivalent about risk and not always: rational in the way they deal with it. 4, Not all risk is created equal: small/iarge, symmetric/ asymmetric, continuous/discrete, macro/micro. 5, Risk can be measured. 6. Risk measurement and assessment should lead to better decisions, 7. The key to risk management is deciding which risks, to hedge, which risks to pass through and which risks to take, GOOD RISK MANAGEMENT = GOOD MANAGEMENT 2. Measure and decide which risks to hedge, avoid, or retain based on impact on enterprise value. Risk hedging is not always optimal and can reduce value in many cases. Having made an inventory of risks, the firm has to decide which risks it will attempt to hedge and which ones it will allow to flow through to its investors. The size of the firm, the type of stockhold- ers that it has and its financial leverage (exposure to distress) will all play a role in making this decision. In Addition, the firm has to consider whether investors can buy protection against the risks in the market on thelr own, 3. For the risk to be hedged, select appropriate risk- hedging products and decide how to manage and monitor retained risks. fa firm decides to hedge risk, it has a number of choices. Some of these choices are market traded, such as currency and interest rate derivatives; some are customized solutions, such as those prepared by investment ‘banks to hedge against risk that may be unique to the firm; and some are insurance products. The firm has to consider the effectiveness of each of the choices as well as the costs. 4. Determine the risk dimensions that provide an advan- tage over the competitors and select an organiza tional structure suitable for risk taking. Here, the firm moves from risk hedging to risk management and from viewing risk as a threat to risk as a potential opportunity. Why would one firm be better at deal- ing with certain kinds of risk than its competitors? It might have to do with past experience. A firm that has operated in emerging markets for decades clearly has a better sense of what to expect in a market melt- down and how to deal with it. It also might come from, Guidance on Risk Over: Mitigating Risk The goal of a risk program is mitigation of risks in. strategy implementation. The board should encourage through written policies and actions a "tone at the top” that shows ethical integrity, legal compliance, strong, controls and strong financial reporting, Strategy and Risk Appetite ‘To fully assess an enterprise's risk appetite, the board must engage in reviewing the enterprises strengths, ‘weaknesses, opportunities, and threats. A fully developed risk profile encompasses the impact on stakeholders including employees, customers, and suppliers. Risk Identification Directors should probe the legitimacy and scope ‘of management's risk assessments. They must help ht from National Association of Corporate Directors Identify potential risks and provide scenarios that the ‘managers may not have considered, Unforeseen risks ‘cause the most problems for companies, Monitoring Risk ‘The board should continually monitor the financial health of the firm, ensuring accurate accounting and safekeeping of corporate assets. An important element of risk identification and monitoring is ensuring the information relied upon is high quality. dependable, and timely. Crisis Response — The board is responsible for ensuring that sound crisis planning has occurred. During a crisis it should remain informed and the board or a committee of the board ‘should remain in contact during the period in which the situation is most critical.Chapter 1 Risk Taking: A Corporate Governance Perspective a the control of a resource—physical or human—that gives the company an advantage when exposed to the risk. Having access to low cost oil reserves might ive an oil company an advantage if oil prices drop. ‘A superior legal team might give a tobacco company a competitive advantage when it comes to litigation risk. Firms also must recognize that risk taking hap- ens within an organizational context, and the appro- priate risk systems, processes, and culture must be built. The Most Important Ingredient in Risk Management Is Luck! There is so much noise in this process that the dominant variable explaining success in any given period is luck and not skill. Proposition 1: Today's hero will be tomorrow's goat. The opposite is true as well. There are no experts. Let your common sense guide you: Proposition 2: Don't mistake luck for skill. Do'not over react either to success oF to failure. — Proposition 3: Life is not fair. You can do everything right and go bankrupt. You cen do everything wrong ‘and make millions. .Financial Risk Manager Part I: Foundations of Risk Management APPENDIX cpu Tere “ACCEPTABLE BETTER “DESIRABLE ——=—=BESTPRACTICE TT Gxabishment? 1. Any wniten docs 1. Incorporated inby- 1. ‘Incorporated incorporate. Samet mrencincaing— lawrorceporate Charter ovaries fa ____Honrdresoliton, __govemance gue tr eating tbe 3 Same and ensring iC Same. fim’sisk polices, thatsenrmanoge- 2. Reviewing the adequacy 2. Same Inching rk oles ment aks ope ofthetinnscaptatand 3. esabishing an dees consent necesayto‘denti, Slocatonstovariousenterpree ge Grtntherskiman- ‘measure montorand business unis consider. ak management Spemert progam conor: ing te types ndszes framework ora (senso Seeson Frits at those business companies inthe sa Ti. Composition 1. Atleastithvee board iL Same members. 2. Material presence of Majority indepen- non-executive board 2. Majonity non-execitie dent members. members board members. 3. Rotation of members. 4 Limit on number of memberships on ‘ther board com- rites, 5, 'Nomore than one comrrittee member serves on both the Rsk Poicy and Audit ‘and Compliance Bg EES Committees. Indhvidual 1. Committee overall committee 1. Some 1 Same. Committee hasroquistestils -membershave requi- 2. Same 2. Same. Membership and knowledge siteskils and know 3. Same 3. Some, (Qualifications adequate 10 edge adequate to 4.-Pesodic profesional 4, Same, fversee the fim’s overs the fir's elk education/raning forall 5._Less than 75 percent fskmanagement management program, committee members. attendance at com- program. 2. Same mittee meetings in 2. Time and desire 10 3. Intvoductory briefing fone year automatic fulfil obtigations for all new committee ‘threshold for nan members. pointe "Overall rak management i generally considered to be pray the responsiblity of execulive management. Risk governance the responriity ofthe board The beards role is to establsh the frm’ general risk pnlosophy and rik tolerances in coch material busines area, and to provide oversight a! the compar’ risk policies and procedures so at ensure that management implements 3 robust rik management progrom- + ase document prepared by Sinclair Capital a 95 afiiate 2 itmay be acceptable incase of rlativey small or sie rms thatthe board of directors has no formal “sk” committee, but ful board regularly checusres nak phlorophy and tolerance lsues, and reviews the adeduacy of zk management as routine Its stratecie and operational review Alternately, the functions ofthe risk policy commttee are sometimes combined with thors of the ‘Audit and Complance Commitee, However, given the canralty of risk management to financial ntitutons, and the requirements of Basel itis function that should be assumed either bythe full Board of crectors, in whats ineroasingy considered best practice, the board should astaolish a separate Rsk Policy Commitee. * Bylows refer to internal corporate documents tht da not have to Be filed externally th corporations registry or the regula. + "Same" Indeatos thatthe recommendation of the identical number inthe column immediately tothe lefts caried over into tho ‘column. should the recommendation be only partiaiy dentical, any differences are alcized. Imjurscetion withthe so called two-tiered board systems, the non-executive rectors refer to members ofthe supervisory boardChapter 1 Risk Taking: A Corporate Governance Perspective Df 43 ESIRABLE Same. i 1 Same, Chair eecutivebostd 2. Same 2, Same chair, board as 2 3. |sanindependent board whole, or the com- member mittee. 2, Has equi sis : ‘and knowledge. ‘adequate to ‘oversee the fms Fisk management re Se poster eee strated VL Appointment 1. Appointed by Same, with fultoard 1. Seme 1. Same, board chair, board ratification ofcommit- 2: One-year renevable 2. Same. 252 whole or tee members where terms. Corporate Gover- nomination i by chair nanceiNominations or Corporate Gover- Committe, ‘rancelNominations 2. Fixed terms, Committee, preferably annual, 2. Fed terms, prefer. butnotesceeding aby annual, but not ‘Vi Remuneration 1.” Is solely related ‘Apmual ommitzetees. 1 Same, (i addition to” to fulfling the 2. Same. 2 Same F Compensation obligations of 3. Additional per meeting 3._ Same. for workas ‘committee prefered form. fees 4 Same. aMember of: member (no form 2. Adequatelevel of 4._Aditional fee fox char the full Board’ of payment which "payment soas to ‘would compromise create expectation of independence eg, responsiblity. = Salary, consulting, ‘finders fees, et): 7 Biseative diveclor- members of the Rsk Paley Commitee do not got adaiional emnunovaion Tor thew services on the commen * tmadditon te regular committee meetings, extraordinary meetings may be held whenever needed end appropriate with agenda set inFinancial Risk Manager Part I: Foundations of Risk Management DESIR 1. Maybecaledby 1. Same, 1. Same, andby any two 1. Same. thecommittee” 2. Same committee members, 2. Same. chai, 3. Atleast quartery. 2. Same. 3. Same, 2. Approved annual 4, Meetings may bere- 3. Same 4 Same. ‘calendar of regular quested by theboad 4. Same. 5. Same, meetings chai, CEO, CFO and 5. Meetings maybein 6. Same. 3. Atleastsemiannu- Chief fisk Officer. person, by telephone, ally ‘web, oF other electronic communication means agreeable to committee 6. Ablity to act by unani- - ‘mous written consent. 1K Attendance 1) Quorum required. 1) Sarte,apdisimple ma- | i. Same: 1 Samm. and Notice 2 Advance notice Jity as. minimum 2. Same, and with °°2, Same, and with require: may 2. Same. ‘minimum 48 hour notice. minimum 1 week bewavedwith 3. same : 3. Sane iosice, ‘unanimous writen 4 Minas tobe prepared 4 Sam 3. Same. consent. anddétrbutedto 5. Same. 4 Same, 3. Approved annual committee members. 