Foundation of Risk Management Topic 5 -8 Flashcards
What are the two key statistics used in Modern Portfolio Theory to evaluate portfolio allocations?
Means (Expected Returns) and variances (Risk or Volatility) of the expected return distributions.
What does a “perfect market” imply under the assumptions of Modern Portfolio Theory?
- No transaction costs and taxes
- Free access to all available information
- Perfect market competition.
According to Modern Portfolio Theory, how should the returns from portfolios be distributed?
Normally distributed.
How is portfolio diversification used in Modern Portfolio Theory?
To decrease risk exposure to each asset and maximize returns at any given level of risk.
What does the Markowitz Efficient Frontier represent?
A curve plotting the maximum return for each level of risk.
What does the CAPM equation represent?
It calculates the expected return of an asset based on its systematic risk.
What Assumptions Underlying CAPM?
- There are no transaction costs or taxes.
- Assets are infinitely divisible and all assets are liquid.
- Unlimited short-selling of securities is allowed.
- Investors are price takers, meaning individual transactions do not affect asset prices.
- Investors are rational, focusing solely on maximizing expected return and minimizing risk.
- All investors have the same single-period focus when considering investments.
What is the CAPM equation?
What is Beta in the context of CAPM?
A measure of an asset’s systematic risk relative to the market.
What is the sytematic Risk?
The risk inherent to the entire market that cannot be diversified away.
What is the Beta Formula?
What is the Covariance?
Covariance is a statistical measure that indicates the extent to which two variables change together.
The covariance is positive if the variables tend to move in the same direction. If they move in opposite directions, the covariance is negative.
What is the Variance?
Variance measures how widely numbers in a set are spread from their average.
It is calculated by averaging the squared differences between each number and the mean of the set.
What is the Capital Market Line (CML)?
It expresses the expected return of a portfolio as a linear function of its standard deviation and the market portfolio’s return.
What does the Sharpe Performance Index measure?
The risk premium per unit of total risk, calculated as
How is the Treynor Performance Index calculated?
measuring the risk premium per unit of systematic risk.
What does Jensen’s Alpha represent in portfolio management?
The excess return of a portfolio over the predicted return by CAPM.
What measures the degree to which a stock or a portfolio’s returns differ from those predicted by the Capital Asset Pricing Model (CAPM), effectively representing the excess or abnormal return after adjusting for market-related risks?
Jensen alphas or alpha of the stock = Actual return of stock−CAPM
What is the relationship between the Treynor and Jensen Performance Indices?
Both indices indicate superior performance if positive, and generally align in ranking portfolios.
Define Tracking Error in portfolio management.
The standard deviation of the difference between the portfolio’s return and the benchmark’s return.
How is the Information Ratio calculated and what does it represent?
It measures the return relative to the benchmark per unit of variability.
What distinguishes the Sortino Ratio from the Sharpe Ratio?
The Sortino Ratio uses a minimum acceptable return and focuses only on downside risk, unlike the Sharpe Ratio.
What is the general formula for calculating Beta (β) in the Capital Asset Pricing Model (CAPM)?
What is the formula for the Sortino Ratio?
How does the Sortino Ratio differ from the Sharpe Ratio in its calculation?
The Sortino Ratio differs in that it uses a target return T instead of the risk-free rate and focuses only on the downside deviation (negative returns below T), whereas the Sharpe Ratio considers the standard deviation of all returns.
What is the main difference between APT and CAPM?
APT uses multiple factors to explain asset returns; CAPM uses only the market factor.
List assumptions of the Arbitrage Pricing Theory.
- Returns from assets can be explained using systemic factors.
- No arbitrage opportunity exists in a well-diversified portfolio allowing for risk-free profits.
- Specific risks can be nearly or completely eliminated through diversification.
What is meant by ‘no arbitrage’ in the context of APT?
There are no opportunities to make risk-free profits through arbitrage in a well-diversified portfolio.
How does diversification affect specific risks according to APT?
Specific, non-systematic risks can be eliminated through diversification.
