Pragya 1 - Foundations of Risk Management.pdf · GOVERNANCE, RISK MANAGEMENT & RISK TAKING Reading: René Stulz, “Governance, Risk Management and Risk-Taking in Banks,” Finance

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FRM 2017 Part 1

Book 1 – Foundations of Risk Management

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RISK MANAGEMENT-A HELICOPTER VIEW

Reading: The Essentials of Risk Management, 2nd Edition (Crouhy, Galai and Mark; McGraw-Hill, 2014)

1. Definitions:

a. Risk: Uncertainty regarding future losses

b. Risk Management: Sequence of activities aimed at reducing or eliminating potential losses

c. Risk Taking: Active assumption of incremental risk to generate incremental gains

d. Economic Capital: Capital required to cover potential losses

e. Expected Loss: Loss that may happen in normal course of business

f. Unexpected Loss: Loss that may happen outside of normal course of business

2. Risk Management Process

a. Identify Risks

b. Quantify and Estimate Exposure

c. Develop Risk mitigation strategy (Avoid, Transfer, Mitigate, Assume)

3. Challenges with Risk Mitigation Process:

a. For risk management to be beneficial, risk must be sufficiently dispersed in the economy

b. Risk Management can be thought of as a zero sum game

4. Risk Classification:

Risk

Market

Credit

Liquidity

Operational

Legal & Regulatory

Strategic and

Business

> Interest Rate > Equity Price > Foreign Exchange > Commodity

> Default > Bankruptcy > Downgrade > Settlement

> Funding Liquidity > Trading Liquidity

> Fraud, Error > IT, HR, Admin

CORPORATE RISK MANAGEMENT-A PRIMER

Reading: The Essentials of Risk Management, 2nd Edition (Crouhy, Galai and Mark; McGraw-Hill, 2014)

1. Disadvantages of Hedging

a. Most hedging theories assume perfect capital markets and no transaction costs or taxes

b. Derivative pricing is not likely to reflect all risk factors

c. All hedging strategies will incur some compliance costs such as for accounting and disclosure

2. Advantages of Hedging

a. Reducing volatility of future cash flows helps with cost of capital

b. May result in operational improvements like locking in a cost

c. Derivatives like IRS may be cheaper than buying insurance

3. Hedging Decisions (Board’s Role)

a. Communicate the firms risk appetite qualitatively and quantitatively

b. Ensure that goals stated are actionable and clear; goals are balanced between debt holders and

shareholders

c. Risk management goals need to be definitive in terms of time lines

4. Mapping Risks: Risks should be mapped to risk categories identified in the previous chapter

5. Hedging Operational and Pricing Risks

a. Pricing Risk: Cost of inputs is locked using forwards or futures

b. Foreign Exchange Risk: Revenue hedging or balance sheet exposures can be managed using forwards. It

needs to take into account the cost of hedging as well as revenue, exchange rate volatility and

correlations

c. Interest Rate Risk: Goal is to control net exposure to unfavorable movements in Interest rates.

6. Static vs. Dynamic Hedging: Static hedging entails initial one time creation of a hedge. Dynamic hedging requires

continuous adjustments to hedge position. Static is less expensive and time consuming but may not remain a

perfect hedge

7. Instruments: Exchange traded instruments cover only certain underlying and are standardized. OTC instruments

are privately traded between a bank and a firm and can be customized. OTC are less liquid and more difficult to

price.

8. Hedging operational risk covers items on the income statement while hedging financial risks covers items on the

balance sheet.

CORPORATE GOVERNANCE AND RISK MANAGEMENT

Reading: The Essentials of Risk Management, 2nd Edition (Crouhy, Galai and Mark; McGraw-Hill, 2014)

1. Definitions:

a. Agency Risk: Management has incentives to take greater risks in order to achieve higher remuneration

b. Risk Appetite: Reflects the tolerance of the firm i.e. how much risk can be pursued by a firm

2. Corporate Governance-Best Practices

a. Board should have majority of independent members

b. Board should be aware of agency risks

c. Board should maintain independence from management

3. Risk management-Best Practices

a. Board should demand substance over form i.e. economic performance over accounting performance

b. Board should setup an ethics committee

c. Board must provide approval to all major transactions

d. Board should have a risk committee in place

e. Risk committee must be separate from Audit committee

4. Risk Advisory Director: Risk Advisory Director would be a board member who is a risk specialist who attends

Risk and Audit committee meetings

5. Compensation Committee: Existence of agency risks necessitates board to implement a compensation

committee

WHAT IS ERM?

