Risk Management

Question 1

List specific risk that must be monitored in an ERM.

Answer 1

Market risk
Liquidity risk
Settlement risk
Credit risk
Operations risk
Model risk
Sovereign risk
Regulatory risk
Political risk
Tax risk
Accounting risk
Legal risk

Question 2

What is the process for risk management?

Answer 2

It is a continual process:

1. Set policies and procedures.
2. Define risk tolerance.
3. Identify risks.
4. Measure risks.
5. Adjust level of risk.

Question 3

What steps must be taken to adjust the risk levels of the firm?

Answer 3

1. Execute risk management transactions using derivatives or non-derivatives.
2. Identify appropriate transaction.
3. Price the transaction.
4. Execute each transaction.

Question 4

What is risk governance?

Answer 4

Risk governance is a part of the overall corporate governance system and refers to the overall process of developing and putting a risk management system into use. The system must specify between centralized and decentralized approaches, reporting methods, methodologies to be used, and infrastructure needs.

Question 5

What are the qualities of high quality risk governance?

Answer 5

1. Transparent
2. Establish clear accountability.
3. Cost efficient in the use of resources.
4. Effective in achieving desired outcomes.

Question 6

What is a decentralized risk governance system and its benefit?

Answer 6

Places responsibility for execution within each unit of the organization.

It has the benefit of putting risk management in the hands of those closet to each part of the organization.

Question 7

What is a centralized risk governance system and its benefit?

Answer 7

The centralized system, aka enterprise risk management (ERM), places execution within one central unit of the organization.

It provides a better view of how the risk of each unit affects the overall risk borne by the firm. Individual risk are less than perfectly correlated, so the risk of the firm is less than the sum of the individual unit risk.

It also places responsibility closer to senior management who bears ultimate responsibility.

Question 8

What are the steps that an effective enterprise risk management (ERM) system will incorporate?

Answer 8

1. Identify each risk factor to which the company is exposed.
2. Quantify each exposure size in money terms.
3. Map the inputs into a risk estimation calculations (e.g., VAR).
4. Identify how each risk contributes to the overall risk of the firm.
5. Setup a process to report on these risk periodically to senior management who will setup up a committee of division heads and execs to determine capital allocation, risk limits, and risk management policies.
6. Monitor compliance with policies and risk limits.

Note: Effective ERM systems always feature centralized data warehouses. This can require significant and continuing investment.

Question 9

On the CFA exam, what questions should be asked when evaluating the strengths and weaknesses of a company’s risk management process?

Answer 9

1. Is senior management consistently allocating capital on a risk-adjusted basis?
2. Does the ERM system properly identify and define all relevant internal and external risk factors?
3. Does the ERM system utilize an appropriate model for quantifying the potential impacts of risk factors?
4. Are risks properly managed?
5. Is there a committee in place to oversee the entire system to enable timely feedback and reactions to problems.
6. The ERM system has built in checks and balances.

Question 10

How is market risk define when referring to a ERM system and not portfolio theory?

Answer 10

Market risk is not referring to systematic risk like in portfolio theory. It refers to the response in the value of an asset to changes in interest rates, exchange rates, equity prices, and/or commodity prices.

Question 11

When measured relative to a benchmark, what is the volatility of the asset’s excess returns called?

Answer 11

The volatility (stand deviation) to an asset’s excess return is called active risk, tracking risk, tracking error volatility, or tracking error.

Question 12

Define VAR.

Answer 12

VAR is an estimate of the minimum expected loss (alternatively, the maximum loss):

• Over a set time period.
• At a desired level of significance (alternatively, at a desired level of confidence).

Question 13

What are the advantages to the analytical method for estimating VAR?

Answer 13

The analytical method (variance-covariance method or delta normal method)

• Easy to calculate and easily understood.
• Allows modeling the correlation of risks.
• Can be applied to different time periods according to industry custom.

Question 14

What are the disadvantages to the analytical method for estimating VAR?

Answer 14

The analytical method (variance-covariance method or delta normal method)

• The need to assume a normal distribution.
• The difficulty in estimating the correlations between individual assets in very large portfolios. [(n^2 - n)/2]

Question 15

What are the advantages to the historical method for estimating VAR?

Answer 15

• Easy to calculate and easily understood.
• No need to assume a returns distribution.
• Can be applied to different time periods according to industry custom.

Question 16

What are the disadvantages to the historical method for estimating VAR?

Answer 16

The assumption that the pattern of historical returns will repeat in the future.

Question 17

What are the advantages to the Monte Carlo method for estimating VAR?

