THE ENERGYALGAE TRADES ARE LEAST LIKELY TO HAVE VIOLATED THE CFA I...

12. The EnergyAlgae trades are least likely to have violated the CFA Institute Standards of

Professional Conduct with regard to:

A. the order in which the shares were traded.

B. share price distortion due to positive media presentations.

C. the adverse and skeptical opinions of EnergyAlgae products.

Karin Larsson Case Scenario

Karin Larsson is a new employee in the risk management group at Baltic Investment Management, Inc.

She is replacing Sten Reinfeldt, who has agreed to help her transition into her new role. Reinfeldt

explains that risk governance refers to the process of setting risk management policies and standards for

an organization, enabling firms to establish appropriate ranges for exposures and to emphasize

individual risk factors within a centralized type of enterprise risk management.

Baltic manages proprietary investment strategies, which creates risk exposures for the firm. Larsson

explains that these risks are both financial and nonfinancial in nature and proceeds to list several

specific sources of risk:

Risk 1: Model Risk

Risk 2: Liquidity Risk

Risk 3: Settlement Risk

Baltic uses value at risk (VAR) as a probability-based measure of loss potential for its fixed income

strategies. Reinfeldt states that the VAR for the fixed income strategy is SEK10 million over any 5-day

time period with a probability of 5 percent. Larsson asks Reinfeldt to estimate the fixed income

strategy’s VAR at given levels of probability for specified time periods.

Baltic manages an equity strategy in addition to the fixed income strategy. The trading desks for each

strategy are each granted risk budgets that consider the allocation of both capital and daily VAR. The

correlation between the equity desk and the fixed income desk is low. Risk-budgeting data for both

desks are provided in Exhibit 1.

Exhibit 1

Trading Desk Data

(SEK million)

Equity Desk Fixed Income Desk

Capital 200 100

Daily VAR 10 10

Monthly Profit 25 15

Reinfeldt comments that the risk management group has adopted stress testing to complement VAR

analysis given some of its limitations. He lists several of the limitations of VAR for Larsson:

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Limitation 1: VAR inaccurately measures risk exposure because it overestimates the magnitude

and frequency of the worst returns.

Limitation 2: VAR incompletely measures risk exposure because it does not incorporate positive

results into its risk profile.

Limitation 3: VAR incorrectly measures risk exposure because there are limited calculation

methods and they often yield similar outcomes.

Larsson is concerned about credit exposure within the fixed income strategy and asks Reinfeldt how

Baltic manages this risk. Reinfeldt responds, “There are a number of ways we manage credit risk. First,

we utilize credit derivatives in order to transfer credit risk. Second, we mark-to-market our credit

derivatives in order to post collateral whenever a credit derivative’s value is positive to Baltic and

negative to the swap counterparty.”