ERM Flashcards — Part 5 FINAL

Risk Responses

Final versions: [Pt.1] [Pt.2] [Pt.3] [Pt.4] [Pt.5] [Pt.6]

• [26] Ways risk management can optimize risk-return profile (4): 1. support selective growth of business; 2. support profitability through risk adjusted pricing; 3. use limit setting to control the size and probability of potential losses; 4. employ techniques to manage existing risks
• [26] Benefit of active portfolio management and duration matching over risk transfer: Active portfolio management is often more cost effective and is a longer term solution (risk transfer tends to be quicker and easier to implement)
• [26] Fundamental concepts in managing a portfolio of risks (5): 1. risk; 2. reward; 3. diversification; 4. leverage; 5. hedging
• [26] Diversification: Reduce overall risk by investing in different projects or assets whose returns are not perfectly correlated
• [26] Leverage: Borrow money and invest, increases potential risk and return profile
• [26] Hedging: Enter into agreement that reduces risk (usually because hedge position is negatively correlated with existing position)
• [26] Specific risk (MVPT): Risk specific to a company, can be eliminated through diversification
• [26] Systematic risk (MVPT): Risk of being in the market, cannot be diversified away
• [26] Efficient frontier: Portfolios with the highest returns for a given level of risk or lowest risk for a given level of return
• [26] Separation theorem: The optimal portfolio of risky assets for an investor can be determined without any knowledge of their preferences toward risk and return (or liabilities)
• [26] Benefits of portfolio management in ERM (4): 1. encourages companies to unbundle business into component projects; 2. provides mechanism for aggregating risks across the company; 3. provides framework for setting risk concentration limits and asset allocation targets; 4. influences investment, transfer pricing and capital allocation decision
• [26] Active versus passive management of a portfolio of risks: There is no appropriate index to track so index-tracking is not an option, using risk concentration limits and asset allocation targets to apply active management then makes sense
• [26] Responses to risk (4): 1. rejection (removal); 2. acceptance; 3. transfer; 4. management
• [26] Process for implementing risk responses (4): 1. research possible responses and their costs; 2. determine response for each risk, with implementation deadlines; 3. assign risk manager responsible for implementation; 4. consider secondary risks
• [26] Characteristics of a good risk response (5): 1. economical; 2. well matched to risk; 3. simple; 4. active; 5. flexible/dynamic
• [26] Methods to reduce risk through transfer (8): 1. insurance; 2. reinsurance; 3. co-insurance; 4. sharing risk with policyholder via product design; 5. securitization; 6. purchase derivatives; 7. ART products; 8. outsourcing
• [26] Securitization: Package risk into a marketable investment
• [26] Elements of ERM that aid risk transfer (3): 1. provides a framework for recognizing net exposure to each type of risk and diversification of risks; 2. provides a framework to assess the cost of different risk transfer strategies; 3. establishes consistent risk transfer policies across company
• [26] Considerations for risk transfer (5): 1. cost, 2. loss of upside potential; 3. counterparty risk; 4. regulatory restrictions; 5. market capacity
• [26] Considerations for risk removal (3): 1. cost; 2. impact of removing risk on likelihood of project meeting original objectives; 3. whether opportunities will be lost as a result
• [26] Situations where risk retention may be appropriate (3): 1. retaining particular risk is part of core business; 2. it is the most economical approach; 3. no alternatives
• [26] Ways to reduce risk without transfer (8): 1. take on uncorrelated risks; 2. increase portfolio size; 3. better match assets and liabilities; 4. stronger internal controls and governance; 5. robust underwriting practices and analysis; 6. due diligence practices and tightly worded agreements; 7. remuneration and bonus systems that align interests; 8. increased capital or funding
• [26] Circumstances giving rise to residual risks (4): 1. decision was made to retain risk; 2. secondary risk from risk response action; 3. imperfect hedge; 4. inability to transfer or fully mitigate risk
• [26] Categories of ART products (2): 1. vehicles based on capital market instruments; 2. unconventional vehicles used to cover conventional risks
• [26] Requirements for a company to develop ART products: 1. ability to quantify risk (likelihood and size); 2. ability to package, underwrite and sell securities; 3. capital if wanting to retain risk
• [26] Advantages of ART products (5): 1. improved organizational focus; 2. customization of product and timing; 3. cost reduction and simplified administration; 4. earnings stability; 5. marking-to-market (establishes a market price for risks)
• [26] Problems associated with ART (4): 1. may have higher initial costs than conventional products; 2. more complex; 3. company may need to change the way it assesses and manages risk in order to benefit; 4. staff may need to be educate
• [26] Potential drivers of higher demand for ART (3): 1. conventional insurance becomes more expensive; 2. ERM becomes more widespread; 3. it becomes widely recognized that companies should focus on core business and eliminate other risks
• [27] Market risk management strategies (3): 1. diversification; 2. investment strategy; 3. hedging
