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Flashcards in S14 Deck (36):
1

Steps in risk management process

- set policies and procedures for managing risk
- define risk tolerance
- identify risks faced by org
- measure current levels of risk
- adjust the levels of risk

2

ERP

centralized risk management system placing execution withing one central unit of the orgnaization

3

effective risk management system will

- identify each risk factor to which firm is exposed
- quantify factor in measurable terms
- include each risk in a single aggregate measure of FIRM WIDE risk (e.g. VAR)
- identify how each risk contributes to overall firm risk
- systematically report risks and support allocation of capital and risk to each business unit
- monitor compliance

4

financial risks

market risk (rates, fx, equity price, commodity price)

credit risk

liquidity (bid ask spread, volume, etc)

5

nonfinancial risks

operational
settlement (one party can default after first party made the payment)
model risk
sovereign - ability and willingness of a foreign govenrment to pay
regulatory risk
tax, accounting, legal, contract risks
environmental social or governance risk
performance netting risk
settlement netting risk

6

VAR formula

VAR = ( Rp - Z * StandDev) * investment value

5% var = Z = 1.65
1% = Z = 2.33

7

StandDev annual to weekly conversion

Annual StandDev / (52 [weeks])^0.5

8

Analytical VAR = Advantages/Disadvantages

Adv:
- easy to calc and understood
- allow modeling of risk correlation
- applicable to both short and long periods
DisAdv:
- some securities have skewed returns
- many assets exhibit leptokurtosis (fat tails)
- stand dev difficult to estimate for large portfolios

9

Historical VAR = Adv / DisAdv

Adv:
- easy to calc / udnerstand
- doesnt assume a returns distribution
- applicable to different periods
Disadv
- assumptions that historical pattern will repeat in future

10

VAR advantages

- is an industry standard risk measure
- required by regulators
- aggregates risk into a single simple number
- can be used in capital allocation
- can compare different assets with dif characteristics

11

VAR disadvantages

some methods difficult and expensive (MCarlo)
Different computaitons lead to different estimates of VAR
Can generate false sense of security
Onesided - ignores upside

12

Stressing models

factor push analysis
maximum loss optimization
worst case scenario

13

credit risk losses are function of

probability of default event
amount of value lost in default

14

forward agreement = value to long =

[[[[[ fx rate is domestic/foreign ]]]]]]

= spot FX / (1+Foreign% ) ^ t - forward FX / (1+Domestic %) ^ t

15

risk budgeting

process of determining which risks are acceptable and how total entreprise risk is allocated across business units or PMs

16

in addition to VAR - market risk can be managed with

position limits
liquidity limits
performance stopout
risk factor limits

17

ways to manage credit risk

Credit VAR
Limiting exposure
Marking to Market
Collateral
Payment netting
Closeout netting
minimim credit standards on a debtor
transfering risk via
--- credit default swaps
--- credit spread forwardd
--- credit spread option
--- total return swap

18

Sharpe ratio

S = ( R - Rf ) / StandDev

19

Return on max drawdown

RoMAD = R / Max Drawdown

20

Sortino ratio

= (R - MAR) / DOWNside deviation

downside deviation - returns below MAR not ZERO

21

information ratio =

(Rpf - Rbench) / StandDev (Rpf - Rbench)

22

VAR is

estimate of minimum loss (or max)
OVER a set time period
at a desired LEVEL OF SIGNIFICANCE/CONFIDENCE

23

standard deviation for 2 asset portfolio =

= (SDa*Wa)^2+
[(SDb*Wb)^2 + 2*Corr*Wa*Wb*SDa*SDb]^.5

24

supplements to VAR to provide more confidence

incremental VAR
CF at risk
Earnings at risk
Tail value at risk

25

futures are H while options are I

Hedging Insurance

26

3 approaches to manage currency exposure

- strategic hedge ratio
- currency overlay (following IPS but PM not responsible for FX... separate manager hired for FX)
- separate asset allocation

27

minimum variance hedge ratio =

translation risk + economic risk

28

for every unit of currency we should hold ????? put options

= 1 / delta

29

impact on fx from lower domestic interest rate

higher fx rate

30

for interest and equity swaps the credit risk is largest at

middle of the life of the swap

31

for currency swaps with payment of notional principal the credit risk is greatest near

the end of the life of the swap

32

benefits of centralized risk management systems

brings risk control closer to the key decision makers
enable org to better manage its risk budget by recognizing the diversification embedded across business units

33

benefits of decentralized risk management system

placing risk control in closer to source of risk taking

34

hedging should be avoided in situation of

natural hedge (e.g. where FX offset commodity movements)

35

forward hedge - 2 sources of imperfection

future value of hedged asset is unknown (potential return/loss in value)

potential change in forward basis caused by a change in interest rate differential

36

in the money options provide XXXXX protection but XXXXXXX the profit potentaial

better / reduces