Financial risk manager FRM exam part i foundations of risk management GARP

PEARSON ' ALWAYS LEARNING Financial Risk Manager (FRM®) Exam Part I Foundations of Risk Management Fifth Custom Edition for Global Association of Risk Professionals 2015 Global Association of Risk Professionals Copyright © 2015, 2014, 2013, 2012, 2011 by Pearson Learning Solutions All rights reserved This copyright covers material written expressly for this volume by the editor/s as well as the compilation itself It does not cover the individual selections herein that first appeared elsewhere Permission to reprint these has been obtained by Pearson Learning Solutions for this edition only Further reproduction by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval system, must be arranged with the individual copyright holders noted Grateful acknowledgment is made to the following sources for permission to reprint material copyrighted or controlled by them: "Risk Management: A Helicopter View," "Corporate Risk Management: A Primer," "Typology of Risk Exposures" and "Corporate Governance and Risk Management," by Michel Crouhy, Dan Galai, and Robert Mark, reprinted from The Essentials of Risk Management, Second Edition (2014), McGraw-Hili Companies "What Is ERM?" by James Lam, reprinted from Enterprise Risk Management: From Incentives to Controls, Second Edition (2014), by permission of John Wiley & Sons, Inc "Implementing Robust Risk Appetite Frameworks to Strengthen Financial Institutions," June 17, 2011, by permission of The Institute of International Finance, Inc "Financial Disasters," by Steve Allen, reprinted from Financial Risk Management: A Practitioner's Guide to Managing Market and Credit Risk, Second Edition (2013), by permission of John Wiley & Sons, Inc "The Credit Crisis of 2007," by John Hull, reprinted from Risk Management and Financial Institutions, Third Edition (2012), by permission of John Wiley & Sons, Inc "Risk Management Failures: What are they and when they happen?" by Rene Stulz, reprinted from the Journal of Applied Corporate Finance 20, no 4, (October 2008) by permission of the author "The Standard Capital Asset Pricing Model," by Edwin J Elton et aI., reprinted from Modern Portfolio Theory and Investment Analysis, Ninth Edition (2014), by permission of John Wiley & Sons, Inc "Applying the CAPM to Performance Measurement: Single-Index Performance Measurement Indicators," by Noel Amenc and Veronique Le Sourd, reprinted from Portfolio Theory and Performance Analysis (2003), by permission of John Wiley & Sons, Inc "Arbitrage Pricing Theory and Multifactor Models of Risk and Return," by Zvi Bodie, Alex Kane, and Alan J Marcus, reprinted from Investments, Tenth Edition (2013), McGraw-Hili Companies "Information Risk and Data Quality Management," by David Loshin, reprinted from Risk Management in Finance: Six Sigma and Other Next-Generation Techniques, edited by Anthony Tarantino and Deborah Cernauskas (2009), by permission of John Wiley & Sons, Inc "Principles for Effective Data Aggregation and Risk Reporting," (January 2013), Basel Committee on Banking Supervision Learning Objectives provided by the Global Association of Risk Professionals All trademarks, service marks, registered trademarks, and registered service marks are the property of their respective owners and are used herein for identification purposes only Pearson Learning Solutions, 501 Boylston Street, Suite 900, Boston, MA 02116 A Pearson Education Company www.pearsoned.com Printed in the United States of America 10 VO 11 19 18 17 16 15 000200010271930506 JH/KE PEARSON ISBN 10: 1-323-01119-6 ISBN 13: 978-1-323-01119-5 CHAPTER RISK MANAGEMENT: A HELICOPTER VIEW Legal and Regulatory Risk 19 Business Risk 19 Strategic Risk 21 What Is Risk? Reputation Risk 21 The Conflict of Risk and Reward Systemic Risk 23 The Danger of Names 10 Numbers Are Dangerous, Too 11 The Risk Manager's Job 12 13 Appendix 14 Market Risk Interest Rate Risk Equity Price Risk Foreign Exchange Risk Commodity Price Risk Credit Risk Credit Risk at the Portfolio Level CORPORATE RISK MANAGEMENT: A The Past, the Future-and This Book's Mission Typology of Risk Exposures CHAPTER PRIMER 27 Why Not to Manage Risk in Theory 28 14 And Some Reasons for Managing Risk in Practice 29 15 15 15 16 Hedging Operations versus Hedging Financial Positions 30 Putting Risk Management into Practice 31 14 16 18 Liquidity Risk 18 Operational Risk 19 Determining the Objective Mapping the Risks Instruments for Risk Management 31 34 34 iii Constructing and Implementing a Strategy Performance Evaluation CHAPTER 36 37 CORPORATE GOVERNANCE AND RISK MANAGEMENT 41 Setting the Scene: Corporate Governance and Risk Management 43 True Risk Governance 45 Committees and Risk Limits: Overview 46 A Key Traditional