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Final Exam Revision > Risk management > Flashcards

Risk management Flashcards

1
Q

How do you measure tactical asset allocation risk?

A
  • this is the risk of following an active rather than passive strategy
  • either use historical tracking error: find difference between actual return and benchmark return and find the standard deviation of this
  • or use forward tracking error: quantitative model to predeict portfolio returns in comparison to benchmark
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2
Q

How do you measure strategic asset allocation risk?

A
  • use historical and forward tracking error

- use difference between returns of actual portfolio and target asset allocation

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3
Q

How do you measure counterparty, interest rate and equity market risk?

A
  • look at amount of capital you need to hold in order to cover risk
  • SAM requires specific internal models
  • Use model under actual and benchmark returns
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4
Q

What is stress testing?

A
  • deterministic way of evaluating risks
  • risk events are extreme
  • models extreme market movements, liquidity and credit risk
  • two types of stress test:
    1. determine weak areas in portfolio by creating localised stress scenarios (change volatilities and correlations)
    2. determine impact of major market turmoil affecting all parameters (ensure correlations are consistent)
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5
Q

What is scenario analysis?

A
  • determinstic way of evaluating risks
  • considers all plausible scenarios
  • useful for operational risk but can measure financial risk (e.g. recession)
  • useful when distribution cannot be assigned to parameters
  • quantifies severity of risk but not probability of it occurring
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6
Q

How can you use scenario analysis to determine cost of operational risk?

A
  1. Divide all risks into different groups
    e. g. all fraud related risks into one group
  2. Create a scenario for each risk group
    - each scenario must be plausible
    - scenario must consider all risks in the group
  3. Make assumptions about different risk factors based on scenario
  4. Calculate financial consequence of risk event occurring e.g. cost of redress
  5. Calculate total costs = sum of financial consequences of the scenario
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7
Q

What are some common risk correlations?

A

OLIFE

  • operational risks have a weak correlation with all risks
  • longevity and mortality risks
  • inflation and expense risk (financial market)
  • falling equity markets and unit-linked lapse rates
  • equity market and interest rates (opposite)
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8
Q

How can we use combination of scenario and sensitivity analysis?

A
  • Scenario testing identifies factors affected in certain scenario
  • Stress tests are performed on these factors
  • Combine the stress test of different factors -> allows for inter-relationships
  • Need to consider how other aspects of business will react to stress scenario
  • Scenarios need to reveal weaknesses in risk exposure and sensitivity -> consider risk factors which most exposed to

Example:
Provider of unit-linked investment bonds want to consider the risk of sustained reduction in market value.

This will affect:

  • Persistency of existing investment bonds
  • New business volumes
  • Regulatory capital requirements
  • Income received from fund manager charges
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9
Q

What are the different types of relationships between the first two lines of defence?

A
  • Offence vs. defence
  • policy and policing
  • partnership
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10
Q

Relationship: policy and policing

A
  • Policing may become outdated since risk management not involved day-to-day
  • Audit and compliance reviews don’t happen regularly -> failure to identify problems
  • Friction due to different viewpoints
  • Line management has little incentive to report problems/policy violations if they are uncertain if it has occurred
  • -Mitigated by incentives for reporting
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11
Q

Relationship: Partnership

A
  • BUs and risk management work together in client-consultant relationship to manage risk
  • BUs should recognise LT importance of risk management
  • Risk management must recognise the importance of consultant and meet needs of BU
  • Independence threaten -> risk management may struggle to have a corporate oversight role
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12
Q

Relationship: offence vs. defence

A
  • Lines şet up in opposition to each other
  • BU focus on maximising returns
  • Risk management focus on minimising losses
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13
Q

What is the role of a CRO?

A 
Managing various risk functions 
Providing leadership and direction 
Designing and implementing ERM framework across the company
Ongoing risk policy development 
Risk reporting (internal and external) 
Allocating capital across the firm 
Communicating with various stakeholders 
Developing systems to monitor and manage risks
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14
Q

What is the role of the central risk function?

A

Either a team of specialist risk managers/one person in small org.
Give advice to board regarding risk
Assess overall risks run by business (include hidden risks and correlations)
Give guidance to line managers on identification of risks
Monitor progress on risk management
Make comparisons between risk appetite and overall risks being run
Act as central point where staff can report new and enhanced risks

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15
Q

What is the role of a board in risk governance?

A

The board is responsible for the success of the company
Thus it has to ensure all risks faced by company are well managed
ERM programme sets risk appetite of the company & ERM framework to manage boundaries
Board sits at the top so has good overview of all risks faced by company (rather than just one department)
Board also sets structure, culture and direction of the company
Easy to side-line risk management until something bad happens -> don’t do this
Manage serious strategic risks

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16
Q

What is risk management governance?

A

Process for engaging with business units
Common way to identify and record risks
Standard risk management procedures
Appropriate incentives for employees linked to behaviour
Clear monitoring and risk reporting

17
Q

Explain the differences between managing risks at BU level vs. Enterprise level.

