Risk Management

Question 1

Enterprise risk management (ERM)

Answer 1

A firmwide or across-enterprise perspective on risk

Question 2

Corporate governance

Answer 2

The system of internal controls and procedures used to manage individual companies

Question 3

Risk management versus corporate governance

Answer 3

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.

Question 4

The risk management process

Answer 4

1. Set policies and procedures
2. Define risk tolerance
3. Identify risks
4. Measure risks
5. Adjust the level of risk

Question 5

Straight-through processing (STP)

Answer 5

Systems that obviate manual and/or duplicative intervention in the process from trade placement to settlement

Question 6

Market risk

Answer 6

Is the risk associated with interest rates, exchange rates, stock prices, and commodity prices

Question 7

Credit risk

Answer 7

Is the risk of loss caused by a counterparty or debtor’s failure to make a promised payment

Question 8

Liquidity risk

Answer 8

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

Question 9

Operational risk

Answer 9

Is the risk of loss from failures in a company’s systems and procedures or from external events

Question 10

Model risk

Answer 10

Is the risk that a model is incorrect or misapplied; in investments, it often refers to valuation models

Question 11

Settlement (Herstatt) risk

Answer 11

Is the risk that one party could be in the process of paying the counterparty while the counterparty is declaring bankruptcy

Question 12

Regulatory risk

Answer 12

Is the risk associated with the uncertainty of how a transaction will be regulated or with the potential for regulations to change

Question 13

Legal/contract risk

Answer 13

Is the possibility of loss arising from the legal system’s failure to enforce a contract in which an enterprise has a financial stake

Question 14

Tax risk

Answer 14

Is the risk associated with uncertainty associated with tax laws

Question 15

Accounting risk

Answer 15

Arises from uncertainty about how a transaction should be recorded and the potential for accounting rules and regulations to change

Question 16

Sovereign risk

Answer 16

Is a form of credit risk in which the borrower is the government of a sovereign nation

Question 17

Political risk

Answer 17

Is associated with changes in the political environment

Question 18

Value at risk (VaR)

Answer 18

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

Question 19

The expected return μ_P and variance σ²_P of a combined position

Answer 19

Question 20

Normal distribution key levels

Answer 20

• 5% = 1.65
• 1% = 2.33

Question 21

Surplus at risk

Answer 21

VaR as it applies to pension fund suplus

Question 22

Incremental VaR (IVaR)

Answer 22

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

Question 23

Marginal Value at risk (MVaR)

Answer 23

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

Question 24

Cash flow at risk (CFAR) and Earnings at risk (EAR)

Answer 24

• 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

Question 25

Tail value at risk (TVaR)

Answer 25

Is defined as the VaR plus the expected loss in excess of VaR, when such excess loss occurs

Question 26

Factor push

Answer 26

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

Question 27

Maximum loss optimization

Answer 27

Stressing model in which we would try to optimize mathematically the risk variable that will produce the maximum loss

Question 28

Worst-case scenario analysis

Answer 28

Stressing model in which we can examine the worst case that we actually expect to occur

Question 29

Cross-default provision

Answer 29

Provision that stipulates that if a borrower defaults on any outstanding credit obligations, the borrower is in default on them all

Question 30

Credit VaR

Answer 30

Reflects the minimum loss with a given probability during a period of time from gains on market positions held

Question 31

Closeout netting

Answer 31

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

Question 32

Enhanced derivatives products companies

Answer 32

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

Question 33

Total return swap

Answer 33

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

Question 34

Credit spread option

Answer 34

An option based on the yield spread between two securities that is used to transfer credit risk

Question 35

Risk-Adjusted Return on Capital (RAROC)

Answer 35

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

Question 36

Return over Maximum Drawdown (RoMAD)

Answer 36

The average return in a given year that a portfolio generates, expressed as a percentage of this drawdown figure

Question 37

Credit risk for options

Answer 37

Is born only by the buyer and the amount is equal to the option’s current price

Question 38

Tool used to manage contagion in times of crisis

Answer 38

Conditionnal correlation matrices. One set of correlation for normal conditions and one set for crisis conditions