6. Sama 8 5. Same, ‘alendar of regular —Theboard has acess io 7: The Chef of internal 6. Same. ‘meetings. review ther © Audithe External 7. Same ‘5. Agenda and related 18 Independent ‘materials to be © members ofthe provided in advance otices of allmeetings: committee meet ‘Unless the cha (or : ‘without executive ‘other convenes) : © offices present at believes confident : each Committee © ty requies otherwise, 2 ‘meeting. inwhich case general descption of subject ae ‘of the meeting to : be crculated, witha fies eee statement fom the Ree chair as to reasons fot confidentiality 6. Chit Fik Officer ang other executive officers attend the meetings? “inaditon to regu coimittee mesings extraordinary meetings may be held when needed and appropriate with agenda set in advanceChapter 1 Risk Taking: A Corporate Governance Perspective 4s DESIRABLE BEST PRACTICE X Reporting to 1, Verbalorwritten 1 1. Same. 1 Same the Board and" reports tothe minutes tc the board 2. Same. 2. Same, Shareholders _boardas needed. following each com- 3. General eportoncom- 3, Same, and includes 2. Annual wniten mittee meeting mittee activities induded ~queitatve and report to the 2 Same. inthe firm's annual quantiative data en- board report. abiing shareholders ‘and general pubic tounderstand the fis sk profile and policies. Ki Eelaaton®™ 1. Annual evaluation of 1. Same : see ‘work the committee 2. Some. Sere has performed over the 3, Periodic evaluation ne c previous yes. of the Commit Bee _ 2. Annual evaluaton of tee Charter, with commitee effectiveness, written report to the including processes and __boatd suggesting procedures improvements, ay, 4, Petodicindepen- dent evaluation of ae. A committee effectve- i. Authority and 1. Having acess to al 1. Same. Same, without meces- 1. Same. , Resoures internal resources, 2. Recommending hing sarlygoing through 2._‘Same. of outside resources the hierarchy (though 3. Same. (eg.tikmanagement the hiererty should be 4. ‘Receiving an annual consultants, course), respected absent com- budget sufficient to ae needed, pling reasons toroid achieve committee ” feeds, and having 2. Having the right to the right to acess ie ouside resources ‘ddtonal funds in without executive ap ‘unforeseen circum- prov stances 3. Authorizing, orcon- ducting, any investiga tions within ts area of responsibility; having the fight to hie indepen dent experts for such investigations, approve terms of such engage= ments, and having such investigations paid for by ‘Tne Corporate Governance/ Nominations Committee may coordinate evaluation ofthe board and al committees at some CompaniesFinancial Risk Manager Part I: Foundations of Risk Management Xl, Responstiliies 1. Reviewing and ee 1. Same, and approv. 1. Sam, and approving 1. Same. =Poliesand —ommending to the ing management's ‘maximum credit expo- 2. Same. Procedures board, in conjunc: recommendations ‘sures for top cients and 3. Same. tion with execute for overal credit and counterparties, so.asto 4. Same officers, proposed marke isk ents, a5 insure diersifcaton. —§. Same aagregateloss limit wells courtyrsk 2. Same 6. Same. targets for various Iimits for non-domestic 3. Same. 7. Same. isk categories (eg. exposures 4 Same, 8 Same, loan losses, market 2. Same. 5. Same. 9. Same, losses, operational 3. Same, andoverseeing 6. Same 40. Same fis. the implementation of - 7. Same, and ensuring 11. Same. 2, Reviewing the the isk management. that isk measurement! 12. Same, Firms sk manage- program andveview- management function. 13. Same. ment infrastructure ing ts quality and has adequate expertse 14, Proactively monitor and control systems soundnes. nd esources to ffilts ing "best practice” toensure adequacy 4. Same responsibites, tisk management rwenforceFim’s 5. Some, 8. Same, developments. risk plies. 6. Receiving exception 9. Reviewing and recom- 3. Ensuring that reports. ‘mending tothe board management (eg, 7. Ensuring that nse approval of rsk mea: (CEO and Chief isk measurementman- surements and rating Office) develons agement function is ‘methodologies including comprehensive independent of any any to Be reported to fiskmanagement line business function. regulators. program. 8. Being consulted by the 10, Reviewing assumptions “4, Reviewing manage- CEO onthe appoint. _ usedin sk measurement ments determi= ment of the Chief Rok modes Insuring that ation of what Officer. model isk sues have constitutes key ‘been properly considered. balance sheet and 11, For bank in particular, offealnce sheet reviewing stress tests On fiks edi liquidity, market 5. Overseeing the ‘and operational sks, Ciel Risk Officer approving contingency. andthe annual planning, plan of his ati 12 Reviewing the level of Ses, elegated authonty. 13, For banks, monitoring the fm’ preparations and implementation of Basel with respect to risk management and IV, Responsibilities 1. Regularly recening 1. Same. 1 1 Same Specific Rsk "summary iskdata 2. Regularyrecening 2 2. Some Reviews and comparing sisangregated data of 3. 3. Same ata to adopted rmajorrskcategories 4. Same. Same risk policies from from responsible man- 5. Receiving copy ofthe 5. Same responsible manag- agers (CEO, Chief Rsk executive evaluation of 6. Same. ers (CEO, Chet Risk Officer, the Chef Risk Officer. 7. Reviewing reports Officer, 3. Forbanks,receling 6, Reviewing exposures toon financial comp requarteporsfiom the major cients, counter- ance issues such as ‘asset laity committee paris, counties, and Compliance risk and andor the management economic sector for banks, mon Fake committee ‘eylaundering risks 4. Receiving and acting (Unless specifically ‘on compliance and reserved for the interna audit reports ‘Audit and Compl- that are relevant to the ‘ance Committe) Fisk function,Chapter 1 Risk Taking: A Corporate Governance Perspective a7 ABOUT THE AUTHORS Oliviero Rogal is the chairperson of the International Risk ‘Management Conference, a professor of corporate finance at the University of Florence, and a visiting professor at New York University’s Stern Salomon Center. Roggi earned his PhD in Management and Finance at Uni= versity of Bologna and City University Business Schoo! European Joint PhD program in 1998 and his BA in benk- ing from the University of Florence. He was a visiting researcher at City University Business School from 1998 to 2000 and was appointed assistant professor in corporate finance in 2000. He has been a professor of corporate finance at the University of Florence since 2004, Rogai served as board director, consultant and certified auditor for several publicly-listed companies. In 2008, he founded the NYU Stern Salomon Center, the International Risk Management Conference, together with Edward Alt- man. The conference is Europe's leading interdisciplin- ary conference on risk management. In 2008-2009 he served as a visiting professor for the Accounting Mas- ters Program at Brazil's Universidade de Fortaleza. He js a consultant for the European Commission, Regione ‘Toscana (Italy) and for publicly-owned entities, and has been conducting research in the area of Enterprise Risk Management since 2004. He is a member of the Scientific Committee of the Country Risk Forum of Associazione Bancaria Italiana (ABI, the Italian Bankers Association). Rogai has published papers and books on SME ratings and on rating models. His book, Risk Value and Company Default was published in 2009. He co-authored the third Italian edition of Applied Corporate Finance with his cok Teague Aswath Damodaran. He has worked as a consultant for IFC since 2010. Maxine Garvey specializes in strategic and financial analy- sis for enhancing the effectiveness and efficiency of enter- prises. She currently is a senior corporate governance officer at IFC and the project lead for the SME Integrity Program. She has worked in Latin America, Asia, Africa, and Europe on World Bank Group projects. She leads the risk management, reporting, and internal control work for the Corporate Governance Unit. Prior to joining IFC, Dr. Garvey worked as a management consultant with Analysis Group (New York), AT Kearney Toronto) and PriceWaterhouseCoopers (Kingston). She provided advisory services in strategy and financial man- ‘agement, working with firms in a wide range of industries, Including financial services, telecommunications, and retail. Dr. Garvey has taught strategy, finance, and inter- national business at New York University and the Mona ‘Schoo! of Business (MSB), University of the West Indies. In addition, she has worked as a manager in industry and consulting firms. She has authored several publica- tions and has served as a board member in the financial, services industry. She started her career as an auditor at KPMG and is a member of the American institute of Certi- fied Public Accountants, the Strategic Management Soci ety and the Academy of Management. Aswath Damodaran holds the Kerschner Family Chair in Finance Education and is a professor of finance at New ‘York University Stern School of Business. Professor Damodaran holds MBA and PhD degrees from the University of California, Los Angeles, as well as a BCom in accounting from Madras University and a PGDM from the Indian Institute of Management Bangalore, Before taking his position at NYU, he served as visiting lecturer at the University of California, Berkeley, from 1984 to 1986. He has received awards for excellence in teaching from both universities and was profiled in Business Week magazine as one of the top 12 business school professors in the United States. He has written several books on equity valuation, as well as on corporate finance, and is widely quoted on the sub= ject of valuation, He is widely published in leading journals of finance, including The Journal of Financial and Quan- titative Analysis, The Journal of Finance, The Journal of Financial Economics, and the Review of Financial Studies. He teaches for the TRIUM Global Executive MBA Program, an alliance of NYU Stern, the London School of Economics ‘and HEC School of Management. Damodaran also teaches for the Master of Science in Global Finance, a joint pro- ‘gram between Stern and the Hong Kong University of Sci ence and Technology.a8 Financial Risk Manager Part I: Foundations of Risk Management Selected References AIRMIC, IRM. “A Risk Management Standard.” Association of Insurance and Risk Managers, Institute of Risk Manage- ment, 2002. Allen S. , Financial Risk Management: A Practitioner's Guide to Managing Market and Credit Risk. Hoboken: John Wiley & Sons, 2003. Altman E:|, "Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy.” Journal of Finance, vol. 23. n. 4 (1968); 589-609. Altman E.l.“A Further Empirical Investigation of the Bankruptcy Cost Question,” Journal of Finance, vol. 39, n 41984): 1087-1089, Associazione Bancaria Italiana. Loss given default: aspetti ‘metodologici e proposta di una struttura dati per la stima. Roma: Bancaria editrice, 2002. —. Commissione Tecnica Per Gli Studi. Metodi avan- zat per la gestione del rischio di credito. Roma: Bancaria, 1995. AS/NZS 436°. Risk Management Standards Australia and Standards New Zealand, 1999. Banks E. Alternative Risk Transfer integrated Risk Manage- ‘ment through Insurance, Reinsurance, and the Capital Mar- ket. Cambridge: Wiley Finance, 2004. Basel Committee on Banking Supervision. “The Internal Ratings-Based Approach,” consultative document. Basilea: Bank for Intemational Settlements, 2003. "International Convergence of Capital Measurement and Capital Standards: a Revised Framework.” Basilea: Bank for International Settlements, 2004, Beder, TS.