THROUGH 18 RELATE TO RISK MANAGEMENT. LARA FRASER CASE SC...

Questions 13 through 18 relate to Risk Management.

Lara Fraser Case Scenario

Lara Fraser is the risk manager for Galaxy & Co., a large investment firm located in

Scotland. She recently hired a new employee, Stuart Wallace, to assist her with

enhancing the firm’s risk management process. Fraser asks Wallace to document the

exposures to risk that have been identified through Galaxy & Co.’s current risk

management process. As Wallace begins the project, Fraser responds to client questions

and requests.

Client A states:

“I am a new client and received my first investment portfolio statement. The statement

specifies, “With 95 percent confidence, the VAR of the portfolio is $1 million for one

month.” My portfolio holds long stock positions along with some option positions on

those stocks and I am concerned about the impact that low probability events may have

on my portfolio performance. Can the VAR measure be adjusted to address this concern?

In addition, please explain the primary limitation of VAR.”

Fraser responds with the following statements:

Statement 1: VAR quantifies potential losses in simple terms.

Statement 2: VAR often underestimates the magnitude and frequency of the worst

returns.

Statement 3: VAR is a forward-looking measure that cannot be backtested against

historical data.

Client B asks:

“I am preparing to make a VAR presentation to my Board of Directors. I am familiar

with the analytical method of measuring VAR that Galaxy & Co. uses. Please describe

other methods for estimating VAR and indicate a disadvantage of each.”

Galaxy & Co.’s senior management wants to be confident that the firm is managing and

measuring credit risk in an appropriate manner. They ask Fraser to provide a specific

example of an investment instrument within the portfolio that may create credit risk.

Fraser chooses to illustrate the concept of credit risk with a swap example. A portion of

the firm’s portfolio is invested in floating rate notes. Galaxy uses interest rate swaps to

manage the interest rate risk exposure of this investment. Specifically, the firm has

entered into a one year pay variable receive fixed interest rate swap. The swap has a

notional value of £1,000,000. The current market value of the swap to Galaxy is

-£47,000.

Fraser is confident that the techniques she employs to mitigate credit risk are

comprehensive and follow industry best practice standards. She drafts a description of

the techniques used at Galaxy and includes the following statement:

By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to

“In keeping with industry standards, our primary means of managing credit risk is

requiring that our counterparties post collateral.”

Meanwhile, Wallace drafts a memo to Fraser with some of his initial thoughts:

“As an investment firm that manages international and domestic fixed income and equity

portfolios, Galaxy & Co. is exposed to both financial and non-financial risks. Each of

these broad topics will be addressed in turn.”

Wallace decides to initially add depth to the financial risks that the firm faces.

13. Fraser’s most appropriate response to Client A’s question regarding the possibility

of adjusting the VAR measure is:

A. an increase in the confidence interval will increase the magnitude of the VAR

measure.

B. the VAR measure will decrease if the time frame of measurement is

increased.

C. for your portfolio, any confidence interval will provide essentially identical

VAR information.

14. Fraser correctly identifies a limitation of VAR in:

A. Statement 1.

B. Statement 2.

C. Statement 3.

15. Fraser drafts a number of possible responses to Client B. An appropriate response

would include:

A. The Monte Carlo simulation method requires an assumption of normally

distributed returns.

B. The historical method is nonparametric and does not allow the user to make

assumptions about the probability distribution of returns.

C. The historical method relies completely on events of the past, and the

probability distribution of the past may not hold in the future.

16. With respect to the plain vanilla interest rate swap, which of the following most

accurately describes Galaxy’s exposure to credit risk?

A. No current credit risk

B. £47,000 at risk of loss

C. £953,000 at risk of loss

17. Fraser’s statement regarding the management of credit risk is most likely:

A. correct.

B. incorrect, because the primary means of managing credit risk is periodic

marking to market.

C. incorrect, because the primary means of managing credit risk is limiting the

total exposure to a given counterparty.

18. As Wallace begins to add depth to the description of the initial source of risks

present at Galaxy & Co., which of the following will he least likely include:

A. taxes.

B. liquidity.

C. interest rates.