DBFI301 Unit-11 PDF

DBFI301: Bank Management & financial risk management Manipal University Jaipur (MUJ)
MASTER OF BUSINESS ADMINISTRATION

SEMESTER 3
DBFI301
BANK MANAGEMENT & FINANCIAL RISK
MANAGEMENT
Unit 11 : Foundations of Risk Management 1

Unit 11
Foundations of Risk Management
Table of Contents
SL Fig No / Table SAQ /

Topic Page No
No / Graph Activity
1 Introduction - -
3-4
1.1 Learning Objectives - -
2 An Understanding Of Corporate Risk
Governance - 1 5-8
3 The Trade-Off Between Risk And Return 1 2 9 - 11

4 The Construction Of Efficient Portfolios - 3 12 - 14
5 Fundamental Asset Pricing Models 2 4 15 - 23
6 Enterprise Risk Management Frameworks 3 5 24 - 28
7 Data Quality Management - 6 29 - 31
8 A Review Of Major Financial Disasters - 7 32
9 Summary - - 33
10 Glossary - - 33
11 Terminal Questions - - 34
12 Answers - - 34 - 36
13 References - - 37
14 Caselet - - 38 - 39
15 Conceptual Map - - 40

1. INTRODUCTION
Even though financial risk has dramatically increased recently, risk and risk management
are not new concerns. The risk may arise from distant events that have nothing to do with
the native market due to more global markets. Due to the rapid availability of information,
market reactions to change also happen quickly.
The risk-return trade-off states that when risk rises, possible profit also rises. This
hypothesis holds that people associate low risk or uncertainty with small potential profits
and high risk or uncertainty with huge potential returns.
A particular investment’s or asset class’s risk level and potential return rate are often
inversely correlated. This relationship is justified by the idea that investors ready to make
hazardous bets and possibly lose money should be compensated for their risk.
The process of identifying, assessing, and controlling risks to an organization’s assets and
revenues is known as risk management. These risks can be brought on by various factors,
including economic instability, legal obligations, technology issues, poor strategic
management, mishaps, and natural disasters. A risk that is unavoidable due to the nature of
the situation or an absolute risk leaves no room for doubt as to whether a loss will occur,
making the risk financially uninsurable.
Risk management’s main objective is to foresee future issues and have a plan to deal with
them. Risk management examines both internal and external threats to a business.
Money set aside for speculative purposes and used for high-risk, high-reward investments is
referred to as risk capital. Risk capital refers to any funds or assets that could potentially lose
value, but the word is frequently reserved for capital set aside for highly speculative
investments.
Risk management, in the context of finance, is the process of recognizing, analyzing, and
accepting (or minimizing) uncertainty in investment decisions. Risk management refers to
the process by which a fund manager or investor assesses and makes an effort to quantify
the possibility of losses in an investment, such as a moral hazard, and then decides the course
of action (or inaction) to be taken in light of the fund’s investment goals and risk tolerance.

1.1 Learning Objectives:
After studying this chapter, you will be able to
❖ Explain the risk and return in trade-off

❖ Explain data quality management
❖ Explain the fundamental asset pricing models

2. AN UNDERSTANDING OF CORPORATE RISK GOVERNANCE

An organization’s comprehensive policies, procedures, and standards are known as
governance or corporate governance. Enterprise risk management (ERM), often known as
risk management, recognizes potential company risks and takes steps to lessen or eliminate
their financial impact.
Corporate governance is the set of laws, regulations, and procedures governing corporations.
The phrase refers to internal and external elements that influence the objectives of the
various parties interested in a firm, such as shareholders, clients, suppliers, government
regulators, and management.
Developing a framework for corporate governance that optimally integrates business

activity with corporate goals falls to the board of directors or corporate executive committee.
Establishing security, transparency, equity, compliance, reliance, and accountability
principles are all part of good corporate governance.
Corporate governance is built on rules, bylaws, policies, and procedures to ensure corporate
accountability. When done correctly, it creates a framework for achieving a company’s goals
across all managerial domains. Furthermore, it acknowledges the significance of
shareholders. Shareholders choose the company’s board of directors, provide funding for
operations, and have a direct say in how the company is run.
A company’s integrity, overall direction, risk management, and succession planning are all
guaranteed by good governance. As a result, businesses may maintain financial viability and
develop great relationships with stakeholders, investors, and the community. Organizations
demonstrating sound corporate governance are frequently regarded as equally vital to
profitability.
Principles of corporate governance
Although corporate governance models may differ, the majority of firms have the following
essential components:

Fair and equitable treatment: All stakeholders—shareholders, clients, staff, and others—
should be treated fairly and equally. Ensuring shareholders are informed of their rights and
how to exercise them is a part of this.
Accountability: Both shareholders and non-shareholders have legal, contractual, and social
obligations that must be upheld. Organizations should establish a code of conduct for senior
executives, board members, and committees like the audit and pay committees. All new
members of those ranks must adhere to the specified requirements.
Diversity: The board of directors must remain dedicated to promoting diversity in corporate
governance and the business.
Oversight and management: Board members must also have the expertise to evaluate
management procedures.
Transparency: All corporate governance practices and policies should be public to all
appropriate parties. This includes regularly and consistently informing staff, clients,
investors, partners, and neighbors of relevant information.
Conflict management in corporate governance
Implementing a system of checks and balances that reduces conflicts of interest between
numerous stakeholders and any one party is one goal of corporate governance.
When two parties disagree on how a business should be managed, it will result in a conflict.
Conflicts of interest can also develop when a stakeholder’s gain from a company activity or
decision they have a vote in could be at issue. The board of directors should offer a neutral
procedure to resolve these disputes.
When executives disagree with shareholders, conflicts can arise. For instance, although the
CEO may want to invest in improved employee engagement initiatives, the shareholders may
prefer to pursue objectives that result in more profits. If different stockholders disagree,
another conflict can develop.
Proxy statements often reveal personal or professional conflicts of interest between

