Accounting Books Pdf: 2016 FRM Part1 Schweser Notes Book

2016 FRM Part1 Schweser Notes Book

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F PART I BooK 1:

FOUNDATIONS OF RISK MANAGEMENT

WELCOME TO THE 2016 SCHWESERNOTES v

READING ASSIGNMENTS AND LEARNING OBJECTIVES

FOUNDATIONS OF RISK MANAGEMENT

• • • Vlll

1: Risk Management: A Helicopter View

2: Corporate Risk Management: A Primer

3: Corporate Governance and Risk Management

4: What is ERM?

5: Risk-Taking and Risk Management by Banks

6: Financial Disasters

7: The Credit Crisis of 2007

8: Risk Management Failures: What Are They and When Do They Happen? 87

Delineating Efficient Portfolios

9: The Standard Capital Asset Pricing Model

1 10

10: Applying the CAPM to Performance Measurement: Single-Index Performance

Measurement Indicators 125

1 1: Arbitrage Pricing Theory and Multifactor Models of Risk and Return 135

12: Information Risk and Data Quality Management

13: Principles for Effective Data Aggregation and Risk Reporting

14: GARP Code of Conduct

SELF-TEST: FOUNDATIONS OF RISK MANAGEMENT

149

157

169

I76

FORMULAS I8I

INDEX

Page iv

FRM 2016 PART I BOOK 1: FOUNDATIONS OF RISK MANAGEMENT

Printed in the United States of America.

ISBN: 978-1-4754-3803-1

PPN: 3200-721 1

Required Disclaimer: GARP® does not endorse, promote, review, or warrant the accuracy of the products or

services offered by Kaplan Schweser of FRM® related information, nor does it endorse any pass rates claimed

by the provider. Further, GARP® is not responsible for any fees or costs paid by the user to Kaplan Schweser,

nor is GARP® responsible for any fees or costs of any person or entity providing any services to Kaplan

Schweser. FRM®, GARP®, and Global Association of Risk Professionals TM are trademarks owned by the

Global Association of Risk Professionals, Inc.

These materials may not be copied without written permission from the author. The unauthorized duplication

of these notes is a violation of global copyright laws. Your assistance in pursuing potential violators of this law is

greatly appreciated.

Disclaimer: The SchweserNotes should be used in conjunction with the original readings as set forth by

GARP®. The information contained in these books is based on the original readings and is believed to be

accurate. However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam

success.

WELCOME To THE 2016 ScHWESERN OTES

Thank you for trusting Kaplan Schweser to help you reach your goals. We are very pleased

to be able to help you prepare for the Part I FRM exam. In this introduction, I want to

explain the resources included with the SchweserNotes, suggest how you can best use

Schweser materials to prepare for the exam, and direct you toward other educational

resources you will find helpful as you study for the exam.

Besides the SchweserNotes themselves, there are many educational resources available at

Schweser.com. Just log in using the individual username and password that you received

when you purchased the SchweserNotes.

SchweserNotes TM

The SchweserNotes TM consist of four volumes that include complete coverage of all FRM

assigned topics and learning objectives, Concept Checkers (multiple-choice questions

for every topic), and Self-Test questions to help you master the material and check your

retention of key concepts.

Online Practice Questions

To retain what you learn, it is important that you quiz yourself often. We offer an online

version of the SchweserPro TM QBank, which contains hundreds of Part I practice questions

and explanations. Quizzes are available for each topic or across multiple topics. Build your

own exams by specifying the topics and the number of questions.

Practice Exams

Schweser offers two fu.114-hour practice exams. These exams are important tools for gaining

the speed and skills you will need to pass the exam. The Practice Exams book contains

answers with full explanations for self-grading and evaluation.

Schweser Study Calendar

Use your Online Access to tell us when you will start and what days of the week you can

study. The online Schweser Study Calendar will create a study plan just for you, breaking

the curriculum into daily and weekly tasks to keep you on track and help you monitor your

study progress.

Book 1

Welcome to the 2016 SchweserNotes

Page vi

The Part I FRM exam is a formidable challenge (covering 66 assigned readings and 400+

learning objectives), and you must devote considerable time and effort to be properly

prepared. There are no shortcuts! You must learn the material, know the terminology and

techniques, understand the concepts, and be able to answer 100 multiple choice questions

quickly and (at least 70o/o) correctly. 250 hours is a good estimate of the study time required

on average, but some candidates will need more or less time, depending on their individual

backgrounds and experience.

To help you really master this material and be well prepared for the FRM exam, we offer

several other educational resources, including:

Online Weekly Class

Our Online Weekly Class is offered each week, beginning in February for the May exam

and August for the November exam. This online class brings the personal attention of a

classroom into your home or office with 30 hours of real-time instruction, led by either

Dr. John Paul Broussard, CFA, FRM or Dr. Greg Filbeck, CFA, FRM, CAIA. The class

offers in-depth coverage of difficult concepts, instant feedback during lecture and Q&A

sessions, and discussion of sample exam questions. Archived classes are available for viewing

at any time throughout the season. Candidates enrolled in the Online Weekly Class also

have full access to supplemental on-demand video instruction in the Candidate Resource

Library and an e-mail address link to use to send questions to the instructor at any time.

Late-Season Review

Late-season review and exam practice can make all the difference. Our Review Package

helps you evaluate your exam readiness with products specifically designed for late-season

studying. This Review Package includes: the Online Review Workshop (8-hour live and

archived online review of essential curriculum topics), the Schweser Mock Exam (one

4-hour exam), and Schweser's Secret Sauce (concise summary of the FRM curriculum).

Book 1

Welcome to the 2016 SchweserNotes

Part I Exam Weights

In preparing for the exam, you must pay attention to the weights assigned to each

knowledge domain within the curriculum. The Part I exam weights are as follows:

Book Knowledge Domains Exam Weight Exam Questions

1 Foundations of Risk Management 20% 20

2 Quantitative Analysis 20% 20

3 Financial Markets and Products 30% 30

4 Valuation and Risk Models 30% 30

How to Succeed

There are no shortcuts to studying for this exam. Expect GARP to test you in a way that

will reveal how well you know the Part I curriculum. You should begin studying early and

stick to your study plan. You should first read the SchweserNotes and complete the Concept

Checkers for each topic. At the end of each book, you should answer the provided Self-Test

questions to understand how concepts have been tested in the past. You should finish the

overall curriculum at least two weeks before the FRM exam. This will allow sufficient time

for Practice Exams and further review of those topics you have not yet mastered.

I would like to take this opportunity to thank the content developers, editors, and graphic

designers who worked countless hours to create the 20 1 6 FRM SchweserNotes. I would

especially like to thank Adam Stueber, CAIA; Derek Burkett, CFA, FRM, CAIA; Tim

Greive, CFA; Craig Prochaska, CFA; Kent Westlund, CFA; Kurt Schuldes, CFA, CAIA;

Laura Goetzinger; Katherine Bourgeois; Chris Zobin; Alyssa Brunner; Julie Porter; Allie

Bottcher; Becca Dargatz; Alissa Knop; David Griswold; Genevieve Kretschmer; Lindsey

Casto; and Jared Heintz for their contributions.

Best regards,

Eric Smith, CFA, FRM

FRM Product Manager

Kaplan Schweser

Page viii

READING ASSIGNMENTS AND

LEARNING OBJECTIVES

The following material is a review of the Foundations of Risk Management principles designed to

address the learning objectives set forth by the Global Association of Risk Professionals.

READING ASSIGNMENTS

Michel Crouhy, Dan Galai, and Robert Mark, The Essentials of Risk Management, 2nd

Edition (New York: McGraw-Hill, 2014).

1 . "Risk Management: A Helicopter View," Chapter 1

2. "Corporate Risk Management: A Primer," Chapter 2

3. "Corporate Governance and Risk Management," Chapter 4

(page 1)

(page 15)

(page 27)

James Lam, Enterprise Risk Management: From Incentives to Controls, 2nd Edition

(Hoboken, NJ: John Wiley & Sons, 2014).

4. "What is ERM?," Chapter 4

5. Rene Stulz, "Risk-Taking and Risk Management by Banks," Journal of Applied

(page 37)

Corporate Finance 27, No. 1 (2015): 8-18. (page 47)

Steve Allen, Financial Risk Management: A Practitioner's Guide to Managi,ng Market and

Credit Risk, 2nd Edition (New York: John Wiley & Sons, 2013).

6. "Financial Disasters," Chapter 4 (page 59)

John Hull, Risk Management and Financial Institutions, 4th Edition (Hoboken: John

Wiley & Sons, 2015)

7. "The Credit Crisis of 2007," Chapter 6 (page 76)

8. Rene Stulz, "Risk Management Failures: What are They and When Do They Happen?"

Fisher College of Business Working Paper Series, October 2008. (page 87)

Edwin J. Elton, Martin J. Gruber, Stephen J. Brown and William N. Goetzmann,

Modern Portfolio Theory and Investment Analysis, 9th Edition (Hoboken, NJ: John Wiley

& Sons, 2014).

9. "The Standard Capital Asset Pricing Model," Chapter 1 3 (page 1 1 0)

Noel Amenc and Veronique Le Sourd, Portfolio Theory and Performance Analysis

(West Sussex, England: John Wiley & Sons, 2003).

Book 1

Reading Assignments and Learning Objectives

10. ''Applying the CAPM to Performance Measurement: Single-Index Performance

Measurement Indicators," Chapter 4, Section 4.2 only (page 125)

Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments, 10th Edition (New York:

McGraw-Hill, 2013).

1 1 . ''Arbitrage Pricing Theory and Multifactor Models of Risk and Return,"

Chapter 10 (page 135)

Anthony Tarantino and Deborah Cernauskas, Risk Management in Finance: Six Sigma

and Other Next Generation Techniques (Hoboken, NJ: John Wiley & Sons, 2009).

12. "Information Risk and Data Quality Management," Chapter 3 (page 149)

13. "Principles for Effective Data Aggregation and Risk Reporting," (Basel Committee on

Banking Supervision Publication, January 2013). (page 157)

14. GARP Code of Conduct. (page 169)

Book 1

Reading Assignments and Learning Objectives

Page x

LEARNING OBJECTIVES

1. Risk Management: A Helicopter View

After completing this reading, you should be able to:

1 . Explain the concept of risk and compare risk management with risk taking. (page 1)

2. Describe the risk management process and identify problems and challenges that

can arise in the risk management process. (page 2)

3. Evaluate and apply tools and procedures used to measure and manage risk,

including quantitative measures, qualitative assessment, and enterprise risk

management. (page 3)

4. Distinguish between expected loss and unexpected loss, and provide examples of

each. (page 4)

5. Interpret the relationship between risk and reward and explain how conflicts of

interest can impact risk management. (page 5)

6. Describe and differentiate between the key classes of risks, explain how each

type of risk can arise, and assess the potential impact of each type of risk on an

organization. (page 6)

2. Corporate Risk Management: A Primer

After completing this reading, you should be able to:

1 . Evaluate some advantages and disadvantages of hedging risk exposures. (page 15)

2. Explain considerations and procedures in determining a firm's risk appetite and its

business objectives. (page 17)

3. 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.

(page 17)

4. Apply appropriate methods to hedge operational and financial risks, including

pricing, foreign currency, and interest rate risk. (page 19)

5. Assess the impact of risk management instruments. (page 20)

3. Corporate Governance and Risk Management

After completing this reading, you should be able to:

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

management. (page 27)

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

(page 29)

3. Evaluate the relationship between a firm's risk appetite and its business strategy,

including the role of incentives. (page 3 1 )

4. Distinguish the different mechanisms for transmitting risk governance throughout

an organization. (page 29)

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

management. (page 31)

6. Assess the role and responsibilities of a firm's audit committee. (page 30)

Book 1

Reading Assignments and Learning Objectives

4. W hat is ERM?

After completing this reading, you should be able to:

1 . Describe enterprise risk management (ERM) and compare and contrast differing

definitions of ERM. (page 37)

2. Compare the benefits and costs of ERM and describe the motivations for a firm to

adopt an ERM initiative. (page 38)

3. Describe the role and responsibilities of a chief risk officer (CRO) and assess how

the CRO should interact with other senior management. (page 40)

4. Distinguish between components of an ERM program. (page 41)

5. Risk-Taking and Risk Management by Banks

After completing this reading, you should be able to:

1 . Assess methods that banks can use to determine their optimal level of risk exposure,

and explain how the optimal level of risk can differ across banks. (page 47)

2. Describe implications for a bank if it takes too little or too much risk compared to

its optimal level. (page 48)

3. Explain ways in which risk management can add or destroy value for a bank.

(page 48)

4. Describe structural challenges and limitations to effective risk management,

including the use of VaR in setting limits. (page 49)

5. Assess the potential impact of a bank's governance, incentive structure and risk

culture on its risk profile and its performance. (page 5 1 )

6. Financial Disasters

After completing this reading, you should be able to:

1 . Analyze the key factors that led to and derive the lessons learned from the following

risk management case studies:

• Chase Manhattan and their involvement with Drysdale Securities

• Kidder Peabody

• Barings

• Allied Irish Bank

• Union Bank of Switzerland (UBS)

• Societe Generale

• Long Term Capital Management (LTCM)

• Metallgesellschaft

• Bankers Trust

• JPMorgan, Citigroup, and Enron (page 59)

7. The Credit Crisis of 2007

After completing this reading, you should be able to:

1 . Analyze various factors that contributed to the Credit Crisis of 2007 and examine

the relationships between these factors. (page 7 6)

2. Describe the mechanics of asset-backed securities (ABS) and ABS collateralized debt

obligations (ABS CDOs) and explain their role in the 2007 credit crisis. (page 77)

3. Explain the roles of incentives and regulatory arbitrage in the outcome of the crisis.

(page 80)

4. Apply the key lessons learned by risk managers to the scenarios provided. (page 8 1 )

Book 1

Reading Assignments and Learning Objectives

Page xii

8. Risk Management Failures: What Are They and When Do They Happen?

After completing this reading, you should be able to:

1 . Explain how a large financial loss may not necessarily be evidence of a risk

management failure. (page 87)

2. Analyze and identify instances of risk management failure. (page 88)

3. Explain how risk management failures can arise in the following areas: measurement

of known risk exposures, identification of risk exposures, communication of risks,

and monitoring of risks. (page 88)

4. Evaluate the role of risk metrics and analyze the shortcomings of existing risk

metrics. (page 90)

9. The Standard Capital Asset Pricing Model

After completing this reading, you should be able to:

1 . Understand the derivation and components of the CAPM. (page 1 14)

2. Describe the assumptions underlying the CAPM. (page 1 10)

3. Interpret the capital market line. (page 1 1 1 )

4. Apply the CAPM in calculating the expected return on an asset. (page 1 17)

5. Interpret beta and calculate the beta of a single asset or portfolio. (page 1 12)

10. Applying the CAPM to Performance Measurement: Single-Index Performance

Measurement Indicators

After completing this reading, you should be able to:

1 . Calculate, compare, and evaluate the Treynor measure, the Sharpe measure, and

Jensen's alpha. (page 125)

2. Compute and interpret tracking error, the information ratio, and the Sortino ratio.

(page 128)

11. Arbitrage Pricing Theory and Multifactor Models of Risk and Return

After completing this reading, you should be able to:

1 . Describe the inputs, including factor betas, to a multi factor model. (page 135)

2. Calculate the expected return of an asset using a single-factor and a multi-factor

model. (page 136)

3. Describe properties of well-diversified portfolios and explain the impact of

diversification on the residual risk of a portfolio. (page 138)

4. Explain how to construct a portfolio to hedge exposure to multiple factors.

(page 140)

5. Describe and apply the Fama-French three factor model in estimating asset returns.

(page 141)

12. Information Risk and Data Quality Management

After completing this reading, you should be able to:

1 . Identify the most common issues that result in data errors. (page 1 50)

2. Explain how a firm can set expectations for its data quality and describe some key

dimensions of data quality used in this process. (page 150)

3. Describe the operational data governance process, including the use of scorecards in

managing information risk. (page 152)

Book 1

Reading Assignments and Learning Objectives

13. Principles for Effective Risk Data Aggregation and Risk Reporting

After completing this reading, you should be able to:

1 . Explain the potential benefits of having effective risk data aggregation and

reporting. (page 157)

2. Describe key governance principles related to risk data aggregation and risk

reporting practices. (page 158)

3. Identify the data architecture and IT infrastructure features that can contribute to

effective risk data aggregation and risk reporting practices. (page 159)

4. Describe characteristics of a strong risk data aggregation capability and demonstrate

how these characteristics interact with one another. (page 159)

5. Describe characteristics of effective risk reporting practices. (page 162)

14. GARP Code of Conduct

After completing this reading, you should be able to:

1 . Describe the responsibility of each GARP member with respect to professional

integrity, ethical conduct, conflicts of interest, confidentiality of information and

adherence to generally accepted practices in risk management. (page 170)

2. Describe the potential consequences of violating the GARP Code of Conduct.

(page 1 72)

The following is a review of the Foundations of Risk Management principles designed to address the learning

objectives set forth by GARP®. This topic is also covered in:

RISK MANAGEMENT:

A HELICOPTER VIEW"

EXAM Focus

This is an introductory topic that provides coverage of fundamental risk management

concepts that will be discussed in much more detail throughout the FRM curriculum.

Topic I

For the exam, it is important to understand the general risk management process and its

potential shortcomings, the concept of unexpected loss, and some of the underlying points

regarding the relationship between risk and reward. Also, the material on the main categories

of financial and non-financial risks contains several testable concepts.

THE CoNCEPT OF RISK

LO 1.1: Explain the concept of risk and compare risk management with risk

taking.

Risk arises from the uncertainty regarding an entity's future losses as well as future gains.

T herefore, in simplified terms, there is a natural trade-off between risk and return. Risk

is not necessarily related to the size of the potential loss. For example, many potential

losses are large but are quite predictable and can be provided for using risk management

techniques. The more important concern is the variability of the loss, especially a loss

that could rise to unexpectedly high levels or a loss that suddenly occurs that was not

anticipated.

& a starting point, risk management includes the sequence of activities aimed to reduce

or eliminate an entity's potential to incur expected losses. On top of that, there is the

need to manage the unexpected variability of some costs. In managing both expected and

unexpected losses, risk management can be thought of as a defensive technique. However,

risk management is actually broader in the sense that it considers how an entity can

consciously determine how much risk it is willing to take to earn future uncertain returns,

which involves risk taking.

Risk taking refers specifically to the active assumption of incremental risk in order to

generate incremental gains. In that regard, risk taking can be thought of in an opportunistic

context.

Topic 1

Cross Reference to GARP Assigned Reading- Crouhy, Galai, and Mark, Chapter 1

Page 2

THE RISK MANAGEMENT PROCESS

LO 1.2: Describe the risk management process and identify problems and

challenges that can arise in the risk management process.

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.

In practice, this process is not likely to operate perfectly in the above sequence. Two key

problems with the process include identifying the correct risk(s) and finding an efficient

method of transferring the risk.

One of the challenges in ensuring that risk management will be beneficial to the economy is

that risk must be sufficiently dispersed among willing and able participants in the economy.

Unfortunately, a notable failure of risk management occurred during the financial crisis

between 2007 and 2009 when it was subsequently discovered that risk was too concentrated

among too few participants.

Another challenge of the risk management process is that it has failed to consistently assist

in preventing market disruptions or preventing financial accounting fraud (due to corporate

governance failures). For example, the existence of derivative financial instruments greatly

facilitates the ability to assume high levels of risk and the tendency of risk managers to

follow each other's actions (e.g., selling risky assets during a market crisis, which disrupts

the market by increasing its volatility).

In addition, the use of derivatives as complex trading strategies assisted in overstating the

financial position (i.e., net assets on balance sheet) of many entities and understating the

level of risk assumed by many entities. Even with the best risk management policies in

place, using such inaccurate information would not allow the policies to be effective.

Finally, risk management may not be effective on an overall economic basis because it only

involves risk transferring by one party and risk assumption by another party. It does not

result in overall risk elimination. In other words, risk management can be thought of as

a zero-sum game in that some "winning" parties will gain at the expense of some "losing"

parties. However, if enough parties suffer devastating losses due to an excessive assumption

of risk, it could lead to a widespread economic crisis.

Topic 1

Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 1

MEASURING AND MANAGING RISK

LO 1.3: Evaluate and apply tools and procedures used to measure and manage

risk, including quantitative measures, qualitative assessment, and enterprise risk

management.

Quantitative Measures

Value at risk (VaR) states a certain loss amount and its probability of occurring. For

example, a financial institution may have a one-day VaR of $2.5 million at the 950/o

confidence level. That would be interpreted as having a 5o/o chance that there will be a loss

greater than $2.5 million on any given day. 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.

To further illustrate the concept of VaR, assume you have gathered 1,000 monthly returns

for a security and produced the histogram shown in Figure 1 . You decide that you want

to compute the monthly VaR for this security at a confidence level of 950/o. At a 950/o

confidence level, the lower tail displays the lowest 5o/o of the underlying distribution's

returns. For this distribution, the value associated with a 95°/o confidence level is a return of

-15.50/o. If you have $ 1,000,000 invested in this security, the one-month VaR is $ 1 55,000

(- 15.5°/o x $ 1,000,000).

Figure 1 : Histogram of Monthly Returns

;:>, 50 c:u 5°/o v V':l 40 Probability v 􀀟 of Loss μ... 30

Monthly Return

Topic 1

Cross Reference to GARP Assigned Reading- Crouhy, Galai, and Mark, Chapter 1

Page 4

Professor's Note: This calculation is an example of historical VtzR. In Book 4,

we will discuss the main types of value at risk: delta-normal VaR, historical

VtzR, and Monte Carlo simulation VtzR.

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

example, if one-day VaR is $2.5 million and the entity holds $2.5 million in liquid reserves,

then it is unlikely to go bankrupt that day.

Qualitative Assessment

Scenario analysis takes into account potential risk factors with uncertainties that are often

non-quantifiable. One option is to consider an adverse scenario or worst-case scenario

analysis to get an idea of the full magnitude of potential losses even if they have a very small

chance of occurring. Worst-case scenario analysis involves examining the effects of possible

macroeconomic scenarios on the entity and within its various divisions, often taking into

account several categories of risk.

Stress testing is a form of scenario analysis that examines a financial outcome based on a

given "stress" on the entity. For example, it is plausible for interest rates or unemployment

rates to rise severely in an economic crisis and stress testing attempts to examine such crisis

situations to determine the outcome on the entity.

Enterprise Risk Management (ERM)

ERM takes an integrative approach to risk management within an entire entity, dispensing

of the traditional approach of independently managing risk within each department

or division of an entity. ERM considers entity-wide risks and tries to integrate risk

considerations into key business decisions. Similar to traditional approaches, ERM makes

use of measures such as economic capital and stress testing. Senior risk committees may

exist within the entity to ensure that risks affecting the entire entity are examined. Within

the ERM framework, the entity and its board of directors agree on specific risk exposure

limits.

EXPECTED AND UNEXPECTED Loss

LO 1.4: Distinguish between expected loss and unexpected loss, and provide

examples of each.

Expected loss considers how much an entity expects to lose in the normal course of

business. It can often be computed in advance (and provided for) with relative ease because

of the certainty involved.

For example, a retail business that provides credit terms on sales of goods to its customers

(i.e., no need to pay immediately) incurs the risk of non-payment by some of those

customers. If the business has been in operation for at least a few years, it could use its

operating history to reasonably estimate the percentage of annual credit sales that will never

be collected. The amount of the loss is therefore predictable and is treated as a regular cost

Topic 1

Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 1

of doing business (i.e., bad debt expense on the income statement). It can be priced into the

cost of the goods directly in the case of the retail business. In contrast, in lines of business

in the financial sector, the cost could be recovered by charging commissions on various

financial transactions or by implementing spreads between a financial institution's lending

rate to borrowers and its cost of obtaining those funds.

Unexpected loss considers how much an entity could lose outside of the normal course of

business. Compared to expected loss, it is generally more difficult to predict, compute, and

provide for in advance because of the uncertainty involved.

For example, consider a commercial loan portfolio that is focused on loans to automotive

manufacturing companies. During an economic expansion that favors such companies

(because individuals have more disposable income to spend on items such as automobiles),

the lender will realize very few, if any, loan defaults. However, during an economic

recession, there is less disposable income to spend and many more loan defaults are likely to

occur from borrowers, likely at the same time. This is an example of correlation risk, when

unfavorable events happen together. The correlation risk drives up the potential losses to

unexpected levels.

Another example of correlation risk lies with real estate loans secured by real property.

Borrowers tend to default on such loans (i.e., default rate risk) at the same time that the

real property values fall (i.e., recovery rate risk-the creditor's collateral is worth less,

thereby compromising the recovery rate on the funds lent to the borrowers). These two risks

occurring simultaneously could drive up the potential losses to unexpected levels.

Realizing the existence of correlation risks helps a risk manager measure and manage

unexpected losses with somewhat more certainty. For example, historical analysis of the

extent of such losses in the past due to correlation risk could be performed, taking into

account which risk factors were involved.

RISK AND REwARD

LO 1.5: Interpret the relationship between risk and reward and explain how

conflicts of interest can impact risk management.

As previously mentioned, there is a trade-off between risk and reward. In very general and

simplified terms, the greater the risk taken, the greater the potential reward. However, one

must consider the variability of the potential reward. The portion of the variability that is

measurable as a probability function could be thought of as risk whereas the portion that is

not measurable could be thought of as uncertainty.

The relationship between risk and return appears easier to examine with publicly traded

securities. For example, consider fixed-income securities. Government bonds have less

credit risk than corporate bonds in general, so the pricing takes into account that the yield

spreads for government bonds are narrower than corporate bonds across various maturities.

However, for a given maturity, the full relationship between risk and return goes further

than merely credit risk (e.g., liquidity risks and taxation impacts may make the relationship

less clear). Additionally, the risk tolerances (i.e., ability and willingness to take on certain

risks) of market participants may change over time. When risk tolerances are high, the

Topic 1

Cross Reference to GARP Assigned Reading- Crouhy, Galai, and Mark, Chapter 1

Page 6

spread between riskless and risky bonds may narrow to an abnormally low level, which

again disguises the true relationship between risk and return.

Examining the relationship between risk and return is made even more challenging when

dealing with non-publicly traded securities because the pricing of such securities is less

reliable compared to publicly traded securities (i.e., no market price validation).

In practice, some entities have weak risk management and/or risk governance cultures,

which allows for potential returns to be overstated because they are not adjusted for risk.

Correlation risks may be ignored, which understate overall risk. Some risk measures may

be computed in a misleading manner because the proper computation may result in lower

reported profits for the entity. For example, for entities that have management bonuses

based on reported profits, the use of mark to market accounting may result in inflated

profits on the income statement (and overstated values for risky assets on the balance sheet)

during a strong year in order to maximize the management bonuses paid. However, at the

same time, there are usually no adjustments made to risk that considers the fact that those

profits have not truly been earned because no cash has been received yet and, in fact, may

never materialize if the investments subsequently lose significant value.

RISK CLASSES

LO 1.6: Describe and differentiate between the key classes of risks, explain how

each type of risk can arise, and assess the potential impact of each type of risk on

• • an organ1zat1on.

Market Risk

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.

Interest rate risk can be illustrated in simple terms by considering a bond earning a fixed

rate of interest. If market interest rates rise, the value of the bond will decrease. Another

form of interest rate risk is the hedging of bonds against a change in the shape of the

yield curve (although it may be properly hedged against a parallel shift in the yield curve).

Furthermore, interest rate risk may also arise from having completely unhedged positions

or having only partially hedged positions due to underlying transactions that did not fully

offset (even though they were meant to offset). In the latter case, the loss could be attributed

to basis risk, which means that the presumed correlation between the price of a bond and

the price of the hedging vehicle used to hedge that bond has changed unfavorably.

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). For the investor,

general market risk cannot be diversified away while specific risk can be diversified away.

Topic 1

Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 1

Foreign exchange risk refers to monetary losses that arise because of unhedged or not fully

hedged foreign currency positions. Foreign exchange risk results from imperfect correlations

in currency price movements as well as changes in international interest rates. Potential

large losses could reduce the extent of an entity's foreign investment and also put it at a

competitive disadvantage compared to its foreign competitors.

Commodity price risk refers to the price volatility of commodities (e.g., precious metals,

base metals, agricultural products, energy) due to the concentration of specific commodities

in the hands of relatively few market participants. The resulting lack of trading liquidity

tends to increase the amount of price volatility compared to financial securities. In addition,

commodities may face significant price discontinuities (i.e., prices suddenly jump from one

level to another).

Credit Risk

Credit risk refers to a loss suffered by a party whereby the counterparty fails to meet its

financial obligations to the party under the contract. Credit risk may also arise if there is

an increasing risk of default by the counterparty throughout the duration of the contract.

There are four subtypes of credit risk: (1) default risk, (2) bankruptcy risk, (3) downgrade

risk, and (4) settlement risk.

Default risk refers to the non-payment of interest and/ or principal on a loan by the

borrower to the lender. The period of default past the due date could be at least 30 or 60

days.

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.

Downgrade risk considers the decreased creditworthiness (based on recent financial

performance) of a counterparty to a transaction. A creditor may subsequently charge the

downgraded entity a higher lending rate to compensate for the increased risk. For a creditor,

downgrade risk may eventually lead to default risk.

Settlement risk could be illustrated using a derivatives transaction between two

counterparties. At the settlement date, one of them is in a net gain ("winning") position and

the other is in a net loss ("losing") position. The position that is losing may simply refuse to

pay and fulfill its obligations.

Continuing with the concept of a net gain position in a transaction, credit risk exists only to

that party. If the losing party defaults, then the winning party may lose some or all of that

net gain. The portion that is expected to be recovered is called the recovery value and the

portion that is expected to be lost is the loss given default (LGD). For example, if a party's

net gain position is $500,000 at settlement and only $400,000 is expected to be recovered,

then the recovery value is $400,000 and the LGD is $ 1 00,000. Expressed as percentages,

the recovery rate is 80o/o and the LGD is 20o/o.

It is also necessary to consider credit risk within a portfolio of loans. The basic issue is to

ensure that the lender charges a rate of interest to the borrower that is commensurate with

Topic 1

Cross Reference to GARP Assigned Reading- Crouhy, Galai, and Mark, Chapter 1

Page 8

the risk taken. In addition, in order to avoid concentration risk, the lender should ensure

sufficient diversification of loans across geographical areas and industries. Somewhat related

to concentration risk are correlation risk and overall economic health. Economic recessions

will result in more loan defaults and there is tendency for loans in similar geographical

areas or industries to default at the same time. Finally, loan portfolios should consider

the maturities of the loans and avoid concentration on specific maturities, giving rise to

portfolio maturity risk. A more diversified portfolio with loans across a reasonable range

of maturities will also help avoid liquidity risk by having more frequent cash inflows (i.e.,

loan principal repayments) over time rather than having most of the cash inflows at only

specified times.

Liquidity Risk

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.

For a transaction that must be executed immediately or in the near future, it might have

to be done at a very significant discount, thereby leading to a huge loss. The loss effect is

magnified for larger transactions.

The impact of trading liquidity risk on an entity could include impairments in its abilities

to control market risk and to cover any funding shortfalls.

Operational Risk

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.

Within a financial institution, the leveraged nature of derivatives transactions makes them

susceptible to operational risk. Additionally, the difficulty in accurately valuing complicated

derivatives transactions adds to operational risk.

A very robust system of internal controls is required within an entity or else there is a risk of

significant losses due to various operational risks.

Legal and Regulatory Risk

In practice, legal and regulatory risk is highly integrated with operational and reputation

risk. Within a two-way financial transaction, an example of legal risk would be one

party suing the other party in an attempt to nullify or terminate the transaction. From

an investing perspective, an example of regulatory risk could be a change in tax law that

increases the tax rate of certain types of income, thereby lowering the after-tax investment

Topic 1

Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 1

returns for many investors, or changes in regulations that involve further areas of

compliance, thereby increasing compliance costs for an entity.