Reading: Enterprise Risk Management: From Incentives to Control, 2nd Edition (James Lam; John Wiley & Sons, 2014)

1. Definitions:

a. ERM: An integrated and centralized framework for risk management

b. Risk: Potential events that may affect the entity or achievement of entities objectives

2. Advantages of ERM:

a. Integration of Risk Organization: Factors in the interdependence of risks

b. Integration of Risk Transfer: Leads to consistent and better risk reporting, prevents over-hedging of risks

c. Integration of Business Process: Improved business performance through RAROC (Risk Adjusted Rate of

Capital)

3. Functions of CRO:

a. Reports to CEO or CFO

b. Dotted line to Board

c. Provides leadership for ERM

d. Develops policies including Risk appetite, on measuring and quantifying risks, setting risk limits and

developing risk systems

4. ERM Framework Components

ERM

Corporate Governance

Line Management

Portfolio Management

Risk TransferRisk Analytics

Data Resources

Stakeholder Management

GOVERNANCE, RISK MANAGEMENT & RISK TAKING

Reading: René Stulz, “Governance, Risk Management and Risk-Taking in Banks,” Finance Working Paper 427/2014, June 2014.

1. Definitions:

a. Good Risk: Risk which increase value of a firm.

2. Optimal Rating: If rating is AAA, banks have to give up many valuable risky projects. By targeting a specific

probability of default (e.g. For A rating, probability of default is 0.08%) the bank can achieve its desired level of

risk. This is also the framework recommended.

3. Risk Appetite:

a. It should specify the firm level VaR

b. VaR limits should depend on profitability of the risk taking unit

c. Marginal unit of risk should have the same expected profit across all units

4. Issue with granular limits of risk:

a. More granular limits for risk taking units make it harder for risk taking units to accumulate large un-

monitored pockets of risk. It also makes it more difficult to take advantage of good opportunities

without negotiation for relaxation of limits

b. Less granular limits help with taking advantage of good opportunities but can result in making it harder

to monitor risks

FINANCIAL DISASTERS

Reading: Financial Disasters (Chapter 4, Steve Allen, Financial Risk Management: A Practitioner’s Guide to Managing

Market and Credit Risk, 2nd Edition (New York: John Wiley & Sons, 2013))

1. Chase Manhattan and Drysdale Securities: Misleading or misreporting risks

In three months of 1976, Drysdale Government Securities, a newly founded subsidiary of an established firm, succeeded

in obtaining unsecured borrowing of about $300 million by exploiting a flaw in the market practices for computing the

value of U.S. government bond collateral. This unsecured borrowing exceeded any amount Drysdale would have been

approved for, given that the firm had only $20 million in capital. To save time and effort, borrowed securities were

routinely valued as collateral without accounting for accrued coupon interest. By seeking to borrow large amounts of

securities with high coupons and a short time left until the next coupon date, Drysdale could take maximum advantage

of the difference in the amount of cash the borrowed security could be sold for (which included accrued interest) and

the amount of cash collateral that needed to be posted against the borrowed security (which did not include accrued

interest). Drysdale used the borrowed money to take outright positions in bond markets. When the traders lost money

on the positions they put on, they lacked cash with which to pay back their borrowings. Drysdale went bankrupt, losing

virtually all of the $300 million in unsecured borrowings. Chase Manhattan absorbed almost all of these losses because it

had brokered most of Drysdale’s securities borrowings.

2. Kidder Peabody: Misleading or misreporting risks

Between 1992 and 1994, Joseph Jett, head of the government bond trading desk at Kidder Peabody, entered into a

series of trades that were incorrectly reported in the firm’s accounting system, artificially inflating reported profits.

When this was ultimately corrected in April 1994, $350 million in previously reported gains had to be reversed. A flaw

in accounting for forward transactions in the computer system for government bond trading failed to take into account

the present valuing of the forward. This enabled a trader purchasing a cash bond and delivering it at a forward price to

book an instant profit. Over the period between booking and delivery, the profit would inevitably dissipate, since the

cash position had a financing cost that was unmatched by any financing gain on the forward position. Although Jett’s

trades had not resulted in any actual loss of cash for Kidder, the announcement of such a massive misreporting of

earnings triggered a substantial loss of confidence in the competence of the firm’s management by customers and

General Electric, which owned Kidder. In October 1994, General Electric sold Kidder to PaineWebber, which dismantled

the firm.

