FRM Level 1 Part 1 Flashcards
basis of risk management
definition: risk is exposure to uncertain, including loss and gains
expected vs unexpected loss
expected loss:
definition: consider how much an entity expects to loss in the normal business and daily life
feature:
as one of the costs of doing business, and it is priced into the products and services
unexpected loss:
definition: consider how much an entity could loss outside of the normal business and daily life
feature:
more difficult to predict, compute and pick-in in advance.
risk vs reward
a trade-off : a higher rate of return need assume more risk
risk management vs risk taking
risk management: how firms actively select the type and level of risk that it is appropriate for them to assume
risk taking: assume additional risk actively for additional gains
risk management process
step 1: identify the risk
step 2: measure and estimate risk exposure (assess effect of exposures)
find instrument and facilities to shift or trade risk (assess cost and benefits of instruments)
step 3: form a risk mitigation strategy: avoid, transfer, mitigate, keep
step 4: evaluate performance
measure and manage risk
quantitative measures
sensitivity measures
definition: examine how portfolio value respond to a small change in a single risk factor
equity exposure measure: Beta
fixed-income exposure measure: duration and convexity
option risk measures:
delta:
delta is a measure of the change in an option’s price or premium resulting from a change in the underlying asset
Gamma:
Gamma measures delta’s rate of change over time, as well as the rate of change in the underlying asset. Gamma helps forecast price moves in the underlying asset.
Vega:
Vega measures the risk of changes in implied volatility or the forward-looking expected volatility of the underlying asset price.
theta:
theta measures its price decay as time passes.
rho:
represents the rate of change between an option’s value and a 1% change in the interest rates. This measures sensitivity to interest rates.
value at risk
definition:
the minimal loss given the significant level
the maximize loss give the confident level
quantitative measures
scenario risk measures
definition:
provides an estimate of the impact on portfolio value of a set of significant change in multiple risk factors
historical scenario approach:
use a set of change that occurred in the past in risk factors
hypothetical scenario approach:
use a set of hypothetical change in risk factors, not actually occurred in the past
stress test: examine the impact on portfolio of a scenario of extreme changes of risk factors
key classes of risk
financial risk
market risk
definition: the risk that changes market prices and rates reduce the value of a securities or a portfolio
category:
interest rate risk (interest rate rise, value of bond decrease)
equity price risk
foreign exchange risk:
because of unhedged or not fully hedge foreign currency positions
commodity price risk:
Because of trading liquidity increase the volatility of commodity price
credit risk
definition: the risk of an economic loss from a failure of a counterparty to fulfilled its contractual obligation, or from the increase risk of default during the term of the transaction
category:
default risk:
debtor’s incapacity or refusal to meet debt obligation
bankruptcy risk:
take over the collateralized, or escrowed assets, of a defaulted borrowed or counterparty
downgrade risk:
perceived creditworthiness of borrower or counterparty might deteriorate
settlement risk:
due to the exchange of cash flow when a transaction is settled.
non-financial risk
operational risk category: inadequate computer systems insufficient internal control management failure model risk fraud human error natural disaster
liquidity risk:
1. funding liquidity risk: related to the firm’s ability to raise the cash to roll over its debt to meet cash / margin requirement/collateral requirement
trading/market liquidity risk: because of temporarily lack of counterparty to transact, the institution will not able to execute a transaction at prevailing marking price
legal and regulation risk
legal risk: the counterparty use the provider firm to avoid meeting its obligation
regulation risk: the potential risk of a change in laws and regulation to the market entity
business risk: the influence to the demand, price, and cost of business
strategic risk: the risk of significant investments for which there is a high uncertainty about success and profitability
reputation risk:
fulfill its promises to the counterparty/creditors
whether is fair dealer and follow ethical practices or not
corporate risk management: a primer
cons and pros of hedging
disadvantages
under MM theory is useless for company
distract its core business
Zero-sum game that has no long-term increase on firm’s cash flow
specialized skills, infrastructure and process supporting
a flaw risk management strategy can drag a firm down more quickly
compliance cost 合规成本
advantages
reduce cost of capital by reducing the volatility of cash flow
good hedging indicate a good risk management
better control of economic performance
may cheaper than insurance
may offer synergies with operations of the firm
process of hedging
step 1: determined the objective: risk appetite
risk appetite: the firm’s tolerance, especially its wiliness to accept risk
the role of board of directors to determine whether to hedge specific risk factor
- set out objectives in a clear and executive directives
- set the criteria in advance
- declare to hedge accounting profits or economic profits, short-term profit or long-term profit
- clarity the time horizon
how to do?
