Risk Management Framework III

Question 1

How does on account for Risk Transfer, Investment Risk and Insurance Risk?

Answer 1

• Risk Transfer – optimising risk/reward by transferring risk to other counterparties e.g. by using credit derivatives
• Investment Risk – Basel rules promote building capital that can be drawn down when markets become stressed
• Insurance Risk – banks typically make economic capital provisions for insurance risk

Question 2

Wrt Investment Risk, what is Alpha and Beta?

Answer 2

• Alpha – measures risk-adjusted return (actual return – expected return). Positive Alpha is over-performance, negative alpha is under-performance.
• Beta – the volatility of a security relative to the market as a whole. Beta of 1 = movement in line with market, Beta < 1 = moves less than market.

Question 3

Wrt Investment Risk what is Arbitrage?

Answer 3

Arbitrage is the simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms.

Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time.

Question 4

Wrt Investment Risk what is Market Neutral – Hedging?

Answer 4

A hedge is an investment to reduce the risk of adverse price movements in an asset. Commonly can use long and short positions in the same sectors to reduce market risk and to exploit mispricing between stocks.

Question 5

Give risks associated to various Investments.

Answer 5

1. Currencies – the value of an asset or income denominated in a foreign currency may vary with exchange rates
2. Interest Rates – savers with variable rates face the risk of interest rates dropping. The inverse is true to borrowers
3. Bonds – if interest rates rise the value of bonds typically fall. Issuer, credit and economic risks also apply
4. Equities – risk that an investor’s equity investment will deprciate due to market dynamics, classic risk v reward. The higher risk associated with equities is reflected in their impressive returns. In the long-term, global equity returns can beat inflation by 5-6%
5. Commodities – price risk is high: movements of world supply and demand, currency risk and basis risk. They do however aid portfolio diversification and are a good inflation hedge. Return is generated from the spot price, margining (e.g. using leverage) and roll yield
6. Property – illiquidity is high due to high transaction costs and potential difficulties in finding a buyer
7. Capital - capital risk is the risk that some or all original capital invested is lost. Dividend risk is inability of firm to pay dividends
8. Cash Deposits – (Rate of return) = (Rate of Interest) – (Rate of inflation). Cash deposits are very secure with good liquidity. In the UK retail deposits to a certain limit have recourse to the PRA
9. Fixed Interest Securities – include corporate & govn. bonds (gilts), zero coupon bonds, corporate bonds and junk bonds.They carry more risk than cash deposit interest. gains because capital value varies. However, return is usually higher.
10. Alternative Investments – include antiques, fine wines, art, hedge funds etc. Hedge funds can outperform all asset classes in bull and bear markets. Similarly private equity returns can be very impressive due to their high risk. They also suffer from poor liquidity.

Question 6

Give examples of Investment Return & Risk in Illiquid Assets.

Answer 6

• Venture Capital – investments in early-stage, high-potential firms. A team of experts use pooled capital to increase the value of the firm with a view to selling or listing the firm for a higher value
• Property – return comes from rental income and capital growth. Returns beat inflation over the long-term. However, most investments are geared and the market has crashed in the past
• Private Equity – equity securities in firms that are not publicly traded. Includes leveraged buy-outs, growth capital, mezzanine capital and distressed debt. High leverage is a big risk as changes in interest rates can result in large losses

Question 7

What are Investment Mandates?

Answer 7

Sets out the assumptions, objectives, constraints and conditions of the portfolio:

1. Styles, such as growth or income
2. Asset classes invested in
3. Investment strategy e.g. long only
4. Investment selection process
5. Securities selection e.g. no derivatives
6. Resources for risk management
7. Long term goals
8. Risks associated with objectives

Question 8

What is Tracking Error, Short Selling, Optimisation and Hedging with Derivatives?

Answer 8

• Tracking Error – when tracking an index, a fund can underperform the index due to tracking error that arises due to a sampling approach
• Short Selling – selling securities that have been borrowed from third parties with the intention of buying them back at a later date
• Optimisation – active managers will try and generate excess returns by exploiting arbitrage and mispricing opportunities
• Hedging with Derivatives – swaps, futures and options are cost effective ways to hedge and manage the risk of a portfolio

Question 9

What is Legal Risk and how may they come about?

Answer 9

Exposure to fines, penalties or punitive damages resulting from supervisory actions as well as private settlements

• Legal Uncertainty – unexpected interpretation of law that can leave a bank exposed
• Changes to the Environment – changes in the legal or regulatory environment deliver legal risk to a bank’s positions e.g. the bankruptcy of Lehman Brothers
• Litigation Risk – the likelihood of a bank being taken to court. Banks must analyse the financial and non-financial risks related to litigation

Question 10

How is Legal Risk managed?

Answer 10

• Senior management must establish an effective legal risk management process
• The entire firm must be kept on a sound legal footing
• Firms need a disputes resolution process

Question 11

Explain manager input into Strategy and Strategic Risk.

Answer 11

1. Align the interests od decisions makers, the business owners and employees
2. Choose the right people for the task
3. Reward mechanisms should encourage good risk taking
4. Cultural and structural aspect

Question 12

What is the Audit Committee?

Answer 12

The Audit Committee aims to enhance the confidence in the integrity of an organisation’s processes and procedures related to internal control and corporate reporting.

Question 13

What does the Audit Committee do?

Answer 13

It monitor and reviews:

• Financial statements
• Reporting
• Internal controls
• Risk Management Framework
• The bank’s relationship with external auditors
• Interdependence
  
  • Audit committee needs a comprehensive policy to regulate the use of external auditors for non-audit services
  • Objective evaluation of external audit performance and fees

Question 14

How may one plan for strategic risk?

Answer 14

1. Have timely and reliable information
2. Speed of response
3. Previous experience
4. Have sufficient resources
5. Investing in right areas