Topics 1-3

Question 1

Risk management process (key steps_)_

Answer 1

The risk management process involves the following five steps:

• Step 1: Identify the risks.
• Step 2 : Quantify and estimate the risk exposures or determine appropriate methods to transfer the risks.
• Step 3 : Determine the collective effects of the risk exposures or perform a cost-benefit analysis on risk transfer methods.
• Step 4: Develop a risk mitigation strategy (i.e., avoid, transfer, mitigate, or assume risk).
• Step 5: Assess performance and amend risk mitigation strategy as needed.

Question 2

In what circumstances is VaR an appropriate measure of risk?

Answer 2

VaR is a useful measure for liquid positions operating under normal market circumstances over a short period of time.

It is less useful and potentially dangerous when attempting to measure risk in non-normal circumstances, in illiquid positions, and over a long period of time.

Question 3

Economic capital, definition

Answer 3

Economic capital refers to holding sufficient liquid reserves to cover a potential loss.

Question 4

What is the correlation risk?

Answer 4

Correlation risk happens when unfavorable events happen together.

The correlation risk drives up the potential losses to unexpected levels.

Question 5

Influence of risk tolerance on relationship between risk and return?

Answer 5

When risk tolerances are high, the spread between riskless and risky bonds may narrow to an abnormally low level, which again disguises the true relationship between risk and return.

Question 6

Market risk and its subtypes

Answer 6

Market risk considers how changes in market prices and rates will result in investment losses.

There are four subtypes of market risk:

• (1) interest rate risk
• (2) equity price risk
• (3) foreign exchange risk, and
• (4) commodity price risk.

Question 7

Basis risk, definition

Answer 7

Basis risk - the presumed correlation between the price of a bond and
the price of the hedging vehicle used to hedge that bond has changed unfavorably.

Question 8

Equity price risk

Answer 8

Equity price risk refers to the volatility of stock prices. It can be broken up into two parts:

• (1) general market risk, which is the sensitivity of the price of a stock to changes in broad market indices, and
• (2) specific risk, which is the sensitivity of the price of a stock due to unique factors of the entity (e.g., line of business, strategic weaknesses).

Question 9

Subtypes of credit risk, Bankruptcy risk

Answer 9

There are four subtypes of credit risk:

• (1) default risk
• (2) bankruptcy risk
• (3) downgrade risk, and
• (4) settlement risk.

Bankruptcy risk involves taking possession of any collateral provided by the defaulting counterparty. The risk is that the liquidation value of the collateral is insufficient to recover the full loss on default.

Question 10

Liquidity risk and its subtypes

Answer 10

Liquidity risk is subdivided into two parts:

• (1) funding liquidity risk and
• (2) trading liquidity risk.

Funding liquidity risk occurs when an entity is unable to pay down or refinance its debt, satisfy any cash obligations to counterparties, or fund any capital withdrawals.

Trading liquidity risk occurs when an entity is unable to buy or sell a security at the market price due to a temporary inability to find a counterparty to transact on the other side of the trade.

Question 11

Operational risk, definition

Answer 11

Operational risk considers a wide range of “non-financial” problems such as inadequate computer systems (technology risk), insufficient internal controls, incompetent management, fraud (e.g., losses due to intentional falsification of information), human error (e.g., losses due to incorrect data entry or accidental deletion of a file), and natural disasters.

Question 12

Business risk. definition

Answer 12

Business risk revolves around uncertainty regarding the entity’s income statement, although, in practice, there is a substantial amount of integration with strategic and reputation risk.

Question 13

Strategic risk

Answer 13

Strategic risk can be thought of in the context of large new business investments, which carry a high degree of uncertainty as to ultimate success and profitability.

Question 14

Reputation risk

Answer 14

Reputation risk consists of two parts:

• (1) the general perceived trustworthiness of an entity (i.e., that the entity is able and willing to meet its obligations to its creditors and counterparties) and
• (2) the general perception that the entity engages in fair dealing and conducts business in an ethical manner.

Question 15

Evaluate some advantages and disadvantages of hedging risk exposures

Answer 15

There are some theoretical reasons for a firm not to hedge risk exposures but most of those reasons make the unrealistic assumption of perfect capital markets, which is not realistic. Also, they ignore the existence of the significant costs of financial distress and bankruptcy.

However, in practice, there are some valid reasons not to hedge, including the distraction from focusing on the core business, lack of skills and knowledge, and transaction and compliance costs.

Many reasons exist for a firm to hedge its risk exposures. Key reasons include:

• lowering the cost of capital
• reducing volatility of reported earnings
• operational improvements, and
• potential cost savings over traditional insurance products.

Question 16

Explain considerations and procedures in determining a firm’s risk appetite and its business objectives

Answer 16

The board, together with management, should set the firms risk appetite using one or more of the following tools:

• qualitative statements of risk tolerance,
• value at risk, and
• stress testing.

A firm must know its risk and return goals before embarking on a risk management plan. These goals must be clear and actionable.

Question 17

Explain how a company can determine whether to hedge specific risk factors, including the role of the board of directors and the process of mapping risks

Answer 17

In hedging specific risk factors, it is necessary to consider the role of the board of directors as well as the process of mapping. There should be clarification whether accounting or economic profits are to be hedged. Likewise, there should be clarification whether short-term or long-term accounting profits are to be hedged. Other points the board should consider include the time horizon and the possibility of implementing definitive and quantitative risk limits.

Mapping risks requires clarification as to which risks are insurable, hedgeable, noninsurable, or nonhedgeable.

