questions

A sound risk culture is characterized by the 4 indicators of the financial stability board

'- Tone from the top: committment to values, expectation that staff acts with integrity and escalates on-compliance

'- Accountability: employees understand, and are capable to perform their roles, and know they are held accountable'

- Effective communication and challange: open communication, effective challange

'- incentives should encourage and reinforce risk management behaviour and core values

A sound risk culture promotes sound risk-taking and ensures that emerging risks and excessive risk-taking activities are assessed, addressed and escalated in a timely manner.

a.) Credit Risk

•Concentra-tion limits/ granularity

•Funded credit protection

•Unfunded credit protection

•Credit enhance-ment

•Derivatives

•Selling claims/assets to third parties

•Building loss absorbing capacities

avoid, reduce, transfer, accept

amount of risk, on a broad level, an entity is willing to accept in pursuit of value.

'- Qualitative (e.g. definition of categories high, medium incl. Requirement to manage risk on an assigned level)

'- quantitatively (e.g. risk metric), risk appetite may be allocated portion of capital or risk bearing capacity

'- through setting of policy

Basle traffic light approach, count outliers over 250 days, <=4 green, >4 < 10 yellow, >= 10 red (assumption problem exists with model)

–Regulatory implied: A regulatory body has defined scenarios that shall be „withstood“, e.g. 200bp Interest Rate Shock, EBA or EIOPA Stress tests or ESRB Stress Test scenarios for CCPs*:

'- Historic: The most extreme movements of risk factors in the available history is used, highest change of an equity index e.g. 1929 Black Friday, highest average probability of default for a rating class, most extreme currency movement, highest change of implied volatility.

'- Forward Looking: Artifical scenarios based on „expert judgement“ what could happen in the future.

–Reverse/Inverse: Based on above scenarios or simple sensitivities, the smallest scenarios are developed (e.g. by scaling) that the company just will not survive

Governance & Culture // Strategy and Objective Setting // Performance (Assessment) // Review & Revision // Information, Communication & Reporting

1st LOD=operational management; 2nd LOD=control unit relevant for the specific risk, e.g. Risk Management or Compliance; 3rd LOD=independent Internal Audit

Factoring:A group (to avoid cherry picking) of short term receivables is sold to financial institution, continuous basis.

Asset Backed Securities: A pool of assets (often selected) is sold to investors, through SPV, rating agency is used to assess risk.

Pension provisions:

Risks resulting from management plan assets (asset management) vs. Fixed rates on liabilities

interest rate risk

stock and fx-investment risk

commodity risk

real estate risk

Risks resulting from pension provisions

longevity of staff, retirees

inflation

interest rate risk due to risk of change of discount rate

b)

Impact discount rate: The higher the discount rate the lower the present value of pension liabilites

And: the lower the discount rate the higher the present value of pension liabilities

Rating impact: determines investment grade, non-investment grade

The better the rating, the better is the access to external funds

The better is the access and range of funding instruments

The better the rating, the cheaper are the interest rate costs; the lower the credit spreads

High rating implies opportunity costs (low leverage; limited risks)

1.) determine which exposure, 2.) how much to hedge and 3.) by which instrument to hedge

Hedging only vs. Optimizing market opportunities, solution: transfer risks to treasury, business can concentrate on its operation, treasury can be limited

A sound risk culture promotes sound risk-taking and ensures that emerging risks and excessive risk- taking activities are assessed, addressed and escalated in a timely manner.

1. ‘Tone at the Top’ starts with the board defining and showing commitment to the entity’s core values and desired behaviours, including the expectation that staff acts with integrity (doing the right thing) and promptly escalates observed non-compliance/excessive risk taking (no surprises approach). Leadership considers the impact of culture on safety and soundness and makes necessary changes.

2. Accountability: Employees understand the core values and the approach to risk, are capable of performing their prescribed roles, and are aware that they are held accountable for their actions.

3. Effective communication and challenge promotes an environment of open communication and effective challenge in which decision-making processes encourage a range of views allowing for testing of current practices;

4. Incentives encourage and reinforce the desired risk management behaviour and core values

Focus should be also on how sound risk taking is embedded in the daily behaviours and decision making processes throughout the organization.

Regulatory Stress Testing

Historic Stress Testing

Forward Looking Stress Tests

Reverse / Inverse Stress Testing

See Cases:

Spot transaction, Purchase /sale of foreign curencies

Prices fixed on trading date

Settlement: Same day or two days after concluding contract due to technical reasons

Implies no hedging effect; full chances and full risks

Forward transactions: Contract price fixed today; settlement date: Forward date

Implies full hedging, but no chances to benefit from future positive fx-rate development

Options contracts: Hedging effect and in addition chance to benefit from favourable market movements

However, implies option fees which can be significant

Major types of FX-Risk Exposures

1. Transaction Exposure risk (trade related)

2. Translation Exposure risk (accounting related)

3. Operational Exposure risk (in the sense: real economic exposure due to long term fx-changes)

Explanation provided in the script

Idea: Reduction Equity ratio / increase debt ratio; positive only if return total capital exceeds debt interest, otherwise negative effect

Implications:reduction creditworthiness; increase financing rates

Potential rating reduction; reduction financing volume