Dear,
Managing means taking decisions; requires giving priority to some actions in front of others and allocating resources to the most important activities.
This is not an exception when it comes to Risk management, every investment and business activity requires taking a risk and it’s a candidate to request risk hedging actions.
But hedging a risk also has a cost that will potentially reduce the profit of the investment; at the end the profit of an investment is determined by all the revenues less all the costs.
Determining the profit of an investment without risk (arbitrage) is relatively easy, it just requires comparing homogeneous magnitudes. A typical example is the following; if we buy 3 oranges from someone for 3 $, and we sell them immediately after to someone else for 5$ we’ll make a non-risk profit of 2 $.
But if we buy the oranges for 3 $ and we exchange them for 3 apples, we can’t determine the profit immediately; we also need the value in $ of the apples to determine our profits.
That’s a typical risk management problem, if we’re storing and selling 2000 barrels of Oil; we’re taking many risks (explosion, leaks, price fluctuation, etc.) which require risk hedging activities. As risk zero does not exist, the more we invest in risk hedging activities (for instance, buying an insurance policy or installing a fire control system) the more costs we’ll support, reducing our profits.
Managing risk requires comparing the cost of the risk hedging activities with the cost of risk of the business activity, and that’s not easy.
Risk hedging activities can be measured in EUR or USD; but how I do it to compare them with the cost of risk? Again, I can’t compare apples with oranges.
This is a handicap of Integrated Information Systems, even SAP-ECC, the most successful of the Integrated ERP’s, does not offer an integrated and homogeneous vision of risk and its associated costs.
In a growing economy this is not a big issue, big margins cover inefficiencies on risk management, but we’re in a new model of limited growing economies with limited margins for the companies. In the new model, efficient management requires integrated Enterprise Risk Management systems.
But, do we have a candidate for building Enterprise Risk Management Information systems, capable of offering an integrated and homogenous vision of risk management?
In my opinion we do, and this is Bank Analyzer.
In the following lines I’ll try to give a brief description of the approach.
First we need the conversion of risk costs in USD, and we’ll look at Financial Mathematics’ for finding the function to convert risk exposures to USD, Oranges in Apples and vice-versa.
In Bank Analyzer, we can determine the NPV of a loan (Key Date Valuation), by discounting the expected cash-flows of the loan according to a yield curve, which depends on the probability of default of the counter-party. This is the probability of the expected cash-flows to become effective.
In a similar way, potential costs due to fluctuations in the Oil price, explosions, leaks, etc. represent expected Cash-Flows; by estimating the probability of those events happening, and selecting a Yield curve according to the probability of the events, we’re also estimating the Net Present Value of the Business Activity.
As you can see, from financial mathematics’ perspective there is not a big difference in calculating the Net Present Value of Lending money or the NPV of storing and selling Oil.
The challenge is modeling the business activity as SDL-Primary Objects. If we do, the risk engines of Bank Analyzer will provide us the Net Present Value, the expected losses due to counterparty risk and in future versions of BA, the Value at Risk and expected losses due to Market Risk.
We saw some weeks ago how to do it with a Sales Order of Crude Oil
http://sapbank.blogspot.com/2014/01/bank-analyzer-for-non-financial.html
I’m working on the modeling of many other business activities that I’ll share with you in future posts.
K. Regards.
Ferran.
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