Answer 17

The ability to incorporate any returns distribution or asset correlation.

Question 18

What are the disadvantages to the Monte Carlo method for estimating VAR?

Answer 18

The ability to incorporate any returns distribution or asset correlation. The analyst must make thousands of assumptions about the returns distributions for all inputs as well as their correlations.

Question 19

What is the primary advantage for all VAR types?

Answer 19

The ability to compare the operating performance of different assets with different risk characteristics.

Question 20

What is the primary disadvantage for all VAR types?

Answer 20

The constant need to estimate inputs and make assumptions, and thus the problem becomes more daunting as the number of assets in the portfolio gets larger.

Question 21

In addition to VAR, what are other methods for managing market risk?

Answer 21

• Position limits - nominal cap on a given position.
• Liquidity limits - dollar trading limits according to the frequency of trading volumes.
• Absolute dollar limit for a loss to a position over a period.
• VAR allocation
• Specific risk factor limits.

Question 22

What are non-VAR measures to help control credit risk?

Answer 22

• Limiting exposure - i.e. limiting the amount of loans or derivative transactions with any one counterparty.
• Marking to market.
• Collateral.
• Payment netting.
• Imposing minimum credit standards.
• Transfer risk through credit derivatives such as credit default swaps, credit forwards, credit spread options, and total return swaps.

Question 23

What is the Sharpe ratio and its principal draw back?

Answer 23

The Sharpe ratio measures excess return (over the risk-free rate) per unit of risk. Its principal drawback is their is an assumption of normality in the excess return distribution. This is troublesome when the portfolio contains options and other non-symmetric payoffs.

Question 24

What is the risk-adjusted return on invested capital (RAROC)?

Answer 24

RAROC is the ratio of the portfolio’s expected return to some measure of risk, such as VAR.

Question 25

What is the Return over maximum drawdown (RoMAD)?

Answer 25

A drawdown is the difference between a portfolio's high water mark s and subsequent lows during a measurement period. The maximum drawdown is the largest drawdown over the total period. RoMAD is such the return over the maximum drawdown.

Question 26

What is the Sortino ratio?

Answer 26

The Sortino ratio is the ratio of excess return to downside risk. Excess return for the Sortino ratio (the numerator) is calculated as the portfolio return less the minimally acceptable portfolio return (MAR). The denominator (downside deviation) is the standard deviation of returns calculated using only returns below the MAR.

Question 27

List other measures that can be used to supplement VAR.

Answer 27

Incremental VAR - the effect of an individual item on the overall risk of the portfolio. Cash flow at risk (CFAR) - measures the risk of the company's cash flow. Earnings at risk (EAR) - is analogous to CFAR Tail value at risk (TVAR) - VAR + expected loss in excess of VAR (average loss in excess of VAR) Credit VAR - projects risk due to credit events. Stress testing

Question 28

What are the nine industry standard stylized scenarios?

Answer 28

1. Parallel yield curve shifts. 2. Changes in steepness of yield curves. 3. Parallel yield curve shifts combined with changes in steepness of yield curves. 4. Changes in yield volatilities. 5. Changes in the value of equity indicies. 6. Changes in equity index volatilities. 7. Changes in the value of key currencies (relative to the U.S. dollar). 8. Changes in foreign exchange rate volatilities. 9. Changes in swap spreads in at least the G-7 countries plus Switzerland.

Question 29

When is the potential credit risk highest for interest rate and equity swaps, and why?

Answer 29

The potential credit risk is largest during the middle period of the swap's life. During the beginning of a swap's life, we would assume that credit risk is small because presumably, the involved counterparties have performed sufficient current credit analysis. At the end of the life of the swap, the credit risk is diminished because most of the underlying risk has been amortized through the periodic payment process.

Question 30

In evaluating a firm's ERM system, the analyst should ask whether:

Answer 30

1. Senior management consistently allocates capital on a risk-adjusted basis. 2. The ERM system properly identifies and defines all relevant internal and external risk factors. 3. The ERM system utilizes an appropriate model for quantifying the potential impacts of the risk factors. 4. Risks are properly managed. 5. There is a committee in place to oversee the entire system to enable timely feedback and reactions to problems. 6. The ERM system has built in checks and balances.

Question 31

To determine the allocation of capital across business units or portfolio managers, upper management must determine the allocation in a way that maximizes potential returns without placing the viability of the firm in jeopardy. The capital process involves setting:

Answer 31

1. Nominal position limits. 2. VAR-based position limits. 3. Maximum loss limits. 4. Internal and regulatory capital requirements. 5. Behavioral conflicts.