Risk quantification management diagnosis and hedging forex

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It emphasis that it is the responsibility of risk manager to evaluate probabilities and distributions. This chapter also describes the Bayesian networks and influence diagrams as a powerful tool to combine elementary beliefs in a rational way. In the second half of this chapter the authors introduced the principle of Monte Carlo simulation as a very powerful mathematical tool when dealing with uncertainty by evaluating the distribution of some random variable generates random variables.

Two examples were giving to give an intuitive feeling of the benefits of Monte Carlo simulation: Risk management example 1 hedging weather risk and Risk management example 2 potential earthquake in cement industry At the end of the chapter the author suggest some Software tools that can be used for quantitative risk modeling. Index 19 3 FoundationsRisk Management starts with Knowledge Management Three important features of risk assessment: First, major catastrophes always hit where and when no one expects them.

Second, it is often inaccurate to consider they were fully unexpected, but rather that they were not considered. Third, the general tendency to fight against risks which have already occurred leaves us unprepared for major catastrophes. And what I believe possible is conditioned by what I know. So always there's a need to fight the hidden exposures of risk! But: A loss distribution approach model is not a risk model but a loss model Loss data must only be considered as part of the available knowledge, the main source being human expertise.

What should happen? A knowledge management process This process transforms human expertise into a probabilistic model to calculate potential loss distribution, identify risk control levers and analyze risk sensitivity. The process has two main steps: Scenario identification by experts then risk manager and scenario quantification by model designer and it involves three actors, the expert, the risk manager, and the model designer The expert has technical knowledge about a specific business or process.

The risk manager identifies scenarios and has to interact with all experts to select relevant risks. The model builder is in charge of quantifying the scenarios. Here qualitative assessments are not enough; an accurate quantification of even probability is a must to hedge Basel II provides a framework for operational risk that ranges from a very simple calculation to a complex, custom-built structure.

Basel definition of operational risk: The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk. The main goal by the following approaches is to calculate the minimum capital requires to cover operational risk. Basel II Three pillars: Pillar one describes the basic formulae needed to calculate the minimum regulatory capital figure applicable to each class of risk.

Basic indicator approach entry-level : All that is required is for the institution to hold capital for operational risk equivalent to a fixed percentage the alpha factor of a three year average of positive annual gross income.

The sound practices paper: Responsibility to implement by: the board of directors and of senior management - Risks must be identified and assessed in all current material areas of the institution, also should cover new products, processes and systems before they are introduced.

The standardized approach: Link the calculation of required levels of minimum operational risk regulatory capital with the risk profile. Split the organization activities into business lines, then the total capital charge calculated by three years average sum and divided by the business lines. This way we can determine depending on the business line which one specifically requires more capital charge than the basic level and which needs to reduce.

This requires involvement from senior management of each business line, and then policies and procedures will be implemented for each business line. The advanced measurement approach AMA : The aim of this approach is to encourage organizations to develop a methodology to calculate the capital that relies on their experience as to how such exposures can be quantified.

The regulatory capital requirement will equal the risk measure generated by the banks internal operational risk measurement system using the quantitative and qualitative criteria for the AMA. Index 21 This gives some freedom for organizations to develop their own quantification methodology and to then agree with their supervisor that the methodology adequately reflects their risk profile and complies with the guidelines outlined in the AMA.

The general guidelines and the qualitative standards are similar to standardized approach: - An independent operational risk management functions responsible for designing the framework, creating policies and reporting procedures for operational risk management and for identifying, assessing, monitoring, controlling and mitigating the operational risk.

Procedures must exist to allocate operational risk capital to business lines - Operational risk losses and profiles must be reported to the board and procedures allow actions to be taken based upon. Data should be collected over minimum 5 years observation period Partial use Organizations can use AMA fully or partially using one of the simpler approaches. For potential damages, we must understand why and how they could occur. Number of independent objects exposed to a given hazard during one period.

Occurrence: the occurrence of the considered hazard striking one exposed object during one period Impact: severity of one particular accident cost of an accident in a given currency Modeling and conditioning exposure at peril: Independent Exposure: Peril striking one exposed object would have no impact on other instances of the object.

Order entry, one order can have error, others not, and does not increase or decrease the probability of occurring make sure that there is no obvious dependence a priori. If it affects other objects then find a wider definition. If the order failure affects routing of other dependent orders, then the exposed objects is hour of trading activity and it is independent. Then, each combination of the causes for that effect is added to the tree as a series of logic expressions.

The tree is generally drawn using conventional logic- gate symbols. A client of this bank will be phished if the three conditions happen together: She receives the email P1. She does not receive a warning from the bank P2. She is naive enough to connect to the website P3. Talk about fig. Impact equation The impact equation is a formal expression involving several variables. Fire protection equipment is a driver But employees discipline and actions inside the bank is not measurable.

