Internal Control

Good day, everyone! Today's topic, a very important one for anybody running a business, is about the benefits of internal control in limiting exposure to unnecessary risk. The role of internal control is to establish a strong and well executed check and balance system throughout a corporation by utilizing audits for an oversight of operations. Internal audits ensure compliance of regulations by defining efficient ways to reduce the risks of asset loss. Risk assessment, monitoring, information and communication, and control operation environment are essential components to the success of an organization.

Insurance Companies use internal audits to verify that procedures are followed and Errors and Omissions risk is minimized. This is done to prevent and correct operations which raise risk and decrease their overall productivity. IIA is a UK based company which prides itself in creating compliance guidelines for the public by publishing a large knowledge base of risk management. IIA is a tool for companies to assure corporate social responsibility and control of internal operations.

Weak control systems can produce undesirable business operations. These systems can be influenced by communication failures between departments and insufficient financial statements which increase the need of risk management. With increased emphasis on the importance of training and using efficient accounting systems along with financial journals, cooperation, and avoiding the consolidation of financial statements, risk can be lowered, therefore creating a strong foundation for a company’s operating system.

Sources:
http://www.ucop.edu/ctlacct/under-ic.pdf
http://www.iia.org.uk/en/Knowledge_Centre/Academic_research/index.cfm
http://www.gm.com/corporate/investor_information/docs/fin_data/gm06ar/content/financials/mar/mar_01.html

Google Risk Map

Above is a risk map based on the risks that Google faces. All information about Google's risks was obtained from Google's Form 10-K at this site http://www.sec.gov/Archives/edgar/data/1288776/000119312507044494/d10k.htm#toc70021_4 . A risk map is a scatter plot with "Frequency" on the x-axis and "Severity" on the y-axis. Risks can be loosely classified into four main categories: High Severity/High Frequency, High Severity/Low Frequency, Low Severity/High Frequency, and Low Severity/Low Frequency. Risks that fall into the High Severity/High Frequency are the events where risk management is necessary to maximize the value of the firm. For Google, these risks are the acquisition of competitors, revenue growth rate decline, and index spammers (manipulation of web search results).

Risks that are in the High Severity/Low Frequency category are the reduction of advertising revenue, international operations/competitors, the interruption of information technology, and new technologies that block ads. A significant amount of Google's revenue comes from advertising and although these events are not that frequent, they still require attention because of their high severity.

In the Low Severity/High Frequency quadrant, we have the risks of losing Google members, intellectual property rights claims, and the violation of US or foreign laws. These events do occur relatively frequently but since their severity is generally low, any risk management would more than likely be wasteful. All other risks on the map are in the Low Severity/Low Frequency category and shouldn't require a lot of attention unless either the severity or the frequency increases.

Obama and the Economy

For today's blog, I decided to read someone else's blog for a change. I know what you're thinking, "but Mike, isn't your blog the only blog worth reading?" Although that might be true, every once in awhile a good post can be found elsewhere. That good post was from Professor Grace himself and was concerning our new president and his affect on the stock market. President Obama’s disinterest with the nation’s weak economy decreases the value of stock prices, hindering the growth of global alliances. These important long-term relationships strengthen the world economy, building confidence among domestic and international consumers. Hugo Chávez's poor opinion of Obama's ignorance for Latin America is a key example of how he is responsible for influencing the decrease in stock prices.(1.) His misdirected concentration of resources used for research (i.e. lifting restrictions on federal funding of human embryonic stem cell research), instead of focusing on steps towards economic growth, abolishes future gain potential in the market.

Another downfall lies in the Social Security and income tax increase which he allocated to the high bracket income earners, in turn making them less apt to put forth maximum effort in the workforce. This will decrease the stock market investment rate, disintegrating prices
further.(2.)

Diminishing long-term investments significantly decreases the value of the stock market by the capital gains tax put forth by the President.(.3) Obama’s taxation on individual investors and large corporations will slow the growth of the market causing the fall of long-term investments making them illiquid if owned over a year. Also, the increase from 15% to 28% on the capital gains tax coupled with the allowance of the 2010 Bush tax cuts to expire, creates an undesirable formula of disaster weakening stock prices.(4.)