3. Barings: Misleading or misreporting risks

The incident involved the loss of roughly $1.25 billion due to the unauthorized trading activities during 1993 to 1995 of a

single, relatively junior trader named Nick Leeson. Leeson, who was supposed to be running a low‐risk, limited return

arbitrage business for Barings in Singapore, was actually taking increasingly large speculative positions in Japanese

stocks and interest rate futures and options. He disguised his speculative position taking by reporting that he was taking

the positions on behalf of fictitious customers. By booking the losses to these nonexistent customer accounts, he was

able to manufacture fairly substantial reported profits for his own accounts, enabling him to earn a $720,000 bonus in

1994. The size of the losses relative to Barings Bank’s capital along with potential additional losses on outstanding trades

forced Barings into bankruptcy in February 1995.

4. Allied Irish Bank: Misleading or misreporting risks

John Rusnak, a currency option trader in charge of a very small trading book in AIB’s Allfirst First Maryland Bancorp

subsidiary, entered into massive unauthorized trades during the period 1997 through 2002, ultimately resulting in $691

million in losses. Rusnak was supposed to be running a small arbitrage between foreign exchange (FX) options and FX

spot and forward markets. He was actually running large outright positions and disguising them from management. He

invented imaginary trades that offset his real trades, making his trading positions appear small. He persuaded back‐

office personnel not to check these bogus trades. He obtained cash to cover his losses by selling deep‐in‐the‐money

options, which provided cash up front in exchange for a high probability of needing to pay out even more cash at a later

date, and covered up his position by offsetting these real trades with further imaginary trades. He entered false

positions into the firm’s system for calculating value at risk (VaR) to mislead managers about the size of his positions.

5. Union Bank of Switzerland: Misleading or misreporting risks

This incident involves losses of between $400 million and $700 million in equity derivatives during 1997, which appear to

have been exacerbated by lack of internal controls. A loss of $700 million during 1998 was due to a large position in

long‐Term Capital Management (LTCM). Less is known about the UBS disaster than the other incidents discussed in this

chapter. Even the size of the losses has never been fully disclosed. Considerable controversy exists about whether the

1997 losses just reflected poor decision making or unlucky outcomes or whether an improper control structure led to

positions that management would not have authorized. The 1998 losses were the result of a position that certainly had

been approved by the UBS management, but evidence suggests that it failed to receive adequate scrutiny from the

firm’s risk controllers and that it was not adequately disclosed to the SBC management that took over the firm.

6. Société Générale: Misleading or misreporting risks

In January 2008, Société Générale reported trading losses of $7.1 billion that the fi rm attributed to unauthorized activity

by a junior trader, Jérôme Kerviel. Kerviel took very large unauthorized positions in equities and exchange‐traded

futures, beginning in July 2005 and ending when his concealment of positions was uncovered in January 2008. His

primary method for concealing these unauthorized positions was to enter fictitious transactions that offset the risk and

P&L of his true trades. The fictitious nature of these transactions was hidden mostly by creating transactions with

forward start dates and then, relying on his knowledge of when control personnel would seek confirmation of a forward‐

dated trade, canceling the trade prior to the date that confirmation would be sought (Kerviel had previously worked in

the middle office of the firm, which may have provided him with particular insight into the actions of control personnel).

The large loss severely damaged Société Générale’s reputation and required it to raise a large amount of new capital.

7. Long Term Capital Management(LTCM): Liquidity Risk

the basic investment philosophy of LTCM, which was to locate trading opportunities that represented what the partners

believed were temporary disruptions in price relationships due to short‐term market pressures, which were almost

certain to be reversed over longer time periods. To take advantage of such opportunities, they needed to know they had

access to patient capital that would not be withdrawn if markets seemed to be temporarily going against them. This also

helped to explain why LTCM was so secretive about its holdings. These were not quick in‐and‐out trades, but long‐term

holdings, and they needed to prevent other firms from learning the positions and trading against them. Dependence on

short‐term swings in valuation represented a potential Achilles’ heel for LTCM’s long‐term focused investment strategy.

