Foundations of Risk Management

FRM 2011 Study Notes Vol. I

By David Harper, CFA FRM CIPM www.bionicturtle.com

Table of Contents
Jorion, Chapter 1: The Need for Risk Management Stulz Chapter 2: Investors & Risk Management Stulz Chapter 3: Creating Value with Risk Management Elton, Chapter 5: Delineating Efficient Portfolios Elton, Chapter 13: The Standard Capital Asset Pricing Model Elton, Chapter 14: Nonstandard Forms of Capital Asset Pricing Models Elton, Chapter 16: Arbitrage Pricing Model (APT) Amenc, Chapter 4: Applying CAPM to Performance Measurement CAS, Overview of Enterprise Risk Management Allen, Chapter 4: Financial Disasters 2 19 27 34 39 44 49 52 57 65

Ren Stulz, Risk Management Failures: What are They and When Do They Happen? 71

www.bionicturtle.com

FRM 2011 FOUNDATIONS OF RISK MANAGEMENT 1

Jorion, Chapter 1:

The Need for Risk Management

In this chapter
Define risk and describe some of the major sources of risk. Differentiate between business and financial risks and give examples of each. Relate significant market events of the past several decades to the growth of the risk management industry. Describe the functions and purposes of financial institutions as they relate to financial risk management. Define what a derivative contract is and how it differs from a security. Describe the dual role leverage plays in derivatives and why it is relevant to a risk manager. Define financial risk management. Define value-at-risk (VaR) and describe how it is used in risk management. Describe the advantages and disadvantages of VaR relative to other risk management tools such as stop-loss limits, notional limits, and exposure limits. Compare and contrast valuation and risk management, using VaR as an example. Define and describe the four major types of financial risks: market, liquidity, credit, and operational. Within market risk: Describe and differentiate between absolute and relative market risk Describe and differentiate between directional and non-directional market risk Describe basis risk and its sources Describe volatility risk and its sources Within liquidity risk: Describe and differentiate between asset and funding liquidity risk Within credit risk: Describe and differentiate between exposure and recovery rate Describe credit event and how it may relate to market risk Describe sovereign risk and its sources Describe settlement risk and its sources Within operational risk: Describe the potential relationships between operational, market and credit risk Describe model risk and its sources Describe people risk Describe legal risk and its sources

www.bionicturtle.com

FRM 2011 FOUNDATIONS OF RISK MANAGEMENT 2

Define risk and describe some of the major sources of risk.

Risk is volatility of unexpected outcomes (value of assets, equity, or earnings). Although Jorion does not differentiate between risk and uncertainty, some authors distinguish between risk and uncertainty: Risk: when the outcome is random but the probability distribution is known or can be estimated or approximated. An example: a six-sided die (we know the distribution is uniform). Much of our FRM study concerns the traditional attempt to parameterize (or otherwise estimate, even if empirically) the approximately distribution of possible losses. Uncertainty: the probability distribution is itself unknown. Example: a terrorist attack. This is when the disribution itself eludes us.

The major sources of risk include: Human (Accident) including regulatory policy (and unintended consequence Human (Deliberate) including terrorism and war Natural disaster including earthquakes and hurricanes Economic growth including the creative disruption caused by technological innovation

Human (Accident) Regulatory policy: unintended consequence

Human (Deliberate) Terrorism War

Natural disaster Earthquake Hurricane

Economic Growth Technological innovation

Jorion defines risk as the volatility of unexpected outcomes (change in value of assets, equity or earnings). In doing so, he defines risk in terms of the most classic, traditional metric (volatility) but this is not gospel. There are other definitions.

www.bionicturtle.com

FRM 2011 FOUNDATIONS OF RISK MANAGEMENT 3

Differentiate between business & financial risks & give examples of each.
Business risks are risks that the corporation assumes willingly. They may do this to create a competitive edge or to add shareholder value. Financial risks are losses due to financial market activities. Examples of financial risk include losses due to interest-rate movements or defaults on financial obligations.

Business Risks
Deliberate, necessary Competitive advantage To create Shareholder value

Financial Risks
Losses due to financial market activities

For example Interest rate exposure Defaults on financial obligations Accounts receivables

For example Business decisions (investments, products) & Business environment (competition & economy)

Shareholders pay for and expect firms to assume business risk!

To a non-financial firm, not core & firm should (probably) hedge

Banks & financial services are in the business of managing financial risk; managing financial risk is (should be) a core strategic activity. However, industrial (non-financial) companies typically want to hedge financial risks; i.e., the assumption of financial risk is often non-strategic to non-financial companies.

www.bionicturtle.com

FRM 2011 FOUNDATIONS OF RISK MANAGEMENT 4

Relate significant market events of past several decades to growth of the risk management industry.

