Exam Flashcards
Three aims of RM:
- Identify, assess and prioritize risks
- Minimize, monitor and control the probability of unfortunate events
- Maximize business opportunities
Risk
probability that an actual return on an investment will be lower than the exp. return
Efficient Frontier
represents the set of all the portfolios that maximize the expected return for a given volatility, thus dominating all other portfolios
CAPM
can be calculated by Systematic Risk (beta * Rm) (not diversified) and Idiosyncratic Risk (e) (diversified) with alpha as extra return and beta obtained by OLS
Difference Exchange Traded & OTC
standard contracts versus computer/telephone network
Difference Forward and Future contract
OTC and Exchange respectively
Net Interest Income
excess of interest received over interest paid
Net Interest Margin
The ratio between Net Interest Income and income producing assets
Duration
weighted average of the times in which payments are made, where the weights are given by the proportions of the bond’s total present value at different times (can be negative by going short on a bond)
Coherency
- Monotonicity allows for an ordering of risks. If Z1 < Z2 then f(Z1) < f(Z2)
- Sub-additivity Incentives to diversification. f(Z1 + Z2) ≤ f(Z1) + f(Z2)
- Positive Homogeneity proportional to risk. f(aZ) = af(Z)
- Translation Invariance neutral risk w.r.t. liquidity. f(Z + b) = f(Z)
Coherency Variance and Std Dev
Variance not coherent because of positive homogeneity and sub-additivity. Std. Dev. always
Value at Risk
VaR is the loss value for which the probability of observing a larger loss, given the available information is equal to 1 minus alpha
Expected Shortfall
average value of all the values exceeding the threshold (VaR)
Credit Risk
the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms
- Default Risk (EAD * LGD)
- Migration Risk (downgrade risk related to deterioration in the counterparty’s creditworthiness)
- Spread Risk (rise in the spreads required by the market from borrowers)
- Recovery Risk (recovery rate actually recorded after liquidation of counterparty’s assets will be smaller than original estimates.
3 approaches to Credit Risk (Basel II-III)
- Standardized Approach (risk weights provided by regulator)
- Foundation Internal Rating Based (can compute PD of their counterparty’s)
- Advanced Internal Rating Based (free to calculate all risk parameters)
LGD
Loss rate experienced on a credit exposure if the counterparty defaults
Basel Framework
- Minimum Capital Requirements (Credit Risk, Market Risk, Operational Risk)
- Supervisory Review Process
- Market Discipline
Moody’s KMV
IMPORTANT is the Distance to Default. Overcomes weaknesses of Merton:
- Gaussianity
- Default may only happen in T
Market Risk
the risk of losses in on-and off-balance sheet positions arising from movements in market prices (VaR and ES)
- Historical-simulation Approach
- Model-building Approach
Operational risk
risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Includes legal risk, excludes strategic and reputational risk. Four sources:
- Process Risk
- People Risk
- System Risk
- External Risk
3 approaches to asses operational risk under Basel II-III
- Basic Indicator
- Standardized Approach
- Advanced Measurement Approach
Difference Basel:
- Basel 1, no model of default correlation
- Basel 2 has the three pillars and the three approaches to Credit Risk
- Basel 2 has the three approaches to Operational Risk
- Basel 2.5 has three changes
o Calculation of Stressed VaR
o New incremental risk charge
o Comprehensive risk measure for instruments dependent on credit correlation - Basel 3 states that a bank’s total capital consists of:
o Tier 1 equity capital
o Additional Tier 1 capital
o Tier 2 capital
