26.a: Discuss features of the risk management process, risk governance,
risk reduction, and an enterprise risk management system.
**The risk management process requires: **
1. Top level management of the organization setting policies and procedures for
2. Defining risk tolerance to various risks in terms of what the organization is willing
and able to bear. For some risks tolerance will be high, for others it will be low.
3. Identifying risks faced by the organization. Those risks can be grouped as financial
and non-financial risks. This will require building and maintaining investment
databases for both types of risk.
4. Measuring the current levels of risk.
5. Adjusting the levels of risk-upward where the firm has an advantage and seeks
to generate return to exploit an advantage, downward in other cases. As part of
adjusting risk levels the firm must:
Risk governance -overall process of developing and putting a risk management system into use.
LOS 26.b: Evaluate strengths and weaknesses of a company’s risk management
LOS 26.c: Describe steps in an effective enterprise risk management system.
Identify each risk factor to which the company has exposure.
Quantify the factor in measurable terms.
Include each risk in a single aggregate measure of firm-wide risk. VAR will be the
most commonly used tool.
Identify how each risk contributes to the overall risk of the firm. This is an
advantage of VAR.
Systematically report the risks and support an allocation of capital and risk to the
various business units of the firm.
Monitor compliance with the allocated limits of capital and risk.
26.d: Evaluate a company’s or a portfolio’s exposures to financial and
nonfinancial risk factors.
Market risk - interest rates, exchange rates, equity prices,
Credit risk - the risk of loss caused by a counterparty’s or debtor’s failure to make a promised payment.
Liquidity risk is inability to take or liquidate a position quickly at a fair price.
Operational or operations risk is a loss due to failure of the company’s systems and procedures or from external events outside the company’s control.
Settlement risk - One party could be making a payment while the other side of the exchange could be in the process of defaulting and fail to deliver on the transaction. ( Herstatt risk)
Model risk/ Sovereign risk / regulatory risk / tax accounting and legal / contract risk
Performance netting risk / Settlement netting risk
26.e: Calculate and interpret value at risk (VAR) and explain its role in
measuring overall and individual position market risk.
The percentage selected will affect the VAR. A 1 % VAR would be expected to show
greater risk than a 5% VAR.
( refer orignal cfa materia)
26.D Compare the analytical (variance-covariance), historical, and
Monte Carlo methods for estimating VAR and discuss the advantages and
disadvantages of each
5% VAR is 1.65 standard deviations below the mean.
• 1 % VAR is 2.33 standard deviations below the mean.
Disadvantages of -
Many assets exhibit leptokurtosis (fat tails). When a distribution has “fat tails,” VAR
will tend to underestimate the loss and its associated probability as extreme returns occur more frequently than assumed by the normal distribution.
The difficulty of estimating standard deviation in very large portfolios.
26.g: Discuss advantages and limitations of VAR and its extensions,
including cash flow at risk, earnings at risk, and tail value at risk.
Incremental VAR (IVAR) is the effect of an individual item on the overall risk of the portfolio. IVAR is calculated by measuring the difference between the portfolio VAR before and after an additional asset, asset class, or other aspect of the portfolio is changed
Cash flow at risk (CFAR) ——–
26.h: Compare alternative types of stress testing and discuss advantages
and disadvantages of each.
Scenario analysis is used to measure the effect on the portfolio of simultaneous movements in one or several factors.
Other forms of scenario analysis include actual extreme events and hypothetical events,
which are quite similar.
Stress testing is just an extreme scenario.
Factor push analysis is a simple stress test where the analyst pushes factors to the
most disadvantageous combination of possible circumstances and measures the
resulting impact on the portfolio.
Maximum loss optimization uses more sophisticated mathematical and computer
modeling to find this worst combination of factors.
Worst-case scenario is the worst case the analyst thinks is likely to occur.
LOS 26.i: Evaluate the credit risk of an investment position, including forward
contract, swap, and option positions.
Current credit risk (also called jumpto-default risk) is the amount of a payment currently due. Because payments are only due on specific dates, current credit risk is zero on all other dates.
Potential credit risk is associated with payments due in the future and exists even if there is no current credit risk. It will change over time.
interest rate and equity swaps - credit risk is hgiher in the middle of the life cycle - for currency swap it is at the end of the life
LOS 26.j: Demonstrate the use of risk budgeting, position limits, and other
methods for managing market risk.
Risk budgeting which risks are acceptable and how total enterprise risk is allocated across business units or portfolio managers.
LOS 26.k: Demonstrate the use of exposure limits, marking to market,
collateral, netting arrangements, credit standards, and credit derivatives to
manage credit risk.
Limiting exposure - limiting the amount of loans to any individual debtor or the amount of derivative transactions with any individual counterparty.
Marking to market-. The party whose value is negative pays this amount to the other party, and the contract is repriced.