• [27] Key activities of market risk management (5): 1. setting and monitoring policies; 2. setting and monitoring limits; 3. reporting; 4. capital management; 5. implementing risk-portfolio strategies (matching, hedging)
• [27] Items covered by market risk policies (7): 1. roles and responsibilities; 2. delegation of authority and limits; 3. risk measurement and reporting; 4. valuation and back-testing; 5. hedging policy; 6. liquidity policy; 7. exception management
• [27] Types of derivatives (4): 1. options; 2. forwards; 3. futures; 4. swaps
• [27] Options: Gives the right, but not the obligation, for one party to exercise the contract in return for premium payment to the counterparty
• [27] Forwards: Obligation for both counterparties to complete a transaction on a future date at a known price
• [27] Futures: Like a forward, but a standardized contract traded on an exchange
• [27] Swaps: Obligation for both counterparties to exchange a series of cashflows
• [27] Characteristics of exchange traded contracts (6): 1. standardized; 2. trading is done through the exchange based on market prices; 3. deals are settled through a clearing-house; 4. clearing-house acts as counterparty to both buyer and seller; 5. counterparty risk is reduced for the clearing-house by pooling many contracts; 6. highly liquid with comparatively low transaction costs
• [27] Characteristics of OTC derivatives (4): 1. trading is done at the convenience of the parties and no money changes hands until delivery date; 2. pricing is negotiable; 3. very flexible; 4. documentation is usually based on standard terms and conditions (published by ISDA)
• [27] Types of OTC derivatives: Forwards, swaps, and some options
• [27] Factors influencing the price of OTC contracts (6): 1. spot price of underlying; 2. time to delivery; 3. expectations of interest rates; 4. expected income yield on underlying; 5. residual counterparty risk; 6. cost of carry (of collateral and underlying)
• [27] Marking-to-market process (3): 1. initial margin (cash) is deposited by counterparty into a margin account; 2. clearing house periodically determines if more or less is needed in the margin account; 3. counterparty must add variation margin if margin account drops below a specified maintenance margin
• [27] Potential advantages of derivatives over underlying asset (3): 1. cheaper; 2. easier; 3. more flexible
• [27] Risks associated with derivatives (9): 1. credit; 2. settlement; 3. aggregation; 4. operational; 5. liquidity; 6. legal; 7. reputation; 8. concentration; 9. basis
• [27] Settlement risk: Risk that one counterparty does not deliver (a security or its value in cash) as agreed to when security was traded, after the other counterparty has already delivered
• [27] Basis (futures contracts): Difference between spot price of asset and price of future, at a particular point in time
• [27] Normal backwardation: Situation where the futures price is below the expected value of the future spot price (may occur if market expects income on asset to outweigh costs, or high demand for short positions in the future)
• [27] Contango: Situation where the futures price exceeds the expected value of the future spot price (may occur due to high storage costs of underlying, or high demand for long positions in the future)
• [27] Cashflow management techniques used for currency risk (2): 1. netting (foreign revenue match foreign expenses/liabilities); 2. leading and lagging (bring forward or delay foreign cashflows to exploit expected movement in exchange rates)
• [27] Delta: Rate of change in portfolio value relative to price of underlying
• [27] Gamma: Rate of change of delta relative to price of underlying
• [27] Vega: Rate of change in portfolio value relative to the assumed level of volatility of the underlying
• [27] FRA: Forward rate agreement is used to hedge direct exposure to interest rates, e.g. one fixed rate for one floating rate
• [27] Techniques for managing direct interest rate risk (3): 1. FRAs; 2. caps; 3. floors
• [27] Techniques for managing indirect interest rate risk (5): 1. cashflow matching; 2. interest rate swaps; 3. swaptions; 4. immunization (protect present value); 5. hedging using model points
• [27] Practical problems with cashflow matching (3): 1. suitable assets may not be available; 2. future cashflows may not be known; 3. expected future cashflows may change frequently (costly)
• [27] Best practices for managing credit risk (4): 1. avoid bad risks; 2. diversify credit exposure; 3. monitor exposure regularly; 4. take immediate action if and when default occurs
• [27] Conditions required for immunization (3): 1. present value of asset and liability cashflows are equal; 2. discounted mean term of asset and liability cashflows are equal; 3. convexity of asset cashflows exceed that of liability cashflows
• [28] Stages in credit risk management process (5): 1. policy and infrastructure; 2. credit granting; 3. exposure monitoring, management and reporting; 4. portfolio management; 5. credit review
• [28] Elements of credit risk management policy and infrastructure stage (5): 1. establish appropriate credit environment; 2. adopt credit risk policies and procedures; 3. implement policies and procedures; 4. develop models; 5. define data standards and conventions
• [28] Elements of credit risk management credit granting stage (4): 1. credit analysis and rating of counterparties; 2. credit approval; 3. pricing and setting terms and conditions for credit; 4. documentation