Mechanism: The Special Role of the Audit Committee of the Board A Key New Mechanism: The Evolving Role of a Risk Advisory Director The Special Role of the Risk Management Committee of the Board The Special Role of the Compensation Committee of the Board Roles and Responsibilities in Practice 47 CHAPTER WHAT Is ERM? ERM Definitions 61 The Benefits of ERM 61 62 62 62 Organizational Effectiveness Risk Reporting Business Performance The Chief Risk Officer 63 Components of ERM 65 66 66 66 67 67 67 67 Corporate Governance Line Management Portfolio Management Risk Transfer Risk Analytics Data and Technology Resources Stakeholder Management 47 CHAPTER 48 49 50 Limits and Limit Standards Policies 52 Standards for Monitoring Risk 53 What Is the Role of the Audit Function? 54 Conclusion: Steps to Success 56 IMPLEMENTING ROBUST RISK ApPETITE FRAMEWORKS Contents 71 Executive Summary 72 Introduction 75 Section 1-Principal Findings from the Investigation 77 Section 2-Key Outstanding Challenges in Implementing Risk Appetite Frameworks 79 Section 3-Emerging Sound Practices in Overcoming the Challenges Risk Appetite and Risk Culture iv • 59 82 82 "Driving Down" the Risk Appetite into the Businesses Capturing Different Risk Types The Benefits of Risk Appetite as a Dynamic Tool The Link with the Strategy and Business Planning Process The Role of Stress Testing within an RAF 83 85 87 Disasters Due to the Conduct of Customer Business Bankers Trust (BT) JPMorgan, Citigroup, and Enron Other Cases Recommendations for Board Directors Recommendations for Senior Management Recommendations for Risk Management CHAPTER 91 94 94 96 97 FINANCIAL DISASTERS Disasters Due to Misleading Reporting Chase Manhattan Bank/Drysdale Securities Kidder Peabody Barings Bank Allied Irish Bank (AlB) Union Bank of Switzerland (UBS) Societe Generale Other Cases Disasters Due to Large Market Moves Long-Term Capital Management (LTCM) Metallgesellschaft (MG) 117 118 119 88 CHAPTER THE CREDIT CRISIS OF Section 4-Recommendations for Firms 117 101 102 103 104 105 106 108 109 111 112 112 116 123 2007 124 The u.S Housing Market The Relaxation of Lending Standards The Bubble Bursts 124 125 126 Securitization Asset-Backed Securities ABS CDOs CDOs and ABS COOs in Practice 126 128 129 The Crisis 130 What Went Wrong? 130 Regulatory Arbitrage Incentives 131 131 Lessons from the Crisis 131 Summary 132 CHAPTER RISK MANAGEMENT 135 FAILURES Abstract 136 Was the Collapse of Long-Term Capital Management a Risk Management Failure? 136 Contents II v / A Typology of Risk Management Failures 138 Mismeasurement of Known Risks Mismeasurement Due to Ignored Risks Ignored Known Risks Mistakes in Information Collection Unknown Risks Communication Failures Failures in Monitoring and Managing Risks Risk Measures and Risk Management Failures Summary CHAPTER 140 140 140 141 142 142 144 CAPITAL ASSET 149 The Assumptions Underlying the Standard Capital Asset Pricing Model (CAPM) 150 Deriving the CAPM-A Simple Approach Deriving the CAPM-A More Rigorous Approach 151 163 Applying the CAPM to Performance Measurement: Single-Index Performance Measurement Indicators 164 The Treynor Measure The Sharpe Measure The Jensen Measure Relationships between the Different Indicators and Use of the Indicators Extensions to the Jensen Measure The Tracking-Error The Information Ratio The Sortino Ratio Recently Developed Risk-Adjusted Return Measures CHAPTER 11 164 164 165 165 167 168 168 169 169 ARBITRAGE PRICING THEORY AND MULTIFACTOR AND RETURN 177 155 156 Conclusion 157 Contents TO PERFORMANCE MODELS OF RISK 151 Prices and the CAPM vi • ApPLYING THE CAPM MEASUREMENT THE STANDARD The CAPM 10 139 146 PRICING MODEL CHAPTER Multifactor Models: An Overview Factor Models of Security Returns 178 178 Arbitrage Pricing Theory 180 Arbitrage, Risk Arbitrage, and Equilibrium 180 Well-Diversified Portfolios Diversification and Residual Risk in Practice Executing Arbitrage The No-Arbitrage Equation of the APT The APT, the CAPM, and the Index Model The APT and the CAPM The APT and Portfolio Optimization in a Single-Index Market 181 182 183 184 185 185 186 A Multifactor APT 188 The Fama-French (FF) Three-Factor Model 189 Summary 191 CHAPTER 12 AND DATA QUALITY Organizational Risk, Business Impacts, and Data Quality Business Impacts of Poor Data Quality Information Flaws Examples Accuracy Completeness Consistency Reasonableness Currency Uniqueness Other Dimensions of Data Quality Mapping Business Policies to Data Rules 199 199 199 199 199 199 199 200 Data Quality Inspection, Control, and Oversight: Operational Data 200 Governance Managing Information Risk via a Data Quality Scorecard 201 Data Quality Issues View Business Process View Business Impact View Managing Scorecard Views INFORMATION RISK MANAGEMENT 198 