directors, audit plan administrators, and corporate executives. Shareholders assess the

qualifications and compensation of the board of directors and top management personnel
via a proxy statement.
According to the Securities and Exchange Commission, proxy statements must be made
available by publicly traded corporations. They are disclosed at annual meetings when a
business asks for shareholder approval on a particular issue, like the appointment of a new
director to the corporate board.
A well-defined and strictly enforced organization that works to everyone’s advantage by

ensuring that the company abides by formal laws, ethical standards, and best practices
illustrates solid corporate governance procedures.
As an alternative, terrible corporate governance refers to running a poorly organized,

unclear, and noncompliant firm. All of these strategies risk harming a company’s reputation
or bottom line.
Because there are uncertainties regarding the nature of the threats to attaining the objectives
or the heart of the possibilities, risk management is essential to corporate governance in any
entity. This is true for the company and the environment in which it operates.
Corporate governance is crucial because it establishes a set of guidelines and procedures

that govern how an organization functions and how it balances the interests of all of its
stakeholders. Financial viability is a result of ethical business activities, which are a result of
good corporate governance that may then draw investors.
Corporate finance’s most significant financial market hazards are interest rates, foreign
exchange rates, currencies, and commodity price risks from oil, corn, and steel. These
dangers have a substantial impact on a company’s profitability. Increased interest rates
impact capital costs.

Self-Assessment Questions - 1
1. Risk management is the process of discovering, ___________, and controlling risks to
an organization’s resources and profits.
2. _________________refers to the set of laws, regulations, and procedures that govern the
corporations.
3. Define diversity.

3. THE TRADE-OFF BETWEEN RISK AND RETURN
A more significant risk is linked to a higher likelihood of a higher return, whereas a lower
risk is connected to a higher possibility of a smaller return. The risk-return trade-off refers
to an investor’s trade-off when weighing investment options between risk and return.
According to the risk-return trade-off, as risk increases, so does the potential return.
According to this theory, people link low levels of uncertainty to low potential returns and
high levels of risk or uncertainty to significant potential returns. The risk-return trade-off
states investing money can only result in more significant rewards if the investor tolerates a
higher likelihood of losses.
Risk and return are positively correlated: The bigger the risk, the more enormous the
potential for gain or loss. The risk-reward trade-off concept states that high levels of
uncertainty are linked to poor returns, and low levels of uncertainty are linked to low
returns.
Risk accounts for the possibility that your investment will lose money, whereas return
represents the amount you can earn over and above your initial investment. A higher risk
investment must provide more profits in a competitive market to balance the possibility of
loss.
The risk-return trade-off is the trading principle that connects high risk with high reward.
The right risk-return trade-off depends on several variables, including the investor’s risk
tolerance, the number of years till retirement, and the possibility of recovering lost cash.
Time is crucial to creating a portfolio with the right balance of risk and return. In contrast, if
an investor can only invest for a short period, the same stocks carry a higher risk of loss. For
instance, if an investor can invest in equities over the long term, this gives the investor the
potential to recover from the risks of bear markets and participate in bull markets.
Investments with greater risk typically yield better returns since that is how the financial
system works. The returns on low-risk investments are also lower. For instance, a higher
risk is involved if you invest in shares. In contrast to a less hazardous investment like

government bonds, returns on equity investments will also be higher. The risk-return trade-
off is the name given to this relationship between risk and returns in finance.
In the case of mutual funds, the names of the funds—such as small-cap, mid-cap, and large-
cap funds—are determined by the market capitalization of the business equity. In this case,
if the fund solely invests in small-cap companies, all of the investments made by the fund will
be in small-cap company equity. This holds for all other assets in mutual funds. Everyone
knows that the more risky investments in mutual funds, the larger the rewards.
The simple formula between risk and return is given by
Return = Risk-free Rate + Risk Premium
The Risk-Free Rate
Given that the risk-free rate is a constant for a particular financial function, an investor
seeking larger returns will naturally be interested in risk premiums. The premium will be
higher the riskier the course of action, increasing returns. A proper balance between return
and risk should be maintained to increase a share's market value. Every business in the
market must make this trade-off between risk and reward.
The Risk-Adjusted Rate
However, a risk-free rate and a risk-free premium must be added to determine the risk-
adjust discount rate. Financial managers typically attempt to balance risks and returns.
Managers use the above calculation to balance risk against premiums and prevent taking on
too much. Figure 1 shows the risk-adjusted rate.

Fig 1: Risk-Return Tradeoff
Source:(https://www.google.com/url?sa=i&url=https%3A%2F%2Fwww.motilaloswal.co
m%2Fblog-details%2FUnderstand-your-risk-return-trade-off-before-investing-in-
equities.)
4. The risk-return trade-off refers to an ___________________ when weighing
investment options between risk and return.
5. The risk-return trade-off is the trading principle that connects high risk with
_______________

4. THE CONSTRUCTION OF EFFICIENT PORTFOLIOS
The anticipated return on investment is the key feature of a successful portfolio. This is the
risk an investor is willing to take in exchange for a return on their investment. It is typically
expressed relative to both inflation and the risk-free rate.
The Markowitz approach to portfolio construction is based on the idea that the mean and
variance of future outcomes are enough for rational decision-making under uncertainty. To
find the optimal opportunity set, also known as the efficient frontier, returns are maximized
for a given level of risk, or risk is minimized for a given level of return.
A portfolio delivers the highest expected return for a given level of risk or has the lowest
level of risk for a given level of expected return, making it an efficient portfolio. The efficient
frontier is the line that connects each of these efficient portfolios.
Investing in derivatives to lower risk or expenses for the fund or to create additional capital
or income without taking on new risk is called efficient portfolio management (EPM).
How to build an investment portfolio
• Decide how much assistance you require.

