Cfa Level Iii - Study Session 14

Front 1

Risk Management
Risk Governance

(SS14)

Back 1

1. Risk management is a process, not a one off, evaluation, revision, evaluation revision.
2. Risk Management - centralised
i. controls all companies risk taking activities
ii. Permits economies of scale
iii. Recognises offsetting nature of distinct exposures. (and sees ways to reduce the need for some hedging)
iv. Can see potential for diversification benefits
v. Overall picture is what counts
Decentralised
i. People closer to actually taking the risk more directly manage it.

Front 2

Risk Management
Types of Risks - Financial

(SS14)

Back 2

Risks coming from the financial market
1. Market risk
i. Interest rates
ii. Exchange rates - selling worldwide
iii. Equity prices - if you're trying to have an IPO
iv. Commodity prices - raw materials
2. Credit Risk - customers purchasing on credit, the loss from promised payments that never happen.
3. Liquidity Risk - can't buy/sell an asset when you need to. A lot of firms hedge, so it comes in there

Front 3

Risk Management
Types of Risks - Non-Financial

(SS14)

Back 3

Risks not coming from the external financial market
1. Operations (weather, internal systems, rogue)
2. Model (derivatives vol., model is misapplied)
3. Settlement (one side might be paying counterparty while the counterparty is declaring bankruptcy)
Netting arrangements can reduce settlement risk
4. Regulations - e.g. US highly regulated financial institutions
5. Legal - contract law that isn't enforced
6. Taxes - exempt may turn taxable.
7. Accounting
8. Political (country may want to stop trading with you, sovereign risk is a type of credit risk where the creditor is the foreign government)
9. ESG - Environmental, Social and Governance
Settlement netting risk is where profitable transactions are realised for the benefit of creditors.

Front 4

Risk Management
Measuring Market Risk

(SS14)

Back 4

Primary sources of risk
i. Beta - market movements linear measure
ii. Durations - for bonds, measures a small parallel shift in the yield curve (linear measure)
iii. Delta - for options, the sensitivity to a small change in the value of the underlying.
Second order risk
i. Convexity - for bonds
ii. Gamma - for options

Front 5

Risk Management
Value at Risk - VAR

(SS14)

Back 5

VAR is a probability-based measure of loss potential for a company.
i. Measures MINimum loss with a given level of PROBability over a specified time period.
1. Expressed as a PERCENTAGE
2. You can then do DOLLAR VAR
3. Actual loss may be MUCH more than VAR estimates, but the VAR model may still be accurate.
4. Can only compare VAR across the same time intervals
NOT monthly to daily comparison of VAR.
5. Potential losses over longer periods should be larger than those over shorter periods. Not linear increase though.....

Front 6

Risk Management
Value at Risk - VAR
Three types of doing VAR

(SS14)

Back 6

1. Analytical or Var-covar Method
i. Assumes normal distribution
ii. expected return and standard deviation
iii. 5% = 1.65 s.d
1% = 2.33 s.d
iv. Annual to daily var return = /250 days
Annual to daily var s.d = /√250
2. Historical Method
Use actual daily values from the past to estimate the future
3. Monte Carlo
Run 1000s of simulations with different estimates for each risk factor
4. "Surplus at Risk" - for pension fund portfolios where they apply VAR to the surplus.

Front 7

Risk Management
Disadvantages/ Advantages
Analytical variance-covariance VAR

(SS14)

Back 7

Var-Covar: Advantage
i. Simple to calc for small numbers of assets
Disadvantage
i. Assumes normal
ii. Calculations with 100s of assets has 1000s of covar is massive
iii. Underestimates fat-tails which means VAR fails at EXACTLY what it is meant to do
iv. Bad for options because options have unlimited upside (limited downside) normal distribution think unlimited upside and downside.

Can't simply convert daily VARs to monthly VARs if there is a trend. To convert the average return has to be zero.

Front 8

Risk Management
Disadvantages/ Advantages
Historical VAR

(SS14)

Back 8

Uses actual daily prices from a user-specified period in the recent past.
Historical: Advantages
i. Not confined by normal distribution (it's non-parametric)
ii. Can give more recent past a greater weight in your VAR analysis
Historical: Disadvantage
i. Distributions from the past may not repeat in the future
ii. Bonds and derivatives behave differently at different times in their lives

Front 9

Risk Management
Disadvantages/ Advantages
Monte Carlo VAR Method

(SS14)

Back 9

Monte Carlo: Advantages
i. Doesn't require normal distribution
ii. Good for portfolios with derivatives and options
iii. Quantifies the loss
iv. Easy to understand by management
Monte Carlo: Disadvantages
i. Difficult to estimate
ii. Underestimates the frequency and magnitude of large negative returns
iii. Difficult to estimate for large banks, but they do it anyway.

Front 10

Risk Management
VAR is useless because

(SS14)

Back 10

VAR is useless
1. Underestimates the magnitude of the worst returns
2. Underestimates the frequency of bad returns
3. VAR for individual doesn't aggregate to a portfolio VAR

Front 11

Risk Management
Supplements to VAR

(SS14)

Back 11

1. Incremental VAR
2. CFAR - Cash Flow at Risk
3. EAR - Earnings at Risk
4. TVAR - Tail value at risk. Tail takes the average of the 5 worst outcomes in the tail.

Front 12

Risk Management
Stress Testing

(SS14)

Back 12

Stress Testing
VAR estimates NORMAL losses, while stress testing looks for unusual circumstances that could lead to losses in excess of those typically expected.
1. Scenario Analysis - different states of the world where you deliberately move key variables
i. parallel shift 100bps
ii. yield curve twist +- 25 bps
iii. equity index change +-10%
iv. currencies moving +- 6%
v. Use actual extreme values from the past
Scenario analysis is a great addition to VAR. It makes you look at worst case scenarios deliberately.
2. Stressing Models
i. Factor Push - to the most disadvantageous value possible
ii. Maximum loss optimization
iii. Worst-case scenario analysis

Front 13

Risk Management
Who has the credit risk on options and forwards?

