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Private: Enterprise Risk Management (IFoA ST9) > Module 27: Management of market risk > Flashcards

Module 27: Management of market risk Flashcards

1
Q

3 Key market risk management strategies

A
  • holding a range of assets so as to limit losses within a portfolio (diversification)
  • ensuring investment strategy is appropriate for the liabilities of the organisation
  • using derivatives to manage (hedge) risk
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2
Q

5 Key market risk management activities

A
  • setting and monitoring policies
  • setting and monitoring limits (both overall and for each asset class, individual security and counterparty)
  • reporting
  • capital management
  • implementing risk-portfolio strategies (eg matching, diversification, hedging)
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3
Q

Market risk policies should cover: (7)

A
  • roles and responsibilities
  • delegation of authority and limits
  • risk measurement and reporting
  • valuation and back-testing
  • hedging policy
  • liquidity policy
  • exception management
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4
Q

3 main advantages of using derivatives to manage market risk:

A
  • cost (compared to trading the underlying asset)
  • flexibility (tailored)
  • speed (of exposure changes)
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5
Q

7 main disadvantages of using derivatives to manage market risk:

A

risks stemming from the use of derivatives:

  • counterparty risk
  • aggregation risk
  • concentration risk
  • operational risk
  • liquidity risk
  • basis risk
  • loss of upside
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6
Q

Counterparty risk (wrt derivatives) may be reduced by the presence of: (2)

A
  • cash deposits (margin) - for most exchange-traded contracts
  • financial securities acceptable to the counterparty (collateral) - for over-the-counter contracts and some exchange-traded contracts
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7
Q

Basis risk

A

The risk arising from differences in the movements of the price of a derivative and the price of the underlying asset, so that offsetting investments in a hedging strategy will not experience exactly offsetting movements of value.

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8
Q

Why might the futures price be below the expected value of the future spot price?

A

eg if there is a high demand for short positions by owners of the asset who want to protect value

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9
Q

Why might the futures price be above the expected value of the future spot price?

A

eg if there is strong demand for long positions due to the high costs of storage of the underlying asset

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10
Q

5 Techniques for managing foreign exchange (FX) risk

A
  • currency forwards and futures
  • currency swaps
  • currency options
  • netting revenues and amounts owing in same currency
  • leading and lagging cashflows to benefit from anticipated FX movements
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11
Q

Why can it become impractical to maintain perfect gamma and vega neutrality for a portfolio linked to the value of many underlying indices or asset prices?

A
  • the number of derivatives required can become large
  • the significant cost of rebalancing limits the frequency at which the portfolio’s higher “Greeks” can be adjusted
  • the lack of suitable traded derivatives or poor quality
  • the responsibility for managing limits on individual asset delta, gamma and vega tends to be separated from the responsibility to managing overall portfolio delta, gamma and vega.
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12
Q

Direct exposure to interest rate risk may be managed using: (2)

A
  • forward rate agreements (FRAs)

- caps and floors

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13
Q

Indirect exposure to interest rate risk may be managed using: (5)

A
  • cashflow matching - removing all market risks, but pure matching is rarely possible
  • interest rate swaps - removing only interest rate risk
  • swaptions - providing one-sided protection
  • immunisation - protecting present value, but only works for small parallel shifts in the interest rate curve, and requires regular rebalancing
  • hedging using model points - choosing an optimum set of assets so as to minimise the difference between the asset and liability cashflows at each of the reference points in the future.
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14
Q

Market risk policy:

roles and responsibilities

A 
Who is responsible within the company for:
- developing
- implementing
- monitoring
- reviewing
policies.
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15
Q

Market risk policy:

Delegation of authority and limits

A

Who is permitted to execute market risk positions and to what extent.

Trading (front-office) and settlement (back-office) functions should be segregated.

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16
Q

Market risk policy:

Risk measurement and reporting

A

How risks are measured and reported, particularly critical issues, such as a limit violation.

