Risk Management - R34 Flashcards
What is the risk management process?
What is the 6-step procedure for enterprise risk management?
Risk management is a process involving the identification of exposures to risk, the establishment of appropriate ranges for exposures, the continuous measurement of these exposure, and the execution of adjustments when these exposures fall outside the target ranges.
- Identfy each risk factor
- Quantify the exposure’s size
- Map the input into a risk estimation calculation
- Identify overall risk and the contribution to overall risk, setting specific tolerance levels
- Reporting risk exposures (deemed appropriate) to stakeholders
- Monitoring the process and taking any necessary corrective actions.
What is risk governance?
Risk governance, a part of the overall corporate governance system, is the name given to the overall process of developing and putting a risk management system into use.
A decentralized risk governance system puts risk management in the hands of individuals closest to everyday operations (managers).
A centralized system (aka Enterprise Risk Management or ERM) provides a better view of how the risk of each unit affects the overall risk borne by the firm.
Specific risks that need to be monitored include:
(categorize them as financial/non-financial risks)
Remember the Mnemonic “Melty Liquid Chocolate SMORS-plat”
Financial:
- Market Risk
- Liquidity Risk
- Credit Risk
Non-Financial:
- Settlement Risk
- Model Risk
- Operations Risk
- Regulatory Risk
- Soverign Risk (can be both)
- Political
- Legal
- Accounting
- Tax
An analyst should understand the following 6 items when evaluating a risk management system. He should determine whether:
- Senior management allocates capital on a risk-adjusted basis
- The ERM system properly identifies all relevant risk factors
- The ERM system utilizes an appropriate model.
- Risks are properly managed.
- There is a committee in place to oversee the entire system.
- The ERM system has built-in checks and balances.
Calculate and interpret value at risk (VAR) and explain its role in measuring overall and individual position market risk.
- What is the formula for VAR?
- What is the definition of VAR?
- What are three methods for estimating VAR?
Analytical VAR: VAR = [Rp - (z)(σ)]Vp
VAR is used as an estimate of the minimum (or maximum) expected loss over a set time period at a designed level of significance.
Overall VAR is not just the sum of individual VARs. The correlations of the returns must be considered.
- Analytical method: aka variance-covariance or delta normal
- Historical method
- Monte Carlo method
Compare the analytical (variance-covariance), historical, and Monte Carlo methods for estimating VAR and discuss the advantages and disadvantages of each.
Analytical VAR assumes normality of past returns and uses ex post standard deviation.
Advantage: simple. Disadvantage: reliance on simplifying assumptions, including normality of returns.
Historical VAR (aka historical simulation) ranks actual past returns.
Advantage: nonparametric (user can avoid assumptions about the type of probability distribution). Disadvantage: past events might not hold true in the future*.
Monte Carlo is computer intensive (disadvantage) but allows assumptions of any distributions and correlations (advantage).
*this is also semi-true of all 3.
Discuss the advantages and limitations of VAR and its extensions, including:
- Cash flow at risk
- Earnings at risk
- Tail value at risk
Advantage of VAR: it is interpreted the same, regardless of the assets in question.
Disadvantage of VAR: does not give the magnitude of potential extreme losses (fat tail risk). Difficult to estimate.
Extensions to VAR
- Incremental VAR (IVAR) is the effect of an individual asset on the overall VAR
- Cash flow at risk (CFAR) is VAR applied to the company’s cash flows
- Earnings at risk (EAR) is analogous to CFAR only from an accounting earnings standpoint
- Tail value at risk (TVAR) is VAR plus the expected value in the lower tail of the distribution
Compare alternative types of stress testing and discuss the advantages and disadvantages of each.
*List and discuss the various models.
Stress testing measures the impacts of unusual events that might not be reflected in the typical VAR calculation.
Scenario analysis is used to measure the effect on the portfolio of simultaneous movements in several factors or to measure the effects of unusually large movements in individual factors.
Stressing models
-
Factor Push Analysis
- Deliberately push a factor(s) to the extreme and measure the impact.
-
Maximum Loss Optimization
- identify risk factors that have the greatest potential for impacting the value of the portfolio
-
Worst-case scenario
- pushes all risk factors to their worst cases.
The basic disadvantage is that the models break down when faced with real-world assumptions.
Evaluate the credit risk of an investment position, including forward contract, swap, and option positions.
*Define/describe current and potential credit risk
*Define Credit VAR
Current credit risk (aka jump-to-default risk) is associated with payments that are currently due.
Potential credit risk is associated with payments due in the future. When measuring potential credit risk, creditors must consider cross-default provisions.
Credit VAR is aka credit at risk or default VAR.Credit managers focus on the upper tail of possible returns. An increase in the value of these assets (e.g., a positive return from falling interest rates), accrues to the debtor in the form of the option to refinance.
What is the formula for the value (credit risk) of a forward contract to the long?
*What is the formula for swap credit risk?
When are the credit risks for interest rate and currency swaps greatest?
credit risk = PV(received) - PV(paid)
The credit risk of an interest rate swap is highest somewhere around the middle of its life.
In a currency swap, both parties can be simultaneously exposed to credit risk. The credit risk of a currency swap is highest between the middle and maturity of the agreement. (Because of the exchange of principals at inception and the return of principals on the maturity date).
When/where is credit risk borne to an option?
Credit risk to an option is *only* borne by the long position. The credit risk to a European option can only be potential until the date it matures.
The credit risk to an American option is >= the European and can become current if the long exercises early.
Demonstrate the use of risk budgeting, position limits, and other methods for managing market risk.
*Define risk budgeting
*3 expansions on position limits
*List the 6 measures that help control credit risk
Risk budgeting is the process of determining which risks are acceptable and how total enterprise risk should be allocated across business units or portfolio managers.
- Position limits place a nominal dollar cap on positions
- Liquidity limits set dollar position limits according to the frequency of trading
- A performance stopout sets an absolute dollar limit for losses over a certain period.
Measures to help control credit risk
- limiting exposure to any single debtor
- marking to market
- assigning collateral to loans
- payment netting agreements
- setting credit standards
- using credit derivatives
- SPVs
- EDPC
- swaps
- credit spread options
- credit spread forwards
- CDS
Know the formulas for the following:
- Sharpe Ratio
- Risk-Adjusted Return on Capital
- Return over Maximum Drawdown
- Sortino Ratio
Sharpe Ratio = Mean Rp - Rfr / Std Dev. Rp
RAROC = Expected Return / Capital at Risk
RoMAD = Mean Rp / Max. drawdown
Sortino = Mean Rp - MAR / downside deviation
Demonstrate the use of VAR and stress testing in setting capital requirements.
List and describe the 5 methodologies in measuring capital requirements
-
Nominal, Notional or Monetary Position Limits
- Amount of money allocated based upon upper management’s desire for return/exposure to risk.
- May not capture effectively correlation and offsetting risks
-
VAR-Based Position limits
- Clearer VAR picture
- Failure to consider correlation of different VARs
-
Maximum Loss Limits
- Sum of individuals = theoretical max the firm will endure.
- Benefit is so firm can allocate capital so max loss never exceeds capital
- Drawback is possibility of units simultaneously exceeding limits
-
Internal Capital Requirements
- Sub to regulatory requirements. Sometimes uses aggregate VAR
-
Regulatory Capital Requirements
- Generally banks/securities firms. Must include it in their process.