1971 1973
10/19/87

Fixed exchange rate system broke down Oil price shocks High inflation Black Monday. US stocks drop 23% Bond debacle (Fed hikes rates 6 times) Deflation of Japanese stock price bubble

Bretton Woods

2
3 4 5

Black Monday

1994 1989

1997
Aug 1998

6 7 8 9
10

Asian turmoil
Russian default Global crisis (LTCM)

9/11/01
Aug 2007

Terrorist attack on New York

Visible subprime crisis

Fed takeover Fannie Mae & Freddie Mac; Merrill Lynch sold; Lehman bankruptcy; AIG

Sep 2008

www.bionicturtle.com

FRM 2011 FOUNDATIONS OF RISK MANAGEMENT 5

Describe functions & purposes of financial institutions as they relate to financial risk management.
Financial institutions (FIs) as brokers: reduce transaction and information costs between households and corporations Financial institutions (FIs) as asset transformers: liquidity and maturity transformation
FI

Brokers Households

Asset Transformers

Corporations

Define what a derivative contract is and how it differs from a security.

A security is a financial claim issued by a corporation to raise capital. Primary securities are backed by real assets while secondary securities are issued by banks and backed by primary securities. A derivative contract is a private contract that derives its value from some underlying asset price, reference rate, or index; e.g. the underlying may be a stock, bond, currency, or commodity. A derivative derives its value from another security. An example would be a forward contract on a foreign currency is a promise to buy a fixed amount at a fixed price on a future date.

Security: Financial claims issued by corporations to raise capital

Primary securities (e.g., equities, bonds) are backed by real assets

Secondary securities are issued by banks [financial institutions] and backed by primary securities

Derivative: Private contract deriving value from an underlying asset price, reference rate, or index

Forward contract on foreign currency is a promise to buy a fixed (notional) amount at a fixed price at a future date

www.bionicturtle.com

FRM 2011 FOUNDATIONS OF RISK MANAGEMENT 6

Balance sheet perspective:

Commercial Firms Assets Real Assets (plant, machinery) Liabilities Primary Securities (debt, equity) Assets Primary securities (debt, equity) Financial Intermediary Liabilities Secondary securities

For example
Compare a corporate bond issuance (security) to a credit default swap (derivative). Both expose investors to credit risk, but one is a security and the other is a derivative. The investor in a corporate bond assumes default risk by purchasing the bond; this investor owns a financial claim on the corporations real assets.

Funded Long Bond

XYZ Bond
Credit Default Swap (CDS) on XYZ Bond

Unfunded Short CDS (Write protection)

Describe the dual role leverage plays in derivatives and why it is relevant to a risk manager.
Leverage is a double-edged sword with advantages and disadvantages: The advantage of leverage: It makes the derivative an efficient instrument for hedging and speculation owing to very low transaction costs (Efficient) The disadvantage of leverage: the absence of upfront cash payment makes it more difficult to assess the potential downside risk; leveraged derivative risks conseqently must be managed more carefully

www.bionicturtle.com

FRM 2011 FOUNDATIONS OF RISK MANAGEMENT 7

Efficient: Low Transaction Costs

But lack of funding makes risk assessment difficult (What is exposure?)

Jorion says Leverage is a double-edged sword: the derivative (unfunded) is efficient but it is harder to assess potential downside

Define financial risk management

Financial risk management is the design and implementation of procedures for Identifying, Measuring, and Managing financial risks

Define value at risk (VaR)

VaR summarizes the worst loss over a target horizon that will not be exceeded with a given level of confidence Under normal conditions, the most the portfolio can lose over a month is about $3.6 million at the 99% confidence level Under normal conditions, the most the portfolio can lose over a month is $X/%X at with (1 ) % confidence

VaR is the worst expected (i.e., with selected confidence) loss over a target horizon. But better is the mathematically equivalent: VaR is the minimum we expect to lose (1- confidence)% of the time over a target horizon.

Specify confidence = 1 significance ()

Specify horizon

VaR is always one-tail!

www.bionicturtle.com

FRM 2011 FOUNDATIONS OF RISK MANAGEMENT 8

Value at risk (VaR): the equivalent but semantically better perspective: Under normal conditions, the portfolio should lose at least $3.6 million 1% of the time Under normal conditions, we expect the portfolio to lose at least $X/%X at the selected significance (1 confidence) level.

Nonparametric VaR: Quantile of an EMPIRICAL distribution

Nonparametric value at risk (VaR) is the quantile of an empirical distribution. For example, where on the distribution does the worst 5% of outcomes fall in the distribution:

100 80 60 40 20 0 -4 -3 -2 -1 0 1 2 3 4
Example of Nonparametric Value at Risk (VaR): Historical Simulation
Assume we observe 30 days of returns and we sort them from best to worst. The 99% VaR is equal to PERCENTILE (array, 100% - 99%). In the sample data from the learning spreadsheet, this worst expected loss is -1.44%, so we say the 99% historical simulation VaR is a loss of 1.44%.

Historical Simulation (HS) VaR (i.e., non-parametric) 1-day HS VaR: 1-day HS VaR: Period Return t-1 -0.9% t-2 -0.8% t - 28 0.6% t - 29 0.4% t - 30 -0.8%

-1.44% 1.44% Sort

www.bionicturtle.com

FRM 2011 FOUNDATIONS OF RISK MANAGEMENT 9