Business Risk

For the purposes of this topic, we will consider business risk from a financial perspective.

In this regard, 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. From an income statement perspective, revenues may be uncertain

because of the uncertainty surrounding the demand for products and/ or the price that

should be set. Production and administration costs may also be uncertain.

Business risk may arise because the actual product demand is significantly lower than

anticipated or the marketplace's toleration of a selling price is much lower than expected.

In addition, there may be production cost overruns or unexpected costs that substantially

increase total expenses. Either way, the decreased revenues and/ or the increased costs may be

significant enough that the entity suffers financial losses.

From a non-financial (i.e., operational) perspective, a manufacturing company may

experience business risk due to testing, production, or shipping delays. The result would be

lost sales and/or substitution to competitors' products by consumers.

Strategic Risk

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. For example, an

entity could spend millions of dollars developing a new product that ultimately fails in the

marketplace because consumers find it unsuitable for their needs.

Alternatively, it could be thought of from the perspective of an entity changing its business

strategy compared to its competitors. For example, a financial institution may choose to

change its lending focus from lending to stable firms and attempt to lend funds to risky

firms at high rates of interest in order to earn higher profits. However, an economic crisis

ensues and many of those risky firms default on their loans, leading to large losses to the

lending financial institution.

The impact of strategic risk will be felt by an entity if its business decision has an

unsuccessful result, thereby incurring large losses and loss of reputation/confidence by

• investors.

Reputation Risk

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.

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Cross Reference to GARP Assigned Reading- Crouhy, Galai, and Mark, Chapter 1

Page 10

Reputation risk could arise partly due to the existence of the internet. For example, social

networking sites and blogs could allow for rumors-true or false-to be spread about an

entity very quickly. An entity's involvement in questionable and sophisticated financial

transactions such as structured finance products or special purpose entities may give rise

to reputation risk for an entity because the interpretation of the accounting and tax rules

related to such transactions may be misleading and border on illegal in some cases.

The impact of reputation risk on an entity could start with lost profits and eventually lead

to insolvency as public perception of the entity diminishes together with the value of the

• entity.

Topic 1

Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 1

LO 1 . 1

Risk arises from the uncertainty regarding an entity's future losses as well as future gains.

Risk management includes the sequence of activities aimed to reduce or eliminate an entity's

potential to incur expected losses. Risk taking refers specifically to the active assumption of

incremental risk in order to generate incremental gains.

LO 1.2

In its basic format, the risk management process is as follows:

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.

LO 1.3

Value at risk (VaR) states a certain loss amount and its probability of occurring.

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

Scenario analysis takes into account potential risk factors with uncertainties that are often

non-quantifiable.

Stress testing is a form of scenario analysis that examines a financial outcome based on a

given "stress" on the entity.

Enterprise risk management takes an integrative approach to risk management within an

entire entity, dispensing of the traditional approach of independently managing risk within

each department or division of an entity.

LO 1.4

Expected loss considers how much an entity expects to lose in the normal course of

business. It can often be computed in advance (and provided for) with relative ease because

of the certainty involved.

Unexpected loss considers how much an entity could lose usually outside of the normal

course of business. Compared to expected loss, it is generally more difficult to predict,

compute, and provide for in advance because of the uncertainty involved.

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Cross Reference to GARP Assigned Reading- Crouhy, Galai, and Mark, Chapter 1

Page 12

LO 1 . 5

There is a trade-off between risk and reward. In very general and simplified terms, the

greater the risk taken, the greater the potential reward. However, one must consider the

variability of the potential reward. The portion of the variability that is measurable as a

probability function could be thought of as risk whereas the portion that is not measurable

could be thought of as uncertainty.

LO 1.6

There are eight key classes of risk: (1) market risk, (2) credit risk, (3) liquidity risk,

(4) operational risk, (5) legal and regulatory risk, (6) business risk, (7) strategic risk, and

(8) reputation risk.

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.

Credit risk refers to a loss suffered by a party whereby the counterparty fails to meet its

financial obligations to the party under the contract. Credit risk may also arise if there is

an increasing risk of default by the counterparty throughout the duration of the contract.

There are four subtypes of credit risk: (1) default risk, (2) bankruptcy risk, (3) downgrade

risk, and ( 4) settlement risk.

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.

Operational risk considers a wide range of non-financial problems such as inadequate

computer systems, insufficient internal controls, incompetent management, fraud, human

error, and natural disasters.

Legal risk could arise when one party sues the other party in an attempt to nullify or

terminate the transaction. Regulatory risk could arise from changes in laws and regulations

that are unfavorable to the entity (e.g., higher tax rates, higher compliance costs).

Business risk revolves around uncertainty regarding the entity's income statement. Revenues

may be uncertain because of the uncertainty surrounding the demand for the products and/

or the price that should be set. Production and administration costs may also be uncertain.

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. Alternatively,

it could be thought of from the perspective of an entity changing its business strategy

compared to its competitors.

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.

Topic 1

Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 1

1 . Which of the following statements regarding risk and risk management is correct?

A. Risk management is more concerned with unexpected losses versus expected

losses.

B. There is a relationship between the amount of risk taken and the size of the

potential loss.

C. The final step of the risk management process involves developing a risk

• • • m1t1gat1on strategy.

D. If executed properly, the risk management process may allow for risk elimination

within an economy.

2. Examining the impact of a dramatic increase in interest rates on the value of a bond

investment portfolio could be performed using which of the following tools?

I. Stress testing.

II. Enterprise risk management.

A. I only.

B. II only.

C. Both I and II.

D. Neither I nor II.

3. Which of the following items would be associated with unexpected losses?

I. Loan defaults are increasing simultaneously while recovery rates are decreasing.

II. Lending losses are covered by charging a spread between the cost of funds and

the lending rate.

A. I only.

B. II only.

C. Both I and II.

D. Neither I nor II.

4. In considering the major classes of risks, which risk would best describe an entity

with weak internal controls that could easily be circumvented with a lack of

segregation of duties?

A. Business risk.

B. Legal and regulatory risk.

C. Operational risk.

D. Strategic risk.

5. Local Bank, Inc., (LBI) has loaned funds to a private manufacturing company,

named We Make It All (Make It). The current balance of the loan is $1 million and

it is secured by a piece of land and the corresponding building owned by Make It.

Due to an economic downturn, Make It suffered a loss for the first time in its 10-

year operating history and is currently experiencing some cash flow difficulties. In

addition, the land and building that is held as collateral has recently been appraised

at only $800,000. Based only on the information provided, which of the following

risks faced by LBI have increased?

A. Bankruptcy risk and default risk.

B. Bankruptcy risk and settlement risk.

C. Default risk and downgrade risk.

D. Default risk, downgrade risk, and settlement risk.

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Cross Reference to GARP Assigned Reading- Crouhy, Galai, and Mark, Chapter 1

Page 14

1 . A Risk management is more concerned with the variability of losses, especially ones that

could rise to unexpectedly high levels or ones that suddenly occur that were not anticipated

(unexpected losses).

Choice B is not correct because risk is not necessarily related to the size of the potential loss.

For example, many potential losses are large but are quite predictable and can be provided

for using risk management techniques. Choice C is not correct because the final step of the

risk management process involves assessing performance and amending the risk mitigation

strategy as needed. Choice D is not correct because the risk management process only

involves risk transferring by one party and risk assumption by another counterparty. It is a

zero-sum game so it does not result in overall risk elimination.

2. C Examining the impact of a dramatic increase in interest rates is an example of stress testing.

Enterprise risk management makes use of measures such as stress testing.

3. A Loan defaults are increasing simultaneously while recovery rates are decreasing is an example

of correlation risk. Correlation risk could drive up the potential losses to unexpected levels.

In contrast, if lending losses are covered with a spread, given that there is sufficient

information to compute such a spread, then the losses would likely be considered expected

losses.

4. C Weak internal controls and lack of segregation of duties would represent a non-financial risk

and be best described as an operational risk.

Choice A is not correct because business risk focuses on the income statement (i.e., revenues

too low and expenses too high). Choice B is not correct because legal and regulatory risk

focuses on the risk of an entity being sued or the risk of unfavorable changes in the rules and

laws that the entity must follow. Choice D is not correct because strategic risk focuses on

significant new business investments or significant changes in an entity's business strategy.

5. A The fact that the loan is secured by land and the building is now worth less than the amount

of the loan outstanding subjects LBI to increased bankruptcy rsi k in the sense that the

liquidation value of the collateral is insufficient to recover the loss if the loan defaults. The

financial loss and the cash flow difficulties suggest that there is increased default risk for LBI

as well.

Downgrade risk does not apply here because Make It's loan is not publicly traded and is

unlikely to be rated by a recognized rating agency. Settlement rsi k does not apply here either

because there is no exchange of cash flows at the end of the transaction that would be

required to incur such risk. In this case, the loan is settled when Make It fully repays the

principal balance owed.

The following is a review of the Foundations of Risk Management principles designed to address the learning

objectives set forth by GARP®. This topic is also covered in:

CORPORATE RISK MANAGEMENT:

A PRIMER

Topic 2

EXAM Focus

This topic builds on the material from the previous topic and provides coverage of additional

fundamental concepts such as the capital asset pricing model (CAPM), the advantages of

hedging, financial versus operating risk, and commonly encountered types of risk such as

pricing risk, foreign exchange risk, and interest rate risk. For the exam, pay close attention

to the material on hedging risk exposures, the role of the board of directors in determining

whether to hedge specific risk factors, and foreign currency risk.

HEDGING RISK EXPOSURES

LO 2. 1 : Evaluate some advantages and disadvantages of hedging risk exposures.

Disadvantages (In Theory)

In 1958, Franco Modigliani and Merton Miller argued that under the assumption of

perfectly competitive capital markets with no transaction costs or taxes, both the firm and

the individual investor are able to perform the same financial transactions at the same cost.

In other words, the value of the firm will remain constant despite any attempt to hedge

risk exposures. Unfortunately, the assumption of no transaction costs or taxes is highly

unrealistic in the real world, which makes it a weak argument not to hedge risk.

In 1964, William Sharpe developed the capital asset pricing model (CAPM), which argues

that under perfect capital markets, firms should only be concerned with systematic risk (or

beta risk; risk that is common to all market participants). Firms should not be concerned

with unsystematic risk (or idiosyncratic risk) that pertains specifically to the firm because

such risk could be reduced through diversification in a large investment portfolio and in

a costless manner. Unfortunately, the perfect capital markets assumption is not realistic in

practice, and diversification activities will result in transaction costs.

There is the belief by many market participants that hedging is a zero-sum game that has

no long-term increase on a firm's earnings or cash flows (because earnings/cash flows are

simply moved between periods). That argument assumes perfect capital markets and that

derivatives pricing fully reflects all of its risk factors. Unfortunately, in practice, derivatives

pricing is extremely complex and not as accurate compared to equity and bond pricing.

Therefore, derivatives pricing is not always likely to reflect all of its risk factors so hedging

with derivatives may not always be a zero-sum game of transferring risk between periods or

between participants.

Topic 2

Cross Reference to GARP Assigned Reading- Crouhy, Galai, and Mark, Chapter 2

Page 16

A noteworthy point is that none of the above arguments consider the existence of the

significant costs of financial distress and bankruptcy, a point that runs contrary to the

assumption of perfect capital markets.

Disadvantages (In Practice)

Hedging activities may be extensive enough that they cause management to lose focus on

the core business activities of the firm, possibly resulting in lost profits. Hedging often

requires very specific skills, knowledge, research, and time, which may not be available

within the management team. In addition, attempting to hedge using a flawed hedging

strategy may result in losses to the firm that are greater than the actual risk(s).

All hedging strategies will incur compliance costs, such as ones related to disclosure

and accounting. Also, the use of derivatives (e.g., futures contracts) to hedge may reveal

operational information that a firm may otherwise prefer to keep private. Such costs would

reduce the firm's incentive to hedge its risks. Finally, hedging to decrease the variability

of the firm's value may end up increasing the variability of the firm's earnings due to the

difference between accounting earnings and cash flows.

Advantages (In Practice)

One of the key reasons for a firm to hedge its risk exposures is the possibility of lowering

its cost of capital (debt or equity), which could lead to increased economic growth. By

reducing the volatility of its earnings/cash flows, a firm may be able to increase its debt

capacity in order to borrow funds to take advantage of lucrative investment opportunities.

Also, borrowing arrangements for firms with less volatile earnings/cash flows usually contain

fewer conditions and restrictions imposed by the lenders.

Similarly, reduced volatility and greater stability of earnings/cash flows is often an indication

to the firm's stakeholders that management is doing a good job. This is often reflected

directly in the firm's stock price being stable or rising.

Hedging may allow management to control its financial performance to meet the

requirements of the board of directors. For example, management is implicitly conveying

the level of risk it is able and willing to accept on an unhedged basis (i.e., its risk appetite)

when it makes choices on hedging specific risk exposures. The risk appetite would need to

be approved in advance by the board so hedging may assist management in meeting the

board's requirements.

Hedging may result in operational improvements within a firm. For example, for a

manufacturing firm, cost and price stability may be achieved if it is able to ascertain a

locked-in price for its inputs.

Hedging through the use of derivatives instruments such as swaps and options may be

cheaper than purchasing an insurance policy. One must consider whether the total cost of

the insurance over the years exceeds the estimated losses.

Some arguments for hedging are focused on taxation. The existence of progressive tax

rates may result in volatile earnings (with no hedging) incurring more income tax liability

Topic 2

Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 2

compared to stable earnings (with hedging). In addition, hedging with derivatives (offbalance

sheet) may allow for more debt financing, which results in more tax deductions

for interest costs incurred. In practice, neither argument seems to have much validity. For

example, the tax liabilities tend to even out between the volatile and non-volatile years,

especially because losses in one year may be offset against income in another year.

HEDGING DECISIONS

LO 2.2: Explain considerations and procedures in determining a firm's risk appetite

and its business objectives.

LO 2.3: 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.

As a start, a firm must know its risk and return goals before embarking on a risk

management plan. Those goals must be evaluated and approved by the board of directors to

ensure the plan is focused and relevant. A major conclusion to consider with the risk/return

trade-off is that firms should accept all projects with a positive net present value (NPV),

taking into account risk, because it will maximize value for the firm's stakeholders.

The Role of the Board of Directors

Management and the board need to set and communicate the firm's risk appetite in a

quantitative and/or qualitative manner. There are several possibilities, including:

• Explicitly stating (qualitatively) which risks the firm can tolerate (to be left unhedged)

and, therefore, which risks it cannot tolerate (to be hedged).

• Using a quantitative metric such as value at risk (VaR) to convey the maximum loss the

firm will tolerate for a given confidence level for a given period of time.

• Using stress testing whereby management considers possible but very severely negative

scenarios to determine the level of losses. From there, the board makes the determination

of which losses are tolerable (to not mitigate or to leave uninsured) and which ones are

not tolerable (to be mitigated or insured).

A problematic issue for the board of directors in determining the firm's risk appetite

centers on the potential conflict between the two major stakeholders-debtholders and

shareholders. Debtholders would likely be more concerned with minimizing all risks

because their upside potential is generally limited to the rate of interest charged. In contrast,

shareholders may be willing for the firm to accept a large but unlikely risk in order to

• • increase equity returns.

The board must ensure that its goals are stated in a clear and actionable manner. From a

performance evaluation/measurement perspective, criteria to determine the relative success

in meeting those goals must be set in advance to ensure objectivity in the process.

The board should clarify its objectives in terms of whether it is accounting or economic

profits that are to be hedged. 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.

Topic 2

Cross Reference to GARP Assigned Reading- Crouhy, Galai, and Mark, Chapter 2

Page 18

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.

Additionally, the issue of hedging short-term versus long-term accounting profits (i.e.,

smoothing the fluctuations over the years) needs to be considered. Doing so may entail

significant effort and cost from a cash flow perspective. However, one argument in favor

of smoothing is that for publicly traded companies, stable reported earnings (rather than

fluctuating) often assist with maintaining or increasing the stock price.

The board must be definitive in the time horizon when determining its risk management

goals for management to achieve. Liquidity, accounting, and tax effects need to be

considered. For example, the use of a futures contract to hedge future sales receipts will

result in a mismatch of profits for accounting purposes (e.g., sales revenue recognized only

upon completion of transaction while the futures contract requires periodic marking to

market), or if the futures contract is in a "gain" position at the end of the year, there may be

taxes payable prior to the receipt of any sales receipts (liquidity and tax effects).

Finally, the board may wish to implement definitive and quantitative risk limits within

which management is allowed to transact at its own discretion. Any amounts outside of

those limits would not be permissible, would require special approval from the board, or

would require hedging.

The Process of Mapping Risks

Mapping risks is the next logical step once management and the board have determined

which risks to accept and which ones to manage. In that regard, it must be clear which risks

are insurable, hedgeable, noninsurable, or nonhedgeable in order to determine what items

could be used to reduce the firm's risk.

Mapping risks could be performed for market risk, credit risk, business risk, and operational

risk. Using currency risk as an example of market risk, consider the impact of currency

risk on a firm's current positions and future transactions. Management could start with the

balance sheet by determining the values of all assets and liabilities that could be impacted

by exchange-rate fluctuations and break them out into the different currencies. Then it

could move on to the income statement and request internal information on confirmed

(and possibly unconfirmed) future sales to foreign customers in the various currencies for

the relevant period. The same would be done for expenses to be incurred. Once all the

information is gathered, the timing of cash inflows and outflows for each currency can be

analyzed to determine the next steps (i.e., how much to hedge, which currencies to hedge).

On an overall basis, the firm should also research and identify the top 10 risk exposures it

faces. For each of those risks, a dollar value should be assigned to indicate the potential loss

Topic 2

Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 2

as well as a probability to indicate the likelihood of it happening. Similarly, management

should be aware of its general exposure to fluctuations in interest rates, foreign exchange

rates, equity prices, and commodity prices.

HEDGING OPERATIONAL AND FINANCIAL RISKS

LO 2.4: Apply appropriate methods to hedge operational and financial risks,

including pricing, foreign currency, and interest rate risk.

Hedging operational risks covers a firm's activities in production (costs) and sales (revenue),

which is essentially the income statement. Financial position risk pertains to a firm's balance

sheet. Making the realistic assumption that there are some imperfections in the financial

markets, a firm could benefit from hedging financial position risk. Hedging activities should

cover both the firm's assets and liabilities in order to fully account for the risks.

Pricing Risk

With production, the cost of inputs may have a significant impact on the firm's ability

to conduct its business in a competitive manner. Therefore, it makes sense to hedge such

pricing risk by purchasing a forward or futures contract to buy a specific quantity of that

input at a fixed cost determined in advance. The same could be done with a firm's domestic

or foreign sales, as will be discussed next.

Foreign Currency Risk

The goal of hedging foreign currency risk is to control exposure to exchange rate

fluctuations that impact future cash flows and the fair value of assets and liabilities.

Revenue hedging can be used when a firm has sales to customers in foreign countries

(with payment in the foreign currency). There is the risk of the devaluation of the foreign

currency in the future, resulting in losses to the firm when the funds are ultimately

converted back to the domestic currency. The firm could hedge some of its expected foreign

currency receipts in the future, taking into account the cost of hedging as well as revenue

and exchange-rate volatilities and correlations. Instruments that could be used include

currency put options (to ensure a known absolute minimum return should the exchange

rate fall beyond the strike rate) and forward contracts (to ensure a known return based on

an exchange rate determined in advance and acceptable by the firm).

In hedging the firm's balance sheet exposures, the focus is on the impact of foreign exchange

rate fluctuations on the net monetary assets of its foreign investments. Forward contracts

are often used in this regard because they allow for the payment ("loss") or receipt ("gain")

by the firm of a fixed amount at a fixed exchange rate that would offset any impact of

rate changes on the net monetary assets (gain or loss; opposite of the forward contract).

Foreign currency debt (liability) could also serve as a natural offset against a decrease in the

value of a firm's foreign investment (asset). Note that in some instances hedging costs are

prohibitively expensive from a cost-benefit perspective and therefore some foreign currency

positions may be left deliberately unhedged.

Topic 2

Cross Reference to GARP Assigned Reading- Crouhy, Galai, and Mark, Chapter 2

Page 20

Interest Rate Risk

The goal of hedging interest rate risk is to control the firm's net exposure (asset or

liability) to unfavorable interest rate fluctuations. From both an investing and a borrowing

perspective, interest rate swaps may be used to protect a firm against losses. Also, it may

help a firm to minimize its borrowing costs. Identical to the point above about high hedging

costs, some interest rate positions may be left deliberately unhedged.

Static vs. Dynamic Hedging Strategies

A static hedging strategy is a simple process in which the risky investment position is initially

determined and an appropriate hedging vehicle is used to match that position as close

as possible and for as long as required. In contrast, a dynamic hedging strategy is a more

complex process that recognizes that the attributes of the underlying risky position may

change with time. Assuming it is desired to maintain the initial risky position, there will

be additional transaction costs required to do so. Significantly more time and monitoring

efforts are required with a dynamic hedging strategy.

Additional hedging considerations include the following:

• The firm must consider relevant time horiwns for hedging and ensure that performance

evaluations are matched with the time horizons.

• The firm needs to assess the (often) complex financial accounting implications of

hedging with derivatives. For example, if the hedge is not an exact match or offset to the

underlying position, then there will be a gain/loss to report on the income statement.

• The taxation of derivatives is a key issue because of its impact on the firm's cash flows

as well as the differing laws between countries. Significant effort and cost (which

increase hedging costs) may be required to decipher the complex tax rules surrounding

derivatives.

RISK MANAGEMENT INSTRUMENTS

LO 2.5: Assess the impact of risk management instruments.

Once the risks are mapped, management and the board need to determine which

instruments to use to manage the risks. As stated previously, a simple example would be a

foreign subsidiary with assets that are hedged with an equal dollar amount of liabilities. The

same can be done for a foreign liability with a foreign asset. The underlying assumption is

that the time horizon is appropriate.

For other transactions, decisions need to be made whether to fully insure, partially insure,

or not to insure (i.e., self-insure) with insurance products, taking into account the benefits

and costs of doing so.

Financial instruments are used to hedge risks and can be classified as exchange traded or

over the counter (OTC). Exchange-traded instrwnents cover only certain underlying

assets and are quite standardized (e.g., maturities and strike prices) in order to promote

liquidity in the marketplace. OTC instrwnents are privately traded between a bank and

a firm and thus can be customized to suit the firm's risk management needs. In exchange

Topic 2

Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 2

for the customization, OTC instruments are less liquid and more difficult to price than

exchange-traded instruments. In addition, there is credit risk by either of the counterparties

(e.g., default risk) that would generally not exist with exchange-traded instruments.

Topic 2

Cross Reference to GARP Assigned Reading- Crouhy, Galai, and Mark, Chapter 2

Page 22

LO 2.1

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.

L0 2.2

The board, together with management, should set the firm's 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.

L0 2.3

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 shortterm

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).

L0 2.4

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.

Topic 2

Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 2

Hedging strategies could be categorized as either static or dynamic, with dynamic

strategies being more complex and requiring additional monitoring and transaction costs.

Additionally, factors such as time horizon, accounting, and taxation need to be considered

within any hedging strategy.

L0 2.5

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.

Topic 2

Cross Reference to GARP Assigned Reading- Crouhy, Galai, and Mark, Chapter 2

Page 24

I. Melody Li is a junior risk analyst who has recently prepared a report on the

advantages and disadvantages of hedging risk exposures. An excerpt from her report

contains four statements. Which of Li's statements is correct?

A. Purchasing an insurance policy is an example of hedging.

B. In practice, hedging with derivatives is not likely to be a zero-sum game.

C. The existence of significant costs of financial distress and bankruptcy is

considered within the assumption of perfect capital markets.

D. Hedging with derivatives is advantageous in the sense that there is often the

ability to avoid numerous disclosure requirements compared with other financial

• instruments.

2. The involvement of the board of directors is important within the context of a firm's

decision to hedge specific risk factors. Which of the following statements regarding

the setting of risk appetite is correct?

I. Risk appetite may be conveyed strictly in a qualitative manner.

II. Debtholders and shareholders are both likely to desire minimizing the firm's

risk appetite.

A. I only.

B. II only.

C. Both I and II.

D. Neither I nor II.

3. Which of the following statements regarding the hedging of risk exposures is correct?

A. The use of a futures contract to hedge future sales receipts may result in

premature taxes payable.

B. Hedging both accounting and economic risk may be done simultaneously but at

a relatively high cost.

C. For publicly traded companies, there is no clear benefit in hedging short-term or

long-term accounting profits.

D. The use of a futures contract to hedge future sales receipts may assist in

matching profits for accounting purposes.

4. Lear, Inc., is a U.S. wine producer that purchases a significant amount of cork for its

wine bottles from Asia. It also sells much of its wine to customers throughout North

America. Based on these two broad transactions, which of the following risks does

Lear, Inc., most likely face?

A. Financial position risk and operational risk.

B. Operational risk and pricing risk.

C. Pricing risk only.

D. Financial position risk, operational risk, and pricing risk.

5. Which of the following statements regarding exchange-traded and over-the-counter

(OTC) financial instruments is correct?

A. There is greater liquidity with exchange-traded financial instruments.

B. There is greater customization with exchange-traded financial instruments.

C. There is greater price transparency with OTC financial instruments.

D. There is credit risk by either of the counterparties inherent in exchange-traded

• instruments.

Topic 2

Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 2

1. B The complexity of derivatives pricing means the pricing may not always be as accurate as

possible so it will not always reflect all of the relevant risk factors. As a result, in practice,

hedging with derivatives may not be a zero-sum game of transferring risk between periods or

between participants.

Choice A is not correct because hedging involves the use of financial derivatives and

insuring involves the use of insurance policies; an insurance policy is not considered a

financial instrument in the same sense as a derivatives instrument. Choice C is not correct

because the existence of significant costs of financial distress and bankruptcy is contrary to

the assumption of perfect capital markets. Choice D is not correct because hedging with

derivatives will require disclosure, including some operational information that the firm may

otherwise prefer to keep private.

2. A Risk appetite may be conveyed in a qualitative and/or quantitative manner, therefore,

qualitative alone may be acceptable.

Debtholders would likely be more concerned about minimizing all risks because their upside

potential is generally limited to the rate of interest charged. In contrast, shareholders may be

willing for the firm to accept a large but unlikely risk in order to increase equity prices.

3. A The use of a futures contract to hedge future sales receipts must take into account that sales

revenue is recognized only upon completion of transaction, although the futures contract

requires periodic marking to market. Therefore, if the futures contract is in a "gain" position

at the end of the year, there may be taxes payable prior to the receipt of any sales receipts.

Choice B is not correct because it is not possible to hedge both accounting and economic

risk at the same time. Choice C is not correct because for publicly traded companies, stable

reported earnings (achieved by hedging short-term vs. long-term accounting profits) often

assist with maintaining or increasing the stock price. Choice D is not correct because the

use of a futures contract to hedge future sales receipts will result in a mismatch of profits for

• accounting purposes.

4. B Operational risk could cover activities pertaining to Lear's input products (i.e., cork) and

products exported to foreign countries (i.e., bottles of wine). In addition, there would be

pricing risk for both the inputs and outputs. For example, the cost of the cork may have

a significant impact on Lear's ability to conduct business in a competitive manner. Also

consider that Lear has sales to customers in foreign countries (with payment in the foreign

currency) where there is the risk of the devaluation of the foreign currency in the future.

Financial position risk refers to the balance sheet of a firm. Neither the purchases nor the sales

impact Lear's balance sheet.

Topic 2

Cross Reference to GARP Assigned Reading- Crouhy, Galai, and Mark, Chapter 2

Page 26

5. A Exchange-traded instruments cover only certain underlying assets and are quite standardized

in order to promote liquidity in the marketplace. As a result, there is less customization

with exchange-traded instruments. OTC financial instruments, in exchange for greater

customization, are less liquid and more difficult to price compared to exchange-traded

instruments. In addition, there is credit risk by either of the counterparties that would

generally not exist with exchange-traded instruments.

The following is a review of the Foundations of Risk Management principles designed to address the learning

objectives set forth by GARP®. This topic is also covered in:

CORPORATE GOVERNANCE AND RISK

MANAGEMENT

EXAM Focus

Topic 3

This topic continues the coverage of risk management concepts in a qualitative and nontechnical

manner. For the exam, pay close attention to the best practices in corporate

governance and risk management. In addition, understand the purpose and function of the

main board committees, such as risk management, compensation, and audit.

BEST PRACTICES

LO 3.1: Compare and contrast best practices in corporate governance with those of

risk management.

Corporate Governance

The board of directors should be comprised of a majority of independent members in order

to maintain a sufficient level of objectivity with regard to making decisions and approving

management's decisions. All members should possess a basic knowledge of the firm's

business and industry, even if they are outside of the industry. Additionally, those who lack

knowledge should be provided some supplemental training prior to joining the board.

The board should be watching out for the interests of the shareholders. For example, on a

general level, the board would have to approve management's decision to assume a certain

risk given its expected return. Also, the board would watch out for the interests of other

stakeholders, such as debtholders, by considering if any of management's decisions contain

extreme downside risk.

The board should be aware of any agency risks whereby management may have the

incentive to take on greater risks in order to maximize personal remuneration (e.g., based

on short-term increases in stock price) that are not consistent with the objectives of the

stakeholders in terms of long-term risk levels. As a starting point, the compensation

committee within the board should design management compensation plans so they are

congruent with corporate goals in addition to minimizing or reducing agency risk.

The board should maintain its independence from management. A key measure involved

would be that the chief executive officer (CEO) would not also be the chairman of the

board because there is already an inherent conflict with the CEO being on both the

management team and the board of directors. As a result, the CEO should not be given

additional powers on the board.

Topic 3

Cross Reference to GARP Assigned Reading- Crouhy, Galai, and Mark, Chapter 4

Page 28

The board should consider the introduction of a chief risk officer (CRO). The CRO would

technically be a member of management but would attend board meetings. The CRO's

objective would be to link the corporate governance duties to the firm's risk management

objectives. In terms of reporting, the CRO could report to the board and/or the

management team, depending on the specific nature of the CRO role within the firm.

Risk Management

The board of directors should demand substance over form. For example, business and

risk management strategies should strive for economic performance, not accounting

performance. To promote a robust risk management process within the firm, the board

should ensure sufficient upward mobility in terms of risk management careers, appropriate

staff remuneration, and logical reporting relationships.

The board should set up an ethics committee (either within the board or within the firm) to

require all staff to adhere to the firm's high ethical standards. The committee could also be

responsible for monitoring duties to ensure that those standards are upheld.

Similar to the issue of agency risk under corporate governance, the board should ensure that

performance measurement and compensation for all staff is consistent with the firm's goals

and the shareholders' interests. Specifically, compensation should be determined based on

performance on a risk-adjusted basis.

The board must provide approval on all major transactions after ensuring the transactions

are within the established risk appetite and consistent with the firm's overall business

strategy. In addition, the board should be prepared to pose probing and relevant questions

to management and other staff in the context of professional skepticism. Corroborating

information from a variety of sources and staff should increase the reliability and validity of

the answers obtained.

The board should have a risk committee in place. Similar to the corporate governance

best practice of having all members possessing a basic knowledge of the firm's business and

industry, all risk committee members need to understand the technical risk issues (e.g., risk

appetite, relevant time period) in order to ask appropriate questions and make informed

decisions.

The risk committee should be separate from the audit committee given the different

knowledge base and skills required in each area. However, it may be useful to have at least

one board member on both committees to ensure that the committees are working toward

the same corporate objectives.

Topic 3

Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 4

RISK GOVERNANCE

LO 3.2: Assess the role and responsibilities of the board of directors in risk

governance.

LO 3.4: Distinguish the different mechanisms for transmitting risk governance

throughout an organization.

In terms of risk governance, the board has some important responsibilities that could be

facilitated with the involvement of a risk advisory director. Given the specialized role of

the risk management and compensation committees, the specific duties of the risk advisory

director are highlighted below.

Risk Advisory Director

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.

