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:
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“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.
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