RISK MANAGEMENT FAILURES: WHAT ARE THEY AND

WHEN Do THEY HAPPEN?

The role of risk management involves performing the following tasks.
• Assess all risks faced by the firm.
• Communicate these risks to risk-taking decision makers.
• Monitor and manage these risks (make sure that the firm only takes the necessary amount of
risk).
A large loss is not necessarily an indication of a risk management failure. As long as risk
managers understood and prepared for the possibility of loss, then the implemented risk
management was successful. With that said, the main objective of risk management should
not be to prevent losses. However, risk management should recognize that large losses are
possible and develop contingency plans that deal with such losses if they should occur.

Risk management can fail if the firm does not do the following: measure risks correctly,
recognize some risk, communicate risks to top management, monitor and manage risks, and
use appropriate metrics.
One of the key issues for risk managers is the occurrence of extreme events (those events
which occur with low frequency, but high severity). Estimates of these rare events require a
degree of subjectivity, which clearly has the potential for mismeasurement.
Failing to take known and unknown risks into account (i.e., ignoring risks) can take three
forms:
1. Ignoring a risk that is known.
2. Knowing about a risk, but failing to properly incorporate it into risk models.
3. Failing to discover all risks.
Not collecting and entering data into the appropriate risk models is another potential source
of disaster.
Another risk that is often ignored is increasing correlations during a time of crisis.

Risk management efforts are wasted unless the results can be effectively communicated to
the appropriate decision makers. This includes timely communication that has not been
distorted by intermediaries.

Mismeasurement can occur when management does not understand the distribution of returns
of a single position or the relationships of the distributions among positions and how the
distributions and correlations can change over time. Mismeasurement can also occur when
managers must use subjective probabilities for rare and extreme events. The subjective
probabilities can be biased from firm politics.
Failing to take known and unknown risks into account can take three forms: (1) ignore a risk
that is known, (2) failure to incorporate a risk into risk models, and (3) not finding all risks.
All three of these are variations of the same concept and can have similar results (e.g., failure
to measure overall risk or expanding operations to areas where risk is not being properly
measured).
Senior managers must understand the results of risk management in order for it to be
meaningful. Unless senior managers have the correct information to make decisions, risk
management is pointless.
Risk managers must recognize how risk characteristics change over time. Many securities
have complex relationships with market variables. Having an adequate incentive structure
and firm-wide culture can help with the risk monitoring and managing process.
Risk metrics such as VaR are usually too narrow in scope. For example, VaR usually
assumes independent losses across periods of time. Risk metrics generally fail to capture the
effect of a firm's actions on the overall market and behaviour patterns such as predatory
trading.
Risk metrics aid the management process by providing managers a target to achieve.
One misuse of VaR is choosing a time period (e.g., daily or weekly) that does not correspond
to the liquidity of the assets in the portfolio. Using daily VaR on a portfolio where the assets
cannot be effectively traded within a day is clearly not appropriate.
 DELINEATING EFFICIENT PORTFOLIOS (optional)

• The piece of the portfolio possibilities curve that lies above the minimum variance portfolio
is concave.
• The piece of the portfolio possibilities curve that lies below the minimum variance portfolio
is convex.
Consider the task of creating portfolios comprising the risk-free asset, F, and a risky
portfolio, P. Assume that Portfolio P lies on the efficient frontier of risky assets. Various
combinations (weightings) of Portfolio P and the risk-free asset can be created. By adding the
risk-free asset to the investment mix, a very important property emerges: The shape of the
efficient frontier changes from a curve to a line.

If all investors agree on the efficient frontier (i.e., they have homogeneous expectations
regarding the risks and returns for all risky assets), they will hold a combination of the market
portfolio and the risk-free asset. Risk-averse investors will create lower risk portfolios by
lending (i.e., investing in the risk-free asset). More risk-tolerant investors will increase
portfolio return by borrowing at the risk-free rate. This result is known as the separation
theorem