1
Q
List: Market RM Strategies (3)
A
- Diversification
- Investment strategy
- Hedging
2
Q
List: Market RM Activities (5)
A
- Setting & monitoring policies
- Setting & monitoring limits
- Reporting
- Capital management
- Implementing risk-portfolio strategies
3
Q
List: What Market Risk Policies Cover (6)
A
- Roles & responsibilities
- Delegation of authority & limits
- Risk measurement & reporting
- Valuation / Back-testing
- Hedging policy
- Exception management
4
Q
Definition: Derivative
A
A financial security whose value depends upon that of some underlying security or reference asset
5
Q
Definition: Forwards
A
A non-standardised, non-exchange-tradable contract btw 2 parties to trade an underlying security on a spec future date at a spec price
6
Q
Definition: Futures
A
A standardised contract traded on an exchange btw 2 parties to trade an underlying security on a spec future date at a spec price
7
Q
Definition: Swaps
A
An obligation for both counterparties to exchange a series of CFs
8
Q
Definition: Interest Rate Swaps
A
Interest calc at a fixed rate applied to a nominal principal is exchanged for interest calc at a floating rate applied to the same nominal principal, but with no exchange of the principal
9
Q
Definition: Currency Swaps
A
Where the interest & the principal in 1 currency are exchanged for those in another
10
Q
List: Characteristics of Exchange-Traded Derivatives (6)
A
- Standardised - Available only on certain As & indices for spec delivery dates
- Trading is done through the exch based on market prices
- Deals are settled through a clearing house
- Clearing house acts as a counterparty to both the long & short party, & takes on counterparty risk
- Counterparty risk is reduced for the clearing house by the pooling of many contracts
- Highly liquid market with low transaction costs
11
Q
List: Characteristics of OTC Derivatives (4)
A
- Trading is done at the convenience of the parties
- Pricing is by negotiation btw parties who takes on the risk of the counterparty defaulting on the arrangement
- Very flexible - Generally provided by banks to address the spec needs of a company
- Documentation usually based on standard Ts & Cs
12
Q
Definition: Collateral
A
Held by 1 or both parties to a contract to provide protection from the costs of any potential default
13
Q
List: Advantages of Derivatives Relative to Underlying A’s (3)
A
- Cheaper & easier to deal than underlying As
- Flexible
- Exposure can be changed quickly
14
Q
List: Disadvantages of Derivatives Relative to Underlying A’s (4)
A
- Ineffective strategies will result in losses
- Hedging a risk means that gains as well as losses may be eliminated
- Costs, spreads, premiums, management time & effort
- Increased exposure to risk
15
Q
Definition: Settlement Risk
A
The risk that one counterparty does not deliver a security as agreed when the security was traded, after the other counterparty has already delivered the security
16
Q
List: Risks Associated With Derivative Trading (9)
Can Saka And Odegaard Lead London’s Red Club Back?
A
- Credit (Counterparty)
- Settlement
- Aggregation
- Operational
- Liquidity
- Legal
- Reputational
- Concentration
- Basis
17
Q
Definition: Normal Backwardation
A
The situation where the current future price is below the future spot price
18
Q
Definition: Contango
A
The situation where current the future price exceeds the expected future spot price
19
Q
Definition: Basis (B_t)
A
The difference between the spot price of an A & the futures price, at a particular point in time i.e. B_t = S_t - F_t
20
Q
Definition: Cross Hedging Risk
A
The A whose price is to be hedged is not the same as the A underlying the futures contract
21
Q
Definition: Netting
A
Using revenue in a particular currency to meet any amounts owing in the same currency
22
Q
Definition: Leading & Lagging
A
Bringing forward or delaying foreign CFs to exploit expected movements in the FX rates
23
Q
Definition: Delta Hedging
A
Adjusting the hedge position so that the portfolio delta = 0, making the portfolio insensitive to small changes in the underlying asset price
24
Q
Definition: Dynamic Hedging
A
The day-to-day hedging activity undertaken by writers of options
25
Definition: Portfolio Delta
Sensitivity of portfolio value to changes in the underlying price - Delta = dV/dS
26
Definition: Portfolio Gamma