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17
Q

Market risk policy:

Hedging policy

A

What risks are to be hedged,

the 
- products, 
- limits and 
- strategies 
for hedging

and how the effectiveness is measured.

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18
Q

Market risk policy:

Liquidity policy

A

How liquidity is to be measured and what the contingency plans are in times of distress.

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19
Q

Describe what is meant by a derivative

A

The gain or loss from a derivative
.. depends on (or derives from)
… changes in the market price of
… the underlying asset or index (the underlying).

A derivative redistributes risk from those who wish to hedge (or protect against) risk to those who are prepared to accept the risk in return for the possibility of a large reward, ie speculators.

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20
Q

The asset underlying a derivative may be: (4)

A
  • an interest rate
  • a foreign exchange rate
  • a commodity (oil, gas, gold, copper, cocoa, etc)
  • an equity (either a single stock or basket of stocks, eg an index)
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21
Q

4 Main types of derivates

A
  • options
  • forwards
  • futures
  • swaps
22
Q

Options

A

The right but not the obligation for one party to exercise the contract in return for payment of a premium to the counterparty.

23
Q

Forwards

A

The obligation for both counterparties to complete a transaction on a future date at a known price.

24
Q

Futures

A

Like a forward, but a standardised contract traded on an exchange.

25
Q

Swaps

A

The obligation for both counterparties to exchange a series of cashflows.

26
Q

Describe th characteristics of exchange-traded contracts

A
  • Standardised. Available only on certain assets and indices and only for specific delivery dates (or date ranges), as determined by the exchange.
  • Trading is done through the exchange based on market prices (which may be subject to a minimum price movement or tick).
  • Deals are settled through a clearing-house.
  • The clearing-house acts as counterparty to both the buyer and seller of the contract and therefore takes on the counterparty risk.
  • Counterparty risk is reduced, for the clearing-house, by the pooling of many contracts. It is managed by forcing the trading parties to provide the clearing-house with collateral.
  • The above features result in a highly liquid market (ie prices being minimally affected by large transactions) with comparatively low transaction costs.
27
Q

4 Characteristics of Over-the-counter (OTC) markets

A
  • Trading is done at the convenience of the parties and no money changes hands until the delivery date.
  • Pricing is by negotiation between the parties who take on the risk of the counterparty defaulting on the arrangement.
  • OTC contracts are very flexible in terms of the choice of both the underlying and the delivery date. They are generally provided by banks to address the specific needs of a company, or other institution, usually for an option or a swap.
  • Documentation is usually based on standard terms and conditions, such as those published by the International Swaps and Derivatives Association (IDSA).
28
Q

6 Main factors that influence the price of an OTC contract

A
  • the spot price of the underlying
  • the time to delivery
  • expectations of interest rates over this period
  • the expected income yield on the underlying over this period
  • residual counterparty risk (allowing for the effect of any collateral)
  • the cost of carry (including: opportunity cost of providing collateral; cost of storage of the underlying, if a commodity).
29
Q

Outline the marking-to-market process

A

At the start of an exchange-traded contract, cash is typically deposited by the counterparty into a margin account - this deposit is called the initial margin.

The amount of initial margin is determined as some function of both the size and the anticipated volatility of the contract.

Subsequently, the clearing house periodically considers whether to add or remove amounts from the margin account based on the intervening movement in the price of the underlying. These additions or deductions reflect the respective profit or loss position of the counterparty - a process known as marking-to-market.

If the margin account drops below a specified level, the maintenance margin, the counterparty must top-up the account to the starting level, by adding to the margin account - known as variation margin.

30
Q

Outline the relative advantages of using derivatives, compared to trading the underlying asset

A
  • It may be cheaper and easier to deal in a derivative than the underlying asset.
  • Derivatives can be very flexible and exposure can be changed quickly without the need to deal in the underlying asset - for example, investment allocation can be changed quickly while still holding the original assets.
31
Q

Settlement risk

A

Risk that one counterparty
… does not deliver a security (or its value in cash) as agreed when the security was traded,
… after the other counterparty has already delivered the security (or cash value).