• Select an account that advances your objectives.
• Based on your level of risk tolerance, choose your investments.
• Choose the most appropriate asset apportionment for you.
• When necessary, rebalance your investment portfolio.
The best-expected return for a given amount of risk, or conversely, the lowest risk for a given
expected return, is what is known as an efficient portfolio, sometimes known as an “optimal
portfolio.” A variety of investment goods make up a portfolio.
It is referred to as an “inefficient portfolio” if, given a certain level of risk, the expected
returns are not fulfilled or if the degree of risk necessary to attain that anticipated level of
return is too high.
According to American economist Harry Max Markowitz, who introduced the Modern
Portfolio Theory in 1952 and was awarded the 1990 Nobel Memorial Prize in Economic

Sciences, the owner of an efficient portfolio cannot diversify further to increase the expected
rate of return without accepting a higher level of risk.
The portfolio expected return, E(Rp), is obtained by adding the securities weights, w, and
their individual expected returns. The portfolio standard deviation is calculated by adding
the weighted covariances.
Where W = w1, w2, ..., wN is the vector of weights, 1 is the unit column vector, and E = 1, w2,...,
wN is the vector of expected security returns, where N is the number of candidate securities.
The portfolio is fully invested, as shown by the sum of the weights in (3).
Choose the best portfolios from all of these by using one of the methods listed below:
Determine all portfolios which share the same risk (volatility). Choose the portfolio with the
highest return from this subset.
Find all the portfolios with identical returns. Pick the portfolio with the lowest risk from this
subset of investments.
Risk-averse investors can build diversified portfolios that maximize their profits while
minimizing unacceptable levels of risk by using the modern portfolio theory (MPT).
Investors attempting to develop effective and diversified portfolios utilizing ETFs may find
the current portfolio theory helpful.
Always be risk-averse when building a portfolio. Your portfolio shouldn’t subject you to
more risk than is required to achieve your goals.
A successful portfolio completes its tasks for the least amount of money.
Risk minimization, tax minimization, simplicity, transparency, and ease of management.

6. The anticipated return on investment is the key feature of a successful
____________________.
7. The _____________ approach to portfolio construction is based on the idea that the
mean and variance of future outcomes are enough for rational decision-making
under uncertainty.

5. FUNDAMENTAL ASSET PRICING MODELS
The fundamental theorem of asset pricing provides an analogy between the lack of arbitrage,
a crucial idea in mathematical finance, and the presence of a probability measure under
which the market’s asset values behave in a particular way.
The capital asset pricing model
A financial model used to determine an asset’s expected rate of return is known as the capital
asset pricing model (CAPM). The predicted returns on the market and a risk-free asset, as
well as the asset’s correlation with or sensitivity to the market, are used by CAPM to achieve
this (beta).
The CAPM has drawbacks, such as relying on a linear interpretation of risk vs. return and
making irrational assumptions.
Despite its flaws, the CAPM formula is often employed as it is straightforward and simplifies
comparing different investment options.
For instance, it is applied alongside MPT to comprehend expected return and portfolio risk.
Given its risk, an asset’s expected return can be calculated using the following formula:
Investors want to be compensated for risk and time worth of money. The risk-free rate in the
CAPM calculation accounts for the time value of money. The other elements of the CAPM
formula take the investor’s increased risk into account.

The CAPM formula determines if a stock is properly valued by contrasting its predicted
return with its risk and time value of money. In other words, one may determine whether a
stock’s current price is reasonable given its expected return by understanding the
components of the CAPM.
Fig 2: CAPM
Source:
https://www.google.com/url?sa=i&url=https%3A%2F%2Fwww.researchgate.net%2Ffigu
re%2FFigure-A1-Representation-of-CAPM-Capital-Asset-Pricing-Model-and-the-SML
Consumption-based CAPM
The CAPM is extended to include projected return premiums above the risk-free rate. The
consumption capital asset pricing model (CCAPM) employs a consumption beta rather than
a market beta. The CCAPM and CAPM formulas’ beta components reflect a risk diversification
cannot mitigate.
The volatility of a specific stock or portfolio serves as the basis for the consumption beta.
According to the CCAPM, the return premium of an asset will be inversely correlated with its
consumption beta. The concept is credited to Robert Lucas, an economist at the University
of Chicago who received the 1995 Nobel Prize in Economics, and Douglas Breeden, a
professor of finance at Duke University’s Fuqua School of Business.

The CCAPM offers a fundamental understanding of the connection between consumption,

wealth, and risk aversion in investors. The CCAPM functions as an asset valuation model to
inform you of the anticipated premium investors must pay to purchase a particular stock and
how the risk associated with consumption-driven stock price volatility affects that return.
The changes in the risk premium (return on asset and risk-free rate) with increasing
consumption serve as a proxy for the amount of risk associated with the consumption beta.
The CCAPM is helpful when determining fluctuations in stock market returns concerning
consumer growth. A greater consumption beta indicates an increased projected return on
riskier assets. An enhanced asset return demand of 2%, for instance, would be implied by a
consumption beta of 2.0 if the market rose by 1%.
The CCAPM considers various wealth types outside of stock market wealth and offers a
framework for comprehending variations in financial asset returns over multiple periods.
This provides an improvement over the CAPM, which only considers asset returns over one
time.
Intertemporal CAPM
The consumption-based capital asset pricing model (CCAPM), known as the intertemporal
capital asset pricing model (ICAPM), is based on the assumption that investors will hedge
their risky positions. Robert Merton, a Nobel laureate, developed the ICAPM as an expansion
of the CAPM in 1973. (CAPM).
A financial investment model called the CAPM helps investors determine possible
investment returns based on risk. In particular, the desire that the majority of investors have

to safeguard their investments against market uncertainty and create dynamic portfolios
that hedge against risk, ICAPM expands this idea by allowing for more realistic investor
behavior.
Financial modeling aims to numerically portray a particular feature of a business or asset.

