# CFA III SS 14 Risk Management

 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 Six Financial Risks interest rateexchange rateequity pricescommodity pricescreditliquidity first four are market risks Eight non-financial risks operationalmodelsettlementregulatorylegal/contracttaxaccountingsovereign VAR estimate of loss at a specified probability over a specified timeex. 5% VAR: E(r) - 1.645*stnd dev = VAR (amount below 0)ignore E(r) for 1 day VAR1% is 2.33 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% VAR3. Monte Carlo: same as historic, but use simulation to determine set of returns Three ways to stress models factor push: push factors in direction that will hurt the firmmaximum loss optimization: optimize mathematically to find the risk variables that will cause the maximum lossworst case scenario: guess at what the worst case would be Current vs potential credit risk current: payment is currently duepotential: payment may be due or is due in the future Calculate option credit risk trading price of option * number of shares (usually number of contracts*100)not dependent on amount in the money Three measures of performance evaluation 1. Sharpe2. RAROC3. ROMAD4. Sortino1. 2. - VAR can be any capital at risk measure3. where maximum drawdown = max return - min return4. where MAR = minimum acceptable return (never less than Rf) and downside deviation is deviation of negative returns Calculate return and standard deviation to domestic investor Return = Rdc = (1+Rfc)(1+Rfx) - 1Rfc = return of asset in foreign currencyRfx = 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) Four types of currency management passive: match benchmark's exposurediscretionary: small deviations, but primary goal is still risk reductionactive: try to earn alpha on currency overlay: separate currency exposure management from asset management Deviations from benchmark currency determined using 1. economic fundamentals2. technical rules3. carry trade4. volatility trading1. 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 premium2. assumes past prices predict future prices; not trusted by CFAI3. 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 wrong4. if volatility will be high, buy put and call; if low, sell put and call. ATM called straddle, OTM called strangle Calculate roll yield (Ft - Fo) - (St - So)Since Ft = St at expiration, roll yield at expiration = (So - Fo)/So Currency cross hedge hedge currency exposure with another, highly correlated currency Currency macro hedge ex. portfolio is long multiple currencies, hedge with basket instead of each one individuallycheaper, but less perfect hedge Minimum variance hedge ratios MVHR uses regression to determine hedge ratio that will minimize riskregress asset returns against currency returns, and multiple the slope coefficient and amount invested to determine amount of currency hedge to obtain Nondeliverable Forward Forward contract in an illiquid currency, so calculate gain/loss and settle in another currency AuthorblackarbsCEO ID316480 Card SetCFA III SS 14 Risk Management DescriptionCFA Updated2016-02-25T02:10:36Z Show Answers