Past Exam Questions: September 2015 Flashcards
Describe the likely motivation for a large firm to appoint a Global Ethics Officer
- To reduce operational risk.
- To protect the firm and its senior management and board members against employees breaking laws, e.g. bribery, corruption, fraud, money-laundering.
- In many cases senior management and the board will be responsible for employees breaking the laws, unless it can be proven that the firm had in place suitable training and record-keeping.
- These issues may already be handled in the compliance function.
- To reduce reputational risk / enhance reputation.
- Appropriate and clearly stated values that are adhered to will both protect and enhance the firm’s reputation.
- The firm’s values and ethics may already be included in the corporate governance systems to some extent.
- To improve future growth and profit potential.
- A global firm is likely to be spread out geographically and by type of individual. This makes it more difficult to ensure that, as well as catering to local requirements, all employees understand and demonstrate the firm’s values and ethics.
- The firm is likely to be trying to maximise profits and it is sometimes easy for employees to overlook values and ethics in pursuit of those profits.
- Values and ethics do not typically fall within ERM, corporate governance, internal audit and compliance functions.
- Unethical behaviour can easily result in a bad reputation and falling future growth and profits.
- To improve the quality of current and future employees.
- To encourage all employees to fully understand and behave in a way which is suited to the firm’s values and ethics.
- This is unlikely to be included as a part of the regular training of employees elsewhere in the firm.
- To meet other pressures or expectations.
- A response to pressure from relevant professional bodies.
- To contribute towards demonstration of compliance with any Corporate Governance Code applicable in the relevant jurisdiction.
- A response to a scandal affecting the firm (or one of its competitors).
- A response to a similar appointment at a rival firm.
- A response to issues raised by an audit (internal or external) investigation.
- A response to comments by rating agencies.
- Change in shareholder focus.
Describe the role of the Own Risk and Solvency Assessment (ORSA) and how it fits into the Solvency II framework
Solvency II is designed around 3 pillars covering:
- – Quantitative requirements
- – Qualitative requirements
- – Disclosure
The ORSA forms part of the Pillar 2 requirements of Solvency II.
It requires each insurer to identify all risks to which it is exposed
… to identify the risk management processes and controls in place
… and to quantify its ongoing ability to continue to meet its minimum and solvency capital requirements.
Outline the advantages of a standardised ORSA template (across a group), from the viewpoint of local managers
- Consistency across a group
- Ease of comparison between local subsidiaries
- Quicker than building a bespoke version for each subsidiary…
… and also cheaper - Availability of group assistance for completing the form
- May encourage collaboration between subsidiaries
- Transfer of knowledge; developing skills locally
- Clarifies what is expected by the group of each subsidiary in respect of the ORSA
- Improves quality of local supporting documentation
- Can help to improve risk management within each entity
- May prompt consideration of risks not already considered
- or may highlight risk management/control or skill shortfalls, for which group expertise/assistance could be sought.
- Helps consolidation to give a group wide view
- Thus identification of overlaps or of diversification potential
… and consequently may lower the capital allocation to a given subsidiary
… which would increase its return on capital.
Suggest challenges that an international group may face in requiring subsidiaries to provide a common set of risk reports
- Difficult to come up with a single form that will suit all subsidiaries…
… and any resulting form may be so cumbersome/detailed that the big picture is missed. - Ensuring a similar standard for the inputs from the different subsidiary companies.
- Ensuring that each subsidiary has interpreted the requirements consistently.
- Different subsidiaries may have different risk taxonomies.
- Some risk exposures may be subjective or difficult to quantify.
- Ensuring that all subsidiaries meet their reporting deadlines / there may be delays.
- Communication between the group head office and each subsidiary may be challenging:
… entities may be in different time zones
… and speak different languages. - The skill and experience levels may also vary significantly, which can exacerbate these problems.
- Potential reporting bias.
- There may be resistance if resentful about the extra work…
… and the perceived loss of independence / control. - Each subsidiary - particularly non-EU subsidiaries - may have different local regulations
… and internal reporting formats
… so the starting point for preparing these risk reports will not be the same as a result. - Different subsidiaries may write very different types of business. Combining the risk reports into a single group report will be difficult.
- In particular, at group level the five largest exposures could be very different to those for individual entities.
- Different metrics used.
- Tick box culture / local differences.
- Difficulties combining different class of business/different weights of different classes for different subsidiaries.
- Data protection and other regulations may make it difficult to share information on individual risks, particularly where this is non-public information.
An international group would like to establish a group-wide scenario testing program as part of its ORSA.
The basis for the scenario test will be the local regulatory reporting basis of each subsidiary, rather than the Solvency II Pillar 1 basis.
Comment on the appropriateness of this basis.
For:
- Market specific
- Can be a useful way for measuring the impact of a stress event / scenario on regulatory solvency and profits.
- Establishes a stress testing program that can be refined and improved later.
- Reduced set-up time - no need to develop a new / group framework.
- Reduced costs.
- Calculation basis is known - no need to carry out a project to educate staff.
- Results can be assessed against current KPIs and KRIs used in the group.
Against:
- Regulatory basis may not give a representative assessment of the subsidiary company or the group’s risk.
- Some risks may be omitted, e.g. operational.
- Not consistent with the key point of the ORSA - i.e. Solvency II capital requirements.
- Pros/cons particularly important for emerging economies.