More specific duties of the director (and the board in general) would include the review and

analysis of the following:

• The firm's risk management policies.

• The firm's periodic risk management reports.

• The firm's risk 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.

Risk Management Committee

Using a bank as an example, the risk management committee (within the board) is

responsible for identifying, measuring, and monitoring financial risks (i.e., credit, market,

liquidity). The committee is responsible for approving credit facilities that are above certain

limits or within limits but above a specific threshold. In addition, the committee monitors

the composition of the bank's lending and investment portfolios in light of the current

economic environment in terms of credit, market, and liquidity risk to determine if any

changes in the portfolio composition are required.

The risk management committee usually maintains an open line of communication with

the external audit, internal audit, and management teams.

Topic 3

Cross Reference to GARP Assigned Reading- Crouhy, Galai, and Mark, Chapter 4

Page 30

Compensation Committee

As discussed previously, the existence of agency risk necessitates the board to implement a

compensation committee to ensure appropriate risk taking in relation to the long-term risks

assumed. The compensation committee is independent of management. Its role is to discuss

and approve the remuneration of key management personnel.

Management compensation above base salary should be congruent with the goals of the

other stakeholders. In that regard, the committee should avoid designing compensation

plans with bonuses based on short-term profits or revenues given the relative ease in

which management may manipulate those amounts. Also, there could be the absence

of any guaranteed bonuses or a cap could be implemented on bonuses. Furthermore,

the committee may consider introducing elements of downside risk with management

compensation. For example, compensation may be deferred until longer-term results

are known or there could be clawbacks of previous bonuses paid if long-term results are

inconsistent with short-term results.

Stock-based compensation is a potential solution to align management and shareholder

interests. However, it is not a perfect solution because there is still potential for management

to take excessive risks; their upside potential is theoretically unlimited based on the stock

price increase but their downside potential is limited if the stock becomes worthless.

Another idea would be to provide "bonus bonds" as compensation that would be taken

away should a specific regulatory ratio requirement be breached.

Audit Committee

LO 3.6: Assess the role and responsibilities of a firm's audit committee.

The audit committee (as part of the board) has traditionally been 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. In that respect, the audit committee may be able to rely

on some or all of the work of the internal audit team, which usually reports directly to the

audit committee.

All members of the audit committee must possess sufficient financial knowledge in order

to perform in their role. This requires an understanding of the relevant accounting rules

(e.g., U.S. GAAP, IFRS), financial statements, and internal controls. As a collective, there

should be a proper balance of independence, knowledge of the business, and ability to ask

probing and relevant questions. The audit committee is largely meant to be independent of

management but it should work with management and communicate frequently to ensure

that any issues arising are addressed and resolved.

Finally, there should be responsibilities for the audit committee in terms of meeting

minimum (or higher) standards in areas such as legal, compliance, and risk management.

Topic 3

Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 4

There could also be duties related to optimizing the firm's operations in terms of

effectiveness and efficiency.

RISK APPETITE AND BUSINESS STRATEGY

LO 3.3: Evaluate the relationship between a firm's risk appetite and its business

strategy, including the role of incentives.

A firm's risk appetite reflects its tolerance (especially willingness) to accept risk. The

subsequent implementation of the risk appetite into defining the firm's risk limits sets some

bounds to its business strategy and to its ability to exploit business opportunities. The board

needs to develop/approve the firm's risk appetite as well as assist management in developing

the firm's overall strategic plan.

There must be a logical relationship between the firm's risk appetite and its business strategy.

As a result, business strategy planning meetings require input from the risk management

team right from the outset to ensure the consistency between risk appetite and business

strategy. For example, planning activities are often focused on maximizing the firm's profit

but some planned activities may need to be eliminated or modified because they exceed

the stated risk appetite. Furthermore, the scope of some planned activities may be too large

in the context of the firm's total assets or equity. Consideration must also be given to the

downside risks of any business strategy.

To make sure that a firm's risk management plan aligns risk appetite with business

decisions, the firm should rely on its risk infrastructure while taking into account incentive

compensation plans. An appropriate infrastructure should be in place to allow the firm to

identify, evaluate, and manage all relevant risks. The results of incentive compensation plans

should also be monitored to ensure that the firm's risk-adjusted return on capital meets the

long-term expectations of stakeholders.

INTERDEPENDENCE OF FUNCTIONAL UNITS

LO 3.5: Illustrate the interdependence of functional units within a firm as it relates

to risk management.

The various functional units within a firm are dependent on one another when it comes

to risk management and reporting. All transactions must be recorded correctly and in the

appropriate period in order to ensure the accuracy of the periodic profit and loss (P&L)

statements. Using an investment bank, consider five separate units: (1) senior management,

(2) risk management, (3) trading room management, (4) operations, and (5) finance. The

interdependence of managing risk among these functional units is illustrated in Figure 1 .

Topic 3

Cross Reference to GARP Assigned Reading- Crouhy, Galai, and Mark, Chapter 4

Page 32

Figure 1 : Interdependence

Senior Management

• Approves business plans and targets

• Sets risk tolerance

• Establishes policy

• Ensures performance

Risk Management

• Develops risk policies

• Monitors compliance to limits

• Manages risk committee process

• Vets models and spreadsheets

• Provides independent view on risk

• Supports business needs

Trading Room Management

• Establishes and manages risk exposure

• Ensures timely, accurate, and complete deal capture

• Signs off on official P&L

Operations

• Books and settles trades

• Reconciles front- and back-office positions

• Prepares and decomposes daily P&L

• Provides independent mark to market

• Supports business needs

Finance

• Develops valuation and finance policy

• Ensures integrity of P&L

• Manages business planning process

• Supports business needs

Crouhy, M., Galai, D., & Mark, R. (2014). Chapter 4: Corporate Governance and Risk

Management (Figure 4-2). The Essentials of Rsi k Management (2nd edition). New York: McGrawHill,

2014.

There are many examples of interdependence among the functional units. Overall, the

operations unit is extremely important to all the other units in terms of generating and

maintaining the data needed to manage risk. All trades are recorded and all reconciliations

are performed within operations.

The finance unit develops valuation and finance policies. Those valuation policies are

subsequently applied by the operations unit when it prepares asset valuations. The P&L

statement (i.e., income statement) is developed by the operations and finance units and

ultimately approved by trading room management. Note the consistent support of the

bank's business needs by the risk management, operations, and finance units.

Topic 3

Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 4

LO 3.1

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.

L0 3.2

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.

LO 3.3

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.

Topic 3

Cross Reference to GARP Assigned Reading- Crouhy, Galai, and Mark, Chapter 4

Page 34

L0 3.4

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.

LO 3.5

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: (1) senior management, (2) risk management, (3) trading room

management, (4 ) operations, and (5) finance.

L0 3.6

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.

Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 4

1 . "Which of the following statements about best practices in corporate governance and

risk management is most accurate?

A. The board should keep the risk committee separate from the audit committee.

B. The board should ensure that it has the firm's chief risk officer as a member of

the board.

C. The board should focus on management's actions and their impact on the

interests of the firm's shareholders.

D. The board should focus on accounting performance instead of economic

performance because of the importance of maintaining or enhancing the firm's

stock price.

2. The role of the risk advisory director on the board is important in ensuring sufficient

risk oversight of the firm by the board. "Which of the following specific items would

the risk advisory director review and analyze?

I. Internal audit reports.

II. Information on the firm's related parties.

A. I only.

B. II only.

C. Both I and II.

D. Neither I nor II.

3. "Which of the following statements regarding the firm's risk appetite and/or its

business strategy is most accurate?

A. The firm's risk appetite does not consider its willingness to accept risk.

B. The board needs to work with management to develop the firm's overall strategic

plan.

C. Management will set the firm's risk appetite and the board will provide its

approval of the strategic plan.

D. Management should obtain the risk management team's approval once the

business planning process is finalized.

4. The various responsibilities surrounding the profit and loss (P&L) statement

illustrate the importance of understanding the interdependence of managing risk

within a firm. Within an investment bank, which functional unit is most likely to

provide final approval of the P&L?

A. Finance.

B. Operations.

C. Senior management.

D. Trading room management.

5. "Which of the following statements regarding the role of the firm's audit committee is

most accurate?

A. At least one member of the audit committee must possess sufficient financial

knowledge.

B. The audit committee may consist of some members of the management team.

C. The audit committee is only responsible for the accuracy of the financial

statements.

D. The audit committee is meant to work dependently with management.

Topic 3

Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 4

Page 36

1 . A The risk committee should be separate from the audit committee given the different

knowledge base and skills required in each area.

Choice B is not correct because the firm's chief risk officer (CRO) is technically a member

of management but does attend board meetings regularly. Although the CRO may report to

management and/or the board, the CRO should not be a member of the board. Choice C

is not correct because the board should consider the impact on all of the firm's stakeholders

(i.e., debtholders, shareholders) and not just the shareholders. Choice D is not correct

because the board should ensure that business and risk management strategies should strive

for economic performance, not accounting performance.

2. C The risk advisory director should review and analyze internal audit reports and information

on the firm's related parties because they are directly relevant in assessing the firm's risk level

from the board's perspective.

3. B The board needs to develop/approve the firm's risk appetite as well as assist management in

developing the firm's overall strategic plan.

Choice A is not correct because the firm's risk appetite considers its willingness to accept

risk. Choice C is not correct because both management and the board will set the firm's risk

appetite. Choice D is not correct because management should involve the risk management

team in the business planning process right from the outset to ensure the consistency

between risk appetite and business strategy.

4. D Trading room management is responsible for signing off on the official P&L. Choice A is

not correct because the .finance unit ensures the integrity of the P&L. Choice B is not correct

because the operations unit prepares and decomposes the daily P&L. Choice C is not correct

because senior management does not have any responsibilities for the P&L from a risk

• management perspective.

5. B The audit committee consists primarily of non-management members but there may be

some management members (e.g., chief .financial officer).

All members of the audit committee must possess sufficient .financial knowledge. The audit

committee is responsible for the accuracy of the .financial statements but that alone does not

comprise its main responsibility. Additionally, the audit committee monitors the underlying

systems in place regarding .financial reporting, regulatory compliance, internal controls, and

risk management. The audit committee is largely meant to be independent of management

but it should work with management and communicate frequently to ensure that any issues

arising are addressed and resolved.

The following is a review of the Foundations of Risk Management principles designed to address the learning

objectives set forth by GARP®. This topic is also covered in:

WHAT IS E ;> •

Topic 4

EXAM Focus

Enterprise risk management (ERM) is a relatively recent concept that emerged in response to

moving away from the traditional approach to risk management under which each risk was

assessed, managed, and mitigated separately by a specific unit within the firm. In this topic,

you will gain familiarity with the concept and definitions of ERM, its benefits and costs, and

the seven major components of ERM. The role of the chief risk officer can also be a critical

component in the implementation and success of the ERM program across the firm. For the

exam, be familiar with the three motivations of the ERM program, and understand each of

the seven components of a successful ERM program.

ENTERPRISE RISK MANAGEMENT

LO 4. 1 : Describe enterprise risk management (ERM) and compare and contrast

differing definitions of ERM.

Companies face a variety of risks that arise from company operations, including but not

limited to: credit, market, liquidity, operational, business, and information technology (IT)

risks. Within the traditional approach to risk management, each of these primary risk types

was evaluated by a specific unit within the organization in isolation, independent of the

other risk types. For example, a company's traders were responsible for managing market

risk, actuaries managed insurance risk, and management analyzed business risk.

While the traditional approach may have been adequate in a less volatile market

environment, it suffers from the shortcoming of ignoring the dynamic nature of risks and

their interdependencies. One risk type can affect another, and risks (or their hedges) can

be offsetting if viewed from the perspective of the entire company. Treating each primary

risk type in isolation ignores these interdependencies and can result in inefficient and costly

overhedging of risks at the firm level. In addition, the various functional units responsible

for evaluating and measuring risks may all use different methodologies and formats in their

risk measurements. Without a centralized risk management system, a company's senior

management and its board of directors would receive fragmented information from the

various units, each potentially utilizing different measurement methods.

Given the noted shortcomings of the traditional approach, an integrated and centralized

framework would significantly increase the efficiency of managing company risks. Such a

centralized approach is referred to as enterprise risk management (ERM).

Topic 4

Cross Reference to GARP Assigned Reading -Lam, Chapter 4

ERM Definitions

Since the concept of ERM is relatively new and is still evolving, there is a lack of a standard

ERM definition. ERM is often defined as a process or activity to manage risks. For example,

the following definition was provided by the Committee of Sponsoring Organizations of the

Treadway Commission (COSO) in 2004:

"ERM is a process, effected by an entity's board of directors, management, and other personnel

applied in strategy setting and across the enterprise, designed to idenrify potential events

that may affect the entity, and manage risk to be within its appetite, to provide reasonable

assurance regarding the achievement of entity objecrives. "

The International Organization of Standardization (ISO 3000) provides the following

definition:

"Risk is the effect of uncertainty on objectives and risk management refers to coordinated

activities to direct and control an organization with regard to risk. "

Both of the previous definitions contain useful ideas of ERM, but they do not define it as a

value-added concept. As a result, a more useful definition of ERM is as follows:

"Risk is a variable that can cause deviation from an expected outcome. ERM is a

comprehensive and integrated framework for managi,ng key risks in order to achieve business

objecrives, minimize unexpected earnings volatility, and maximize firm value. "1

ERM is crucial in establishing a firm-wide, integrated set of policies, procedures, and

standards. From senior management's perspective, an ERM system provides an invaluable

overall risk perspective and control.

ERM BENEFITS AND COSTS

LO 4.2: Compare the benefits and costs of ERM and describe the motivations for a

firm to adopt an ERM initiative.

There are three primary motivations for a firm to implement an ERM initiative:

(1) integration of risk organization, (2) integration of risk transfer, and (3) integration of

business processes. The respective benefits are better organizational effectiveness, better risk

reporting, and improved business performance. However, implementation of an integrated

firm-wide initiative is costly (both capital and labor intensive) and time-consuming. This

process could last several years and requires ongoing senior management and board support.

Integration of Risk Organization: Increased Organizational Effectiveness

While most companies have many individual risk management functions, including market,

credit, and various other risk units, an effective ERM strategy aggregates these risks under

a centralized risk management process. Under a centralized process, the role of a chief

1 James Lam, Enterprise Risk Management: From Incentives to Controls, 2nd Edition, (Hoboken,

NJ: John Wiley & Sons, 2014), 53.

Topic 4

Cross Reference to GARP Assigned Reading - Lam, Chapter 4

risk officer (CRO) is often created, which reports to the company's chief executive officer

(CEO) and/or the board, while the various risk management units report to the CRO. The

benefit of a centralized approach is a top-down, coordinated framework that factors in the

relationships and interdependencies of various risks.

Integration of Risk Transfer: Better Risk Reporting

Under the traditional, non-ERM approach, the various risks facing the company were

evaluated by individual units within the organization, where each unit managed its own

risk. For example, market risk was managed through derivatives, while operational risk

was managed with insurance. This approach is useful in mitigating isolated risks, but it

does not account for diversification within or across the various risk types, which could

lead to over-hedging of risks or taking out excessive insurance coverage. Further, since no

one unit is responsible for overall risk reporting, reporting of risks can be inconsistent and

contradictory.

By contrast, ERM enables the company to take a holistic view of all risks and risk hedges

used in order to hedge only those undesirable residual risks that still remain after factoring

in diversification across risks. Risks are categorized under a risk dashboard of key risks,

which includes an enterprise level description of key exposures, total losses, policy

exceptions, and even early warning indicators. Senior management and the board are,

therefore, able to take a big picture view of the interplay between each of the risks and can

take appropriate measures to mitigate any residual risk.

Integration of Business Processes: Improved Business Performance

The third element of ERM is integrating risk management into the company's business

processes. ERM can optimize business performance through business decisions, including

capital allocation, product development and pricing, and efficient allocation of resources.

This optimization results in reduced risk and only takes on the most profitable risks

(i.e., maintains only those risks whose cost is less than the benefit of the corresponding

project). Traditional risk measures such as value at risk (VaR) and risk-adjusted return on

capital (RAROC) have been increasingly used to measure not only market risk but also

credit and operational risk, while alternative risk measures such as credit derivatives are

increasingly used to mitigate additional risks. The end result is a reduction in losses, lower

earnings volatility, increased earnings, and higher shareholder value.

An effective ERM initiative allows company management to understand the major risk

exposures and to set up adequate risk reporting. At the same time, auditors and regulators

assess the company's ERM and set the necessary capital and compliance requirements for

the board and senior management. In order to adequately address these requirements, the

role of a "risk champion" has become more widespread, typically in the position of a CRO.

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Page 40

THE CHIEF RISK OFFICER

LO 4.3: Describe the role and responsibilities of a chief risk officer (CRO) and

assess how the CRO should interact with other senior management.

The specific role of the CRO was created in the early 1990s in response to the emergence of

new financial instruments and the integration of capital markets. The CRO is responsible

for all risks facing a company, including market, credit, operational, and liquidity risks,

and specifically responsible for developing and implementing an ERM strategy. The role

is prominent among financial firms, firms with significant investment activities or foreign

operations, and energy firms.

The CRO is a top-level executive responsible for overall risk management in a centralized

role. Reporting to the CRO typically are the heads of the various risk functions, including

the heads of credit, market, operational, and insurance risks. The CRO provides overall

leadership, vision, and direction for ERM and develops a framework of management

policies, including setting the overall risk appetite of the firm. This includes measuring

and quantifying risks and setting risk limits, developing the requisite risk systems, and

communicating a clear vision of the firm's risk profile to the board and to key stakeholders.

Within the firm's hierarchy, the CRO typically reports to the CEO or the chief financial

officer (CFO); however, the role is placed somewhere between the CEO/CFO and the

board. Often there is a dotted line relationship with dual reporting to both the CEO/CFO

and to the board. The dotted line relationship is intended to minimize any potential friction

between the CRO and the firm's CEO or other top executives due potentially to excessive

risk taking, regulatory issues, or outright fraud by the CEO or executives. In order to

properly establish the reporting structure, it is important that the role of the CRO is clearly

defined with clear goals and responsibilities for hiring and firing decisions.

Of course, the creation of the CRO role is not the only solution to establishing top-level

risk oversight. The firm's audit committee could also take on this role; however, the audit

functions are typically already stretched in their capacity to take on additional oversight

roles. The centralization of all risk responsibilities could also be assigned to the CEO or

CFO; however, there is strong support for establishing a separate oversight function in the

role of the CRO who has experience and focused responsibility for risk management.

Over the last couple of decades, the CRO position, with its focused approach to risk

management, has provided greater visibility and effectiveness to the role and to ERM. The

role now represents the culmination of the risk executive functions with escalating salaries,

and a company's CRO is often a contender for the highest executive roles including the

role of the CEO. An ideal CRO possesses five critical skills: (1) leadership, (2) power of

persuasion, (3) ability to protect the firm's assets, ( 4) technical skills to understand all risks,

and (5) consulting skills to educate the board and business functions on risk management.

Topic 4

Cross Reference to GARP Assigned Reading - Lam, Chapter 4

ERM FRAMEWORK COMPONENTS

LO 4.4: Distinguish between components of an ERM program.

There are seven components of a strong ERM framework: (1) corporate governance, (2) line

management, (3) portfolio management, (4) risk transfer, (5) risk analytics, (6) data and

technology resources, and (7) stakeholder management.

Corporate governance is critical in the implementation of a successful ERM program and

ensures that senior management and the board have the requisite organizational practices

and processes to adequately control risks. Corporate governance practices have evolved

considerably through recent regulatory initiatives including the Turnbull Report and the

Sarbanes-Oxley Act. A successful corporate governance framework requires that senior

management and the board adequately define the firm's risk appetite and risk and loss

tolerance levels. In addition, management should remain committed to risk initiatives and

ensures that the firm has the required risk management skills and organizational structure

to successfully implement the ERM program. An effective framework also requires that

all key risks are successfully integrated into the ERM program and those responsible for

implementing the program have clearly defined risk roles and responsibilities, including the

role of the CRO. Oversight, audit, and monitoring targets are also crucial components of

the ERM governance process.

Line management is the management of activities that relate directly to producing a firm's

products and services. Line management is critical as it integrates business strategy into

corporate risk policy, assesses the relevant risks, and incorporates them into pricing and

profitability decisions. The assessment process should include adequate due diligence to

determine which risks line managers can accept without senior management or board

approval. In terms of addressing relevant risks, managers should include the cost of risk

capital and expected losses in decisions about product pricing or investment returns.

Portfolio management provides a holistic view of the firm's risks if these risks are viewed as

individual components of the aggregate risks facing the firm. Active portfolio management

aggregates risk exposures and allows for diversification of risks (partly through offsetting risk

positions) and prudent monitoring of risk concentrations against preset limits. Firms that

manage each of their financial risks independently will need to integrate these risks into a

comprehensive ERM process to optimize firm risk and return.

Risk transfer reduces or transfers out risks that are either undesirable risks or are desirable

but considered concentrated (i.e., excessive risks). Concentrated risks can be especially risky

for a company, and it is crucial that these positions are adequately monitored and mitigated.

Risks could also be transferred to third parties if it is more cost effective to manage them

externally. Risks can be offioaded through derivatives, insurance, and hybrid products.

Natural hedges within the portfolio could also be incorporated into the risk transfer process

to reduce hedging and insurance costs, even in the absence of third-party protection.

Risk analytics quantifies risk exposures for use in risk analysis, measurement, and

reporting. Many of the risks facing the firm can be quantified including credit, market,

and operational risk. Risk analytics can be used to calculate the cost-effective way of

reducing risk exposures. It is also useful in evaluating the cost of managing risks in-house

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Page 42

or externally as long as the cost of managing them externally is cheaper. The analysis and

quantification of various risks can ultimately increase shareholder value, boosting net

present value (NPV) and economic value added (EVA).

Data technology and resources improve the quality of data used in evaluating risks.

Management faces the challenge that various systems used by the firm capture different

price, volatility, or correlation metrics. Data technology and resources can mitigate these

challenges by being incorporated into the firm's ERM program. Even if the technological

resources available to the firm are not perfect, firms should incorporate them into the ERM

system as early as possible.

Stakeholder management facilitates communicating a firm's internal risk management

process to external stakeholders, including shareholders, creditors, regulators, and the

public. The information shared with stakeholders is also important for rating agencies

and analysts as they use this information in developing their research and credit opinions.

A firm's internal risk management should be transparent to stakeholders, should provide

adequate assurances that management follows prudent risk practices, and should include

regular updates on the key risk factors facing the organization.

Topic 4

Cross Reference to GARP Assigned Reading - Lam, Chapter 4

LO 4.1

An integrated and centralized approach under ERM is significantly more effective in

managing a company's risks than under the traditional silo approach of managing and

centralizing risks within each risk/business unit. ERM is a comprehensive and integrated

framework for managing a firm's key risks to meet business objectives, minimize unexpected

earnings volatility, and maximize firm value.

L0 4.2

The key motivations of an ERM initiative include integration of risk organization,

integration of risk transfer, and integration of business processes, which lead to increased

organizational effectiveness, better risk reporting, and improved business performance,

respectively.

L0 4.3

The chief risk officer (CRO) is responsible for all risks facing a company, including market,

credit, and operational risks and is responsible for developing and implementing an ERM

strategy. The CRO provides overall leadership for ERM and develops policies and standards,

including setting the firm's overall risk appetite, measuring and quantifying risks and setting

risk limits, and developing risk systems.

The CRO generally reports to the CEO or CFO but could also have a dotted line

relationship to both the CEO/CFO and to the board to minimize any potential friction

between the CRO and the CEO/CFO (due to excessive risk taking, regulatory issues, or

fraud).

An ideal CRO possesses five critical skills: (1) leadership, (2) power of persuasion, (3) ability

to protect the firm's assets, (4) technical skills to understand all risks, and (5) consulting

skills to educate the board and business functions on risk management.

L0 4.4

A strong ERM framework has seven main components: (1) corporate governance, (2) line

management, (3) portfolio management, (4) risk transfer, (5) risk analytics, (6) data and

technology resources, and (7) stakeholder management.

Topic 4

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Page 44

I. The basis of enterprise risk management (ERM) is that:

A. risks are managed within each risk unit but centralized at the senior

management level.

B. the silo approach to risk management is the optimal risk management strategy.

C. risks should be managed and centralized within each risk unit.

D. it is necessary to appoint a chief risk officer to oversee most risks.

2. Jimi Chong is a risk analyst at a mid-sized financial institution. He has recently

come across an article that described the enterprise risk management (ERM)

process. Chong does not believe this is a well-written article, and he identified four

statements that he thinks are incorrect. -which of the following statements identified

by Chong is actually correct?

A. One of the drawbacks of a fully centralized ERM process is over-hedging risks

and taking out excessive insurance coverage.

B. Effective ERM has three key benefits: improved business performance, better

risk reporting, and stronger stakeholder management.

C. Managing downside risk and earnings volatility are optional ERM strategies.

D. A prudent ERM strategy allows a firm to accept more of the profitable risks.

3. -which of the following statements regarding the responsibilities of the chief risk

officer ( CRO) is least accurate?

A. The CRO should provide the vision for the organization's risk management.

B. In addition to providing overall leadership for risk, the CRO should

communicate the organization's risk profile to stakeholders.

C. Although the CRO is responsible for top-level risk management, he is not

responsible for the analytical or systems capabilities for risk management.

D. The CRO may have a solid line reporting to the CEO or a dotted line reporting

to the CEO and the board.

4. Luke Drake has been recently appointed as the chief risk officer (CRO) of a nonprofit

organization. Drake is looking to implement a comprehensive enterprise risk

management (ERM) program and had several discussions with senior management

on this topic. During one of these discussions, Drake made the following statements:

Statement 1 : ''Risk analytics is a key component of ERM and refers to the integration

of risk management into the revenue generating activities of the

. . ,, organization.

Statement 2: "While an organization can hedge desirable risks, it is unable to hedge

undesirable risks. "

Is Drake correct regarding risk analytics and risk hedging?

Risk analytics Risk hedging

A. Correct Incorrect

B. Incorrect

C. Correct

D. Incorrect

Incorrect

Correct

Topic 4

Cross Reference to GARP Assigned Reading - Lam, Chapter 4

5. Allen Richards sits on the board of directors of a Canadian financial institution.

Richards read the following statements in a presentation made to the board of

directors by management on the institution's enterprise risk management strategies:

Statement 1 : "To manage undesirable risks, the insriturion could use third-party

protection, including insurance products. "

Statement 2: "Although third-party protecrion is expensive, this is a cost of business, and

it is not possible to reduce these costs. "

Richards believes both of these statements are incorrect. Richards' assessment is

accurate with respect to:

A. Statement 1 only.

B. Statement 2 only.

C. Both statements.

D. Neither statement.

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Cross Reference to GARP Assigned Reading -Lam, Chapter 4

Page 46

1 . A The basis of enterprise risk management (ERM) is that risks are managed within each risk

unit but centralized at the senior management level.

The traditional approach to risk management was the silo approach, under which each

firm unit was responsible for managing its own risks, setting its own policies and standards,

without coordination between the risk units. ERM is a superior approach because

management benefits from an integrated approach to handling all risks (for example,

management can see risks within the firm that cancel out and, therefore, do not need to be

separately hedged). It is common, but not necessary, to appoint a chief risk officer to oversee

all risks under ERM.

2. D A strong ERM strategy allows a firm to accept more of the profitable risks and reject

unprofitable risks.

Over-hedging risks and taking out excessive insurance coverage are issues faced by companies

that do not have an integrated ERM strategy. In addition to improved business performance

and better risk reporting, the third benefit of effective ERM is improved organizational

effectiveness. Managing downside risk and earnings volatility are strategies typical of

companies with a defensive approach to risk management, whereas effective ERM focuses on

optimizing performance, influencing pricing, and allocating resources effectively.

3. C While it is accurate that the CRO is responsible for top-level risk management, he is also

responsible for the analytical or systems capabilities for risk management.

4. B Both of Drake's statements are incorrect. Line management, not risk analytics, refers to the

management of activities that relate directly to producing a firm's products and services. Line

management is critical as it integrates business strategy into corporate risk policy.

Through risk transfer, management can utilize a successful ERM program to transfer out

both undesirable risk and desirable, concentrated risks. Hedging is typically done with

derivatives, insurance, and hybrid products.

5. B Richards was wrong in identifying Statement 1 as being incorrect. Statement 1 is, in fact,

correct because when managing undesirable risks, an institution could use third-party

protection, including various hedges and insurance products.

Richards accurately identified Statement 2 as being incorrect. While it is true that thirdparty

protection can be expensive, by incorporating natural hedges in a risk portfolio, the

institution could reduce its hedging and insurance costs.

The following is a review of the Foundations of Risk Management principles designed to address the learning

objectives set forth by GARP®. This topic is also covered in:

RISK-TAKING AND RISK MANAGEMENT

BY BANKS

EXAM Focus

Topic 5

This topic begins by discussing how a bank's optimal level of risk exposure is tied to a target

default probability or credit rating. From there, it examines the impact of a bank taking

on too little or too much risk compared to its optimal level, along with actions that may

add or destroy value for the bank. For the exam, understand how banks determine their

optimal level of risk exposure and be able to describe implications for risk-taking activities. In

addition, understand the limitations of and challenges to effective risk management as well as

the impacts of governance, incentives, and culture on a bank's risk profile and performance.

OPTIMAL LEVEL OF RISK

LO 5.1: Assess methods that banks can use to determine their optimal level of risk

exposure, and explain how the optimal level of risk can differ across banks.

Methods to Detem1ine Optimal Level of Risk Exposure

Targeting a certain default probability or targeting a specific credit rating. In general, a bank

should not always aim to earn the highest credit rating possible (e.g., AAA). Earning the

AAA rating would likely involve a large opportunity cost as the bank would have to forego

risky projects that could otherwise earn high profits. For example, assume that the necessary

research and analysis has revealed that a bank's optimal level of risk exposure is represented

by an AA credit rating (i.e., a very low probability of default-less than 0.08o/o). In that

case, the bank should target the appropriate probability of default in determining its

optimal level of risk exposure. Aiming for AAA may constrain the bank's risk-taking ability

and reduce its returns due to lost profitable projects. Aiming for BBB may result in lost

customers due to the perception that the bank is engaging in excessive risk-taking activities.

Sensitivity analysis or scenario analysis. Alternatively, a bank could determine its optimal

level of risk exposure by the impact of specific shocks. For example, there could be adverse

impacts on the value of a bank due to changes in one or more of the following items:

interest rates, foreign exchange rates, or inflation. Measuring the cumulative impact on the

bank's value for a given scenario may be problematic because the individual shocks may

work in opposition to one another (i.e., one shock may decrease value while the other shock

may increase value).

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Page 48

How the Optimal Level of Risk Can Differ Across Banks

The optimal level of risk depends on the specific focus of the bank's activities, so it will

differ among banks. For example, a bank that is focused on deposits, relationship lending

customers, or both would usually set the level of risk lower and target a higher credit rating

in order to satisfy its customers' desire for safety. The same would occur if the bank is a

frequent counterparty in long-term derivatives transactions; the other counterparties would

want to ensure the bank is a safe and reliable counterparty to deal with. In contrast, a bank

that is focused more on transactional activities would usually set the level of risk higher and

target a lower credit rating.

The relationship between the value of a bank and its credit rating is concave, which suggests

that there is a maximum or optimal value at a specific credit rating. At a high target rating

(e.g., A rated), the value of the bank will decrease significantly if the bank takes on more

risk than is optimal, and the value will only increase slightly if the bank takes on more risk

toward the optimal level. At a lower target rating (e.g., BB rated), the value of the bank will

also decrease significantly if the bank takes on more risk than is optimal, but the value will

increase significantly as it takes on more risk toward the optimal level.

RISK-TAKING IMPLICATIONS

LO 5 .2: Describe implications for a bank if it takes too little or too much risk

compared to its optimal level.

Overall, banks need to take on an optimal amount of risk (usually not zero) in order to

maximize shareholder value while satisfying the constraints imposed by bank regulators.