Data Quality Expectations 195 196 13 201 201 202 202 Summary CHAPTER 201 PRINCIPLES FOR EFFECTIVE RISK DATA 196 197 AGGREGATION AND RISK REPORTING 205 197 Employee Fraud and Abuse Underbilling and Revenue Assurance Credit Risk Insurance Exposure Development Risk Compliance Risk 197 Introduction 206 198 Definition 207 198 198 Objectives 207 198 198 Scope and Initial Considerations 207 Contents II vii _ _._-_._._ _ - - I Overarching Governance and Infrastructure Principle Principle II Risk Data Aggregation Capabilities Principle Principle Principle Principle III Risk Reporting Practices Principle Principle Principle Principle 10 Principle 11 IV Supervisory Review, Tools and Cooperation Principle 12 Principle 13 Principle 14 209 210 211 211 211 212 212 212 213 214 214 215 215 215 215 216 14 GARP CODE OF CONDUCT 209 210 V Implementation Timeline and Transitional Arrangements 216 vi ii II Contents CHAPTER 219 Introduction 220 Code of Conduct 220 Principles Professional Standards Rules of Conduct 220 220 221 Professional Integrity and Ethical Conduct Conflict of Interest Confidentiality Fundamental Responsibilities General Accepted Practices 221 221 221 221 222 Applicability and Enforcement 222 Sample Exam QuestionsFoundations of Risk Management 225 Sample Exam Answers and ExplanationsFoundations of Risk Management 228 Index 231 2015 FRM COMMITTEE MEMBERS Dr Rene Stulz (Chairman) Ohio State University Dr Victor Ng Goldman Sachs & Co Richard Apostolik Global Association of Risk Professionals Dr Elliot Noma Garrett Asset Management Richard Brandt Citibank Dr Matthew Pritsker Federal Reserve Bank of Boston Dr Christopher Donohue Global Association of Risk Professionals Liu Ruixia Industrial and Commercial Bank of China Herve Geny London Stock Exchange Dr Til Schuermann Oliver Wyman Keith Isaac, FRM® TO Bank Nick Strange Bank of England, Prudential Regulation Authority Steve Lerit, CFA UBS Wealth Management Serge Sverdlov Redmond Analytics William May Global Association of Risk Professionals Alan Weindorf Visa Michelle McCarthy Nuveen Investments ix SAMPLE EXAM QUESTIONS-FOUNDATIONS OF RISK MANAGEMENT The efficient frontier is defined by the set of portfolios that, for each volatility level, maximizes the expected return According to the capital asset pricing model (CAPM), which of the following statements are correct with respect to the efficient frontier? A The capital market line always has a positive slope and its steepness depends on the market risk premium and the volatility of the market portfolio B The capital market line is the straight line connecting the risk-free asset with the zero beta minimum variance portfolio C Investors with the lowest risk aversion will typically hold the portfolio of risky assets that has the lowest standard deviation on the efficient frontier D The efficient frontier allows different individuals to have different portfolios of risky assets based upon their individual forecasts for asset returns A high net worth investor is monitoring the performance of an index tracking fund in which she has invested The performance figures of the fund and the benchmark portfolio are summarized in the table below: What is the tracking error of the fund over this period? A 0.09% B l10% C 3.05% D 4.09% Suppose that the correlation of the return of a portfolio with the return of its benchmark is 0.8, the volatility of the return of the portfolio is 5%, and the volatility of the return of the benchmark is 4% What is the beta of the portfolio? A lOO B 0.64 C.0.80 D -lOO Sample Exam Questions-Foundations of Risk Management • 225 In characterizing various dimensions of a bank's data, the Basel Committee has suggested several principles to promote strong and effective risk data aggregation capabilities Which statement correctly describes a recommendation which the bank should follow in accordance with the given principle? A The integrity principle recommends that data aggregation should be completely automated without any manual intervention B The completeness principle recommends that a financial institution should capture data on its entire universe of material risk exposures C The adaptability principle recommends that a bank should frequently update its risk reporting systems to incorporate changes in best practices D The accuracy principle recommends that the risk data be reconciled with management's estimates of risk exposure prior to aggregation Which of the following is not necessarily considered a failure of risk management? A Incorrect measurement of known risks B Failure in communicating risk issues to top management C Failure to minimize losses on credit portfolios D Failure to use appropriate risk metrics Which of the following is a common attribute of the collapse at both