THROUGH 24 RELATE TO RISK MANAGEMENT WILLIAM PEARSON CASE...

Questions 19 through 24 relate to Risk Management William Pearson Case Scenario William Pearson is a head of risk governance at Everest Investment Management (EIM). His firm follows a centralized risk governance structure, also known as the Enterprise Risk Management System. A recently hired subordinate, James Stephen, is concerned about how companies manage risk. Pearson responds to Stephen as follows: Statement 1: “Companies manage their risk which means that when they perceive a competitive advantage, they bring their risk exposures to the minimum level.” Although Stephen does have knowledge about the two types of risk governance structures, he is still confused about their peculiar characteristics. Pearson explains: Statement 2: “In contrast to the decentralized structure, companies using a centralized governance structure take into account total risk exposures and thereby increase their overall need to hedge.” Stephen has listed down various types of risk categories. The list is as follows. A. Financial risks i. Liquidity risk ii. Credit risk iii. Commodity price risk iv. Equity price risk v. Exchange rate risk vi. Interest rate risk B. Nonfinancial risks i. Operations risk ii. Model risk iii. Settlement risk iv. Regulation risk v. Legal risk vi. Taxes vii. Accounting risk

CFA Level III Mock Exam 3 – Solutions (PM)

Stephen states “only regulated markets are exposed to regulation risk”. Davis Marshall, CFA, a portfolio manager at EIM, is managing the investment portfolio of a large mining company, Shining Stones (SS). The portfolio is specifically designed to help the company hedge its risk associated with commodity prices and foreign exchange rate risk. The company has entered into various OTC forwards and option contracts. Marshall is concerned about managing liquidity risk associated with investing in various OTC derivatives which are of large trade sizes. His assistant has been charged with measuring this liquidity risk. Marshall explains to his assistant that due to large trade sizes, it is not useful to use bid-ask quotations; rather, it is better to use the illiquidity ratio. In addition, SS holds an exchange-traded credit derivative instrument and entered into a forward contract with a specific counterparty. When the settlement was due on the forward contract, in spite of no change in credit worthiness of the counterparty, the counterparty failed to settle the contractual obligations due to financial difficulties resulting from activities of a rogue-trader. EIM also manages a hedge fund, which has two strategies managed independently by two separate portfolio managers, James Joe and Emmy Gide. Joe generated 10% gain whereas Gide generated 0% gain. In the hedge fund, an asymmetric incentive fee contract exists. On analyzing the performance of the two managers, Blain Lee, an analyst at EIM, made the following statements: Statement 3: “The hedge fund is exposed to performance nettingassociated losses.” Statement 4: “Settlement netting risk arises due to the absence of a netting arrangement.” 19. With regard to Pearson’s response to Stephen which of the following is most likely correct? A. Statement 1 is correct; Statement 2 is incorrect. B. Statement 1 is incorrect; Statement 2 is correct. C. Statement 1 is incorrect; Statement 2 is incorrect. 20. Which of the following risk is least likely linked to market supply and demand? A. Liquidity risk B. Currency risk C. Interest rate risk 21. What does the illiquidity ratio measure; and is Marshall correct in using this ratio to measure the liquidity risk of OTC derivatives? A. Illiquidity ratio measures price impact per $1 million trades in a day; Marshall is incorrect. B. Illiquidity ratio measures total trading cost per $1 million trades in a day; C. Illiquidity ratio measures trade size relative to average daily trading volume; Marshall is correct. 22. With respect to the exchange-traded credit derivative instrument, SS is most likely exposed to: A. Market risk B. Credit risk C. Settlement risk 23. With respect to the forward contract, SS is most likely exposed to which of the following risks and how can this risk be reduced? A. Operational risk; using insurance. B. Settlement risk; using a netting arrangement. C. Credit risk; using a credit derivative instrument. 24. With regard to Statement 3 and 4, which of the following is most likely incorrect? A. Statement 3 is correct; Statement 4 is correct B. Statement 3 is correct; Statement 4 is incorrect. C. Statement 3 is incorrect; Statement 4 is correct.