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Enterprise Risk Management ??????

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Title: Enterprise Risk Management ??????


1
Enterprise Risk Management??????
  • Steve DArcy
  • ??????
  • Chairman of the Board of the Casualty Actuarial
    Society
  • ???????????
  • Professor of Finance at the University of
    Illinois
  • ???????????
  • Presented at Shanghai University of Finance
    Economics
  • ??????
  • July 3, 2006

2
What is ERM?
  • ERM is the application of basic risk management
    principles to all risks facing an organization
  • ERM ??????????????????
  • Other names for ERM ??
  • Integrated risk management ??????
  • Global risk management ??????

3
Basic Risk Management Principles????????
  • Identifying loss exposures ??????
  • Measuring loss exposures ????
  • Evaluating the different methods for handling
    risk ?????????????
  • Risk assumption ????
  • Risk transfer ????
  • Risk reduction ????
  • Selecting a method ??????
  • Monitoring results ????

4
Where Did ERM Come From?ERM ??
  • Traditional risk management ??????
  • Formally developed as a field in the 1960s
  • ?60 ???????????
  • Focused on pure risks ??????
  • Loss/no loss situation ??/?????
  • Often could be insured ???????
  • Developed from insurance purchasing area
  • ?????????

5
New Elements of Risk 1970s70?????????
  • Foreign exchange risk ????
  • End of Bretton Woods agreement in 1972
  • 1972?????????????
  • Commodity price risk ??????
  • Oil price fluctuations of the 1970s 70?????????
  • Equity risk ????
  • Development of option markets - 1973 ???????
  • Interest rate risk ????
  • U. S. Federal Reserve Board policy shift 1979
  • ??????????

6
Failure to Manage Financial Risk ???????????
  • Foreign exchange risk ????
  • Laker Airlines 1970s ??????
  • Borrowing in dollars ?????
  • Revenue in pounds ?????
  • Interest rate risk ????
  • U. S. Savings and Loans 1980s ??????
  • Borrowing short ??????
  • Lending long ??????
  • Commodity price risk ??????
  • Continental Airlines 1990 ??????
  • Fuel costs not hedged ??????????
  • Oil price doubled with Gulf War ??????????

7
The New Risk Management -1980s??????
  • Financial risk management ??????
  • Dealt with financial risk ??????
  • Foreign exchange risk ????
  • Interest rate risk ????
  • Equity risk ????
  • Commodity price risk ??????
  • Use derivatives to hedge financial risk
  • ?????????????

8
Financial Risk Management Toolbox ????????
  • Forwards ??
  • Futures ??
  • Swaps ????
  • Options ??

9
Forward Contracts ????
  • A forward contract obligates one party to sell
    and another party to buy an asset
  • ???????????,????????,???????????
  • The exchange takes place in the future
  • ???????
  • The price is fixed today ????????
  • No payment is made until maturity ????????
  • The buyer has a gain if the asset value increases
  • ??????,????

10
Futures Contracts ????
  • A future obligates one party to buy and another
    to sell a specified asset in the future at a
    price agreed on today ????????????????????????????
    ???,????,??????????
  • Futures are standardized contracts traded on
    organized exchanges
  • ???????,???????????????
  • Price changes are settled each day
  • ??????????
  • Margin accounts must maintained
  • ??????????????

11
Swap Contracts ??????
  • An agreement between two parties to exchange (or
    swap) periodic cash flows
  • ????????????????????
  • At each payment date, only the net value of cash
    flows is exchanged ?????????????
  • The cash flows are based on a notional principal
    or notional amount ????????????????
  • The notional amount is only used to determine the
    cash flows ?????????????

12
Option Contracts ????
  • Options provide the right, but not the
    obligation, to buy or sell an asset at a fixed
    price
  • ??????????????????????
  • Call option is right to buy ??????????
  • Put option is right to sell ??????????
  • Options are one sided agreements ???????
  • Exercising the option forces the seller to
    perform
  • ??????????????????
  • Expiration date is the date at which the option
    ceases to exist ??????????

13
New Elements of Risk 1990s90?????????
  • Failure to manage derivatives appropriately
  • ???????????
  • Financial model failures ??????
  • Improper accounting for derivatives
  • ????????????????

