Book 1 Flashcards
(182 cards)
1
Q
What is the definition of risk?
A
Uncertainty surrounding outcomes in investing.
2
Q
What is the trade-off associated with risk?
A
Higher risk opportunities have potential for higher returns; lower risk opportunities have lower return potential.
3
Q
What is the purpose of risk management?
A
Reduce or eliminate expected losses and manage unexpected variability.
4
Q
List the steps in the risk management process.
A
- Identify risks
- Analyse and measure risks
- Evaluate impact
- Manage risks
5
Q
What are the decision options in risk management?
A
- Avoid risk
- Retain risk
- Mitigate risk
- Transfer risk
6
Q
What are known risks?
A
Predictable and quantifiable risks (expected and unexpected losses).
7
Q
What are unknown risks?
A
- Known unknowns
- Unknown unknowns
8
Q
What is Value at Risk (VaR)?
A
Estimates potential loss given a certain probability.
9
Q
What does a one-day VaR of $2.5 million at 95% confidence mean?
A
A 5% chance of losing more than $2.5 million in one day.
10
Q
What is Expected Shortfall (ES) / Conditional Value at Risk (CVaR)?
A
Measures extreme losses beyond the VaR threshold.
11
Q
What is Economic Capital?
A
Liquid capital needed to cover unexpected losses.
12
Q
What is the definition of expected loss?
A
The amount an entity expects to lose in the normal course of business.
13
Q
What is the formula for expected loss?
A
EL = PD × EAD × LGD
14
Q
What is unexpected loss?
A
The amount an entity could lose in excess of their average expected loss scenarios.
15
Q
What is the trade-off between risk and reward?
A
Greater risk taken generally leads to greater potential reward.
16
Q
Define operational risk.
A
Losses from inadequate/failed internal processes, human error, or external events.
17
Q
What is legal risk?
A
Potential for litigation to create uncertainty.
18
Q
What is business risk?
A
Variability in inputs affecting revenues or costs.
19
Q
What is reputation risk?
A
Loss in public perception or consumer acceptance.
20
Q
What is the definition of liquidity risk?
A
Potential of losses due to inability to take or liquidate a position at a fair price.
21
Q
What is the purpose of scenario analysis?
A
Considers potential future risk factors and alternative outcomes.
22
Q
What is the definition of risk appetite?
A
Level and types of risk a firm is willing to retain.
23
Q
List the subcomponents of risk appetite.
A
- Risk Willingness
- Risk Ability
24
Q
What is the role of the board of directors in risk management?
A
Defining risk appetite and communicating it.
25
What are the two types of communication methods for risk appetite?
* Qualitative
* Quantitative
26
What is the difference between debtholders and shareholders regarding risk?
Debtholders prefer minimizing risks; shareholders may accept larger risks for higher equity returns.
27
True or False: Risk management is more concerned with expected losses than unexpected losses.
False
28
Fill in the blank: The risk management process involves _______ by one party and risk assumption by another counterparty.
risk transferring
29
What does Value at Risk (VaR) convey?
Maximum loss tolerance
## Footnote
VaR is a quantitative metric used in risk management to estimate the potential loss in value of a portfolio.
30
What is stress testing in risk management?
Assess potential losses in severely negative scenarios
## Footnote
Stress testing helps organizations understand their risk exposure under extreme conditions.
31
What is the difference between debtholders and shareholders regarding risk?
Debtholders prefer minimizing risks; shareholders may accept larger risks for higher returns.
32
What is the concept of risk appetite?
The level of risk an organization is willing to accept in pursuit of its objectives.
33
What are the different types of risks mentioned that may have different appetites?
* Market risk
* Credit risk
34
What is the purpose of risk mapping?
Assemble an inventory of all known risks.
35
What is the definition of hedging?
Taking an offsetting position in an investment to neutralize potential gains/losses.
36
What are some advantages of hedging?
* Lower Cost of Capital
* Increased Debt Capacity
* Cash Flow Enhancement
* Signalling Stability
* Easier Business Planning
* Cost-Effective Risk Management
37
What does the Modigliani-Miller Theorem state regarding hedging?
Under perfect markets, hedging does not change the firm's value.
38
What are some disadvantages of hedging in practice?
* Unplanned Costs
* Complexity of Derivatives
* Inaccurate Pricing
39
What is a static hedging strategy?
A straightforward process where the risky investment position is initially determined.
40
What characterizes a dynamic hedging strategy?
Requires frequent monitoring and adjustments.
41
What is the goal of interest rate risk hedging?
