An article I read, titled "The Causes and Cures of the Financial Crisis," by Ira Robbin described the recent financial crisis of America as a "financial tsunami." This article discussed the far-reaching problems caused by this tsunami and how lessons learned from it will be seen in risk management practices for years to come.
The article is particularly aimed at actuaries, and describes them as the premier enterprise risk professionals who will be able to share substantial insight into what went wrong and the implications for the future.
The article descries the causes of the financial crisis as simple. Saying that now there is "little confidence in balance sheet valuations because too many assets are overstated, too many liabilities are understated, and too much information is hidden. The crisis has spread due to a systematic failure of the regulatory system. Over the last 20 years regulations that fostered market stability were eliminated, and new financial instruments were allowed to propagate without any real oversight."
Robbins also details ways to get ourselves out of this financial crisis, saying that instead of bailing out weak financial firms, we should be liquidating them. Additionally, all doubtful assets need to be written down as soon as possible, and all accounting should be clear and transparent.
Robbins explains that "Government can help in this effort to clean up our accounting system. But it needs to stop being an investor propping up those that should be in the morgue. It needs to conservatively regulate all financial instruments. It should foster liquidity and stoke demand.
That is what needs to be done to get out of this crisis."
I think that it will be interesting to see the new risk management techniques and ideas that stem from this recent financial crisis, and particularly the role of actuaries in solving these problems.
Thursday, January 29, 2009
THE INCREASING IMPORTANCE OF ENTERPRISE RISK MANAGEMENT
I recently read an article from the SOA (Society of Actuaries) about the importance of Enterprise Risk Management in today's organizations, and thought it tied in well to many concepts discussed in class.
The article is titled "The Increasing Importance of Enterprise Risk Management" and it basically details how ERM offers a framework for effectively managing uncertainty, responding to risk and harnessing opportunities on a broader scale than ever before, it is of key importance in today's complex and evolving business environment.
It focused a great deal on the role of actuaries in ERM, and this is most interesting to me, as this is the career path I plan to pursue. The article explained that actuaries are uniquely qualified to be enterprise risk managers because of their ability to bring a complex future into focus by applying unique insight to risk and opportunity. Leading actuaries predict more of a role for the profession in ERM because of actuaries' broad understanding of the insurance environment, financial markets and their highly skilled technical abilities.
This article also had links to many other articles on ERM, such "Leveraging ERM Techniques" and "The Evolution of Enterprise Risk Management." These articles further detailed ERM and gave interesting charts and graphs showing the main risk management problems faced by Fortune 1000 companies (as analyzed by actuaries).
The article is titled "The Increasing Importance of Enterprise Risk Management" and it basically details how ERM offers a framework for effectively managing uncertainty, responding to risk and harnessing opportunities on a broader scale than ever before, it is of key importance in today's complex and evolving business environment.
It focused a great deal on the role of actuaries in ERM, and this is most interesting to me, as this is the career path I plan to pursue. The article explained that actuaries are uniquely qualified to be enterprise risk managers because of their ability to bring a complex future into focus by applying unique insight to risk and opportunity. Leading actuaries predict more of a role for the profession in ERM because of actuaries' broad understanding of the insurance environment, financial markets and their highly skilled technical abilities.
This article also had links to many other articles on ERM, such "Leveraging ERM Techniques" and "The Evolution of Enterprise Risk Management." These articles further detailed ERM and gave interesting charts and graphs showing the main risk management problems faced by Fortune 1000 companies (as analyzed by actuaries).
VALUE AT RISK
Value at risk (VaR) is described as "a technique used to estimate the probability of portfolio losses based on the statistical analysis of historical price trends and volatilities" (Investopedia).
Value at risk is commonly used by banks, security firms and companies that are involved in trading energy and other commodities. It is able to measure risk while it happens and is an important consideration when firms make trading or hedging decisions.
There was a very recent article in the New York Times, titled "Risk Mismanagement" which explained their thoughts on how VaR played a major role in the recent financial crisis of 2007-2008. In the article they interviewed many risk managers and determined that though VaR was helpful for risk experts, it created a problem by giving false security to bank executives and regulators. The article described VaR as "an air bag that works all the time, except when you have a car accident." They explain that though VaR is a powerful and helpful tool, and can cause great problems when it is not used correctly.
They explained in the article that VaR...
Value at risk is commonly used by banks, security firms and companies that are involved in trading energy and other commodities. It is able to measure risk while it happens and is an important consideration when firms make trading or hedging decisions.