Metallgesellschaft and Long-Term Capital Management (LTCM)? A Cash flow problems caused by large mark to market losses B High leverage C Fraud D There are no similarities between the causes of the collapse at Metallgesellschaft and LTCM Portfolio A has an expected return of 8%, volatility of 20%, and beta of 0.5 Assume that the market has an expected return of 10% and volatility of 25% Also, assume a risk-free rate of 5% What is Jensen's alpha for portfolio A? A.0.5% B 1.0% C.10% D 15% According to the Capital Asset Pricing Model (CAPM), over a single time period, investors seek to maximize their: A wealth and are concerned about the tails of return distributions B wealth and are not concerned about the tails of return distributions C expected utility and are concerned about the tails of return distributions D expected utility and are not concerned about the tails of return distributions 226 • Financial Risk Manager Exam Part I: Foundations of Risk Management Gregory is analyzing the historical performance of two commodity funds tracking the Reuters/Jefferies-CRB@ Index (CRB) as benchmark He collated the data on the monthly returns and decided to use the information ratio (IR) to assess which fund achieved higher returns more efficiently and presented his findings What is the information ratio for each fund, and what conclusion can be drawn? = I= A IR for Fund I 0.212, IR for Fund II B IR for Fund 0.212, IR for Fund II = 0.155; = 0.155; Fund II performed better as it has a lower IR Fund I performed better as it has a higher IR C IR for Fund I = 0.248, IR for Fund II = 0.224; Fund I performed better as it has a higher IR D IR for Fund I = 0.248, IR for Fund II = 0.224; Fund II performed better as it has a lower IR 10 An analyst is estimating the sensitivity of the return of stock A to different macroeconomic factors He prepares the following estimates for the factor betas: I3lndustrial production ;,= 1.3 l3interest rate = -0.75 Under baseline expectations, with industrial production growth of 3% and an interest rate of 1.5%, the expected return for Stock A is estimated to be 5% The economic research department is forecasting an acceleration of economic activity for the following year, with GDP forecast to grow 4.2% and interest rates increasing 25 basis points to 1.75% What return of Stock A can be expected for next year according to this forecast? A.4.8% B 6.4% C.6.8% D.7.8% Sample Exam Questions-Foundations of Risk Management III 227 SAMPLE EXAM ANSWERS AND EXPLANATIONSFOUNDATIONS OF RISK MANAGEMENT Answer: A Explanation: The capital market line connects the risk-free asset with the market portfolio, which is the efficient portfolio at which the capital market line is tangent to the efficient frontier The equation of the capital market line is as follows: - R =R + e F RM -R Fa e aM where the subscript e denotes an efficient portfolio Since the shape of the efficient frontier is dictated by the market risk premium, (RM - R F ), and the volatility of the market, the slope of the capital market line will also be dependent on these two factors Answer: C Explanation: Relative risk measures risk relative to a benchmark index and measures it in terms of tracking error or deviation from the index We need to calculate the standard deviation (square root of the variance) of the series: {O.OS, 0.04, 0.02, 0.01, 0.005} Perform the calculation by computing the difference of each data point from the mean, square the result of each, take the average of those values, and then take the square root This is equal to 3.04% Answer: A Explanation: The following equation is used to calculate beta: ~ = p a(portfolio) = O.S * 0.05 = lOO a(benchmark) where p represents the correlation coefficient and 0.04 (J' the volatility Answer: B Explanation: The completeness principle recommends that a bank be able to capture and aggregate all data on the material risks to which it is exposed across the organization This will allow it to identify and report risk exposures, concentrations, and set exposure limits Answer: C Explanation: A failure to minimize losses on credit portfolios is not necessarily a failure of risk management The firm may have used prudent risk management and decided that the potential rewards from entering into the credit agreements adequately compensated the firm for the risks taken It could also have ignored the advice of its risk managers to attempt to minimize its credit losses Either way, this is not necessarily a failure of risk management 228 II Financial Risk Manager Exam Part I: Foundations of Risk Management Answer: A Explanation: Metallgesellschaft and Long Term Capital Management (LTCM) dealt in the derivatives market in huge quantities, and both experienced a cash flow crisis due to the change in economic