Control net exposure to unfavorable interest rate fluctuations.
42
What are some hedging instruments for foreign currency risk?
* Currency Put Options
* Forward Contracts
43
What are the benefits of exchange-traded derivatives?
* Liquidity
* Low Transaction Costs
* Reduced Counterparty Risk
44
What is basis risk?
The risk that the price of the actual commodity and the futures contract do not move in sync.
45
What is a significant change in corporate risk governance post-global financial crisis?
The board needs to prioritize which stakeholder goals have the highest priority.
46
What does Basel III address?
It directly addresses the 2007-2009 financial crisis.
47
What is the role of the Chief Risk Officer (CRO)?
Supervise the risk management function and report to the board.
48
What should compensation structures aim to avoid?
Incentivizing undesired risk-taking.
49
What should be included in effective risk communication?
Clear articulation of risk appetite and management processes.
50
What is the purpose of a risk committee?
To oversee risk management and ensure alignment with risk appetite.
51
Fill in the blank: Risk governance is the methods in which risk taking is permitted, optimized, and ______.
monitored
52
True or False: The existence of significant costs of financial distress contradicts the assumption of perfect capital markets.
True
53
What is the definition of risk governance?
Methods in which risk taking is permitted, optimized, and monitored in a firm
## Footnote
Clear accountability, authority, and communication are essential in risk governance.
54
What is the role of a risk advisory director?
An independent board member with industry-specific risk expertise
## Footnote
Responsibilities include attending risk and audit committee meetings and educating board members on best practices.
55
What are the responsibilities of a risk committee?
* Set the firm's risk appetite
* Independently monitor ongoing risk management
* Maintain contact with internal and external auditors for compliance
* Supervise known risks and approve high-level risk decisions
* Approve significant credit facilities in banking
56
What should the compensation committee align with?
Risk appetite
## Footnote
This alignment ensures that compensation structures do not incentivize excessive risk-taking.
57
What is the purpose of the rem committee?
Ensures appropriate risk-taking aligned with long-term goals
## Footnote
Responsibilities include discussing and approving key management personnel remuneration.
58
How does risk appetite relate to business strategy?
Risk appetite should reflect the firm's tolerance to accept risk
## Footnote
Strategic goals impose credit risk parameters and may require futures for operational risks.
59
What is the Chief Risk Officer (CRO) responsible for?
Overseeing day-to-day risk supervision and reporting to the CEO
## Footnote
The CRO acts as a liaison between the board and senior management.
60
True or False: There is no tension between business objectives and risk goals.
False
## Footnote
There can be tension, as seen when a bank considers a profitable loan that exceeds approved credit risk limits.
61
What are some elements of downside risk in compensation?
* Defer compensation until long-term results are known
* Implement clawbacks for bonuses
* Provide bonus bonds that can be revoked if regulatory ratios are breached
62
What is the function of internal auditors?
Monitor risk management procedures and track system progress
## Footnote
Internal auditors report to the audit committee.
63
What is credit risk?
The risk of a borrower defaulting on a loan or financial obligation
## Footnote
This is considered the core risk for banks.
64
What is a credit default swap (CDS)?
Financial derivatives that pay out when the issuer of a reference instrument defaults
## Footnote
The buyer pays periodic premiums and receives payment in case of default.
65
What are the advantages of credit default swaps?
* Encourages innovation
* Provides steady cash flow for sellers
* Isolates pure credit risk pricing
66
What is a collateralized debt obligation (CDO)?
Structured products made from repackaged loans
## Footnote
CDOs consist of various tranches with different risk and return profiles.
67
What are the disadvantages of collateralized debt obligations?
* Encourages risk-taking
* Creates risk concentration
* Complexity makes them difficult to understand
68
What is the difference between a CDO and a CDO squared?
A CDO squared is made from tranches of other CDOs
## Footnote
Its purpose is to increase marketability rather than reduce risk.
69
What is exposure netting?
Offsetting multiple exposures to the same counterparty to determine net financial impact
## Footnote
This technique helps manage risk exposure.
70
What are the four key steps in securitization?
* Create a Special Purpose Vehicle (SPV)
* Loan Acquisition
* Tranching
* Sale to Investors
71
What is the purpose of the Dodd-Frank Wall Street Reform Act?
To regulate financial markets and prevent systemic risk
## Footnote
Key provisions include the Volcker Rule and oversight of swap contracts.
72
What does the term 'moral hazard' refer to in the context of the originate-to-distribute model?