Because the firm was seeking opportunities where market pressures were causing deviation from long‐run relationships,

a strong possibility always existed that these same market pressures would push the deviation even further. LTCM

wouldthen immediately need to come up with cash to fund the change in market valuation. This would not be a problem

if some of the trades were moving in its favor at the same time as others were moving against it, since LTCM would

receive cash on upswings in value to balance having to put up cash on downswings (again, the same structure as

exchange‐traded futures). However, if many of its trades were to move against it in tandem, LTCM would need to raise

cash quickly, either from investors or by cutting positions. In the actual events of August and September 1998, this is

exactly what led to LTCM’s rapid downfall. The initial trigger was a combination of the Russian debt default of August,

which unsettled the markets, and the June 1998 decision by Salomon Brothers to liquidate proprietary positions it was

holding, which were similar to many of those held by LTCM. The LTCM fund’s equity began to decline precipitously from

$4.1 billion as of the end of July 1998, and it was very reluctant to cut positions in a turbulent market in which any large

position sale could easily move the valuations even further against it. This left the option of seeking new equity from

investors. LTCM pursued this path vigorously, but the very act of doing so created two perverse effects. First, rumors of

LTCM’s predicament caused competitors to drive market prices even further against what they guessed were LTCM’s

positions, in anticipation of LTCM being forced to unload the positions at distressed prices. Second, to persuade

potential investors to provide new money in the midst of volatile markets, LTCM was forced to disclose information

about the actual positions it held. As competitors learned more about the actual positions, their pressure on market

prices in the direction unfavorable to LTCM intensified. By 2000, the fund had been wound down with the 14 creditors

having recovered all of the equity they had invested and having avoided any losses on the LTCM positions they had held

at the time of the bailout. This outcome lends support to two propositions: LTCM was largely right about the long‐term

values underlying its positions, and the creditors were right to see the primary problem as one of liquidity, which

required patience to ride out.

8. Metallgesellschaft (MG): Basis Risk

In 1992, an American subsidiary of MG, Metallgesellschaft Refining and Marketing (MGRM), began a program of

entering into long‐ term contracts to supply customers with gas and oil products at fixed costs and to hedge these

contracts with short‐term gas and oil futures. The futures being used to hedge were exchange‐traded instruments

requiring daily cash settlement. The long‐term contracts with customers involved no such cash settlement. So no matter

how effective the hedging strategy was, the consequence of a large downward move in gas and oil prices would be to

require MGRM to pay cash against its futures positions that would be offset by money owed to MGRM by customers

who would be paid in the future. In 1993, when a large decrease in gas and oil prices had resulted in funding needs of

around $900 million, the MG parent responded by closing down the futures positions, leaving unhedged exposure to gas

and oil price increases through the customer contracts.

9. Bankers Trust: Conduct of customer business

BT was sued by Procter & Gamble (P&G) and Gibson Greetings. Both P&G and Gibson claimed that they had suffered

large losses in derivatives trades they had entered into with BT due to being misled by BT as to the nature of the

positions. These were trades on which BT had little market or credit risk, since it had hedged the market risk on them

with other derivatives and there was no credit issue of P&G or Gibson being unable to pay the amount they owed. it was

quite clear that the exact nature of the structures hadn’t been tailored to meet client needs, why had BT utilized so

complex a design? The most probable reason was that the structures were designed to be complex enough to make it

difficult for clients to comparison shop the pricing to competitor firms. However, this also made the clients highly

dependent on BT on an ongoing basis. If they wanted to unwind the position, they couldn’t count on getting a

competitive quote from another firm.

10. JPMorgan, Citigroup and Enron: Conduct of customer business

Enron sold oil for future delivery, getting cash, and then agreed to buy back the oil that it delivered for a fixed price. So,

in effect, no oil was ever delivered. When you canceled out the oil part of the trades, what was left was just an

agreement for Enron to pay cash later for cash it had received up front—in practice, if not in legal terms, a loan. The

advantage to Enron was that it did not have to report this in its public statements as a loan, making the firm appear

more desirable as an investment and as a borrower. JPMorgan Chase and Citigroup were Enron’s principal

counterparties on these trades. In the end, they agreed to pay a combined $286 million for “helping to commit a fraud”

on Enron’s shareholders.

