Past Exam Questions: April 2018 Flashcards
4 Main sources of operational risk for any organisation
- People
- Internal Processes
- Systems
- External events
Comment on the use of expected shortfall as a risk metric in general
- Easy to calculate
- Can be calculated using a number of different approaches
- It considers not only whether a particular likelihood of loss would result in insolvency
… but also the distribution of losses beyond that point. - Unlike VaR…
… it is a coherent risk measure
… i.e. it behaves sensibly when loss distributions are altered or combined. - It gives credit for diversification between risks.
- However, it has little intuitive meaning / hard to explain.
- It is not easy to relate to the current value of a portfolio.
- It is also difficult to model as it focusses on tail events.
Why might a one-month time horizon be inappropriate for expected shortfall as a risk metric for a fast-food chain?
- One month is a short time period
- May be exposed to the risk for more than one month
- Impact or cost of risk may not materialise fully in one month
On the other hand, it is more difficult to assess the probability of loss over a month than over a shorter time period…
… due to lack of independence of loss events
… and their ability to recur.
- Regulatory capital requirements may be risk-based and the regulator may require a different time horizon…
… so it could be more efficient to use the same time horizon for both external and internal reporting. - Shareholders may be interested in profit variation over a longer time period.
- Seasonality
Assess the suitability of a franchise requiring franchise owners to calculate their own expected shortfall for their top 5 operational risks, while providing an optional standard list of operational risks and tables of associated probability distributions.
- Individual franchise owners may be best placed to identify and assess their own top 5 operational risks, as they know their specific branch best.
- Providing a standard list should help with identification of key risks.
- However, allowing full individual choice of top 5 risks could lead to inconsistencies between franchises.
- There should be many operational similarities between branches
… so it may be more effective to identify key operational risks centrally. - But branches may operate very differently
… so key risks may be different. - Since expected shortfall is a coherent risk measure…
… it can be aggregated across franchises. - Providing a standard probability table ensures some consistency.
- However, it may not be appropriate for each individual franchise.
- The whole business may be exposed to parameter risk from the standard table.
- Expected loss is not included in what is provided, so has to be determined by each franchise individually.
- Each franchise may not have the data or skill to do this effectively.
Assess the suitability of Pearson’s rho as a correlation measure in assessing operational risk
- Pearson’s rho is widely used
… and easy to calculate - Pearson’s rho is impacted by the actual values of the data
… unlike rank correlation coefficients.
… so it requires accurate data. - It is only valid as a correlation measure when the data series are jointly elliptical.
- But operational risks tend to be more skewed.
- Operational risk events include high severity low frequency events…
… so it may be more appropriate to use a copula
… since the relationship will vary
… particularly in the tail
Recommend actions a fast-food franchise can take to reduce operational risk
- Improve health training for staff, e.g. Health and Safety, Food hygiene, First aid, Money laundering, Customer service.
- Purchase insurance including:
- – buildings insurance (flood, fire, external events)
- – business continuity insurance
- – public liability / legal insurance
- Put a disaster recovery and/or business continuity plan in place
- Improved controls and checks on processes
- Improved controls and checks on systems including:
- – alarm systems
- – regular maintenance
- – backup systems
Outline the items that should be included in a Regulatory Engagement Policy
- Relationship management accountability and coordination
- Identify people responsible for engaging with the regulator
- And for maintaining the list of key contacts with the regulator
- And for analysing the relationship / maintaining relationship development plans
- Governance around data submitted to the regulator
- Timeline for regular interactions and submissions to the regulator
- Senior management visibility
- Clear process/plan/logistics management for regulator site visits
- Development of positive perception of supervisors internally within the company
- Proactive and early engagement
- – respond to any consultations/surveys within deadlines
- – respond in as much detail as possible
- – responding promptly to investigations / data requests
- – identification of opportunities for engagement
- – including monitoring supervisory priorities, objectives and pressure points
- – provide constructive feedback on proposals
- – process for lobbying for change in the supervisor’s policy position
- Communication transparency
- – early notification of any issues / potential breaches
- – early notification and involvement in strategic decisions
- – responses to queries include all relevant data even if not requested
- Alignment with supervisory objectives
- – any strategic decisions include consideration of supervisory objectives
- – timelines for responses to regulatory recommendations
- Presentation and enhancement of corporate reputation
- – governance around public statements
- – adopt best practice before mandated
2 Methods by which a credit default swap (CDS) can be settled
- either for cash (“cash settlement”)
- or with the transfer of the underlying bond (“physical settlement”)
Outline the residual risks that would remain (including any additional risks that would arise) if a CDS were to be used.
- Liquidity risk from the time taken for CDS to settle once default has occurred.
- Liquidity risk in relation to marketability of the CDS / ability to close it out early if required.
- Potential lack of availability of new CDS when this one expires
- Credit/counterparty risk of the investment bank
- Basis risk: the bond CDS may not pay out under exactly the same circumstances in which the company would default.
- Risk of dispute over definition of “default”
- New operational risk is introduced (e.g. wrong trade put on, wrong expiry, wrong amount, wrong name)
- Risk arising from potential lack of expertise in derivatives management
- Expense risk: under-estimation of additional expenses relating to the management of the CDS.
- Regulatory risk: e.g. change to accounting / regulatory treatment of CDSs.
Describe the key features that measures of economic capital typically include
They refer to the amount of additional assets or cash flows…
… required to cover unexpected events
… to a specified measure of risk tolerance
… with risk being measured in some way
… over a specified time horizon.
The risks to which an insurer is commonly exposed
- Insurance risk (risk of higher than expected claims)
- Adverse selection
- Concentration risk (many claims in a single area)
- Credit/counterparty risk (service providers)
- Equity value risk (Investment Market risk)
- Currency risk
- Interest rate risk
- Liquidity risk
- Operational risk (administrative errors)
- Expense risk
- Lower than expected new business / renewals
- Economic risk
- Risk of loss of business to competitors
- Reputational risk
- Strategic risk
- Risk of regulatory / legal changes with adverse impact
