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.
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