Chapter 4 - Managing risks Flashcards
What is market risk also referred to as
Systematic risk
How does price volatility arise?
Unanticipated fluctuations in factors that commonly affect the entire financial market
What macro variables associated with the financial market must an investor focus on?
- inflation
- interest rates
- the balance of payments situation
- fiscal deficits
- geopolitical factors
What is another name for market risk and why
Undiversifiable risk because it affects all asset classes and is unpredictable
What are the four components of market risk
- Interest rate risk
- Exchange rate risk
- Commodity price risk
- Equity price risk
What are the 4 main components of market risk
- Interest rate risk
- Exchange rate risk
- Commodity price risk
- Equity price risk
What causes interest rate risk
Arises as a result of unanticipated fluctuations in the interest rates due to monetary policy changes by the Central bank
What securities are primarily associated with interest rate risk
Fixed income securities
Why do volatilities in commodity prices trickle down to affect the entire market
Commodities are essential for any econmand compliment the production process of many good due to their utilisation as indirect inputs
How do commodity risk affect the market
- Supply side crisis
- Decline in stock prices and performance based dividends
- Reduces company’s ability to honor the value of the principal itself
How do some emerging economies deal with foreign exchange risk
By maintaining foreign exchange reserves that they can sell to offset depreciation
What are some considerations to take into account when making an international investment
- Degree of political stability
- Level if fiscal deficit
- Proneness to natural disaster
- Regulatory environment
- Ease of doing business
Why do normal techniques not work for market risk
Market risk cannot be diversified away, it can hedged against for minimal exposure
What are some good measures of market risk
- Volatility
- VAR
- Beta - CAPM (measures the anticipated return of an asset)
In addition to VAR, what other methods exists for mitigating market risk
- Position limit
- Liquidity limit
- Performance stopout
- Portfolio manager limits
- Scenario analysis limits
- Leverage limits
Why is it difficult to measure credit risk
Default is rare and therefore there is very little data to help with decisions
What are the strategies for managing credit risk
- Limiting exposure
- Marking to market
- The use of collateral
- Payment netting
- Closeout netting
How is credit risk managed by limiting exposure
By limiting the quantum of loans to an individual or institutional debtor or number of derivative transactions with any counterparty
What does the term mark to market refer to
The method under which the fair market values of accounts that are subject to periodic fluctuation are measured
What is used as collateral in derivative trading
Margins (posted)
When is payment netting employed
Used in transactions such as derivative trading where both parties have credit risk; value and net the two to determine who has a larger obligation
When is closeout netting used
In bankruptcy situations
What are the ways in which risk can be transferred to others using credit derivatives
- Credit default swaps
- Credit spread forward
- Credit spread options
- Total return swap
What happens to banks whose stressed capital falls below a minimum set by regulators
They are prevented from making capital distributions such as dividends and stock repurchases
What is stress testing
- An extreme scenario
- An extension of scenario analysis focusing on adverse outcomes
- A compliment to VAR
- It may reveal outcomes not typically captured in a VAR calculation
What is scenario analysis typically used for
Typically used to estimate changes in portfolio value in response to an unfavorable event and may be used to examine a theoretical worst-case scenario
What are the potential weaknesses in scenario planning
- Inability to measure the by-products of major factor movements
- The effect of simultaneous movements in risk factors
