S14 Flashcards
Steps in risk management process
- set policies and procedures for managing risk
- define risk tolerance
- identify risks faced by org
- measure current levels of risk
- adjust the levels of risk
ERP
centralized risk management system placing execution withing one central unit of the orgnaization
effective risk management system will
- identify each risk factor to which firm is exposed
- quantify factor in measurable terms
- include each risk in a single aggregate measure of FIRM WIDE risk (e.g. VAR)
- identify how each risk contributes to overall firm risk
- systematically report risks and support allocation of capital and risk to each business unit
- monitor compliance
financial risks
market risk (rates, fx, equity price, commodity price)
credit risk
liquidity (bid ask spread, volume, etc)
nonfinancial risks
operational settlement (one party can default after first party made the payment) model risk sovereign - ability and willingness of a foreign govenrment to pay regulatory risk tax, accounting, legal, contract risks environmental social or governance risk performance netting risk settlement netting risk
VAR formula
VAR = ( Rp - Z * StandDev) * investment value
5% var = Z = 1.65
1% = Z = 2.33
StandDev annual to weekly conversion
Annual StandDev / (52 [weeks])^0.5
Analytical VAR = Advantages/Disadvantages
Adv:
- easy to calc and understood
- allow modeling of risk correlation
- applicable to both short and long periods
DisAdv:
- some securities have skewed returns
- many assets exhibit leptokurtosis (fat tails)
- stand dev difficult to estimate for large portfolios
Historical VAR = Adv / DisAdv
Adv: - easy to calc / udnerstand - doesnt assume a returns distribution - applicable to different periods Disadv - assumptions that historical pattern will repeat in future
VAR advantages
- is an industry standard risk measure
- required by regulators
- aggregates risk into a single simple number
- can be used in capital allocation
- can compare different assets with dif characteristics
VAR disadvantages
some methods difficult and expensive (MCarlo)
Different computaitons lead to different estimates of VAR
Can generate false sense of security
Onesided - ignores upside
Stressing models
factor push analysis
maximum loss optimization
worst case scenario
credit risk losses are function of
probability of default event
amount of value lost in default
forward agreement = value to long =
[[[[[ fx rate is domestic/foreign ]]]]]]
= spot FX / (1+Foreign% ) ^ t - forward FX / (1+Domestic %) ^ t
risk budgeting
process of determining which risks are acceptable and how total entreprise risk is allocated across business units or PMs
in addition to VAR - market risk can be managed with
position limits
liquidity limits
performance stopout
risk factor limits
ways to manage credit risk
Credit VAR Limiting exposure Marking to Market Collateral Payment netting Closeout netting minimim credit standards on a debtor transfering risk via --- credit default swaps --- credit spread forwardd --- credit spread option --- total return swap
Sharpe ratio
S = ( R - Rf ) / StandDev
Return on max drawdown
RoMAD = R / Max Drawdown
Sortino ratio
= (R - MAR) / DOWNside deviation
downside deviation - returns below MAR not ZERO
information ratio =
(Rpf - Rbench) / StandDev (Rpf - Rbench)
VAR is
estimate of minimum loss (or max)
OVER a set time period
at a desired LEVEL OF SIGNIFICANCE/CONFIDENCE
standard deviation for 2 asset portfolio =
= (SDa*Wa)^2+
[(SDbWb)^2 + 2CorrWaWbSDaSDb]^.5
supplements to VAR to provide more confidence
incremental VAR
CF at risk
Earnings at risk
Tail value at risk
futures are H while options are I
Hedging Insurance
3 approaches to manage currency exposure
- strategic hedge ratio
- currency overlay (following IPS but PM not responsible for FX… separate manager hired for FX)
- separate asset allocation
minimum variance hedge ratio =
translation risk + economic risk
for every unit of currency we should hold ????? put options
= 1 / delta
impact on fx from lower domestic interest rate
higher fx rate
for interest and equity swaps the credit risk is largest at
middle of the life of the swap
for currency swaps with payment of notional principal the credit risk is greatest near
the end of the life of the swap
benefits of centralized risk management systems
brings risk control closer to the key decision makers
enable org to better manage its risk budget by recognizing the diversification embedded across business units
benefits of decentralized risk management system
placing risk control in closer to source of risk taking
hedging should be avoided in situation of
natural hedge (e.g. where FX offset commodity movements)
forward hedge - 2 sources of imperfection
future value of hedged asset is unknown (potential return/loss in value)
potential change in forward basis caused by a change in interest rate differential
in the money options provide XXXXX protection but XXXXXXX the profit potentaial
better / reduces
