УДК 33

The risk management methodology and techniques

Курбанов Нуршидин Муратжанович – магистр Университета НАРХОЗ (Алматы, Казахстан).

Рузиева Эльвира Абдулмитовна – профессор Университета НАРХОЗ (Алматы, Казахстан).

Abstract: The article is devoted to the study of the risk management methodology. Calculating-analytical methods. Assess the level of price risk, depending on the values of the planned indicators of economic activity. Depending on whether the estimated price risk is attributed to consumable or lucrative portraits, the following methods include: a method for analyzing the appropriateness of costs; analytical method.

Аннотация: Статья посвящена исследованию методологии управления рисками. Расчетно-аналитические методы. Оцените уровень ценового риска в зависимости от значений планируемых показателей хозяйственной деятельности. В зависимости от того, связан ли оценочный ценовой риск с расходными материалами или с прибыльными портретами, следующие методы включают: метод анализа целесообразности затрат; аналитический метод.

Keywords: risk analysis, preliminary risk analysis, detailed risk analysis.

Ключевые слова: анализ рисков, предварительный анализ рисков, подробный анализ рисков.

In a small organization, it is important to perform risk analysis on the basis of risk management techniques in two steps:

• Preliminary risk analysis – to assess which of the objects (assets, systems, processes, etc.) is crucial to the operation of the company and which is exposed to considerable risks;
• Detailed risk analysis of the objects thus defined.

Generally, methods with which to work in risk analysis can be divided in terms of variables with which to work. These are quantitative and qualitative methods of expressing quantities of the risk analysis, and these methods can be used separately or in combination. Qualitative methods are characterized in that the risks are expressed in a certain range (for example, they are scored <1-10>, or determined by probability <0; 1> or verbally). The level is usually determined by an educated guess. Qualitative methods are simpler and faster, but more subjective. The lack of a clear financial expression makes it difficult to control the cost-effectiveness.

A small company uses mainly the qualitative methods - but in deciding whether to use only those methods, it is necessary to assess the assessor’s approach as well (typically a manager or the owner) to risks. It is a personal approach to deal with risk situations and experiences of previous risk decisions. Other aspects that influence the approach to risk management are the economic situation of the company and its internal environment.

There are few techniques of financial risk management:

• Avoidance risk;
• Risk mitigation;
• Risk acceptance;
• Risk transfer.

Risk transfer is a process in which risk is transferred to another party under a legal agreement. The following are common examples:

• Insurance
• Derivatives

A small company can use insurance in an aim to transfer risks which connected with a likelihood of occurrence of fire or flood in locations where assets are located. In terms of insurance policy, an insurer has to pay the sum insured to insurant.

Alternative Risk Transfer (often referred to as ART) is the set of techniques other than traditional insurance and reinsurance to transfer risk to bearing entities with coverage or protection. (Risk Waters, London, 2002) Most of these methods allow investors in the capital markets to play a more direct role in providing insurance and reinsurance protection, and therefore a broad area of alternative risk transfer is said to lead to the convergence of insurance and financial markets. Standardization and trading of risk in non-indemnity form is another area of alternative risk transfer and includes industry loss warranties. In addition, a number of approaches involve funding risk transfer, often within the structures of the traditional reinsurance market. Captive insurance companies are formed by firms and re/insurers to receive premiums that are generally held and invested as a "funded" layer of insurance for the parent company. Some captives purchase excess of loss reinsurance and offer coverage to third parties, sometimes to leverage their skills and sometimes for tax reasons. Financial reinsurance in various forms (finite, surplus relief, funded, etc.) consists of various approaches to reinsurance involving a very high level of prospective or retrospective premiums relative to the quantity of risk assumed. While such approaches involve "risk finance" as opposed to "risk transfer", they are still generally referred to under the heading of alternative risk transfer. Alternative risk transfer is often used to refer to activities through which reinsurers or insurers transform risks from the capital markets into insurance or reinsurance form. Such transformation can occur through the policy itself, or through the use of a transformer reinsure, a method important in credit risk markets, hard asset value coverage and weather markets. Reinsurers were notable participants in the early development of the synthetic CDO and weather derivative markets through such activities.

A subset of activities in which reinsurers take capital markets risks is dual-trigger or multiple trigger contracts. Such contracts exist between a protection buyer and a protection seller, and require that two or more events take place before a payment from the latter to the former is "triggered." For example, an oil company may desire protection against certain natural hazards, but may only need such protection if oil prices are low, in which case they would purchase a dual trigger derivative or re/insurance contract. There was a great deal of interest in such approaches in the late 1990s, and re/insurers worked to develop combined risk and enterprise risk insurance. Reliance Insurance extended this further and offered earnings insurance until the company suspended its own business operations.