A

BU level

  • requires company to divide overall risk appetite amoung BUs
  • each BU has its own management team to run business as well as manage risk appetite they have been allocated

Enterprise level

  • group risk management function established at the enterprise level
  • models/analyses/results from risk exposed at the business unit level are combines into an assessment model at the enterprise level
18
Q

Advantages and disadvantages of BU management

A

perks

  • easy and cheap to implement
  • easy to understand

cons

  • no allowance for diversification of risks across units
  • not most efficient use of capital
19
Q

Pros and cons of Enterprise level managmenet

A

pros

  • explicit allowance for diversification
  • overall understanding of risk of entire enterprise
  • strategic opportunities identified in time to be exploited
  • threats dealt with promptly

cons

  • expensive/complex to establish
  • difficult to communicate
20
Q

What is risk budgeting?

A
  • deciding how much risk to take and where to use risk to maximise returns
  • depends on risk appetite
  • depends on how much believe active management can do better than passive management
  • want alternative investment classes to increase diversification
21
Q

Risk budgeting process for investment risk?

A
  • decide how to allocate maximum fund risk between strategic and active
    i. e. how much can depart from benchmark and how much risk can take to depart from benchmark
  • allocate total fund active risk across component portfolios (bonds, equity etc.)
22
Q

What is structural risk?

A
  • Risk that aggregate of portfolio benchmarks and total fund benchmark are not aligned
  • Total fund benchmark compared to index/peers
23
Q

What factors affects risk appetite?

A
  1. Perception of risk (frequency/severity)
  2. Financial consequences
  3. Ability to alter/reduce financial consequences
  4. Financial resources available
  5. Perceived upside
  6. Current exposure to risk
  7. Regulation

Story: you went to percept dinner party (risk and upside). There were lots of resources available to limit your exposure to the sun. However, you failed to alter the sun ray too much and suffered financial consequences.

24
Q

How is risk appetite communicated?

A
  • risk management function establish risk appetite of company and translate that into risk tolerances for the rest of organisation
  • linked to a measure of risk
  • expressed in terms of: solvency level, credit value and economic value
  • must say “there is a 95% chance of solvency falling below 5% over 3 years”
  • make reference to multiple risk measures to appeal to multiple stakeholders
25
Q

What is bank underwriting?

A

Bank underwriting - bank decides whether creditworthy enough to receive a loan

  • Willingness and capacity to pay loan
  • Internal scorecard assessment to determine creditworthiness
  • Credit history and past performance
  • Customer identify and income verification
  • Collateral valuation if secure lending
26
Q

What are management control systems?

A

DOM PAQ

  • Data recording - good data on risks written to ensure adequate provisions established & operational risk reduced
  • Options and guarantees - monitor whether they’ll bite
  • Monitoring liabilities taken on
  • Protect against aggregation of risks
  • Accounting and auditing - enable proper provisions
  • Quantify amount of new business strain
27
Q

What are claims control systems?

A
  • Guard against fraudulent or excessive claims but can be costly
  • Automatically accept small claims
  • See multiple quotes if claim above monetary limit
  • Require inspection if above further limit by employee
  • Regularly assess illness during claim period to ensure claim is valid
28
Q

What is risk financing?

A
  • If you decide to retain risk the price to be paid must be adequate and still allow profits to be made
  • Evaluating and pricing risks can be difficult
  • Risks need to be managed to ensure profits emerge
29
Q

How can a portfolio be constructed to ensure risk minimised and return maximised?

A
  1. Set strategic portfolio benchmark
    - set based on the behaviour of liabilities
    - if perfectly matched portfolio is 70% bonds and 30% equities
    - then choose 60% bonds and 40% equities if it produced extra returns
  2. Decide on the level of risk relative to the strategic benchmark
    - managers use expertise and judgement to decide on level of risk
    - each portfolio is given a benchmark e.g. equity portfolio given equity index as benchmark
    - active return is the level of return achieved over and above strategic benchmark
30
Q

How does one quantify risks?

A
  1. Use model
    - assign pdfs to probability and severity of event
    - either define an event: 25% drop in equity market
    - or define frequency of loss event: 0.5% probability in drop in equity market
    - getting distributions for rare events will be difficult
  2. Subjective assessment
    - record type of risk
    - rate the loss and probability out of 5
    - risks which have highest score get the most priority
31
Q

How do you quantify operational risk?

A
  1. Use broad-brush risk measure
    - add % uplift to non-operational risks
    - done in Basel III and Solvency II
  2. Use scenario testing
  3. Divide operational risk into groups e.g.
    - fraud activities
    - failed internal systems etc.
  4. Create plausible scenario of each risk group
    - scenario must be inclusive of all risks
  5. Make assumptions about the different risk factors of each scenario
  6. Calculate financial consequence of risk event occuring
    - usually midpoint of values is taken
    - financial consequence: cost of redress, cost of regulation
  7. Total costs is the sum of financial consequences of all risks within the scenario
32
Q

How does risk management optimise risk/returns of an organisation?

A

Control the size and profitability of losses

  • this is done through setting limits
  • exposure limits, stop loss limit and sensitivity limit (avoid excessive concentrations of risk)

Support business growth:

  • Process for assessing new business opportunities
  • Assess risk adjusted return in process
  • Allocate capital and other resources to BUs with high risk-adjusted return

Support profitability through pricing
- Prices should reflect = cost of risk + funding cost + operational expenses

Manage existing risks

  • Active portfolio management - portfolio has own risk characteristics
  • Reduce risk e.g. duration matching
  • Transfer risk to third party e.g. derivatives
33
Q

What is the difference between uncertainty and risk?

A

Uncertain means that the outcome is not predictable

Risk is a consequence of an action that is taken that involves uncertainty

Final Exam Revision (6 decks)

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