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Applied Business Statistics Case studies Introduction to risk management concepts. Mauro Bufano Risk Management – Banca Mediolanum Spa. Risk Management: what is it? .
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Risk Management – Banca Mediolanum Spa
1: Douglas Hubbard "The Failure of Risk Management: Why It's Broken and How to Fix It" pg. 46, John Wiley & Sons, 2009
An efficient risk management process is therefore crucial in the life of a firm!
Relevance analysis: an example
Monitored, but not reported
Monitored and reported weekly, with risk limits
Monitored and reported yearly, no risk limits
>=15% of net assets
< 15% of net assets
The chart above shows the movements of the Index of European credit default swaps (insurance against default of a company).
Using historical or parametric analysis in June 2007, the movements happened in august 2007 should have occurred not even in the entire age of the universe!2 (approx. 25 sigma events)
2See also Haldane, A. G., “Why banks failed the stress test”, Bank of England, February 2009
Given that, how should we take into account extreme events like these?
Once the risks are estimated and quantified, it’s necessary to fix risk limits for every risk and for every business unit interestedin order to monitor and signal to the top management an eventual overstep
How to fix risk limits?
One of the main activities of the risk management unit is the production of reports to the top management, in which risks are quantified
The periodicity of reports depends on the nature of the risk and of the business. Examples
N.B. Risk reports must be as clear as possible, because they must be instruments for the top management to take important and quick decisions!
The histogram chart shows a simulated loss distribution (in terms of millions €). A common risk management practice (particularly used in credit risk) is to consider average losses (or expected losses) a “cost” to be budgeted periodically (e.g. yearly), while unexpected losses are by their nature an extreme event, and have to be covered with capital
One of the most used risk measures in finance is Value at Risk (VaR): it expresses the maximum loss that a portfolio of asset can experience with a given confidence level and within a given time
It’s widely used in financial reporting to monitor market risk, but it’s also starting to be used to measure credit risk (e.g. a pool of mortgage loans)
Its importance is also recognized by the regulators (e.g. the Bank of Italy), being one of the parameters used to work out minimum capital requirements
In defining Value at Risk, we must choose