Topic 5: Risk and Risk Management

Question 1

After which event was single-stock circuit breakers introduced?

Answer 1

Single-stock circuit breakers were introduced into the industry after the 2010 Flash Crash (when the Dow fell about 9% within a very short period in a single day). Circuit breakers were designed to halt trading at specific points to enable markets to stabilize.

Question 2

Which hedge fund suffered enormous losses on a strategy that involved borrowing at low short-term rates and investing the capital in Freddie Mac and Fannie Mae mortgage bonds?

Answer 2

Carlyle Capital’s strategy involved borrowing at low short-term rates and investing in long-term Freddie Mac and Fannie Mae securities. In early 2008, the value of these securities fell drastically, as investors fled to quality during the U.S. housing/credit crisis.

Question 3

For which of the following hedge funds did the U.S. Federal Reserve reduce interest rates several times in an attempt to prevent the systematic effect of its collapse on financial markets?

Answer 3

LTCM

Question 4

Describe the issues/causes with the following cases:
1. Dow Jones Flash Crash
2. Knight Capital
3. Caryle Capital
4. Lancer
5. LTCM
6. Bayou
7. Amaranth
8. XIV

Answer 4

1. Dow Jones Flash Crash - spoofing by UK trader
2. Knight Capital - tech glitch
3. Caryle Capital - borrow short term rates to buy Freddie/Fannie Mae
4. Lancer - Illegal window dressing, valuation done by own people
5. LTCM - RV trades with high leverage; done for when Russia defaulted on bonds and caused a liquidity crisis
6. Bayou - earned comms on trades by own brokerage firm; fraud in general
7. Amaranth - divergent trade on winter contracts on natural gas
8. XIV - short vol trade

Question 5

Performance of systematic, trend-following strategies and their comparisons to the performance of diversified portfolios of actual trend-following CTAs?

Answer 5

1. Passive trend-following indices are reasonable benchmarks for trend-following CTAs.
2. Trend-following CTAs have LOW exposures to TRADITIONAL assets and LONG-ONLY commodity indices.
3. LESS THAN HALF of the historical excess return earned by trend-following CTAs is attributable to their BETA to passive trend-following indices. More than half of the returns cannot be captured by passive indices.
4. Discretionary CTAs have LOW exposures to traditional assets, long-only commodity indices, and passive trend-following indices.
5. PEER GROUPS appear to be the most suitable benchmark for discretionary CTAs.

Question 6

Which of the following is NOT true of listed private equity indices?

1. They are made up of share prices of publicly-traded private equity firms.
2. They reflect the assets in which institutional investors typically invest.
3. They include fees earned by the underlying investments’ general partners.

Answer 6

NOT true: They reflect the assets in which institutional investors typically invest.

Question 7

Most suitable benchmark for managed futures trading system:
1. Bloomberg Commodity Index
2. S&P Goldman Commodity Index
3. Mount Lucas Management Index

Answer 7

Since he is evaluating a trend-following trading system, a passive, trend-following index would be best. The MLMI is a passive benchmark that follows a trend-following strategy.

Side note: In addition, to assess the performance of managed futures, he should use a benchmark that incorporates long and short positions (since CTAs take both long and short positions).

The S&P GSCI and BCOM indices only use long futures positions.

Question 8

The CAPM asserts that investors should only be rewarded for bearing which of the following types of risk?

Answer 8

The CAPM maintains that investors should only be rewarded for bearing systematic risk, since unsystematic (or diversifiable) risk can be diversified away by combining investments with low correlations.

Question 9

EXCESS vs TOTAL return commodity indices

Answer 9

EXCESS: price movement of commodity futures contract

TOTAL: fully collateralised returns

Question 10

Is S&P Goldman Sachs Commodity Index an example of value or production weighted index

Answer 10

Production

Question 11

What are the characteristics of an appropriate investment benchmark?

Answer 11

appropriate investment benchmark has 7 characteristics: 1) unambiguous, 2) investable, 3) measurable, 4) specified in advance, 5) appropriate, 6) reflective of current investment opinion, and 7) owned.