Weaker underwriting standards due to misaligned incentives
## Footnote
This can lead to a focus on short-term gains over long-term stability.
73
What do investors seek to maximize?
Utility
## Footnote
Investors aim to maximize their satisfaction from investments.
74
What do investors prefer in terms of returns and risk?
Higher returns for the same level of risk
75
What are the characteristics of perfect capital markets?
* No taxes or transaction costs
* Full access to information
* Perfect competition
76
How is portfolio return calculated?
Weighted average of individual asset returns
77
What does portfolio variance depend on?
Correlation between assets
78
What is the effect of ρ = +1 on portfolio variance?
No diversification benefit; portfolio variance is weighted average of individual variances
79
What happens to portfolio risk when ρ < 1?
Diversification reduces portfolio risk; portfolio variance declines below weighted average of individual variances
80
What does ρ = -1 indicate?
Perfect negative correlation can eliminate risk entirely
81
What is idiosyncratic risk?
Company-specific risk (e.g., fraud, cyberattacks)
82
Can idiosyncratic risk be diversified away?
Yes, by holding a sufficiently large and diversified portfolio
83
What is market risk?
Systematic risk that cannot be diversified
84
What is the efficient frontier?
Set of portfolios offering the highest return for a given level of risk
85
What is the Global Minimum Variance Portfolio?
Portfolio with the lowest total risk
86
What characterizes efficient portfolios?
Lie on the efficient frontier
87
What characterizes inefficient portfolios?
Lie below the frontier
88
What characterizes unattainable portfolios?
Lie above the frontier
89
What influences investor choice regarding portfolios?
Risk tolerance
90
What is a risk-free asset?
An asset with a guaranteed return and no risk of default
91
What is a common proxy for risk-free assets?
U.S. Treasury bills (T-bills)
92
What does the Capital Market Line (CML) represent?
The risk-return trade-off when combining a risk-free asset with the market portfolio
93
Where does the CML touch the efficient frontier?
At the market portfolio (M)
94
What do investors to the left of M on the CML do?
Lend at the risk-free rate
95
What do investors to the right of M on the CML do?
Borrow at the risk-free rate to leverage investment
96
What does the market portfolio represent?
A diversified portfolio of all risky assets
97
What is the CAPM?
A model that describes the relationship between systematic risk and expected return
98
What is one key assumption of CAPM?
All investors have access to the same information at no cost
99
What does beta measure?
An asset’s systematic risk—its sensitivity to movements in the overall market
100
What does a beta of 1 indicate?
The market portfolio has a beta of 1 by definition
101
What does the Security Market Line represent?
A graphical representation of the CAPM
102
What is the Sharpe Ratio used for?
Performance evaluation measure
103
What does the Treynor ratio evaluate?
Performance relative to systematic risk
104
What is the Jensen’s alpha?
A measure of performance on a risk-adjusted basis
105
What does Arbitrage Pricing Theory (APT) explain?
Asset returns using multiple sources of systematic risk
106
What is a significant challenge in using multifactor models?
Factor selection requires judgment and periodic updates
107
What does the Fama-French Three-Factor Model include?
SMB and HML factors
108
What does SMB stand for?
Small Minus Big
109
What does HML stand for?
High Minus Low
110
What is the purpose of good risk data aggregation?
Supports risk reporting and performance measurement against a bank’s risk appetite
111
What are the consequences of poor data quality?
* Inaccurate risk assessments
* Regulatory non-compliance
* Missed or misjudged exposures
112
What is a critical component of governance in risk data aggregation?
Integration with Risk Management Framework
113
What must risk data be reconciled with?
Accounting and other internal data sources
114
What is the principle of completeness in data governance?
Include on- and off-balance sheet risks
115
What is the principle of adaptability in risk data systems?
Systems must support ad hoc queries and include new risks
116
What are reasonableness tests, error reports, and logical consistency checks used for?
To ensure accuracy and reliability in risk management reporting.
## Footnote
These checks help identify discrepancies and maintain data integrity.
117
What do materiality standards in risk reporting require?
Accuracy commensurate with accounting standards; material errors must be avoided.
## Footnote
This is crucial for maintaining stakeholder trust.
118
What is the focus of Principle 8 - comprehensiveness in risk reporting?
Full risk coverage, including forecasts, stress tests, and emerging risks.
## Footnote
Reports should be tailored to the audience's complexity and needs.
119
What is the difference between Pillar 1 and Pillar 2 risks?
Pillar 1: Core risks (credit, market, operational); Pillar 2: Broader risks (strategic, reputational, concentration).