32
Q

Normal backwardation

A

The situation where a futures price is below the expected value of the future spot price.

33
Q

Contango

A

The situation where the futures price exceeds the expected future spot price.

34
Q

Why might backwardation occur in practice?

A

Due to the market expecting the income on the asset to outweigh any costs (hence a preference to hold the asset)
or
due to high demand for short positions in the future (eg from the asset holder protecting the value of their assets).

35
Q

Why might contango occur in practice?

A

Contango may arise due to demand for long positions in the future (for example, where storage costs of the underlying commodity are particularly high).

36
Q

Define the optimal hedge ratio, h

A

h = ρ σˢ / σᶠ

Where:

σˢ is the standard deviation of ΔS, the change in spot prices over the life of the hedge.

σᶠ is the standard deviation in ΔF, the change in futures price over the life of the hedge.

ρ is the correlation coefficient between the two.

37
Q

Define delta

A

The delta of a portfolio is the rate of change in its value, V, relative to changes in the price of the underlying, S.

Δ = δV / δS

38
Q

Delta neutral portfolio

A

A portfolio containing options is delta neutral or delta hedged when it consists of positions with offsetting positive and negative deltas, and these balance out to bring the net delta of the portfolio to zero.

39
Q

Define Gamma

A

Gamma is the rate of change of delta with the price of the underlying.

I.e. Γ = δΔ / δS

40
Q

Define Vega

A

Vega is the rate of change of the price of the derivative, V, with respect to a change in the assumed level of volatility of the underlying, σ.

vega = δV / δσ

41
Q

Dynamic hedging

A

refers to the day-to-day hedging activity undertaken by writers of options.

Option writing institutions will employ traders to ensure that their portfolios remain delta neutral.

42
Q

Define interest rate risk

A

Interest rate risk can be considered as a type (or component) of market risk.

It arises when assets and/or liabilities are sensitive to changes in interest rates.

43
Q

2 types of interest rate risk

A
  • direct exposure

- indirect exposure

44
Q

Direct exposure interest risk

A

Change in interest rates have a direct effect on the size of the company’s cashflows (ie income or outgoings),

eg a rise in interest rates increasing the cost of a floating rate loan.

45
Q

Indirect exposure interest risk

A

Changes in interest rates affect the VALUE of future cashflows.

E.g. a change in interest rates altering the present value of future payments due on an annuity portfolio.

46
Q

Define an interest rate cap

A

Designed to provide insurance against the rate of interest on an underlying floating rate note rising above a certain level, known as the cap rate.

47
Q

Define an interest rate floor

A

Provides a payoff when the interest rate on an underlying floating rate note falls below a certain rate.

48
Q

3 Key factors involved in cashflow matching

A
  • the nature of the liabilities, ie whether the cashflows are fixed monetary amounts or linked to either prices or interest rates
  • the term over which the liabilities are payable
  • the currency in which the liabilities are payable
49
Q

3 Practical problems with cashflow matching

A
  • suitable assets may not be available
    (the term of the bond may not be long enough or cross-hedging risk may be introduced)
  • future cashflows (of the assets and/or liabilities) may not be known
  • expected future cashflows may change frequently, making it costly to alter the portfolio.

Unfortunately, very few profiles are easy to match and so complete matching / pure matching is rarely possible in practice.

50
Q

3 Conditions for immunisation

A

Immunisation requires:

  • the present values of the liability and asset cashflows to be equal
  • the discounted mean term of the asset cashflows to be equal to the discounted mean term of the liability cashflows
  • the convexity of the asset cashflows exceeds that of the liability cashflows.
51
Q

5 Limitations of immunisation

A
  • it relates to ensuring that the present value of assets is no less than that of the liabilities, rather than matching the timings and amounts of the individual cashflows themselves.
  • it only protects the present value against changes in interest rates.
  • it only works for small changes in interest rates.
  • it only works where interest rates change equally at all terms.
  • it requires regular rebalancing of the assets.

Private: Enterprise Risk Management (IFoA ST9) (48 decks)

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