Risk Modeling Approach
- Develop deterministic model for business process
- Acquire information regarding model inputs from historical data, expert opinion, and other sources
- Identify appropriate probability distributions for model inputs
- Convert deterministic model to Monte Carlo simulation model
- Execute simulation model and obtain empirical probability distributions and descriptive statistics for model outputs
- Optimize business decision making based on probabilistic results
See below for more details on several important broad classes of business risks.
The largest asset class on most banks’ balance sheets are loans. Analogously, companies in the real sector often carry substantial accounts receivable balances as a result of trade activities. Of course, on the other side of the ledger are companies carrying these loans and payables as liabilities. While most of these liabilities are paid off, it is a fact of commerce that some organizations default and become unable to pay their obligations. This is called credit default risk; because of the importance of debt assets, it is vital that credit default risk is appropriately modeled and managed. RDC consultants can provide world-class consultancy regarding quantitative modeling of credit default risk, which is based on 4 important quantities: Probability of Default, Exposure at Default, Loss Given Default, and Default Correlation.
Companies carrying out large-scale complex operations (such as the banking, energy, and construction sectors), as well as organizations with very many employees, are often exposed to operational risk. This risk is related to the potential for harm to the company caused by improper actions and poor performance by its systems and employees, as well as external factors. The first step in managing operational risk is to examine historical data (both corporate and sector) to identify probable risk events and associated frequencies / severities. Industry experts can also be an invaluable source of relevant information. Starting from all this information, RDCs risk consultants can provide guidance on developing models to quantify operational risk and the impact on corporate solvency and viability. Finally, we can help identify optimal remedial actions, and can even help design relevant internal controls.
Many types of organizations are exposed to interest rate risk, including: banks, investment funds, firms holding substantial bonds and debt assets, and equity trading companies. Essentially, this risk can affect any company carrying cash & similar liquid assets. For example, as prevailing interest rates increase, the value of a fixed-rate bond portfolio decreases. If this portfolio is held as cash reserves for a bank, this drop in value is a regulatory risk. If the fixed-rate bond portfolio is held as collateral for debt, the holder could face credit risk. RDC consultants have the statistical modeling expertise required to develop reliable interest rate models to and help manage this risk.
The term “commodity” is typically applied to fungible items like electricity, natural gas, coal, oil products agriculture products, metals, etc… Companies that produce or use these products are exposed to commodity risk. A decrease in prices can make a production operation uneconomic; an increase in prices can erase profits for a manufacturer. Using industry-standard mathematical & stochastic time-series processes and historical pricing data, RDC consultants can develop models to forecast future commodity price movements. These models can be used to value commodity-based positions, and the estimate the probability of losses. When commodity risk exposure is sufficiently large, the usual response is to hedge the risk by taking offsetting positions in the commodity (or a similar product). RDC consultants have the financial risk management expertise to develop valuable hedging programs to mitigate commodity risk.
Many enterprises transact in foreign currencies, and hence often carry exposure to foreign currencies on their balance sheet. Changes in the Turkish Lira parity relative to carried foreign currencies causes foreign exchange (FX) risk. Swings in parity can significantly impact an organization’s balance sheet – and hence, their ability to maintain operations or obtain capital. RDC consultants can help prepare models to predict and estimate the effect of FX risk on business operations and the affected balance sheets. Depending on the magnitude of FX risk, hedging programs can be put in place to mitigate some of this risk. Enterprises with substantial FX risks can rely on our expertise in financial risk management to develop effective and efficient FX hedging programs.
One of the biggest problems of the insurance industry is accurate calculation of IBNR provisions. RDC consultants have experience analyzing the historically long-tailed losses in the insurance industry. We can leverage this expertise to guide preparation of statistically-valid IBNR models according various industry-standard methodologies. We also offer consultation regarding back-testing and validation of existing IBNR models.
One of the decisions that has the largest direct affect on the profitability of insurance companies is how much risk to transfer to reinsurance companies. If the risks from too many policies – or from the wrong types of policies – is transferred, too much premium income will be lost. On the other hand, carrying too much risk can increase the probability of an insufficient liquidity event. This is an especially important consideration in Turkey, as the insurance companies rely heavily on reinsurance to spread the risk. So as to balance the need to transfer risk while remaining profitable, optimal transfer rates should be estimated through risk-based models. RDC consultants can help develop stochastic optimization models that balance these two vital factors.