Analysts and investors use economic models to decide whether to invest.
Financial models like CAPM, CCAPM, and ICAPM aim to forecast the projected return on a
security. The CAPM is frequently criticized as an economic model because it assumes that
investors are only interested in an investment’s return volatility to exclude other aspects.
However, by accounting for investors’ interaction with the market, ICAPM gives greater
accuracy than other models. Investment opportunities over time are referred to as
“intertemporal” opportunities. It accounts for the fact that most investors engage in market
activity over a long period. When investors want to hedge over longer time horizons,
investment opportunities may alter as risk perceptions change.
Investors may seek to hedge against various macroeconomic and microeconomic events
using their portfolios. These uncertainties include an unexpected decline in a business or
within a particular industry, high unemployment rates, or escalating hostilities between
nations.
If a downturn in the business cycle is anticipated, investors can consider holding certain
investments or asset classes because they have historically performed better in bear
markets. Using this method, an investor may hold a hedging portfolio of defensive equities,
often outperforming the market during economic downturns.
In order to account for these risks, an investment strategy based on ICAPM includes one or
more hedging portfolios. Since ICAPM spans several time frames, various beta coefficients
are employed.
Even though the ICAPM recognizes the significance of risk considerations in investing, it does
not adequately explain these risk factors or how they affect asset prices. The model claims
that these variables impact the prices investors are prepared to pay for assets, but it doesn’t
address all the risk factors or quantify impact they have on pricing. Due to this ambiguity,

several analysts and scholars have studied historical pricing data to determine how risk
variables and price variations are related.
Single-index model
According to the single-index model (SIM), a security’s returns can be shown as a linear
relationship with any economic variable pertinent to the security.
In the case of stocks, this single factor is the market return.
The SIM for stock returns can be represented as follows:
$$r{s}-r{f}=\alpha +\beta \left ( r{m} - r{f}\right )+\varepsilon$$
Where:
Alpha (α) represents the abnormal returns for the stock
β(rm − rf) describes the movement of the market modified by the stock’s beta
ε represents the unsystematic risk of the security due to firm-specific factors.
This equation states that an asset’s returns are affected by the market, as shown by beta, and
includes firm-specific risk and excess returns (the residual).
The number of estimations needed to choose a portfolio is lower. The risk is divided into
market-wide and firm-specific components by the index methodology. It assists with
security risk premium assessment, demonstrating diversification’s value.
Alpha = R – Rf – beta (Rm-Rf)
R is a symbol for portfolio return. Rf denotes the risk-free rate of return. The systematic risk
of a portfolio is represented by beta. According to a benchmark, Rm stands for the market
return.
An alternative is to take multiple indices into account. We must consider each covariance
term in the variance-covariance matrix when using the Markowitz model.

The single-index approach simplifies the analysis by assuming that just one macroeconomic
factor, represented by the rate of return on a market index, such as the S&P 500, drives
systemic risk and affects all stock returns. According to this model, the return of any stock
can be divided into three categories: the return resulting from market-wide macroeconomic
events, the unexpected microeconomic events that only affect the firm, and the expected
excess return of the individual stock due to firm-specific factors, commonly denoted by its
alpha coefficient (). The return of stock I is specifically:
ri = αi + βirm + ei
The term “irm” refers to the stock’s return due to market movement modified by the stock’s
beta I. In contrast, the term “ei” refers to the security’s unsystematic risk due to firm-specific
characteristics.
The unexpected microeconomic events that affect the returns of specific firms, such as the
death of key employees or a reduction in the firm’s credit rating, would have an impact on
the firm but would have little effect on the economy. Macroeconomic events, such as changes
in interest rates or the cost of labor, cause systemic risk that affects the returns of all stocks.
Diversification can eliminate all unsystematic risks in a portfolio caused by firm-specific
characteristics.
The following is the foundation for the index model:
Because all equities react to macroeconomic events similarly, most stocks exhibit positive
covariance.
But some businesses are more sensitive to these factors than others. This firm-specific
variance is often shown by its beta (), which quantifies its variance relative to the market for
one or more economic factors.
Other securities react differently to macroeconomic conditions, which causes covariance

among them. As a result, by multiplying each stock’s beta by the market variance, one may
determine its covariance (2):

Cov(Ri, Rk) = βiβkσ2
The computations required by this final equation are significantly reduced because it does
not require calculating the covariance of each potential pair of securities in the portfolio
using historical returns. To calculate covariance utilizing this equation, only the betas of the
individual securities and the market variance need to be determined. As a result, the index
approach significantly decreases the calculations required for an extensive portfolio with
thousands of stocks.
Multiple factor models. Fama–French three-factor model. Carhart four-factor model.
The Fama and French three-factor model, often known as the Fama French model, is an asset
pricing model that builds on the CAPM by including size risk and value risk elements in
addition to the market risk factor present in CAPM. It was created in 1992. This model
considers the recurring outperformance of markets by value and small-cap stocks. The
model corrects for this tendency of outperforming, which is expected to improve its
usefulness as a tool for assessing management performance.
To more accurately gauge market returns, Nobel laureate Eugene Fama and researcher
Kenneth French, both former professors at the University of Chicago Booth School of
Business, discovered that value companies outperform growth stocks through study.
Similar to how small-cap companies typically do better than large-cap equities. When used
as a tool for evaluation, portfolios with a high proportion of small-cap or value companies
would perform worse than the CAPM result because the three-factor model makes a
downward adjustment for observed outperformance of small-cap and value stocks.
The size of the firms, book-to-market valuations, and excess return on the market are the
three components of the Fama and French model. In other words, the three components are
the portfolio’s return less the risk-free rate of return, high minus low (HML), and small minus
big (SMB). While HML accounts for value equities with high book-to-market ratios that
produce higher returns than the market, SMB accounts for publicly traded companies with
modest market caps that make higher returns.