(’VAR: Seductive but Dangerous.” Financial Analysts Journal, September-October 1995. Cattaneo, M. Analisi Finanziaria e di bilancio. Milan: ETAS libri, 1976. —. Finanza Aziendale. Bologna: II Mulino, 1998, Copeland, T.E. and V. Antikarov. Real Options: A Practitio- ner's Guicle. New York: Texere, 2003. Damodaran, A. Investment Valuation, Second Edition. New York: John Wiley & Sons, 2005. Damodaran, A. The Dark Side of Valuation, Second Edi- tion. New York: Prentice Hall, 2008. — Applied Corporate Finance, Third Edition. New York: John Wiley & Sons, 2009. DeMarzo, PM. and D. Duffie. “Corporate Incentives for Hedging and Hedge Accounting.” The Review of Financial ‘Studies, v8 (1995): 743-771 Dolde, W. “The Trajectory of Corporate Financial Risk Management" Journal of Applied Corporate Finance, v6 (1993): 33-4, Hertz, D. “Risk Analysis Business Review, 1964. in Capital Investment,” Harvard Kahneman, D. and A. Tversky. “Prospect Theory: An Analy- sis of Decision under Risk.” Econometrica, v47 (1979): 263-292 Kahneman D., P. Slovic, and A. Tversky. Judgement under Uncertainty: Heuristics and Biases. Cambridge: Cambridge University Press, 1982. Kaplan, M. and E. Kaplan. Adventures in Probability. New York: Viking Books, 2006. ‘Knight, F-H. Risk, Uncertainty and Profit. New York: Hart, ‘Schaffner and Marx, 1921. Lewent, J. and J. Kearney. “Identifying Measuring and Hedging Currency Risk at Merck." Journal of Applied Cor- porate Finance, vol. 2 (1990): 19-28. Lintner, J. "The Valuation of Risk Assets and the Selec tion of Risky Investments in Stock Portfolios and Capital Budgets.” Review of Economics and Statistics, 47 (1965): 13-37 Markowitz, H.M. “Portfolio Selection.” The Journal of Finance, 7: (1952): 77-81. Meulbroek, L. “Integrated Risk Management for the Firm: A Senior Manager's Guide." Journal of Applied Corporate Finance, vol. 14 (2002): 56-70. Mian, S.L “Evidence on Corporate Hedging Policy.” Jour- nal of Financial and Quantitative Analysis, vol. 31(1996): 419-439, Miccolis J,, and S. Shah S. Enterprise Risk Management: An Analytic Approach. Tillighast-Towers Perrin, 2000.Chapter 1 Risk Taking: A Corporate Governance Perspective 49 PricewaterhouseCoopers. “Enhancing Shareholder Wealth by Better Managing Business Risk.” International Federa- tion of Accountants, 1996. Rappaport A. Creating Shareholder Value: the New Stan- dard for Business Performance. New York: Free Press, 1986. Reen J, "Three Decades of Risk Research: Accomplish- ment and New Challenges.” Journal of Risk Research, United Kingdom, 1998. Rogai ©. Valore intrinseco e prezzo di mercato nelle oper- azioni di finanza straordinaria. Milan: Franco Angeli, 2003. Roggi O. "Basel Il and Default Risk Estimation,” Confer- ence proceedings, 2007. —. "Small Business Banking and Financing: a Global Perspective.” Cagliari, 2007, Sharpe, William F. “Capital asset prices: A theory of market equilibrium under conditions of risk.” Journal of Finance, 19: 3 (1961): 425-442. ‘Smithson, C. “Does Risk Management Work?” Risk (July 1999); 44-45. Taleb, N.N. Fooled by Randomness. New York: Texere, 2004, Tufano, P. "Who Manages Risk? An Empirical Examination of Risk Management Practices in the Gold Mining Indus- try" Journal of Finance, vol. 51 (1996): 1097-1137.Sian ratatata taser esata taeaaennn as epee SSeS eR ara Ee aero aG ee eRe Tae Rasta ttasarararata re sar er aea ranean earn tara rae SSeS RRS Rea earner Nene eRe RENEE eae SESE SES Ree ae ee eee ee ee eee eae Senn Se a ee eee pa tetataeseeaea tate ee tae tetas saa aetna taceeatateracacetatecaeetecaeaeicateceents a Gocatarntaraeneneer st seat aeor sear neat? por ar Sat ae ateS sari rar urasiroer oe arar snr ae Er neat aaa a cpeeareok rope recon root ro rentraede Base cestcareca ra naoe Peon apa rean Te caaeCR eae ce OR REOR TE RDe aE Pate a eee ae eeer ec aeataeaen SERRE SEES PURE ReC SESE aC ERE HERE SE SE RC OEE SEnE SEHR AERIS SEE ERE SESE Paras nearararnraeatucaenrersenr se nenracaen BEE OE SEH RERE SEE HEREC RC HE Her eae HEENE HEE He SESE RERE Nene BCSCR SES Saroeoenraraenr acsenruestar seat aear acy oc SERENE ese Seseseae Me ae ne nase sae BE DERE GENE SESE NE SEES Poca aenrueaeacac sear nen oeaeoeeraearaet senes Soe Seen SuSE Senet ie Sassi eae eee aS gororarornroencoceraceorseorscar arora Paredes ated turnrerar ac asatnear arene aaRES RESEeRR ERR oeenenece Ree ee Henc Hee REECE pEseR Dees ae ne see Rene nese se seae ae Buenensene ease scene sea ae neg ef Pentre aeeraene mata aae peteeeerecaenrs pecaeacoencacnaroen eecoeecoencoencs pereeareree na Soeenenesenenes Seaeeceenr ae aeeruc ear ararts pococuendnrataes poeeracatar sea paraenearaecee iecacacecaeetacaearae seteeneeesroes Bo esene seeune Se SCRraeRene naeeocnenencnes ovaraencacneae neat eats coesessseneacaes Posner esereeaeataenetat parerareracadee sens coesesacs coro aeeraeeevene et Sueaeene sear seated Parenter nr ar near ce arin ae aE eg aeGes cuenraenrencoenraenes Poca aces ncnanc acer srarerarasnae ants Soreeereracaenc ae atars Scene nae Nene MeRR a Sen eRe Hee ees garneneacocncacoencs Ser aPaESroeeSr EN ae roe oeRE oH SueReorsesese secure ten PorRRnr ete rRS REC eater aCe aS Boesesenene scans sencacatarotareenr sears sueneeenes Sucocaroeneaeneaes BaRoGne nent sear Se sene sane er aeay SeSenr SES gaceeeteceendecuanrs ECE REESE teehee Srenenraenee ness nes eases eter eee enras nen atar saat ces Ree e rater eseearoea coencs pee aeocecoreravaanracaes meneae eae oe Hee seat ane pEeReReReceae Geese ne aenese ae cTene Seen aenenes pacaeetetaceracoeers coenractnccee peeararse arse seat Wear sere sane oeer sere Pac ae arc oene acum crater ear ets : sereeonataeaearacaenes geben ee Sea ceeetesenereces cera raratanani NCR sEenEESucE ee PRG SESE Rae SN SS ete ete at at re ee et eR re PoC a irae Meer Uae STR SEES ENE SE RE NESE SESE See HERE Nee a a ee eae nO ESE Be EEE ERE NESE ENE Ne EDEN NEMESIS PPR PRET ERE ESE ERE DENCE Ne Dane DED SE Haar Hen a Net Hee MEE SENSES RE SER EE Bara ER HE RTE HS MEE Raa nC aaa EE SES ERC SRE SCR NS SE SERS GENE E EES eee eae near ene ae ar erneRE ne nene eaneneaeoe parear aera ater or EBEHE Gen : gateeacs SPREE SME HEREC eae eee rant aa secbeer tater aauraeerararaeataroe eaten poroeereraencaeaene® Roancveneotnananenent seneoensoaseneaeseae ven Searcats SNepese senate sane ne sag PSRRRRrachr sear acne abate aene acer seater Gens aaaes peeoeerareeaeaenene ae! SEReSe Hear See NraeTenE deneaene oe neneoes eeaseee sesnreraeucaeseac nes Pace teach usar Sear ene aeReRr ene ae grat caren Braeer acne seaeaeae ar aeees Seenrcaenracarasareenracaenr sear ors paces a syenes Soceearasercaearscaroear scse ae sun es earaears : poraratarararataraeataraentararate Paaatoeass pacaretaceracatreaterataraentaed paerrory DEDEUeReaene aE earners oe se neae ne ae nase eet See oe pocaenearoronnene Bete nnree Senate cenenE Seay SeSeReEESESESESES Soerenes t ora rararneaaataearararasatasReT Cann aeaneS foes Brataeaeer nese ae eae cucu nena as Rese eneneseneeseaeaes sareearararaee ata aeaes poearaeenesenrs Bear ovataeaenr ar aensaeaears Saecenraraccenacoeerur ac narnrs Serene oe nea aenE Ne aenes Pasa Po rae ne aanr nen eae nae aasaeny Paaea ear eeae Ge aS SeEE NES ParaMerncnc ana sear ae aeer sense arses Soeeae eae DeSE SSE TERE RE SERRA HEN IC Hene ona vee Pocecaemcaeneat ne ae near ses Reeser aeenene ne Saas i ParSraPararearaenr sen aenr nee Seearadnracar araranaenraen 5 Paani aerate sea reatea tear ae ae nears Paterna arate ae ate ree aaa Pareeec areca aroenr rata aencaes Beteaeeraearae sane necenr acne | + ReSeneeataearee nen asae aegis BRS aeRE PRE SESreRr GEESE NSS URGE SESE BSreeeracear arene ae neat tenes BORER SCOR NE EEN SESE HE ene ERE poeneseaeacamacaee te es cS ceaeeeariea SERENE See seas FaeSTae Tne necanereeaPea tio Paea? =- Delineating Efficient iol dod okt Excerpt is Chapter § of Modern Portfolio Theory and Investment Analysis, 8th Edition, by Edwin Elton, Martin Gruber, Stephen Brown and William Goetzmann. Learning Objectives After completing this reading, FRM Candidates should be able to: + Calculate the expected return and volatility of a portfolio of risky assets. + Explain how covariance and correlation affect the expected return and volatility of a portfolio of risky assets. + Describe the shape of the portfolio possibilities curve. Define the minimum variance portfolio. Define the efficient frontier and describe the impact on it of various assumptions concerning short sales and borrowing.52 Financial Risk Manager Part I: Foundations of Risk Management In this chapter we look at the risk and return characteris- tics of combinations of securities in more detall. We start off with a reexamination of the attributes of combinations ‘of two risky assets. In doing so, we emphasize a geo- metric interpretation of asset combinations. Itis a short step from the analysis of the combination of two or more risky assets to the analysis of combinations of all possible risky assets. After making this step, we can delineate that subset of portfolios that will be preferred by all investors ‘who exhibit risk avoidance and who prefer more return to less! This set is usually called the efficient set or efficient frontier. Its shape will differ according to the assumptions that are made with respect to the ability of the investor to sell securities short as well as his ability to lend and bor- row funds. Alternative assumptions about short sales and lending and borrowing are examined. COMBINATIONS OF TWO RISKY ASSETS REVISITED: SHORT SALES NOT ALLOWED Previously, we treated the two assets as if they were indi- vidual assets, but nothing in the analysis so constrains them. In fact, when we talk about assets, we could equally well be talking about portfolios of risky assets. Recall that the expected return on a portfolio of two assets is given by Bae R= XR, +X Ry any where the fraction of the portfolio held in asset A the fraction of the portfolio held in asset B the expected return on the portfolio Bis the expected return on asset A Ris the expected return on asset B In addition, since we require the investor to be fully invested, the fraction she invests in A plus the fraction she invests in 8 must equal one, or X+X,=1 "in this chapter and most of those that follow, we assume that ‘mean variance is the relevant space for portfolio analysis. 2 Short selling is defined at a later point inthis chapter. ‘We can rewrite this expression as X= 1-X, @2) Substituting Equation (2.2) into Equation (2:), we can ‘express the expected return on a portfolio of two assets as 8, =X,8, +0-X)R Notice that the expected return on the portfolio is a simple-weighted average of the expected returns on the individual securities, and that the weights add to one. The same is not necessarily true of the risk (standard deviation of the return) of the portfolio. The standard deviation of the return on the portfolio was shown to be equal to (C403 + X33 + 2X X05)” where ‘is the standard deviation of the return on the portfolio 3 Is the variance of the return on security A 93 is the variance of the return on security 8 ‘4 is the covariance between the returns on security ‘A and security 8 If we substitute Equation (2.2) into this expression, we obtain Xio} +0-X, 05 +2X,0-X,2091? 