## Footnote
Understanding these distinctions is essential for comprehensive risk management.
120
What are the key requirements for clarity and usefulness in risk management reports?
Tailored reporting, risk data, risk analysis, interpretation of risks, qualitative explanations.
## Footnote
Reports must support informed decision-making.
121
True or False: Risk management reports should be customized for different users.
True.
## Footnote
Different roles, such as traders or lenders, require different information.
122
What is the importance of qualitative interpretation in risk reporting?
As data is aggregated, qualitative interpretation becomes more important.
## Footnote
This helps in understanding the implications of the data.
123
What should boards ensure regarding risk management?
The bank operates within its risk appetite and reviews relevant risk information.
## Footnote
This is critical for strategic oversight.
124
What does Principle 10 - frequency state about risk reports?
The frequency of reports should match the needs of recipients and the nature of risks.
## Footnote
Timeliness is crucial in both normal and crisis periods.
125
What are the requirements for distributing risk reports?
Timely dissemination, confidentiality, effective reporting interface.
## Footnote
Reports should be user-friendly to support rigorous analysis.
126
What is Enterprise Risk Management (ERM)?
A centralized and integrated approach to identifying, assessing, managing, and monitoring risks across an organization.
## Footnote
ERM considers interdependencies between different types of risks.
127
What are the shortcomings of silo-based risk management?
Ignores interdependencies, leads to inefficient overhedging, inconsistent metrics, fragmented information.
## Footnote
This approach lacks strategic integration with capital management.
128
What are the key motivations for adopting an ERM initiative?
Defines risk appetite, focuses on critical threats, identifies cross-business line risks, manages emerging risks.
## Footnote
These motivations align risk management with strategic objectives.
129
What are the characteristics of a strong risk culture?
Tone from the top, effective communication, aligned incentives, accountability, awareness of risk appetite.
## Footnote
These traits foster a proactive approach to risk management.
130
What is scenario analysis in ERM?
A risk management tool that evaluates the impact of multiple variable changes on a firm's performance.
## Footnote
It builds narratives around why and how these changes occur.
131
What are the advantages of scenario analysis?
* No need to estimate probabilities
* Intuitive and transparent
* Encourages worst-case thinking
* Flexible
* Strategic use
* Scalable
## Footnote
These advantages enhance preparedness for extreme events.
132
What are the disadvantages of scenario analysis?
* Difficult to quantify
* Complexity in construction
* Risk of underestimation
* Scenario selection bias
* Credibility concerns
* Backward-looking bias
## Footnote
These factors can limit the effectiveness of scenario analysis.
133
What is the purpose of stress testing in the U.S.?
To assess the resilience of banks to extreme but plausible events.
## Footnote
This includes programs like DFAST and CCAR.
134
What are the CCAR requirements for banks?
* Forecast revenues and loan loss provisions
* Submit capital plans for each scenario
* Describe capital adequacy methodologies
* Discuss business plan changes
* Plan for dividends and capital raising
## Footnote
These requirements ensure banks maintain minimum capital standards.
135
What is liquidity risk?
The risk that a firm will be unable to meet short-term cash obligations.
## Footnote
It can arise from external market conditions, internal operational issues, or structural imbalances.
136
What is a hedging strategy?
A risk management approach used to offset potential losses by taking an opposite position in a related asset.
## Footnote
This strategy requires access to data and suitable models for analysis.
137
What is the difference between static and dynamic hedging?
Static hedging is a one-time hedge; dynamic hedging is frequently rebalanced to reflect market changes.
## Footnote
Dynamic hedging is more responsive but incurs higher transaction costs.
138
What went wrong in the Metallgesellschaft Refining and Marketing (MGRM) case?
Oil prices dropped, resulting in massive margin calls due to futures in contango, leading to realized losses.
## Footnote
The mismatch between long-term liabilities and short-term hedging contributed to the crisis.
139
What are long-term fixed-price contracts used for?
Oil and gasoline
140
What strategy is used to hedge exposure in rolling hedge?
Short-term futures in a stack-and-roll strategy
141
What is backwardation?
Spot price > futures price
142
What is contango?
Futures price > spot price
143
What happened when oil prices dropped?
Futures in contango led to massive margin calls
144
What issue did MGRM face during margin calls?
Lacked liquidity to meet margin calls
145
What was the mismatch in MGRM's strategy?
Long-term liabilities vs. short-term hedging instruments
146
What do accounting rules require regarding futures?