conditions This led to huge mark-to-market losses and margin calls Answer: A Explanation: The Jensen measure of a portfolio, or Jensen's alpha, can be calculated using the following equation: fXp = E(Rp) - RF - f3[E(R M ) - RFJ In this example, fXp = 8% - 5% - 0.5 * (10% - 5%), or 0.5% Answer: D Explanation: CAPM assumes investors seek to maximize the expected utility of their wealth at the end of the period, and that when choosing their portfolios, investors only consider the first two moments of the return distribution: the expected return and the variance Hence, investors are not concerned with the tails of the return distribution Answer: B Explanation: The information ratio may be calculated by either a comparison of the residual return to residual risk or the excess return to tracking error The higher the IR, the better 'informed' the manager is at picking assets to invest in Since neither residual return nor risk is given, only the latter is an option IR = E(Rp - Rb)/Tracking Error For Fund I: IR = 0.00073/0.00344 = 0.212; For Fund II: IR = 0.00053/0.00341 = 0.155 10 Answer: B Explanation: The expected return for Stock A equals the expected return for the stock under the baseline scenario, plus the impact of "shocks," or excess returns of, both factors Since the baseline scenario incorporates 3% industrial production growth and a 1.5% interest rate, the "shocks" are 1.2% for the GDP factor and 0.25% for the interest rate factor Therefore the expected return for the new scenario = Baseline scenario expected return f3lndustrial production or 5% * Industrial production shock + f3interest rate + * Interest rate shock + (1.3 * 1.2%) + (-0.75 * 0.25%) = 6.37% Sample Exam Questions-Foundations of Risk Management • 229 ABS CDOs, 128-129, 130, 131, 132 accrual accounting, 20 accuracy data quality and, 199 risk data aggregation and, 211 risk reporting and, 212-213 actuarial approach, 171 adaptability, risk data aggregation and, 212 adjustable rate mortgages (ARMs), 124 Adoboli, Kweku, 112 agency costs, 131 agency risk, 29, 44 Allen, Steven, 101-121 Allied Irish Bank (AlB), 103, 106-108 alternative risk transfer (ART), 67 Amenc, Noel, 163-174 amortized cost accounting, 20 Anti-Kickback Statute, 198 arbitrage defined,180 executing, 183-184 regulatory, 131 arbitrage activity, 180 arbitrage pricing theory (APT) arbitrage, risk arbitrage, equilibrium and, 180-181 CAPM and, 185-186 diversification and residual risk, 182 executing arbitrage, 183-184 to find cost of capital, 190 multifactor, 188-189 no-arbitrage equation of, 184-185 portfolio optimization in single-index market and, 186-188 well-diversified portfolios, 181-182 arbitrageurs, 181 Arthur Andersen, 119 Askin, David, 112 Askin Capital Management, 112 asset-backed securities (ABS), 126-129 Association of Certified Fraud Examiners Report to the Nation (2006),197-198 audit committee, 47 available for sale (AFS), 20 backwardation, 37 Bank Secrecy Act, 197 Bankers Trust (BT), 117-118 banking, types of risk in, 22 banking book, 20, 131 bankruptcy risk, 16 Banziger, Hugo, 64, 109 Barings Bank, 103,105-106 Basel Committee on Banking Supervision, 205-216 Basel II Accord, 19, 197 Basel III reforms, 43 basis risk, 15 BBB bonds, 130, 132 BBB tranche, 130, 132 beta risk, 28 board composition, corporate governance and, 44 board directors, risk recommendations for, 94-96 board risk oversight, corporate governance and, 44 Bodie, Zvi, 177-192 Brown, Stephen J., 149-160 Buehler, Kevin, 64-65 business impact view, 201 business impacts, of poor data quality, 196-197 business performance, ERM and, 61-62 business planning, risk appetite and, 88-91 business process view, 201 business risk, 19, 21, 22 business unit mandate, obtaining approval of, 51 Cabiallavetta, Mathis, 108 capital asset pricing model (CAPM), 28 applying to performance measurement, 164-174 APT, and, 185-186 prices and, 156-157 rigorous approach to, 155-156 simple approach to, 151-155 underlying assumptions, 150-151 capital market line, 152 capital markets activities, 22 capital planning, risk appetite and, 90 Cernauskas, Deborah, 195-202 Chase Manhattan Bank/Drysdale Securities, 103-104 Chicago Board of Trade (CBOT), 35-36 Chicago Board Options Exchange (CBOE), 35 Chicago Mercantile Exchange (CME), 36 chief risk officer (CRO), 45, 52, 63-65 Citigroup, 118-119, 130 clarity, risk reporting and, 214 cliff risk, 130 Code of Conduct, GARP, 220-221 collateralized debt obligations (CDOs), 127-129 Committee of Sponsoring Organizations of the Treadway Commission (COSO), 61 Committee on Market Best Practices (CMBP), 75-76 commodity price risk, 16 communication failures, 142 compensation, corporate governance and, 44 compensation committee, 49-50 completeness data quality and, 199 risk data aggregation and, 211 