Reflects the exposure to the risks assc with jumps in prices & the risks of hedging at discrete times - Gamma = d^2V/dS^2
27
Definition: Portfolio Vega
How sensitive the portfolio is to changes in the volatility of the underlying index or A price - Vega = dV/d(sigma)
28
List: Types of Interest Rate Risk (2)
1. Direct Exposure - Changes in interest rates have a direct effect on the size of a company's CFs
2. Indirect Exposure - Changes in interest rates affect the value of future CFs
29
List: Managing Indirect Interest Rate Risk Exposure (3)
1. CF matching
2. Immunisation
3. Hedging using model points
30
List: CF Matching Factors (3)
1. Nature
2. Term
3. Currency
31
List: Practical Problems with CF Matching (3)
1. Suitable As may not be available
2. Future CFs may not be known
3. Expected future CFs may change frequently making it costly to alter the portfolio
32
List: Immunisation Conditions (3)
1. PV A CFs = PV L CFs
2. DMT A CFs = DMT L CFs
3. The convexity of the A CFs > convexity L CFs (ensures A portfolio value increases more / decreases less than L's for any interest rate change)
33
List: Limitations of Immunisation (5)
1. Relates to ensuring that the PV of As >= Ls, rather than matching the timings & amounts of the individual CFs
2. Only protects the PV against interest rates
3. Only works for small changes in interest rates
4. Only works where the interest rates change equally at all terms
5. Requires regular rebalancing of the A's
34
List: Stages in the Credit RM Process (5)
1. Policy & infra
2. Credit granting
3. Exposure monitoring, management & reporting
4. Portfolio management
5. Credit review
35
List: Policy & Infra Elements (5)
1. Establishing an appropriate credit env
2. Adopting credit risk policies & procedures
3. Implementing credit risk policies & procedures
4. Developing methodologies & models, with appropriate systems
5. Defining data standards & conventions
36
List: Exposure Limit Uses (4)
1. Risk control
2. Allocation of risk-bearing capacity
3. Delegation of authority
4. Regulatory compliance
37
Definition: Portfolio Management Function
Aims to optimise the desired risk-return trade-offs by defining a target portfolio
38
List: Credit Insurance Cost Factors (5)
1. Industry sector
2. Country risk
3. Nature of goods & services
4. Terms of trade
5. Historical info
39
List: Benefits / Cover of Credit Insurance (7)
1. Protection against some / all bad debts
2. Cover for some / all debtors
3. Cover for domestic or international trade
4. Specialist advice based on the experience of the insurer
5. Cover for expenses incurred
6. International cover for country risk, debt recovery services & any losses on FX
7. An ability to secure better terms for financing
40
Definition: Credit Default Swap (CDS) (3)
1. Protection buyer pays a periodic fee to the protection seller
2. Seller makes a credit default protection payment if a credit event on the reference asset occurs
3. Hedges default risk but does NOT explicitly hedge price risk
41
Definition: Total Rate of Return Swap (TRORS) (3)
1. Total return from one or a group of A's is swapped for the return on another
2. Creates a hedge for BOTH market (price) risk AND credit (default) risk
3. Investors who cannot short securities can hedge a long position by paying the total return in a TRORS
42
Definition: Repudiation
When the debt issuer simply chooses to cancel all the outstanding interest payments & capital repayments of the debt
43
Definition: Cross-Default
Clause on a bond where a credit event on another security of the issuing firm will also be considered a credit event on the reference bond
44
List: Credit Events (5)
1. Bankruptcy
2. Ratings downgrade
3. Repudiation
4. Failure to pay a particular coupon
5. Cross-default
45
Definition: Securitisation
The pooling together of a group of As, combined with the issue of 1+ tranches of asset-backed securities - The CFs generated by the pool of As are used to service the interest & capital payments on the asset-backed securities
46
Definition: SPV (Special Purpose Vehicle)
Entity created to purchase A's from the originator & issue debt securities backed by those A's - Structured to be bankruptcy remote: in the event of default, the investor has no recourse to the A's of the original owner & vice-versa
47
List: Benefits of Securitisation (5)