14
Mismanagement of Financial Risk??????????
  • Mismanagement of derivatives ????????
  • Gibson Greetings
  • Barings Bank ????
  • Orange County, California ??,??
  • Model failure ??????
  • Long Term Capital Management ??????
  • Accounting improprieties ?????
  • Enron ????
  • Arthur Andersen ?????

15
The New Risk Management - 1990s and
beyond90???????????
  • Enterprise Risk Management ??????
  • Initial focus on avoiding derivative disasters
  • ????????????????
  • Developing into optimizing firm value
  • ??????????
  • Chief Risk Officer ?????????
  • Sarbanes-Oxley Act in the U. S. 2002 SOX??
  • Increased focus on risk models
  • ????????????

16
ERM Risk Categories ????
  • Common risk allocation ????
  • Hazard risk ????
  • Financial risk ????
  • Operational risk ????
  • Strategic risk ????
  • Bank view New Basel Accord
  • Credit risk ????
  • Loan and counterparty risk ????
  • Market risk (financial risk) ??(??)??
  • Operational risk ????

17
Hazard Risk ????
  • Pure loss situations ?????
  • Property ??
  • Liability ???
  • Employee related ?????
  • Independence of separate risks ?????????
  • Risks can generally be handled by ????
  • Insurance, including self insurance ??,??
  • Avoidance ??
  • Transfer ??

18
Financial Risk ????
  • Components ??
  • Foreign exchange rate ??
  • Equity ??
  • Interest rate ??
  • Commodity price ????
  • Correlations among different risks
  • ?????????
  • Use of hedges, reinsurance or risk transfer
  • ????, ????????
  • Securitization ???

19
Operational Risk ????
  • Causes of operational risk ??
  • Internal processes ????
  • People ?
  • Systems ??
  • Examples ??
  • Product recall ????
  • Customer satisfaction ?????
  • Information technology ????
  • Labor dispute ????
  • Management fraud ?????

20
Strategic Risk ????
  • Examples
  • Competition ??
  • Regulation ??
  • Technological innovation ????
  • Political impediments ????

21
ERM Approach ?????
22
Evolution of ERM ??
  • Control function ????
  • How much can we lose? ????????
  • Risk adjusted returns ????????
  • Capital allocation ????
  • Compensation ????
  • Bonuses ????
  • Optimization ???
  • Maximize shareholder value ???????
  • Vision of the future ????

23
Impediments to Effective ERM????ERM???
  • Risk models and technology ???????
  • Organization ??
  • Motivation ??
  • Operating infrastructure ????
  • Data problems ????
  • Regional fiefdoms ??????
  • High failure rate of IT projects IT???????

24
Increased Use of Risk Models??????????
  • Technological advances ????
  • Theoretical advances ????
  • Allocation of economic capital ???????
  • Used for divisional profitability ????
  • Impacts bonuses ????
  • Dueling models ?????????

25
Chief Risk Officer ???????
  • Reports to CFO, CEO or Board
  • ??????????????????
  • Responsible for managing all aspects of risk
  • ?????????????
  • Understand technology ????
  • Communication skills ????

26
How ERM Can Increase Firm Value ERM????????
  • Process can focus on protecting
  • Value ??
  • Cash flows ???
  • Earnings ??
  • Cannot protect all three at once ????????
  • Examples
  • Reducing taxes is earnings based strategy
  • ????????????????
  • Insuring to prevent assets from declining is
    value based
  • ??????????????????
  • Hedging to maintain internal funding sources is
    cash flow based ??????????????????????

27
Future of ERM ??
  • ERM will continue as risk consolidation and
    aggregation
  • ERM????????????
  • Process increases value of risk management skills
  • ?????????????????
  • Management is concerned with risk control issues
  • ???????????
  • Chief Risk Officer will be a visible figure in an
    organization
  • ??????????????????
  • Many paths to CRO, diverse skills required
  • ??????CRO, ???????
  • ERMs role in optimization has a long way to go
  • ERM????????????????
  • Potential benefit is worth pursuing for pioneers
  • ????????
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