Whether the outperformance tendency is caused by market efficiency or market inefficiency

is a hotly contested topic. The additional risk typically explains the outperformance that
value and small-cap companies experience due to their higher cost of capital and higher
business risk, which supports market efficiency. Market participants misprice the worth of
these enterprises, which results in the excess return over time as the value adjusts,
explaining the outperformance in favor of market inefficiency. Investors are more inclined
to support the efficiency side if they accept the evidence offered by the efficient market
hypothesis (EMH).
According to the Fama and French three-factor model, investors must be ready to withstand
the added volatility and sporadic underperformance in the short term. Investors with a long-
term time horizon of at least 15 years will be rewarded for short-term losses. Investors can
adjust their portfolios to earn an average expected return following the relative risks they
take because the model can account for up to 95% of the recovery in a diversified stock
portfolio.
Arbitrage pricing theory
An asset’s returns can be anticipated using the linear relationship between the asset’s
expected return and various macroeconomic factors that represent a systematic risk,
according to the arbitrage pricing theory (APT), a multi-factor asset pricing model. It is a
helpful tool for value investors to employ when examining portfolios to find assets that might
be momentarily mispriced.

In the APT model, linear regression estimates the beta coefficients. To estimate the factor’s
beta, past security returns are typically regressed.
As an illustration, the return on a stock can be explained by the following four components,
and their sensitivity and related risk premiums have been determined.
Gross domestic product (GDP) growth: ß = 0.6, RP = 4%
Inflation rate: ß = 0.8, RP = 2%
Gold prices: ß = -0.7, RP = 5%
Standard and Poor’s 500 index return: ß = 1.3, RP = 9%
The risk-free rate is 3%
Using the APT formula, the expected return is calculated as follows:
Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x 9%) = 15.2%
8. CAPM full form
9. APT full form
10. GDP full form

6. ENTERPRISE RISK MANAGEMENT FRAMEWORKS
Based on the department’s risk appetite and the context of our risk environment, the
enterprise risk management framework (ERMF) is a comprehensive approach to identifying,
assessing, and managing risk. The strategic plan-referenced departmental priorities are
intended to be supported by the ERMF.
Fig 3: ERMF
Source: https://alt-qed.qed.qld.gov.au/publications/management-and-
frameworks/enterprise-risk-management-framework
An ongoing procedure called ERM is created to handle all hazards within a company. ERM is
a process implemented by an entity’s board of directors, management, and other personnel
and used in strategy setting across the enterprise. It is intended to identify potential events
that could affect the entity and manage risk to be within its risk appetite to provide
reasonable assurance regarding the achievement of entity objectives.

A firm may see its entire risk level by establishing an ERMF, which is crucial. The procedures
must be followed to create an ERMF, and potential advantages and difficulties are covered
below.
Process for Establishing an ERM Framework
Common language around risk: The organization must introduce standard terms for risk via
the risk management department (or an equivalent). A popular definition of risk is the
possibility of loss or a reduced opportunity for gain that could prevent a company from
achieving its goals. Communication between business units will be facilitated by shared
terminology.
Risk management steering committee: To oversee the use of the ERMF, it is crucial to create
a high management-level committee. The committee will also aid in defining the situations
and duties within the framework.
Roles and responsibilities: The entire organization must clearly understand functions and
duties.
The CEO and board of directors are ultimately responsible for all risks. Periodic discussions
about risk management procedures and reviews and approvals of policies about risk
management are required.
Senior management should create, implement, and maintain an efficient framework.

Establish and monitor the risk appetite, develop policies and procedures, and provide the
board of directors with frequent updates. Encourage a risk-conscious culture.
Business units should identify, evaluate, quantify, track, manage, and communicate risks to
senior management. Manage pertinent risks following the guidelines set forth by senior
management. Authenticate that policies and procedures are being followed.
Supporting departments (such as legal, human resources, and information technology) help
business divisions create and enforce policies and procedures.
Internal audit and compliance: Keep an eye on the framework’s efficacy and offer
independent assurance.

Risk management: Organize the frameworks creation and offer risk management
knowledge.
ERM methodology: The ERMF technique should be developed. Definitions of essential risk
words, explanations of roles and duties, and detailed guidelines for identifying, measuring,
mitigating, monitoring, and reporting risks should all be included.
Risk appetite statements: A formal document that includes all important business sectors.
The composition ought to consider the goals and strategic direction of the company. It must
state the firm’s willingness to accept risk and its tolerance for possible loss. Additionally,
senior management and the board of directors must regularly examine and approve a risk
appetite.
Risk identification: This can be done using the risk control self-assessment (RCSA) method
under the supervision of risk management and with the assistance of subject-matter
specialists. The applicable hazards, inherent risk levels, effectiveness of internal controls,
and residual risk levels are all identified using this method using a risk taxonomy. The steps
in the procedure are as follows:
Determine the hazards that apply to your business unit and explain the business activity that
puts it at risk. This covers operational, event, market, liquidity, and strategic risk.
Determine the level of inherent risk (H, M, or L) and the average annual damage. Anything
that prevents the attainment of corporate objectives without taking internal controls into
account is considered an inherent risk. The business unit’s subjective assessment of previous
(actual losses) and possible future occurrences might be used to estimate the typical yearly
damage.
Evaluate and score the level of internal controls (H, M, L) and the basis for the evaluation.
Internal controls adopt policies, procedures, and standards to reduce the inherent risk.
After accounting for applicable internal controls, determine the remaining risk level (H, M,
L). For instance, a high residual risk level will be produced by a medium inherent risk and
low caliber of internal controls.