1. Converts a bundle of As into a structured financial instrument which is then negotiable
2. Method to raise money that is linked to the CF receipts it anticipates to receive
3. An alternative source of financing
4. Passing risk in the As to a 3rd party, removing them from the BS & reducing capital reqs
5. Method to sell an otherwise un-marketable pool of As
48
List: Desirable Features of RM Controls (8)
1. Focused on results
2. In place for both measurable & non-measurable events
3. Std for efficient comms
4. High quality
5. Few
6. Meaningful & appropriate
7. Timely
8. Simple
49
List: Actions Aimed at Managing Operational Risks (11)
1. Outsourcing
2. Due diligence
3. Business continuity & crisis management plans
4. Horizon scanning
5. Maintenance
6. Security
7. Good HR practices
8. UW, product design & pricing
9. Education, checks & balances
10. Good change management
11. Sound ERM framework that is integrated into the business
50
List: Steps to Transfer Operational Risk (7)
1. ID operational risk exposures
2. Quantification
3. Integration
4. Establish limits
5. Implement controls
6. Dev strategies for risk transfer & pricing
7. Evaluate alternatives
51
List: Actions to Manage Liquidity Risk (7)
1. Active monitoring within & across legal entities
2. Active monitoring of ability to raise capital
3. Investment strategy
4. Swaps
5. Contingency funds
6. Diversifying sources of funding
7. Obtaining contingent sources of funding
52
List: Reducing Feedback Risk (5)
1. The use of circuit breakers by exchanges
2. Certain government actions
3. Regs requiring the establishment of additional reserves in good times
4. Avoiding pro-cyclical regs
5. Physically separating certain types of businesses
53
List: Processes to Manage Demographic & Insurance Risks (5)
1. UW
2. Risk transfer
3. Reducing risk concentrations
4. Improving diversification
5. Hedging
54
Definition: Internal Capital Model
Used to sim a company-spec view of the capital needed
55
List: Uses of ICMs (13)
1. Cover all risks faced by a company in a consistent way
2. Determining company or product risk profile
3. Capital budgeting
4. Assessing the impact of strategic decisions on capital reqs
5. Insurance product pricing
6. Risk tolerances / constraints
7. Setting investment strategy
8. Calc risk-adj rate of return on capital
9. Performance measurement
10. Incentive compensation
11. Alternative to a rating agency / reg reqs
12. Modelling the impact of extreme events
13. Disaster planning
56
List: Desirable Features of AL Models (4)
1. Allows for correlations btw diff A classes over time
2. L model considers reinsurance & correlations btw classes of risk
3. The A/L model should be integrated
4. Dynamic
57
List: Benefits of Dynamic ALM (6)
1. Improved understanding of the dynamics of the current strategy
2. Consideration of the impacts of implementing diff strategies
3. Examination of the impact using diff srcs of capital
4. Useful for due diligence for corp transactions
5. Assesses the risk-adjust perf of diff business units
6. Determines an optimal A mix
58
List: Differences Between ICMs & GCMs (6)
1. Views on volatility of various A classes
2. Allowances for diversification btw / within risk types
3. Objectives, risk tolerance levels & diff treatment of the same risks
4. Accounting assumptions
5. Inclusion of diff risk types & diff treatment of the same risks
6. Views regarding the availability of certain types of A as capital
59
List: Stages Operating CM (6)
1. ID purpose
2. ID & rank risks
3. Choose the sim approach for each risk
4. Define the risk metrics
5. Selecting the model criteria
6. Decide on the method of implementation
60
List: Basis of the Standard Formula (4)
1. Based on spec deterministic basis, but with some stochastic elements
2. Deals with market risk through limited admissibility of some As + stress tests
3. Deals with credit risk through limiting exposure to individual counterparties
4. Deals with UW risk by req solvency margins, calc with reference to bus volumes or risks
61
List: ICM Standards (6)
1. A use test
2. Statistical quality standards
3. Calibration standards
4. P/L attribution
5. Validation standards
6. Documentation standards
62
Formula: RAROC
RAROC = Risk-Adjusted Return / Capital
Can be calculated for: whole org, parts of an org, or projects
Can be based on actual or expected capital
63