2.3) Recalling that ag = pugitg Where Pg Is the correlation coefficient between securities A and , then Equation @3) becomes 8, = (Xi0} +1-X,05 +2X,0-X Pu 9,64)" 4) ‘The standard deviation ofthe portfolio snot. in general, a simple-welahted average of the standard deviation of tach security. Cross-product terms are involved and the ‘weights do notin general, add to one. In order to lea Geen Eee ro abiren ocean ce Cite cases Involving cfferen degrees of co-moverent between securities, We know that a correlation coefficient has maximum value of +1 and minimum value of ~1. A value of +1 means that two securities will always move in perfect unison, ‘while a value of ~1 means that their movements are ‘exactly opposite to each other. We start with an examina~ tion of these extreme cases; then we turn to an exami= nation of some intermediate values for the correlation coefficients. As an aid in interpreting results, we examineChapter 2 Delineating Efficient Portfolios 83 a specific example as well as general expressions for risk and return. For the example, we consider two stocks: a large manufacturer of automobiles (“Colonel Motors") and an electric utility company operating in a large eastern city ("Separated Edison”). Assume the stocks have the fol- lowing characteristics: Expected Standard i Return Deviation Colonel Motors (©) 14% 6% Separated Edison (S) 8% 3% ‘AS you might suspect, the car manufacturer has a bigger expected return and a bigger risk than the electric utility. Case 1—Perfect Positive Correlation (p = +1) Let the subscript C stand for Colone! Motors and the subscript S stand for Separated Edison. ifthe correla- tion coefficient is +1, then the equation for the risk on the portfolio, Equation (2.4), simplifies to X20} + 1- X,"0 +2X,(1- X_)0,0,1 Note that the term in square brackets has the form X24 2X7 + Y? and, thus, can be written as (%0, +0-X.)0,7 @s) Since the standard deviation of the portfolio is equal to the positive square root of this expression, we know that 0, = X.0,+0-X08, hile the expected return on the portfolio is B= X.R+0-X OR, Thus with the correlation coefficient equal to +1, both risk and return of the portfolio are simply linear combinations of the risk and return of each security, In footnote 3 we The Expected Return and Standard Deviation of a Portfolio of Colonel Motors and Separated Edison When p= + [02] o4[ os | os[ oa | io R, | 80/92] 104| 1 | ne | ize | 140 0 | 36 | 42| 45 | 48 [sa | 60 xo show that the form of these two equations means that, all combinations of two securities that are perfectly cor- related will lie on a straight line in risk and return space? ‘We now illustrate that this is true for the stocks in our ‘example. For the two stocks under study aces, ‘Table 2-1 presents the return on a portfolio for selected values of X,, and Figure 2-1 presents a graph of this rela- tionship. Note that the relationship is a straight line. The ‘equation of the straight line could easily be derived as follows. Utilizing the equation presented above for «to solve for X. yields Substituting this expression for X, into the equation for and rearranging yields* R, =2+20, In the case of perfectly correlated assets, the return and risk on the portfolio of the two assets is a weighted aver- age of the return and risk on the individual assets. There is no reduction in risk from purchasing both assets. This can bbe seen by examining Figure 2-1 and noting that combina- tions of the two assets lie along a straight line connecting the two assets. Nothing has been gained by diversifying rather than purchasing the individual assets. * Solving for X. in the expression for standard deviation yields eo 8 ‘Substituting this into the expression for expected return yields Which is the equation of a straight line connecting security Cand security $in expected return standard deviation space. “An alternative way to derive this equation isto substitute the ‘appropriate values for the two firms into the equation derived in footnote 3. Ths yields54 Financial Risk Manager Part I: Foundations of Risk Management a0 60 e GIUEEES Relationship between expected return and standard deviation when p = +1. Case 2—Perfect Negative Correlation (p= 1.0) We now examine the other extreme: two assets that move perfectly together but in exactly opposite directions. in this case the standard deviation of the portfolio is {from Equation (2.4) with p = ~10) 6, = [X02 + (1 X,)'o? ~ 2X,0~ X_)6,0,1"" (2.6) (Once again the equation for standard deviation can be simplified. The term in the brackets is equivalent to either Of the following two expressions: [x0 == X07 or [-X,0, +0-X,96,F en Thus ¢, is either X96 I~ Xia, “X04 0-X0, en Since we took the square root to obtain an expression, for ¢, and since the square root of a negative number is imaginary, either of the above equations holds only when its right-hand side is positive. A further examination shows that the right-hand side of one equation is simply =I times the other. Thus, each equation is valid only when the right-hand side is positive. Since one is always positive when the other is negative (except when both equations ‘equal zero), there is a unique solution for the return and, risk of any combination of securities C and S. These equa- tions are very similar to the ones we obtained when we had a correlation of +1. Each also plots as a straight line when o, is plotted against X.. Thus, one would suspect that an examination of the return on the portfolio of two assets as a function of the standard deviation would yield two straight lines, one for each expression for o,, As we ‘observe in a moment, this is, in fact, the case* The value of 6, for Equation (2.7) or (2.8) is always smaller than the value of o, for the case where p = +1 [Equation (25)1 for all values of X_ between O and 1. Thus the risk ‘on a portfolio of assets is always smaller when the cor- relation coefficient is ~1 than when itis +1. We can go cone step further. If two securities are perfectly negatively correlated Cie. they move in exactly opposite directions), it should always be possible to find some combination of these two securities that has zero risk. By setting either Equation (2.7) or (2.8) equal to 0, we find that 8 portfolio with X, = o,/(@, + @,) will have zero risk. Since @, > O and ©, + 0, > 0, this implies that 0 < X, <1or that the zero- risk portfolio will always involve positive investment in both securities. Now let us return to our example. Minimum risk occurs when X_ = 3/(3 + 6) = 4 Furthermore, for the case of per- fect negative correlation, @, = -6X, + 30-X,) there are two equations relating g, to X,. Only one Is appropriate for any value of X,.. The appropriate equation to define o, for any value of X, is that equation for which o,, = 0. Note that if @, > O from one equation, then 6, < 0 for the other. Table 2-2 presents the return on the portfolio for 5 This occurs for the same reason that the analysis for p = +1 led to one straight line, and the mathematical proot is analogous to that presented for the case of p = +Chapter 2 Delineating Efficient Portfolios 55 EETIEERY The Expected Return and Standard Deviation of a Portfolio of Colonel Motors and Separated Edison When ee x3 [0 02 [04 | 06 | oa | 10 R, | 80 | 92 | 104 | n6 | 128) | 140 «| 30 | 12 | o6 | 2a | a2 | 60 140} c 100 20] s a0 60 a GIGUEEERY Relationship between expected return and standard deviation when p = —1. selected values of X,, and Figure 2-2 presents a graph of this relationship Notice that a combination of the two securities exists that provides a portfolio with zero risk. Employing the formula developed before for the composition of the zero-risk portfolio, we find that X, should equal 3/(3 + 6) or}. We The equation for a6 a function of «, can be obtained by solv ing the expression relating a, and XC for XC and using thi #2 eliminate ¥ in the expression for R, This yields 14d) 100) 29] 30 60 FEUER Relationship between expected return and standard deviation for various correlation coefficients. can see this is correct from Figure 2-2 or by substituting for X, in the equation for portfolio risk given previously. We have once again demonstrated the most powerful result of diversification: the ability of combinations of securities to reduce risk. In fact, it is not uncommon for combinations of two securities to have less risk than either of the assets in the combination, We have now examined combinations of risky assets for perfect positive and perfect negative correlation. in Figure 2-3 we have plotted both of these relationships on the same graph. From this graph we should be able to see intuitively where portfolios of these two stocks should lie if correlation coefficients took on intermedi ate values. From the expression for the standard devia~ tion [Equation (2.4)], we see that for any value for X, between 0 and 1 the lower the correlation, the lower the standard deviation of the portfolio. The standard deviation reaches its lowest value for p = ~1 (curve SBC) and its highest value for p= +1 (curve SAC). Therefore, these two curves should represent the limits within which all portfolios of these two securities must lie for intermediate values of the correlation coefficient. We would speculate that an intermediate correlation might produce a curve such as SOC in Figure 2-3. We demon- strate this by returning to our example and constructing56 Financial Risk Manager Part |: Foundations of Risk Management SENSEI The Expected Return and Standard Deviation for a Portfolio of Colonel Motors and Separated Edison with p=0 02 |o4 | 06 | 08 | 10 92 jis [us | 28 | 40 268 379-| 484] 60 3.00, the relationship between risk and return for portfolios of our two securities when the correlation coefficient is assumed to be O and +0.5. ‘Case 3—No Relationship between Returns on the Assets (p = 0) ‘The expression for return on the portfolio remains unchanged; however, because the covariance term drops ‘out, the expression for standard deviation becomes Xto2 +0- Xo? For our example this yields 0, = UGX? + @RA- X.Y? 6, = [45X27 -18X, +91 Table 2-3 presents the returns and standard deviation on the portfolio of Colonel Motors and Separated Edison for selected values of X,. A graphical presentation of the risk and return on these portfolios is shown in Figure 2-4, There is one point on this figure that is worth special attention: the portfolio. that has minimum risk. This portfolio can be found in gen- eral by looking at the equation for risk: 6, = (X302 +0-X_ Fo} + 2X,- X,26,0,Peg!