CFA III SS 14 Risk Management

  1. Centralized vs decentralized risk system
    • centralized: identifies, quantifies, reports and monitors firm-wide risks; preferred 
    • decentralized: each unit manages own risk, does not consider correlations
  2. Six Financial Risks
    • interest rate
    • exchange rate
    • equity prices
    • commodity prices
    • credit
    • liquidity

    first four are market risks
  3. Eight non-financial risks
    • operational
    • model
    • settlement
    • regulatory
    • legal/contract
    • tax
    • accounting
    • sovereign
  4. VAR
    • estimate of loss at a specified probability over a specified time
    • ex. 5% VAR: E(r) - 1.645*stnd dev = VAR (amount below 0)
    • ignore E(r) for 1 day VAR
    • 1% is 2.33
  5. Three VAR methods
    • 1. Analytical: variance and covariance; easy to apply; relies on normality (which is probably not true)
    • 2. Historical: uses actual historic returns; ex if have 100 returns, take the 5th lowest and thats the 95% VAR
    • 3. Monte Carlo: same as historic, but use simulation to determine set of returns
  6. Three ways to stress models
    • factor push: push factors in direction that will hurt the firm
    • maximum loss optimization: optimize mathematically to find the risk variables that will cause the maximum loss
    • worst case scenario: guess at what the worst case would be
  7. Current vs potential credit risk
    • current: payment is currently due
    • potential: payment may be due or is due in the future
  8. Calculate option credit risk
    • trading price of option * number of shares (usually number of contracts*100)
    • not dependent on amount in the money
  9. Three measures of performance evaluation
    • 1. Sharpe
    • 2. RAROC
    • 3. ROMAD
    • 4. Sortino
    • 1. Image Upload 1
    • 2. Image Upload 2 - VAR can be any capital at risk measure
    • 3. Image Upload 3 where maximum drawdown = max return - min return
    • 4. Image Upload 4 where MAR = minimum acceptable return (never less than Rf) and downside deviation is deviation of negative returns
  10. Calculate return and standard deviation to domestic investor
    • Return = Rdc = (1+Rfc)(1+Rfx) - 1
    • Rfc = return of asset in foreign currency
    • Rfx = relative change in foreign currency value

    Var(Rdc) = Var(Rfc) + Var(Rfx) + 2*std(Rfc)*std(Rfx)*corr(Rfc,Rfx)

    If asset is risk free, std(Rdc) = std(Rfx)(1+Rfc)
  11. Four types of currency management
    • passive: match benchmark's exposure
    • discretionary: small deviations, but primary goal is still risk reduction
    • active: try to earn alpha on currency 
    • overlay: separate currency exposure management from asset management
  12. Deviations from benchmark currency determined using
    • 1. economic fundamentals
    • 2. technical rules
    • 3. carry trade
    • 4. volatility trading
    • 1. assume purchasing power parity holds in long-run and short run deviations can be exploited. Increase in relative currency value associated with low value relative to long-term, low inflation, higher real rates, decreasing currency risk premium
    • 2. assumes past prices predict future prices; not trusted by CFAI
    • 3. borrow at low interest rate and lend at high interest rate; assumes currency lent in will not depreciate as dictated by IRP; usually works, but very bad when goes wrong
    • 4. if volatility will be high, buy put and call; if low, sell put and call. ATM called straddle, OTM called strangle
  13. Calculate roll yield
    • (Ft - Fo) - (St - So)
    • Since Ft = St at expiration, roll yield at expiration = (So - Fo)/So
  14. Currency cross hedge
    hedge currency exposure with another, highly correlated currency
  15. Currency macro hedge
    • ex. portfolio is long multiple currencies, hedge with basket instead of each one individually
    • cheaper, but less perfect hedge
  16. Minimum variance hedge ratios
    • MVHR uses regression to determine hedge ratio that will minimize risk
    • regress asset returns against currency returns, and multiple the slope coefficient and amount invested to determine amount of currency hedge to obtain
  17. Nondeliverable Forward
    Forward contract in an illiquid currency, so calculate gain/loss and settle in another currency
Card Set
CFA III SS 14 Risk Management
CFA Level 3 Cards shared by Max Kelly