compliance risk, 196, 198 comprehensiveness, risk reporting and, 213 concentration risks, 18 confidence levels, confidence-based impacts, of data quality, 196 consistency, data quality and, 199 contango, 37 corporate governance committees and risk limits, 46-50 ERM and, 66 limits and limit standards policies, 52-53 overview, 42-45 role of audit function, 54-56 roles and responsibilities, 50-52 Sarbanes-Oxley Act (SOX), 42 standards for monitoring risk, 53-54 true risk governance, 45-46 corporate risk management constructing and implementing a strategy, 36-37 determining the objective, 31, 33-34 dynamic strategies that failed, 37 hedging operations vs hedging financial positions, 30-31 instruments for, 34-36 mapping the risks, 34 overview, 28 performance evaluation, 37-38 reasons not to manage risk, 28-29 reasons to manage risk, 29-30 credit cards, 22 credit default swaps (CDS), 17, 143 credit derivatives, 17 credit events, defined, 17 credit risk, 10, 16-18, 198 232 III Index credit risk assessment, 197 Crosby, James, 64 Crouhy, Michel, 3-57 currency, data quality and, 199 currency risks, 34 Daiwa Bank, 111 data aggregation, ERM and, 67 data architecture, risk data aggregation and, 210 data governance (DG), 196 data quality compliance risk, 198 credit risk and, 198 development risk, 198 employee fraud and abuse, 197-198 expectations, 198-199 information flaws, 197 inspection, control, and oversight, 200 insurance exposure, 198 issues view, 201 managing via data quality scorecard, 201-202 mapping business policies to data rules, 200 other dimensions of, 199 poor, business impacts of, 196-197 underbilling and revenue assurance, 198 data quality scorecard, 200 De Angelis, Anthony, 103 default risk, 16 default-rate risk, delegation process, for market risk authorities, 51 Department of Defense Guidelines on Data Quality, 197 Deutsche Bank, 109, 118 development risk, 198 distribution, risk reporting and, 215 diversification, residual risk in practice and, 182, 183 Dodd-Frank Act, 23-24 downgrade risk, 17 Drysdale Securities, 103-104 Economist Intelligence Unit (EIU), 21 efficient frontier, 151, 152 efficient portfolios, 152 Eliot, T S., 206 Elton, Edwin J., 149-160 employee fraud and abuse, 197-198 Enron, 118-119 enterprise risk management (ERM) benefits of, 61-63 chief risk officer (eRO) and, 63-65 components of, 65-68 definitions, 61 overview, 60 enterprise-wide risk management (ERM), 11 Equator Principles, 23 equilibrium, arbitrage, risk arbitrage, and, 180-182 equity price risk, 15 equity tranche, 126-127 exchange-traded financial instruments, 35 expected loss (EL), factor betas, 179 factor loadings, 179 factor portfolio, 188 Fama-French (FF) three-factor model, 189-191 Federal Reserve Bank, 136 Federal Reserve Board, 4, 130 Feldman, Matthew, 64 financial disasters Allied Irish Bank (AlB), 106-108 Bankers Trust (BT), 117-118 Barings Bank, 105-106 Chase Manhattan Bank/Drysdale Securities, 103-104 Citigroup, 118-119 due to conduct of customer business, 117-119 due to large market moves, 112-117 due to misleading reporting, 102-112 Enron, 118-119 JPMorgan, 118-119 Kidder Peabody, 104-105 Long-Term Capital Management (LTCM), 112-116 Metallgesellschaft (MG), 116-117 Societe Generale, 109-111 Union Bank of Switzerland (UBS), 108-109 financial impacts, of data quality, 196 Financial Stability Board (FSB), 206 Financial Stability Oversight Council (FSOC), 23-24 flight to quality, 23 foreign currency risk management, 32 foreign exchange risk, 15-16 frequency, risk reporting and, 214 funding liquidity risk, 18-19 Galai, Dan, 3-57 GARP Code of Conduct, 220-221 Rules of Conduct, 221-222 General Electric, 104 Gibson Greetings, 117-118 Giescke, Henning, 110 global systemically important banks (G-SIBs), 206, 208 Goetzmann, William N., 149-160 governance, risk data aggregation and, 209-210 Graham-Leach-Bliley Act (1999), 197 Granite Capital, 112 Greenspan, Alan, 4-5, 130 Gruber, Martin J., 149-160 Hamanaka, Yasuo, 111-112 hedging, operations vs financial positions, 30-31 Heisenberg Principle, 144 home/host cooperation, risk data aggregation, risk reporting, and,216 Hull, John C., 123-133 human factor risk, 19 Iguchi, Toshihida, 111 incentives, mortgage lenders and, 131 increased risk, 16 incremental VaR (IVaR), 171 index model, APT, CAPM, and, 185-188 information collection, 140-141 information flaws, 197 information ratio, 168-169, 174 Institute of Internal Auditors (IIA), 55 Institute of International Finance (lIF), 71-98 insurance exposure, 198 integrity, risk data aggregation and, 211 interest rate risk, 15 interest rate risk management, 32 International Finance Corporation (IFC), 23 International Monetary Market (IMM), 36 International Organization of Standardization (ISO), 61 International Professional