* To find the value of X, that minimizes this equation, we take the derivative of it with respect to X,, set the deriva- tive equal to zero, and solve for X_. The derivative is 6, _(1)[2X,02 ~ 202 + 2X_02 + 20.9.c5 ~4X,0,0:9-1] ax, (2) DXtot + 0-08 + 2X0 X08,6,0,5)" Setting this equal to zero and solving for X, yields FE =O.0Pcs ©" Gi +a! - 20,0, (2.9) Pos 140 ea) 30 80 3 Relationship between expected return and standard deviation when p = 0. In the present case (p,, = 0), this reduces to Continuing with the previous example, we find that the value of X_ that minimizes risk is 9 11 Xe" 5456 5 020 ‘This is the minimum-risk portfolio that was shown in Figure 2-4, Case 4—Intermediate Risk (p = 0.5) ‘The correlation between any two actual stocks is almost always greater than and considerably less than 1. To show a more typical relationship between risk and return for two stocks, we have chosen to examine the relation- ship when p= +055. The equation for the risk of portfolios composed of Colo- ‘nel Motors and Separated Edison when the correlation is, Sis 6, = UGX? + GA X, + 2X, - X EXON? 0, = 7X2 +9)" ‘Table 2-4 presents the returns and risks on alternative Portfolios of our two stocks when the correlation between them is 05.Chapter 2 Delineating Efficient Portfolios 37 BETSEY The Expected Return and Standard Deviation for a Portfolio of Colonel Motors and Separated Edison When p=05 Xe | 0 02 |o4 | o6 | o8 10, R, | 80 |92 |104 | ne | ize | 140 3.00. | 317 4.33 | 513, | 6.00 3.65 ‘This risk-return relationship is plotted in Figure 2-5 along with the risk-return relationships for other intermediate values of the correlation coefficient. Notice that in this example if p = 0.5, then the minimum risk is obtained at value of X_ = 0 or where the investor has placed 100% of his funds in Separated Edison. This point could have been derived analytically from Equation (2.9). Employing this equation yields 9- 1805) Xe 3536 218)(0.5) In this example (ie. p., = 0.5), there is no combination of the two securities that is less risky than the least risky asset by itself, hough combinations are stil less risky than they were in the case of perfect positive correlation. The particular value of the correlation coefficient for which no ‘combination of two securities is less risky than the least risky security depends on the characteristics of the assets in question. Specifically, for all assets there is some value of pp such that the risk of the portfolio can no longer be made less than the risk of the least risky asset in the portfolio? We have developed some insights into combinations of two securities or portfolios from the analysis performed to this point. First, we have noted that the lower (closer to ~1.0) the correlation coefficient between assets, all ‘other attributes held constant, the higher the payoff from diversification, Second, we have seen that combinations of > The value of the correlation costficient where this occurs is easy to determine. Equation (2.9) is the expression for the fraction Cf the portfolio to be held in X, to minimize risk. Assume X, is the least risky asset. When X, equals zero in Equation (2.9) that ‘means that 100% of the funds are Invested in the least risky asset (ie. X, = 1) to obtain the least risky portfolio. Setting X, equal to zero in Equation (2.9) and solving for pc, GWveS fe, = 84/~ SO when pg, is equal to ¢,/e,. X- ill equal zero, and the least risky “combination” of assets wll be 100% invested in the least risky asset alone. If pis greater than o./o,, then the least risky combi- ‘ration involves short selling C. 140 30 60 o GIEUAEERA Relationship between expected return and standard deviation of return for various correlation coefficients. two assets can never have more risk than that found on a straight line connecting the two assets in expected return standard deviation space. Finally, we have produced a simple expression for finding the minimum variance port- folio when two assets are combined in a portfolio. We can Use this to gain more insight into the shape of the curve along which all possible combinations of assets must lie in expected return standard deviation space. This curve, which is called the portfolio possibilities curve, is the sub- lect of the next section. THE SHAPE OF THE PORTFOLIO POSSIBILITIES CURVE Reexamine the earlier figures in this chapter and note that the portion of the portfolio possibility curve that lies above the minimum variance portfolio is concave while that which lies below the minimum variance portfolio is convex.* This is not due to the peculiarities of the exam~ ples we have chosen but rather is a general characteristic of all portfolio problems. © A concave curve is one where a straight line connecting any two points on the curve lies entirely under the curve. If curve is convex, a straight line connecting any two points les totaly ‘above the curve. The only exception to this is that a straight line is both convex and concave and so can be referred to as either58 Financial Risk Manager Part I: Foundations of Risk Management This can easily be demonstrated. Remember that ‘the equations and diagrams we have developed are appropriate for all combinations of securities and portfolios. We now examine combinations of the mi mum variance portfolio and an asset that has a higher return and risk. Figures 2-6a, 2-6b, and 2-6c represent three hypoth- esized shapes for combinations of Colonel Motors and the minimum variance portfolio. The shape depicted in 2-6b cannot be possible since we have demon strated that combinations of assets cannot have more risk than that found on a straight line connecting two assets (and that occurs only in the case of perfect pos- itive correlation). But what about the shape presented. in Figure 2-6c? Here all portfolios have less risk than the straight line connecting Colonel Motors and the minimum variance portfolio. However, this is impossi- ble. Examine the portfolios labeled U and V. These are simply combinations of the minimum variance portfo- lio and Colonel Motors. Since U and V are portfoliés, all combinations of U and V must lie either on a straight line connecting U and V or above such a straight line? Hence 2-6c is impossible and the only legitimate shape js that shown in 2-63, which is a concave curve. Analo- ‘gous reasoning can be used to show that if we con- sider combinations of the minimum variance portfolio, and a security or portfolio with higher variance and lower return, the curve must be convex, that is, it must look like Figure 2-7a rather than 2-7b or 2-7¢. Now that we understand the risk-return properties of, ‘combinations of two assets, we are in a position to study the attributes of combinations of all risky assets. The Efficient Frontier with No Short Sales In theory we could plot all conceivable risky assets and combinations of risky assets in a diagram in return stan- dard deviation space. We used the words in theory not because there is a problem in calculating the risk and, return on a stock or portfolio, but because there are an finite number of possibilities that must be considered. Not only must all possible groupings of risky assets be 4 If the correlation between U and V equals +1, they will be on the straight line, iFit is less than +1, the risk must be less, so combina ions must be above the straight line. o GIVES Various possible relationships for expected return and standard deviation when the minimum variance portfolio and Colonel Motors are combined. considered, but all groupings must be considered in all possible percentage compositions, If we were to plot all possibilities in risk-return space, we would get a diagram like Figure 2-8. We have taken the liberty of representing combinations as a finite number of points in constructing the diagram. Let us examine the diagram and see if we can eliminate any part of it from consideration by the investor. An investor would prefer more return to less and would prefer less risk to more. Thus, if we could find a set of portfolios that 1. offered a bigger return for the same risk, or 2. offered a lower risk for the same return, we would have identified all portfolios an investor could consider holding. All other portfolios could be ignored. Let us take a look at Figure 2-8. Examine portfolios A and B. Note that portfolio 8 would be preferred by all investors to portfolio A because it offers a higher returnChapter 2 Delineating Efficient Portfolios 59 Various possible relationships between expected return and standard deviation of return when the minimum variance Portfolio is combined with portfolio S. with the same level of risk. We can also see that port- folio C would be preferable to portfolio A because it offers less risk at the same level of return. Notice that at this point in our analysis we can find no portfolio that dominates portfolio C or portfolio B, It should be obvi- ous at this point that an efficient set of portfolios cannot include interior portfolios. We can reduce the possibil- lty set even further. For any point in risk-return space we want to move as far as possible in the direction of, increasing return and as far as possible in the direction of decreasing risk. Examine point D, which is an exterior point. We can eliminate D from further consideration iven the existence of portfolio E, which has more return for the same risk. This is true for every other portfolio. {a5 we move up the outer shell from point D to point C. Point C cannot be eliminated since there Is no portfo- lio that has less risk for the same return or more return for the same risk. But what is point C? Itis the global Expected return Risk GIEUEEERY Risk and return possibilities for various assets and portfolios. minimum variance portfolio!” Now examine point F. Point Fis on the outer shell, but point £ has less risk for the same return. As we move up the outer shell curve from point F, all portfolios are dominated until we come to portfolio 8. Portfolio B cannot be eliminated for there is no portfolio that has the same return and less risk or the same risk and more return than point 8. Point 8 represents that portfolio (usually a single security) that offers the highest expected return of all portfolios. Thus the efficient set consists of the envelope curve of all portfolios that lie between the global minimum variance portfolio and the maximum return portfolio. This set of portfolios is called the efficient frontier. Figure 2-9 represents a graph of the efficient frontier. Notice that we have drawn the efficient frontier as a con- ‘cave function. The proof that it must be concave follows logically from the earlier analysis of the combination of two securities or portfolios. The efficient frontier cannot contain a convex region such as that shown in Figure 2-10 ° The global minimum variance portfolio Is that portfolio that has the lowest risk of any feasible portfolio.60 Financial Risk Manager Part |: Foundations of Risk Management The efficient frontier. since as argued eartier U and V are portfolios and combi- nations of two portfolios must be concave.” Up to this point we have seen that the efficient frontier is @ concave function in expected return standard deviation space that extends from the minimum variance portfolio to the maximum return portfolio. The portfolio problem, then, isto find all portfolios along this frontier. The Efficient Front Short Sales Allowed In the stock market (and many other capital markets), {an investor can often sell a security that he or she does not own. This process is called short selling, However, the mechanics of short sales are worth repeating here. It involves in essence taking a negative position in a secu- rity, Short sales exist in sizable amounts on the New York Stock Exchange (as well as other securities markets) and the amount of short sales in New York Stock Exchange stocks is reported in the New York Times every Monday. In r with ® Furthermore, there can be linear segments ifthe two efficient Portfolios are perfectly correlated. Since a linear relationship is both concave and convex, we can still refer to the efficient fron- tor as concave. ‘An impossible shape for the efficient frontier a moment we will discuss the incorporation of short sales into our analysis. Before we do so, however, it