Study Session 14 - Risk Management

Question 1

Risk Management Procdess

Answer 1

1) Identifying and measuring risk exposures
2) Setting specific risk tolerance levels
3) Reporting risk exposures to stakeholders
4) Monitoring process and taking corrective actions

Question 2

Risk Governance

Answer 2

originates from senior mgmt

determines structure of system (centralized or decentralized)

Question 3

Decentralized Risk Governance System benefits

Answer 3

decentralized: benefit - putting risk mgmt in hands closes to daily ops

Question 4

Centralized Risk governance system

Answer 4

ERM - enterprise risk management system

provides better view how risks of biz units are correlated

Question 5

Evaluation of ERM system questions

Answer 5

1) senior mgmt consistently allocates capital on risk-adjusted basis
2) system properly IDs and defines all relevant internal/external risk factors
3) system uses appropriate model for quantifying potential impacts of risk factors
4) risks are properly managed
5) committee to oversee entire system to enable timely feedback and reactions to problems
6) has checks and balances

Question 6

What to do when a problem occurs?

Answer 6

1) ID problem and access damage
2) Determine if problem is due to temp aberration or a long-term change in capital market structure or pricing fundamentals
3) If problem is temp - best to do nothing
4) If problem stems from risk factor that was previously modeled incorrectly - revisit risk model
5) If problem stems from risk factor not originally ID’d/priced - mgmt must determine whether to manage the risk or hedge it
6) pob can arise from reliance on incorrectly specified risk pricing model

Question 7

ERM risk factors

Answer 7

Market, liquidity, settlement, credit, operations, model,sovereign, regulatory, and some other (political, tax, legal, accounting)

Question 8

Volatility of asset’s excess returns relative to benchmark

Answer 8

=std

= active risk, tracking risk, tracking error volatility, or tracking error

Question 9

What is active risk?

Answer 9

std of asset’s returns in excess of benchmark’s returns

Question 10

What is tracking error?

Answer 10

active risk = std of assets returns in excess of benchmark’s return

Question 11

Information Ratio formula

Answer 11

IR = active return/active risk = (Rp - Rb)/ std (Rp-Rb)