Sources:
1. http://kdka.com/politics/hugo.chavez.barack.2.965323.html
2. http://www.consumeraffairs.com/news04/2008/07/mccain_obama.html
3. http://theeprovocateur.blogspot.com/2008/06/barack-obama-vs-stock-market.html
4. http://boards.msn.com/thread.aspx?ThreadID=691804

Normal Distribution

Hi, everybody! Today I'm going to talk about the misuse of the normal distribution in the financial world. The normal distribution is a continuous distribution where the mean, the mode, and the median are all equal. Another defining characteristic of the normal distribution is that it has a skewness of 0, in other words it is symmetrical. The standard deviation helps tell us the cumulative probability of getting a certain x within the distribution. The distribution holds that 68.27% of all values fall within plus/minus one standard deviation, 95.45% are within plus/minus two standard deviations, and 99.73% are within plus/minus three standard deviations.
While the normal distribution is appropriate for many phenomena such as people's height, thermal noise, and IQ tests which are actually based on the normal distribution, among others, people tend to overuse it and ignore the long-tails that occur in some financial distributions. Although many financial measures can be approximated using the normal distribution, events such as worst case scenarios regarding cash flow can have some long-tails which don't fit under the normal curve. A distribution such as the pareto or the log-normal would account better for large losses since these distributions are skewed to the right allowing the possibility of large losses to be realized.

Stem Cell Policy

It's been awhile since I've been able to bestow some knowledge on y'all and luckily I've come across a very interesting article. The article is from the Wall Street Journal Online and is called "Obama to Reverse Policy on Stem Cells". The link for the article is http://online.wsj.com/article/SB123637565340956847.html . The piece tells us that President Obama will issue an executive order lifting restrictions on federal funding as it relates to stem cell research. Former President Bush had basically grandfathered the stem cell research at the time but stopped any future funding for stem cell lines not being researched. Of course, the hope is that stem cells may help us find cures for diseases such as Parkinson's and diabetes among others. The issue is controversial since opponents view it as taking a life to save a life, since days-old embryos are destroyed in the process.
I know what you're thinking, "Interesting article but I thought this was a blog about risk management?" Well it is, and this is how it relates. Looking at the very big picture, I would suggest that this is a way of the government looking at the risk management of their citizens. If we were to have a cure for diabetes, for example, people would spend less on their continuing diabetes treatment. This would allow people to spend their money elsewhere, in a way helping the economy. The main benefit would be that there would be more people who live longer. This increase in people would lead to more tax revenue for the government. Therefore, the government is managing the risk of their citizens dying.

Cash Flow at Risk

Good day to all the loyal followers of my blog. Although you currently number less than one, it's comforting to know that you all come to me for your risk management knowledge. Today we're going to look more at the variables in the net present value equation and the increased risk to a firm when adding new projects. In an example in class we had a pharmaceutical company that is considering the introduction of a new drug. There is, of course, litigation risk. The cost of the drug is $100M and expected revenue for year one is $140M. The standard deviation of current drug earnings is $25M and $20M for the new drug. The cost of capital is 6%, the marginal cost of holding risk capital is 11%, and the correlation between the new and existing drugs is 25%. Here we look at the 95% level and find that CaR is $41M currently and $59M when the new drug is added. Thus, the NPV is (140/1.06)-100-.11(59-41)=$30.13M.
Now let's assume that three things have changed from above but the rest has remained the same. Expected revenue in year one is now $106, the cost of capital has dropped to 5%, and we're going to look at the 99% level. The 99% level means in this case that we are looking at the worst loss in cash flow we could expect one percent of the time. The net present value in this case would be (106/1.05)-100-.11*((59*2.326)-(25*2.326))=-1.8M. If we ignored the increased risk to the company, then the NPV would be a positive $1M and the new drug would be added. But since we need to consider the added risk, this new drug would not be added. Also, I looked at the same numbers but at the 95% level and that alone reduced the NPV by $800K. So, it depends on what level we want to be protected at.

The Demise of Fannie Mae

I came across an interesting article from the New York Times Online regarding the failure of Fannie Mae and the subsequent takeover by the government. The link for this website is http://www.nytimes.com/2008/10/05/business/05fannie.html?pagewanted=1&_r=1. For those of you who don't know, Fannie Mae is a government sponsored enterprise created to increase the availability and reduce the cost of credit in the mortgage market. Fannie Mae makes their money by purchasing mortgages from lenders, holding some and reselling most to Wall Street investors. Loans are classified according to their level of risk. Fannie Mae will guarantee to pay a loan it sells in case of default for a fee according to its risk. If the risks are accurately classified the fees should cancel out the cost of the loan.
Where Fannie Mae went wrong was in taking on too many risks. There was pressure from shareholders, Congress, and even the mortgage companies they were buying the loans from. Countrywide Financial, a longstanding and important trading partner, demanded that Fannie take on riskier loans or else they would sell to competitors. Fannie Mae felt that too much business would be lost and bought loans they weren't necessarily comfortable with. I think the main problem was that the risks weren't being properly identified. A former employee speaking on the condition of anonymity said that they were buying loans that would have previously been rejected and that they weren't charging nearly enough for payment in case of default. They felt they had to keep up with competitors and this was justification for taking on so much risk. For a two year period, they didn't have a Chief Risk Officer. When they did hire one he urged the CEO to charge more for the risky loans, but that urging went unheeded.