Past Exam Questions: September 2011 Flashcards
Outline the areas to be covered in a risk policy
Administrative points such as:
- policy owner
- sign off
- date to sign off and next review
- applicability to business units, activities and products
- approved risk taxonomy
The risk policy should also include the:
- risk appetite
- risk tolerances
- risk limits
The risk policy should provide guidance on the - identification - measurement - selection - management of risk.
The risk policy should cover risk governance including roles and responsibilities. In particular, the escalation process should be outlined.
Describe ways in which management should aim to improve the risk culture
- The board should ensure that it is leading by example, prioritising risk management issues as a matter of course.
- All line managers should have defined responsibility for managing the risks within their areas of accountability.
- Line managers should be required to report on the more important risks to a central point.
- The bank should communicate regularly and openly about management matters to all staff, e.g. via regular e-bulletins.
- The bank’s intranet could be used to highlight the importance of management buy-in.
- There should be clear processes in place that enable all staff - not just managers - to be involved in the identification of new and enhanced risks.
- Easy reporting mechanisms should be implemented for other aspects, e.g. ideas for increasing opportunities, mitigation suggestions, procedure failures.
- The bank could offer regular prizes to staff for the best risk management related suggestions.
- Performance management for all staff could be introduced that are clearly related to risk management objectives.
- Performance based remuneration for all staff could be introduced that are clearly related to risk management objectives.
- The bank should ensure that there are risk management champions throughout each part of its international operations, and that there is strong liason between them.
- It should also engage with its outsourcing suppliers to ensure that there is consistency in terms of risk management culture, to avoid dilution of the messages.
- The bank should ensure that there are adequate checks and validations within the risk management framework to minimise the risk of bias.
- Train all staff in the important / role of risk management.
Outline Lam’s seven “key lessons learned” that can assist the Board when integrating risk management frameworks of two businesses
KNOW YOUR BUSINESS
-recognise the importance of understanding specific risks of the company.
SET LIMITS AND BOUNDARIES
- risk limits and metrics should be specific to each of the businesses, taking into account different products, target markets, geographical areas of operation, possibly sizes, capital structures, risk types.
USE THE RIGHT YARDSTICK
These limits and metrics should influence the choice of performance objectives and measures set for managers and staff.
These should be consistent for similar roles across the two organisations, allowing where appropriate for specific issues.
PAY FOR THE PERFORMANCE YOU WANT
Compensation policies should be aligned to the risk measures and objectives of the company.
To avoid staff dissatisfaction, they should be consistent between the two organisations for roles of similar levels and responsibilities.
ESTABLISH CHECKS AND BALANCES
Care should be taken not to create excessive concentrations of risk.
Avoid creating increased concentration of power or authority of specific individuals.
KEEP YOUR EYE ON THE CASH
This applies equally to ensure that the management of cash flow for the entity remains appropriate to their requirements.
The entity should assess the quality of the insurer’s financial authorisation and control processes, and might either adopt them itself or introduce its own internal processes, depending on their relative strengths.
BALANCE THE YIN AND THE YANG
Management should not overlook the “softer side” of risk management and the development of a combined culture for the firms.
A large bank’s trading book comprises interest rate and foreign exchange rate swaps with a wide range of counterparties.
Describe the main risks to the bank arising from its trading book.
The bank is exposed to the risk of the market value of the net trading book being less than expected.
3 Main sources of risk:
Foreign exchange movements relative to the bank’s reporting currency. This will be on the net trade position gross of any collateral.
Interest rate risks This is made up of: delta - vertical changes in the curve gamma - changes in the shape vega - rate of change in the slope
Counterparty risk remaining after trades are netted and collateral is taken into account.
Risk Tolerance Statement
A company’s risk tolerance statement is a relatively detailed set of statements, many of which will be quantitative or statistical in nature.
the statements will likely include targets and limits to specific categories of risk and/or units of business.
Risk tolerance often includes the Board’s appetite for reductions in its profits and/or the ability to pay dividends.
This concept incorporates the idea of wishing to increase or at least maintain profitability but recognising that there are risks and sometime profit will be lower than desired.
Importantly the profit objective may not be an equal priority for all stakeholders. The risk tolerance statement will include other metrics which together should comprise a more balanced set of objectives to meet the group of stakeholders.
In order for a company to operate at the limit of its stated risk tolerance, it will need to: (4)
- Implement and embrace ERM at a level of sophistication which is at least equal to the detail contained in the risk tolerance statement.
- Regularly publish the risk tolerance statement. It will incentivise both the board and management to make the risk tolerance statement clear, comprehensive and up to date.
- Regularly publish the risk tolerance statement. It will incentivise both the board and management to make the risk tolerance statement clear, comprehensive and up-to-date.
- Regularly publish information describing whether the company believes it is operating at / below / above its stated risk tolerance. This level of information will be very useful to stakeholders wishing to analyse the company.
- Have the capital in order to have the capacity to operate at its chosen risk appetite threshold.
State the formula that defines Value at Risk
VaR α = inf{ y ∈ R : F ( y ) ≥ α }
where:
α is the confidence level
F (.) is the cumulative distribution function of loss L
L is a random variable representing the loss on a portfolio of assets and
liabilities
State the formula that defines
Tail Value At Risk
TVaR_α = 1 / (1 – α) ∫ _α ^1 VaR_p( L ) dp
Alternatively:
TVaR_α = E[ L | L > VaR_α ]
L is a random variable representing the loss on a portfolio of assets and
liabilities
4 Axioms of a coherent risk measure
- Translation invariance
- Subadditivity
- Positive homogeneity
- Monotonicity
Translation invariance
The Risk Measure should show that the amount of capital required supports the perceived variability of a loss and not its expected amount.
Adding or subtracting a fixed amount from a loss leaves the capital (being the amount excess of the expected loss) unchanged.
Subadditivity
Compounding loss distributions should create a diversification benefit.
If the distributions were 100% correlated, the Risk Measure of the compounded distribution should not exceed the sum of the Risk Measures of the individual distributions.
Positive Homogeneity
Also known as positive scalability, the Risk Measure should show that the capital required to support “n” identical losses is equal to “n” times the capital need to support one loss.
Monotonicity
The Risk Measure should show that the capital needed to support a smaller loss (with the same distribution) is less than the capital needed to support a larger loss.
Discuss the suitability of using VaR and TVaR
The VaR approach provides a simple method of setting the society’s risk capital. The VaR approach is widely used to set risk capital under regulatory regimes - e.g. Basel III and Solvency II - and by rating agencies.
However, the VaR approach does not give any indication of the extent to which losses might potentially exceed the 97.5% quantile. The TVaR approach addresses this issue since it is defined as the expected loss given that the loss exceeds the VaR at the same confidence level.
In addition, the VaR approach has poor aggregation properties. Specifically it fails the important subadditive property of a coherent risk measure. This means that the VaR for aggregate losses will not necessarily be less than the sum of the VaR for the individual loss distributions.