Question 12

What are the three key factors used to determine the weights of commodities when constructing a commodity index?

Answer 12

1. World Production
2. Liquidity
3. Open Interest

Question 13

Describe risk premium modelling

Answer 13

Risky asset’s expected return = Riskless rate + Risk premium.

Since the approach includes the current interest rate, which fluctuates due to inflation, this approach essentially adjusts expected returns for different levels of inflation and interest rates. The investment horizon determines the maturity of the riskless rate.

Question 14

How to estimated returns from non-core / opportunistic real estate investments?

Answer 14

Risk Premium Approach

1. Using observed cap rates – This yields inaccurate results since estimates of NOI for non-core real estate are less reliable than those of core real estate.
2. Using absolute hurdle rates – This may be inappropriate since it does not account for changing interest rates and inflation.
3. Using a risk premium approach – This is an effective approach for determining non-core properties’ expected returns (typically expressed relative to core real estate investment returns).

Question 15

If stock returns are ___ in a Delta Neutral portfolio, what happens to underlying stock/option payout?
1. Upwards
2. Downwards
3. Mean-reverting

Answer 15

1. Stock Upwards: Stock lose money; high option payout
2. Stock downwards: Stock win money; option expire worthless
3. Mean-reverting: Stock win money, option suffers time decay

Question 16

Rebalancing yield contributes more to portfolio returns when components are stable/volatile and have high/low correlations with each other

Answer 16

Rebalancing yield contributes more to portfolio returns when components are VOLATILE and have LOW
correlations with each other

Question 17

Rebalancing benefits higher/lower for commodity-based vs stock-bond portfolio (Erb and Harvey 2006)

Answer 17

Erb and Harvey (2006) found that the average correlation across several commodity futures was very low and the average volatility was high, which indicates that a commodity-based portfolio likely has greater rebalancing benefits (due to the mean-reverting trait of commodities) than a stock-bond portfolio (which has higher correlations between the portfolio assets).

Question 18

For Delta Neutral portfolios, when is re-hedging positive?

Answer 18

• when there is negative autocorrelation (mean reversion)
• when options are short dated and near the money

Question 19

In the context of delta hedging, what is a slack variable?

Answer 19

A slack variable is a variable that assumes any value to make an optimal solution feasible, without affecting the objective function’s value.

The delta of a position can be hedged using the underlying asset. This keeps the portfolio delta-neutral and does not affect its vega or gamma.

Question 20

Six steps to monitor private partnerships

Answer 20

1. Planned vs Implemented
2. Review investment, valuation, divestment
3. Effect of market trends
4. Individual treatments to overall portfolio
5. Performance against benchmark
6. Legal and compliance status

Question 21

How often should institutional investors typically make investment manager calls for risk measurement purposes?

Answer 21

Quarterly

Question 22

How often should Third-party background and reference checks on each external manager be done

Answer 22

Once every three years

Question 23

Which of the following issues on cybersecurity needs improvement?

Answer 23

1. Untailored (e.g., vague) policies and procedures
2. Lax firm adherence
3. Inadequate system maintenance (e.g., outdated operating systems)

Question 24

What sort of data should be collected daily, monthly, quarterly and annually?

Answer 24

DAILY: Values, returns, position size, volume, index and benchmark data, and keyword alerts.

MONTHLY: manager changes, position changes, and regulatory risks

QUARTERLY: manager calls and reports, and valuations of illiquid positions.

ANNUALLY: site visits, audits of illiquid positions, and reference updates.

Question 25

NIS Cybersecurity Compliance Measures

Answer 25

Identify critical systems and those with confidential data.

Perform penetration tests and cybersecurity risk assessments.

Provide training and awareness initiatives for employees.

Have an incident response plan.

Question 26

What are the seven categories of quantitative info for illiquid asset review?