In general terms, if a subject bank takes on too little risk, it may fail to capitalize on

enough profitable opportunities and, therefore, may generate suboptimal returns for its

shareholders. Ultimately, too little risk may decrease the value of the subject bank. On the

other hand, if a subject bank takes on too much risk, it may become distressed, which could

result in losses for other banks that are counterparties to the subject bank that is defaulting

on unsecured obligations. As more banks suffer similar losses, there is an increasing threat to

the stability of the financial system. Ultimately, too much risk may also decrease the value of

the subject bank.

Consider a general situation where a bank is valued for its ability to provide safe and liquid

investments to its customers. If the bank takes on too much risk, then that may impair its

ability to provide safe and liquid investments. As mentioned earlier, too much risk may

reduce the value of the bank.

LO 5.3: Explain ways in which risk management can add or destroy value for a

bank.

If incremental changes in risk taken do not result in much change in the value of a bank,

then investing in risk management is destroying the bank's value due to the fixed cost of

having a risk management department. However, if taking on incremental risk would

Topic 5

Cross Reference to GARP Assigned Reading - Stulz

otherwise result in excessive total risk and a significant decrease in the bank's value, then

there is added value in having risk management policies to prevent the bank from taking on

excessive risk. In other words, if there is a very high cost of having incremental risk above

the optimal level, then there is value in having a risk management department to ensure

compliance with specific risk limits.

If a bank adopts a risk management process that is inflexible in order to manage the

bank's risk below a set acceptable threshold level, it may end up controlling risk, but not

allowing for any value creation. In contrast, a more flexible and properly functioning risk

management process would allow a bank to take on profitable risks and take advantage

of investment opportunities that could increase its value. In that sense, risk management

becomes a crucial part of the bank's operations that aims to create policies intended to

increase the bank's value.

Different business units are unable to determine for certain whether the risks they are taking

will add or destroy value to the firm as a whole. That is because the total amount of risk

that the bank is able to take is dependent on all of the risks taken by the various business

units. As a result, the risk management function can add value by requiring all business

units to take the perspective of the entire bank when making decisions regarding risks. This

perspective will assist the bank in operating at its optimal level of risk.

RISK MANAGEMENT CHALLENGES AND LIMITATIONS

LO 5.4: Describe structural challenges and limitations to effective risk

management, including the use ofVaR in setting limits.

Limitations of Hedging

Risk management through hedging alone will not result in risk management becoming a

passive activity due to (1) risk measurement technology limitations, (2) hedging limitations,

and (3) risk-taker incentive limitations.

Real-time risk measures do not exist for entire banks although they do exist for certain

banking activities. Additionally, risk measures are far from perfect and can result in

inaccurate computations. A potential solution to underestimating risk would be to create

a risk buffer by placing a limit significantly below the target for any given risk measure.

Finally, excessive optimism and the effects of group decision making could result in key

issues being overlooked.

In theory, hedging would reduce risk perfectly if a bank was able to measure its risk

perfectly. However, in practice, many risks are nearly or entirely impossible to hedge

(e.g., terrorism risk), and some hedges are imperfect because of the inability to perfectly

match the hedging vehicle with the underlying asset to be hedged.

Some risk takers within the bank (e.g., traders) are motivated to maximize their

compensation by taking excessive risks that may ultimately reduce the value of the bank.

Limitations in risk measurement tools may allow such activities to occur without the

knowledge of the bank's management.

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Page 50

& a result, the bank must actively measure, monitor, and manage its risk on an on-going

basis.

Role of Risk Management Within the Bank

Ideally, effective risk management would require that the risk management function within

a bank be independent of the activities of its business lines. However, it is not possible for

risk management merely to have a verification function. For example, risk management also

involves advising whether to accept or reject a risky project based on established risk limits.

There must be a separation between the manager to whom the risk manager reports and the

manager of the business line that he is monitoring. However, if the risk manager aspires to

work in that business line in the future, then there may be a problem with independence.

Another key point is that if the risk management process is viewed as a form of internal

policing, then the necessary dialogue between risk managers and business unit managers

will not exist. Specifically, it will be difficult for risk managers to obtain information and

understand the business units' strategies. The risk managers will probably not be given

the necessary information to assess the bank's risks, thereby potentially causing them to

make incorrect risk assessments (e.g., underestimation) and not enabling them to propose

mitigation procedures in a timely fashion.

Value at Risk

A unit within a bank that uses the value at risk (VaR) measure in setting limits must

consider its ability to adjust its VaR by trading efficiently (i.e., quickly and at a low cost). If

the bank is able to do so, then it can stay near the limit. If it is unable to do so, then it will

want to operate at a lower level of risk in order to take advantage of opportunities that may

arise later on. The same could conceivably occur in other units so that, overall, the bank is

not making optimal use of its ability to take risk, potentially resulting in lower profits.

Banks often break down their risks into three categories: (1) market, (2) credit, and

(3) operational risk. In measuring risk at the firm level, the resulting VaR is not likely

to account for all risks, especially operational. Many banks earn non-interest income

(e.g., service charges, set-up fees); such income is variable in nature and is typically low

if there are loan losses incurred by the bank. Therefore, non-interest income must be

specifically modeled in obtaining a more accurate measure of firmwide VaR. Interest rate

risks pertaining to a bank's liabilities are usually not included in firmwide VaR measures.

Additionally, credit VaR measures do not consistently take into account the risks pertaining

to unexpected interest rate and credit spread changes. Finally, firmwide VaR measures often

do not consider funding liquidity risk. Funding liquidity risk refers to a sudden reduction in

funding to the bank, which often necessitates a sale of assets at a discount or loss.

The aggregation of market, credit, and operational risks in arriving at a firmwide risk

measure needs to consider the correlation estimates between such risks; the higher the

correlations, the higher the firmwide VaR (and vice versa). Unfortunately, there is usually

insufficient data available to make such estimates accurately. Furthermore, errors in

computing such estimates may result in the bank holding insufficient capital and exceeding

its targeted risk of default.

Topic 5

Cross Reference to GARP Assigned Reading - Stulz

Different types of risk will lead to differing statistical distributions. For example, market

risk is usually modeled reasonably accurately using the normal (symmetrical) distribution,

despite market risk having fatter tails. It is relatively easy to sum up the risks that follow a

normal distribution. However, credit and operational risks have distributions that are both

fat-tailed and very skewed. As a result, it is much more challenging to add up risks that

follow a non-normal distribution.

When examining a daily VaR level, for example, of 0.08o/o (corresponding approximately

to the probability of default for a bond rated AA), there is the issue of not having enough

history to properly determine if the VaR level is unbiased, biased upward, or biased

downward. In comparison, a 5o/o daily VaR suggests that it will be exceeded about 13 times

annually (given 250 trading days), so empirical results (e.g., exceeded more or less than

13 times) can be used to test the underlying assumptions.

Similarly, unknown risks have no impact when VaR is estimated at a probability level that is

not exceedingly low. Unknown risks become an issue ifVaR is estimated at an extremely low

level such as 0.08o/o. Losses at such a low VaR level would be due to extremely rare events.

In that case, analyzing historical data is insufficient because there would not be enough

historical data spanning a long enough period to determine an accurate measure of extreme

losses that have a 0.08o/o chance of occurring.

BANK RISK PROFILE AND PERFORMANCE

LO 5.5: Assess the potential impact of a bank's governance, incentive structure and

risk culture on its risk profile and its performance.

Governance

In general, it is difficult to demonstrate that a bank's governance has a significant impact on

its risk profile and performance. First, there is very limited data on how the risk function

operates in banks. Second, risk function characteristics are affected by the bank's risk

appetite in addition to governance. For example, it may be optimal for a bank not to carry

much risk based on the characteristics of its risk function. In fact, for such a bank it may be

very expensive to carry too much risk. Therefore, by having risk management policies that

promote low risk, one might incorrectly conclude that carrying low risk is a result of good

governance. Third, it is possible that at the firm level, poor performance will occur even in

the presence of strong governance. A negative outcome is not always indicative of taking

on too much risk or poor governance. It is possible that an extremely low probability event

occurred that was already considered by the bank in setting risk.

One study by Lingel and Sheedy (2012)1 looks at the returns of the 60 largest publicly

traded banks between 2004 and 2010 as well as the role of the chief risk officer (CRO).

The study demonstrates that stronger governance in one year leads to lower risk (in terms of

stock return volatility and worst weekly return) in the following year. It also demonstrates

that banks that have CROs with higher status (e.g., one of the top executives, one of

1 Lingel, Anna, and Elizabeth Sheedy. "The Influence of Risk Governance on Risk OutcomesInternational

Evidence" (working paper, Macquarie University, 2012).

Topic 5

Cross Reference to GARP Assigned Reading- Stulz

the most highly paid) have lower risk. However, there is no evidence that such stronger

governance leads to higher performance in terms of ex-post returns.

At the same time, there is some evidence of the impact of governance on risk and

performance. Some studies have focused on the CRO centrality variable ( CRO

compensation as a percentage of CEO compensation) whereby a higher CRO centrality

leads to lower volatility and higher performance. Other studies have determined that banks

performed better where the CRO reports to the board instead of the CEO. Finally, one

study by Berg (2014)2 considers a situation at a bank where loan officers are paid bonuses

based on loan volumes generated. By adding a risk management element through the

monitoring of loan decisions, there is empirical evidence that the default rate on the loans

decreases as a result.

Incentive Structure

In general, incentives must be designed so that they do not merely reward managers for the

performance of their respective business units alone. Incentives should reward managers for

taking risks that create value for the overall bank while at the same time penalize them for

taking risks that destroy value.

In designing incentives to compensate management, the concept of risk capital needs to be

considered. Risk capital is the amount of capital a bank holds in order to support its risk

appetite. Therefore, the cost of acquiring more equity capital to support the risks taken by

the bank has to be considered when deciding whether or not to take a risk. If the cost is too

high, management may decide against taking the risk.

Incentives are not perfect and cannot be so precise that they properly reward managers for

every possible scenario. Some scenarios that were completely unexpected may occur, and

not all risks can be properly identified or quantified.

Risk Culture

Two studies have been conducted that pertained to using employee surveys to determine

the attractiveness of working at certain companies. One of these studies concluded that

companies where managers were perceived as honest and trustworthy were more profitable

and were given higher valuations. The other study concluded that shareholder governance

improvements would change a firm's culture from focusing on employee integrity

and customer service to focusing on end results. From a performance perspective, the

shareholders will benefit from the improved governance, but some of those benefits will be

subsequently lost as a result of the firm's culture change.

The following three examples illustrate the impact of corporate culture on risk management

in the context of a bank.

Example 1: A loan officer's role is to decide whether or not to grant a loan based on the

assessed risk of the applicant using the written and verbal information obtained. The loan

officer is compensated based on the number and the size of the loans granted.

2 Berg, Tobias. "Playing the Devil's Advocate: The Causal Effect of Risk Management on Loan

Quality'' (working paper, Bonn University, 2014).

Topic 5

Cross Reference to GARP Assigned Reading - Stulz

One form of corporate culture may be very restrictive by severely reducing the reliance

on the loan officer's judgment and, instead, relying on statistical tools to automate loan

decisions. That may not be an optimal outcome for the bank because it would ignore the

qualitative information that the loan officer may obtain, which may result in a different

decision (i.e., automated loan decision making may result in reduced profits by granting

loans that should not have been granted or by not granting loans that should have been

granted). Another form of corporate culture may be less restrictive by only moderately

reducing the reliance on the loan officer's judgment and also relying on internal controls

(e.g., peer reviews of loan decisions) and corporate culture (e.g., promoting only the best

interests of the bank).

Example 2: A corporate culture that has traders constantly fighting with risk managers when

questioned would make it difficult for the risk managers to properly assess risk positions

and possible mitigation activities.

Example 3: A manager from another team notices that a trader has taken a position that

will always be unprofitable for the bank as a whole but will be profitable to the trader if

it is successful. The trader's supervisor does not notice it, and because no limits have been

breached, risk management does not notice it either. In one culture, the manager may

remain silent because he is not responsible for the activities of that team. In a different

culture, the manager may attempt to discuss the situation with the trader or the supervisor.

A bank with the latter culture is likely engaging in risk-taking activities that improve the

bank's performance and increase its value.

Finally, one of the risk culture studies attempted to show the link between culture and

risk outcomes. It hypothesized that a strong culture should lead to greater consistency

and should serve as a control mechanism. In turn, the stronger control mechanism should

result in less variability in outcomes. The study compared the volatility of unexpected

performance and the strength of corporate culture, and the result was a strong negative

relation between both variables.

Topic 5

Cross Reference to GARP Assigned Reading- Stulz

Page 54

LO 5 . 1

Methods to determine the optimal level of risk exposure include targeting a certain default

probability or credit rating and sensitivity or scenario analysis. In targeting a certain

default probability or credit rating, a bank should not always aim to earn the highest credit

rating possible because the rating would likely involve a large opportunity cost as the bank

would have to forego risky projects that could otherwise provide high profits. Sensitivity

or scenario analysis involves a bank determining its optimal level of risk exposure by the

impact of specific shocks. There would be an analysis of the adverse impacts on the value of

a bank due to changes in interest rates, foreign exchange rates, inflation, et cetera.

The optimal level of risk depends on the specific focus of the bank's activities (e.g., lending,

deposits, derivatives), so it will differ among banks.

LO 5.2

Banks need to take on an optimal amount of risk in order to maximize shareholder value

while satisfying the constraints imposed by bank regulators. If a bank takes on too little risk

compared to its optimal level, it may not generate sufficient returns for its shareholders,

which could decrease the value of the bank. Taking on too much risk may also decrease the

value of a bank.

LO 5.3

Investing in risk management might not be worth its cost if incremental changes in

risk taken do not result in much change in the value of a bank. On the other hand, risk

management may add value if taking on incremental risk would otherwise result in excessive

total risk and a significant decrease in the value of a bank.

If a bank adopts an inflexible risk management process in order to manage the bank's risk

below a set acceptable threshold level, it may not allow for any value creation. In contrast,

a more flexible risk management system may allow the bank to take on profitable risks and

take advantage of investment opportunities that could increase its value.

The risk management function of a bank can add value by requiring business units to take

the perspective of the entire bank when making decisions regarding risks.

LO 5.4

Risk management through hedging alone will not result in risk management becoming a

passive activity due to (1) risk measurement technology limitations, (2) hedging limitations,

and (3) risk taker incentive limitations.

Ideally, the risk management function within a bank would be independent of the activities

of the business lines. However, risk management involves both a verification function and

advising on whether to accept or reject a risky project based on established risk limits.

Topic 5

Cross Reference to GARP Assigned Reading - Stulz

Therefore, such independence is difficult to achieve in practice. In addition, if the risk

management process is viewed as a form of internal policing, then the necessary dialogue

between risk managers and business unit managers will not exist.

All individual banking units must consider their ability to adjust their VaR by trading

efficiently to ensure that, overall, the bank is making optimal use of its ability to take risk

and maximizing its profits.

Firmwide VaR is not likely to account for all of the bank's risks, especially operational

risks. The aggregation of market, credit, and operational risks in arriving at a firmwide risk

measure needs to consider the correlation estimates between such risks, although in practice,

there is usually insufficient data available to make such estimates accurately. Different

types of risk will lead to differing statistical distributions. For example, market risk can

be approximated by a normal distribution, but credit and operational risks follow a nonnormal

distribution, which makes them more challenging to quantify.

LO 5.5

It is difficult to demonstrate that a bank's governance has a significant impact on its risk

profile and performance for three main reasons. First, very limited data exists on how the

risk function operates in banks. Second, risk function characteristics are also affected by the

bank's risk appetite (in addition to governance). Third, it is possible that at the firm level,

poor performance will occur even in the presence of strong governance.

Incentives must be designed so that they do not merely reward managers for performance

based on their respective business units alone. Incentives should reward managers for taking

risks that create value for the overall bank while at the same time penalize them for taking

risks that destroy value.

Two studies examined the impact of culture. One of these studies concluded that companies

where managers were perceived as honest and trustworthy were more profitable and

were given higher valuations. The other study concluded that shareholder governance

improvements would change a firm's culture from focusing on employee integrity and

customer service to focusing on end results.

Topic 5

Cross Reference to GARP Assigned Reading- Stulz

Page 56

I. Which of the following statements regarding the optimal level of risk exposure is

correct?

A. A bank should aim to earn the highest credit rating possible.

B. A bank that is focused on deposit customers would usually set its level of risk

higher.

C. A bank that is focused on transactional activities would usually target a lower

credit rating.

D. A bank and its credit rating have a convex relationship, meaning that there is a

maximum value at a specific credit rating.

2. Which of the following statements regarding the amount of risk taken by a bank and

the impact on the value of a bank is most likely correct?

A. Banks need to take on a small amount risk in order to maximize shareholder

value while satisfying the constraints imposed by bank regulators.

B. Banks that are conservative in practice and take on less risk will always end

up generating more value because they avoid incurring losses that would be

associated with taking on more risk.

C. Banks that are valued for their ability to provide liquid investments to their

customers should take on less risk in order to maximize value.

D. Banks that are conservative in practice typically assume an optimal amount of

risk of zero.

3. In which of the following situations would the existence or addition of an

independent risk management department add value to a bank?

A. When there is a low cost to the bank of having incremental risk above the

optimal level.

B. When there are multiple business units within a bank, all guided by specific risk

objectives of their respective units.

C. When the risk management process is flexible and consistently succeeds in

managing the bank's risk below the set acceptable threshold level.

D. When the fixed costs of having a risk management department outweigh the

benefits.

4. Which of the following risks is/are least likely to be accounted for in a bankwide

value at risk (VaR) measure?

I. Credit risk and market risk.

II. Operational risk and funding liquidity risk.

A. I only.

B. II only.

C. Both I and II.

D. Neither I nor II.

Topic 5

Cross Reference to GARP Assigned Reading - Stulz

5. "Which of the following statements regarding the impact of a bank's governance,

incentive structure, and risk culture on its risk profile and performance is correct?

A. Having stronger governance through a chief risk officer does not lead to higher

returns.

B. An appropriate incentive plan should be designed to reward managers for

performance based solely on their respective business units.

C. "When managers are perceived as honest and trustworthy, there is no impact on a

company's profit or valuation.

D. The link between culture and risk outcomes demonstrates that there is a strong

positive relation between unexpected performance and the strength of corporate

culture.

Topic 5

Cross Reference to GARP Assigned Reading - Stulz

Page 58

1 . C A bank that is focused more on transactional activities would usually set the level of risk

higher and target a lower credit rating.

Response A is not correct because a bank should not always aim to earn the highest credit

rating possible. Earning such a rating would likely involve a large opportunity cost as the

bank would have to forego risky projects that could otherwise provide high profits. Response

B is not correct because a bank that is focused on deposit customers would usually set the

level of risk lower and target a higher credit rating in order to satisfy its customers' desire for

safety. Response D is not correct because the relationship between the value of a bank and its

credit rating is concave, which suggests that there is a maximum or optimal value at a specific

credit rating.

2. C When a bank is valued for its ability to provide safe and liquid investments to its customers,

it should not take on too much risk because that may impair its ability to provide safe and

liquid investments and may ultimately reduce the value of the bank.

A bank needs to take on an optimal amount of risk in order to maximize shareholder value

while satisfying the constraints imposed by bank regulators. In theory, the optimal amount

may be zero, although in practice, that is rarely the case. If a bank takes on too little risk, it

may fail to capitalize on enough profitable opportunities and, therefore, generate suboptimal

returns for its shareholders. Ultimately, too little risk may lower the value of the bank.

3. B The total amount of risk that the bank is able to take is dependent on all of the risks taken

by the various business units. As a result, the risk management function can add value by

requiring the business units to take the perspective of the entire bank when making decisions

regarding risks.

If there is a very high cost of having incremental risk above the optimal level, then there is

value in having a risk management department to ensure compliance with specific risk limits.

If there is a very low cost of having incremental risk above the optimal level, then the fixed

costs of having a risk management department may outweigh the benefits, thereby destroying

value for the bank.

If a bank has a risk management process that is very inflexible in order to manage the bank's

risk below a set acceptable threshold level, it may end up controlling risk but not allowing for

any value creation.

4. B Banks often break down their risks into three categories: market, credit, and operational. In

measuring risk at the firm level, the resulting VaR is most likely not to account for all of the

operational risk. In addition, firmwide VaR measures often do not consider funding liquidity

risk, the sudden reduction in funding to the bank, which often necessitates a sale of assets at

a discount or loss.

5. A One risk culture study shows that banks that have chief risk officers with higher status have

lower risk. However, there is no evidence that such stronger governance leads to higher

performance in terms of ex-post returns.

Response B is not correct. Incentives should not merely reward managers for performance

based on their respective business units alone. They should reward managers for taking

risks that create value for the overall bank while at the same time penalize them for taking

risks that destroy value. Response C is not correct. One study concluded that companies

were more profitable and were gi,ven higher valuations when managers are perceived as honest

and trustworthy. Response D is not correct. One study on the link between culture and

risk outcomes demonstrates that there is a strong negative relation between unexpected

performance and the strength of corporate culture.

The following is a review of the Foundations of Risk Management principles designed to address the learning

objectives set forth by GARP®. This topic is also covered in:

FINANCIAL DISASTERS

Topic 6

EXAM Focus

These case studies illustrate a number of financial and operational risk management failures.

Specifically, we will examine cases involving misleading reporting, large unexpected market

movements, and inappropriate customer conduct. Pay close attention to the causes of these

financial disasters and how they could have been prevented. You should be prepared to

handle questions on these recurring themes.

LO 6. 1 : Analyze the key factors that led to and derive the lessons learned from the

following risk management case studies:

• Chase Manhattan and their involvement with Drysdale Securities

• Kidder Peabody

• Barings

• Allied Irish Bank

• Union Bank of Switzerland (UBS)

• Societe Generale

• Long Term Capital Management (LTCM)

• Metallgesellschaft

• Bankers Trust

• JPMorgan, Citigroup, and Enron

MISLEADING REPORTING CASES

The following cases demonstrate situations where investors, firms, and lenders were misled

about the nature and size of investment positions. In all cases, the motivation to mislead

was driven by the desire to make a large profit. The large potential gain was sought by

taking large risky positions, thereby creating a severe moral hazard issue. The importance of

independent risk management oversight is apparent after reading these cases.

Chase Manhattan Bank and Drysdale Securities

In 1 976, Drysdale Government Securities was able to borrow $300 million in unsecured

funds from Chase Manhattan. The borrowed funds far exceeded Drysdale's capital of $20

million and consequently any amount it would have normally been approved to borrow.

The company used the borrowed funds to take bond positions, which eventually declined

in value. Given the loss in market value, Drysdale was unable to repay the borrowed funds

and was forced into bankruptcy. Almost all of the losses had to be absorbed by Chase

Manhattan since it brokered most of Drysdale's borrowings.

Drysdale obtained these funds by exploiting a flaw in the market's system for computing

the value of collateral of United States government bonds. In an effort to save time, this

Topic 6

Cross Reference to GARP Assigned Reading - Allen, Chapter 4

Page 60

collateral was often valued without the consideration of accrued interest. This imprecise

calculation method allowed Drysdale to take advantage of the difference between the cash

value borrowed securities could be sold for, which accounted for accrued interest, and the

amount of cash collateral required to be posted against the borrowed securities, which did

not account for accrued interest.

Clearly, misleading reporting was used by Drysdale in order to obtain the borrowed

funds. However, Chase Manhattan was partially to blame for assuming that it was simply

the middleman in the transactions and the positions taken had a low level of risk. The

inexperienced managers at Chase failed to realize that the contract wording with Drysdale

indicated that Chase would be held responsible for any payments due. This financial

disaster convinced the securities industry to develop more accurate methods for computing

collateral when borrowing bonds. The situation also led Chase and other firms to seek the

approval of a risk control function when issuing new funds.

Kidder Peabody

The head of the government bond trading desk at Kidder Peabody, Joseph Jett, misreported

a series of trades between 1992 and 1994, which allowed him to report substantial artificial

profits. After these errors were detected, $350 million in falsely reported gains had to be

reversed. The series of events did not result in actual losses for the firm since the profits

were fake; however, the trades triggered a loss of confidence in the management of Kidder

Peabody, which was owned by General Electric (GE). GE ended up selling Kidder to Paine

Webber, which ultimately dismantled the troubled company.

Jett was able to report false profits since the computer system used to report government

bond trading activity did not account for a forward contract's present value. This enabled

Jett to earn an instant profit when purchasing a bond for cash and delivering the forward

contract. The system failed to realize that this profit would disappear once financing costs

for the cash bond were taken into account.

Increasing the size of the forward contracts, as well as the length of the delivery period,

enabled Jett to further exploit the computer's accounting error. Eventually, Jett's profits

came under fire after Kidder realized that no individual trading strategy could produce the

substantial profits that were being reported. This misleading reporting case demonstrates the

importance of investigating large profits from unknown trading strategies.

Barings

Nick Leeson, a British Barings junior trader in Singapore, took speculative derivative

positions in an effort to recoup prior trading losses that he was able to hide fraudulently.

The losses went undetected due to inadequate control systems.

In 1994, Leeson lost $296 million through his trading activities, but reported a profit

of $46 million to management. His trading supposedly involved two main strategiesselling

straddles on the Nikkei 225 and arbitraging price differences on Nikkei 225 futures

contracts that were trading on different exchanges. A short straddle strategy involves selling

calls and puts. It is profitable when the underlying index remains relatively unchanged over

the life of the straddle, in which case the calls and puts expire worthless, leaving the option

Topic 6

Cross Reference to GARP Assigned Reading -Allen, Chapter 4

writer with the option premiums. The Nikkei 225 futures arbitrage involves taking a long

futures position on one exchange where the price is relatively low and hedging with an

offsetting short position on another exchange where the price is relatively higher.

Leeson had previously incurred huge trading losses that would have cost him his job if they

were revealed. In an effort to recover those losses, he abandoned the hedged posture in the

long-short futures arbitrage strategy and initiated a speculative long-long futures position on

both exchanges in hope of profiting from an increase in the Nikkei 225. This move exposed

the firm to enormous market risk and event risk, which stems from unexpected major

events that, while not directly related to markets, can affect markets.

On January 17, 1995, an earthquake hit Japan. The Nikkei plunged, creating huge losses

on both the short straddle and the double-long futures position. The resulting margin

calls were satisfied for a time because in 1994, Leeson had requested and received without

question $354 million from the London office because they believed his strategy was

riskless. This lack of oversight contributed to Barings' failure as the Nikkei continued to

drop. Between 1993 and 1995, Leeson's actions resulted in losses of approximately $ 1 .25

billion and forced Barings into bankruptcy.

In addition to being Barings' floor manager on the Singapore International Monetary

Exchange (SIMEX) trading floor, Leeson was in charge of settlement operations. This

position allowed him to influence back-office employees to hide his trading losses from the

London office. He was able to hide speculative positions by reporting these positions for

fictitious customers. He used an old error account to book losing trades for these fictitious

customers and used his back-office influence to prevent that trading activity from being

reported to the main office in London.

To book profits that would be reported to London, Leeson initiated cross trades on the

SIMEX in which the same firm buys and sells a security at the current market price. Again

using his back-office influence, he directed settlement employees to modify the execution

price, making one side of the trade profitable and the other unprofitable. The profitable

trade was booked to the standard trading accounts, which were reported to management,

while the unprofitable trade was booked to the old error account that escaped reporting

to senior management. By incorrectly booking these losses, Leeson was able to report

substantial profits in 1994, which allowed him to earn a $720,000 bonus.

Leeson was able to illegally book fraudulent trades because there was little management

oversight of the settlement process. Leeson was responsible for reporting to multiple managers

in a convoluted organizational structure. This situation created ambiguity concerning

who was responsible for performing specific oversight functions. In addition, political

power struggles and senior management's lack of understanding about Leeson's role eroded

oversight and allowed trading losses to be hidden.

Officially, Leeson was subject to risk controls that limited the amount of speculative trades

he was allowed to make. In practice, however, he ignored and vastly exceeded those limits.

These violations went undetected because Barings lacked risk management oversight that

would have monitored positions, strategies, and risk. This oversight was so poor that the

London office transferred $354 million to meet margin calls without questioning Leeson.

If management had a better understanding of Leeson's trading strategies, they would have

recognized that his reported profits were disproportionate to the purported riskless trading.

Topic 6

Cross Reference to GARP Assigned Reading - Allen, Chapter 4

Page 62

In sum, weak management at Barings failed to establish information, reporting, and control

systems. If trading and settlement responsibilities rested with different people, coordinating

the trading and settlement schemes required to hide trading losses would be much more

difficult. It would have created a system of checks and balances that might have prevented

Leeson from taking wildly speculative positions.

Allied Irish Bank

Between 1997 and 2002, a currency trader for Allied Irish Bank (AIB), John Rusnak, hid

$691 million in losses from management. Rusnak used a number of deceptive means to

hide these losses including bullying back-office workers into not following-up on trade

confirmations for imaginary trades. However, in 200 l, the back-office supervisor realized

that something was amiss when he saw that confirmations were missing for a number of

trades. After this problem was corrected, the fraudulent actions were eventually identified.

Management believed that Rusnak was running a small currency arbitrage trading strategy.

However, the strategy actually being implemented involved very large currency positions.

Rusnak was able to hide these trading activities from management by creating fake trades to

offset his real trades. The result was the appearance of a trading strategy that involved small

positions. Rusnak made a point of only reporting modest gains as to not raise any red flags.

For a time, he was able to cover losses by selling deep in the money options, which provided

him with large option premiums. He further disguised his actions from management by

entering false positions in the firm's system for calculating risk measures such as value at risk

(VaR).

AIB's management was partially to blame for its inexperience in being unable to figure

out Rusnak's trading activates. Suspicious trades and trading profits were ignored by

management as Rusnak continually manipulated the firm's operations staff. For a time,

Rusnak even forged trade confirmations after the back-office supervisor realized the

incorrect actions. This case is similar to the actions that led to the bankruptcy of Barings.

However, Rusnak did not have the advantage of Leeson of also running the back-office

operations. Instead, Rusnak used his strong personality to bully back-office employees and

took advantage of the fact that trades were being transacted in the over-the-counter market,

which did not require immediate cash settlement.

Union Bank of Switzerland

During 1997, Union Bank of Switzerland's (UBS) equity derivatives business lost between

$400 and $700 million. An additional loss of $700 million followed the next year, which

was mostly due to its large stake in Long-Term Capital Management (LTCM). Losses at

UBS forced the firm to merge with Swiss Bank Corporation (SBC).

It is unclear which trades directly influenced the losses at UBS, but it is accepted that the

losses resulted due to inadequate actions on the part of the firm's risk controllers. The equity

derivatives business at UBS was being run with an unusual amount of independence. The

department's senior risk manager was also the head of quantitative analytics, which enabled

him to not only provide input for business decisions, but also have his compensation tied to

trading results.

Topic 6

Cross Reference to GARP Assigned Reading -Allen, Chapter 4

It is suspected that the losses in 1997 were due, in some part, to the following four factors:

(1) British law tax changes; (2) large Japanese bank warrants, which were inappropriately

hedged against a drop in the underlying stocks; (3) incorrect valuation of long-dated

options on equity baskets; and ( 4) inappropriate modeling of other long-dated options.

The suspected losses in 1998 were largely tied to the failure ofLTCM. UBS's exposure to

LTCM involved a 400/o direct investment in the hedge fund and a 600/o exposure to written

options on the fund. By taking these two positions, UBS was hoping to delta-hedge their

exposure to LTCM; however, LTCM's lack of transparency made it difficult for UBS to fully

understand the nature of its positions. It was believed that UBS failed to properly analyze

and stress test its positions.

Societe Generale

In January 2008, it was discovered that one of Societe Generale's junior traders, Jerome

Kerviel, was involved in unauthorized trading activity that resulted in losses of $7.1 billion.

The incident damaged the reputation of Societe Generale and required the bank to raise

additional funds to meet capital needs.

