Risk Management Flashcards
(31 cards)
List specific risk that must be monitored in an ERM.
Market risk Liquidity risk Settlement risk Credit risk Operations risk Model risk Sovereign risk Regulatory risk Political risk Tax risk Accounting risk Legal risk
What is the process for risk management?
It is a continual process:
- Set policies and procedures.
- Define risk tolerance.
- Identify risks.
- Measure risks.
- Adjust level of risk.
What steps must be taken to adjust the risk levels of the firm?
- Execute risk management transactions using derivatives or non-derivatives.
- Identify appropriate transaction.
- Price the transaction.
- Execute each transaction.
What is risk governance?
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.
What are the qualities of high quality risk governance?
- Transparent
- Establish clear accountability.
- Cost efficient in the use of resources.
- Effective in achieving desired outcomes.
What is a decentralized risk governance system and its benefit?
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.
What is a centralized risk governance system and its benefit?
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.
What are the steps that an effective enterprise risk management (ERM) system will incorporate?
- Identify each risk factor to which the company is exposed.
- Quantify each exposure size in money terms.
- Map the inputs into a risk estimation calculations (e.g., VAR).
- Identify how each risk contributes to the overall risk of the firm.
- 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.
- Monitor compliance with policies and risk limits.
Note: Effective ERM systems always feature centralized data warehouses. This can require significant and continuing investment.
On the CFA exam, what questions should be asked when evaluating the strengths and weaknesses of a company’s risk management process?
- Is senior management consistently allocating capital on a risk-adjusted basis?
- Does the ERM system properly identify and define all relevant internal and external risk factors?
- Does the ERM system utilize an appropriate model for quantifying the potential impacts of risk factors?
- Are risks properly managed?
- Is there a committee in place to oversee the entire system to enable timely feedback and reactions to problems.
- The ERM system has built in checks and balances.
How is market risk define when referring to a ERM system and not portfolio theory?
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.
When measured relative to a benchmark, what is the volatility of the asset’s excess returns called?
The volatility (stand deviation) to an asset’s excess return is called active risk, tracking risk, tracking error volatility, or tracking error.
Define VAR.
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).
What are the advantages to the analytical method for estimating VAR?
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.
What are the disadvantages to the analytical method for estimating VAR?
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]
What are the advantages to the historical method for estimating VAR?
- Easy to calculate and easily understood.
- No need to assume a returns distribution.
- Can be applied to different time periods according to industry custom.
What are the disadvantages to the historical method for estimating VAR?
The assumption that the pattern of historical returns will repeat in the future.
What are the advantages to the Monte Carlo method for estimating VAR?
The ability to incorporate any returns distribution or asset correlation.
What are the disadvantages to the Monte Carlo method for estimating VAR?
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.
What is the primary advantage for all VAR types?
The ability to compare the operating performance of different assets with different risk characteristics.
What is the primary disadvantage for all VAR types?
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.
In addition to VAR, what are other methods for managing market risk?
- 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.
What are non-VAR measures to help control credit risk?
- 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.
What is the Sharpe ratio and its principal draw back?
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.
What is the risk-adjusted return on invested capital (RAROC)?
RAROC is the ratio of the portfolio’s expected return to some measure of risk, such as VAR.
