Chapter 17: Risk control Flashcards
Risk-free rate of return
the risk-free rate of return can be defined as the rate a which money is borrowed or lent when there is no credit risk, so that money is certain to be repaid.
Deterministic model vs Stochastic model
- a deterministic model is based on a set of specific assumptions about the future.
- a stochastic model allows for the random nature of some of the model parameters.
Different forms of financial risks (5)
- Market risk
- Credit risk
- Operational risk
- Liquidity risk
- Relative performance risk
Market risk & how it can be controlled
market risk is the risk relating to changes in the value of the portfolio due to movements in the market value of assets held.
It can be measured using Value at Risk and controlled by regular modelling and reporting
Credit risk and how it can be controlled
credit risk is the risk that a counterparty to an agreement will be unable or unwilling to fulfill their obligations.
It can be controlled:
- by limiting the creditworthiness of the counterparties
- by limiting the total exposure to each counterparty
- using credit derivatives.
Operational risk & how it can be controlled
operational risk is the risk of loss due to fraud or mismanagement within the fund management organisation itself.
it can be controlled by appropriate internal reporting and by separation of front office and back office functions.
Liquidity risk
liquidity risk is the risk of not having sufficient cash to meet operational needs at all times
Relative performance risk & how it can be controlled
relative performance risk is the risk of under-performing comparable institutional investors.
it can be measured and controlled in the same way as market risk
Mean-variance portfolio theory / Modern portfolio theory (MPT)
it specifies a method for an investor to construct a portfolio that gives the maximum expected return for a specified level of risk, or the minimum risk for specified expected return.
The application of the mean-variance framework to portfolio selection falls conceptually into two parts:
- First the definition of the properties of the portfolios available to the investor - the opportunity set.
- Second, the determination of how the investor chooses one out of all the feasible portfolios in the opportunity set.
Assumptions of mean-variance portfolio theory: (7)
- all expected returns, variances and covariances of pairs of assets are known.
- investors make their decisions purely based on expected return and variance
- investors are non-satiated
- investors are risk-averse
- there is a fixed single-step time period
- there are no taxes or transaction costs
- assets may be held in any amounts, i.e. short-selling, infinitely divisible holdings, no maximum investment limits.
When is a portfolio inefficient
A portfolio is inefficient if the investor can find another portfolio with the same (or higher) expected return and lower level of risk, or the same (or lower) level of risk and higher expected return.
What is an efficient portfolio
An efficient portfolio is a portfolio which gives the highers expected return for a given level of risk or the lowest risk that produces the required level of return.
Indifference curves
Indifference curves join points of equal expected utility in expected return - standard deviation space.
Describe the “Liquidity Risk Elasticity”: (3)
Liquidity risk elasticity considers the impact of changes in market conditions. The process consists of two steps:
- Calculate the present value 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 paid to raise money.)