is worth- while pointing out that we have not been wasting our time by studying the case where short sales are disallowed, ‘There are two reasons why this is true. The first is that most institutional investors do not short sell. Many institu= tions are forbidden by law from short selling, whereas stil others operate under a self-imposed constraint forbidding short sales. The second is that the incorporation of short sales into our analysis involves only a minor extension of the analysis we have developed up to this point. In this section we will employ a simplified description of the way short sales work. This has been the general description of short sales in the literature, but in foot notes we present both the deficiencies of this descrip= tion and an alternative, more realistic description of short sales, Our description of short sales, which treats short sales as the ability to sell a security without own- ing it, assumes that there are no special transaction costs involved in this process. Let us see how this process might work. Let us assume an investor believed that the stock of ABC company, which currently sells for $100 per share, is likely to be selling for $95 per share (expected value) at the end of the year. In addition, the investor expects ABCcompany to pay 2 $3.00 dividend at the end of the year. If the investor bought one share of ABC stock, the cash flow would be ~$100.00 at time zero when the stock is pur- chased and +$3.00 from the dividend, plus +$95,00 from selling the stock at time 1. The cash flows are Time ° Purchase Stock 100 Dividend +3 Sell Stock #95, Total Cash Flow =i00 +98, Unless this stock had very unusual correlations with other securities, it is unlikely that an investor with these ‘expectations would want to hold any of it in his own. portfolio. in fact, an investor would really like to own negative amounts of it. How might the investor do so? Assume a friend, Joelle, owned a share of ABC com- pany and that the friend had different expectations and wished to continue holding it. The investor might bor- row Joelle’s stock under the promise that she will be no worse off lending him the stock. The investor could then sell the stock, receiving $100. When the company pays the $3.00 dividend, the investor must reach into his, ‘own pocket and pay Joelle $3.00. He has a cash flow of $3.00. He has to do this because neither he nor Joelle now owns the stock and he promised that Joelle would be no worse off by lending him the stock. Now at the end of the year, the investor could purchase the stock for $95 and give it back to Joelle. The cash flows for the investor are Time ° 1 Sell Stock +100 Pay Dividend Buy Stock Total Cash Flow +100 Notice in the example that the lender of the stock is no worse off by the process and the borrower has been able to create a security that has the opposite characteris- ties of buying a share of the ABC company. In the real ‘world, Joelle might require some added compensation Chapter 2. Delineating Efficient Portfolios a for lending her stock, but we will continue to use this sim- plified description of short selling in analyzing portfolio possibilities.® It was clear that when an investor expected the return ‘ona security to be negative, short sales made sense. Even in the case where returns are positive, short sales can make sense, for the cash flow received at time zero from short selling one security can be used to purchase ‘a security with a higher expected return. Return to an. ‘example employing Colonel Motors and Separated Edi- son. Recall that the expected retum for Separated Edison was 8% while it was 14% for Colonel Motors. If we disal- low short sales, the highest return an investor can get is 14% by placing 100% of the funds in Colonel Motors. With short sales, higher returns can be earned by short sell ing Separated Edison and placing the investor's original capital plus the initial cash flow from short sales in Colonel Motors. In doing so, however, there is a commensurate Increase in risk. To see this more formally, we return to, the case where the correlation coefficient between the two securities is assumed to be 0.5 and see what hap- pens when we allow short sales. The earlier calculations in Table 2-4 and the diagram in Figure 2-5 are still valid, but now they must be extended to consider values of X greater than 1 and less than 0. Some sample calculations are shown in Table 2-5. The new diagram with short sales is shown in Figure 2-1. The reader should note that with short sales, portfo- lios exist that give infinite expected rates of return. This should not be too surprising since with short sales one can sell securities with low expected returns and use the proceeds to buy securities with high expected returns. For example, suppose an investor had $100 to invest in Colonel Motors and Separated Edison. The investor could place the entire $100 in Colonel Motors and get a return of $14, or 14%, On the other hand, the investor could sell $1,000 worth of Separated Edison stock short and buy ® In the case of actual short sales, a broker plays the role of the friend and demands that funds be put up as security for the loan Of the stock. These funds are in addition to the proceeds from the short sele. Since, in most cases, the amount of the funds that must be put up is quite large and the broker pays no return on these funds, the description of short sales commonly used in the. literature overstates the return from short sales.62 Financial Risk Manager Part |: Foundations of Risk Management EZEEEA The Expected Return and Standard Deviation When Short Sales Are Allowed x | -os |-06 |-o4 =02 +12 +14 +16 8 | +20 R | 20 32 44 56 68 152 16.4 76 188 200 e | 60 513 433 | 365 317 6.92 787 | 384 982 | 10.82 $1100 worth of Colonel Motors. The expected earnings on the investment in Colonel Motors is $154 while the expected cost of borrowing Separated Edison is $80. Therefore, the expected return would be $74, or 74%, on the original $100 investment. Is this a preferred position? The expected return would increase from 14% to 74%, but the standard deviation would increase from 6% to 57.2%. Whether an investor should take the position offering the higher expected return would depend on the investor's preference for return relative to risk In Figure 2-11 we have constructed the diagram for ‘combinations of Colonel Motors and Separated Edison, assuming a correlation coefficient of 0.5. Notice that all Portfolios offering returns above the global minimum vari- ance portfolio lie along a concave curve. The reasoning, for this is directly analogous to that presented when short sales were not allowed. Ge Expected return standard deviation combinations of Colonel Motors and Separated Edison when short sales are allowed, ‘When we extend this analysis to the efficient frontiers of all securities and portfolios, we get a figure such as Figure 2-12, where MVBC is the efficient set. Since com- binations of two portfolios are concave, the efficient set is concave. The efficient set still starts with the minimum variance portfolio, but when short sales are allowed it hhas no finite upper bound. THE EFFICIENT FRONTIER WITH RISKLESS LENDING AND BORROWING Up'to this point we have been dealing with portfolios of risky assets. The introduction of a riskless asset into our portfolio possibility set considerably simplifies the analy- sis. We can consider lending at a riskless rate as invest ing in an asset with a certain outcome (e.g,, a short-term ‘government bill or savings account). Borrowing can be mv GIEUEEES The efficient set when short sales are allowed. ' Merton (1972) has shown that the efficient set is the upper half of a hyperbola.Chapter 2 Delineating Effi considered as selling such a security short; thus borrowing can take place at the riskless rate. We call the certain rate of return on the riskless asset R,. Since the return is certain, the standard deviation of the return on the riskless asset must be zero. We first examine the case where investors can lend and borrow unlimited amounts of funds at the riskless rate. ini- tially assume that the investor is interested in placing part of the funds in some portfolio A and elther lending or bor- rowing. Under this assumption, we can easily determine the geometric pattern of all combinations of portfolio A and lending or borrowing, Call X the fraction of original funds that the investor places in portfolio A. Remember that X can be greater than | because we are assuming that the investor can borrow at the riskless rate and invest more than his initial funds in portfolio A. If Xis the fraction of funds the investor places in portfolio A, (1 ~ X) must be the fraction of funds that were placed in the riskless asset, The expected return on the combination of riskless asset and risky portfolio is given by =20R, + Xi The risk on the combination is 6, = [0 X90? + X703 +2XC1- 98,0, 4)” Since we have already argued that g, is zero, 9, = X03)!" = Xo, Solving this expression for X yields 6, x= Substituting this expression for X into the expression for expected return on the combination yields R (-eJe + sR, Note that this is the equation of a straight line. All com- binations of riskless lending or borrowing with portfolio A lie on a straight line in expected return standard devia~ tion space. The intercept ofthe line (on the return axis) Js R,, and the slope is (R, ~ R,)/a, . Furthermore, the line passes through the point (04, 8,). This line is shown in Figure 2-13. Note that to the left of point A we have com- binations of lending and portfolio A, whereas to the right of point A we have combinations of borrowing and port- folio A. The portfolio A we selected for this analysis had no spe- cial properties. Combinations of any security or portfolio and tiskless lending and borrowing lie along a straight line in expected return standard deviation of return space. Examine Figure 2-14. We could have combined portfolio, B with riskless lending and borrowing and held combina- tions along the line R,B rather than R,A Combinations along R-B are superior to combinations along R,A since they offer greater return for the same risk. It should be ‘obvious that what we would like to do Is to rotate the straight line passing through R, as far as we can in a coun- terclockwise direction. The furthest we can rotate it is through point G™ Point G is the tangency point between the efficient frontier and a ray passing through the point Ron the vertical axis, The investor cannot rotate the ray GISUEGESH Expected return and risk when the risk-free rate is mixed with portfolio A. “in this section we have dravn the efficient frontier as it would tock if short sales were not allowed. However, the analysis is gen- eral and applies equally well to the case where short sales are allowed.64 Financial Risk Manager Part I: Foundations of Risk Management Combinations of the riskless asset and various risky portfolios. further because by the definition of the efficient fron- tier there are no portfolios lying above the line passing through R, and G. All investors who believed they faced the efficient fron- tier and riskless lending and borrowing