What does the notation ( \beta_{iK} ) represent in the APT equation?
The sensitivity of the return on asset ( i ) to the ( k^{th} ) risk factor.
What is the key premise of multifactor models in finance?
They use multiple macroeconomic factors to explain asset prices and calculate expected returns.
What does CAPM stand for, and how many factors does it use?
Capital Asset Pricing Model; it uses one factor (the market factor).
Can you name a widely used multifactor model developed after CAPM?
The Fama-French Three-Factor Model.
What is hedging in the context of multifactor models?
Applying strategies to neutralize risk exposures to specific factors using derivatives or opposite positions.
What are the challenges of using multifactor models for hedging?
Model risk, cost of frequent adjustments, and tracking errors.
How does the Fama-French model explain the returns of different sized firms?
Through the SMB factor, which captures the size effect on stock returns.
Explain the HML factor in the Fama-French model.
HML represents the difference in returns between high and low book-to-market firms, capturing the value effect.
State the general formula for return on asset (i) according to APT.
What is the formula for the expected return on a well-diversified portfolio according to Ross (1976)?
State the Fama and French three-factor model formula.
Define the ‘SMB’ factor in the Fama-French model.
SMB stands for “Small Minus Big” and measures the excess returns of small-cap stocks over big-cap stocks.
Define the ‘HML’ factor in the Fama-French model.
HML stands for “High Minus Low” and measures the excess returns of stocks with high book-to-market ratios over those with low ratios.
What is risk data aggregation?
Collecting, organizing, and processing data to measure a bank’s risk exposure against its risk tolerance.
How does effective risk data aggregation benefit a bank?
- Anticipates problems
- Manages financial stress better
- Supports effective resolution of system risks
- Enhances decision-making for profitability and efficiency
What is the governance principle in risk data aggregation and reporting?
It requires strong governance, integration into risk management, thorough documentation, independent validation, and comprehensive implementation.
What does the data architecture principle state about IT infrastructure?
Banks should maintain IT systems that support risk data processes effectively in both normal and crisis situations.
What are the key attributes of accurate and integrity-focused risk data aggregation?
- Reliable and accurate data
- Largely automated aggregation
- A single authoritative source for each risk type
What does completeness in risk data aggregation entail?
Capturing all material risk data across the bank, including off-balance sheet risks.
Define timeliness in the context of risk data aggregation.
Producing and reporting risk data promptly, especially under stressful or crisis conditions.
What does adaptability mean in risk data aggregation?
Ability to modify risk data systems to accommodate new regulations, emerging risks, and ad hoc reporting needs.
How should risk management reports reflect accuracy?
They should be precise, validated, and reliably depict the risk situation.
What should be included in comprehensive risk management reports?
- All significant risk areas
- Detailed components for each risk type
- Important risk-related measures
- Emerging risk forecasts
What criteria should clarity and usefulness in risk reports meet?
Reports should be clear, concise, and detailed enough to support informed decision-making.
How is the frequency of risk reports determined?
Based on the needs of recipients, nature and volatility of risks, and their importance in risk management.
What guidelines should be followed for the distribution of risk reports?
Effective distribution while ensuring confidentiality.
What is the role of supervisory review in risk data practices?
To periodically evaluate a bank’s compliance with risk management principles.
What actions should supervisors take for deficiencies in risk data practices?
Enforce timely corrections and improvements through appropriate supervisory tools.
How should global supervisory cooperation work?
Supervisors should coordinate cross-border to oversee compliance and remedial actions effectively.
What operational challenges can undermine risk data aggregation?
- Diverse IT systems
- Inconsistent data definitions
- Manual processes prone to errors
How should a bank handle emerging risks in data reporting?
Adjust aggregation and reporting systems to include new risk types and scenarios promptly.
What should be the basis for validating risk management reports?
Verification against authoritative data sources and internal consistency checks.
Why is it important to maintain an effective IT infrastructure for risk data?
To ensure risk data is processed efficiently and accurately, especially during times of high operational stress.
