Aug 11

FRM 2008 Episode #11: Operational Risk B (OpRisk B)

by David Harper, CFA, FRM, CIPM

FRM | |

In this issue

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About Episode #11 (Operational Risk B)

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We published today the latest screencast episode (Operational Risk B). This is the second screencast in the Operational Risk discipline. This screencast episode has a 95 page PowerPoint you can download in two parts (part 1= hour plus part 2 = 45 minutes).

We continue to follow the sequence of GARP's 2008 FRM Study Guide. Please find links to earlier episodes (#1 to #10) at the end of this note.

Enterprise risk management (ERM)

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The assigned reading ERM: Theory & Practice by Nocco and Stulz is short but dense (important to operational risk). Main ideas include:

  • Companies are vehicles for taking strategic and business risks. A key idea is, which risks should be retained or transferred to shareholders? Answer: the companies should retain core risks where it has a comparative advantage in risk-bearing vis-a-vis shareholders.
  • New projects should be evaluated according to their marginal impact on the firm's total risk.
  • The goal of maximizing shareholder value (i.e., present value of future expected cash flows) is probably in tension with a goal of smooth (accounting) earnings
  • Regulatory capital is mandated but economic capital is useful: an economic capital framework allows the firm to aggregate risks across business units and risk types (credit, market, operational)

How Risk Management Creates Value

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The two Stulz chapters (Chapter 2 & 3) have a single overarching theme: when does risk management create firm value? Broadly, there are two answers:

  • Under perfect financial markets the risk management irrelevance proposition applies. Risk management in this case does not add value: shareholders do not pay for the reduction of diversifiable risk because they can diversify themselves; and reducing systemic risk tends to reduce expected cash flows.
  • But financial markets are not perfect, so risk management can indeed create value in many cases. In particular, risk management potentially adds value if it reduces the costs of financial distress (including the sub-class of bankruptcy costs), if it shifts income to lower tax regimes, and if it enables higher leverage nearer to the firm's optimal capital structure (i.e., where its weighted average cost of capital, WACC, is lower).

 

Risk-adjusted return on capital (RAROC)

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Crouhy chapter on Capital Allocation and Performance Management is also important. Key ideas include:

  • Although RAROC could have VaR in the denominator, in our case (the assigned reading) the denominator is economic capital (EC).
  • Economic capital (EC) = Value at Risk (confidence) - expected losses (EL)
  • Good financial ratios exhibit consistency: the income or flow-based numerator maps to the balance sheet or stock-based denominator. To illustrate: ROE includes net income but not interest expense in the numerator because shareholders do not receive the interest; but ROIC includes interest expense because the denominator includes debt holders. Therefore, it is consistent to deduct expected loss (EL) in the numerator because it is excluded from EC in the denominator. Put another way, an acceptable alternative RAROC, but one we are not using, would be to add both EL to the numerator and denominator.
  • First-generation RAROC compares RAROC to a hurdle rate; i.e., if RAROC is above a firm-wide hurdle rate (e.g., cost of equity capital), then the project is accepted. But its flaw is that it will reward risky projects: projects that have higher a RAROC but add to the firm's total risk (which is not incorporated).
  • Second-generation RAROC fixes this by requiring that the project's RAROC exceed the firm's expected return; i.e., projects are accepted if RAROC > [Market return - riskless rate]*Beta + riskless rate

New Learning Spreadsheets Added

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For this episode (OpRisk B), I uploaded the following all-new learning spreadsheets to the member page:

  • Optimal WACC (Stulz on capital structure)
  • Hedging Price Risk, Stulz (simple illustration of why hedging price risk does not create value)
  • Debt overhang
  • RAROC
  • RAROC’s problem (motivation for “second-generation” RAROC)
  • Target PD Implies Equity Cushion (Nocco & Stulz ERM) .

As more than (50) learning spreadsheets are uploaded, I highlighted in yellow the more critical subset from an exam perspective. Yellow signifies an important or archetypal idea; yellow means: "I hope you review this spreadsheet." Non-yellow can be ignored, if your schedule does not allow. These "learning worksheets" can be accessed in three ways. None of the five new spreadsheets have a yellow highlight: I don't think you need to review them from an exam-passing strategy. But feel free to use them to explore these ideas further.

  1. Simply view in the browser,
  2. To open directly into Excel! Select File > Export As > Excel (.xls),or
  3. Most have a downloadable "native" Excel file (XLS) associated with the entry.

Screencast Tutorial

Paid member access the screencast in the member section. In addition to the viewable screencast:

  • You can downloadable the underlying Power Point slides (in PDF format). For this episode, there is a single 95 page deck.
  • An ipod format (.m4v)
  • A downloadable version of the screencast in a .zip file. (Save to new directory on local and launch the .html file.)

Non-members can sample the start of the screencast tutorial here.

Practice Questions

As always, I wrote some engagement-type questions just to provoke your thinking on the episode.

Question 1 (Enterprise Risk Management)

In regard Enterprise Risk Management (Brian Nocco & Rene Stulz), are the following statements true or false?

(i) Companies should seek to offload business and strategic risks.
(ii) Companies should try to minimize the probability of financial distress
(iii) Company VaR is a multiple of the volatility of its asset value
(iv) Management's goal should be to minimize earnings volatility

Question 2 (Stulz Risk Management & Derivatives)

According to Rene Stulz (Chapter 2 & 3), identify whether the following risk management tactics increase value, and if so, why.

(i) Reduce idiosyncratic (firm-specific) risk
(ii) Reduce systemic risk
(iii) Hedge price risk
(iv) Reduce the costs of financial distress
(v) Shift income to other tax years
(vi) Alter capital structure

Question 3 (Crouhy Capital Allocation)

Assume the following: a loan portfolio with a principal of $1 billion paying an annual rate of 10%. Economic capital (EC) held against the loan is 8% of the loan; it is invested in securities returning 8%. Therefore, $920 million ($1 billion - 8%) in deposits fund the loan. The deposits cost the bank 7%. Operating cost is $10 million (i.e., the portion allocated to the loan). The expected loss (EL) is 2% of the loan.

(i) What is the loan's risk-adjusted return on capital (RAROC)?
(ii) If the bank's hurdle rate is 12%, will the loan "project" be approved/accepted?
(iii) If the equity beta is 2.0, the riskfree rate is 5%, and the market's expected return is 11%, what is the loan "project's" adjusted RAROC?

Question 4 (Case Studies)

For each of the following, try to name the single most significant risk factor and, similarly, try to identify the single alternative measure that might have prevented losses (operational or otherwise).

(i) Metallgesellschaft
(ii) Sumitomo
(iii) Long-Term Capital Management (LTCM)
(iv) Barings Bank

Question 5 (Liquidity risk)

A portfolio has an initial value of $1 million and a daily volatility of 1%. The portfolio's average bid-ask spread is 0.3% (0.003).

(i) What is the 1-day liquidity-adjusted VaR (LVaR) at 99% confidence?
(ii) What is the 10-day LVaR?
(iii) What assumptions are required to extend (scale) the 1-day LVaR to 10-day LVaR?
(iv) What are the problems in using the bid-ask spread as a measure of liquidity?

My answers to these questions

Previous newsletters

Here are links to Episodes #1 through #6:

Thanks very much.

David Harper, CFA, FRM, CIPM
Founder
www.bionicturtle.com

David-Harper_100w

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