Chapter 18: Risk Control Flashcards
f) methods for monitoring and controlling xposure to risk
List five main financial risks faced by an institutional investor.
Financial risks
- Market risk - the risk relating to changes (falls) in the valye of pf due to movements in the market value of the assets held.
- credit risk - the risk that counterparty to an agreement will be unable or unwilling to fulfil their obligations
- Liquidity risk
- for all companies - cashflows generated by assets are insufficient to meet liabilities in all future periods.
- financial services institutions - risk of not being able to raise funds (by having access to cash balances, borrowing or sale of assets) reasonable cost at all times. - Operational risks - the risk of loss due to fraud or mismanagement within fund management organisation itself.
- Relative performance risk - risk of under-performing comparable institutional investors.
f) methods for monitoring and controlling xposure to risk
Explain:
- how market risk might be measured/defined in practice
Financial risks
Measuring market risk:
- Suitable measure might be the variance of pf returns over specifed period or VaR
- Returns may be measured in absolute terms or relative to a benchmark, value liabilities and industry median fund.
- Time scales will depend on the institution
f) methods for monitoring and controlling xposure to risk
Decribe how market risk can be monitored and controlled.
Financial risks
- identifying and defining (market) risks as above
- Modelling risk - establishing a mathematical model that will allow the risk to me calculated at any point in time (simulations, VaR or mean-varience framework)
- Systems, reporting and benchmark - The next is ensure that computer systems and data inputs are in place to calculate the risk exposrure as often as required.
- The levels of the market risk should be monitored regular intervals and results shared with decisions makers so they can make informed decisions. - Provide managers with guidelines that can be translated into practical benchmarks and limits (load differences and load ratios)
- Risk control needs to be clearly documented and those responsible for monitoring should be independent of the fund managers.
f) methods for monitoring and controlling xposure to risk
Explain the difference between load difference and load ratio.
Financial risks
- Load difference - specifies limit for departure from benchmark asset allocation as % of the total pf.
- Load ratio - specifies limit from departure from benchmark asset allocation as % of benchmark allocation to that class. (effect is that a constant load ratio permits a smaller absolute variation in the lower weighted asset classes)
f) methods for monitoring and controlling xposure to risk
Outline the desirable features and requirements of market risk monitoring system.
Financial risks
- Senior management should receive regular reports
- Up to date reporting of Risk Exposure (e.g, VaR, benchmark asset distributions between main classes toggether with deviations from benchmark)
- reporting done on a Regular basis
- Monitoring personal should be Independent of fund managers
- Output should be quantifiable
- Factors that determine risk should be Understandable to fund managers and other personnel using the system
- Standard (automated) data input procedures so that changes ( e.g., asset values, pf mix) are capture quickly.
- Managers should be able to See effect of proposed changes
f) methods for monitoring and controlling xposure to risk
State the two key factorsr in controlling credit risk and list six ways in which it can be controlled.
Financial risks
Key factors in managing credit risk are:
- creditworthiness of conterparties
- total exposure to each counterparty
Controlling these:
- (creditworthiness) placing limits (depending on length of exposure) on credit ratings of counterparties
- (credit risk) by trading derivatives on recognised exchanges
- demanding collateral and/or margin payment
- (credit exposure) placing limits on individual credit exposures to any singe counterparty
- avoid aggregations of exposure
- use credit derivatives
f) methods for monitoring and controlling xposure to risk
List five ways operational risk can be controlled.
Financial risks
- Good management practices including having established and documented chains of reporting and responsibility
- suitable qualifications, training and experience for those with responsibilities
- management should understand the complex nature of deals undertaken by traders
- seperation of front office (trading, transacting, sourcing and making deals) and back office functions (settlement and accounting)
- setting up audit trails1.
f) methods for monitoring and controlling xposure to risk
List sources of operational risks for a small domestic company.
Financial risks
People:
- Fraud and theft
- Human error
- Staff resource problems
Processes:
- manufacturing failures
- delivery failures
- Internal control problems
Technology:
- IT problems
- Confidentiality and security breaches
External:
- product liability
- health and safety issues
- disasters
- third-party dependency
f) methods for monitoring and controlling xposure to risk
Explain how a balance sheet model (Gap analysis) of liquidity can be used to control liquidity risk.
Financial risks
All assets are allocated one of two categories - liquid or illiquid.
All liabilities are classified 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 liquid assets and volatile liabilities.
Allowance should be made for liquidation costs associted with cnoverting items to cash, e.g., brokerage and investment banking fees and basis bid-offer spread in the market for assets involved, as well as the time available for conversion.
Liquid (volatile) assets (liabilities) have a maturity (are due in) of 6 months or less.
The main issue with this approach is that it does not quantify the potential cost or impact of such a gap under stress situations such as an increase in the cost of finance.
f) methods for monitoring and controlling xposure to risk
Explain how liquidity duration or liquidity risk elasticity of liquidity can be used to control liquidity risk.
Financial risks
It considers the impact of changes in market condition and potential cost of the liquidity gap.
This process consists of two stages:
- Calculate the present value of assets and liabilities using the ‘cost of funds’ rate as discount rate.
- Measure the change in the institution’s equity ((LRE from a change in the the cost of funds (due to an increase in the risk premium paid to raise money)
If the LRE is zero, then the institution has zero liquidity risk by this measure. if it is sharply negative, it may pay more for the institution to shorten the maturity of its assets and lengthn the maturity of its liabilities, thereby increasing liquidity.
f) methods for monitoring and controlling xposure to risk
Explain how relative perforamance risk can be monitored and controlled.
Financial risks
The techniques for monitoring and controlling RPR are the same as those for controlling market risk except that performance is measured relative to the institution’s competitors rather than absolute terms or relative to the whole market.
f) methods for monitoring and controlling xposure to risk
Outline the typical objectives of controlling and monitoring RPR and how to minimize it.
Financial risks
Typical objectives to aim to minimise risks of achieving:
- below median investment returns over one or more specified terms, e.g., 1 year, 3 year, 5 year year and/or 10 years terms.
- median or above investments returns less than 90% of the time (for any particular term)
- returns below those yielded by a particular investment index
Ways to minimise relative performance risk might therefore:
- commercial matching, i.e holding similar investment pfs to your competitors
-index tracking
f) methods for monitoring and controlling xposure to risk
Outline the major difficulties when attempting to assess relative performance risk.
Financial risks
- identifying the appropriate peer group to compare with…
…may be straightforward for unitised that it is for insurance company with-profit fund with different liability profile from other insurers. - obtaining reliable and accurate data on performance of competitors
- making allowance for the risk of position taken
f) Mean-variance portfolio
Outline what is meant by Mean-variance Portfolio Theory (MPT).
Portfolio theory
Specifies a method for an investor to construct a pf that gives the maximum expected return for a specified level of risk, or minimum risk for a specified level of expected return.
(The theory ignores the investor’s liabilities, thus, actuarial risk)
f) Mean-variance portfolio
List the seven assumptions underlying MPT.
Portfolio theory
- All expected returns, variances and covariances of pairs of assets are known
- Investors are non-satiated
- Investors make decisions pure baseed on expected returns and variance of returns
- investors are risk averse
- there are no taxes and transaction costs
- assets may be held in any amounts, i.e., short-selling is possible, we can have infinitely divisible holdings, and there are no maximum investment limits.
- there is a fixed single-step time period.
