R27 Risk Managment Flashcards
Difference between Centralized & Decentralized Risk Management Systems with their pros & cons
Centralized risk control systems bring all risk management activities under the responsibility of a single risk control unit or under one head like a CFO or CRO on firm level. Advantages : it brings risk control closer to the key decision makers in the organization and enables the organization to better manage its risk budget by recognizing the diversification embedded across business units.
Decentralized systems, each business unit is responsible for its own risk control. The decentralized approach has the advantage of placing risk control in nearer proximity to the source of risk taking. However, it has the disadvantage of not accounting for portfolio effects across units.
Recommend and justify the risk exposures that should be reported as part of an Enterprise Risk Management System (Classify as Financial & Non Financial Risk)
Financial Risk
Market Risk: largest component of risk arises from changes in supply and demand. Includes Currency Risk Interest Rate Risk, Commodity Risk & Equity Risk.
Credit Risk : Risk of Customers/debtors not paying or defaulting.
Liquidity Risk :Lack of availability of funds or funding sources. Loss arising due inability to take or liquidate a position quickly at fair price.
Non Financial Risk
Operational Risk : loss due to companies system failure or events outside company’s control
Settlement Risk: Counter Party Risk
Political Risk : unfavorable changes in policies
Model Risk : Decisions based Wrongly constructed models, incorrect data.
Sovereign Risk : Govt Default. Regulatory Risk: Unclear regulation or possibility of changes.
ESG : Risk to company’s market value because of environmental social or governance reasons.
What is Risk Management Process
Risk Management Can be defined as Identification of exposures to risk (Eg for bonds : Interest rate Risk, Credit Risk.)Establishing ranges or factors to which one wants to be exposed to a particular risk and managing exposure level when it falls outside target ranges.
Steps to Risk Management Process Set Policies & Procedures Define Risk Tolerance Identify Risk Measure Risk Adjust Level Of Risk
Businesses could take risks in the area of their expertise and aim to manage or reduce risks in other areas.
What is Risk Governance
Process of setting policies and standards in risk management is called risk governance
What is VAR and Formula for calculating VAR Value At Risk ?
VAR is Value at Risk an estimate of the loss that we expect to exceed at a given level of probability over a specified time period. Expected Mean Return - (Z value) x SD Ans is in % Z Values 1% = 2.33 5% = 1.65 10% = 1.28
How to convert Standard Deviation from monthly to weekly to Daily and Vice Versa
When converting SD to a smaller time frame eg : Yearly to Monthly we divide. Yearly SD / sqrt 12
When converting SD to a larger time frame eg from weekly to Yearly we multiply. Weekly SD x Sqrt52
Advantages and Disadvantages of VAR
Advantages : Industry Standard accepted and required by regulators Aggregates risk into one single number. Easy to Understand Can be used for capital allocation
Disadvantages
It is probabilistic and not precise actual results can be worse
Create false sense of security.
Can be expensive and complex to caluculate using some methods like mote carlo
Performance Netting Risk
Occurs when there are asymmetric incentive fee arrangements to different departments individually instead of on net firm wide basis.
Should VAR (variance Co-variance Method) be used for an Portfolio consisting options
VAR assumes normal distribution which implies unlimited up and downside. However Options have either upside or downside unlimited with a limit on the other side making it problematic. Also calculating co variance for two options and options with other assets is difficult as options have different dynamics at different points in their life cycle
Three Methods Used for Calculating VAR
Variance/ Co-variance Method (Low Cost)
Historical VAR
Monte Carlo suited for large organizations with complex derivative positions and willingness to invest in technology and human capital
How can an Organization Increase accuracy of its overall exposure assesments
Scenario Analysis helps a firm visualize and prepare for risk exposures better
American and European Options with respect to credit risk
American options can be exercised at anytime before or on expiry so there is ongoing credit risk. however European options can only be exercised at expiry and therefore have zero credit risk prior to expiration
Four Measures to calculate risk adjusted return
Sharpe Ratio : uses SD of the portfolio as measure of risk. Pr-Rfr/SDp.
Risk Adjusted Return on Capital (RAROC) : uses capital at risk as the measure of risk
Risk of Maximum Drawdon : (RoMAD) uses maximum drawdown which is the the difference between the maximum point of return to the lowest point of return over a given time period
Sortino Ratio : uses downside deviation to measure risk.
Computes volatility using only data which is below a minimum acceptable return.