Practices Framework (IPPF), 55 International Securities Exchange (ISE), 35 International Swaps and Derivatives Association (ISDA), 17 IT infrastructure, risk data aggregation and, 210 Jensen measure, 165, 166, 167-168 Jett, Joseph, 103, 104-105 JPMorgan Chase, 118-119 Kahneman, Daniel, 12 Kane, Alex, 177-192 Kerviel, Jerome, 109-111 Kidder Peabody, 103, 104-105 King, Mervyn, Knight, Frank, Lam, James, 59-68 Law of One Price, 180 Le Sourd, Veronique, 163-174 Leeson, Nick, 103, 105-106 legal risk, 19 Leung, Mona, 64 "liar loans," 125 limits, corporate governance and, 52-53 line management, ERM and, 66 liquidity risk, 18-19, 20 London Interbank Offered Rate (LlBOR), 113 Long-Term Capital Management (LTCM), 5, 108-109, 112-116, 136-138 loss given default (LGD), 18 Lynch, Gary, 105 M&M analysis, 28 Marcus, Alan, 177-192 margin call, 23 Mark, Robert, 3-57 market risk, 10 commodity price risk, 16 equity price risk, 15 foreign exchange risk, 15-16 interest rate risk, 15 overview, 14-15 Index III 233 Merck,32 Merrill Lynch, 112, 129, 130 Metallgesellschaft (MG), 116-117 Metallgesellschaft Refining & Marketing, Inc (MGRM), 36, 37, 116-117 Mezz ABS CDO, 128-129, 132 mezzanine tranche, 126-127 Miller, Merton, 28 minimum acceptable return (MAR), 169 Modigliani, Franco, 28 Modigliani and Modigliani measure, 173, 174 Morgan Grenfell Asset Management, 119 Morningstar rating system, 169-171 mortgage banking, 22 mortgage lending practices, 124-126 multifactor models, 178-180 arbitrage pricing theory (APT), 188-189 Fama-French (FF) three-factor model, 189-191 of security returns, 178-180 Muralidhar measure, 174 National Westminster Bank, 112 "NINJA" borrowers, 125 no-arbitrage equation, of APT, 184-185 Nokia, 22 non-recourse mortgages, 125 NTL,198 Observations on Developments in Risk Appetite Frameworks and IT Infrastructure (SSG), 72, 76 one-factor capital asset pricing model, 156-157 operational data governance, 200 operational risk, 10, 19 organizational effectiveness, ERM and, 61 organizational risk, business impacts, data quality, and, 196-197 overcollateralization, 129 over-the-counter financial instruments, 35 Paine Webber, 104 Palm, 21 parallel shifts, 15 performance evaluation, risk management and, 37-38 performance management, risk appetite and, 90 performance measurement information ratio, 168-169 Jensen measure, 165, 166, 167-168 recently developed risk-adjusted return measures, 169-174 relationships between different indicators and use of indicators, 165-166 Sharpe measure, 164-165, 166, 167 Sortino ratio, 169 tracking-error, 168 Treynor measure, 164, 166, 167 PMI (policies, methodologies, infrastructure) framework, 56 portfolio management, ERM and, 66-67 prices, CAPM and, 156-157 PricewaterhouseCoopers (PwC), 21, 198 Procter & Gamble (P&G), 117-118 • Index productivity impacts, of data quality, 196 Prudential-Bache Securities, 119 reasonableness, data quality and, 199 recovery rates, 18 recovery value, 18 recovery-rate risk, Reform in the Financial Services Industry: Strengthening Practices for a More Stable System (IIF), 72, 76 regulatory arbitrage, 131 regulatory risk, 19 remedial actions, risk data aggregation, risk reporting, and, 215-216 reputation risk, 21, 23 residual risk, diversification and, 182, 183 retail banking, 22 revenue assurance, 198 review, risk data aggregation, risk reporting, and, 215 reward, vs risk, 8-10 risk See also specific types defining, 5-8 ignored, 140 known, 139-140 modeling of, vs reward, 8-10 types of, 10 unknown, 141-142 risk advisory director, 47-48 risk aggregation, 93-94 risk analytics, ERM and, 67 risk appetite, 6, 33 articulation of statement, 83-84 benefits of, 87-88 capturing different risk types, 85-87 corporate governance and, 44, 45 defined,72 "driving down" into the business, 83-85 framework implementation challenges, 79-82 incorporating different risks into RAF, 85-87 introduction, 75-77 link with strategy and business planning process, 88-91 overview, 72-75 principal findings, 77-79 recommendations for firms, 94-98 risk culture and, 79, 82-83 stress testing and, 91-94 risk appetite framework (RAF), 72 risk arbitrage, arbitrage, equilibrium, and, 180-181 risk capacity, 72 risk committee, 50 risk culture, 79 defined,82 risk appetite and, 82-83 risk data aggregation capabilities, 210-212 defined, 207 introduction, 206-207 overarching governance and infrastructure, 209-210 risk exposures, 14-24 risk factors, 6, risk impacts, of data quality, 196 risk limits, 34 corporate governance and, 52-53 risk management business risk and, 19, 21, 22 corporate See corporate risk management corporate governance and See corporate governance credit risk and, 16-18 danger of names, 10-11 danger of numbers, 11-12 definition of risk, 5-8 failures in See risk management failures