There was a very recent article in the New York Times, titled "Risk Mismanagement" which explained their thoughts on how VaR played a major role in the recent financial crisis of 2007-2008. In the article they interviewed many risk managers and determined that though VaR was helpful for risk experts, it created a problem by giving false security to bank executives and regulators. The article described VaR as "an air bag that works all the time, except when you have a car accident." They explain that though VaR is a powerful and helpful tool, and can cause great problems when it is not used correctly.
They explained in the article that VaR...
- Led to excessive risk-taking and leverage at financial institutions
- Focused on the manageable risks near the center of the distribution and ignored the tails
- Created an incentive to take “excessive but remote risks”
- Was “potentially catastrophic when its use creates a false sense of security among senior executives and watchdogs”
So I guess the lesson to take from this is that though VaR can be a great tool for risk management, it is a tool that needs to be used carefully and wisely so that it does not create excessive risks for companies.
Thursday, January 22, 2009
RISK MANAGEMENT ("The Unseen Predator")
A recent article I read from RM Magazine described risk management as an unseen predator due to the colossal failures seen recently in the economy. I thought this article was interesting because it focused on recent failures, such as AIG, and brought up how they thought risk management would soon undergo many changes. In particular, noting the new presidential administration, with the inauguration of Obama, and how he would likely change things.
The article explained how investor confidence has been shaken to the extreme. It said that many increased regulations would likely be coming out of Washington soon from Obama's administration, as the new Congress convenes. Those new regulations would likely be broad in nature and apply to a whole host of industries, not just the financial sector. Since "after all, there are thousands of publicly traded companies, private companies with public debt, companies that trade in the commodities markets, and organizations that have 401(k) programs in various stocks, bonds and other funds."
One of the things I found most interesting about the article were their suggestions on how companies should start to view risk management. Saying that organizations need to stop viewing risk management as something that constrains their profits, and more as something that is integral to achieving business objectives. Although at the same time it is noted that sometimes risk is necessary, such as for starting new businesses, for insurance companies, advances in health care, etc.
I do think that from looking at most companies today they are starting to focus more on risk management and its importance. Though sometimes risk is unavoidable or even good, each company still needs to make sure it is actively managed and monitored.
The article explained how investor confidence has been shaken to the extreme. It said that many increased regulations would likely be coming out of Washington soon from Obama's administration, as the new Congress convenes. Those new regulations would likely be broad in nature and apply to a whole host of industries, not just the financial sector. Since "after all, there are thousands of publicly traded companies, private companies with public debt, companies that trade in the commodities markets, and organizations that have 401(k) programs in various stocks, bonds and other funds."
One of the things I found most interesting about the article were their suggestions on how companies should start to view risk management. Saying that organizations need to stop viewing risk management as something that constrains their profits, and more as something that is integral to achieving business objectives. Although at the same time it is noted that sometimes risk is necessary, such as for starting new businesses, for insurance companies, advances in health care, etc.
I do think that from looking at most companies today they are starting to focus more on risk management and its importance. Though sometimes risk is unavoidable or even good, each company still needs to make sure it is actively managed and monitored.
CAPM
The Capital Asset Pricing Model (CAPM) is "A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities" (Investopedia). And the basic idea of this is that reducing or removing risk has no effect on the value of the publicly traded firm.
However there are many assumptions associated with CAPM. And they are as follows:
However there are many assumptions associated with CAPM. And they are as follows:
- Publicly traded firm
- Many shareholders with diversified portfolios
- Management is risk neutral
- No agency problems
- Uninsured risk is uncorrelated with risk of other securities in portfolio
- No taxes
Although the assumptions listed above are virtually impossible to meet, CAPM still remains one of the most widely used investment models to determine risk and return. For example, as discussed in class, most shareholders are not very well diversified at all which really affects this model. For example, since they are not well diversified when there is a loss it will not be spread out well between them. So, whereas they technically should each only bear a small fraction of the loss, they may be greatly affected. Also, another huge assumption that affects this model is that there are no transactions costs or taxes. In fact, there will always be these costs and they will have a very adverse impact on the expected rate of return.
The website Suite 101 has a great article which depicts what CAPM is, as well as its assumptions and limitations (as these links show).
HEDGING
According to investopedia, hedging is described as "Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract" (Investopedia)
From reading a bit about hedging, it seems like its a great thing for companies to do if they foresee a great deal of market fluctuations in the future. I suppose that a hedge would be considered perfect if it reduces their cost of risk to zero. Hedges can be very useful also, when companies may be just unsure of what the market is going to do in the future.
One great example of hedging that we have seen recently in the economy is that of oil. This is specifically important for companies within the airline industry because they consume so much oil. Many airlines have been able to protect themselves from rising prices for oil by locking in a specific price. Airlines are able to hedge in several ways, by making financial transactions with banks, energy companies or other trading partners.