rates shown in Figure 2-14 would hold the same portfolio of risky assets~portfolio G. Some of these investors who were very risk-averse would select a portfolio along the seg- ment R,~G and place some of their money in a riskless asset and some in risky portfolio G. Others who were, much more tolerant of risk would hold portfolios along the segment G—H, borrowing funds and placing their original capital plus the borrowed funds in portfolio G. Stil other investors would just place the total of their original funds in risky portfolio G. All of these investors would hold risky portfolios with the exact composition of portfolio G. Thus, for the case of riskless lending and borrowing, identification of portfolio G constitutes a solution to the portfolio problem. The ability to deter mine the optimum portfolio of risky assets without hav- ing to know anything about the investor has a special ame. It is called the separation theorem. = The words separation theorem has, at times, been used to describe other phenomena in finance. We continue to use it in the ‘above sonse throughout this book | GISUEESEY The efficient frontier with lending but not borrowing at the riskless rate. Let us for a moment examine the shape of the efficient frontier under more restrictive assumptions about the ability of investors to lend and borrow at the risk-free rate, ‘There is no question about the ability of investors to lend at the risk-free rate (buy government securities). If they can lend but not borrow at this rate, the efficient frontier becomes R,—G-H in Figure 2-15. Certain investors will hold portfolios of risky assets located between G and H. However, any investor who held some riskless asset would place all remaining funds in the risky portfolio G. ‘Anether possibility is that investors can lend at one rate but must pay a different and presumably higher rate to borrow. Calling the borrowing rate R;, the efficient frontier would become R,—G—H-I in Figure 2-16. Here there is a small range of risky portfolios that would be optional for investors to hold. fR, and R; are not too far apart, the assumption of riskless lending and borrowing at the same rate might provide a good approximation to the optimal range G—H of risky portfolios that investors might consider holding. EXAMPLES AND APPLICATIONS In this section, we will discuss some considerations that affect the choice of inputs to the portfolio selection prob- lem and provide some examples of the use of the analysis just presented.Chapter 2. Delineating Efficient Portfolios The efficient frontier with riskless lending and borrowing at different rates. Considerations in Determining Inputs Almost all asset allocation analysis starts out by estimat- ing some of the inputs to the portfolio selection process Using historical data. Analysts usually modify these histori- cal estimates so that they better reflect beliefs about the future. However, before we do so, we will discuss some general considerations in using historical data. Inflation-Adjusted Inputs to Optimization ‘The efficient frontier technology is widely used in prac to make asset allocation decisions for long-term invest- ment, particularly for pension fund assets. When the investment horizon is measured in decades, itis important to consider how the change in the purchasing power of Returns with No Inflation Adjustment 6s currency affects investment choice. In particular, investors may care more about the future purchasing-power value of the portfolio—that is, the value after adjusting for the effects of inflation—than they care about the future nomi- nal value of the portfolio. One approach to this problem Is to apply the efficient frontier technology to inflation- adjusted returns. Table 2-6 compares historical statistics for US. stocks, government bonds, Treasury bills, and inflation. Notice that Treasury bill returns are correlated with inflation and have a larger return when inflation is higher and a lower return when inflation is less. This suggests that Treasury bills may serve as a pattial inflation hedge. ‘Table 2-7 reports statistics for inflation-adjusted returns to stocks, bonds, and Treasury bills. The reader can use these inputs as a starting point when creating an efficient fron- tier for inflation-adjusted returns. Although some securities like Treasury bills provide a par- tial hedge against inflation, there is no “riskless” asset in the above example—even Treasury bills have some expo- sure to inflation. One security recently developed in the United States and used for some time in other countries, such as the United Kingdom, provides a near-perfect inflation hedge. Since 1997, the United States has issued Inflation-linked securities whose value is determined, in part, by changes in the Consumer Price Index (an infla~ tion measure). The return of these bonds varies with infla~ tion, making the bonds a good hedge against inflation. At times, inflation has been over 10% per year in the United States, which means that wealth invested in assets uncor- related to changes in inflation effectively loses 10% of its purchasing power per year. Thus inflation-linked securities have the potential to protect against serious erosion of Investor wealth in inflationary times. Correlations Arithmetic | Standard Mean Deviation ‘Sap Bonds T Bills Inflation Stocks 10.03 1567 “100 Bonds 573 m4 0.22 | Teills 456 319 =015 024 1.00 Inflation 424 3.65 -036 0.20 038 1.0066 Financial Risk Manager Part I: Foundations of Risk Management Returns After Adjusting for Inflation Arithmetic Standard Mean Deviation S&P Bonds ‘S&P 5.78 f 17.32 1.00. Bondi us 1239 037 ig open Tails ‘os ar O38 sa 56 In performing invest ment analysis, the analyst may well want to examine inflation-adjusted returns along with or instead of nominal returns. Furthermore, inflation-linked securities are increasingly likely to be an important asset class in portfolio optimization. Input Estimation Uncertainty Reliable inputs are crucial to the proper use of mean- variance optimization in the asset allocation decision. It is common to use historical risk, return, and correlation as a starting point in obtaining inputs for calculating the efficient frontier. If return characteristics do not change through time, then the longer the data are available, the more accurate is the estimate of the mean. To see this, note that the formula for the standard error of the mean of a sequence of independent random variables is $ , where N is the sample size. For 2 sequence of independent returns observed through time, Nis the number of time periods since the beginning of the his- torically observed data. Thus, under the assumption of stationary (or unchanging) expected returns and returns uncorrelated through time, more historical data will improve the estimate of expected return included in the mean-variance model, although the improveent is, diminishing. To illustrate the importance of this issue for portfolio. choice, imagine that the investor is forced to choose betwecn two investments, each with identical sample ‘means and variances. Other things equal, the standard approach would view the two investments as equivalent. If you consider the additional information that the first sam~ pple mean was based on I year of data and the second on 10 years of data, common sense would suggest that the second alternative is less risky than the first. Furthermore, we can assume that the investor is mainly concerned about next month's return, which has a mean return of and a variance of o3,,= 0? + © where dijayis the predicted variance series «is the variance of monthly return Tris the number of time periods The first part of the expression captures the inherent risk in the return, The second term captures the uncertainty that comes from lack of knowledge about the true mean return. In a Bayesian’analysis, the sum of the two terms on the right-hand side of this equation is referred to as the variance of the predictive distribution of returns. Notice that predicted variance is always greater than historical variance because of uncertainty as to the future mean, Characteristics of security returns usually change over time. Thus, there is a trade-off between using a long time frame to improve the estimates and having potentially Inaccurate estimates from the longer time period because the security characteristics have changed. Because of this conflict, most analysts modify historical estimates to reflect their beliefs about how current conditions differ, from past conditions. The choice of the time period is more complicated when 2 relatively new asset class is added to the mix, and the available data for the new asset is much less than for other assets. For example, consider the addition of the International Financial Corporation's (IFC) index of emerging equity markets, which is available from 1985, An analyst who wishes to use historical data as a start- ing point for optimization could use all available data for calculating means, standard deviations, and correlations, or Use data from only the common period of observa- tion. Applying the first approach to U.S. capital market data would mean using the entire historical data from 1926 to the present from stocks and bonds. The secondChapter 2. Delineating Efficient Portfolios 67 EETIEERY Risk and Return over Different Horizons Arithmetic | Arithmetic Standard Mean Return | Mean Return Deviation Beginning | Starting in | Starting in | Starting in | Starting in Date 1926 1985 1926 1985 ‘SAP 500 Hea) oe [Eo as 2208 1789 US. Small Stocks 1926 12:36 34.46 3533 2369 “US, Government Bonds 1926 - 832 1198 gos | oan ieee anak nr oe fa ‘i ie Ee Source: Courtesy of Ibbotson Associates Correlation over Different Horizons Top Triangle: All Periods S&P 500 ‘Small Bonds lees S&P 500 = 5100 das oi 4s Small os? 3.00 008 046 Bonds 030. 