• [28] Factors reflected in credit analysis and rating (4): 1. borrower’s repayment history; 2. analysis of borrower’s ability to pay; 3. their reputation; 4. availability and enforceability of guarantees or collateral
• [28] Goals of the credit risk management monitoring stage (3): 1. prevent undue exposure to individual counterparty; 2. ensure appropriate portfolio diversification; 3. provide early warning of adverse credit events
• [28] Uses of credit risk management exposure limits (4): 1. risk control; 2. allocation of risk-bearing capacity; 3. delegation of authority; 4. regulatory compliance
• [28] Responsibilities of a credit review group (5): 1. review a sample of transactions and associated documentation to ensure data is correct; 2. test systems are working; 3. enforce underwriting standards; 4. check policies and procedures are being followed; 5. communicate to management
• [28] Ways to transfer credit risk (3): 1. credit insurance; 2. credit derivatives; 3. securitization of assets
• [28] Potential benefits of credit insurance (7): 1. protection against bad debts; 2. coverage for specific debtors; 3. coverage for specific region; 4. coverage for expenses; 5. coverage for international risks; 6. specialist advice; 7. ability to secure better terms for financing
• [28] Examples of credit events (5): 1. bankruptcy; 2. rating downgrade; 3. repudiation; 4. failure to pay coupon; 5. cross-default
• [28] Uses of TRORS (2): 1. increase diversification; 2. manage specific risks
• [28] Benefits of securitization to the originator (5): 1. convert a bundle of assets into a negotiable structured financial instrument; 2. raise money, that is linked to future expected cashflows; 3. provide alternative source of finance; 4. pass asset risk to third party; 5. sell assets that may otherwise be unmarketable
• [28] Credit linked note: Collateralized vehicle consisting of a bond with an embedded credit default swap
• [29] Key to managing operational risk: Have sufficient effective controls (combination of information, assessment and response)
• [29] Desirable characteristics of controls (8): 1. focused on results; 2. accounts for both measurable and non-measurable events; 3. standardized for efficient communication; 4. high quality; 5. few, rather than many; 6. meaningful and appropriate; 7. timely; 8. simple
• [29] Considerations for deciding to outsource (5): 1. regulatory environment; 2. financial standing of third party; 3. competency of third party; 4. legal agreements (right to terminate, sub-contract); 5. how to monitor third party
• [29] Ways to mitigate business disruptions from operational risks (3): 1. business continuity plan for identified business interruption risks; 2. crisis management plan; 3. consequential loss insurance
• [29] Actions to manage technology risks (7): 1. keep systems up to date; 2. routine maintenance; 3. thorough testing; 4. quick IT helpdesk response; 5. staff training; 6. restrictions on employee usage; 7. implement and test security software and routines
• [29] Ways to manage people risk (4): 1. recruitment process; 2. training; 3. performance appraisals; 4. relationship management (with unions)
• [29] Techniques to manage process risk (4): 1. pilot studies; 2. precise definition of requirements; 3. design systems that can be easily maintained; 4. careful deployment with user education
• [29] Defenses against reputational risks (3): 1. sound ERM framework; 2. business continuity and crisis management plans; 3. strong relationship with key stakeholders
• [29] Features of best practice operational risk management (5): 1. broad definition of operational risk; 2. internal and external early warning indicators; 3. qualitative and quantitative assessment tools; 4. capital is allocated to operational risk; 5. insurance function is fully integrated with operational risk function
• [29] Actions aimed at managing operational risks (11): 1. outsourcing; 2. business continuity and crisis management plans; 3. horizon scanning; 4. maintenance; 5. security; 6. HR; 7. careful underwriting, product design and pricing; 8. education, checks and balances; 9. good change management; 10. strong relationship with key stakeholders; 11. sound ERM framework that is integrated into the business
• [29] Enterprise-wide process for transferring operational risk (7): 1. identify exposure; 2. quantify; 3. integrate operational risk with credit and market risks to establish enterprise risk profile; 4. establish risk limits; 5. implement internal controls; 6. develop strategies for risk transfer and financing; 7. evaluate alternatives based on cost/benefit analysis
• [29] Actions to manage retained operational risk (2): 1. establish reserves; 2. allow for operational risk when allocating capital (give management incentives to improve)
• [29] Actions to manage liquidity risk (6): 1. active monitoring of liquidity requirements; 2. varying investment strategy; 3. using swaps; 4. maintenance of a contingency fund; 5. diversify sources of funding; 6. obtain contingent sources of funding
• [29] Ways for a company to manage systemic risk (2): 1. ensure diverse range of counterparties; 2. trading via exchanges
• [29] External regulatory actions to reduce feedback risk (5): 1. use of circuit breakers by exchanges; 2. government actions (propping up bank); 3. regulations requiring establishment of reserves; 4. avoid pro-cyclical regulations; 5. physically separating certain types of business
• [29] Ways to manage insurance risk (5): 1. underwriting; 2. risk transfer; 3. reduce risk concentrations; 4. improve diversification; 5. hedging