Another area of convergence is the emergence of pure insurance risk hedge funds that function economically like fully collateralized reinsurers and sometimes operate through reinsurance vehicles but take the form of hedge funds.

Life insurance companies have developed a very extensive battery of alternative risk transfer approaches including life insurance securitization, full recourse reserve funding, funded letters of credit, surplus relief reinsurance, administrative reinsurance and related techniques. Because life reinsurance is more "financial" to begin with, there is less separation between the conventional and alternative risk transfer markets than in the property & casualty sector.

Emerging areas of alternative risk transfer include intellectual property insurance, automobile insurance securitization, and life settlements. It should be possible to adapt these instruments to other contexts. It has, for example, been suggested adapting cat bonds to the risks that large auditing firms face in cases asserting massive securities law damages.

• Country Risk

Assessment of country risk may be done on two different levels, it may be done on the level of a country (microanalysis) or it may be done on the level of MNC's business (microanalysis). The sum of these two levels means overall country risk analysis.

Types of country risk assessment:

• A macro-assessment of country risk is an overall risk assessment of a country without considering of the MNC’s business
• A micro-assessment of country risk is the risk assessment of a country as related to the MNC’s type of business.

Checklist method:

Firstly, the political factors are assigned values within some arbitrarily chosen range (such as values from 1 to 5, where 5 is the best value, the lowest risk). Next, these political factors are assigned weights (representing a degree of importance), which should add up to 100%. The assigned values of the factors times their respective weights can then be summed to derive a political risk rating. The process is then repeated to derive the financial risk rating. All financial factors are assigned values (from 1 to 5, where 5 is the best value, the lowest risk). Then the assigned values of the factors times their respective weights can be summed to derive a financial risk rating. Once the political and financial risk ratings have been derived, a country’s overall country risk rating as it relates to a specific project can be determined by assigning weights to the political and financial ratings according to their perceived importance. The political and financial ratings multiplied by their respective weights will determine the overall country risk rating for a country as it relates to a particular project.

• Using the Country Risk Rating for Decision Making

If the country risk is too high, then the firm does not need to analyze the feasibility of the proposed project any further. Some firms may contend that no risk is too high when considering a project. Their reasoning is that if the potential return is high enough, the project is worth undertaking. When employee safety is a concern, however, the project may be rejected regardless of its potential return.

Even after a project is accepted and implemented, the MNC must continue to monitor country risk. Since country risk can change dramatically over time, periodic reassessment is required, especially is required, especially for less stable countries.

• Foreign exchange rate risk

The basic approach is to calculate net balance sheet exposure by currency and relate this to the potential change in value given changes in the associated exchange rate. [1]

A net balance sheet exposure in currency j (NEXPj) is the number of assets minus the number of liabilities denominated in currency j.

If NEXPj >0 the bank or MNC is long on currency j on its balance sheet.

If NEXPj<0 the bank or MNC is short on currency j on its balance sheet.

The Gain or Loss in a Position with Currency j = NEXPj x Spot Exchange Rate.

The Company will gain if:

1. It’s long on currency and currency appreciates in value (the currency buys more of another currency)
2. It’s short on currency and the currency depreciates in value (the currency buys less of another currency)

And on the other hand, the Company will lose if:

1. It’s long on currency and currency depreciates in value (the currency buys less of another currency)
2. It’s short on currency and the currency appreciates in value (the currency buys more of another currency).

The relationship between spot rates and forward rates is determined by the same factors that influence relative interest rates between countries. Arbitrage transactions essentially guarantee that interest rate changes produce changes in foreign exchange rates and vice versa.

The pure definition of arbitrage is the simultaneous purchase of a security in one market and the sale of it or a derivative product in another market in which no money is put at risk. The object of an arbitrage is to profit from price differentials between the two markets.

The profit is riskless because the trader has borrowed in one currency yet covered the transaction by selling the expected foreign exchange after investment for the original currency in the forward market. A profit is available because the interest rate differential between securities in the two countries is out of line with the spot-to-forward exchange rate differential. This series of trades is called covered interest arbitrage.

If the exchange rates and interest rates were this far out of line and the large profit was available, arbitrageurs would quickly negotiate the same series of transactions until prices moved back in line to eliminate (net of transactions costs) the riskless return. Interest rate parity exists when covered interest arbitrage profit potential is eliminated.