0.07 100 ~018 Fe O43 046 =015 100 “Bottom Triangle Common Sa 500 Smal Bonds 1c ‘Source: Courtesy of Ibbotson Associates. approach would use only data on U.S. markets from 1985, to the present. Table 2-8 shows the inputs for the two separate approaches. Notice that the mean return for small stocks—that is, for companies with smaller capitalization—is greater than that for large stocks over the period from 1926, but less over the period since 1985. In both periods, however, the risk of smaller stocks is substantially higher than that of large stocks. Statisties over the longer term are consis~ tent with an equilibrium in which a higher investor risk is compensated by higher investor expected return. Statis- tics over the period of common observation, beginning in 1985, are inconsistent with the argument of expected. reward for additional risk. Which set of inputs makes more sense as the basis for optimization? Are the differences, due to poor estimation, to the small amount of data, or to changes in economic conditions? How will these different sets of inputs affect the efficient frontier? Correlations for the two different periods are provided in Tables 2-9-2-1, ‘The reader is urged to calculate the two different efficient frontiers and examine the differences. Even without pe forming the two optimizations, however, the reader will note that the highest mean portfolio on the frontier dif- fers, depending on which set of inputs is used. Correlations over Different Time Periods ‘The entries to the right of the main diagonal (1.00s) in ‘Table 2-9 give the correlations calculated over the longest available period for both series. The entries to the left of the main diagonal (1.00s) give the correlation over the period of common observation beginning in 1985. Does the correlation between stock and bond returns follow a predictable pattern that could help with input ‘estimation? Li (2002) showed that the stock-bond corre- lation followed similar time trends across many countries. It reached a peak in 1996 of around 0.5 in most of the ‘major industrialized countries except Japan. By 2002, thePart I: Foundations of Risk Management The Effect of Time Horizon on Risk Annualized | Arithmetic Mean Standard Return Based | Arithmetic Mean | Deviation Based Standard Time Period on Annualized | Return Based on | on Annualized |. Deviation Based 1926-1991 10-Year Returns | Annual Returns | 10-YearReturns | on Annual Returns SaP 500 9.8% 96% 20.7% 19.9% US. Government : Bonds 43% 4% 61% 27% Treasury Bilis 3.6% 3.6% 60% 32% ‘Source: . Edwards and W. Goetzmann (1994). stock-bond correlation turned negative. Why? Li found that this critical correlation changed with shifts in uncer- tainty about future inflation. As inflation uncertainty rises, the stock-bond correlation rises. The correlation among international equity markets changes significantly through time as well. The average correlation between major stock markets over the past 150 years has ranged from less than 10% (1880s and 1890s, and 1940 to 1980) to over 30% (1860s, 1930s, 1990s). Goetzmann, Li, and Rouwenhorst (2005) studied the relationship between globalization and market correlations over this time period. They attribute the higher correlations among equity markets to periods of greater liberalization in cross-border flows. The result of research on time variation in correlations suggests that macroeconomic conditions may have an effect on cor relation forecasts, which indeed appears to be the case (Brown et al., 2009). Short-Horizon Inputs and Long-Horizon Portfolio Choice Another important consideration in estimating inputs to the optimization process is the effect of the investment time horizon on variance. In the previous example, we saw that under the assumption that returns were uncor- related from one period to the next, the standard error of the mean decreased with the square root of time. This is based on a more general result that the sum of the vari ance of a sequence of random variables is equal to the variance of the sum. When actual returns are examined, some securities have returns that are highly correlated over time (eg., autocorrelated). Treasury bill returns, for example, tend to be highly autocorrelated, meaning that the return to investing in T-bills in one year does a good job at predicting the return to investing in T-bills the next year. High T-bill returns are more likely to be followed by high returns than low returns. Thus, although the stan- dard deviation of T-bills is low over short intervals, on a percentage basis it significantly increases as the time period of observation increases from I to § to 10 years. Thus T-bills are effectively an increasingly risky asset as the investment time horizon grows. For example, research by Edwards and Goetzmann (1994) shows that the esti- mated annualized standard deviation for Treasury bill returns over the 10-year horizon is about 6%, compared to the 3.2% annual standard deviation measured at the ‘one-year horizon. Table 2-10 shows the annualized means and standard deviations for 10-year returns, derived from a simulation procedure that takes into account their autocorrela~ tion. It also reports the means and standard devia tions based on the annual returns, not accounting for autocorrelation. Notice that the mean returns are not greatly affected by the correction for autocorrelation; however, the volatility for stocks is slightly reduced at longer horizons while the volatility for bonds and T-bills is increased, ‘The reader can use the mean and standard deviations in Table 2-10 and the correlations provided in Table 2-11 to calculate the efficient frontier over the 1-year horizon and the 10-year horizon.Chapter 2 Delineating Efficient Portfolios 69 EZEIEESH Correlations over Different Time Horizons Top Triangle: 10-Year sep Bonds Taille SRP 500 100 0.06 019) Bonds on 100 0.08 T-Bills -0.03 0.22 | 1.00. Bottom Triangle: 1-Year | = THREE EXAMPLES Consider first the allocation between equity and debt. The minimum variance portfolio is given by Equation (2.9). The estimated inputs for bonds and stocks are 12.5% 14.9% 6% 48% = 45, Pow Plugging the values for standard deviation and correlation into Equation (2.9) gives (48) = 45(4.8)04.9) Gay + 049F - (4548)04 9) -051 x, x, ‘Thus the minimum variance portfolio involves short selling stock. The associated standard deviation is 4.75%, which is slightly less than the standard deviation associated with investing 100% in bonds, The dots in Figure 2-17 are plots of all combinations of the S&P index and Lehman Brothers aggregate bond index, ranging from the global minimum variance portfolio to the portfolio representing 150% in common stock and 50% In bonds. The dot next to the global minimum variance portfolio represents tho expected return and standard deviation of the portfolio ‘with 0% in common stocks. As we move to the right, each dot represents the expected return and standard devia tion of a portfolio with 10% more in common stock. This is the efficient frontier with short sales allowed (although it ‘would continue to the right). In this case, the global mini- mum variance portfolio is 100% in bonds. At the time of this revision the interest rate on Trea~ sury bills was about 5%. Using this as a riskless lending and borrowing rate, the tangency portfolio is portfolio T shown in Figure 2-17. The expected return and risk for T Foonds Eo 75.00 GIEIEESEA the efficient front 70.00 20.00 25.00 portfolio T as read from the graph are 13.54% and 16.95%, respectively. Thus the slope of the line connecting the tan- gency portfolio and the efficient frontier is 1354-5, 1695 150 ‘and the equation of the efficient frontier with riskless lending and borrowing is +050s, (Once we know the expected return of portfolio 7, we can easily determine its composition. Simply recall that sarPsap +1 Xsap)Ry Therefore VBS A = X25) #0~ Xu)60 and = T6% X, = 16%70 Financial Risk Manager Part I: Foundations of Risk Management 000 S00 10.00 —¥8.00 GIEEESE The efficient frontier. The second example we examined was a combination of ‘a domestic portfolio represented by the S&P index and an international portfolio represented by an average interna- tional fund, Note that part of these combinations is inef- ficient. The estimated inputs were Rep 125% 4p = 14.9% R,=105% og, Psa ne = 0-53 Solving for the global minimum variance portfolio we have Gay -03304)049) Gagy + cay + @SA4049) Xeup = 045, Thus the global minimum variance portfolio is obtained by investing 0.45 in the S&P index and 0.55 in the foreign portfolio. The resulting standard deviation is 11.76%, which is less than the standard deviation of both portfolios. This is an example of how diversification can reduce risk. Note that it is inefficient to hold the foreign portfolio by itself. An investor wishing to accept the risk of 14% on the for- eign portfolio could obtain an expected return of 12.31% by putting 90.7% in the S&P index and 9.3% in the foreign portfolio. Thus at a 14% standard deviation, the increase in expected return from using the optimum combination is 1.81% with no increase in risk. The efficient frontier with no short sales is the scatter of dots in Figure 2-18 from the global minimum variance portfolio to 100% in the S&P index. The dot to the right of the global minimum variance portfolio is the expected return and standard deviation of return when there is 50% in the S&P index. Each dot as we move to the right represents the expected return and 02 4 6 8 0 2 14 16 GIEEESE Combinations of bonds, domestic stocks, and international stocks. standard deviation of return as we increase the amount in the S&P index by 10%. The efficient frontier with short sales allowed is the complete scatter of dots shown in Figure 2-18 (although it would continue to the right). If the riskless lending and borrowing rate is 5%, then the tangency portfolio is 61% in the S&P index and 39% in the international portfolio. The associated mean return is 11.72%, and standard deviation of return Is 12.04%. Thus the slope of the efficient frontier with riskless lending and borrowing is 558 1204 and the equation of the ef R, jent frontier is 5 +5880, Asa third example, consider the asset allocation problem across bonds, domestic stocks, and international stocks. ‘We continue to use all the inputs from the prior examples. We need one additional input, the correlation coefficient between bonds and the international portfolio. Past data indicate a value of 0.05 is reasonable. Various combi- rations of these three assets, some of which lie on the efficient frontier and some of which do not, are plotted as dots in Figure 2-19. Note that both the international portfolio and the bond portfolio are obviously dominated by other portfolios. The figure does not include portfolios involving short sales. Thus, since the S&P has the highest expected return, its not dominated. The efficient frontier would be the dots that have the highest mean return for a given standard deviation.Chapter 2 Delineating Efficient Portfolios | The tangency portfolio with a riskless lending and borrow- ing rate has the following proportions: Xyyp = 0581 X, = 0.038 X_= 0381 ‘The expected return of this portfolio is 11.49%, and the standard deviation is 11.64% Thus the slope of the effi- cient frontier with riskiess lending and borrowing is 558 and the equation of the efficient frontier is R, =5+0888e, Compare this to the efficient frontier derived with two risky assets and a riskless asset. This efficient frontier dominates the efficient frontier using only the S&P and bonds as the risky assets but to three places to the right of the decimat point is identical to the efficient frontier using only the S&P ‘and the international portfolio as the risky assets. Thus, ‘adding bonds to the combination of the S&P and interna- nal portfolio doesn't lead to much improvement in the efficient frontier with riskless lending and borrowing, CONCLUSION In this chapter we have defined the geometric properties of that set of portfolios all risk-avoiding investors would hold regardless of their specific tolerance for risk. We have defined this set—the efficient frontier—under alternative assumptions about short sales and the ability of the inves tor to lend and borrow at the riskless rate. Now that we understand the geometric properties of the efficient fron- tier, we are in a position to discuss solution techniques to the portfolio problem, BIBLIOGRAPHY 1. 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