LIQUIDITY CREDIT CRUNCH 2007-2008

Reading: Markus K. Brunnermeier, 2009. “Deciphering the Liquidity and Credit Crunch 2007—2008,” Journal of Economic

Perspectives 23:1

1. Definitions:

a. Credit Default Swaps (CDS): Insurance contracts that pay off in the event of the default of a bond or a

tranche

b. Funding Liquidity: Ability of an institution to settle its obligations when they are due or risk that buyers

of commercial paper stop buying it preventing SIV from rolling over short term debt

c. Market Liquidity: Ease with which an asset can be sold without having to lower the price to attract a

buyer

d. Liquidity backstop: Liquidity provider (a bank) acts as a buyer of last resort thus injecting liquidity into

the SIV

e. Loss spiral: Forced sale of an asset by a leveraged investor to maintain margin or leverage ratio

requirement

f. Margin Spiral: Forced sale of an asset because of an increase in margins or decline in leverage ratio.

Results in a lower overall position as compared to a loss spiral

g. TED Spread: Difference between LIBOR and US T-Bills. The long-term average of the TED spread has

been 30 basis points but during the crisis, it reached 457 basis points

2. Reasons for liquidity squeeze

a. Risk transfer through securitization

i. Structured products like CDO (Collateralized Debt Obligations), where underlying loans are

sliced into tranches (Equity, Mezzanine and Senior). This enables originating institution to

distance itself from default risk of the pool of assets

b. Asset liability maturity mismatch

i. Banks created SIV (Special Investment vehicles) to invest in the structured products. They raised

money by issuing short term commercial paper to fund long term assets giving rise to funding

liquidity risk

ii. Due to liquidity backstop, banks injected a lot of money into the SIV even though the SIV were

off-balance sheet items

FINANCIAL CRISIS: A ONE WEEKEND GUIDE

Reading: Gary Gorton and Andrew Metrick, 2012. “Getting Up to Speed on the Financial Crisis: A One-Weekend Reader’s

Guide,” Journal of Economic Literature

1. Definitions:

a. Asset Backed Commercial paper (ABCP): Any notes (issued by bank) that are backed by trade receivables

b. Bank Run: Depositors withdraw cash when they think bank is going to fail

c. Repos (Repurchase Agreements): Agreement to purchase an asset back some time in the future fir

borrowing against that asset and paying a repo rate for short term cash/ liquidity

d. ESI (Economic Stress Index): Confidence measures from business and consumers, non-financial stock

prices etc.

e. FSI (Financial Stress Index): Composite of stock prices, interbank spreads and bank credit

2. Pattern before financial crisis: Increased public and private debt, increased credit supply and increased housing

prices

3. Panic Period during the crisis:

a. August 2007: As housing prices decreased, homeowners started defaulting causing prices of ABCP to

decrease and cause a run on the money market mutual funds

b. September 2008: bankruptcy of Lehman brothers caused a major shock to all financial institutions

4. Government Policy Response:

a. Reduction in interest rates

b. Higher credit lines, longer funding terms etc. for liquidity

c. Recapitalization through capital injection

d. Liability guarantee through debt guarantee and depositor protection

e. Asset purchases

RISK MANAGEMENT FAILURES

Reading: René Stulz, “Risk Management Failures: What are They and When Do They Happen?” Fisher College of Business

Working Paper Series, (Oct 2008)

1. Large loss is not a risk failure: Deciding whether to take a known risk is not a decision for risk managers. The

decision depends on the risk appetite of an institution. However, defining the risk appetite is a decision for the

board and top management. That decision is at the heart of the firm’s strategy and of how it creates value for its

shareholders. A decision to take a known risk may turn out poorly even though, at the time it was made, the

expectation was that taking the risk increased shareholder wealth and hence was in the best interest of the

shareholders. As long as the risks were understood, it was not a Risk management failure. E.g. LTCM

2. How Risk management can fail: Two types of mistakes can be made in measuring risk: Known risks can be mis-

measured and some risks can be ignored, either because they are unknown or viewed as not material. Once

risks are measured, they have to be communicated to the firm’s leadership. A failure in communicating risk to

management is a risk management failure as well. Types of Risk Management failures can be classified as: A)

Mis-measurement of known risks. B) Failure to take risks into account. C) Failure in communicating the risks to

top management. D) Failure in monitoring risks. E) Failure in managing risks. F) Failure to use appropriate risk

metrics.

