Risk Management Flashcards
Enterprise risk management (ERM)
A firmwide or across-enterprise perspective on risk
Corporate governance
The system of internal controls and procedures used to manage individual companies
Risk management versus corporate governance
Risk management incorporates a centralized type of risk management called “enterprise risk management” (ERM). ERM’s distinguishing feature is a firmwide or across-enterprise perspective. The corporate governance structure is much broader than risk governance and encompasses the system of internal controls and procedures used to manage individual companies.
The risk management process
- Set policies and procedures
- Define risk tolerance
- Identify risks
- Measure risks
- Adjust the level of risk
Straight-through processing (STP)
Systems that obviate manual and/or duplicative intervention in the process from trade placement to settlement
Market risk
Is the risk associated with interest rates, exchange rates, stock prices, and commodity prices
Credit risk
Is the risk of loss caused by a counterparty or debtor’s failure to make a promised payment
Liquidity risk
Is the risk that a financial instrument cannot be purchased or sold without a significant concession in price because of the market’s potential inability to efficiently accommodate the desired trading size
Operational risk
Is the risk of loss from failures in a company’s systems and procedures or from external events
Model risk
Is the risk that a model is incorrect or misapplied; in investments, it often refers to valuation models
Settlement (Herstatt) risk
Is the risk that one party could be in the process of paying the counterparty while the counterparty is declaring bankruptcy
Regulatory risk
Is the risk associated with the uncertainty of how a transaction will be regulated or with the potential for regulations to change
Legal/contract risk
Is the possibility of loss arising from the legal system’s failure to enforce a contract in which an enterprise has a financial stake
Tax risk
Is the risk associated with uncertainty associated with tax laws
Accounting risk
Arises from uncertainty about how a transaction should be recorded and the potential for accounting rules and regulations to change
Sovereign risk
Is a form of credit risk in which the borrower is the government of a sovereign nation
Political risk
Is associated with changes in the political environment
Value at risk (VaR)
Is an estimate of the loss (in money terms) that we expect to be exceeded with a given level of probability over a specified time period
The expected return μP and variance σ2P of a combined position
Normal distribution key levels
- 5% = 1.65
- 1% = 2.33
Surplus at risk
VaR as it applies to pension fund suplus
Incremental VaR (IVaR)
Measures the incremental effect of an asset on the VaR of a portfolio by measuring the difference between the portfolio’s VaR while including a specified asset and the portfolio’s VaR with that asset eliminated
Marginal Value at risk (MVaR)
MVaR reflects the effect of a very small change in the position size. In a diversified portfolio, marginal VaR may be used to determine the contribution of each asset to the overall VaR
Cash flow at risk (CFAR) and Earnings at risk (EAR)
- CFAR is the minimum cash flow loss that we expect to be exceeded with a given probability over a specified time period
- EAR is defined analogously to CFAR but measures risk to accounting earnings
Tail value at risk (TVaR)
Is defined as the VaR plus the expected loss in excess of VaR, when such excess loss occurs
Factor push
Stressing model that pushes the prices and risk factors of an underlying model in the most disadvantageous way and to work out the combined effect on the portfolio’s value
Maximum loss optimization
Stressing model in which we would try to optimize mathematically the risk variable that will produce the maximum loss
Worst-case scenario analysis
Stressing model in which we can examine the worst case that we actually expect to occur
Cross-default provision
Provision that stipulates that if a borrower defaults on any outstanding credit obligations, the borrower is in default on them all
Credit VaR
Reflects the minimum loss with a given probability during a period of time from gains on market positions held
Closeout netting
In a bankruptcy, a process by which multiple obligations between two counterparties are consolidated into a single overall value owed by one of the counterparties to the other
Enhanced derivatives products companies
A type of subsidiary separate from an entity’s other activities and not liable for the parent’s debts. They are often used by derivatives dealers to control exposure to ratings downgrades. Also called special purpose vehicles
Total return swap
A swap contract that involves a series of exchanges of the total return on a specified asset or equity index in return for specified fixed or floating rate payments
Credit spread option
An option based on the yield spread between two securities that is used to transfer credit risk
Risk-Adjusted Return on Capital (RAROC)
Divides the expected return on an investment by a measure of capital at risk, a measure of the investment’s risk that can take a number of different forms
Return over Maximum Drawdown (RoMAD)
The average return in a given year that a portfolio generates, expressed as a percentage of this drawdown figure
Credit risk for options
Is born only by the buyer and the amount is equal to the option’s current price
Tool used to manage contagion in times of crisis
Conditionnal correlation matrices. One set of correlation for normal conditions and one set for crisis conditions