Between July 2005 and January 2008, Kerviel established large, unauthorized positions in

futures contracts and equity securities. To hide the size and riskiness of these unauthorized

positions, he created fake transactions that offset the price movements of the actual

positions. Kerviel created fake transactions with forward start dates and then used his

knowledge of control personnel confirmation timing to cancel these trades right before

any confirmations took place. Given the need to continuously replace fake trades with new

ones, Kerviel ultimately created close to 1,000 fictitious trades before the fraud was finally

discovered.

A number of reasons were cited that explained how Kerviel's unauthorized trading activity

went undetected, including the incorrect handling of trade cancellations, the lack of proper

supervision, and the inability of the bank's trading system to consider gross positions.

Regarding trade cancellations, the bank's system was not equipped to review trading

information that was entered and later canceled. In addition, the system was not set up to

flag any unusual levels of trade cancellations. Regarding the lack of supervision, oversight

of Kerviel's trading activity was weak, especially after his manager resigned in early 2007.

Under the new manager, Kerviel's unauthorized trading activity increased significantly.

Regarding the size of Kerviel's positions, the bank's system was only set up to evaluate net

positions, instead of both net and gross positions. Thus, the abnormally large size of his

trading positions went undetected. Had the system properly monitored gross positions, it is

likely that the large positions would have issued a warning sign given the level of riskiness

associated with those notional amounts. Also, the large amount of trading commissions

should have raised a red flag to management.

Additional reasons that contributed to the unauthorized positions going undetected

included the inaction of Kerviel's trading assistant to report fraudulent activity, the violation

of the bank's vacation policy, the weak reporting system for collateral and cash accounts,

and the lack of investigation into unexpected reported trading gains.

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Kerviel's trading assistant had immediate access to Kerviel's trading activities. Because the

fictitious trades and the manipulation of the bank's trading system went unreported, it

was believed that the trading assistant was acting in collusion with Kerviel. Regarding the

bank's vacation policy, the rule that forced traders to take two weeks of vacation in a row

was ignored. Had this policy been enforced, another trader would have been responsible for

Kerviel's positions, and likely would have uncovered the fraudulent activity of rolling fake

transactions forward. Regarding collateral and cash reports, the fake transactions did not

warrant any collateral or cash movements, so nothing balanced the collateral and cash needs

of the actual trades that were being offset. If Societe Generale's collateral and cash reports

had been more robust, it would have detected unauthorized movements in the levels of

these accounts for each individual trader. Regarding reported trading gains, Kerviel inflated

trading gains above levels that could be reasonably accounted for given his actual authorized

trades. This action should have prompted management to investigate the source of the

reported trading gains.

Ultimately, the unauthorized trading positions were discovered by chance after one of

Kerviel's fake trades was detected by control personnel during a routine monitoring

of positions. Kerviel's inability to explain the fictitious transaction led to a rigorous

investigation, revealing the depth of his fraudulent activities.

The lessons from this control failure are similar to lessons from the other case studies

of Kidder Peabody, Barings, and Allied Irish Bank. Given the common events among

these cases, the importance of tighter operational controls that lead to better detection of

fictitious trading activities cannot be overstated. Lessons to be learned specific to this case

include the following:

• Traders who perform a large amount of trade cancellations should be flagged, and, as a

result, have a sample of their cancellations reviewed by validating details with trading

counterparties to ensure cancellations are associated with real trades.

• Tighter controls should be applied to situations that involve a new or temporary

manager.

• Banks must check for abnormally high gross-to-net-position ratios. High ratios suggest

a greater probability of unauthorized trading activities and/ or basis risk measurement

• issues.

• Control personnel should not assume the independence of a trading assistant's actions.

Trading assistants often work under extreme pressure, and, thus, are susceptible to

bullying tactics given that job performance depends on them following direction from

traders.

• Mandatory vacation rules should be enforced.

• Requirements for collateral and cash reports must be monitored for individual traders.

• Profit and loss activity that is outside reasonable expectations must be investigated

by control personnel and management. Reported losses or gains can be compared to

previous periods, forecasted values, or peer performance.

Daiwa

A Treasury bond trader, Toshihide Iguchi, covered up $ 1 . 1 billion in losses over an 1 1 -year

time span from 1984 to 1995. Iguchi was able to not only hide these losses, but also forge

customer trading slips, which actually made his actions appear profitable to Daiwa Bank's

management. This misleading reporting went undetected due to Iguchi's dual role as the

head of both trading and the back-office support function. When senior executives finally

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Cross Reference to GARP Assigned Reading -Allen, Chapter 4

learned of the fraud, they failed to promptly report it to the authorities. As a result, Daiwa

lost its trading license in the United States.

Sumitomo

Yasuo Hamanaka, the lead copper trader for Sumitomo, attempted to corner the copper

market in a classic market manipulation strategy. Because the copper market was relatively

small, Hamanaka had the potential to control and corner it.

He essentially established a dominant long position in futures contracts and simultaneously

purchased large quantities of physical copper. As the futures contracts approached delivery,

the party with the short position would find little physical copper available for delivery

and would be forced to either pay a large premium for physical copper or unwind its short

position by taking an offsetting long futures position. Either way, the price of copper and/ or

copper futures prices would rise and create handsome profits for Hamanaka and Sumitomo.

The risk, of course, was that severe losses would be unavoidable if copper prices fell.

Subjecting the firm to enormous market risk to help finance his long copper positions,

Hamanaka sold put options, which exposed the trading strategy to the risk of falling copper

• prices even more.

Hamanaka's unusually low degree of supervision and broad powers allowed him to

implement this fraudulent trading strategy without detection, until the Commodity Futures

Trading Commission ( CFTC) began an investigation of market manipulation in December

of 1995. The CFTC's interest was piqued by the possibility that Sumitomo had purposely

influenced the price of copper with positions that were unrelated to legitimate commercial

needs, a critical element in the determination of market manipulation.

In May of 1996, Hamanaka was reassigned to another position, sparking suspicion among

other copper traders who began to sell their copper holdings in anticipation of Sumitomo

doing the same. A continuation of plummeting copper prices resulted in a $2.6 billion

trading loss and a $ 1 5 0 million fine from the CFTC. Hamanaka was fired, prosecuted,

and jailed. The size of Sumitomo's copper positions in relation to the size of the market

exacerbated the drop in copper prices.

Sumitomo's lack of supervision on Hamanaka created a high degree of operational risk,

which could have been reduced with proper internal controls. For example, because

Hamanaka had almost total autonomy, he was able to give power of attorney to brokerage

firms to execute highly leveraged transactions in a scheme to help finance his accumulation

of copper. In addition, the lack of supervision allowed him to keep two sets of trading

books, one of which reported large profits. The other set recorded huge losses and was

secret, which allowed the illegal activities to go undetected.

Large transactions should have required multiple approvals by senior management, who

would have an understanding of the trading strategy. In Sumitomo's case, however, no

approvals were necessary, and senior management was unequipped to understand the

complex transactions.

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Page 66

Askin Capital Management and Granite Capital

David Askin managed both the Askin Capital Management and Granite Capital hedge

funds, which invested in mortgage securities. He misled investors by valuing positions with

incorrect values instead of dealer quotes. Askin reported these incorrect values to potential

clients in order to generate interest in his funds. Both funds went bankrupt in 1994,

suffering losses of $600 million.

Merrill Lynch

In 1987, Merrill Lynch reported losses of $350 million from its trading in mortgage

securities. The losses resulted from a mistake in the firm's calculation of duration. The firm

was using a 1 3-year duration calculation for 30-year mortgages, which is generally correct

when considering all interest and principal payments. However, since Merrill Lynch was

selling the interest-only portion of the mortgage securities, the correct duration was actually

more in-line with the duration of the principal-only portion, which was 30 years.

National Westminster Bank

National Westminster Bank's (NatWest) traders used incorrect volatility inputs for interest

rate caps and swaptions between 1994 and 1997. It was reported that traders were only

using a sample of market volatility estimates due to the illiquid nature of these investments.

The loss from this incorrect reporting was close to $140 million. NatWest was forced to sell

the Royal Bank of Scotland due to investor's loss of confidence in management's oversight.

LARGE MARKET MOVEMENT CASES

The following two cases on Metallgesellschaft and Long-Term Capital Management

illustrate financial disasters related to large unexpected market movements. Unlike the

previously discussed cases, misleading positions were not the cause of the substantial

losses. These two cases share many common financial themes, including an extreme lack of

liquidity.

Metallgesellschaft

In 1 99 1 , Metallgesellschaft Refining and Marketing (MGRM), an American subsidiary

of Metallgesellschaft (MG), an international trading, engineering, and chemicals

conglomerate, implemented a marketing strategy designed to insulate customers from price

volatility in the petroleum markets for a fee.

MGRM offered customers contracts to buy fixed amounts of heating oil and gasoline at

a fixed price over a 5- or 1 0-year period. The fixed price was set at a $3 to $5 per barrel

premium over the average futures price of contracts expiring over the next 12 months.

Customers were given the option to exit the contract if the spot price rose above the fixed

price in the contract, in which case MGRM would pay the customer half of the difference

between the futures price and contract price. A customer might exercise this option if she

did not need the product or if she were experiencing financial difficulties. In later contracts,

the customer could receive the entire difference in exchange for a higher fixed contract

• price.

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The customer contracts effectively gave MGRM a short position in long-term forward

contracts. MGRM hedged this exposure with long positions in near-term fotures using a

stack-and-roll hedging strategy. In this strategy, the firm buys a bundle of futures contracts

with the same expiry date, known as a stack. Just prior to delivery, the firm liquidates the

stack and buys another stack of contracts with longer expirations, known as a roll. The level

of uncertainty in the cost of this strategy should have prompted MGRM to use a valuation

reserve since they were currently basing roll costs on historical data rather than potential

future costs.

MGRM used short-term futures to hedge because alternatives in the forward market were

unavailable and long-term futures contracts were highly illiquid. As it was, MGRM's open

interest in unleaded gasoline contracts was 55 million barrels in the fall of 1993, compared

to average trading volume of 1 5 to 30 million barrels per day. In December of 1993,

MGRM cashed out its positions and reported losses of approximately $ 1 .5 billion.

Although some market observers cite the maturity mismatch between MGRM's short

position in long-term fixed-rate contracts with customers and its long position in near-term

futures contracts, many economists believe this hedging strategy is fundamentally sound.

Over the life of a properly constructed hedge, the cash flows from the forward and futures

contracts would balance out, provided the hedging firm could withstand interim cash flow

requirements from marked to market losses, margin calls, credit risks, and liquidity risks

associated with adverse market movements. The fundamental issue for MGRM was a cash

flow problem that constrained the company's ability to ride out the hedge. This cash flow

problem had several causes and severe consequences, which are discussed next.

Gains and losses on forward contracts are realized at the agreement's expiration, whereas

futures contracts are marked to market such that the gains and losses are realized on a daily

basis. In MGRM's case, gains and losses on its customer contracts were realized if and when

the customers took delivery, which would occur over a 5- to 1 0-year period.

During 1993, oil prices dropped from a high of about $21 per barrel to about $ 1 4 per

barrel, resulting in losses of $900 million on MGRM's long positions, which were realized

immediately as the futures contracts were marked to market. The offsetting gains on

their customer contracts, however, would not be realized for years to come, which created

potential short-term cash outflows, and resulted in funding liquidity risk. Declining oil

prices also created margin calls that exacerbated the cash flow problem. Due to these losses,

MG ordered MGRM to close out of its customer contracts. This forced the firm to unwind

its positions at very unfavorable terms.

According to German accounting rules, MGRM was required to report losses associated

with its futures hedges, but was not permitted to show associated gains from its customer

contracts, which the futures were meant to hedge. The magnitude of the losses caused its

credit rating to drop, increasing its perceived credit risk and restricting the company's access

to credit. The losses also created a crisis of confidence with its counterparties, which began

to suspect the firm was speculating rather than hedging and, therefore, demanded collateral

to secure contract performance. These same concerns induced the New York Mercantile

Exchange to increase the firm's margin requirements. It is interesting to note that these

consequences, which aggravated an already mounting cash flow problem, did not stem from

a fundamental flaw in MGRM's hedging program. They occurred due to overly conservative

financial reporting requirements that failed to recognize the relationship between hedging

losses and offsetting gains on the underlying positions that motivated the hedge in the first

place.

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The cash outflows might have been tolerable and possibly balanced out by cash inflows over

the life of the hedge were it not for the sheer size of MGRM's position, which would have

taken ten days to liquidate. To liquidate without affecting market prices would have taken

from 20 to 55 days. As a result, the company lacked liquidity to unwind its positions, if

necessary, without significant market impact, and was therefore subject to trading liquidity

risk. To make matters worse, MGRM was carrying a heavy debt load and had little equity

to withstand losses and cash flow problems on positions of this size.

Long-Term Capital Management

Long-Term Capital Management (LTCM), a hedge fund founded in early 1994, generated

stellar returns in its first few years of operation: 43o/o in 1995 and 4 1 o/o in 1996. The

partners worked together at Salomon Brothers (now Citigroup) and, given their success,

decided to start their own fund and proceeded to seek capital from investors. Funding was

provided to LTCM despite the secretive nature of its positions. In addition, investors were

locked into investments for long periods of time in order to prevent liquidation issues since

the fund was focused on long-term investment strategies. In the later years of operations,

the partners at LTCM invested a large portion of their net worth in the fund since they

believed so strongly in the success of their trading strategies.

With positions in equity, fixed income, and derivatives markets all around the globe, LTCM

grew enormously. At the beginning of 1998, it had $ 1 25 billion of assets on $4.7 billion

of equity capital, yielding leverage of 28 to 1 . Although this balance sheet leverage was in

line with other large investment banks, it underestimated the true leverage by overlooking

the economic leverage in LTCM's positions. For example, LTCM's positions represented

notional principal in excess of $ 1 trillion. The astronomical use of leverage was possible

because financial institutions often waived initial margin requirements based on the

reputation of the principals, freeing up capital to take on more leverage.

Most of LTCM's investment strategies could be classified as relative value, credit spreads,

and equity volatility. Their relative value strategies involved arbitraging price differences

among similar securities and profiting when the prices converged. One benefit of this

convergence strategy is that being long and short similar securities hedges risk exposure and

reduces volatility.

LTCM believed that, although yield differences between risky and riskless fixed-income

instruments varied over time, the risk premium (or credit spread) tended to revert to

average historical levels. Noticing that credit spreads were historically high, they entered

into mortgage spreads and international high-yield bond spreads intending to profit when

the spreads shrank to more typical historical levels. Similarly, their equity volatility strategy

assumed that volatility on equity options tended to revert to long-term average levels. -when

volatility implied by equity options was abnormally high, LTCM "sold volatility'' until it

regressed to normal levels.

In August of 1998, Russia unexpectedly defaulted on its debt, sending Russian interest

rates soaring to 200o/o and crushing the value of the ruble. This economic shock triggered

investor concern about already faltering economies in the Pacific rim, causing the yields

on developing nations' debt to increase and a flight to the quality of government bonds

in industrialized countries. Yields on corporate debt-both high and low quality-also

increased sharply. In other words, the flight to quality increased, rather than decreased,

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credit spreads, causing huge losses for LTCM. Shortly thereafter, Brazil also devalued its

currency, thereby further increasing interest rates and risk premiums. The general increase

in volatility also generated losses in LTCM's equity volatility strategies.

Although prices in relative value arbitrage strategies sometimes diverge and create temporary

losses before they ultimately converge, the large increase in yield spread caused huge losses

and severe cash flow problems caused by realizing marked to market losses and meeting

margin calls. The effect of the losses and the cash flow crisis were compounded by the firm's

hyper leverage. LTCM lost 440/o of its capital in just one month. The firm's lack of equity

capital created a cash flow crisis and made it necessary to liquidate positions to meet margin

calls.

If LTCM had sufficient equity to withstand the cash flow crisis created by the sharp

divergence of asset prices, it might have ultimately been able to realize the benefits of

convergence. Instead, LTCM risked the possibility of insolvency before convergence could

occur. Notice the similarity to the funding liquidity risk in the Metallgesellschaft case.

One of the fundamental risks faced by LTCM was model risk, the risk that valuation or

trading models are flawed. Their models assumed that historical relationships were useful

predictors of future relationships, which is often true in the absence of economic shocks.

However, external shocks often cause correlations that are historically low to increase

sharply. When Russia defaulted on its debt, credit spreads, risk premiums, liquidity

premiums, and volatility around the world increased. LTCM partly adjusted for this

possibility by using correlations that were greater than historical correlations in their stress

tests. However, these adjustments inadequately captured the spike in correlations caused by

the cascading effect of economic shocks.

The models also assumed that low-frequency/high-severity events were uncorrelated

over time. Rather than occurring highly infrequently and independently over time, one

economic shock triggered another so that extremely low probability events were occurring

several times per week. As a result, traditional VaR models underestimated risk in the tails of

the distribution.

LTCM was diversified across the globe, across different asset classes, and across different

trading strategies. Fundamentally, however, all of its trading strategies were based on the

notion that risk premiums and market volatility would ultimately decline. Since the success

of all its trading strategies hinged on a single economic prediction, LTCM was far less

diversified than a cursory examination would suggest and was, therefore, subject to market

risk.

LTCM's extreme leverage enabled it to assume extremely large, high-profile positions that

attracted the attention of imitators who initiated similar or identical trades, thereby adding

to the size of LTCM's positions in some sense. When it became necessary to liquidate

positions, the firm found itself in the position of being a market maker, rather than a price

taker as traditional valuation models assume. In addition to suffering the price impact of

liquidating its own enormous positions, LTCM found itself competing with imitators who

were also liquidating their positions. Market prices largely depended on expectations about

LTCM's actions.

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Page 70

Falling prices resulting from LTCM's forced liquidation created more marked to market

losses and margin calls, which forced more liquidations that resulted in a self-reinforcing

cycle. LTCM considered the possibility of market impact to some extent in its short

risk measures, but underestimated the magnitude of its influence on market prices,

particularly in the event of forced liquidation. Trading liquidity risk was also present in the

Metallgesellschaft case.

& a hedge fund, LTCM's reporting obligation to regulators was limited. Although the size

of its positions required financial statement reporting and daily position reporting, these

reports were incomplete and lacked disclosure of derivative positions and trading strategies.

Ultimately, the Federal Reserve Bank of New York orchestrated a bailout in which 14

leading banks and investment houses invested $3.65 billion for a 90o/o stake in LTCM.

The LTCM case demonstrated the need for several suggested improvements when

implementing risky investment strategies and seeking investor funds. One suggestion is to

ensure that an initial margin is provided. LTCM had to mark their positions to market,

but in many cases, the initial margin was waved. Another suggestion is to incorporate

potential liquidation costs into prices in the event of adverse market conditions. A third

suggestion is the need for greater position disclosure. A final suggestion is better utilization

of stress testing when evaluating financial risk; namely credit risk. LTCM planned for the

possibility of increasing disruptions in short-term market movements. However, it failed

to supplement VaR measures with stress scenarios that incorporated the possibility that

competitors were holding similar positions that might be liquidated at the same time in the

event of extreme market movements.

CUSTOMER CONDUCT CASES

These cases describe actions that led to significant decreases in firm reputation among its

customers (i.e., reputational risk). The actions relate to misleading investors on the risk of

certain investments. Failure to perform the necessary due diligence subjected customers

to huge losses which were, in some cases, followed by fines and settlements for the firms

involved. The actions themselves, however, did not create direct losses for the firms.

Bankers Trust

Procter & Gamble (P&G) and Gibson Greetings sought the assistance of Bankers Trust

(BT) to help them reduce funding costs. BT used derivative trades, which promised the

two companies a high-probability, small reduction in funding costs in exchange for a lowprobability,

large loss. Unfortunately, the derivative trades only resulted in significant losses

for both P&G and Gibson.

The derivative structures developed by BT were intentionally complex and prevented P&G

and Gibson from fully understanding the trade values and risks that were involved. In

addition, the structures were not comparable to other company derivative trades making it

impossible to get a competitive quote. P&G and Gibson were further misled into thinking

that the structures were tailored to meet their individual needs. In 1994, P&G and Gibson

finally realized that they had been misled after discovering that they had suffered huge

losses. & a result, the two companies sued BT.

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It was common practice for BT to tape phone conversations of its traders and marketers in

an effort to resolve possible verbal contract disputes. Unfortunately for BT, these tapes were

used as evidence during the lawsuit since they picked up internal conversations regarding

the derivative structures in question. In some of these conversations, BT's staff bragged

about how badly they fooled clients with complex structures and showed how price quotes

given to P&G and Gibson were manipulated.

The Bankers Trust scandal severely damaged its reputation and forced its CEO to resign.

BT was eventually acquired by Deutsche Bank and ultimately dismantled. The actions at

BT led to tighter controls for dealing with clients at other firms. This case demonstrated

the importance of matching trades with a client's needs and providing price quotes that

are independent from the front office. It also demonstrated the importance of exercising

caution with any form of communication that could eventually be made public, as it could

damage a firm's reputation if unethical practices are present.

JPMorgan, Citigroup, and Enron

In the wake of the Bankers Trust scandal, investment banks worked to prevent future

exploitation of customers. However, at the time, banks still did not assume responsibility for

protecting third parties against adverse actions taken by its borrowers. This changed once

the financial shenanigans at Enron surfaced in 200 l, which eventually led to the company's

bankruptcy. The Enron scandal revealed the use of questionable accounting practices to

disguise the size of borrowings from lenders and investors. One practice accounted for

borrowed amounts as oil futures contracts.

Given that the Enron Corporation was heavily involved in the energy markets, it was not

uncommon for the company to trade large amounts of oil futures contracts. However, the

futures contracts that were actually used did not involve any stake in oil price movements.

Enron collected cash by selling oil for future delivery, and, in turn, agreed to buy back

the delivered oil at a fixed price. Thus, no oil was actually delivered, so the agreement

was essentially a loan where the company paid cash at a later date to receive cash at the

beginning of the agreement. The advantage for Enron was that the company did not have to

account for these transactions as loans on its financial statements, which made the company

look healthier to both investors and lenders.

JPMorgan Chase and Citigroup were the main counterparties in these transactions. When

Enron's actions were ultimately revealed, the investment banks declared that they shared

no role in determining how the transactions were accounted for on Enron's financial

statements. According to JPMorgan and Citigroup, the transactions were correctly reported

as loans on the bank's financial statements, and therefore, they did not trick their own

investors and lenders. However, it was later revealed that the investment banks fully

understood Enron's intent when entering into these loan-type transactions. As a result,

JPMorgan and Citigroup agreed to pay a $286 million fine for assisting with fraud against

Enron investors. In addition, future controls were established to improve the transparency

of client derivative transactions for investors.

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Page 72

Prudential-Bache Securities

Prudential-Bache Securities misled investors regarding the risk of investments in limited

partnerships. The incorrect identification of risk impacted thousands of investors and was so

severe that it resulted in over $ 1 billion in fines and settlements.

Morgan Grenfell Asset Management

A fund manager at Morgan Grenfell Asset Management incorrectly directed investors into

highly speculative equity investments. In addition, this manager found a way to bypass legal

restrictions regarding the percentage of a stock that a mutual fund could hold at one time.

In 1995, Morgan Grenfell was ordered to pay approximately $600 million to investors to

make up for losses incurred by incorrectly investing in speculative securities.

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LO 6.1

Drysdale Securities was able to borrow $300 million in unsecured funds from Chase

Manhattan by exploiting a flaw in the system for computing the value of collateral.

The head of the government bond trading desk at Kidder Peabody, Joseph Jett, reported

substantial artificial profits. After the false profits were detected, $350 million in previously

reported gains had to be reversed.

Hidden trading losses at Barings induced Nick Leeson to abandon hedging strategies in

favor of speculative strategies. A lack of operational oversight and his dual roles as trader

and settlement officer allowed him to conceal his activities and losses.

A currency trader for Allied Irish Bank, John Rusnak, hid $691 million in losses. Rusnak

bullied back-office workers into not following-up on trade confirmations for imaginary

trades.

UBS's equity derivatives business lost millions in 1997 and 1998. The losses were mostly

due to incorrect modeling of long-dated options and the firm's stake in Long-Term Capital

Management.

Jerome Kerviel, a junior trader at Societe Generale, participated in unauthorized trading

activity and concealed this activity with fictitious offsetting transactions. The fraud resulted

in $7.1 billion in losses and severely damaged the reputation of Societe Generale.

Extreme leverage, a lack of diversification, and inadequate risk models put Long-Term

Capital Management in a cash flow crisis when an economic shock created intolerable

marked to market losses and margin calls. A forced liquidation of its huge positions drove

prices down, further compounding their losses.

The financial crisis at Metallgesellschaft resulted fundamentally from cash flow timing

differences associated with the positions making up its hedge. Cash flows on short forward

contracts occurred over the distant future. Cash flows on long futures contracts occurred

daily. In addition, the sizes of the positions were so large that it prevented the company

from liquidating its positions without incurring large losses.

Bankers Trust developed derivative structures that were intentionally complex and prevented

Procter & Gamble and Gibson Greetings from fully understanding the trade values and

risks that were involved. In taped phone conversations, BT's staff bragged about how badly

they fooled clients.

JPMorgan Chase and Citigroup were the main counterparties in Enron's derivative

transactions. After the Enron scandal was revealed, these investment banks agreed to pay a

$286 million fine for assisting with fraud against Enron shareholders.

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Page 74

1 . Which of the following was least influential in the Metallgesellschaft debacle?

A. Fraud.

B. Timing differences in the cash flows of its long and short positions.

C. The size of its positions influenced market prices.

D. Financial reporting requirements.

2. Which of the following financial disasters created a situation that resembled a classic

Ponzi scheme where artificial profits are shown, but never materialize into actual

profits?

A. Drysdale Securities.

B. Bankers Trust.

C. Kidder Peabody.

D. Merrill Lynch.

3. In 1 997, equity derivative losses at the Union Bank of Switzerland (UBS) appeared

to be related to four different factors. Of the factors shown below, which ones are

unique to UBS (i.e., did not impact competitors)?

I. British law tax changes and large Japanese bank warrants.

II. Incorrect valuation of long-dated options on equity baskets and inappropriate

modeling of other long-dated options.

A. I only.

B. II only.

C. Both I and II.

D. Neither I nor II.

4. Hedging models at Long-Term Capital Management accounted for the:

I. spike in correlations among asset class prices during times of economic crisis.

II. dependence of catastrophic events through time during global economic

shocks.

A. I only.

B. II only.

C. Both I and II.

D. Neither I nor II.

5. Nick Leeson's now infamous trading strategies in 1994 and 1995 at Barings Bank

focused on calculated bets on the Nikkei 225. Which of the following trading

strategies did not contribute to the staggering losses that ultimately forced Barings

into bankruptcy?

I. Long-long futures arbitrage.

II. Long straddle.

A. I only.

B. II only.

C. Both I and II.

D. Neither I nor II.

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Cross Reference to GARP Assigned Reading - Allen, Chapter 4

1. A The fundamental problem at Metallgesellschaft was that the timing of the marked to market

losses and margin calls on its futures contracts were mismatched with the cash flows on the

forward contracts it was trying to hedge. The problem was compounded by the enormous

size of the positions, which made liquidation costly, and by conservative financial reporting

requirements that did not recognize the gains on the forward contracts. Neither fraud nor

deception is central to the Metallgesellschaft case.

2. C The head of the government bond trading desk at Kidder Peabody, Joseph Jett, misreported

a series of trades, which allowed him to report substantial artificial profits. After these errors

were detected, $350 million in falsely reported gains had to be reversed. This situation of

hypothetical profits in place of promised profits resembles a classic Ponzi scheme.

3. B Statement I resembles factors that affected UBS as well as its competitors. The bank warrant

positions may have been larger than its competitors, but they were not unique to UBS.

Statement II resembles factors that were unique to UBS.

4. D The models used by LTCM primarily relied on historical correlations to measure risk. In

doing so, the firm failed to account for the spike in correlations caused by economic shocks,

such as Russia defaulting on its debt. The models also did not consider that infrequent

shocks might be clustered in time, one causing another. As it happened, risk premiums rose

across the globe, forcing LTCM to liquidate positions because its relatively miniscule equity

basis was insufficient to withstand the losses. The size of its positions aggravated negative

price trends that were already set in motion.

5. B After incurring huge trading losses, Leeson made an effort to recover those losses by

abandoning his original hedged position in a long-short futures arbitrage strategy and

initiated a long-long futures position on two trading exchanges. As well, one of his other

trading strategies was selling straddles on the Nikkei 225 (which would have been profitable

had the underlying index remained relatively unchanged).

Page 76

The following is a review of the Foundations of Risk Management principles designed to address the learning

objectives set forth by GARP®. This topic is also covered in:

THE CREDIT CRISIS OF 2007

Topic 7

EXAM Focus

The credit crisis that began in 2007 was the worst since the Great Depression. In fact, in

many ways it was even more damaging given the contagion effect of the crisis across global

financial markets. Virtually all financial institutions were affected to some measure; many

had to be bailed out, and some failed completely (e.g., Bear Sterns, Lehman Brothers). In this

topic, we look at the background and origin of the crisis, examine the causes of the problems,

and look at the key lessons learned. We begin by discussing the U.S. housing market,

followed by a detailed overview of the mortgage securitization process, and examine various

types of asset-backed securities. For the exam, understand the key causes of the housing crisis,

the structure of asset-backed securities (and additional securitized products derived from

them), including the various risks of tranches, the priority of interest and principal (pre)

payment cash flows, and why asset-backed securities may be considered riskier than similarly

rated bonds.

FACTORS CONTRIBUTING TO THE CREDIT CRISIS

LO 7 . 1 : Analyze various factors that contributed to the Credit Crisis of 2007 and

examine the relationships between these factors.

The period leading up to the 2007 credit crisis, especially the period between 2000 and

2006, was characterized by ever-increasing real estate prices within a very low interest rate

environment. This period saw a significant rise in subprime mortgage lending. Subprime

mortgages are mortgages that are considered to be a higher risk than traditional mortgages

and are granted to borrowers with weak credit histories.

Relaxed Lending Standards

With the increase in home prices leading up to the year 2000, many families found

themselves unable to qualify for mortgages and afford a home based on their incomes. In

addition, many families with weaker credit histories did not have a sufficiently strong credit

profile to qualify for a mortgage. Starting around 2000, mortgage lenders began to relax

their mortgage underwriting standards in order to attract new entrants into the market and

began lending more to higher-risk borrowers. It was typical for lenders to offer adjustable

rate mortgages (ARMs) with teaser rates that were very low for the first few years before the

rates increased significantly in later years. Teaser rates of 1 o/o or 2o/o were not uncommon.

From the lenders' perspective, risks were low as the continued increase in home prices

meant that a potential borrower default was adequately mitigated by a stable and increasing

collateral value (i.e., the home).

Topic 7

Cross Reference to GARP Assigned Reading - Hull, Chapter 6

At the same time, the federal government pressured lenders to increase lending to lowand

medium- income households and was not incentivized to regulate mortgage lending.

Relaxed lending standards and the lack of adequate government regulation gave rise to

predatory lending. Liar loans (no vetting of the accuracy of an applicant's information) and

NINJA borrowers (no income, no job, no assets) became common. As lending standards

were relaxed, certain zip codes in the United States that previously had high levels of

rejected mortgage applications saw a material rise in mortgage origination (i.e., more

applications were accepted) during the 2000-2007 period.

The Housing Bubble

As mortgage origination increased and lending standards were relaxed, additional demand

continued to drive up home prices. However, by the second half of 2006, many of the teaser

rates ended. At the higher interest rates, borrowers could no longer afford their mortgages,

and lenders were forced to foreclose on their homes. This put downward pressure on

demand, and home prices started to decline. As more owners foreclosed, the supply of

homes increased, and demand and home prices declined further in a self-feeding loop.

An important feature of mortgage lending in the United States is that in several states,

mortgages are nonrecourse. Under a nonrecourse mortgage, a lender can only take

possession of (have recourse to) the borrower's home but not to any of their other assets.