Mapping risks could be performed for various risks such as market, credit, business, and operational. Essentially it involves a detailed analysis of the impacts of such risks on the firm’s financial position (balance sheet) and financial performance (income statement).

Question 18

Apply appropriate methods to hedge operational and financial risks,
including pricing, foreign currency, and interest rate risk

Answer 18

Hedging operational risks tend to cover a firm’s income statement activities while hedging financial risks tend to cover the balance sheet.

Pricing risk could be thought of as a type of operational risk, requiring the hedging of revenues and costs.

Foreign currency risk refers to the risk of economic loss due to unfavorable changes in the foreign currency exchange rate; to the extent that there is production and sales activity in the foreign currency pricing risk would exist simultaneously.

Interest rate risk refers to the risk inherent in a firm’s net exposure to unfavorable interest rate fluctuations.

Hedging strategies could be categorized as either static or dynamic, with dynamic
strategies being more complex and requiring additional monitoring and ransaction costs.

Additionally, factors such as time horizon, accounting, and taxation need to be considered within any hedging strategy.

Question 19

Assess the impact of risk management instruments

Answer 19

Once the risks are mapped, management and the board need to determine which instruments to use to manage the risks. The relevant instruments can be classified as exchange traded or over the counter (OTC).

Exchange-traded instruments are generally quite standardized and liquid.

OTC instruments are more customized to the firm’s needs and therefore less liquid. An element of credit risk is also introduced with OTC instruments.

Question 20

Examples of hedging economic and accounting profits

Answer 20

For example, a domestic firm may have an overseas subsidiary with assets that are financed by loans (for the exact same dollar value) in the same currency. This represents a hedging of economic profits.

However, if that subsidiary is not considered self-sustaining and is integrated with the domestic firm, then the loan is maintained in the foreign currency but the assets must be translated to the domestic currency, thereby creating foreign exchange risk for the accounting profits. So if the foreign currency appreciates relative to the domestic currency, upon translation to the domestic currency, there will be a translation loss for accounting purposes. Of course, the accounting profits could be hedged by purchasing a forward contract on the foreign currency; however, that will create economic risk.

The bottom line is that it is not possible to hedge both accounting and economic risk at the same time, so a choice between the two must be made.

Question 21

Risk Advisory Director

Answer 21

A risk advisory director would be a board member who is a risk specialist who attends risk committee and audit committee meetings and provides advice to increase effectiveness.

The risk advisory director also meets with senior management on a regular basis and could be viewed as a liaison between the board and management.

Overall, the role would involve educating members on best practices in both corporate governance and risk management.

Question 22

Compare and contrast best practices in corporate governance with those of
risk management

Answer 22

There are numerous best practices in corporate governance, including:

• Board is comprised of a majority of independent members with basic knowledge of the firm’s business and industry.
• Board watches out for the interests of all stakeholders, including shareholders and debtholders who may have somewhat differing interests.
• Board is aware of any agency risks and takes steps to reduce them (e.g., compensation committee).
• Board maintains its independence from management (e.g., CEO is not the chairman of the board).
• Board should consider the introduction of a chief risk officer.

There are numerous best practices in risk management, including:

• Board should focus on the firm’s economic performance over accounting performance.
• Board should promote a robust risk management process within the firm (e.g., upward mobility for risk management careers).
• Board should set up an ethics committee to uphold high ethical standards within the firm.
• Board should ensure that compensation is based on risk-adjusted performance.
• Board should approve all major transactions.
• Board should always apply professional skepticism to ask probing and relevant questions to management.
• Board should have a risk committee in place.

Question 23

Assess the role and responsibilities of the board of directors in risk
governance

Answer 23

The role of the board of directors in governance would include the review and analysis of:

• The firm’s risk management policies.
• The firm’s periodic risk management reports.
• The firm’s appetite and its impact on business strategy
• The firm’s internal controls.
• The firm’s financial statements and disclosures.
• The firm’s related parties and related party transactions.
• Any audit reports from internal or external audits.
• Corporate governance best practices for the industry
• Risk management practices of competitors and the industry.

Question 24

Evaluate the relationship between a firm’s risk appetite and its business
strategy, including the role o f incentives

Answer 24

A firm’s risk appetite reflects its tolerance (especially willingness) to accept risk. There is subsequent implementation of the risk appetite into defining the firm’s risk limits. Ultimately there must be a logical relationship between the firm’s risk appetite and its business strategy.

Question 25

Assess the role and responsibilities of a firms audit committee

Answer 25

The audit committee is responsible for the reasonable accuracy of the firm’s financial statements and its regulatory reporting requirements. It must ensure that the firm has taken all steps to avoid the risk that the financial statements are materially misstated as a result of undiscovered errors and/or fraud. In addition to the more visible verification duties, the audit committee monitors the underlying systems in place regarding financial reporting, regulatory compliance, internal controls, and risk management.

Question 26

Distinguish the different mechanisms for transmitting risk governance throughout an organization

Answer 26

Two mechanisms for transmitting risk governance throughout a firm are the audit committee of the board and the use of a risk advisory director.

Additionally, the role of the risk management committee and the compensation committee further transmit risk governance.

Question 27

Illustrate the interdependence of functional units within a firm as it relates to risk management

Answer 27

The various functional units within a firm are dependent on one another when it comes to risk management and reporting. Using an investment bank as an example, areas such as valuations, the profit and loss statement, and risk policy require input from more than one of the following units:

• senior management,
• risk management,
• trading room management,
• operations, and
• finance.