determined risk appetite by board of directors
details request:
communicate with management and set the firm’s risk appetite
ensure consistency between risk appetite with business strategy
consider potential conflict between debt holders and shareholders
step 2 mapping the risks
step 3: choosing the instruments for risk management
step 4: constructing and implementing a strategy
step 5: performance evaluate
corporate government and risk management
Best practice in corporate government
page 7
the objectives: provides the framework within an organization
minimize and manage the conflicting interests
核心主体: board of director
- keep independent from the management
- looks after the interest of all stakeholders
- develops the clear business strategy and are transparent to stakeholders
- be careful of potential agency risks
- consider the introduction of the chief risk officer (CRO)
Best practices in risk management
- demand substance over form
- promote a robust risk management process
- set up an ethics committee and establish
- make sure that the way staff are rewarded and compensated is based on risk-adjusted performance and is adjusted with shareholders’ interests
- approves all major transaction after ensure the transactions are within risk appetite and consistent with the firm’s overall business strategy
- set up a risk committee that separate from audit committee (at least one board member in both committees)
- risk management plan aligns risk with business strategy
mechanisms of risk Governance
risk management committee
responsibility
1. identify, measure, and monitor financial risk
2. approved credit facilities that are above certain limits or within limits but above a specific threshold
3. monitor the composition of the bank’s lending and investment portfolios
audit committee
requirement:
to be financially literate
independent but productive with management
responsibility:
the accuracy of the financial and regulatory reporting;
ensure that the firms compiles with minimum or best practices standards
compensation committee requirement: make incentive compensation based on long-term interest and risk-adjusted return; stock based compensation; keep independent of management
risk adversary director
definition:
board member and a risk specialist who attend risk committee nd audit committee to provide for firm
detail advice:
risk appetites and risk management policies;
internal controls, financial statements and disclosures;
the firm’s related parties and related parties transactions;
periodic risk management report and any audit reports
best practices of corporate government and risk management for industry
enterprise risk management (ERM)
definition:
a comprehensive and integrated framework for managing key risks in order to achieve business objectives, minimize unexpected earnings volatility, maximum firm value
integration 体现在三方面
a integrated risk organization;
integrated of risk transfer strategy;
integrated of risk management into business processes
benefits and cost benefits: increased organization effectiveness; better risk reporting improved business performance cost: ERM implies multi-year initiative that requires ongoing senior management sponsorship
component summary: components of ERM 1. corporate government establish to-down risk management 2. line management business strategy alignment 3. portfolio management think and act like a "fund manager" 4. risk transfer transfer out concentrated or inefficient risk 5. risk analytic develop advanced analytical tool 6. data and technology resources integrate data and system capacity 7. stakeholder management improve risk transparency for key stakeholders
CRO
definition:
the CRO is a senior executives who will sponsor a major program to establish an ERM approach
responsibility:
overall leadership, vision and direction for ERM;
estimate the integrated risk management framework;
develop risk management policy;
implement risk indicators and reports;
allocated economic capital and optimizing risk portfolio;
communicate risk profile to the key stakeholders ;
develop analytical, systems and data management capabilities
reporting:
- typically CRO report to CEO/CFO and have a dotted line with board or risk committee
- The dotted line can changed into the solid between extreme situation
risk management, government, culture, and risk taking in bank
optimal level of risk for bank
bank with more of deposit franchise prefer a higher rating;
bank that enter into long-term derivatives contracts might a higher rating;
risky bank 比如投行 prefer a lower rating that deposit bank
图像描述 page 11
risk management for bank the approach to increase bank value: 1.incremental value exceeds fixed cost 2. manage risk using ERM but not by single unit challenge and limits 1. risk measurement technology limitations 2. hedging limitations 3. risk taking incentive limitations 4. VaR metrics limitations
Government, incentive structure and risk culture
the difficult of bank government:
data limitation
nature of business is different
strong government doesn’t necessary lead to good performance
incentive structure:
requirement:
1. set reward of management contribution to entire organization but not units alone
2. reward based on risk-adjusted basis
a strong culture
benefit: consistency and less variability on performance
principle of effective data aggregation and risk reporting
risk data aggregation
definition: defining, gathering and processing risk data to enable the bank to measure its performance against it tolerance/appetite
benefit:
better anticipation of problem
easier to identify steps to return to financial health
improve resolvability in term of bank stress or failure
increase probability
principle:
overarching government and infrastructure:
1. strong government
2. data architecture and IT infrastructure
risk data aggregation capabilities:
1. accuracy and integrity: generate accurate and reliable risk data
2. completeness: capture and aggregate all material risk data
3. timeless: it depends on: the nature and potential volatility, critically of overall risk profile, bank-specific frequency requirements
4. adaptability: generate aggregate risk data to meet on-demand, ad hoc risk reporting request:
request during stress / crisis situation; request due to changing internal needs; request to meet supervisory queries
risk reporting
definition: the right information represented to the right people at the right time
principle:
1. accuracy
2. comprehensive: cover all material risk areas
3. clarity and usefulness: easy to understand and comprehensive to facilitate informed decision-making;
meaningful information tailored to the needs of the recipients
4. frequency: requirement: the needs of recipients, the nature of risk reported, the speed that risk change, the importance of reports, increase during stress/crisis period
5. distribution: distributed to relevant parties while ensuring confidentiality