For example, hedging has helped Southwest Airlines reduce the margin of their losses due to increasing oil prices. Though these hedging transactions can be very expensive, they can also be very beneficial. In an article from June 2008 about Southwest's oil hedging, it says "Southwest spent $52 million on hedging premiums last year and $14 million in the first three months of this year." But, this hedging saved them a lot of money. In fact, "As a result mostly of trades made years ago, Southwest has hedged 70 percent of this year's fuel needs at $51 per barrel instead of the current price of more than $140 per barrel" (International Herald Tribune).
From reading a bit about hedging, it seems like its a great thing for companies to do if they foresee a great deal of market fluctuations in the future. I suppose that a hedge would be considered perfect if it reduces their cost of risk to zero. Hedges can be very useful also, when companies may be just unsure of what the market is going to do in the future.
One great example of hedging that we have seen recently in the economy is that of oil. This is specifically important for companies within the airline industry because they consume so much oil. Many airlines have been able to protect themselves from rising prices for oil by locking in a specific price. Airlines are able to hedge in several ways, by making financial transactions with banks, energy companies or other trading partners.
For example, hedging has helped Southwest Airlines reduce the margin of their losses due to increasing oil prices. Though these hedging transactions can be very expensive, they can also be very beneficial. In an article from June 2008 about Southwest's oil hedging, it says "Southwest spent $52 million on hedging premiums last year and $14 million in the first three months of this year." But, this hedging saved them a lot of money. In fact, "As a result mostly of trades made years ago, Southwest has hedged 70 percent of this year's fuel needs at $51 per barrel instead of the current price of more than $140 per barrel" (International Herald Tribune).
ENTERPRISE RISK MANAGEMENT
Enterprise risk management (ERM) is described as "the methods and processes used by organizations to manage risks and seize opportunities related to the achievement of their objectives...which typically involves identifying particular events or circumstances relevant to the organization's objectives (risks and opportunities), assessing them in terms of likelihood and magnitude of impact, determining a response strategy, and monitoring progress" (Wikipedia).
Essentially, this enterprise risk management is what most companies are using nowadays to protect themselves from a variety of different risks they may face in their businesses and industries. It can involve a variety of different actions on the part of the company, including avoidance, reduction, sharing, and acceptance, depending on what the risk is.
From reading the Wikipedia article I think it is great how many companies are embracing this process of protecting themselves from risks - it helps everyone from management, to the organizations themselves, to the shareholders, and even the community.
One example I found of a company using ERM effectively is Walmart (GOLIATH Business Knowledge). Walmart has created a very structured ERM process designed around four basic questions: "What are the risks? What are we going to do about these risks? How will we measure whether we are having a positive or negative impact on the risks? How will we demonstrate shareholder value?"
Walmart's results have been very positive from implementing this process:
"Mario Pilozzi, the company's country president in Canada has been very active with the process. A year ago, he presented his results at the audit committee meeting. He reported: 'ERM helped us identify clear deliverables directly related to risk mitigation. It enabled the team to remain focused on key risk areas, and ERM challenged us to tie our results from our action plans to the bottom line and shareholder value.'"
Clearly through strategic planning, operations management, and internal controls such as those implemented by Walmart, ERM can be very effective for helping companies manage the many risks they face.
Essentially, this enterprise risk management is what most companies are using nowadays to protect themselves from a variety of different risks they may face in their businesses and industries. It can involve a variety of different actions on the part of the company, including avoidance, reduction, sharing, and acceptance, depending on what the risk is.
From reading the Wikipedia article I think it is great how many companies are embracing this process of protecting themselves from risks - it helps everyone from management, to the organizations themselves, to the shareholders, and even the community.
One example I found of a company using ERM effectively is Walmart (GOLIATH Business Knowledge). Walmart has created a very structured ERM process designed around four basic questions: "What are the risks? What are we going to do about these risks? How will we measure whether we are having a positive or negative impact on the risks? How will we demonstrate shareholder value?"
Walmart's results have been very positive from implementing this process:
"Mario Pilozzi, the company's country president in Canada has been very active with the process. A year ago, he presented his results at the audit committee meeting. He reported: 'ERM helped us identify clear deliverables directly related to risk mitigation. It enabled the team to remain focused on key risk areas, and ERM challenged us to tie our results from our action plans to the bottom line and shareholder value.'"
Clearly through strategic planning, operations management, and internal controls such as those implemented by Walmart, ERM can be very effective for helping companies manage the many risks they face.
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