Risk prioritization: Prioritize significant risks following the residual risk levels using the
RCSA results for each business unit. With the risk management steering group, review all
high residual risks and establish risk mitigation strategies.
Risk mitigation plans (RMPs): To address the areas with the highest control inadequacies
and the greatest potential for loss, RMPs must be designed using a risk-based approach. The
increased risk must be prioritized since businesses typically run out of resources before they
run out of risk. Accountable owners and target completion dates must be chosen to make the
risk mitigation process easier.
Risk monitoring and reporting: The board of directors and senior management must be
updated on any significant risks regularly.
ERM advantages: The creation of an ERMF is a continuous process that involves many
people. It is a comprehensive, dynamic, and ongoing process that calls for firm-wide
involvement. ERM will provide the organization with several benefits when properly
implemented. A successful ERMFwill:
➢ Empowering a business to understand its overall risk exposure

➢ Growing firm-wide awareness of risks and controls
➢ Cut back on operational losses
➢ Maximize the use of capital
➢ Contest risk tolerance and strategy (business objectives)
➢ Board and senior management oversight is made easier
➢ Break down silos across all risks and among multiple departments (promote
transparency)
➢ Allow for the more effective utilization of resources
➢ Enhance perceptions among shareholders, rating agencies, and regulators
➢ Improving internal control
➢ Encourage a culture of risk awareness.
It is shocking to learn that just 36% of the institutions taking part in Deloitte’s Sixth Global
Risk Management Survey have an ERM program in place after considering the advantages of

implementing an ERM Framework. However, 72% of respondents said ERM’s benefits

outweigh its drawbacks.
11. ERMF full form
12. Internal Audit and Compliance
13. RMPs full form

7. DATA QUALITY MANAGEMENT
Data quality management offers a context-specific approach for boosting the acceptability of
data used for analysis and decision-making. Deriving insights about that data’s condition
involves applying various approaches and technologies to progressively larger and more
complex data sets.
Making sense of your data is crucial for improving your business’s bottom line. Data quality
management is a critical step in this process.
To begin with, effective data quality management creates a base for all business initiatives.
Data that is out-of-date or untrustworthy might result in errors and mistakes. A data quality
management program establishes a framework for all organizational departments that lays
forth and upholds standards for data quality.
Second, current, accurate data gives you a clear view of your business’s daily operations,
allowing you to have faith in the upstream and downstream applications that make use of all
that data. Management of data quality also reduces wasteful expenditures. Poor quality can
result in expensive oversights and mistakes, such as losing track of orders or spending. With
a solid understanding of your data, data quality management creates an information
foundation that enables you to comprehend your business and costs.
Data quality management is also necessary to achieve compliance and risk goals.
Transparent processes, effective communication, and vital underlying data are required for
good data governance. For the health of the data, a data governance council, for instance,
may specify what constitutes “acceptable” behavior. In the database, though, how is it
defined? How are the policies monitored and applied? Data quality is how the policy is
implemented at the database level.
The dimensions of data quality management
Various data quality metrics are in use. This list expands as data becomes more varied and
large, but some key aspects are constant across data sources.

To accurately draw inferences from your data, accuracy is essential. Accuracy assesses how
accurately data values are recorded.
When data is complete, every component has quantifiable values.
Consistency focuses on consistent data pieces across various instances with values drawn
from a well-known reference data domain.
Age addresses the idea that data should be current and up-to-date overall, with all values
being current.
To prevent duplications, uniqueness shows that each record or element is only ever
represented once in a data set.
Key features of data quality management
The system used by a competent data quality program has several elements that help
increase the reliability of your data.
Data cleansing first aids in correcting duplicate records, irregular data representations, and
unidentified data kinds. The data standards requirements necessary to produce insights
from your data sets are enforced through cleansing. To tailor data to meet your particular
needs, reference data definitions and data hierarchies are also established.
Data validation against accepted statistical measures, association discovery, and data
verification versus descriptions are all accomplished through data profiling, the act of
monitoring and cleaning data. Data profiling techniques will identify trends that can be used
to find, comprehend, and perhaps even highlight data contradictions.
You may react to poor-quality data before it hurts your firm by validating business rules and
establishing a business lexicon and lineage. This requires formulating specifications and
descriptions for system-to-system translations of business terms. Data can also be checked
against predefined rules or standard statistical measures.

14. A context-specific strategy for enhancing the suitability of data used for analysis and
decision-making is provided by __________________ management.
15. __________________ first aids in correcting duplicate records, irregular data
representations, and unidentified data kinds.

8. A REVIEW OF MAJOR FINANCIAL DISASTERS
The Great Depression of 1932, the Suez Crisis of 1956, the International Debt Crisis of 1982,
the East Asian Economic Crisis of 1997 to 2001, the Russian Economic Crisis of 1992 to 1997,
the Latin American Debt Crisis in Mexico, Brazil, and Argentina from 1994 to 2002, and the
Global Economic Recession of 2007 to 2009 are the seven crises that will be discussed.
A financial crisis occurs when the value of financial assets and instruments drastically drops.
As a result, companies struggle to pay their debts, and financial institutions cannot fund
projects or satisfy urgent needs due to a shortage of available cash or convertible assets.
Multiple factors may contribute to a financial crisis. Generally, an overvalued asset or

institution can trigger an emergency, which can be worsened by irrational or herd-like
investor behavior. For instance, when a bank failure is rumored, a rapid succession of selloffs
can lead to decreased asset prices, causing people to dump assets or withdraw substantial
sums of money from their savings.
Systemic breakdowns, unexpected or uncontrollable human behavior, incentives to take on

too much risk, regulatory absence or failures, or contagions that amount to a virus-like
spread of issues from one institution or country to the following are all contributory reasons
for a financial crisis. If a crisis is not contained, it may cause an economy to enter a recession
or depression. Even when measures are taken, financial crises still have the potential to
develop, spread, or worsen.
Financial shocks and crises impact the real economy because asymmetric information is
growing. Consequently, more asymmetric information results in less money flowing from
investors to business owners. Businesses reduce production due to a lack of external
financing, lowering overall economic activity.
Self-Assessment Questions – 7
16. A ______________________ occurs when the value of financial assets and instruments
drastically drops.
17. _________________ reduce production due to a lack of external financing, lowering overall
economic activity.