Payment netting , close out netting
Transferring Credit Risk with Credit Derivatives -
credit default swap, the protection buyer pays the protection seller in return for the right to receive a payment from the seller in the event of a specified credit event.
In a total return swap, the protection buyer pays the total return on a reference obligation (or basket of reference obligations) in return for floating-rate payments. If the reference obligation has a credit event, the total return on the reference obligation should fall; the total return should also fall in the event of an increase in interest rates, so the protection seller (total return receiver) in this contract is actually exposed to both credit risk and interest rate risk.
A credit spread option is an option on the yield spread of a reference obligation and over a referenced benchmark
a credit spread forward is a forward contract on a yield spread.
26.l: Discuss the Sharpe ratio, risk-adjusted return on capital, return
over maximum drawdown, and the Sortino ratio as measures of risk-adjusted
The Sharpe ratio measures excess return (over the risk-free rate) per unit of risk,
measured as standard deviation.
it can’t be used for non- linear returns
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 . Management can then compare the manager’s RAROC to his historical or expected RAROC or to a benchmark RAROC.
Return over maximum drawdown (RoMAD). RoMAD is the annual return divided by
the fund or portfolio’s largest percentage drawdown.
The Sortino ratio is the ratio of excess return to risk. Excess return for the Sortino
ratio (the numerator) is calculated as the portfolio return less the minimum acceptable portfolio return (MAR).
Sortino ratio = (Mean portfolio return – MAR)/Downside deviation
26.m: Demonstrate the use of VAR and stress testing in setting capital
Nominal, notional, or monetary position limits.
Max loss limits.
Internal and regulatory capital requirements.
VAR is only as good as the assumptions used in its calculation, and it does not
consider all worst-case scenarios.
VAR may not be well understood by the business units.
Diversification issues can be counterintuitive. It may be appropriate to allocate
capital to a very low return unit if the diversification benefit is large enough to allow
an increase in allocation to a higher risk and return unit.
Stress testing is the natural complement to VAR as it can consider more extreme outlier
events that may not be reflected in the VAR calculation.
27 A. demonstrate the use of equity futures contracts to achieve a target beta for a
stock portfolio and calculate and interpret the number of futures contracts
Bt = Desired portfolia beta
Bp =Portfolia beta
27 B construct a synthetic stock index fund using cash and stock index futures
c explain the use of stock index futures to convert a long stock position into synthetic
demonstrate the use of equity and bond futures to adjust the allocation of a
portfolio between equity and debt;
demonstrate the use of futures to adjust the allocation of a portfolio across equity sectors and to gain exposure to an asset class in advance of actually committing funds to the asset class;
G. explain the limitations to hedging the exchange rate risk of a foreign market
portfolio and discuss feasible strategies for managing such risk.
29.a: Demonstrate how an interest rate swap can be used to convert a floating-rate (fixed-rate) loan to a fixed-rate (floating-rate) loan.
Company X agrees to pay Company Ya periodic fixed rate on a notional principal over the tenor of the swap. In return, Company Y agrees to pay Company X a periodic floating rate on the same notional principal.
29.b: Calculate and interpret the duration of an interest rate swap
The convention is to treat the duration of the floating
rate side of the swap as being half the reset period.
For a pay-floating counterparty in a swap, the duration can be expressed as:
D pay floating = D fixed - D floating > 0
The swap diagram is an easy way to remember how to calculate swap
duration. The arrow coming in represents an asset; add the duration of what is
received on the swap. The arrow going out represents a liability; subtract the duration
of what is paid on the swap. The result is the swap duration.
29.c: Explain the effect of an interest rate swap on an entity’s cash flow
It is common to refer to converting a floating-rate liability to fixed-rate as a hedge. In
the sense that it reduces cash flow risk, it is a hedge. However, it is essentially converting highly visible cash flow risk into less visible market value risk.
LOS 29.d: Determine the notional principal value needed on an interest rate
swap to achieve a desired level of duration in a fixed-income portfolio
29 .f: Demonstrate how a firm can use a currency swap to convert a series
of foreign cash receipts into domestic cash receipts.
Divide the foreign cash flow received by the foreign interest rate to determine the
corresponding foreign-denominated notional principal (NP).
a. This is the foreign NP that would have produced the foreign cash flow at the
given foreign interest rate.
2. Using the current exchange rate, convert the foreign NP into the corresponding
3. Enter a swap with this NP.
a. Pay the foreign cash flows received on the assets and receive the equivalent
b. The amount of each domestic cash flow is determined by multiplying the
domestic interest rate by the domestic NP.
29.g: Explain how equity swaps can be used to diversify a concentrated
equity portfolio, provide international diversification to a domestic portfolio,
and alter portfolio allocations to stocks and bonds
29.e: Explain how a company can generate savings by issuing a loan or
bond in its own currency and using a currency swap to convert the obligation
into another currency