Riskd – Risk Management Blog

BPS is a software company which produces Integrated risk management software.  This article on their blog is an eye opener for people who believe things should be done the traditional way.

At this age of reduced pricing, increased quality, optimized workforce a differentiating factor for any company is how they are perceived by their existing customers and by the public in general. ‘Reputation’ matters.

Reputation may be an intangible but it is a highly prized asset, often equated with the goodwill of the business. For the majority of enterprises it is seen as the most critical risk. One of the major reasons for this is measuring this and putting a price on this considered more of an art than a science. And very few companies have mastered this art.

The CEO may be directly responsible for the management of reputational risk, this is normally shared with the Board of Directors, while deploying a number of functions such as corporate communications in its day-to-day operational mode.

There is, however, some consensus on the key elements of managing reputational risk:

• Prompt and effective communication with all categories of stakeholder – shareholders, employees, customers and suppliers.
• Strong and consistent enforcement of controls on governance, business and legal compliance.
• Continuous monitoring of threats to reputation.
• Ensuring ethical practice throughout the supply chains.
• Establishment and continual updating of a crisis management plan and establishment of a crisis management team, empowered with specific power and authority.

Controlling reputational risk through a managed or controlled way is very possible, a marketing and PR division of an organization should be involved in all aspects of setting this up.

To quote from wikipedia http://en.wikipedia.org/wiki/Market_risk

Market risk is the risk that the value of an investment will decrease due to moves in market factors. The four standard market risk factors are:

• Equity risk, or the risk that stock prices will change.
• Interest rate risk, or the risk that interest rates will change.
• Currency risk, or the risk that foreign exchange rates will change.
• Commodity risk, or the risk that commodity prices (i.e. grains, metals, etc.) will change.

As time progressed, three major composite measures of risks for a Portfolio were adopted by the risk professionals.

1. Treynor Index
2. Sharpe Performance Index
3. Jensen Performance Index
   

Treynor Index :

In order to use the Treynor Index, you must know three things; the portfolio return, the risk-free rate of return, and the beta of the portfolio. For the risk-free rate of return, you may use the average return (over the period of time) of some government bond or note. The beta of the portfolio is a measure of the systematic risk of the portfolio. Using the beta, rather than the standard deveiation, you are assuming that the portfolio is a well diversified portfolio. If you are looking at the return of a mutual fund, this figure is typically available from the fund company itself.

For those of you who want to know the formula for the index;

Treynor = (Portfolio Return – Risk-Free Return) / Beta

Let’s use the same example information. A portfolio manager achieved a return of 15.0%, his portfolio had beta measurement of 1.1 and the market achieved a return of 14.6% vs. a risk free rate of return of 7%. To calculate the Jensen Index:

index = (.15 – .07) / 1.1 = 0.0727

To compare, another portfolio manager achieved a return of 13.5% with a beta of .81. The Treynor index for this porfolio manager is:

index = (.135 – .07) / 0.81 = 0.0802

This means that the 2nd portfolio manager out performed the first portfolio manager on a risk-adjusted basis.

Sharpe Performance Index :
In order to use the Sharpe Index, you must know three things; the portfolio return, the risk-free rate of return, and the Standard Deviation of the portfolio. For the risk-free rate of return, you may use the average return (over the period of time) of some government bond or note. The Standard Deviation of the portfolio is a measure of the systematic risk of the portfolio. Using the Standard Deviation, rather than the beta (as in the Treynor Index), you are assuming that the portfolio is NOT a deversified portfolio.

Because the numerator is the Portfolio’s Risk Premium, the Sharpe Index measures the Risk Premium earned per unit of total risk.

Si = Ri – RFR / oi

Ri = Average Rate of Return for Portfolio
RFR = Average Rate of Return for Risk-Free Assets
oi = Standard Deviation of Rate of Portfolio’s Return

Jensen Peformance Measure:

Superior portfolio managers who accurately predict market turns or who identify undervalued investments earn higher have consistently positive random error terms

rjt = rfrt + bj[rmt - rfrt ] + ujt

this version of capm suggests that return is a function of risk-free rate, plus risk premium that depends on systematic risk, plus, random error term with an intercept to measure the positive or negative difference,

the equation becomes rjt – rfrt = alpha + bj[rmt - rfrt ] + ujt

rearranged —– alpha = (rjt – rfrt) – bj (rmt – rfrt)

where alpha measures how much of the rate of return on the portfolio is attributable to the manager’s ability to derive above-average returns adjusted for risk

Risks which exists ‘already’ before you address it is called Inherent Risk ; i.e., the risk to your company in the absence of any actions you might take to alter either the likelihood or impact. Every company in every
industry faces inherent risk; of course, not every company manages it
effectively or efficiently. Some examples for this are

• lack of management competence. Management competence refers to the competence of directors and other senior management personnel. It includes matters such as their:
  • industry experience,
  • knowledge of the entity’s business,
  • commercial skills,
  • common sense,
  • knowledge of good corporate governance, and
  • communication and judgement ability.

Auditors can assess management competence by speaking to directors individually as well as considering such factors as the number of years experience of each director in the industry, the number of years experience with the entity, and the extent of changes to management during the past several years.

• another example is the extent of significant and prolonged under staffing of the accounting department. Such understaffing could be indicative of management’s lack of interest in quality reporting, or even a positive interest in poor quality reporting.

Residual risk is also known as your “vulnerability” or “exposure”; .e., the risk that remains after you have attempted to mitigate the
inherent risk. Companies can only understand residual risk if they ave first addressed inherent risk. An example for this which could be unique to a company are strikes, the outcome of unfavorable litigation, or a natural catastrophe that can be eliminated through diversification.

An asset is something which within your context has some value which is important to preserve.

• Business
  • Project
• Deliverables
• Life
• Health
• Savings
• Legacy
• Digital Assets
• Property
  • Cars
• Reputation

and many more…

This is a process of determining which risks might affect the project (an example of an asset) and documenting their characteristics.

Risk Identification is an iterative process, involving the project team, management team, stakeholders and subject matter experts (if required).

Risk Identification process is a part of “Project Planning Phase”.

The major components for risk management would be the following :

1. Asset (Includes anything you deem important and could include current assets and projected assets)
2. Risk (anything which can reduce the value of your asset)
   1. Risk Event / Instance (the actual event)
3. Probability of the Risk happening
4. Impact (Quantifiable change in your asset value)