Answer 26

1. Historical performance
2. Historical risk measurement (e.g., minimum value, standard deviation, downside deviation, skewness, kurtosis, and correlation).
3. Asset allocations and capital balances
4. Gross contribution (manager, sector, strategy, asset class and, if extraordinary, position level)
5. Activity reports (e.g., investment mandate tracking, exception reports, exposure, purchase, sale, and manager turnover; overlapping and offsetting positions, allocations, top positions, cash, cash flow, and illiquid positions)
   6.Fixed-income reports (includes e.g., yields, duration, convexity, credit, illiquidity, and gross and net exposure)
6. CTA and managed futures exposures (includes portfolio’s diversification level across geographies, markets, models, time frames, and margin-to-equity).

Question 27

What are the three ways to approximate short term values for illiquid securities?

Answer 27

1. Capital statement valuations (used to estimate changes in quarterly valuation estimates)
2. Discounted cash flow model-based calculations (used to approximate valuations during interim periods)
3. Customized index-based calculations (used to approximate valuations frequently)

Question 28

What do most risk measurements focus on?

Answer 28

1. Deviations from expected results.
2. Capital market and related risks.

Question 29

What are the three levels of assets?

Answer 29

1. Level 1 assets are highly liquid assets, with prices accepted as values with high degrees of confidence.
2. Level 2 assets may be valued using observable inputs.
3. Level 3 assets are illiquid assets, with values based on models with fairly low degrees of confidence.

Question 30

According to the SEC’s findings on the regularity of four cybersecurity functions among advisers, only one functions was conducted by almost half of the advisers:

Answer 30

penetration tests and vulnerability scans.

Question 31

As part of a risk measurement program, an asset allocator typically reviews manager turnover reports over which of the following time periods?

Answer 31

Monthly

Question 32

Risk reporting’s 12 dimensions of risks

Answer 32

Strategy
Liquidity
Concentration
Geography
Leverage
Transparency
Valuations
Key person
Business operations
Legal, regulatory, and compliance
Other risks (e.g., idiosyncratic risks associated with the investment or investment manager)
Emerging risks

Question 33

By which year did European Union member countries have to comply with the Directive on Security of Network and Information Systems?

Answer 33

2018

Question 34

Define an exception report used in risk measurement and reporting.

Answer 34

An exception report filters data (0.5pts) to discuss only cases in which risk measures and other data are outside preset bands (0.5pts) considered to be appropriate for further analysis at a more senior level. (0.5pts)

Question 35

A large institutional investor is preparing a risk aggregation summary report. How should the institutional investor best measure potential risk exposures of its alternative investments that exhibit option-like traits to present in the report?

Answer 35

Many alternative investments have non-linear risk exposures (e.g., due to use of option-like strategies).
1pt: Potential future risk exposures of these strategies are typically best identified using simulation models (e.g., scenario analysis and stress-testing).

Question 36

State Amaranth Advisors, LLC’s main trading strategy shortly before its demise, and explain how the trade work against them.

Answer 36

Amaranth’s main trading strategy was long (0.5pts) winter (0.5pts) delivery natural gas (0.5pts) contracts and short (0.5pts) non-winter (0.5pts) contracts.
1pt: The strategy failed when the spread between the winter and non-winter natural gas contracts tightened.

Question 37

Name a few incidents of how funds fail

Answer 37

1. Over-leverage
2. Danger of overconfidence in trading (e.g., with convergence trades)
3. Unpredictability of all risks (particularly in highly quantitative financial systems)
4. Importance of due diligence

Question 38

In CAPM model, what are the representations of “Intercept A” and “Slope B”

Answer 38

Intercept A: statistically equal to zero
Slope B: shout not be statistically unequal to asset’s true beta

Question 39

An investment has an omega ratio of 0.84 and an annual target return of 2.8%. Interpret this measure in terms of the investment’s performance.

Answer 39

An omega ratio less than one indicates that the investment did not earn a summed return greater than the target level; i.e., in this case, the investment’s summed return was less than 2.8%.

Question 40

Difference between different types of Alpha
- manufactured
- transitional
- inaccesible

Answer 40

manufactured: repeatable prcocess oriented

transitional: short term changes and market inefficiencies that prevent some LT investors from holding

inaccessible: like transitional but quasi permananet, represents yield