Reporting losses on futures but not gains on customer contracts
147
What is model risk?
The risk of financial loss or poor decision-making due to errors in financial models
148
What was Victor Niederhoffer's assumption that led to losses?
A daily drop >5% was nearly impossible
149
What was the outcome of Niederhoffer's strategy?
Triggered a $50 million margin call and fund liquidation
150
What was the flaw in Long-Term Capital Management's (LTCM) model?
Underestimated correlation spikes and volatility during crises
151
What triggered LTCM's massive losses?
1998 Russian debt default
152
What lesson was learned from LTCM's collapse?
Sophisticated models can fail under tail risk and liquidity stress
153
What was the issue with the London Whale case?
Risk managers adjusted models to justify bad trades
154
What was the outcome of the London Whale's trading?
Losses exceeded $6 billion
155
What are the key failures in Nick Leeson's trading at Barings Bank?
No segregation of duties, lack of oversight, ignored red flags, incentive misalignment
156
What should traders remember about seemingly good trades?
If it seems too good to be true, it probably is
157
What is financial engineering?
The use of tools like forwards, futures, swaps, options, and securitized products
158
What was the lesson from Procter & Gamble's use of leveraged swaps?
Don’t use hedging tools to speculate, especially with leverage
159
What incident led to Orange County's bankruptcy?
Investing in inverse floaters while heavily borrowed using repos
160
What is reputation risk?
The potential for operational or financial damage due to negative public perception
161
What scandal affected Volkswagen's reputation?
Emissions scandal involving cheating on emissions tests
162
What does corporate governance ensure?
Transparency, accountability, board independence, diversity, and effective risk oversight
163
What was a key governance failure in Enron?
Agency risk and lack of board oversight
164
What is cyber risk?
The risk of financial or reputational loss due to technology breaches
165
What happened in the SWIFT & Bangladesh Bank case?
Hackers stole $81 million via the SWIFT system
166
What were the key contributing factors to the global financial crisis?
Low interest rates, financial innovation, relaxed lending standards, maturity mismatch, liquidity risk, global contagion
167
What are subprime mortgages?
Loans to borrowers with poor credit or no documentation
168
What is a collateralized debt obligation (CDO)?
Securitized pools of mortgages sliced into tranches
169
What is maturity mismatch in finance?
Long-term assets funded by short-term liabilities
170
What is a Structured Investment Vehicle (SIV)?
Off-balance sheet entities used by banks to hold long-term assets funded by short-term liabilities
171
What is the purpose of the GARP Code of Conduct?
To ensure professional integrity and ethical conduct among members
172
What must GARP Members do regarding conflicts of interest?
Act fairly and disclose any actual or potential conflicts
173
What are the consequences of violating the GARP Code of Conduct?
Suspension or permanent removal from GARP membership, revocation of the FRM designation
174
What may result from violating the GARP Code?
Suspension or permanent removal from GARP membership, revocation of the FRM designation, sanctions after a formal investigation by GARP
## Footnote
Local laws take precedence if they conflict with the Code.
175
What must GARP Members not offer or accept?
Any gift, benefit, compensation, or consideration that could compromise independence and objectivity
## Footnote
Example: Schleifer rejected hotel accommodations and ChemCo's jet but cannot accept dinner tickets.
176
Why is Schleifer's acceptance of dinner tickets a violation?
The tickets may influence his future research in favor of ChemCo, violating Professional Integrity and Ethical Conduct (Standard 1.2)
## Footnote
Even with disclosure to his employer, the potential influence is a concern.
177
What is Bixby in violation of regarding her portfolio expectations?
Standard 1.4: GARP Members shall not knowingly misrepresent details relating to analysis, recommendations, actions, or other professional activities
## Footnote
Bixby implied a guarantee of the fund's expected performance despite the portfolio's variance from the S&P 500 Index.
178
Fill in the blank: Violations of the GARP Code may lead to _______.
suspension or permanent removal from GARP membership.
179
True or False: Local laws always override the GARP Code.
True
180
What does Standard 1.2 of the GARP Code emphasize?
Professional Integrity and Ethical Conduct
## Footnote
It prohibits actions that allow for potential influence on research or decisions.
181
What is the expected performance variance for a mid-cap portfolio compared to the S&P 500 Index?
There will be periods of wide variance
## Footnote
A 40-to-60 stock mid-cap portfolio cannot reasonably be expected to track the S&P 500, which is a large-cap index.
182
Fill in the blank: Bixby's expectation of a 2% to 4% premium is _______.
not assured.