Letting:

i₁ = Annual interest rate in Country 1;

i₂ = Annual interest rate in Country 2;

s_1,2 = Spot exchange rate equal to the number of units of Country 2’s currency for one unit of Country 1’s currency;

f_l,2 = One-year forward exchange rate equal to the number of units of Country 2’s currency for one unit of Country 1’s currency.

Interest rate parity is determined by a formula

The equilibrium condition, expressed in Equation # 2, suggests that the forward exchange rate differential as a fraction of the spot rate should equal the interest rate differential relative to 1 plus an interest factor to eliminate arbitrage profits. Conceptually, if interest rates are relatively low in one country, that country’s currency should sell at a forward premium. Any gain from borrowing at low rates and investing at higher rates is exactly offset when the borrower attempts to sell the investment proceeds forward at a premium price.

• Locational arbitrage:

Locational arbitrage capitalizes on discrepancies in different financial assets across locations. When quoted exchange rates vary among locations, participants in the foreign exchange market can capitalize on the discrepancy. Specifically, they can as locational arbitrage which is the process of buying a “Currency” at the location where it is priced cheap and immediately selling it at another location where it is priced higher. In other words, Locational Arbitrage may occur if foreign exchange quotations differ among banks or exchange offices. The act of locational arbitrage should force the foreign exchange quotations of banks to become realigned and locational arbitrage will no longer be possible.

Gain from locational arbitrage is based on the amount of money that is capitalized on the exchange rate discrepancy, along with the size of the discrepancy.

• Triangular arbitrage:

Triangular arbitrage is related to cross-exchange rates. Cross-exchange rate between two currencies is determined by the values of these two currencies with respect to a third currency. Therefore, to calculate the cross exchange rate, find out the value of the currencies to one unit of the common currency. Then equate those values and convert the equation to a traditional form. If the actual cross exchange rate of these two currencies differs from the rate that should exist, triangular arbitrage is possible. The act of triangular arbitrage should force cross exchange rate to become realigned, at which time triangular arbitrage will no longer possible. Triangular arbitrage which is the act of exploiting an arbitrage opportunity resulting from a pricing discrepancy among three different currencies in the foreign exchange market. If a quoted direct exchange rate differs from the appropriate cross exchange rate (as determined by the proceeding formula) you can attempt to capitalize on the discrepancy. Specifically, you can use triangular arbitrage, in which currency transactions are conducted in the spot market to capitalize on a discrepancy in the cross-exchange rate between two currencies.

Triangular arbitrage is also referred to as cross-currency arbitrage or three-point arbitrage.

Diagram 1. Cross Exchange Rates.

A triangular arbitrage strategy involves three trades:

1. Exchanging the initial currency for a second.
2. The second currency for a third.
3. The third currency for the rate is not aligned with the implicit cross exchange rate.

• Operational risk

As a first step, organizations must identify the relevant operational risks associated with their activities, processes, products, and systems. One of the methods for determining risks is to monitor all processes and create a list of potential sources of risk (the so-called "Display of business processes"). This step should be implemented by the risk management unit in conjunction with well-informed and well-trained employees of various departments of the organization. This method facilitates open communication/discussion and allows identifying individual risks, establishing the interdependence of risks and the areas of their control, as well as identifying vulnerabilities in the risk management system. Other risk identification methods include critical self-assessment, actuarial models, scenario analysis, external data collection and comparative analysis (see Risk Analysis Methods).

After identifying risks, organizations should assess their impact on a quantitative and qualitative basis. Quantitative estimates are associated with direct financial losses, which can potentially be caused by the actualization of risk. Quantitative assessments are necessary only for risks that could potentially lead to direct financial losses for the company. In assessing each risk, the following factors are taken into account:

1. The frequency of occurrence: how often can the risk event occur? To determine the frequency of occurrence, analyze events that have already occurred, and also which may occur in the future. It will also be useful to refer to events that occurred outside the company (other organizations in the banking industry).
2. Typical damage: what are the average estimated financial losses? If this event occurred in the past, estimate the average damage caused.
3. Atypical (exceptional) damage: how serious are the financial losses? It should be analyzed what level of losses will be received if this event occurs.

The key component of risk management is the measurement of the size and volume of the company's risks. However, at the moment there is no clearly defined single way of measuring operational risk at the firm level. Therefore, several key approaches have been developed. An example is the "matrix" approach, in which losses are classified according to the type of event and the business line in which the event occurred. In this way, the firm can determine which events have the greatest impact on the entire organization, and which business processes are most are subject to operational risk.

Once the potential and actual losses are identified, the firm will be able to analyze, and possibly also model their appearance. This requires the creation of databases to monitor such losses and the creation of risk indicators that summarize these data. Examples of such indicators are the number of failed transactions for a certain period of time and the level of staff turnover within the unit.