- Market may expect more than this.
- Different regulatory bases may make it difficult to consolidate the results at group levels.
- Particularly due to different calibration levels.
- May not identify concentrations of risk within the group…
… for example, where one subsidiary reinsures risk to another subsidiary of the same insurance group.
Outline the main features of the Generalised Extreme Value (GEV) distribution.
- Consider the maximum observations from each of a sample of independent, identically distributed random variables.
As the size of the sample increases, the distribution of the maximum observation converges to the GEV distribution.
Parameters of the GEV include:
- “location” (analogous to mean)
- “scale” (analogous to standard deviation, must be >0)
- “shape”
Under the “standard” GEV distribution, location = 0 and scale = 1.
The shape parameter determines the range of distributions to which the extreme values belong.
It does this by giving a particular distribution that has the same shape as the tail of a number of other distributions.
FRECHET-TYPE:
“shape” > 0
The tail follows a power law.
e.g. extreme values could have come from a students’ t-, Pareto- or Levy distribution.
GUMBEL-TYPE
“shape” = 0
The tail is exponential.
e.g. extreme values could have come from a normal or gamma distribution.
WEIBULL-TYPE
“shape” < 0
The tail has an upper limit.
This is unlikely to be useful for modelling extreme risks.
Describe how the GEV distribution could be fitted to modelling the probability of extreme investment returns of monthly return of less than -50%.
- The historical monthly investment return data must be divided into equally-sized blocks.
- A decision on how much data is used (volume vs relevance) must be made.
- An “extreme value” is defined for this investigation as an investment return which is significantly negative.
- To model the probability of investment returns falling below -50%, the return period approach would most likely be used.
- The number of observations below the threshold (i.e. less than -50%) in each block is counted…
… so the result of the analysis is the distribution of the rate of extreme observations per X (where X is the number of observations per block). - The return level approach might also be used in order to understand the distribution of extreme values.
- Under this approach, the lowest (i.e. most extreme negative) observation in each block of data is chosen…
… so the result of the analysis is the distribution of the lowest (most negative) observation per X. - The GEV parameters are then fitted using maximum likelihood estimation techniques or method of moments (or similar).
Discuss the extent to which a GEV approach is appropriate for modelling the probability of extreme investment returns
- The GEV approach assumes that the sample data is independent and identically distributed, and neither of these assumptions is likely to be reasonable.
- Also, volatility tends to cluster
… and change over time. - If the number of observations within each block is kept low, there is less information under the return level approach.
- However, if the number of blocks used is instead kept low, then the variance of parameter estimates is high.
- To obtain more data, the analysis could go further back historically.
- However, the longer the historic time period, the increasingly less relevant the data is likely to be for modelling future (extreme) returns.
… e.g. due to changes in investment strategies
… or changes in investment managers
… or changes in the underlying economy. - Data from other funds could be aggregated into the analysis in order to increase the size of the data sample.
- But again, there is likely to be inherent heterogeneity between such funds.
- Doesn’t make use of all of the data.
- It could provide more information on the distribution of monthly returns below -50% rather than just the probability.
- The proposed approach does nothing to consider how various funds might behave in similar ways in extreme circumstances
i. e. tail correlations. - Past is not necessarily like the future.
What is the main risk relating to an investor investing in a Collateralized Debt Obligation and how might it be mitigated?
CREDIT/COUNTERPARTY risk
mitigated by due diligence
or possibly credit insurance / credit default swap
When setting out stress tests, it is important to mention:
- Collection of appropriate historic information: WHAT
- Collection of appropriate historic information: FROM WHERE
- Projection of historic trends.
- Distribution fitting.
- Capital charge assessment, e.g. VaR or TVaR
- Use of expert opinion in relation to sparse data
- Use of expert opinion in relation to the projection of trends.
What is the payoff at maturity for the buyer of a put option with strike price E.
max(
E - Xₜ,
0
)
Buying a put spread with “higher strike” Eₕ and “lower strike” Eₗ is equivalent to…
Buying a put option with an exercise price of Eₕ
and
Selling a put option with exercise price Eₗ.
Payoff:
max( Eₕ - Xₜ, 0 ) - max( Eₗ - Xₜ, 0 )
Discuss the advantages and disadvantages of using futures to manage equity risks
- Using a future involves no initial cost - although margin collateral would need to be posted.
- If equity markets fall, the value of the future rises, offsetting the fall in the value of the equity holdings.
… The converse is also true, so futures are the ideal solution for minimising economic capital and stabilising surplus economic capital. - However, the hedge would be imperfect, as the mix of equities is unlikely to mirror that underlying the benchmark indices that are referenced by futures (i.e. basis risk).
- Exchange-traded derivatives such as futures have lower counterparty risk than OTC derivatives such as (some) options.
- Futures are exchange-traded and so should have greater price transparency and liquidity than puts and spreads, if the latter are only available “over-the-counter” from investment banks.
Discuss the advantages and disadvantages of using put options / spreads to manage equity risks
- With put options, a firm would be purchasing downside protection and not passing away the upside potential.
- For this a premium must be paid upfront.
This is likely to be an expensive way to hedge equity risk, particularly if the firm is not looking to hedge a one-sided guarantee. - Basis risk remains
DO THE CALCULATIONS IN QUESTION 5
THEY’RE LONG, MANY MARKS, AND DIFFICULT.
