Questions 13 to 18 relate to Risk Management
Laura Hackett Case Scenario
Laura Hackett is a risk management consultant who helps investment companies build and enhance
their risk management process. Jardins Advisors, a financial services firm with equity, fixed income, and
commodity trading desks, recently hired her to evaluate and recommend improvements to their
processes. Jardins’ senior management outlines their current risk management process to Hackett as
follows: “First, we establish policies and procedures for risk management. Next, we identify the types of
risk we face. We then measure our exposures to those risks. Finally, we determine our risk tolerance and
adjust levels of risk as appropriate.” They ask her, “Is this process appropriate?”
Alpha Asset Management Inc., another of Hackett’s clients, hired her to identify and separate its market
risk exposures into categories. Alpha was incorporated during the current year and focuses on one
investment strategy to generate returns. Alpha issues debt with a maturity of less than one year and
invests the proceeds in emerging market debt. Hackett creates a list of Alpha’s market risk categories.
Hackett asks Anthony Mackenzie, a recently hired associate, to apply the analytical method to estimate
the VAR for Alpha Asset Management’s portfolio, which is valued at $20 million. The portfolio has an
expected annual return of 7.5% and a standard deviation of 22.4%.
Another of Hackett’s clients is Beta Investment Advisors. Beta invests in a variety of asset classes and
international markets. It uses a historical simulation approach to measure the VAR of its portfolio, based
on the previous 24 months of market data. Beta asks Hackett to evaluate its approach relative to other
methods used for estimating portfolio VAR.
Sigma Investment Management Inc. is a potential new client that wishes to measure the credit risk of an
over-the-counter American call option on a security. The call option has a strike price of $65 and was
purchased at a price of $3.50 per option. The option’s current value is $8.50 per option.
In addition to measuring credit risk, Sigma asks Hackett to evaluate its over-the-counter derivative
positions and recommend ways to decrease credit risk associated with these positions. Sigma provides a
thorough explanation of its current process. At least 20 counterparties are used, each is limited to 7% of
Sigma’s total derivatives positions, and each must meet a minimum credit rating threshold. The
contracts have a typical term of two years, at which time they are marked to market and all payments
under the contract are netted and gains or losses settled.
13. What response would Hackett most likely make to Jardins Advisors’ senior management? The
firm should:
A. measure its risk levels before defining its risk tolerance.
B. define its risk tolerance before identifying the risks it faces.
C. identify the risks it faces before setting policies and procedures.
14. Which of these risk categories is least likely to be on Hackett’s list for Alpha?
A. Political risk
B. Liquidity risk
C. Interest rate risk
15. Assuming normally distributed returns, the 5% yearly VAR for the Alpha Asset Management
portfolio is closest to:
A. $2,980,000.
B. $5,892,000.
C. $8,052,000.
16. Hackett’s description of Beta’s current approach to VAR estimation would most likely mention
that it:
A. is a nonparametric method of estimating VAR.
B. often assumes a daily portfolio expected return of zero.
C. produces a wide range of randomly generated potential outcomes.
17. If the security held by Sigma Investment Management trades at $70, the credit risk is closest to:
A. $3.35.
B. $5.00.
C. $8.50.
18. Sigma can most likely reduce credit risk in its over-the-counter derivatives positions by changing
which of the following practices?
A. Netting
B. Limiting counterparty exposure
C. Frequency of marking-to-market
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