Potential losses can be classified broadly as "high frequency, low impact (HFLI) events, such as minor accounting errors or bank teller errors, as well as "low frequency, high impact "events (low frequency, high impacts (LFHI), such as terrorist attacks or major fraud. Data on losses associated with HFLI events are usually available from the company's internal audit systems. Therefore, the modeling and budgeting of these expected future losses as a consequence of operational risk can potentially be performed fairly accurately. At the same time, LFHI events are unusual (rare, atypical) and, thus, limit the individual organization in obtaining sufficient data for modeling purposes. Qualitative types of assessment, such as scenario analysis, an integral part of measuring the firm's operational risks.

It is relatively easy for an organization to establish and maintain specific measurable levels of market and credit risk since there are models that predict the potential impact of market movements or changes in the cost of a loan. It should be noted, however, that these models are so good as the incoming assumptions are of high quality, and a significant part of the recent financial crises arose from the fact that the estimates obtained by these models for specific types of investments were based on incorrect assumptions. On the contrary, it is relatively difficult to determine or assess levels of operational risk and its multiple sources. Historically, organizations have taken an operational risk as the inevitable cost of doing business. Many now accumulate data on operational losses - for example, in case of system failure or fraud - and use these data to model operational risk and calculate the capital reserve against future operating losses.

In Basel(2) sets out three approaches (methods) for calculating the amount of capital deducted for operational risk:

• The basic method of indicators (BIA - Basic Indicator Approach);
• The standardized method (TSA - Standardized Approach);
• Advanced measurement methods (AMA methods - Advanced Measurement Approaches group).
• Commodity risk

When calculating capital requirements using the "Ladders" method of payment timing based on seven-time bands (intervals), first of all, it is necessary to express the position of each product in standard natural units (barrels, kilograms, grams, etc.). Next, a net position is determined for each type of product, which is estimated at the current market value in national currency. When calculating a net position, the long (demand, or the right of demand for delivery of the goods) and the short (the obligation to supply the goods) positions for each type of goods can be determined on a net basis as the difference between the long and short positions. As a rule, positions in different goods are not compensated, except for cases when different subcategories of the same goods are delivered against each other. All long and short positions for each commodity, expressed in standard units of measurement, are arranged in the form of a "ladder" depending on the period remaining until their repayment. In each time interval, the value of the closed and clean open position is determined, respectively. The amount of matched long and short positions for each temporary the interval is first multiplied by the cash rate of securities, then by the spread risk bet for that interval. After that, the residual net positions from the nearest time interval can be carried forward to compensate for the risk in the intervals further down the time. The value of the "cumulative" cumulative closed position is calculated (by offsetting the open positions of the previous time intervals). At the same time, to each time interval, the residual net position from which is transferred forward, a markup equal to 0.6 percent of the net position is applied. As a result, the minimum capital requirements for covering commodity risk are calculated by summing up 1.5 percent of the value of the closed position in each time interval (including the value of the closed position resulting from the transfer of the open position from previous time intervals); 0.6 percent of the size of a net open position, calculated taking into account previous periods, for each transfer of this position for one time interval forward; 15 percent of the remaining net position.

When calculating capital requirements using a standardized (simplified) approach, the same procedure is used as in the previous method. However, the requirement for capital is calculated by summing up 15 percent of the net position (regardless of whether it is long or short) for each commodity and 3 percent of the total position size (the sum of long and short positions without a sign) for each type of product. When assessing the objectives of gross positions in derivatives, the bank must use the current cash rate of securities. Both of these methods allow us to calculate the risk using a standardized procedure, applying the so-called "building bricks" principle, in which special commodity and general commodity risks are determined separately and then added arithmetically.

• Price risk

Methods for assessing price risks can be classified into four groups:

• Calculated and analytical;
• Mathematical and statistical;
• Analogies;
• Expert assessments.

Calculating-analytical methods. Assess the level of price risk, depending on the values of the planned indicators of economic activity. Depending on whether the estimated price risk is attributed to consumable or lucrative portraits, the following methods include: a method for analyzing the appropriateness of costs; analytical method.

The method of analyzing the feasibility of costs. The calculation of price risk is based on taking into account the indicators of financial stability of the enterprise.

References

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4. Adrian, T., R. K. Crump, and Emanuel Moench. “Pricing the Term Structure with Linear Regressions.” Working Paper, Federal ReserveBank of New York, May 9.
5. Myskova, R. “Approach to Risk Management Decision-Making in the Small Business” (2015).