It is important to understand the implications of this feature. In essence, when borrowers

took out a mortgage, they also purchased an American-style put option that allowed them

to sell their home at any time until mortgage expiration for the principal outstanding on the

mortgage. For borrowers, especially for those who borrowed 1 OOo/o or close to 1 00°/o of the

value of their homes, this meant that when their home price declined below the outstanding

value of the mortgage resulting in negative equity in their homes, it was no longer in

the borrower's best interest to service this mortgage. Instead, the borrower's optimal

decision was to exercise the put option and sell the home to the lender at the price of their

outstanding mortgage.

Many borrowers suffered greatly as they lost their family homes. For other borrowers,

foreclosing was simply the economically feasible solution. With the increase in foreclosures,

lenders were faced with diminishing recovery rates, which declined from an average 750/o

prior to the crisis to as low as 250/o during the crisis.

THE ROLE OF ASSET-BACKED SECURITIES

LO 7.2: Describe the mechanics of asset-backed securities (ABS) and ABS

collateralized debt obligations (ABS CDOs) and explain their role in the 2007

credit crisis.

Securitization is the process of pooling mortgages into a large pool, dividing the pool

into smaller units, and selling the units as financial investments to investors. By selling

mortgages to investors, lending institutions could repackage their mortgages and transfer

their risk to the markets.

Topic 7

Cross Reference to GARP Assigned Reading- Hull, Chapter 6

Page 78

The securitization process inevitably influenced the mortgage origination and underwriting

process. Mortgage originators' decisions were influenced primarily by whether the

underlying mortgages could be pooled and resold rather than whether the risks were

acceptable to the lending institution. The only relevant information to aid in this decision

was the borrower's credit score and the loan-to-value ratio (i.e., the ratio of the mortgage

amount to the appraised value of the home).

Asset-Backed Securities

An asset-backed security (ABS) is a financial security created through securitization from

the cash flows of financial assets including mortgages, loans, auto loans, bonds, credit card

receivables, or even aircraft leases. To create an ABS, the originator of a portfolio of assets

sells its assets to a special purpose vehicle (SPV), which is a bankruptcy-remote entity set

up solely to acquire and finance assets. (It is typically a subsidiary of the originator.) After

the financial assets are sold to the SPV, the cash flows from the assets are then allocated to

different segments based on the priority of cash flows. The segments are called tranches, and

typically each security has three tranches: the senior tranche, the mezzanine tranche, and the

equity tranche. Figure 1 is an example of an ABS structure with three tranches.

Figure 1 : ABS Structure

Senior Tranche

Principal: $300 million

Return: 5%

ABS Asset Pool

Principal: $400 million

! Special Purpose

Vehicle (SPV)

! Junior Tranche

Principal: $80 million

Return: 7%

Equity Tranche

Principal: $20 million

Return: 15o/o

From a cash flow perspective, the senior tranche has the lowest expected return at 5o/o

(indicating the lowest risk) and the equity tranche receives the highest expected return

at 1 5o/o (indicating the highest risk). The high return on the equity tranche reflects its

significantly higher risk because this segment is less likely to receive its indicative return

than the other segments. This is because cash flows are paid out based on a "waterfall"

structure under which both interest and principal payments are first allocated to the senior

tranche until all of its promised interest and outstanding principal is paid off. Once the

senior tranche is paid off, interest and principal payments are then made to the mezzanine

tranche, and only once the mezzanine tranche receives all of its promised cash flows are any

residual cash flows allocated to the equity tranche.

From a risk perspective, the equity tranche has the highest risk, and in our example will

absorb the first 5°/o of losses ($20 million of the $400 million). The mezzanine tranche will

absorb the next 20o/o of losses. Therefore, these two tranches together absorb 25o/o of losses.

If losses exceed 25o/o, the equity and mezzanine tranches lose their entire principal, and any

incremental loss will be absorbed by the senior tranche.

Topic 7

Cross Reference to GARP Assigned Reading - Hull, Chapter 6

From a ratings perspective, the senior tranche typically receives an AAA rating (highest

possible rating) given its low risk. The mezzanine tranche is typically rated BBB given its

moderate risk, while the equity tranche is generally not rated. Assigning a rating was often

a negotiated process between the ABS creator and the rating agencies, and the ABS creator

would present several structures to the rating agencies for evaluation.

ABS Collateralized Debt Obligations

A collateralized debt obligation (CDO) is a type of asset-backed security where the

underlying assets are fixed-income securities, including mortgages. In an ABS structure,

finding investors for the AAA-rated senior tranches from underlying subprime mortgages

pools was not challenging given its top rating. In addition, the originators of mortgages

typically retained the equity tranche. The difficulty lay in finding willing investors for the

mezzanine tranches. As a result, firms became creative and, through financial engineering,

created ABS CDOs.

Before the credit crisis hit, an ABS CDO was created from the mezzanine tranche of an

ABS that was backed by subprime mortgages. The new ABS CDO was then also segmented

into tranches the same way as the original ABS, with a senior, mezzanine, and an equity

tranche. If we assume the same principal allocation to the tranches as in our earlier example

(75/20/5), it is important to understand the outcome of this financial engineering: whereas

the original ABS had a total of75o/o in the AAA-rated senior instruments, the new ABS

CDO was 90o/o AAA-rated (75o/o in the ABS plus an additional 1 5o/o = 75o/o of 20o/o). If we

repeat this process multiple times, a pool of underlying high-risk subprime mortgages could

be turned into investments that were almost entirely AAA-rated.

Of course, ABS and ABS CDO investments did not all contain exactly three tranches, and

could have their cash flows segmented for each rating category (AAA, AA+, AA, AA-, and

so on). Riskier segments were often subject to overcollateralization, which means they were

backed by mortgages worth more than 1 OOo/o of the principal value of the investment.

From a risk perspective, the senior tranche of the ABS CDO was significantly riskier than

the senior tranche of the original ABS. In the ABS CDO, any losses in excess of 25o/o would

accrue to the senior ABS CDO tranche. Because the new ABS CDO was created entirely

from the original ABS mezzanine tranche, the 25o/o loss in the ABS CDO represented a 5o/o

mezzanine loss in the ABS (25o/o of 20o/o). This meant that any losses in excess of lOo/o of

the overall pool of mortgages would accrue to the ABS CDO senior tranche investors.

The conclusion from this discussion is that the more removed a new structured investment

is from the original investment, the riskier the tranches, especially the senior tranche,

despite all senior tranches having been assigned a very high rating (e.g., AAA). However,

assigning the same rating to investments that differed by risk misstated the true risk of the

investments. This was a problem as investors often compared the ABS ratings to identical

bond ratings. For example, if a BBB-rated bond yielded 8o/o while a BBB-rated ABS yielded

9o/o, investors would have preferred the higher yielding, but equivalently rated investment,

and would have potentially ignored the difference in risks.

Another risk issue to consider is that during periods of crisis, correlations between assets and

asset classes often increase. This was observed during the financial crisis as well, and with

Topic 7

Cross Reference to GARP Assigned Reading- Hull, Chapter 6

Page 80

increased default correlations, the risk of the higher-risk ABS and ABS CDO investments

also increased compared to traditional investments such as bonds.

ABSs, ABS CDOs, and the Credit Crisis

As mortgage defaults began to climb during the credit crisis, principal and interest cash

flows on ABSs and ABS CDOs began to decline, leading to losses for investors in these

investment vehicles. As the quality of mortgages declined, rating agencies downgraded ABSs

and ABS CDOs, and the market for tranches of these investments became illiquid. Investors

who relied on the ratings provided by the rating agencies for these complex products now

suffered losses and could often only receive pennies on the dollar at best. As investors

became reluctant to invest in higher-risk investments, the market experienced a flight to

quality to safe haven Treasury instruments. As the price of Treasuries increased and the price

of structured investments decreased, credit spreads widened.

Many financial institutions did not escape the credit crisis unscathed. Banks including

Citigroup, Merrill Lynch, and UBS experienced large losses, while other entities had to

be bailed out by governments, or, as in the case of Lehman Brothers, were allowed to fail.

Following the crisis, government and regulatory oversight of financial institutions increased

under legislations such as the Dodd-Frank Act.

THE ROLES OF INCENTIVES AND REGULATORY ARBITRAGE

LO 7 .3: Explain the roles of incentives and regulatory arbitrage in the outcome of

the crisis.

There is no singular cause of the credit crisis; instead, many factors contributed to it.

First, human psychology played a role. Mortgage originators, securitized asset creators,

and investors all assumed that home prices would continue to increase indefinitely even

though this belief was not supported by economic fundamentals. This behavior is known as

irrational exuberance. Second, relaxed lending standards allowed investors with weak credit

to qualify for subprime mortgages. Third, these subprime mortgages were then securitized

into ABSs and ABS CDOs, which were then rated by rating agencies. However, the rating

agencies had little experience in rating complex structured investments and, as a result,

materially underestimated the risks of these products.

Incentives

Incentives describe the differing motivations of players in structured product creation.

When incentives do not align, it is known as an agency cost.

The incentive of mortgage originators was to create loans acceptable for inclusion as assets

in the ABS and ABS CDO tranches. The incentive of those valuing homes was to provide

the highest possible valuation. This was favorable to lenders who were, therefore, more

motivated to transfer additional business to those valuing homes. By contrast, the incentives

of the creators of ABSs and ABS CDOs were driven by profitability in the form of excess

cash inflow from these investments over cash outflows. They also sought to maximize the

Topic 7

Cross Reference to GARP Assigned Reading - Hull, Chapter 6

volume of AAA-rated tranches (easiest to sell) by using their knowledge of rating criteria by

rating agencies. Rating agencies were paid for their ratings and were incentivized by issuing

(favorable) recommendations on these products.

Employee compensation arrangements contributed to another form of agency cost and

incentives. Compensation has three components: salary, bonus, and stock options. Traders

often received the bulk of their compensation in year-end (or intra-year) bonuses, which

were short-term incentives that often rewarded short-term risky behavior. For example, a

trader who correctly foresaw that the housing bubble would burst in 2007 (and should,

therefore, have stopped trading risky securitized products) was still better off trading in

2006 and collecting a bonus for the year.

Regulatory Arbitrage

Regulatory arbitrage refers to the scenario where the banks that originated, securitized,

and sold their mortgages were also the investors in these securitized assets. The banks'

primary motivation for their strategy was accounting driven and specifically related to

capital requirements. Under capital requirement rules, banks had to keep mortgages in the

"banking book," whereas the tranches of securitized assets were kept in the "trading book."

Capital requirements for these two books were very different (note that the specific capital

requirement and accounting treatment is beyond the scope of this topic).

LESSONS LEARNED

LO 7.4: Apply the key lessons learned by risk managers to the scenarios provided.

The credit crisis yielded the following eight key lessons:

1 . Human psychology plays a role in financial markets. Risk managers should look for

evidence of irrational exuberance and never assume that bull markets will continue

indefinitely.

2. Traditional correlations can break down during periods of crisis, and default

correlations can increase. Investors should not estimate correlations from normal

market conditions.

3. As default rates increase in stressed markets, recovery rates decline. Investors should not

estimate recovery rates from normal market conditions.

4. Traders' compensation arrangements including bonuses should be aligned with the

interests of their employers. Bonuses should be spread out over several years, with

a clawback provision to pay back part of the bonus if a year of good performance is

followed by a year of bad performance.

5. Investments that initially appear to be good investments may be poor investments after

further scrutiny. AAA-rated senior tranches of ABSs typically offered higher return than

AAA-rated bonds. The difference in returns was due to the higher risk that the ABS

carried.

Topic 7

Cross Reference to GARP Assigned Reading- Hull, Chapter 6

Page 82

6. Investors should conduct their own analyses rather than solely rely on ratings provided

by rating agencies.

7. Transparency is crucial in financial markets. A lack of transparency in markets can cause

liquidity to dry up during stressed periods.

8. Resecuritization (i.e., using an investment from a previous round of securitization

to create a new set of investments) results in investments that have risks that tend to

exceed their expected returns.

Topic 7

Cross Reference to GARP Assigned Reading - Hull, Chapter 6

LO 7.1

One of the key causes of the credit crisis of 2007 was the relaxation of lending standards

by mortgage lenders to attract new entrants into the market. Another cause was a lack of

government regulation. Relaxed lending standards and the lack of adequate government

regulation encouraged predatory lending.

By the second half of 2006, many borrowers could no longer afford their mortgages.

Lenders were forced to foreclose, putting downward pressure on demand and home prices

and increasing supply, which put further price pressure on homes.

Given that mortgages were nonrecourse in many states, borrowers had no financial liability

beyond their mortgage. The economically optional decision for borrowers who had negative

equity in their homes was to sell their home to the lender at the price of the outstanding

mortgage.

L0 7.2

Securitization is the process of repackaging a pool of mortgages into financial investments

that are then sold to investors.

An asset-backed security (ABS) is a financial security created through securitization from

the cash flows of financial assets. The cash flows are allocated to different tranches based

on the priority of cash flows, including senior, mezzanine, and equity tranches. The least

risky segment is the senior tranche, which receives the highest rating (often AAA) and has

the lowest default risk. The highest risk segment is the equity tranche, which is typically

unrated and retained by the ABS creator and has the highest default risk. Cash flows are

paid out based on a "waterfall" structure, under which interest and principal payments are

allocated to tranches based on seniority.

An ABS CDO could be created from the mezzanine tranche of an ABS backed by a pool of

subprime mortgages. The new ABS CDO could also be segmented into tranches. However,

the senior tranche of the ABS COO is riskier than the senior tranche of the ABS.

As mortgage defaults began to climb during the credit crisis, cash flows on ABSs and ABS

CDOs began to decline, leading to losses for investors in those investment vehicles.

L0 7.3

Factors that contributed to the credit crisis included irrational exuberance, relaxed lending

standards, and the lack of experience by rating agencies in rating complex structured

• investments.

Each participant (mortgage originators, individuals valuing homes, the creators of

structured investments, rating agencies, and investors) in the creation of a structured

product has different motivations/incentives. Agency costs occur when these incentives do

Topic 7

Cross Reference to GARP Assigned Reading- Hull, Chapter 6

not align. Employee compensation arrangements, which often reward riskier short-term

behavior, also result in agency costs.

Regulatory arbitrage refers to the scenario where the banks that originated, securitized, and

sold their mortgages were also the investors in these securitized assets. The motivation for

banks was driven by differing capital requirements for mortgages and investment tranches.

L0 7.4

The credit crisis yielded several key lessons:

• Risk managers should be aware of potential irrational exuberance in the markets.

• Correlations can increase during periods of stress.

• Investors should not estimate recovery rates from normal market conditions.

• Traders' compensation arrangements should reflect prudent practices.

• The risk differential between bonds and ABS should be considered by ratings agencies.

• Analysts should conduct their own risk analyses when evaluating ABS.

• Transparency is important for a well-functioning financial market.

• Investments from resecuritization are excessively risky.

Topic 7

Cross Reference to GARP Assigned Reading - Hull, Chapter 6

1 . A bank recently created an asset-backed security (ABS) from its pool of subprime

mortgages. Subsequently, the bank created a collateralized debt obligation (ABS

CDO) from the mezzanine tranche of the ABS. Each structured security has a

senior, mezzanine, and equity tranche. The senior tranche of the ABS CDO has:

A. lower risk than the equity tranche of the ABS COO but higher risk than the

mezzanine tranche of the ABS.

B. equivalent risk to the senior tranche of the ABS but lower risk than the

mezzanine tranche of the ABS COO.

C. lower risk than the equity tranches of both the ABS and ABS COO.

0. lower risk than both the equity and mezzanine tranches of the ABS.

2. The terms "liar loans" and "NINJA borrowers" are typically associated with which of

the following concepts?

A. Teaser rates.

B. Overcollateralization of mortgage loans.

C. Irrational exuberance.

0. Relaxed lending standards.

3. Which of the following statements about asset-backed securities (ABSs) is least

accurate?

A. The waterfall structure of an ABS alters the priority of principal and interest

cash flows.

B. The highest expected return, lowest-risk tranche is the senior tranche.

C. A 5o/o overcollateralization indicates that for every $ 1 00 in an ABS created, $ 1 05

in underlying mortgages is required.

0. The total cash flow of the underlying mortgages and the total cash flow of the

ABS are the same.

4. Anna Panich is a fixed-income analyst currently evaluating structured mortgage

products. She believes that the incentives of mortgage originators differ from the

incentives of the creators of asset-backed securities. Which of the following terms is

most likely associated with these different incentives?

A. Securitization.

B. Irrational exuberance.

C. Regulatory arbitrage.

0. Agency costs.

5. The senior tranche of a IO-year, asset-backed security collateralized debt obligation

(ABS COO) is rated AAA. Given that a comparable 1 0-year bond is also rated AAA,

which of the following statements is least accurate?

A. There is likely considerable irrational exuberance in the markets.

B. The rating agencies did not fully consider all of the ABS CDO's risks.

C. The probability of loss of the ABS CDO is lower than the probability of loss of

the bond.

0. The AAA-rated senior tranche is less risky than the equity tranche of the same

ABS CDO.

Cross Reference to GARP Assigned Reading- Hull, Chapter 6

Page 86

1 . C Since the ABS CDO has been created from the mezzanine tranche of the ABS, all tranches of

the ABS CDO have lower risk than the equity tranche and have higher risk than the senior

tranche of the ABS. The senior tranche of the ABS CDO also has lower risk than both the

mezzanine and equity tranches of the same ABS CDO.

2. D "Liar loans" (loans where borrowers lied on their mortgage loan applications) and "NINJA

borrowers" (mortgage borrowers with no income, no job, and no assets) are associated with

relaxed lending standards and are viewed as two of the contributing factors to the housing

• • cr1s1s.

3. B The senior tranche is the lowest-risk tranche but also is the lowest expected return tranche

(the equity tranche has the highest risk but offers the highest expected return). All other

statements are accurate.

4. D Incentives indicate the motivations of players in the structured product creation, including

the mortgage originator, individuals valuing homes, the creator of structured investments,

rating agencies, and the investor. When these incentives do not align, agency costs are

incurred.

5. C The probability of loss of the ABS CDO is higher than the probability of loss of the bond

because the ABS CDO carries additional risks including mortgage prepayment risk and

subordination risk to the senior tranche of the ABS (because the ABS CDO is created from

the mezzanine tranche of an ABS).

When there is considerable irrational exuberance in the markets, observers may ignore

the warning signs in the housing market, assume that the status quo holds and, therefore,

incorrectly view the risks of the ABS CDO and the bond as the same. It is also correct

that rating agencies did not fully consider all of the ABS CDO's risks in their ratings and,

as a result, assigned AAA ratings to the senior tranches of ABS CDOs even though these

securities carry higher risk than comparable nonsecuritized products.

The AAA-rated senior tranche is less risky than both the mezzanine and equity tranches of

the same ABS CDO.

The following is a review of the Foundations of Risk Management principles designed to address the learning

objectives set forth by GARP®. This topic is also covered in:

RISK MANAGEMENT FAILURES: WHAT ARE

THEY AND WHEN Do THEY PEN?

EXAM Focus

Topic 8

Risk management failures result from not correctly recognizing, measuring, and/or

monitoring risks as well as not appropriately communicating these risks to top management.

Mismeasurement of risk can result from not recognizing how return distributions change,

using subjective inputs concerning rare events, and failing to take all risks into account. For

the exam, understand the use of value at risk (VaR) as a risk metric. VaR is a very useful tool

for measuring and monitoring market, credit, and operational risk.

THE ROLE OF RISK MANAGEMENT

LO 8.1: Explain how a large financial loss may not necessarily be evidence of a risk

management failure.

The role of risk management involves performing the following tasks.

• Assess all risks faced by the firm.

• Communicate these risks to risk-taking decision makers.

• Monitor and manage these risks (make sure that the firm only takes the necessary

amount of risk).

The risk management process focuses on the output of a particular risk metric [e.g., the

value at risk (VaR) for the firm] and attempts to keep the measure at a specified target

amount. When a given risk measure is above (below) the chosen target amount, the firm

should decrease (increase) risk. The risk management process usually evaluates several risk

metrics (e.g., duration, beta).

A large loss is not necessarily an indication of a risk management failure. As long as risk

managers understood and prepared for the possibility of loss, then the implemented risk

management was successful. With that said, the main objective of risk management should

not be to prevent losses. However, risk management should recognize that large losses are

possible and develop contingency plans that deal with such losses if they should occur.

Topic 8

Cross Reference to GARP Assigned Reading- Stulz

Page 88

INCORRECTLY MEASURING AND MANAGING RISK

LO 8.2: Analyze and identify instances of risk management failure.

LO 8.3: Explain how risk management failures can arise in the following

areas: measurement of known risk exposures, identification of risk exposures,

communication of risks, and monitoring of risks.

The process of risk management can fail if one or more of the following events occur.

• Not measuring known risks correctly.

• Not recognizing some risks.

• Not communicating risks to top management.

• Not monitoring risk adequately.

• Not managing risk adequately.

• Not using the appropriate risk metrics.

It is important for the firm to recognize all relevant risks and to measure all known risks

correctly. These risks need to be managed and monitored using the appropriate risk metrics,

and the results need to be properly communicated to top management.

Risk mismeasurement can occur when risk managers do not understand the distribution

of returns of a single risky position or the relationships of the distributions among different

positions. Understanding the distribution of a given position means being able to identify

the underlying return distribution and the probabilities associated with that particular

distribution. Understanding the relationships among return distributions means being able

to identify how risky positions are correlated. In both cases, it is crucial to understand the

degree to which return distributions and/ or correlations can change over time. It is well

known, for example, that correlations tend to increase during times of stress.

One of the key issues for risk managers is the occurrence of extreme events (those events

which occur with low frequency, but high severity). Estimates of these rare events require a

degree of subjectivity, which clearly has the potential for mismeasurement. Unfortunately,

firm politics can play a role in reducing the accuracy of risk estimates since some

departments may wish to understate risks by using subjective measures. Mismeasurement

can also occur from ignoring relevant risks.

Failing to take known and unknown risks into account (i.e., ignoring risks) can take three

forms:

I . Ignoring a risk that is known.

2. Knowing about a risk, but failing to properly incorporate it into risk models.

3. Failing to discover all risks.

A firm ignores known risks by failing to realize how various position risks can lead to a

potential disaster. This was the case when Long-Term Capital Management (LTCM) failed

to recognize that high-yielding Russian debt had not only default risk, but also currency

risk, sovereign risk, and counterparty risk. For example, the managers of LTCM had

thought they had hedged currency risk by selling rubles forward, but the Russian banks on

the other sides of the transactions failed during the 1998 Russian crisis.

Topic 8

Cross Reference to GARP Assigned Reading - Stulz

Not collecting and entering data into the appropriate risk models is another potential source

of disaster. In this case, the firm may make an attempt to recognize the risk. However, not

obtaining proper data to measure the risk adequately will have similar consequences to

ignoring risks.

One of the severe consequences of either ignoring or not adequately using data in risk

models is that the firm might expand its operations in areas where risks are not being

properly accounted for. For example, consider a particular trading office within a firm

where the firm has made a risk allocation to the office, but then the firm ignores the data

generated by this trading office and does not monitor to see if allocation adjustments are

needed. Another example is blindly accepting a given assumption (i.e., AAA-rated assets are

very low risk) and ignoring data that would indicate the contrary.

Another risk that is often ignored is increasing correlations during a time of crisis. Not

recognizing the possibility of increasing correlations could potentially lead to large losses.

Consider, for example, the correlation between credit risk and market risk for banks.

In the recent credit crisis, market risk caused decreases in security values issued through

securitization, and credit risk caused decreases in the utilization of securitization. The

important point is that firms must use all available data to adequately measure all risks and

relationships among risks.

Some risks may go completely undetected by risk managers. Clearly, the same unfavorable

outcomes discussed previously would result. In some cases, however, unknown risks may

not be too severe of a problem. There are ultra-extreme events (e.g., asteroid crashing to

earth) where the probability is so low and the outcome is so horrific that exploring it would

not be worthwhile. Also, the nature of some risks can be unknown while their consequences

are known. For example, simply knowing that a given random variable follows a normal

distribution may be adequate. Furthermore, as long as management realizes that not all risks

will be known and makes appropriate capital allocations to account for this, then unknown

risks may not be a severe problem.

PROPERLY COMMUNICATING RISKS

The purpose of risk management is to allow senior managers of the firm to make the

optimal strategic decisions to maximize firm value. Thus, risk management efforts are

wasted unless the results can be effectively communicated to the appropriate decision

makers. This includes timely communication that has not been distorted by intermediaries.

Furthermore, the risk management process may be harmful if there is miscommunication,

and the senior managers get a false sense of security from the information that is provided.

The bottom line is this-it is very important to communicate the results of the risk

management process effectively.

ONGOING RISK MANAGEMENT

Risk managers must recognize how portfolio risk profiles can change even during the

absence of trading. The properties of some securities can change for several reasons (e.g.,

changes in interest rates, embedded derivatives). Also, some securities can have complex

relationships with market variables; for example, a security may increase in value when

Topic 8

Cross Reference to GARP Assigned Reading- Stulz

Page 90

interest rates decline over one particular range and then decline in value as interest rates

decline further outside of that range.

The pricing of subprime derivatives serves as an example of changing risk exposures.

Previously, the ABX indices (i.e., asset-backed securities indices) showed no variation for

AAA-rated tranches of securitization. However, during the recent financial crisis, the values

declined suddenly and dramatically, and anyone who had relied on historical values of the

ABX indices for allocations incurred large losses. Obviously, a key element for successful

risk management is to recognize how quickly and dramatically risk characteristics can

change. Thus, it is important to be able to respond quickly and have contingency plans if/

when needed.

It is also important to understand that the act of monitoring and managing risk can change

the nature of risk. The Heisenberg Principle says that increasing the certainty for one

variable may introduce uncertainty for another variable. Marking to market in one firm, for

example, may start a chain reaction of adjustments in other firms which changes the risk

characteristics of those firms and the overall market, thus, increasing market risk.

Another cautionary note concerning monitoring and managing risk too carefully is that

it could stifle a trading department's innovation. Employees should have some degree of

flexibility; therefore, a firm's management may rightly decide not to, or "fail" to, monitor

and manage some risks on an ongoing basis. The downside of course is that this flexibility

could make it possible for risks to emerge in remote corners of the firm. This is one of the

many trade-offs senior management must consider.

Firms can fail to monitor and manage risk on an ongoing basis by not having an adequate

incentive structure and/or culture that promotes effective risk management. If risk is

everyone's concern, then unobserved risks are less likely. In addition, if compensation is a

function of risk, then employees will likely take more interest in lowering firm risk.

THE ROLE OF RISK METRICS

LO 8.4: Evaluate the role of risk metrics and analyze the shortcomings of existing

risk metrics.

Risk metrics aid the management process by providing managers a target to achieve (e.g.,

a particular VaR level). Monitoring these risk metrics allows managers to appropriately

manage risk. However, risk metrics may be too narrow in scope, which can make it more

difficult to achieve the overall objective of managing risk in an effort to create value.

VaR is a widely used risk metric that is narrow in scope in several ways. Usually, a firm

simply reports the number of times losses exceeded VaR in a given period. Over a year, a

firm may have zero daily losses greater than daily VaR, but it could end up with an annual

loss in the event that most days incurred losses (without exceeding VaR). Furthermore, for a

firm that exceeds its VaR for a certain number of days, the VaR approach does not indicate

the size of those losses. It is well known that VaR does not capture the implications of

extremely large losses that have a very low probability of occurring.

Topic 8

Cross Reference to GARP Assigned Reading - Stulz

One misuse ofVaR is choosing a time period (e.g., daily or weekly) that does not

correspond to the liquidity of the assets in the portfolio. Using daily VaR on a portfolio

where the assets cannot be effectively traded within a day is clearly not appropriate. Taking

a longer term horizon to account for liquidity of the assets may not be sufficient either. The

problem is that any given horizon, such as a month or a year, may have a low probability

of default because the probability of a crisis in these intermediate horizons is very low.

Financial institutions generally focus on firm-wide risk management at a one-year horizon

and try to achieve credit ratings that imply a low probability of default for that horizon.

However, without looking ahead multiple periods, the firm has little incentive to factor in

a potential crisis, which would drastically change default probabilities. The firm needs a

strategy to survive those unfortunate years where crises do occur, which means that focusing

on only a one-year horizon will likely fall short.

VaR also assumes the distributions of losses are not correlated over time. In the recent

financial crisis, huge losses on one day led to drastic falls in liquidity, which led to large

losses on the following day. The fact is that a crisis can change the nature of a return

distribution for a given period as well as across periods.

Another complication is that a given firm's losses can exacerbate the risk in the overall

market. This is related to an earlier discussion on how the marking to market of one firm

can lead to adjustments in other firms. The point is that a firm with large losses in a given

market can influence the activity in that market. This firm can also fall victim to predatory

trading. Predatory trading occurs when other firms in a market see that a large player in the

market is in trouble and the other firms attempt to push the price down further in order to

hurt the large player. Such activity is difficult to incorporate into risk metrics.

In its risk management process, a firm can attempt to capture such complications with

scenario analysis. The scenarios would include a crises and/or a firm's behavior in the overall

market. Scenario analysis requires input from people who have a solid understanding of not

only mathematics, but also the complexities of human behavior.

Topic 8

Cross Reference to GARP Assigned Reading- Stulz

Page 92

LO 8.1

Risk management involves assessing, communicating, monitoring, and managing risks.

A large loss does not necessarily mean that risk management has failed. Losses are the result

of risk taking, which is required for value creation.

LO 8.2

Risk management can fail if the firm does not do the following: measure risks correctly,

recognize some risk, communicate risks to top management, monitor and manage risks, and

• • use appropriate metrics.

LO 8.3

Mismeasurement can occur when management does not understand the distribution of

returns of a single position or the relationships of the distributions among positions and

how the distributions and correlations can change over time. Mismeasurement can also

occur when managers must use subjective probabilities for rare and extreme events. The

subjective probabilities can be biased from firm politics.

Failing to take known and unknown risks into account can take three forms: (1) ignore a

risk that is known, (2) failure to incorporate a risk into risk models, and (3) not finding

all risks. All three of these are variations of the same concept and can have similar results

(e.g., failure to measure overall risk or expanding operations to areas where risk is not being

properly measured).

Senior managers must understand the results of risk management in order for it to be

meaningful. Unless senior managers have the correct information to make decisions, risk

management is pointless.

Risk managers must recognize how risk characteristics change over time. Many securities

have complex relationships with market variables. Having an adequate incentive structure

and firm-wide culture can help with the risk monitoring and managing process.

LO 8.4

Risk metrics such as VaR are usually too narrow in scope. For example, VaR usually assumes

independent losses across periods of time. Risk metrics generally fail to capture the effect of

a firm's actions on the overall market and behavior patterns such as predatory trading.

Topic 8

Cross Reference to GARP Assigned Reading - Stulz

1 . "Which of the following is not part of the risk management process?

A. Monitoring risk.

B. Assessing the risks faced by the firm.

C. Properly communicating the risks to upper management.

D. Reducing the probability of loss to as close to zero as possible.

2. Paul Frank, FRM, manages several positions within a portfolio. He has determined all

possible outcomes for every single position. The result of his detailed work means that:

A. risk mismeasurement is not possible.

B. risk mismeasurement is still possible for each of the positions and the overall

portfolio.

C. risk mismeasurement is only possible if the possible outcomes change and Frank

does not make the necessary adjustments.

D. risk mismeasurement is not possible for each of the positions, but it is possible

for the overall portfolio because correlations have not been addressed.

3. The Tower Corporation has several divisions, and each must give updated reports

on its risk levels. The nature of Tower's business is that there is the possibility of

large losses that are very infrequent, some of which have never actually been realized.

Tower requires that the manager of each division include subjective assessments

of these risks in their reports. With respect to this risk assessment, which of the

following statements is most accurate? This action:

A. is the best way to avoid risk mismeasurement.

B. is always an appropriate method for managing risk.

C. can be a source of risk mismeasurement, but Tower can expect the errors to be

unbiased.