9. SUMMARY
A risk that is unavoidable due to the nature of the situation or an absolute risk leaves no
room for doubt as to whether a loss will occur, making the risk financially uninsurable.
The board of directors or corporate executive committee is responsible for creating a

corporate governance structure that combines business operations with organizational
objectives. Good corporate governance includes all of the following: security, transparency,
equity, compliance, reliance, and accountability.
EPM is investing in derivatives to reduce risk or expenses for the fund or generate more
capital or income without assuming additional risk.
Several things may cause a financial crisis. An emergency can generally be started by an
overvalued asset or institution and made worse by irrational or herd-like investor behavior.
For instance, when a bank failure is suspected, a series of quick selloffs can result in falling
asset prices, prompting people to sell their possessions or withdraw sizable sums from their
savings.
10. GLOSSARY
Risk: Exposure to the effects of uncertainty is a risk. It encompasses the prospect of economic
or financial gain or loss, bodily harm, human hurt, delay, or failure to meet goals due to future
uncertainty.
Risk-Return Trade-off: According to the risk-return trade-off, as risk increases, so does the
potential return. According to this theory, people link low levels of uncertainty to low
potential returns and high levels of risk or uncertainty to significant potential returns.
Financial Risk: The potential for financial loss in an investment or commercial enterprise.
Credit risk, liquidity risk, and operational risk are a few more typical and distinct economic
hazards. Financial risk is a type of risk that could cause interested parties to lose money.

11. TERMINAL QUESTIONS
1. Define the trade-off between risk and return

2. Explain data quality management
3. What are the fundamental asset pricing models?
4. Explain a review of major financial disasters.
5. Define the construction of efficient portfolios.
12. ANSWERS
Self-Assessment Answers:
1. evaluating
2. Corporate governance
3. The board of directors must remain dedicated to promoting diversity in corporate
governance and the business.
4. investor’s trade-off
5. high reward
6. portfolio
7. Markowitz
8. capital asset pricing model
9. Arbitrage pricing theory
10. Gross domestic product
11. Enterprise risk management framework
12. keep an eye on the framework’s efficacy and offer independent assurance.
13. Risk mitigation plans
14. data quality
15. Data cleansing
16. financial crisis
17. Businesses

Terminal Questions Answers:
1. An investment idea known as the risk-return trade-off suggests that the potential
benefit increases with risk. Investors must take into account various aspects, including
their general risk tolerance, ability to replenish lost cash, and more, to determine the
suitable risk-return trade-off.
The phrase “risk-return trade-off” refers to the link between an investor’s risk
tolerance and return realization levels. The possibility for more significant rewards
grows as risk does and vice versa.
2. A context-specific strategy for enhancing the suitability of data used for analysis and
decision-making is provided by data quality management. The objective is to derive
insights about the state of that data utilizing various techniques and technologies on
progressively greater and more intricate data sets.
Executives cannot trust the data or make informed judgments without accuracy and
dependability in data quality. This could lead to increased operating costs and chaos
for users further down the supply chain. Analysts rely on incomplete reports and draw
the wrong inferences from them.
3. Capital asset pricing model.

Consumption-based CAPM.
Intertemporal CAPM.
Single-index model.
Multiple factor models. Fama–French three-factor model. Carhart four-factor model.
Arbitrage pricing theory.
4. When the value of financial assets and instruments drastically drops, a financial crisis
occurs. As a result, companies struggle to pay their debts, and financial institutions
cannot fund projects or satisfy urgent needs due to a shortage of available cash or
convertible assets.
Financial crises have more damaging and subtle repercussions than just high costs. As
the world becomes more integrated, preserving the supply of global public goods will

be extremely difficult. But if we don’t first get rid of the effects of the crisis, we won’t be
able to manage these difficulties successfully.
5. An efficient portfolio combines investable assets to maximize expected returns given

risk or minimizes risk to maximize returns. The efficient frontier is a line that connects
all of these efficient portfolios.
The Markowitz approach to portfolio construction is based on the idea that the mean
and variance of future outcomes are enough for rational decision-making under
uncertainty. To identify the best opportunity set, efficient frontier, where returns are
maximized for a given level of risk, or minimize risk for a given level of return.

13. REFERENCE
• MacDonald, S. S., & Koch, T. W. Management of banking, 6th Edition, Indian: Cengage
Learning.
• Shrivastava, R. M., & Nigam, D. (2019). Management of Indian financial institutions, 8th
edition. Himalaya Publications.
• Gup B., & Kolari J. W. Commercial banking –the management of risk. 3rd Edition,Wiley
India edition.
• Hull, J. C. Risk management and financial institutions. Pearson.
• Dun, B. Financial risk management. Tata McGraw Hill.
• General Management Bank Management. IIBF Books for CAIIB Exam, Macmillan
Publication.
• Risk Management. IIBF Books for CAIIB Exam, Macmillan Publications.
• Asthana, V. Financial risk management. Himalaya Publishing House.
• Bhattacharya, H. Banking strategy – credit appraisal and lending strategies – a risk
return framework. Oxford University Publications.
• Mukherjee, D. D. Credit appraisal, risk analysis and decision making. 4th enlarged and
revised edition. Snow White Publications.

