Chapter 18: Risk Control

Question 1

List the five main financial risks faced by an institutional investor

Answer 1

Market Risk - Risk relating to changes (falls) in value of portfolio due to movements in market value of the assets held

Credit risk - risk that counterparty to agreement will be unable or unwilling to fulfil their obligations
Operational risk - risk of loss due to fraud or mismangement within fund management organisations itself
Liquidity risk - risk of not having sufficient cash to meet operational needs at all times
Relative performance risk - risk of under performing comparable institutional investors

Question 2

Explain

How market risk might be measured in practice
The difference between a load difference and a load ratio

Answer 2

Suitable measure might be variance of portfolio return over specified period of time or value at risk
Returns may be measured in absolute terms or relative to benchmark such as index, or value of liabilities
Load difference specifies limit for departure from benchmark asset allocation as percentage of total portfolio
Load ratio specifies limit for departure from benchmark asset allocation as a percentage of bench allocation to that class

Question 3

State the two key factors in controlling credit risk and list six ways in which they can be controlled

Answer 3

Key factors in controlling credit risk

Creditworthiness of counterparties

Total exposure to each counterparty

Control these by

+Placing limits on credit ratings
+Trading derivatives on a recognised exchange
demanding collateral and/or margin payments
+Placing limits on individual credit exposures avoiding aggregations of exposure
+using credit derivatives

Question 4

List 5 ways in which operational risk can be controlled

Answer 4

Operational risk can be controlled

Management understanding complex deals undertaken by traders

separating front office and back office functions

setting up audit trails

clearly defining roles and responsibilities

training and qualifications

Question 5

Explain how a balance sheet model of liquidity can be used to control liquidity risk

Answer 5

+All assets are allocated to one of two categories liquid or iliquid

+All liabilities are classed as either stable or volatile

+The focal point of the analysis is the concept of net liquid assets or the liquidity gap - the difference between the level of liquid assets and volatile liabilities

+Allowance should be made for the liquidation costs associated with converting items to cash ie brokerage and invesment banking fees and thef basis bid - offer spread in the market for the assets involved, as well as the time available for conversion

Question 6

Explain how liquidity duration or liquidity risk elasticity(LRE) can be used to control liquidity risk

Answer 6

Calculate the present value of assets and liabilities using the cost of funds rate as the discount rate
Measuring the change in the market value of the institution’s equity from a change in the cost of funds (due to an increase in the risk premium paid to raise money).
I the LRE is zero the institution has zero liquidity risk (by this measure), If the LRE is sharply negative, it will pay the institution to shorten the maturity of its assets and lengthen the maturity of its liabilities, thereby increasing liquidity

Question 7

List 7 assumptions underlying mean - variance portfolio theory

Answer 7

Investors prefer more to less
investors are risk averse
Investors base investment decisions only on mean and variance of return
Investors consider single step time period only
investors can estimate all means, variances and covariances
There are no taxes and transaction costs
assets may be held in any amounts

Question 8

In the context of mean - variance portfolio theory, explain what is mean by each of the following

Opportunity set
efficient portfolio 
efficient frontier
indifference curves 
optimal portfolio

Answer 8

Opportunity set

Set of combinations of mean and variance attainable from available securities

Efficient portfolio

Portfolio such that no other portfolio offers higher expected return for same or lower variance or lower variance for same or higher expected return

Efficient frontier

Set of efficient portfolios

Indifference curves
Line joining all combinations of mean and variance of investment returns between which investor indifferent because they offer same expected utility

Optimal portfolio

Combination of available securities that maximises investor’s expected utility