D. can be a source of risk mismeasurement due to the subjective input and the fact

that there may be bias in the input.

4. If risk managers are not certain of all risks faced by the firm:

A. the firm will most likely fail.

B. this can be a source of risk management failure, but not in all cases.

C. this is a cause of risk management failure and is always avoided with adequate

research.

D. this is a source of risk management failure and usually cannot be avoided with

adequate research.

5. Crane Corporation has a multi-tier management structure. Risk management

occurs in each division at the base level of the structure (i.e., in each division). The

results of the process are then successfully communicated to higher tiers, where it is

reviewed and revised at each tier, and then sent to the appropriate decision makers

for the firm. This process is:

A. not appropriate because it allows for distortions between the managers of risk

and the decision makers.

B. not appropriate because risk management should not be done at the base level of

• a corporation.

C. appropriate, and it would also be appropriate to have the base tier report directly

to the top management tier.

D. appropriate because it allows for maximum input into the process.

Topic 8

Cross Reference to GARP Assigned Reading - Stulz

Page 94

1 . D Some losses are to be expected if risk taking is aimed at creating value.

2. B Frank must also consider the probabilities of the outcomes and not just the outcomes

themselves. He must also consider the correlations across positions.

3. D Subjective inputs will have random errors and, in this case, may very well exhibit bias because

each manager likely has a motive to understate risk.

4. B Some risks may not be known explicitly, but they can still be accounted for. In this case,

risk management can still be successful. Also, not knowing the risks themselves but

understanding the results of the risk (i.e., the distribution of returns) can be adequate for

successful risk management.

5. A The fact that intermediate tiers can modify the information without being directly involved

in the risk management process can introduce distortions.

DELINEATING EFFICIENT PORTFOLIOS

EXAM Focus

This optional reading addresses fundamental concepts regarding portfolio return and

volatility. Be familiar with the calculations of expected return and volatility for a two-asset

portfolio and understand the importance of correlation in portfolio diversification. It is also

important to understand the shape of the portfolio possibilities curve and what is meant by

the minimum variance portfolio. Additionally, you should know what the efficient frontier

looks like and how short sales and riskless borrowing affect it. We have included Concept

Checkers at the end of this reading for additional practice with these concepts.

EXPECTED RETURN AND VOLATILITY OF A Two-ASSET PORTFOLIO

The expected return on a portfolio is a weighted average of the expected returns on the

individual assets that are included in the portfolio. For example, for a two-asset portfolio:

where:

E(Rp)

w1. E(J\)

= expected return on Portfolio P

= proportion (weight) of the portfolio allocated to Asset i

= expected return on Asset i

The weights (w1 and w2) must sum to 1000/o for a two-asset portfolio.

The variance of a two-asset portfolio equals:

where:

cr􀀙 = variance of the returns for Portfolio P

crr = variance of the returns for Asset 1

cr􀀭 = variance of the returns for Asset 2

wi = proportion (weight) of the portfolio allocated to Asset i

Cov 1,2 = covariance between the returns of the two assets

Delineating Efficient Portfolios

Page 96

The covariance, Cov 1,2, measures the strength of the relationship between the returns

earned on assets 1 and 2. The covariance is unbounded (ranges from negative infinity to

positive infinity); therefore, it is not a very useful measure of the strength of the relationship

between two asset's returns. Instead, we often scale the covariance by the standard deviations

of the two assets to derive the correlation coefficient, p1,2:

From the previous equation, notice that the covariance equals p1,2cr 1 cr2. Therefore, the

variance of the two-asset portfolio can also be written as:

The portfolio standard deviation or portfolio volatility is the positive square root of the

portfolio variance.

Example: Expected return and volatility for a two-asset portfolio

Using the information in the following figure, calculate the expected return and standard

deviation of the two-asset portfolio.

Characteristics for a Two-Stock Portfolio

Amount invested

Expected return

Standard deviation

Correlation

Answer:

Caffeine Plus

$40,000

1 1 %

15%

0.30

Spark/in'

$60,000

25%

20%

First, determine the weight of each stock relative to the entire portfolio. Since the

investments are $40,000 and $60,000, we know the total value of the portfolio is

$100,000:

we = investment/portfolio value = $40,000 I $100,000 = 0.40

w5 = investment/portfolio value = $60,000 I $100,000 = 0.60

Delineating Efficient Portfolios

Next, we determine the expected return on the portfolio:

E(Rp) = W cE (Rc) + w5E (R5)

E(RP) = (0.40)(0.1 1 ) + (0.60)(0.25) = 0.1940 = 19.40%

Then, we calculate the variance of the portfolio:

2 2 2 2 2 O'p = WcO'c + Ws O"s + 2wcWsPcsO'cO's

= (0.40)2 (0.15)2 + (0.60)2 (0.20)2 + 2(0.40)(0.60) (0.30)(0.15) (0.20)

= 0.02232

And, finally, the standard deviation of the portfolio:

cr P = M = '10.02232 = 0. 1494 = l 4.94o/o

THE PORTFOLIO Poss1B1L1T1Es CuRVE

In the Caffeine Plus and Sparklin' example, we calculated the expected return and volatility

of one possible combination: 40o/o in Caffeine Plus and 60°/o in Sparklin'. However,

an infinite number of combinations of the two stocks are possible. We can plot these

combinations on a graph with expected return on the y-axis and standard deviation on the

x-axis, commonly referred to as plotting in risk/return "space." The graph of the possible

portfolio combinations is referred to as the portfolio possibilities curve. Figure 1 shows

some of these combinations.

Figure 1 : Portfolio Returns for Various Weights of Two Assets

W Caffeine Plus lOOo/o 80% 60% 40% 20% 0%

W5 par kl1" n' 0% 20% 40% 60% 80% 100%

Rp 1 1.00% 13.80% 16.60% 19.40% 22.20% 25.00%

O"p

1 5.00% 13.74% 13.72% 14.94% 17.10% 20.00%

The plot in Figure 2 represents all possible expected return and standard deviation

combinations attainable by investing in varying amounts of Caffeine Plus and Sparklin'.

Delineating Efficient Portfolios

Page 98

Figure 2: Expected Return and Standard Deviation Combinations

E(Rp)

25o/o

16.6%

1 1 %

60% Caffeine Plus

- - - - - - - - - - - - - - - - - - - - - - - - - - - - -

40% Sparkli11' /"

•

- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - •

•

100% Sparklin'

.--+-100% Caffeine Plus

􀀗􀀞􀀞􀀞􀀞􀀞􀀞􀀞􀀞􀀞􀀞􀀞· 􀀞􀀞􀀞􀀞􀀞􀀞􀀞􀀞􀃋CTP

13.7°1<> 15% 20%

There are several things to notice about Figure 2:

• If 100°/o of the portfolio is allocated to Caffeine Plus, the portfolio will have the expected

return and standard deviation of Caffeine Plus (i.e., Caffeine Plus is the portfolio), and

the investment return and risk combination is at the lower end of the curve.

• As the investment in Caffeine Plus is decreased and the investment in Sparklin' is

increased, the investment moves up the curve to the point where the portfolio's expected

return is 16.60/o with a standard deviation of 1 3 .72% (labeled 60% Caffeine Plus/40%

Sparklin').

• Finally, if 1 00% of the portfolio is allocated to Sparklin', the portfolio will have the

expected return and standard deviation of Sparklin', and the investment return and

risk combination is at the upper end of the curve (e.g., higher risk and higher expected

return).

MINIMUM VARIANCE PORTFOLIO

The minimum variance portfolio is the portfolio with the smallest variance among all

possible portfolios on a portfolio possibilities curve. The minimum variance portfolio

consisting of Caffeine Plus and Sparklin' contains approximately 70% Caffeine Plus and

30% Sparklin' and has an expected return of 1 5.3% and a standard deviation of 1 3 .6%. On

the portfolio possibilities curve, the minimum variance portfolio represents the left-most

point on the curve. Figure 3 illustrates the minimum variance portfolio for Caffeine Plus

and Sparklin' (point A).

Delineating Efficient Portfolios

Figure 3: Minimum Variance Portfolio

25%

1 1 o/o

•

- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -

1 OOO/o Sparklin'

•

• .---;-:-100°/o Caffeine Plus

20%

CORRELATION AND PORTFOLIO DIVERSIFICATION

Perfect Positive Correlation

In the case where two assets have perfect positive correlation (i.e., p = 1), the portfolio

standard deviation reduces to the simple weighted average of the individual standard

deviations indicating no diversification. This is shown mathematically as:

Since expected portfolio return is a linear combination of the individual asset returns, and

risk is a linear combination of the individual asset volatilities, the portfolio possibilities

curve for two perfectly correlated assets is a straight line. This line is given as:

No diversification is achieved if the correlation between assets equals + 1 . As the correlation

between two assets decreases, however, the benefits of diversification increase. As the

correlation decreases, there is less tendency for stock returns to move together. The separate

movements of each stock serve to reduce the volatility of a portfolio to a level that is less

than the weighted sum of its individual components (e.g., less than w1 a 1 + w2a2).

Perfect Negative Correlation

The greatest diversification is achieved in the case where two assets have perfect negative

correlation (i.e., p = -1). In this case, the portfolio standard deviation reduces to two linear

equations, which are:

Delineating Efficient Portfolios

Page 100

When two assets have perfect negative correlation, it is possible to construct a portfolio with

zero volatility by setting the standard deviation equal to zero and solving for the portfolio

weights. The portfolio with zero volatility has portfolio weights of:

Given that the standard deviation reduces to two linear equations, the portfolio possibilities

curve for two assets with perfect negative correlation will be two line segments.

Zero Correlation

When the correlation between two assets is zero, the covariance term in the portfolio

standard deviation expression is eliminated, and the resulting expression is:

In this case, the standard deviation expression reduces to a non-linear equation, and the

portfolio possibilities curve will be non-linear.

Assuming that the standard deviations of the individual assets are greater than zero, it

is impossible to construct a portfolio with zero volatility. The weights of the minimum

variance portfolio can be solved as previously discussed. The weights are calculated as:

CY􀀭

CYf + CY􀀭

Moderate Positive Correlation

Most equities are positively correlated (i.e., 0 < p < 1). If we assume that two assets are

moderately correlated (e.g., p = 0.5), then the portfolio standard deviation reduces to:

1/2

2 2 2 2 1 [ 2 2 2 2 1112

CYP

= W1 CYl +w2CY2 +2w1w2 x 2 X CY1CY2 = W1 CYl + w2CY2 +w1W2CY1CY2

Similar to the case of zero correlation, assets with moderate correlation have non-linear

portfolio possibilities curves.

An Example of Correlation and Portfolio Diversification

To illustrate the effects of correlation on diversification, consider the expected return and

standard deviation data derived for domestic stocks, OS, and domestic bonds, DB as shown

in Figure 4.

Delineating Efficient Portfolios

Figure 4: Diversification Example

Domestic Stocks (DS)

Domestic Bonds (DB)

Expected

Return

0.20

0.10

Standard

Deviation

0.30

0. 1 5

Figure 5 shows the expected return and standard deviation combinations for various

portfolio percentage allocations to domestic stocks and domestic bonds for each of the

correlations + l , 0.5, 0, and - 1 .

Figure 5: Expected Return/Standard Deviation Combinations for Various Allocations

DS % Allocation DB % Allocation

100.00 0.00

66.67 33.33

50.00 50.00

33.33 66.67

0.00 100.00

0.200

0.167

0 . 1 50

0.133

0.100

p = l p = 0.5 p = O p = -1

0.300 0.300 0.300 0.300

0.250 0.229 0.206 0.150

0.225 0 . 1 98 0. 168 0.075

0.200 0. 173 0. 141 0.000

0.150 0.150 0. 150 0.150

Figure 6 shows the plot of the expected returns and standard deviations for each of the four

correlations.

Figure 6: Effects of Correlation on Portfolio Risk

E(Rp)

0.25

0.20

0.15

0.10

0.05

p=- 1

0.05 0.10

􀂔 p= l

DB P= 0.5

0.15 0.20 0.25

0.30 0.35

As indicated in Figure 6, the lower the correlation between the returns of the stocks in

the portfolio, the greater the diversification benefits. If the correlation equals + 1 (the solid

black line), the minimum-variance frontier is a straight line between the two points (DB

and DS), and there is no benefit to diversification. If the correlation equals - 1 (the solid

blue line), the minimum-variance frontier is two straight-line segments, and there exists a

portfolio combination of stocks and bonds with a standard deviation of zero (the allocation

of 66.67°/o to domestic bonds and 33.330/o to domestic stocks).

Delineating Efficient Portfolios

Page 102

THE SHAPE OF THE PoRTFOLIO PossIBILITIES CuRVE

Professor's Note: In this section, we are not considering the special cases where

the portfolio possibilities curve is a straight line (i.e., p = I) or two line segments

(i.e., p = -1). In all other cases, the portfolio possibilities curve is a curve

similar to Figure 7.

Looking at Figure 7, the shape of the portfolio possibilities curve is best described in two

• pieces.

• The piece of the portfolio possibilities curve that lies above the minimum variance

portfolio (from point C through point G) is concave.

• The piece of the portfolio possibilities curve that lies below the minimum variance

portfolio (from point A through point C) is convex.

Figure 7: Shape of the Portfolio Possibilities Curve

E(Rp)

0.16

0.14

0.12

0.10

0.08

0.06 c

0.04

0.02

global minimum

- variance portfolio

0.00 �----------------------- (J2

0.00 0.02 0.04 0.06 0.08 0 . 1 0 0.12 0.14 0.16 0 . 1 8

Professor's Note: A concave function is one where the function lies above a

straight-line segment connecting any two points on the function. A convex

function lies below a straight-line segment connecting any two points on the

function.

In Figure 7, the function is above the line segment from C to G. Therefore, the

portion of the portfolio possibilities curve from C to G is concave. The function

is below the line segment from A to C. Therefore, the portion of the portfolio

possibilities curve from A to C is convex.

Another important aspect regarding the shape of the portfolio possibilities curve is that

the curve must lie to the left of a line segment connecting any two points on the curve.

From the discussion of portfolio diversification and correlation, combinations of two assets

with perfect positive correlation result in a straight line. Combinations of assets with lower

correlation will always lie to the left of that line.

Delineating Efficient Portfolios

THE EFFICIENT FRONTIER

Plotting all risky assets and potential combinations of risky assets will result in a graph

similar to Figure 8.

Figure 8: Efficient Frontier

Notice that the graph includes some portfolios that no rational investor would select. All

portfolios lying on the inside of the curve are inefficient. Additionally, some portfolios

offer higher returns with identical risk. For example, portfolios A and E have identical risk;

however, Portfolio E has a much higher expected return, and a similar contrast exists for

Portfolio D versus Portfolio B. All rational investors would prefer Portfolio D over Portfolio

B, and Portfolio E over Portfolio A.

Portfolios such as D and E are called efficient portfolios, which are portfolios that have:

• Minimum risk of all portfolios with the same expected return.

• Maximum expected return for all portfolios with the same risk.

The efficient frontier is a plot of the expected return and risk combinations of all efficient

portfolios, all of which lie along the upper-left portion of the possible portfolios (from Point

C to Point G in Figure 8).

Short Sales and the Efficient Frontier

When short sales are allowed, the shape of the efficient frontier changes. To examine how it

changes, consider again the Caffeine Plus and Sparklin' example.

Referring back to the example, Caffeine Plus has an expected return of 1 1 o/o and a standard

deviation of 1 5%, and Sparklin' has an expected return of 25% and a standard deviation

of 20%. The correlation between Caffeine Plus and Sparklin' is 0.30. Although neither

stock has a negative return, it may make sense to short sell one of the stocks. In this case,

Sparklin' has a higher expected return, so shorting Caffeine Plus and investing in Sparklin'

would expand the efficient frontier. Figure 9 highlights the portfolio return and volatility

for combinations of Sparklin' and Caffeine Plus including short sales.

Delineating Efficient Portfolios

Page 104

Figure 9: Portfolio Returns for Various Weights of Two Assets (w/ Short Sales)

WC afef ine Plus 1000/o 80% 60% 40% 20% 0% -20% -40% - 60% -80% - 100%

wSparklin' 0% 20% 40% 60% 80% 100% 120% 140% 160% 180% 200%

RP 11.00% 13.80% 16.60% 19.40% 22.20% 25.00% 27.80% 30.60% 33.40% 36.20% 39.00%

O'p 15.00%13.74% 13.72% 14.94% 17.10%20.00% 23.28% 26.82% 30.53% 34.36% 38.28%

When allowing for short sales, the efficient frontier expands up and to the right. By

shorting, it is possible to create higher return and higher volatility portfolio combinations

that would not be possible otherwise. Theoretically, with no limitations on shorting, it

would be possible to construct a portfolio with infinite return.

Professor's Note: Up to this point, we have discussed risky assets. Now, we add

the risk-free asset to the set of asset choices and examine the effect it has on

investment choices.

Combining the Risk-Free Rate with the Efficient Frontier

So far, our portfolios have consisted of risky assets only. However, in reality, investors

usually allocate their wealth across both risky and risk-free assets. The following discussion

illustrates the effects of the inclusion of the risk-free asset. A risk-free asset is a security that

has a return known ahead of time, so the variance of the return is zero.

Consider the task of creating portfolios comprising the risk-free asset, F, and a risky

portfolio, P. Assume that Portfolio P lies on the efficient frontier of risky assets. Various

combinations (weightings) of Portfolio P and the risk-free asset can be created. By adding

the risk-free asset to the investment mix, a very important property emerges: The shape of the

efficient frontier changes from a curve to a line.

Recall that the expected return for a portfolio of two assets equals the weighted average of

the asset expected returns. Therefore, the expected return on Investment C that combines

the risk-free asset and risky Portfolio P equals:

where:

Wp = percentage allocated to the risk-free asset

Wp = percentage allocated to Portfolio P

Delineating Efficient Portfolios

Also, recall that the variance of the portfolio of two assets (F and P) equals:

<J2c = W2p <Jp2 + W2p <J2p + 2wpwp c OVpp

where:

(Jc2

(J2

(Jp2

= variance for Investment C

= variance for the risk-free asset

= variance for Portfolio P

CovFP = covariance between F and P

Observe that since we know that the variance and the standard deviation of the risk-free

asset both equal zero, and that the covariance of the risk-free asset with any risky asset also

equals zero, the equations for the variance and standard deviation for Investment C simplify

to:

<Jc = WpCYp

Because the expected return and portfolio standard deviation of the combination of a

risk-free asset and risky portfolio are both linear, the efficient frontier reduces to a linear

equation. That is, by including the risk-free asset, we have caused the efficient frontier to

become a straight line. The equation for the efficient frontier becomes the capital market

line (CML).

E(Rc ) = Rp +

E(R p ) - Rp

<Jp

Figure 1 0 illustrates the combination of the risk-free asset with the risky portfolio.

Figure 10: Efficient Frontier including the Risk-Free Asset

E(R)

Borrowing

Lending 􀀬 Portfolio P

When the risk-free asset is combined with the risky Portfolio P, the efficient frontier

becomes a line with:

• The intercept equal to the risk-free rate, and

• The slope equal to the reward-to-risk ratio for the risky portfolio.

Delineating Efficient Portfolios

Page 106

Note that the capital market line is tangent to the efficient frontier. The point of tangency,

Portfolio P, is known as the market portfolio. This portfolio contains all available risky assets

in proportion to their total market values.

If all investors agree on the efficient frontier (i.e., they have homogeneous expectations

regarding the risks and returns for all risky assets), they will hold a combination of the

market portfolio and the risk-free asset. Risk-averse investors will create lower risk portfolios

by lending (i.e., investing in the risk-free asset). More risk-tolerant investors will increase

portfolio return by borrowing at the risk-free rate. This result is known as the separation

theorem.

1 . Assume the following information for stocks A and B.

• Expected return on Stock A = 1 8 0/o.

• Expected return on Stock B = 23%.

• Correlation between returns of Stock A and Stock B = 0 . 1 0.

• Standard deviation of returns on Stock A = 40%.

• Standard deviation of returns on Stock B = 50°/o .

The expected return and standard deviation of an equally weighted portfolio of

stocks A and B are closest to:

Expected return (%)

A. 20.5

B . 20.5

C. 33.5

D . 33.5

Standard deviation (%)

33.54

1 1 .22

33.54

Use the following data to answer Questions 2 and 3.

Assume the expected return on stocks is 1 8 % (represented by Z in the figure), and the

expected return on bonds is 8% (represented by point Yon the graph).

Portfolio Possibilities Curve: Stocks and Bonds

E(llp)

20%

z w.-----

16%

120/o x

80/o

10% 20%

2. The graph shows the portfolio possibilities curve for stocks and bonds. The point

on the graph that most likely represents a 90% allocation in stocks and a 10°/o

allocation in bonds is Portfolio:

A. W.

B. X.

C. Y.

D. Z.

Delineating Efficient Portfolios

Page 107

Delineating Efficient Portfolios

Page 108

The efficient frontier consists of the portfolios between and including:

A. X and W

B. Y and Z.

C. X and Z.

D. Y and X.

Which of the following best describes the shape of the portfolio possibilities curve?

A. The curve is strictly convex.

B. The curve is strictly concave.

C. The curve is concave above the minimum variance portfolio and convex below

the minimum variance portfolio.

D. The curve is convex above the minimum variance portfolio and concave below

the minimum variance portfolio.

When short sales are possible (i.e., there are no short sale restrictions), the efficient

frontier is:

A. a straight line between the risk-free asset and the market portfolio.

B. two line segments, which indicate a negative relationship between short and

long positions.

C. expanded to include portfolios with higher return and lower volatility.

D. expanded to include portfolios with higher return and higher volatility.

Delineating Efficient Portfolios

2. A Since the return to Wis the nearest to Z (stocks), it is logical to assume that point W

represents an allocation of 90% stocks/10% bonds. The return for Wis lower than Z, but it

also represents a reduction in risk.

3. C The efficient frontier consists of portfolios that have the maximum expected return for any

given level of risk (standard deviation or variance). The efficient frontier starts at the global

minimum-variance portfolio and continues above it. Any portfolio below the efficient

frontier is dominated by a portfolio on the efficient frontier. This is because efficient

portfolios have higher expected returns for the same level of risk.

4. C The portfolio possibilities curve is concave above the minimum variance portfolio and

convex below the minimum variance portfolio.

5. D When short sales are allowed, the efficient frontier expands up and to the right (i.e., higher

return and higher volatility portfolio combinations become feasible). When considering two

stocks, by shorting the stock with lower expected return and using the proceeds to increase

the investment in the other stock, it is possible to increase portfolio return. This increased

return comes at a cost of higher volatility, though.

Page 1 1 0

The following is a review of the Foundations of Risk Management principles designed to address the learning

objectives set forth by GARP®. This topic is also covered in:

THE STANDARD CAPITAL ASSET

PRICING MODEL

EXAM Focus

Topic 9

This topic discusses the capital market line (CML) and the capital asset pricing model

(CAPM). The CAPM requires many assumptions, such as the existence of a risk-free asset

and that all investors have the same type of utility function and expectations. The existence

of a risk-free asset means the efficient frontier becomes a straight line, which allows for the

use of simple expressions to analyze price risk. It is important to have a firm grasp on the

CAPM calculation methodology.

THE CAPITAL ASSET PRICING MODEL (CAPM)

LO 9 .2: Describe the assumptions underlying the CAPM.

The capital asset pricing model (CAPM), derived by Sharpe, Lintner, and Mossin, is one

of the most celebrated models in all of finance. The model describes the relationship we

should expect to see between risk and return for individual assets. Specifically, the CAPM

provides a way to calculate an asset's expected return (or "required" return) based on its level

of systematic (or market-related) risk, as measured by the asset's beta.

CAPM Assumptions

In the derivation of any economic or scientific model, simplifying assumptions regarding

the market, which the model represents, must be made. The CAPM has a number of

underlying assumptions:

I . Investors face no transaction costs when trading assets. This assumption simplifies

the computation of returns. If transaction costs were considered, returns would be a

function of transaction costs, which would then have to be estimated.

2. Assets are infinitely divisible. It is possible to hold fractional shares.

3. There are no taxes; therefore, investors are indifferent between capital gains and income

or dividends.

4. Investors are price takers whose individual buy and sell decisions have no effect on asset

prices. The market for assets is perfectly competitive.

5. Investors' utility functions are based solely on expected portfolio return and risk. This

assumption provides a framework for how investors make investment decisions.

6. Unlimited short-selling is allowed. Investors can sell an unlimited number of shares of

an asset short.

Topic 9

Cross Reference to GARP Assigned Reading - Elton, et al., Chapter 1 3

7. Investors can borrow and lend unlimited amounts at the risk-free rate.

8. Investors are only concerned about returns and risk over a single period, and the single

period is the same for all investors.

9. All investors have the same forecasts of expected returns, variances, and covariances.

This is known as homogeneous expectations.

10. All assets are marketable, including human capital.

THE CAPITAL MARKET LINE (CML)

LO 9.3: Interpret the capital market line.

In the presence of riskless lending and borrowing, the efficient frontier transforms from

a curve to a line tangent to the previous curve. Investors will choose to invest in some

combination of their tangency portfolio and the risk-free asset. Assuming investors have

identical expectations regarding expected returns, standard deviations, and correlations of

all assets, there will be only one tangency line, which is referred to as the capital market line

(CML).

Under the assumptions of the CML, all investors agree on the exact composition of the

optimal risky portfolio. This universally agreed upon optimal risky portfolio is called the

market portfolio, M, and it is defined as the portfolio of all marketable assets weighted in

proportion to their relative market values. For instance, if the market value of Asset X is

$ 1 billion, and the market value of all traded assets is $ 1 00 billion, then the weight

allocated to Asset X in the market portfolio equals 1 o/o.

The key conclusion of the CML can be summarized as follows: All investors will make

optimal investment decisions by allocating between the risk-free asset and the market portfolio.

Figure 1 provides a graph of the CML.

Figure 1 : The Capital Market Line

E(Rr)

E(RM)

CML

c 􀀫 􀂘Market Portfolio, M

I '--��--'-��􀀊 cr r CTM

Topic 9

Cross Reference to GARP Assigned Reading - Elton, et al., Chapter 13

Page 1 1 2

The equation for the CML is:

The slope of the CML is often called the market price of risk and equals the

reward-to-risk ratio (or Sharpe ratio) for the market portfolio. This is calculated as:

E(RM ) - Rp

Professor's Note: we will examine the calculation of risk-adjusted return measures,

such as the Sharpe ratio, in Topic 10.

The CML is useful for computing the expected return for an efficient (diversified)

portfolio; however, it cannot compute the expected return for inefficient portfolios or

individual securities. The CAPM must be used to compute the expected return for any

inefficient portfolio or individual security.

BETA

LO 9.5: Interpret beta and calculate the beta of a single asset or portfolio.

The sensitivity of an asset's return to the market return is referred to as the asset's beta. Beta

is a standardized measure of the covariance of the asset's return with the market return. Beta

can be calculated as follows:

􀁠- = covariance of Asset i's return with the market return = Covi,M

1 variance of the market return cr􀂛

We can use the definition of the correlation between the returns on Asset i with the returns

on the market to get the covariance equation:

Cov - i' M Pi,M -

cricrM

Cov· M = 1, p1· ,M cr1· crM

Therefore, by substituting for Cov. M in the equation for 􀁠-, we can also calculate beta as: 1, 1

Topic 9

Cross Reference to GARP Assigned Reading - Elton, et al., Chapter 13

Example: Calculating an asset's beta

The standard deviation of the market return is estimated as 200/o.

1 . If Asset Xs standard deviation is 300/o and its correlation of returns with the market

index is 0.8, what is Asset !\s beta?

U · th c ul r.l cri h r.l

0.30 smg e rorm a: 1--'i = Pi,M , we ave: 1--'i = 0.80 = 1.2.

crM 0.20

2. If the covariance of Asset !\s returns with the returns on the market index is 0.048,

what is the beta of Asset A?

. Covi M 0.048 Usmg the formula: 􀁠i = 2

' , we have: 􀁠i = 2 = 1 .2.

crM 0.2

In practice, we estimate asset betas by regressing returns on the asset on those of the market

index. While regression is a concept discussed in Book 2, for the purposes of this topic,

you can think of it as a mathematical estimation procedure that fits a line to a data plot. In

Figure 2, we represent the excess returns on Asset i as the dependent variable and the excess

returns on the market index as the independent variable. The least squares regression line is

the line that minimizes the sum of the squared distances of the points plotted from the line

(this is what is meant by the line of best fit). The slope of this line is our estimate of beta.

In Figure 2, since the line is steeper than 45 degrees, the slope is greater than one, and the

asset's estimated beta is greater than one. Our interpretation is that the returns on Asset i are

more variable in response to systematic risk factors than the overall market, which has a beta

of one.

Figure 2: Regression of Asset Excess Returns against Market Asset Returns

Asset

Excess

Return

(}\-􀂖)

a. 1

• •

•

• Security

Characteristic

Line

Cov. ./---J 􀅖· M = Slope =

•

1 crM 2 •

Market Excess Return (􀂗-􀂖)

This regression line is referred to as the asset's security characteristic line. Mathematically,

the slope of the security characteristic line is: Covi,M I er􀂛, which is the same formula used

to calculate beta.

Topic 9

Cross Reference to GARP Assigned Reading - Elton, et al., Chapter 13

Page 1 14

Portfolio Beta

In addition to individual assets, beta can also be computed for portfolios. The beta of a

portfolio is the sum of the weighted individual asset betas within a portfolio.

Example: Calculating portfolio beta

Consider the following individual asset weights and betas for a 4-asset portfolio.

Asset Portfolio Weight Beta

1 25% 1.2

2 15% 1.8

3 35% 0.9

4 25% 1 .4

Calculate the beta of this 4-asset portfolio.

Answer:

􀁠P = W1􀂟1 + w2􀁠2 + w3􀂟3 + w4􀂟4

􀁠p = (0.25 x 1 .2) + (0.15x 1.8) + (0.35 x 0.9) + (0.25 x 1 .4)

􀁠p = 0.3 + 0.27 + 0.315 + 0.35 = 1.235

DERIVING THE CAPM

LO 9 . 1 : Understand the derivation and components of the CAPM.

A Straightforward Derivation

The procedure used to derive the equation for the capital asset pricing model requires an

understanding of the characteristics of expected return, beta, the risk-free rate, and the

security market line. The following steps illustrate how the CAPM is derived. The end result

will be an equation where the expected return on a single security or portfolio of securities is

equal to:

Rp + Betai[E(RM) - Rp ]

The first step in the derivation is to recognize that beta identifies the appropriate level of

risk for which an investor should be compensated. An important concept in finance is that,

as a portfolio becomes more diversified, idiosyncratic risk (i.e., unsystematic risk or assetspecific

risk) in the portfolio becomes less of an issue as only systematic risk remains.

Topic 9

Cross Reference to GARP Assigned Reading - Elton, et al., Chapter 13

Professor's Note: Starting with the formula for portfolio variance, and assuming

n equally-weighted assets (e.g., each w = Jin), it is possible to show that the

portfolio variance for an equally-weighted portfolio is:

2 1 2 n - I -

ap = -ai + Cov

n n

where:

af = average variance of all assets in the portfolio

Cov = average covariance of all pairings of assets in the portfolio

Note that the equally-weighted portfolio variance equals the sum of two components

(unsystematic risk: the variance term and systematic risk: the covariance term), each

of which is affected by the size of the portfolio:

• (I I n) x af gets closer to zero as n gets larger because 1 In approaches zero.

• ( n -1) I n) x Cov gets closer to the average covariance as n gets larger because

n - 1) I n approaches 1.

Therefore, the following important result emerges: The variance of an equallyweighted

portfolio approaches the average covariance as n gets large.

Since diversification is costless and systematic risk is the only remaining risk in a

diversified portfolio, an investor should only be compensated for systematic risk (or beta)

exposure. Therefore, all assets with the same beta should earn the same return.