(SS14)

Back 13

Forward Contracts (Bilateral credit risk)
i. so no credit risk at start, no credit risk during because no payments are due.
ii. No cash due until the end, so ONLY credit risk at the end
iii. Who ever is in the positive is the party that bears the credit risk that the other side won't pay up.

Swaps
i. Credit risk whenever there is a payment, so there is risk at points along the life of a swap.
ii. If no payment is due, there is only POTENTIAL credit risk.
iii. Interest rate swaps potential credit risk is in the MIDDLE because there are fewer payments left at the end of the swap.
iv. Equity swaps credit risk is biggest in the MIDDLE
v. Currency swaps greatest potential credit risk is at the end because the principal is exchanged
and the notional is larger relative to the payments.

Options (Unilateral credit risk)
i. European options have a potential credit risk throughout
ii. American options have an ACTUAL current credit risk throughout the time if the other side decides to exercise them
iii. Buyer of the option pays premium at the start and doesn't owe anything else.

Front 14

Risk Management
Managing Credit Risk

(SS14)

Back 14

Best way to manage credit risk:
1. Reducing credit risk by limiting exposure to the one counterparty
2. By marking-to-market and settling up to that point in time. Only works for bilateral credit risk contracts like swaps.
3. Reducing credit risk with collateral
4. Reduce credit risk with netting - payment netting. Associate this with bankruptcy process, it reduces cherry-picking where bankrupt company only enforces contracts that are profitable and walks away from unprofitable.
5. Transfer the credit risk with derivatives - credit default swaps if a credit event happens.

NB: You don't ALWAYS want to back away from credit risk, sometimes you may want to assume it to diversify other risks in your portfolio.

Front 15

Risk Management
Performance Evaluation for Risk

(SS14)

Back 15

Risk adjusted performance
1. Sharpe Ratio
2. Risk-Adjusted Return on Capital (RAROC) - designed to be used against a benchmark. e.g. A firms RAROC must exceed a benchmark RAROC before capital is allocated to it.
3. RoMAD Return over Maximum Drawdown - is the average return a pf gets as a percentage of the drawdown figure. i.e. Can I accept an occasional drawdown of X% in order to generate an average return of Y % 10/15 X/Y = RoMAD = 1.5
drawdown
--------------
return
4. Sortino Ration - Downside deviation.
It tries to take out the good volatility because big positive returns are good.
3.

Front 16

Risk Management
Capital Allocation

(SS14)

Back 16

1. Notional or Monetary position limits
2. VAR-based position limits
3. Maximum loss limits
4. Internal Capital Requirements
5. Regulatory Capital Requirements

Front 17

Currency Risk Management
Hedged portfolio example

(SS14)

Back 17

You are French and own a portfolio of U.S stocks worth $1m. Current spot and forward 1 euro per $. You are worried about a depreciation of the dollar and you sell forward $1m to hedge currency risk. A week later your pf has gone up to $1.02m and the spot and forward ER are now (euro 0.95 per $)
1. Pf went up 2% but the dollar lost 5% relative to euro. If the portfolio HADN'T been hedged its return in euros would have been:
1,020,000 x 0.95 - 1,000,000 x 1
---------------------------------
1,000,000 x 1

Your profit on the hedge portfolio in euros is
Profit = 1,020,000 x 0.95 - 1,000,000 x 1 - 1,000,000 x (0.95 - 1) = 19,000
The rate of return on the hedged pf in euros is equal to
19,000
------------- = 1.9%
1,000,000
which is very clost to the 2% pf rate of return in dollars.

Front 18

Currency Risk Management
Minimum Variance Hdge Ratio

(SS14)

Back 18

1. There is an 'optimal' hedge (0 < 1) that will reduce your variability of the hedged pf returns.
2. If your hedge ratio is 1, you are selling forward 1m pounds if you have a pf of 1m pounds.
3. cov(R,Rf) cov pf return with return on futures
-------------------
s.df (s.d futures)
4. Min var hedge ratio is
= translation risk + economic risk
A perfect currency hedge nullifies the currency exchange movement.
5. Economic risk is where the foreign currency value of a foreign investment reacts systematically to an exchange rate movement.

Front 19

Currency Risk Management
Influence of Basis

(SS14)

Back 19

1. Changes in the basis can affect hedging strategies, creating basis risk
2. Futures and spot exchange rates differ by a basis.
3. Forward discount/ premium (% different between spot and futures) is the interest rate differential
BASIS = INTEREST RATE DIFFERENTIAL
Interest rate parity ties in here.
Anything over 6 months implies there is basis risk.
You can take out the currency risk by hedging, but not the basis risk (fortunately the basis risk is quite small)

Front 20

Currency Risk Management
Implementing Hedging Strategies

(SS14)

Back 20

For long-term hedges a manager can choose from three basic contract terms
1. Short term contracts, which must be rolled until maturity
2. Contracts with matching maturity to the period you want to hedge for
3. Long-term contracts cut short to your desired hedge time period. These have a maturity extending beyond the hedging period.

All of these avoid actual physical delivery of a currency.
It is difficult to keep rebalancing your hedge because of the transaction costs involved.

Front 21

Currency Risk Management
hedging Multiple Currencies

(SS14)

Back 21

Cross-hedges are sometimes used for closely linked currencies.
1. Some fear the depreciation of only a couple of currencies
2. Hedge a few key currencies and that means that you don't have to hedge all 25 currencies in your portfolio which is time consuming and expensive.