legal and regulatory risk and, 19 liquidity risk and, 18-19, 20 market risk and, 14-16 operational risk and, 19 overview, 4-5 past and future of, 13-14 process, recommendations for, 97-98 reputation risk and, 21, 23 risk manager's job, 12-13 risk vs reward, 8-10 strategic risk and, 21, 22 systematic risk and, 23-24 ups and downs in, 13 risk management committee, 48-49 risk management failures abstract, 136 communication failures, 142 ignored known risks, 140 Long-Term Capital Management (LTCM) and, 136-138 mismeasurement due to ignored risks, 140 mismeasurement of known risks, 139-140 mistakes in information collection, 140-141 in monitoring and managing risks, 142-144 risk measures and, 144-146 typology of, 138-146 unknown risks, 141-142 Risk Management Lessons from the Global Banking Crisis of 2008 (SSG), 72, 75, 76 risk measurement, failures in, 144-146 risk posture, 90, 91 risk reporting ERM and, 61 implementation timeline and transitional arrangement, 216 practices, 212-215 supervisory review, tools, and cooperation, 215-216 risk transfer, ERM and, 67 danger of numbers, 11-12 risk-adjusted performance (RAP), 173-174 risk-adjusted rating (RAR), 169, 171 risk-adjusted return on capital (RAROC), 12 business performance and, 63 Ristuccia, Henry, 64 rolling hedge strategy, 37 Royal Bank of Scotland, 112 Rules of Conduct, GARP, 221-222 Rusnak, John, 103, 106-108 S&P/Case-Shiller composite-10 index, 124 Salomon Brothers, 112 Sarbanes-Oxley, 197 Sarbanes-Oxley Act (SOX), 42 satisfaction impacts, of data quality, 196 scorecard views, 202 Securities and Exchange Commission (SEC), 28, 43 securitization ABS CDOs, 128-129 asset-backed securities (ABS), 126-127 defined, 126 security market line, 154, 158 security returns, factor models of, 178-180 self-reinforcing link, with risk culture, 82 senior management, risk recommendations for, 96-97 senior risk committee, 50 Senior Supervisors Group (SSG), 72, 75, 76 senior tranche, 126-127 service-level agreements (SLAs), 200 settlement risk, 17-18 shape of the yield curve, 15 Sharpe, William, 28 Sharpe measure, 164-165, 166, 167, 173, 174 Sharpe-Lintner-Mossin form, 151 silo approach, 61 single-factor model, 178-179 single-index market, APT and portfolio optimization in, 186-188 single-index performance measurement indicators See under performance measurement Societe Generale, 109-111 Sortino ratio, 169 Spitzer, Eliot, 21 SRAP (style/risk-adjusted performance) measure, 172-173 stakeholder priority, corporate governance and, 44 stakeholders, ERM and, 67-68 standard capital asset pricing model (CAPM) See capital asset pricing model (CAPM) Steering Committee on Implementation (SCI), 72, 76 strategic planning, risk appetite and, 88-91 strategic risk, 21, 22 stress testing, risk appetite and, 81, 91-94 Stulz, Rene, 135-146 subprime mortgages, 132 Sumitomo Corporation, 111-112 supervisory measures, risk data aggregation, risk reporting, and, 215-216 system development risks, 197 systematic risk, 23-24, 28 Tarantino, Anthony, 195-202 technology, ERM and, 67 technology risk, 19 The Rock (Eliot), 206 Index III time diversification, 18 timeliness, risk data aggregation and, 211-212 tracking portfolio, 188 tracking-error, 168 trading book, 20, 131 trading liquidity risk, 18-19 tranches, 126-127 Treynor measure, 164, 166, 167 Treynor-Black (T-B) procedure, 186-188 t-statistic, 168 two mutual fund theorem, 152 2007 credit crisis the crisis, 130 factors contributing to, 130-131 lessons from, 131-132 securitization, 126-130 U.S housing market, 124-126 underbilling, 198 unexpected loss (UL), UniCredit Group, 110 Union Bank of Switzerland (UBS), 108-109, 112, 130 • Index uniqueness, data quality and, 199 U.S Federal Reserve Board, USA PATRIOT Act, 197 usefulness, risk reporting and, 214 value accounting, 20 value-at-risk (VaR) analysis based on, 171-172 business performance and, 63 risk management and, 7-8 risk management failures and, 145 wealth management, 22 well-diversified portfolios, 181-182, 186 Working Group on Risk Appetite (WGRA) (SCI), 72, 77 World Bank, 23 Yankowski, Carl, 21 yield curve, shape of, 15 zero expected value, 178 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 ... Capabilities Principle Principle Principle Principle III Risk Reporting Practices Principle Principle Principle Principle 10 Principle 11 IV Supervisory Review, Tools and Cooperation Principle... Market risk and credit risk are referred to as financial risks In this figure, we've subdivided market risk into equity price risk, interest rate risk, foreign exchange risk, and commodity price risk. .. April 2007 Financial Risk Manager Exam Part I: Foundations of Risk Management Interest Rate Risk The simplest form of interest rate risk is the risk that the value of a fixed-income security will