TO 18 RELATE TO RISK MANAGEMENT LAURA HACKETT CASE SCENAR...

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.

Answer = B

“Risk Management,” Don M. Chance, Kenneth Grant, and John Marsland

2013 Modular Level III, Vol. 5, Reading 34, Section 2

Study Session 14–34–a

Discuss the main features of the risk management process, risk governance, risk reduction, and

an enterprise risk management system.

B is correct because the risk management process is as follows: (1) set policies and procedures,

(2) define risk tolerance, (3) identify risks, (4) measure risks, and (5) adjust the level of risk.

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

Answer = A

2013 Modular Level III, Vol. 5, Reading 34, Section 4.1, Section 4.11

Study Session 14–34–d

Evaluate a company’s or a portfolio’s exposures to financial and nonfinancial risk factors.

A is correct because although the company is exposed to political risk via its investment in

emerging market debt, this risk is not a type of market risk. Market risks include risks associated

with interest rates, exchange rates, stock prices, and commodity prices.

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.

2013 Modular Level III, Vol. 5, Reading 34, Section 5.2.2

Study Session 14–34–e

Calculate and interpret value at risk (VAR) and explain its role in measuring overall and individual

position market risk.

B is correct because there is a 5% chance the portfolio will lose 29.46%:

0.075 – (1.65 × 0.224) = 0.075 – 0.3696 = –0.2946;

hence the annual 5% VAR is

$20,000,000 × 0.2946 = $5,892,000.

With a standard normal distribution, 5% of possible outcomes are likely to be smaller than –1.65

times the standard deviation of the distribution.

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.

2013 Modular Level III, Vol. 5, Reading 34, Section 5.2.3

Study Session 14–34–f

Compare the analytical (variance-covariance), historical, and Monte Carlo methods for

estimating VAR and discuss the advantages and disadvantages of each.

A is correct because the historical simulation approach to VAR measurement calculates what the

change in the current portfolio’s value would have been had it been held in the past, without

making any assumptions about the distribution of asset returns.

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.

Answer = C

2013 Modular Level III, Vol. 5, Reading 34, Section 5.6.4

Study Session 14–34–i

Evaluate the credit risk of an investment position, including forward contract, swap, and option

positions.

C is correct because the amount at risk is the current value of the option, $8.50. Once the seller

has sold the option, all the credit risk falls on the buyer. In this instance, the amount of credit

risk is the value of the option because this amount is what the buyer stands to lose if the seller

were to default immediately.

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

2013 Modular Level III, Vol. 5, Reading 34, Section 6.2

Study Session 14–34–k

Demonstrate the use of exposure limits, marking to market, collateral, netting arrangements,

credit standards, and credit derivatives to manage credit risk.

C is correct because Sigma typically enters two-year contracts and does not mark to market until

expiration of the contract. Increasing the frequency of the marking to market will decrease

credit risk. When a contract is marked to market, the party to whom the contract has a positive

value receives payment from the counterparty, thus eliminating credit risk. Consequently, more

frequent marking to market decreases credit risk.