Formula: EIC (Economic Income Created)
EIC = (RAROC - Hurdle Rate) x Capital
A monetary amount - used to encourage marginal growth opportunities
64
Formula: SHV & SVA (2)
1. SHV = Capital x (RAROC - g) / (Hurdle - g), where g = prospective future growth
2. SVA = Capital x [(RAROC - g) / (Hurdle - g) - 1] -- Measures the extent SHV exceeds the capital invested
65
Formula: Sharpe Ratio
Sharpe Ratio = (R_p - R_f) / sigma_p
Where: R_p = portfolio return, R_f = risk-free rate, sigma_p = portfolio std dev
66
List: Capital Allocation Approaches (5)
1. Total capital retained fully by the company centrally in the main corp bus line
2. Allocated using a risk measure (e.g. Euler principle)
3. Marginal approach - Each line receives the change in capital from adding it to the diversified portfolio (depends on order of consideration)
4. Pro-rata basis
5. Calc individually & then remaining held by main corp bus line (stand-alone - ignores diversification)
67
Definition: Euler Principle for Capital Allocation (2)
1. If F(L) is positively homogeneous, then F(L) = sum of partial derivatives dF(L)/dp_i evaluated at p=1
2. Capital allocated to business unit i: C_i = dF(L)/dp_i |p=1
Key property: Gives a unique, order-independent allocation that respects diversification & sums exactly to total capital
68
List: Capital Allocation Approach Considerations (7)
1. Complexity & computational intensity
2. Ease of comm
3. Degree to which allocation is affected by presence of other bus units
4. Degree to which allocation is affected by basis
5. Degree to which method may lead to under-investment in bus units providing diversification benefits
6. Degree to which method may lead to over-investment in risky bus units
7. Correspondence with marginal pricing principal
69
List: Main Business Applications of RM (3)
1. Loss reduction
2. Uncertainty management
3. Performance optimisation
70
List: Controls for Limiting Downside Risk (5)
1. Credit controls
2. Investment & liquidity policies
3. Other internal controls
4. Audit processes
5. Insurance coverage
71
List: Lam's 5 Stage Maturity Model (5)
1. Definition & Planning
2. Early Development
3. Standard Practice
4. Business Integration
5. Business Optimisation
72
List: Lam's Definition & Planning (4)
1. ID internal & external reqs for ERM
2. Obtaining Board & management support
3. Dev overall framework & plan
4. Appointing key personnel
73
List: Lam's Early Development (4)
1. Establishing ERM policies & risk fcts
2. ID key risks
3. Co-ordinating risk & ctrl processes across the fcts
4. Education & training
74
List: Lam's Standard Practice (4)
1. Establishing risk databases for events & losses
2. Dev KRIs
3. Establishing risk models for Market, Credit & Op risk
4. Measuring risk-adjusted perf
75
List: Lam's Business Integration (6)
1. Eval bus risks
2. Quantifying the cost of risk to support pricing & risk transfer decisions
3. Automating risk reporting
4. Allocating capital according to risk
5. Using risk triggers to prompt bus decisions
6. Measuring the effectiveness of ERM processes & linking to exec renumeration
76
List: Lam's Business Optimisation (3)
1. Expanding the scope of ERM to include strategic risk
2. Integrating ERM into strategic planning processes
3. Allocating capital & resources to optimise risk-adjusted performance
77
List: McKinsey 4-Stage Risk Maturity Model (4)
1. Initial risk transparency
2. Systemic loss reduction
3. Risk-return management
4. Risk as a competitive advantage
Focus: Outputs / benefits rather than processes (contrast with Lam's process focus)
78
List: Deloitte 5-Stage Risk Maturity Model (5)
1. 'Unaware' / Planning
2. 'Fragmented' / Specialist silos
3. Top-down
4. Systematic
5. Risk intelligent
79
List: Case Studies - Risk Management Failures (4)
1. Barings (1995) - Rogue trader Nick Leeson, no segregation of front/back office. Fix: Operational controls & 3LoD
2. Metallgesellschaft (1993) - Stack-and-roll hedging, basis risk & margin calls. Fix: Understand derivative risks & CF implications
3. Societe Generale (2008) - Rogue trader, failure of operational controls. Fix: Robust internal controls & monitoring
4. 2008 GFC Rating Failure - Agencies failed to account for systemic risk, conflict of interest (paid by issuers). Fix: S&P ERM framework, independent assessment
F106 V2
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