Author Recommendation: When quantifying the risks, one should only use observable drivers. When reducing the risks, one should consider any driver that seems reasonably efficient. The quantification of risks is aimed at increasing the awareness of risks, not at limiting it through a dogmatic approach!

Sample impact Draw the remaining drivers of the impact, until all variables involved in impact calculation are known, and finally compute the impact; cumulate all losses incurred for the current instance Brief about Fat fingers When issuing an order, an operator may mistype the amount, the direction buy or sell , the currency, the recipient ID, or any other information.

This can cause serious consequences if one zero is added or the customer id was changed to another customer. For deep information, application on Fat Fingers example is available at the book; it covers all the topics mentioned. It includes: - Modeling the exposure: All orders issued as part of the Assets Management activity are exposed to a possible mistake.

Each order is assumed to be independently exposed to a possible mistyping. Possibility of error: The order is mistyped and is below 1 million. The order is mistyped, is above 1 million, and the double-check procedure fails. Further analysis showed that double-check fails when end of day. Predictable drivers cannot really be influenced by a decision, but their evolution can be predicted to some extent. Observable drivers cannot be influenced, or predicted. They can only be observed after the facts, a posteriori.

Hidden drivers cannot be measured directly, not even a posteriori, but may be controlled to some extent. Loss Control, A qualitative View The main objective of loss control measures is to reduce or contain the long-term economic weight of exposures, by impacting frequency and severity.

Action on frequency or probability tends to reduce the number of events by acting on the chain of causes that generate them. Action on severity or impact tends to limit the consequences financial or others of the event that has taken place or might take place. Risk Elimination Avoidance: Eliminating societal risk as well as organizational risk Transfer: Find a partner, such as a subcontractor or supplier on the upstream side, or a customer or partner on the downstream side, to do the job.

Introduction to Cindynics Science of Danger Basic concepts A hazardous situation cindynic situation can be defined only if: The field of the hazards study is clearly identified by: Limits in time life span Limits in space boundaries Limits the actors networks involved. The perspective of the observer studying the system. Therefore, its main goal is derived from the goals of the finance department, i. The fundamental strategic question for any CEO or board of directors is: What risks should be retained to build an efficient frontier risk portfolio, and which are more economically transferred?

There is no risk financing plan relying only on retention or only on transfer. Any plan is a hybrid; each organization can find its optimal balance through a mix of different instruments. For SMEs small and medium size businesses , buying insurance covers remains the most sensible alternative, at least for all risks that are insurable at a reasonable price.

A quantitative evaluation of risks is necessary to support the selection of the appropriate risk financing instruments, to negotiate a deal with an insurer or understand the cost of a complex financing process. The benefits of quantification are to enhance the process of selection of a risk financing solution. For any risk financing mechanisms, there are five elements to be examined: 1.

Planning how is the instrument designed and implemented. Where will the funds come from when called upon to compensate a loss? What are the accounting consequences before and after the loss. What are the fiscal implications, before and after the loss?

Who bears the uncertainty of the outcomes volatility? Index 27 Risk Financing Techniques 1. Retention Techniques It means how you can finance the risk from the internal sources. Current Treatment It is the least complex form of retention. It needs planning and cannot be haphazard. Losses will be paid as they occur, taken out of current cash flows the actual budget line must be divided in monthly cash needs, in this case this would be one of the risk managers duty.

Losses are accounted for as current costs. Losses must be forecast with a degree of certainty compatible with budgeting practices. Reserves Planning for a reserve is actually a purely accounting mechanism whereby the annual addition is considered as a current cost for managerial accounting purposes, but not fiscally deductible. It will appear at the bottom of the debt column in the balance sheet, just above the capital and the general reserves as it still belongs to the shareholders.

When a loss occurs, the amount is deducted from the reserve and the cost of the loss is offset, at least as long as the reserve is large enough at the time of the loss to be reported to the shareholders. The loss is considered as a deductible expense. There are three possibilities: Current cash will be tapped if no other source has been set up would normal cash levels meet the expenses? This is often called an unfunded reserve.

Borrowing provided a specific line of credit has been secured ahead of time for this specific use to match the reserve level. This is often called borrowing for losses. Enterprise-wide risk management ERM is a key issue for board of directors worldwide.

Furthermore, Risk quantification is the cornerstone of effective risk management,at the strategic and tactical level, covering finance as well as ethics considerations. Only thus will an optimum return on capital and a reliable protection against bankruptcy be ensured, i. Within the ERM framework, each individual operational entity is called upon to control its own risks, within the guidelines set up by the board of directors, whereas the risk financing strategy is developed and implemented at the corporate level to optimise the balance between threats and opportunities, systematic and non systematic risks.

Beyond traditional probability analysis, used since the 18th Century by the insurance community, it offers insight into new developments like Bayesian expert networks, Monte-Carlo simulation, etc.