“RISK MANAGEMENT” THE CANDIDATE SHOULD BE ABLE TO

37. “Risk Management” The candidate should be able to: b) recommend and justify the risk exposures an analyst should report as part of an enterprise risk management system; h) compare and contrast alternative types of stress testing and discuss the advantages and disadvantages of each; i) evaluate the credit risk of an investment position, including forward contract, swap, and option positions; 2008 Level III Guideline Answers Morning Session – Page 24 of 40 Question: 7 Topic: Portfolio Management – Risk Management Minutes: 17 Guideline Answer: PART A Template for Question 7-A Describe one source of each of the following risks facing RR. Risk Note: A single source may not be used for both liquidity and settlement risk. RR has recently made an acquisition through a relatively large short-term syndicated loan. If RR faces difficulty in raising funds to pay back the short-term syndicated loan at maturity, RR may be forced to sell securities from its investment portfolio on short notice, and at unfavorable prices. i. Liquidity risk RR invests in OTC derivatives. RR could be required to liquidate positions prior to expiration at unfavorable prices. RR invests in OTC derivatives that involve settlement through the execution of bilateral agreements. The risk is that one party could be in the process of paying the counterparty while the counterparty is declaring bankruptcy. ii. Settlement risk In the case of currency swaps, settlement risk is increased because the contracts often require the exchange of principal in addition to interest payments. Morning Session – Page 25 of 40 PART B Template for Question 7-B Recommend one other stress testing method, in addition Explain one advantage of this method. to stylized scenarios, to effectively supplement VAR. Actual extreme events Focuses on the portfolio effects of events that have occurred in the past but may have a higher probability than given by the probability model or specific historic time period used in developing the VAR estimate. Hypothetical events Focuses on the portfolio effects of events that have not occurred and are assigned a low probability. Emphasizes a range of possibilities and may give insight into Stressing models, including the probability of different scenarios, and portfolio factor push sensitivities to various combinations of events. Identifies the risks that are most likely to occur in the worst maximum loss optimization or case and are most important to control. worst case scenario analysis PART C Template for Question 7-C Identify whether RR or its counterparty bears Justify each response with one reason. Contract the credit risk for each position. (circle one) Based on the comparison between the forward rate 15.00 JPY/ZAR and the spot rate 17.50 JPY/ZAR, the short-yen counterparty (RR) receives the payment, so RR bears the Red River Forward credit risk. Counterparty Morning Session – Page 26 of 40 For Red River, the present value of the liability side of this swap (fixed-leg) is greater than the present value of the asset side of the swap (floating-leg). Therefore, the market value of the swap for RR is negative. The counterparty’s market value of the swap is positive, thus subjecting the counterparty to credit risk. The present values of the fixed-leg and floating-leg are: The PV of floating-leg equals 1 (the notional principal) plus the next floating payment discounted by the 2-month factor. Swap PV(floating-leg) =(1+(0.054*(180/360))*0.9911)=1.0179 The PV(fixed-leg) = ((1+(0.055*(180/360)*0.9911)+ ((1+(0.055*(180/360)))*0.9649)=1.0187 Therefore the market value of swap to RR equals = 1.0179-1.0187 = (0.0008) Where the PV factors for 2 and 8 months are, respectively: