CFA 2018 r27 risk management

Level III Risk Management www.ift.world Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Contents Introduction Risk Management as a Process Risk Governance Identifying Risks Measuring Risk Managing Risk www.ift.world Introduction • Portfolio manager needs to understand risk management as it relates to his firm • He should also understand the risk management process of firms where he invests • Important questions related to risk management: www.ift.world Risk Management as a Process www.ift.world www.ift.world www.ift.world Risk Governance • Risk governance is an element of corporate governance • Risk governance is the process of setting overall policies and standards in risk management • Centralized vs decentralized risk governance  Decentralized: risk management by those who understand the risks well  Centralized: offsetting of risk exposures; bring risk management closer to senior management • Centralized risk management is now called enterprise risk management (ERM) www.ift.world An effective risk management system incorporates the following steps www.ift.world www.ift.world www.ift.world 10 www.ift.world 48 Managing Risk 6.1 Managing Market Risk 6.2 Managing Credit Risk 6.3 Performance Evaluation 6.4 Capital Allocation 6.5 Psychological and Behavioral Considerations www.ift.world 49 6.1 Managing Market Risk • Identify sources of market risk and define how these risks will be measured; set appropriate risk tolerance levels and identify corrective action if actual risk is outside tolerance levels • Risk budgeting focuses on where to take risk and efficient allocation of risk      FX desk: allocated capital = 100 mm and permitted daily VAR = mm Fixed income desk: allocated capital = 200 mm and permitted daily VAR = mm FX profit = 20 mm and fixed income profit = 25 mm Fixed income did better on VAR allocation; FX did better on capital allocation Risk and capital are finite resources and must be allocated carefully • Sum of risk budgets for individual units typically exceeds risk budget for organization because of diversification effect www.ift.world 50 Example 10: Fund Management Company and Risk Budgeting www.ift.world 51 www.ift.world 52 6.2 Managing Credit Risk • Credit risk is one sided and returns are not symmetric  not easily measured using standard deviation and VAR • Reduce credit risk by limiting exposure  Limiting exposure to a given party is the primary means of managing credit risk  Banks have regulatory constraints on the amount of credit risk they can assume • Reduce credit risk by marking to market  Futures contracts typically require daily mark to market  Concept can be applied in OTC market www.ift.world 53 www.ift.world 54 Managing Credit Risk (Cont…) • Reduce credit risk with collateral  Futures markets require that all participants post collateral  Many OTC derivative markets have collateral posting provisions • Reduce credit risk with netting  Payment netting reduces amount of money that must be paid • Reduce credit risk with minimum credit standards and enhanced derivative product companies (EDPC) Dealer with multiple lines of business End User www.ift.world 55 Managing Credit Risk (Cont…) • Credit derivatives can be used to transfer risk to another party  Credit default swap  Total return swap  Credit spread option (yield spread)  Credit spread forward (yield spread) www.ift.world 56 6.3 Performance Evaluation Risk adjusted return: measure performance against the risks that are taken Sharpe Ratio Risk Adjusted Return on Capital (RAROC) Return over Maximum Drawdown (RoMAD) Sortino Ratio www.ift.world 57 What is the standard complaint about standard deviation? www.ift.world 58 MAR is the minimum acceptable return www.ift.world 59 6.4 Capital Allocation Risk management is an important component in the process of allocating capital across units of a risk taking enterprise; capital allocation methods include: Methodology Comment Nominal, Notional or Monetary Position Limits Enterprise defines capital for each business unit Simple and allows us to calculate percentage return on capital allocated Does not capture effects of correlation and offsetting risks Individual may be able to work around limits VAR-Based Position Limits Use VAR limit as alternative or supplement to notional limit Limit regime only as effective as VAR calculation Relation between overall VAR and individual VARs is complex Maximum Loss Limits Establish maximum loss limit for each risk-taking unit Internal Capital Requirements Specify level of capital that will be appropriate for the firm Example: Enough capital such that probability of insolvency over 1-year is 0.01 Regulatory Capital Requirements Many institutions such as banks and security firms must calculate and meet regulatory capital requirements www.ift.world 60 6.4 Psychological and Behavioral Considerations www.ift.world 61 Conclusion • Examples • Summary • Practice Problems • Learning Objectives www.ift.world 62 ... Decentralized: risk management by those who understand the risks well  Centralized: offsetting of risk exposures; bring risk management closer to senior management • Centralized risk management. .. Introduction Risk Management as a Process Risk Governance Identifying Risks Measuring Risk Managing Risk www.ift.world Introduction • Portfolio manager needs to understand risk management as... the risk management process of firms where he invests • Important questions related to risk management: www.ift.world Risk Management as a Process www.ift.world www.ift.world www.ift.world Risk