14. CASE STUDY
Advising on risk management to individuals and families raises several challenges. These
challenges include how identified, and evaluated risks can be reduced and/or addressed
using insurance policies or self-insurance. Families’ financial circumstances and risks evolve
over time, and financial advisers should review and update the solutions addressing these
risks accordingly. Risk management solutions recommended by advisers should consider
the family’s overall health, wealth, and long-term goals.
This case study explores some risk management issues for a married couple living in a
hypothetical country in the Eurozone. The case spans several decades and follows the couple
through different stages of life from their early career phase, when they are in their late
twenties, all the way to retirement. We will show how risk management methods need to
change as the family’s circumstances evolve. Particularly important prior readings related to
this case are the Level III readings “Risk Management for Individuals” and “Overview of
Private Wealth Management.”
The assumptions used are drawn from what is typical for many European countries. The
circumstances and risks this married couple faces are influenced by the environment in
which they find themselves. Despite the differences between Europe and other parts of the
world, their goals, the risks they face, the assessment of their circumstances, and the
suggested methods are by no means unique to the region. Therefore, the risk analysis
methodology and its application would be valid in a much broader context.
For simplicity, we assume that economic conditions and tax rates remain unchanged
throughout this case study's four decades. The terms “adviser” and “wealth manager” are
used interchangeably throughout this case study. The amounts that appear in exhibits
throughout the case study are rounded.
The case is divided into six major sections. Section 1.1 provides background information
about the hypothetical country in which the Schmitt family resides. Sections 1–4 provide
initial case facts relating to the family’s early career stage, risk management analysis, and
solutions relevant to that stage. In Sections 5 and 6, we revisit the couple in their career
development stage when they are 45. Sections 7–10 examine their lives at age 55, the peak

accumulation phase, and age 64 when they prepare to retire. The final section provides a
summary of the case.
Summary
This case study follows a family from their early career to the retirement stage. It touches on
a small and simplified selection of a wide range of issues and considerations that a family
may face. A great range of skills and competencies is required to provide financial advice,
from conducting in-depth risk analysis to making recommendations on risk mitigation
strategies, including choosing insurance products, performing asset allocation, tax
optimization, retirement planning, and estate planning. All of this must be done with a clear
understanding of the applicable legal environment, the level of access, and the cost of
accessing financial products. In practice, it is very unlikely that a single financial professional
can master all the foregoing competencies. The key to success is to understand at what point
the generalist needs to bring in or refer the client to a subject matter expert.
In this case study:
We identify and analyze the Schmitt’s’ risk exposures. We observed that the types of risk
exposure change substantially from the early career stage to the early retirement stage. We
conducted the analysis holistically, starting from the economic balance sheet, including
human capital.
We recommend and justify methods to manage the Schmitt family’s risk exposures at
different stages of their professional life. We use insurance, self-insurance, and adjustments
to their investment portfolio.
We prepare summaries of the Schmitt’s’ risk exposures and the selected methods of
managing those risk exposures.
We recommend and justify modifications to the Schmitt’s’ life and disability insurance at
different stages of the income earners’ lives.
Finally, we recommend a justified a plan to manage risk to the Schmitt’s’ retirement lifestyle
goals.

15. CONCEPTUAL MAP

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DBFI301: Bank Management & financial risk management Manipal University Jaipur (MUJ)

MASTER OF BUSINESS ADMINISTRATION

Unit 11 : Foundations of Risk Management 1

SL Fig No / Table SAQ /

3 The Trade-Off Between Risk And Return 1 2 9 - 11

Unit 11 : Foundations of Risk Management 2

Unit 11 : Foundations of Risk Management 3

1.1 Learning Objectives:

After studying this chapter, you will be able to

❖ Explain the risk and return in trade-off

Unit 11 : Foundations of Risk Management 4

2. AN UNDERSTANDING OF CORPORATE RISK GOVERNANCE

Developing a framework for corporate governance that optimally integrates business

Principles of corporate governance

Unit 11 : Foundations of Risk Management 5

Conflict management in corporate governance

Proxy statements often reveal personal or professional conflicts of interest between

Unit 11 : Foundations of Risk Management 6

A well-defined and strictly enforced organization that works to everyone’s advantage by

As an alternative, terrible corporate governance refers to running a poorly organized,

Corporate governance is crucial because it establishes a set of guidelines and procedures

Unit 11 : Foundations of Risk Management 7

Unit 11 : Foundations of Risk Management 8

3. THE TRADE-OFF BETWEEN RISK AND RETURN

Unit 11 : Foundations of Risk Management 9

The simple formula between risk and return is given by

Return = Risk-free Rate + Risk Premium

The Risk-Free Rate

The Risk-Adjusted Rate

Unit 11 : Foundations of Risk Management 10

Fig 1: Risk-Return Tradeoff

Unit 11 : Foundations of Risk Management 11

4. THE CONSTRUCTION OF EFFICIENT PORTFOLIOS

How to build an investment portfolio

• Decide how much assistance you require.

Unit 11 : Foundations of Risk Management 12

Risk minimization, tax minimization, simplicity, transparency, and ease of management.

Unit 11 : Foundations of Risk Management 13

Unit 11 : Foundations of Risk Management 14

5. FUNDAMENTAL ASSET PRICING MODELS

The capital asset pricing model

Unit 11 : Foundations of Risk Management 15

Unit 11 : Foundations of Risk Management 16

The CCAPM offers a fundamental understanding of the connection between consumption,

Unit 11 : Foundations of Risk Management 17

Financial modeling aims to numerically portray a particular feature of a business or asset.

Unit 11 : Foundations of Risk Management 18

In the case of stocks, this single factor is the market return.

The SIM for stock returns can be represented as follows:

$$r{s}-r{f}=\alpha +\beta \left ( r{m} - r{f}\right )+\varepsilon$$

Alpha (α) represents the abnormal returns for the stock

ε represents the unsystematic risk of the security due to firm-specific factors.

Alpha = R – Rf – beta (Rm-Rf)

Unit 11 : Foundations of Risk Management 19

The following is the foundation for the index model:

Other securities react differently to macroeconomic conditions, which causes covariance

Unit 11 : Foundations of Risk Management 20