What is Enterprise Risk Management (ERM)?
A holistic framework for managing all risks across an organization.
How does ERM compare to traditional silo-based risk management?
- ERM: Integrates and manages risks across the entire organization
- Silo-Based: Manages risks in isolation within each department
What are the motivations for a firm to adopt an ERM initiative?
- Define risk appetite
- Focus on critical threats
- Identify comprehensive risks
- Manage emerging risks
- Ensure regulatory compliance
- Reassure stakeholders
- Understand crossover risks
- Optimize risk transfer costs
- Integrate risk into strategy
What are the best practices for the governance and implementation of an ERM program?
- Strong corporate governance
- Define risk appetite and tolerance
- Commitment from senior management
- Sufficient skills and resources
- Integration of key risks
- Clear roles and responsibilities
- Regular oversight and monitoring
What responsibilities does the board have in ERM?
- Approve and oversee strategic objectives
- Manage governance framework
- Foster corporate culture
What qualifications should board members possess?
- Be and remain qualified
- Understand oversight and governance role
- Exercise objective judgment
What are the five dimensions of an ERM program?
- Targets
- Structure
- Identification and metrics
- ERM strategies
- Culture
What should be included in the Targets dimension of ERM?
- Set risk targets
- Align with firm’s risk appetite
- Consider strategic goals
What should be included in the Structure dimension of ERM?
- Define roles (e.g., CRO, risk committees)
- Describe governance structure
- Establish reporting lines
What metrics are used in the Identification and Metrics dimension of ERM?
- Scenario analysis
- Stress testing
- Value at Risk (VaR)
- Total cost of risk
- Risk mapping
- Risk-specific metrics
- Risk flagging tools
What should be considered in the ERM Strategies dimension?
- Methods to manage risks
- Avoid, mitigate or transfer risks
- Identify risk transfer instruments
What elements are vital in the Culture dimension of ERM?
- Foster risk-aware culture
- Communicate importance of risk management
- Align top management practices
What defines a firm’s risk culture?
Goals, customs, values, and beliefs influencing employee behaviors.
What are characteristics of a strong risk culture?
- Leadership tone
- Effective communication
- Aligned incentives
- Clear accountability
- Risk literacy
What challenges are involved in establishing a strong risk culture?
- Individual differences
- Group norms
- Risk education
How can firms measure risk culture?
- Tone from the top
- Effective communication
- Incentives
- Accountability
What is scenario analysis in the context of ERM?
Assessing the impact of multiple variables on risks and performance.
What are the advantages of scenario analysis in ERM?
- Plausibility focus
- Intuitive narratives
- Worst-case planning
- Focus on key risks
- Early warning systems
What are the disadvantages of scenario analysis in ERM?
- Complexity
- Possible underestimation
- Selection bias
- Credibility issues
How is scenario analysis used in stress testing programs?
Evaluates impact under multiple scenarios for regulatory and strategic planning.
What are common scenarios used in U.S. stress testing?
- Baseline
- Adverse
- Severely adverse
What is the role of the Comprehensive Capital Analysis and Review (CCAR)?
Assess banks’ ability to manage capital under varying conditions.
What are the key requirements for banks under stress testing regulations?
- Project financials over nine quarters
- Include revenue, loan loss provisions, credit losses
- Submit detailed capital plans
What is reverse stress testing?
Identifying worst-case outcomes and tracing back to likely scenarios.
How does stress testing integrate with ERM?
Aligns risk management with strategic and regulatory requirements.
What variables are considered in the complexity of CCAR scenarios?
- Stock market volatility (VIX)
- GDP forecasts
- Interest rates
4, Real estate indices
What benefits do stress tests provide beyond compliance?
- Specify risk appetites
- Develop risk limits
- Enhance strategic planning
How do ERM and capital planning relate?
Both are intertwined, ensuring financial stability and risk management.
What impact does a successful ERM implementation have on regulatory compliance?
Ensures that risk management aligns with regulatory standards and requirements.
