Chapter 18: Risk Control

Question 1

List the five main financial risks faced by an institutional investor

Answer 1

• Market Risk - Risk relating to changes (falls) in value of portfolio due to movements in market value of the assets held
• Credit risk - risk that counterparty to agreement will be unable or unwilling to fulfil their obligations
• Operational risk - risk of loss due to fraud or mismangement within fund management organisations itself
• Liquidity risk - risk of not having sufficient cash to meet operational needs at all times
• Relative performance risk - risk of underperforming comparable institutional investors

Question 2

Explain

• How markket risk might be measured in practice
• The difference between a load difference adn a load ratio

Answer 2

• Suitabnle measure might be variance of portfolio return over specified period of time or value at risk
• Returns may be measured in absolute terms or relative to bencchmark such as index, or value of liabilities
• Load difference specifies limit for departure from benchmark asset allocation as percentage of total portfolio
• Load ratio specifies limit for departure from benchmark asset allocation as a percentage of bench allocation to that class

Question 3

State the two key factors in controlling credit risk and list six ways in which they can be controlled

Answer 3

Key factors in controlling credit risk

• Creditworthiness of counterparties
• Total expsure to each counterparty

Control these by

• Placing limits on credit ratings
• Trading derivatives on a recongnised exchange
• demanding collateral and/or margin payents
• Placing limits on individual credit exposures avoiding aggregations of exposure
• using credit derivatives

Question 4

List 5 ways in which operational risk can be controlled

Answer 4

Operational risk can be controlled

• Management understanding complex deals undertaken by traders
• seperating front office and back office functions
• setting up audit trails
• clearly defining roles and responsibilities
• training and qualifications

Question 5

Explain how a balanccce sheet model of liquidity can be used to control liquidity risk

Answer 5

• All assets are allocated to one of two categories liquidi or iliquid
• All liabilities are classiied as either stable or volatile
• The focal point of the analysis is the concept of net liquid assets or the liquidity gap - the difference between the level of liquid assets and volatile liabilities
• Allowance should be made for the liquidation costs associated with converting items to cash ie brokerage and invesment banking fees and thef basis bid - offer spread in the market for the assets involved, as well as the time available for conversion

Question 6

Explain how liquidity duration or liquidity risk elasticity(LRE) can be used to control liquidity risk

Answer 6

• Calculate the present value of assets and liabilities using the cost of funds rate as the discount rate
• Measuring the change in the arket vlaue of the insistution’s equity from a change in the cost of funds (de to an increase in the risk premium paid ot raise money).
• I fhte LRE is zero the insitution has zero liquidity risk (by this meaure), If the LRE is hsarply negative, it will pay the instiution to shortern the matrurity of tis assets and lengthen the maturity of tis liabilities, thereby increasing liquidity

Question 7

List 7 assumptionps underlying mean - variance portfolio theory

Answer 7

• Investors prefer more to less
• investors are risk averse
• Investors base investment decisions only on mean and variance of return
• Investors consider single step time period only
• investors can estimate all means, variances and covariances
• There are no taxes and transaction costs
• assets may be held in any amounts

Question 8

In the context of mean - variance portfolio theory, explain what is mean by each of the following

• Oppertunity set
• efficient portfolio
• efficient frontier
• indfference curves
• optimal portfolio

Answer 8

• Oppertunity set
  
  • Set of conbinations of mean and variance attainable from available securities
• Efficient portfolio
  
  • Portfolio such that no other portfolio offers higher expected return for same or lower variance or lower variance for same or higher expected return
• Efficient frontier
  
  • Set of effiicient portfolios
• Indffierence curves
  
  • Line joining all combinations of mean and variance of investmennt returns between which investor indeifferent because they offer same expected utility
• Optimal portfolio
  
  • Combination of available securities that maximises invesetor’s expected utility

Question 9

In the case of two securities (A and B), state a forumla for the proportion invested in the first security (X_A) that defines tthe minimum variance portfolio

Answer 9

The minimum variance can easily by shown to occur when

XA = (V_B - C_AB)/(V_A - 2C_AB + V_B)

Where

• X_A is the proportion invested in the first security (A)
• V_I - is thhe variance of returns on security i
• C_AB is the covariance of the returns on the two securities

Question 10

Discuss the theoretical benefits of diversiication in terms of its effect on the risk of a portfolio

Answer 10

• In most markets, the correlation coefficient and the covariance between assets is positive. In these markets, the risk on the portfolio cannot be made to go to zero, but can still be much less than the variance of an individual asset
• If for example the portfolio is invested equally across N securities, then the contribution to the portolio variance of the variances of the individual secuirites goes to zero as N gets very larkge. However, the contribution of the covariance terms approaches the average covariance as the N gets large
• So the individual risk of securities can be diversified away, but the contribution to the toal risk caused by the covariance terms cannot be diversified away