Ch 17 - Risk Control

Question 1

Risk-free return

Answer 1

The rate at which money is borrowed or lent when there is no credit risk

Question 2

Why is a risk-free rate unlikely to occur in reality

Answer 2

Shared currencies (euro) or currencies that are tied closely to another (like the dollar) - so can’t necessarily just print money in order to repay debts

Currency risk and inflation risk are other risks that effect government bonds etc

Question 3

Advantages of asset liability modelling

Answer 3

Encourages investors to formulate explicit objectives

• Quantifiable and measurable performance target
• Defined performance horizons
• Quantified confidence levels for achieving the target

Feedback between model output and the setting of the objectives

Can monitor the success of the strategy or model by means of regular valuations

Question 4

Deterministic ALM - *check past papers (or Assignment X5) for more in-depth explanation

Answer 4

Based on a single set of assumptions about future experience

Scenario modelling is then required to test whether the assets are of the right type

Question 5

Stochastic ALM

Answer 5

Allows for the random nature of some of the model parameters
-Key parameters are random variables with a given mean and defined probability distribution

Typically depending upon

• Past values of itself
• Present and past values of other economic and/or investment variables (i.e. correlations)

Question 6

Main risks with ALMs

Answer 6

Model risk – risk that the model structure is wrong

Parameter risk – risk that the model parameters, such as expected future return, are incorrectly specified

Question 7

Other actuarial techniques that may be used to develop an appropriate investment strategy and that take into account the liabilities

Answer 7

Matching

Immunisation

Deterministic ALM (possibly with scenario modelling)

Stochastic ALM

Mean-variance portfolio theory applied to the surplus

Question 8

List Financial Risks

Answer 8

Market risk
Credit risk
Liquidity risk
Operational risk
Relative performance risk

Question 9

Market risk definition

Answer 9

Risk relating to changes in the value of the portfolio due to movements in the market value of the assets held

Question 10

Credit risk definition

Answer 10

Risk that a counterparty to an agreement will be unable or unwilling to fulfil their obligations

Question 11

Operational risk definition + examples (5)

Answer 11

Risk of loss due to fraud or mismanagement within the fund management organisation itself

e.g. disasters

Fraud and theft

Human error

Third-party dependencies

Internal control problems

Question 12

Liquidity risk definition (2)

Answer 12

Risk of not having sufficient cash to meet operational needs (/liabilities) at all times

For financial services institutions it is the risk of not being able to raise funds at a reasonable cost at all times

Question 13

Relative performance risk definition

Answer 13

Risk of under-performing comparable to institutional investors

Question 14

Controls for market risk

Answer 14

Define risk and modelling the risk
Systems, reporting and benchmarks (risk monitoring system)
Load differences
Load ratios

Question 15

What to do if developing a risk monitoring system

Answer 15

Automated
Understandable
Prior
Reports
Documented
Independent 
Output = quantifiable

Question 16

Controls for credit risk

Answer 16

Limiting the creditworthiness of the counterparties
Limiting the total exposure to each counterparty
Using credit derivatives

Question 17

Controls for operational risk

Answer 17

Depends on good management practices

• established and documented chains of (internal and external) reporting and responsibility
• those with responsibility should have suitable qualifications and experience
• separation of “front office” and “back office” functions
• management understands the nature of complex deals undertaken by traders

Question 18

Controls for liquidity risk

Answer 18

Cash budgeting / short-term financial planning are techniques that can be used for identifying and measuring liquidity risk

Gap analysis

Duration analysis

Question 19

Gap Analysis - what is net liquid assets equal to?

Answer 19

Level of liquid assets – volatile assets

Question 20

Weakness of gap analysis

Answer 20

Does not quantify the potential cost or impact of such a gap under stressing conditions such as an increase in the cost of finance

Question 21

Duration analysis - LRE

Answer 21

Liquidity duration or liquidity risk elasticity (LRE) considers the impact of changes in market conditions

Question 22

Process of duration analysis (2 steps)

Answer 22

Calculate the PV of assets and liabilities using the “cost of funds” rate as the discount rate

Measure the change in the market value of the institution’s equity (LRE) from a change in the cost of funds (due to an increase in the risk premium to raise money)

Question 23

If LRE is negative then…

Answer 23

the duration of assets is longer than that of liabilities

Higher duration means that the value of assets will drop by more when interest rates increase

Therefore, will want to shorten the maturity of assets and lengthen liabilities to increase liquidity

Question 24

Controls for relative performance risk

Answer 24

Can be measured and controlled in the same way as market risk (just compare to peers rather than whole market)

Commercial matching

Index tracking

Question 25

Difficulties in assessing relative performance risk

Answer 25

Identifying an appropriate peer group

Obtaining reliable and accurate data on the performance of competitors

Making appropriate allowance for the risk of positions taken

Question 26

Immunisation

Answer 26

Investment of assets in such a way that the PV(Assets) - PV(Liabilities) is immune to a general small change in the rate of interest.

Question 27

Theoretical and practical problems with Immunisation

Answer 27

AIFRM DTF Ella

Assets of suitably long DMT may not exist

Interest rate changes must be small

Flat yield curve is assumed and level interest rate changes at all terms

Rebalancing constantly in practice (for DMT and convexity)

Mismatching profits removed apart from a small second-order effect

Dealing costs are ignored in theory (from ARM notes but not in F105)

Fixed monetary liabilities is the aim for immunisation generally

Timing of proceeds and outgo may be uncertain

Amounts of the liabilities (and some assets as pointed out below) may not be known with certainty

Equities and property are ruled out as investments even though they have high expected returns, due to their uncertain returns (from ARM notes but not in F105)

Question 28

Opportunity set

Answer 28

Set of combinations of means and variances that the investor is able to obtain by constructing portfolios of the available securities

Question 29

Efficient frontier

Answer 29

Set of efficient portfolios in the E-V space

A portfolio is efficient if there is no other portfolio with either a higher mean and the same or lower variance, or a lower variance and the same or higher mean.

Question 30

Optimal portfolio

Answer 30

The portfolio that maximises the investor’s expected utility as a function of the mean and variance of investment returns

Question 31

Indifference curves

Answer 31

Join points of equal expected utility in E-V space