The next step in the derivation is to recognize that expected return is a linear function

of beta. Since portfolio beta is the weighted average of the individual betas and expected

portfolio return is a weighted average of the individual expected returns, the portfolio

expected return is a linear function of beta.

E (R p ) = a + m x 􀁠P

where:

- CovpM '

cr􀂛

Covp,M = covariance between the returns for Stock P and the market portfolio

cr􀂛 = variance of the returns on the market portfolio

Topic 9

Cross Reference to GARP Assigned Reading - Elton, et al., Chapter 13

Page 1 1 6

Professor's Note: To show that portfolio return is a linear function of beta, start with

the functions for expected portfolio return and portfolio beta.

E ( R p ) = W1 E ( R1 ) + ( 1 - W1 ) E ( R2 )

{3 P = Wl !31 + ( J - Wl ) !32

Solve w 1 in the portfolio beta equation:

Substitute w 1 into the portfolio expected return equation:

E ( R p ) = a + m/3 p

where:

f3 2 [ E ( R1 ) - E ( R2 ) ]

a = E(R2 ) ------- f31 - !32 [ E ( R1 ) - E ( R2 ) ]

m =------ /31 - !32

Assets with equivalent betas should earn the same return because arbitrage will prevent

assets with the same risk from earning different returns. So, if 􀂙i = 􀂙P and E(Ri) = E(Rp),

then we can express the expected return for asset i as a linear function of its beta:

As shown in Figure 3, this equation plots a straight line, known as the security market line

(SML) with an intercept of a and slope of m. Thus, the SML is a graphical representation of

the CAPM.

Figure 3: The Security Market Line

E(R)

SML

Market Portfolio

Topic 9

Cross Reference to GARP Assigned Reading - Elton, et al., Chapter 13

The final step in this derivation is to find two points on the SML and solve for the CAPM.

To solve for the equation of a line (which is known as identifying the line), we need to

know two points on the line. Fortunately, we do know two of the points on this line: the

risk-free asset and the market portfolio. Since it has no risk, the risk-free asset has a beta of

zero; therefore, the intercept of the SML is RF, and our first point is (0, Rp). The market

portfolio has a beta of one, so the second point is [l, E(RM)]. With these two points, we can

find the slope of the line, m:

E(􀅸) = a + m x 􀂚i

Professor's Note: It is relatively straightforward to see that the beta of the market is

one. The covariance of the market with itself is equal to the variance of the market.

Therefore, solving for market beta, we get:

f3M = CovM,M = a-1' = 1

a-1- a-1-

With information on both the intercept (a) and the slope (m), we are now able to display

the well-known capital asset pricing model:

CALCULATING EXPECTED RETURN USING THE CAPM

LO 9.4: Apply the CAPM in calculating the expected return on an asset.

Example: Expected return on a stock

Assume you are assigned the task of evaluating the stock of Sky-Air, Inc. To evaluate the

stock, you calculate its required return using the CAPM. The following information is

available:

expected market risk premium 50/o

risk-free rate 40/o

Sky-Air beta 1 .5

Using CAPM, calculate and interpret the expected return for Sky-Air.

Topic 9

Cross Reference to GARP Assigned Reading - Elton, et al., Chapter 13

Page 1 1 8

Answer:

The expected return for Sky-Air is:

E(R5A) = 0.04 + 1 .5(0.05) = 0. 1 1 5 = 1 1 .50/o

The market risk premium is the expected market return minus the risk-free rate. The

CAPM return can be viewed as the minimum return that investors should be willing to

accept (i.e., the required rate of return), commensurate with the risk associated with the

asset. For example, if investors predict that the return will exceed 1 1 .50/o, then they should

buy Sky-Air stock. However, if investors predict that the return will be less than 1 1 .5%,

then they should sell Sky-Air stock (or short the stock).

Figure 4 illustrates the required return for Sky-Air on the SML.

Figure 4: Sky-Air Plotted on the Security Market Line

E(R)

E(RsA) = 0 . 1 1 5 - - - - - - - - - - - - - - - - - - - -

E(RM) = 0.09

RF= 0.04 I

SML

In the previous example, we calculated the required rate of return, which always lies on

the security market line. If through the valuation of an asset an analyst determines that

the expected return is different from the required rate of return implied by CAPM, then

the security may be mispriced according to rational expectations. A mispriced security

would not lie on the security market line. In general:

• An overvalued security would have a required rate of return (computed by CAPM) that

is higher than its expected return (computed by the analyst's valuation). An overvalued

security would lie below the security market line.

• An undervalued security would have a required rate of return (computed by CAPM) that

is lower than its expected return (computed by the analyst's valuation). An undervalued

security would lie above the security market line.

In addition to computing the required or expected return for an individual asset, it is

possible to solve for the expected return on the market and/or the market risk premium

given the risk-free rate, expected return on an asset, and the systematic risk for that asset.

Topic 9

Cross Reference to GARP Assigned Reading - Elton, et al., Chapter 13

Example: Using CAPM to calculate the expected market return

A stock has a beta of 0.75 and an expected return of 130/o. The risk-free rate is 40/o.

Calculate the market risk premium and the expected return on the market portfolio.

Answer:

According to CAPM: 0.13 = 0.04 + 0.75[E(RM) - Rp].

Therefore, the market risk premium is equal to: [E(RM) - Rp] = 0. 12 = 120/o.

The expected return on the market is calculated as: [E(RM) - 0.04] = 0.12, or E(RM) =

0.16 = 16°A>.

Topic 9

Cross Reference to GARP Assigned Reading - Elton, et al., Chapter 13

Page 120

LO 9.1

There are three major steps in deriving the CAPM:

I . Recognize that since investors are only compensated for bearing systematic risk, beta is

the appropriate measure of risk.

2. By knowing that portfolio expected return is a weighted average of individual expected

returns and portfolio beta is a weighted average of the individual betas, we can show

that portfolio return is a linear function of portfolio beta. Since arbitrage prevents

mispricing of assets relative to systematic risk (beta), an individual asset's expected

return is a linear function of its beta.

3. Use the risk-free asset and the market portfolio, which are two points on the security

market line, to solve for the intercept and slope of the CAPM. The equation for CAPM

• 1s:

LO 9.2

The capital asset pricing model ( CAPM), derived by Sharpe, Lintner, and Mossin, expresses

the expected return for an asset as a function of the asset's level of systematic risk (measured

by beta), the risk-free rate, and the market risk premium (the expected return of the market

minus the risk-free rate). There are several assumptions underlying the CAPM.

• Investors face no transaction costs.

• Assets are infinitely divisible.

• There are no taxes.

• Investors are price takers whose individual buy and sell decisions have no effect on asset

• prices.

• Investors' utility functions are based solely on expected portfolio return and risk.

• Unlimited short-selling is allowed.

• Investors are only concerned about returns and risk over a single period, and the single

period is the same for all investors.

• All investors have the same forecasts of expected returns, variances, and covariances.

• All assets are marketable.

LO 9.3

The capital market line ( CML) expresses the expected return of a portfolio as a linear

function of its standard deviation, the market portfolio's return and standard deviation, and

the risk-free rate.

Topic 9

Cross Reference to GARP Assigned Reading - Elton, et al., Chapter 13

LO 9.4

The expected return for an asset can be computed using the CAPM given the risk-free rate,

the market risk premium, and an asset's systematic risk.

LO 9.5

Beta can be calculated using the following equation:

Covi M A. = ' t-'1 crM2

Portfolio beta is the weighted average of the asset betas in a portfolio.

Topic 9

Cross Reference to GARP Assigned Reading - Elton, et al., Chapter 13

Page 122

1 . Which of the following statements is most likely an assumption of the capital asset

pricing model (CAPM)?

A. Investors only face capital gains taxes.

B. Investors' actions affect the prices of assets.

C. Transaction costs are constant across all assets.

D. All assets including human capital are marketable.

Use the following graph to answer Question 2.

Mean-Variance Analysis

30°/o

20°/o

1 5°/o

T-Bills

10°/o I

5°/o

Oo/o 5% 10% 1 5% 20% O"p 25°/o

2. Portfolio P in the mean variance analysis represents the tangency point between the

capital market line and the portfolio possibilities curve. In this analysis, the market

price of risk would be the:

A. standard deviation of Portfolio P.

B. expected return on the minimum-variance portfolio.

C. slope of the line connecting T-bills and Portfolio P.

D. point at which the straight line intersects the expected return axis.

3. At a recent analyst meeting at Invest Forum, analysts Michelle White and Ted Jones

discussed the use of the capital market line (CML). White states that the CML

assumes that investors hold two portfolios: 1) a risky portfolio of all assets weighted

according to their relative market value capitalizations; and 2) the risk-free asset.

Jones states that the CML is useful in determining the required rate of return for

individual securities.

Are the statements of White and Jones correct?

A. Only Jones's statement is correct.

B. Only White's statement is correct.

C. Both statements are correct.

D. Neither statement is correct.

Topic 9

Cross Reference to GARP Assigned Reading - Elton, et al., Chapter 13

4. Patricia Franklin makes buy and sell stock recommendations using the capital asset

pricing model. Franklin has derived the following information for the broad market

and for the stock of the CostSave Company (CS):

• Expected market risk premium 8o/o

• Risk-free rate 5o/o

• Historical beta for CostSave 1 .50

Franklin believes that historical betas do not provide good forecasts of future beta,

and therefore uses the following formula to forecast beta:

forecasted beta = 0.80 + 0.20 x historical beta

After conducting a thorough examination of market trends and the CS financial

statements, Franklin predicts that the CS return will equal 1 Oo/o. Franklin should

derive the following required return for CS along with the following valuation

decision (undervalued or overvalued):

Valuation CAPM required return

A. overvalued 8.30/o

B. overvalued 13.80/o

C. undervalued 8.30/o

D. undervalued 13.80/o

5. Albert Dreiden wants to estimate the expected return on the market. He believes

that the stock of the Hobart Materials Company is fairly valued, and gathers the

following information:

• Expected return for Hobart

• Risk-free rate

• Beta for Hobart

7.50°/o

4.50°/o

0.80

Based on this information, the estimated expected return for the market portfolio is

closest to:

A. 3.00o/o.

B. 3.750/o.

C. 6.900/o.

D. 8.250/o.

Topic 9

Cross Reference to GARP Assigned Reading - Elton, et al., Chapter 13

Page 124

1 . D The capital asset pricing model (CAPM) assumes that all assets including human capital are

marketable. Additionally, CAPM assumes no taxes, no transaction costs, and that investor

actions do not affect market prices.

2. C The CML is the line connecting T-bills and Portfolio P. The market price of risk is the

slope of the CML. Had risk been measured on the graph with beta, the graph would

represent the SML. The market price of risk would still be the slope of the line.

3. B The CML assumes all investors have identical expectations and all use mean-variance

analysis, implying that they all identify the same risky tangency portfolio (the "market

portfolio") and combine that risky portfolio with the risk-free asset when creating their

portfolios. Because all investors hold the same risky portfolio, the weight on each asset

must be equal to the proportion of its market value to the market value of the entire

portfolio. Therefore, White is correct. The CML is useful for determining the rate of

return for efficient portfolios, but it cannot be used to determine the required rate of

return for inefficient portfolios or individual securities. The capital asset pricing model

(CAPM) is used to determine the required rate of return for inefficient portfolios and

individual securities. Therefore, Jones is incorrect.

4. B The CAPM equation is:

Franklin forecasts the beta for CostSave as follows:

beta forecast = 0.80 + 0.20 (historical beta)

beta forecast = 0.80 + 0.20(1.50) = 1. 1 0

The CAPM required return for CostSave is:

0.05 + 1 .1 (0.08) = 13.8%

Note that the market premium, E(RM) - RF , is provided in the question (8o/o).

Franklin should decide that the stock is overvalued because she forecasts that the CostSave

return will equal only 10%, whereas the required return (minimum acceptable return) is

13.8%.

5. D The CAPM equation is:

Using the given information, we can solve for the expected return for the market portfolio as

follows:

7.50% = 4.50% + 0.80[E(RM) - 4.50%]

E(RM) = (7.50% - 4.50%) I 0.80 + 4.50% = 8.25%

Based on the information given and using the CAPM, the expected return on the market is

8.25%.

The following is a review of the Foundations of Risk Management principles designed to address the learning

objectives set forth by GARP®. This topic is also covered in:

APPLYING THE CAPM TO PERFORMANCE

MEASUREMENT: SINGLE-INDEX

PERFORMANCE MEASUREMENT

INDICATORS

Topic 10

EXAM Focus

This topic further expands on the concepts of the capital market line and the security market

line by examining measures used to assess portfolio performance on a risk-adjusted basis.

In the previous topic, we mentioned that the risk-to-reward ratio for the capital market

line (i.e., its slope) is known as the Sharpe ratio. In addition, we discussed how to assess a

portfolio's alpha return when comparing actual performance to expected performance based

on the CAPM. The formal expression for this calculation is known as Jensen's alpha. The

Treynor measure is another popular performance metric, and is similar to the Sharpe ratio

but uses beta as the risk measure instead of standard deviation. Toward the end of this topic,

we examine additional risk-return assessment measures such as the information ratio and the

Sortino ratio. In general, all of the performance measures introduced evaluate excess return

over some form of risk. For the exam, memorize these measures of performance since they

are popular concepts to test.

MEASURES OF PERFORMANCE

LO 10.1: Calculate, compare, and evaluate the Treynor measure, the Sharpe

measure, and Jensen's alpha.

Modern portfolio theory and the CAPM are built upon the link between risk and return.

Three measures exist to assess an asset's or portfolio's return with respect to its risk.

• The Treynor measure is equal to the risk premium divided by beta, or systematic risk:

Treynor measure of a portfolio = E(Rp ) - Rp

􀁿p

• The Sharpe measure is equal to the risk premium divided by the standard deviation, or

total risk:

Sharpe measure of a portfolio = E(Rp ) - Rp

crp

Topic 1 0

Cross Reference to GARP Assigned Reading -Amenc and Le Sourd, Chapter 4 (Section 4.2)

Page 126

• The Jensen measure (or Jensen's alpha or just alpha), is the asset's excess return over the

return predicted by the CAPM:

Jensen measure of a portfolio = ap = E(Rp) - [Rp + [E(RM) - RpJPpJ

In all three cases, for a given portfolio, the higher, the better. The two that are most similar

are the Treynor and Sharpe measures. They both normalize the risk premium by dividing

by a measure of risk. Investors can apply the Sharpe measure to all portfolios because it uses

total risk, and it is more widely used than the other two measures. The Treynor measure

is more appropriate for comparing well-diversified portfolios. Jensen's alpha is the most

appropriate for comparing portfolios that have the same beta.

Some consider the Sharpe measure a better method for measuring historical performance.

Since betas must be estimated and the portfolio beta is the weighted average of the betas of

assets in a portfolio, the Treynor measure is considered a more forward-looking measure.

In addition to these comparisons, it is useful to realize that some relationships exist between

the measures. For instance:

Treynor measure = O'.p + [E(RM) - Rp]

􀂚p

For a well-diversified portfolio we can use the following approximation: 􀂘P 􀂀 crp

. crM

Substituting this into the expression for Jensen's alpha and applying some algebra gives us:

ap E(RM) - Rp Sharpe measure 􀂀 + ----- crp crM

Applying the approximation 􀂚P 􀂀 crp again gives us: crM

Sharpe measure 􀂀 Treynor measure

Professor's Note: Do not focus too much attention on these approximations. The key

to this LO is understanding how to calculate the three measures of performance as is

shown in the following example.

Topic 10

Cross Reference to GARP Assigned Reading -Amenc and Le Sourd, Chapter 4 (Section 4.2)

Example: Calculating performance measures

For a portfolio of ten stocks, we may find, via fundamental analysis estimates of the

individual stocks, that the portfolio's expected return is 14o/o with a standard deviation of

25o/o. The beta of the portfolio is 1 . 1 . The expected return of the market is 12.5o/o with

a standard deviation of 20.2o/o. The risk-free rate is 2.6o/o. Calculate the Treynor, Sharpe,

and Jensen measures.

Answer:

Treynor measure =

Sharpe measure -

" E(Rp ) - Rp

(3p

E(Rp ) - Rp

O'p

Jensen measure = ap = E(Rp)

0. 14- 0.026 6 = = 0.103

1.1

- 0.14 - 0.026

= 0.456

0.25

[RF + [ E(R M) - RF] 􀁿P)

= 0.14 - (0.026 + (0.125 - 0.026)(1.1)) = 0.0051

We can compare these to the corresponding measures of the market portfolio:

Treynor measure of the market =

Sharpe measure of the market -

0.125- 0.026

0.202

= 0.099

= 0.4901

Jensen measure of a portfolio = 0.125 - [0.026 + (0.125 - 0.026)(1)] = 0.0

Based upon the Treynor measure and the Jensen measure of the preceding example, the

portfolio of ten stocks is superior to the market. However, the relationship is reversed using

the Sharpe measure. This implies that the manager has selected ten stocks that offer superior

returns relative to their systematic risk; however, a 10-stock portfolio is much less diversified

than the market. The standard deviation for the 1 0-stock portfolio (crp = 25°/o), when

compared to aM = 20.2°/o, reflects the lower level of diversification.

Extensions to Jensen's Alpha

There are several ways to modify or extend the Jensen measure. Since Jensen's measure is

simply a raw return in excess of some reference (i.e., that implied by the CAPM in the case

of the standard Jensen's measure) we can simply replace that reference with a value that we

feel is more appropriate. One reference would be the required return based on the CML.

The manager has created a portfolio with risk O"p , which then has a reference return equal

to E(􀃥eference) as given by the equation:

Topic 1 0

Cross Reference to GARP Assigned Reading -Amenc and Le Sourd, Chapter 4 (Section 4.2)

Page 128

The alpha in this case would be the portfolio's return minus the reference return:

alpha = E(Rp) - E(Rrefe rence)

Other extensions of Jensen's measure would use a measure of E(Rreferenc􀂕 derived from a

multifactor model (i.e., more than one independent variable). Another value of E(Rreferenc􀂕

could be derived from a variation of the CAPM called the Black model, which uses the

return on a "zero-beta" portfolio in place of the risk-free rate. In all cases, the idea is the

same: measure the raw return difference of the managed portfolio against the required

return given its level of risk.

LO 10.2: Compute and interpret tracking error, the information ratio, and the

Sortino ratio.

If a manager is trying to earn a return higher than the market portfolio or any other

reference or benchmark, the difference will have some variability over time. In other words,

even if the manager is successful in generating a positive alpha, the alpha will vary over

time. Tracking error is the term used to describe the standard deviation of the difference

between the portfolio return and the benchmark return. This source of variability is another

source of risk to use in assessing the manager's success. Typically, the manager must keep

the tracking error below a stated threshold. The manager must weigh transactions and other

costs in managing the portfolio to reduce tracking error against the extra risk it introduces

into the management process.

The information ratio is essentially the alpha of the managed portfolio relative to its

benchmark divided by the tracking error. If we let RB denote the return of the benchmark

• we can write:

tracking error = cr ep

information ratio = E(Rp) - E(RB) - ap

crep crep

This is a measure used to assess if the manager's deviation from the benchmark has reaped

an appropriate return. It is called an "information ratio" because it is essentially a measure of

how well the manager has acquired and used information compared to the average manager.

Example: Calculating the information ratio

A manager typically generates an alpha of 1 .50/o with a tracking error of 2.250/o. Calculate

the information ratio.

Answer:

information ratio = 1.5

2.25

= 0.667

Topic 10

Cross Reference to GARP Assigned Reading -Amenc and Le Sourd, Chapter 4 (Section 4.2)

The Sortino ratio is similar to the Sharpe ratio except for two changes. We replace the

risk-free rate with a minimum acceptable return, denoted Rmin' and we replace the standard

deviation with a type of semi-standard deviation. A semi-standard deviation measures

the variability of only those returns that fall below the minimum acceptable return. The

measure of risk in the Sortino ratio is the square root of the mean squared deviation from

Rmin of those observations in time periods t where RPt < Rmin' else zero. Letting Rmin denote

the minimal acceptable return and MSD min the risk measure:

Sortino ratio = E(Rp) - Rmin

􀂖MSDmin

where:

L: (Rpt - Rmin)2

MSD . = RP__r<_Rmin_ ____ rrun

The Sortino ratio can be interpreted as a variation of the Sharpe ratio that is more

appropriate for a case where returns are not symmetric.

Example: Calculating the information ratio and the Sortino ratio

Over a 1 0-year period, a manager uses a covered call strategy to enhance the return of

the index fund she manages. The record of the fund's returns is (0.095, 0.08, -0.022,

0.1 1 , 0.09, -0.05, -0.035, 0.124, 0.072, 0.055). The corresponding benchmark returns

record is (0.087, 0.078, -0.034, 0. 124, 0.10, -0.064, -0.042, 0.131, 0.062, 0.059). The

minimum acceptable return is 4o/o. Calculate the information ratio and the Sortino ratio.

Assume tracking error = 0.00992 and mean squared deviation (min) = 0.0017569.

Answer:

If we were to compute the tracking error, the first step would be to compute the

differences between the portfolio and the benchmark. Those differences are: (0.008,

0.002, 0.012, -0.014, -0.01, 0.014, 0.007, -0.007, 0.01, -0.004). The tracking error is

the standard deviation of these numbers.

Professor's Note: In Book 2, we will examine the formula for standard deviation

that is used for the tracking error calculation. It is based on the sum of the

squared differences between each data point and the mean. This sum is divided

by the number of observations adjusted for degrees of freedom (in this case

n - 1). The square root of the computed value will be the standard deviation.

To compute the information ratio, divide the mean of the differences by the tracking

error.

information ratio = 0.0018 I 0.00992 = 0.1815

Topic 1 0

Cross Reference to GARP Assigned Reading -Amenc and Le Sourd, Chapter 4 (Section 4.2)

Page 130

The Sortino ratio is the mean of the ten portfolio returns minus 40/o, which is

0.0519 - 0.04 = 0.01 19, divided by the square root of MSDmin·

MSDmin = 0.0017569

Sortino ratio = 0.0119 I 0.0419 = 0.2840

Topic 10

Cross Reference to GARP Assigned Reading -Amenc and Le Sourd, Chapter 4 (Section 4.2)

LO 10.1

Three commonly used risk/ return measures are:

• Treynor measure of a portfolio = E(R P ) - RF

􀂘p

• E(Rp ) - Rp

Sharpe measure of a portfolio = crp

• Jensen measure of a portfolio = ap = E(Rp) - [Rp + [E(RM) - Rp]􀂗p]

The three risk measures above give different perspectives and may give different rankings for

portfolios. A portfolio with low diversification may have a higher Treynor measure, a higher

alpha, but a lower Sharpe measure than another portfolio.

Alpha can be modified by the use of other reference portfolios.

LO 10.2

Tracking error and the information ratio build upon Jensen's alpha. Tracking error is the

standard deviation of alpha over time. The information ratio is the average alpha over time

divided by the tracking error.

The Sortino ratio should be used when there is more focus on the likelihood of loss:

Sortino ratio = E(Rp) - Rmin

􀂖MSDmin

The MSDmin is a semi-variance that only measures the variability of the portfolio's return

observations below Rmin'

Topic 1 0

Cross Reference to GARP Assigned Reading -Amenc and Le Sourd, Chapter 4 (Section 4.2)

Page 132

1. For a given portfolio, having a Treynor measure greater than the market but a Sharpe

measure that is less than the market would most likely indicate that the portfolio is:

A. not well diversified.

B. generating a negative alpha.

C. borrowing at the risk-free rate.

D. not borrowing at the risk-free rate.

2. With respect to performance measures, the use of the standard deviation of portfolio

returns is a distinguishing feature of the:

A. beta measure.

B. Jensen measure.

C. Sharpe measure.

D. Treynor measure.

3. For a given portfolio, the expected return is 9o/o with a standard deviation of 160/o.

The beta of the portfolio is 0.8. The expected return of the market is 120/o with a

standard deviation of 200/o. The risk-free rate is 3o/o. The portfolio's alpha is:

A. -1.20/o.

B. -0.60/o.

C. +0.6o/o.

D. +1.2o/o.

4. You are given the following information:

Risk-free rate

Minimum acceptable return

Benchmark return

Expected return on portfolio

Expected return on market

Beta

Standard deviation (portfolio)

Semi-standard deviation (portfolio)

4o/o

6o/o

100/o

120/o

9o/o

1.25

7.30/o

8.2°/o

The Sortino ratio of the portfolio is closest to:

A. 0.24.

B. 0.73.

C. 0.82.

D. 0.98.

Topic 10

Cross Reference to GARP Assigned Reading -Amenc and Le Sourd, Chapter 4 (Section 4.2)

5. An analyst has compiled the following data on Stock P:

CovarianceP., mar ke t

O"StockP

a market

Expected market return

Risk-free rate

Stock P actual return

0.03 1 5

16.500/o

15.00o/o

1 1 .800/o

4.500/o

13.250/o

Calculate and interpret Jensen's Alpha for Stock P.

A. + 1.470/o overperformed.

B. -1.470/o underperformed.

C. + 1.450/o overperformed.

D. -1 .450/o underperformed.

Topic 1 0

Cross Reference to GARP Assigned Reading - Amenc and Le Sourd, Chapter 4 (Section 4.2)

Page 134

1 . A Low diversification can produce this result because it will likely increase the standard

deviation of the portfolio's returns, thus decreasing its Sharpe ratio. Using margin is not

directly related to the risk-adjusted performance because adjusting for risk removes the effect

of leverage. A Treynor ratio greater than the market Treynor ratio would result in a positive

alpha (not a negative alpha).

2. C The Sharpe measure is the portfolio return minus the risk-free rate divided by the standard

deviation of the return. The Treynor and Jensen measures use beta. The answer "beta

measure" is a nonsensical choice for this question.

3. A The alpha is 9% - [3o/o + 0.8 x (12% - 3%)] = -1.2%.

4. B (portfolio return - minimum acceptable return) I semi-standard deviation

(0.12 - 0.06) I 0.082 = 0.7317

Choice A is incorrect because it uses the benchmark return in the numerator instead of the

minimum acceptable return.

Choice C is incorrect because it uses the standard deviation in the denominator instead of

the semi-standard deviation.

Choice D is incorrect because it uses the risk-free rate in the numerator instead of the

minimum acceptable return.

5. B Jensen's Alpha = actual return - CAPM expected return

CAPM: E(R) = Rp + f3 (RM - Rp)

􀂽 =

• covar1ancep, marker

• variance marker

Step 1: Calculate f3

f3 = 0.0315 I 0.152 f3 = 1.4

Step 2: Calculate the CAPM expected return

E(R) = 4.5 + 1.4(1 1.80 - 4.5) = 14.72%

Step 3: Calculate Jensen's Alpha

Jensen's Alpha = actual return - CAPM E(R) = 13.25% - 14.72% = -1 .47%

Stock P has underperformed the market by 1 .47% when taking into account its level of

systematic risk as measured by beta.

The following is a review of the Foundations of Risk Management principles designed to address the learning

objectives set forth by GARP®. This topic is also covered in:

ARBITRAGE PRICING THEORY AND

M ULTIFACTOR MODELS OF RISK AND

RETURN

EXAM Focus

Topic 1 1

The relationship between risk and return is one of the most important concepts in finance.

The capital asset pricing model ( CAPM) asserts that the expected return on any asset is

solely determined by its exposure to the market portfolio. The risk exposure in the CAPM is

known as beta. In contrast, the arbitrage pricing theory (APT) asserts that expected returns

are determined by exposures to economy-wide risk factors. The risk exposures in the APT are

known as factor betas. For the exam, be able to calculate expected returns using single-factor

and multifactor models. In addition, know how to construct the security market line (SML)

for a well-diversified portfolio using a single-factor model. Also, be able to explain the APT,

and know how to construct a portfolio to hedge exposure to multiple risk factors.

THE MuLTIFACTOR MODEL OF RisK AND RETURN

LO 1 1 . 1 : Describe the inputs, including factor betas, to a multi factor model.

The inputs to a multifactor model, for any stock, are as follows:

• Expected return for the stock.

• Factor betas, also known as factor sensitivities or factor loadings.

• Deviation of macroeconomic factors from their expected values.

• Firm-specific return.

The equation for a multifactor model for stock i can be expressed as follows:

where:

􀂓 = return on stock i

E(Ri) = expected return for stock i

􀂚i" = ;tli factor beta for stock i

F/ = deviation of macroeconomic factor j from its expected value

ei = firm-specific return for stock i

Regarding macroeconomic factors, assume that one of the macro factors is gross domestic

product (GDP). In this case, FGDP will represent the deviation of GDP from its expected

value. If we assume that the consensus forecast for GDP equals 3o/o, and GDP for the

period ended up being 4o/o, FGDP would equal 0.01 (0.04 - 0.03 = 0.01).

Topic 1 1

Cross Reference to GARP Assigned Reading- Bodie, Kane, and Marcus, Chapter 10

Page 136

The factor beta, 􀂚ij' equals the sensitivity of the stock return to a I -unit change in the

factor. For example, for stock i, assume 􀂚i,GDP = 2. Therefore, for every one percentage

point change in GDP, this stock's return changes, on average, by two percentage points.

The firm-specific return, ei, is the portion of the stock's return that is unexplained by macro

factors (i.e., the F terms in the equation). The firm-specific return will be a nonzero value

whenever unexpected firm-specific events take place (e.g., a strike that impacts a single

firm). However, the expected value of the firm-specific return equals zero, because, by

definition, firm-specific events are random.

Professor's Note: For the moment, we will assume that the expected return,

E(Ri), is known. Later, we will use the arbitrage pricing theory to derive the

expected return. In that case, the factor betas will be estimated as the slope

coefficients in a multiple linear regression.

LO 1 1 .2: Calculate the expected return of an asset using a single-factor and a

multi-factor model.

The factor model just described can be used to revise the estimate of a stock's expected rate

of return. The number of factors to include in a factor model should be as small as possible,

yet still capture the priced sources of nondiversifiable (or systematic) risk. The simplest

version of the model consists of just one macro factor: the single-factor model. We will

consider examples of a single-factor model first, and, then, will consider a 2-factor model.

For the first example, assume the common stock of HealthCare Inc. (HCI) is examined

with a single-factor model, using unexpected percent changes in GDP as the single factor.

Assume the following data is provided:

Expected return for HCI = IOo/o

GDP factor beta = 2.00

Expected GDP growth = 3o/o

Given this data, we can see that the stock return for HCI is strongly impacted by GDP. On

average, the stock price changes by two percentage points for every one percentage point

change in GDP.

Suppose new macroeconomic information indicates that GDP growth will equal 4o/o

rather than the original consensus forecast of 3o/o. Also assume there's no new information

regarding firm-specific events. The revised expected return for HCI using a single-factor

model can be calculated as follows:

RHCI = 0. 1 0 + 2(0.01) = 0.12 = 1 2o/o

Therefore, based on the single-factor model, the analyst should revise the expected return

for HCI from IOo/o to 12o/o, because GDP was revised above its original expected value. The

Topic 1 1

Cross Reference to GARP Assigned Reading - Bodie, Kane, and Marcus, Chapter 10

additional two percentage points resulted from the one percentage point deviation of GDP

from its expected value, combined with the GDP factor beta of 2: 2 x 0.01 = 0.02 = 2o/o.

For the second example, assume the common stock of HealthCare Inc. (HCI) is examined

using a multifactor model, based on two factors: unexpected percent changes in GDP and

unexpected percent changes in consumer sentiment. Assume the following data is provided:

Expected return for HCI

GDP factor beta

Consumer sentiment (CS) factor beta

Expected growth in GDP

Expected growth in consumer sentiment

= 100/o

= 2.00

= 1.50

= 3o/o

= 1 o/o

Suppose new macroeconomic information indicates that GDP will grow 4o/o rather than

3o/o, and that consumer sentiment will grow 3o/o rather than 1 o/o. A 2-factor model to

calculate the return for HCI can be expressed as follows

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