3. Risk Communication Failure: Risk management has to provide timely information to the board and top

management that enables them to make decisions concerning the firm’s risk and to factor the firm’s risk in their

decisions. In order for the board and the top management to understand the risk situation of the firm, this

situation has to be communicated to them in a way that they can understand properly. E.d Subprime

Communication being complex

4. Failure in monitoring and managing risks: Risk management is responsible for making sure that the firm takes

the risks that it wants to take and not others. As a result, risk managers must constantly monitor the risks the

firm is taking. E.g. Complex exposures to derivatives which invalidate even daily MTM

5. Risk Metrics: Relying on historical data alone for models and prediction of future values would not have helped

in cases such as LTCM. Also, VaR does not show catastrophic losses. Even if it predicts with 99% confidence that

losses would not exceed certain amount, it does not say how bad the loss 1% of the time can be. VaR also losses

meaning if there is market illiquidity as it assumes complete liquidity in market. Most existing models do no

capture crisis scenarios and how to survive such scenarios.

STANDARD CAPM

Reading: The Standard CAPM (Chapter 13, Edwin J. Elton, Martin J. Gruber, Stephen J. Brown and William N. Goetzmann,

Modern Portfolio Theory and Investment Analysis, 9th Edition (Hoboken, NJ: John Wiley & Sons, 2014)).

1. Standard CAPM: Standard Capital Asset Pricing Model provides a way to calculate an asset’s expected return

based on its level of systematic (Market) risk which is measured by Beta (β).

E(Rp) = Rf + βp (Rm - Rf)

E(Ri)=Expected Return on Asset i, Rf = Risk Free Rate, Rm = Return on Market portfolio and βi = Systematic Risk of Individual asset i

2. Assumptions of CAPM:

a) Investor can borrow and lend at risk free rate of return; b) All investors have same expectations of Risk and Return; c)

There is only a single period; d) There are no taxes or transactions costs

3. CML (Capital Market Line): The line connecting the risk free asset and Market portfolio.

The CML equation is very similar to the CAPM equation.

E(Rp) = Rf + (Rm−Rf

σm) σp

where the slope is the Sharpe Ratio of Market Return. Note that for the Sharpe

Ratio of an individual security, you need to replace Rm with Ri and

correspondingly change σm with σi in the bracket portion of the equation.

4. Beta (Systematic Risk of an Asset): Beta, also called the systematic risk of an asset, is defined as the level of risk

for which an investor must be compensated for an individual security. The Beta is defined as the slope of the

SML and can be approximated as β ≈ σp

σm⁄ . The actual formula for Beta is by

a. β = Covariancep.m

σm2

b. where Covariance p,m = (ρp,m x σp x σm)

Risk Premium

PORTFOLIO PERFORMANCE MEASUREMENT

Reading: Applying the CAPM to Performance Measurement: Single-Index Performance Measurement Indicators (Section

4.2 from Noel Amenc and Veronique Le Sourd, Portfolio Theory and Performance Analysis (West Sussex, England: John

Wiley & Sons, 2003))

1. Treynor Ratio: The Treynor Ratio is used to analyze whether portfolio risk is being appropriately rewarded. It is

given as (by re-arranging the terms of CAPM, term on the right of equation is Treynor Ratio):

a. E(Rm) – Rf = E(Rp) – Rf

βp

b. It is more appropriate for comparing a well-diversified portfolio as it uses systematic risk(βi)

2. Sharpe Ratio: The Sharpe ratio is defined as reward to variability ratio. It is defined as

Sp = E(Rp) – Rf

σp

a. Since this measure is based on the total risk, it enables the relative performance of portfolios that are

not very diversified to be evaluated, because the unsystematic risk taken by the manager is included in

this measure.

3. Jensen’s Alpha: It is defined as the differential rate of return on the portfolio compared to expected return as

per CAPM. It is defined as:

𝛼𝑝 = 𝑅𝑝 – [𝑅𝑓 + 𝛽𝑝 (𝑅𝑚 − 𝑅𝑓)]

a. The equation in the square brackets is that of CAPM or E(Ri). Testing for statistical significance of α can

give us whether the returns are due to luck or not

4. Tracking Error: Tracking error (Te) is the Standard Deviation of αp over a period of time. It is used to analyze

benchmarked funds and the fund manager is required to keep the tracking error below a minimum threshold.

5. Information Ratio: It allows us to check that the risk taken by the manager, in deviating from the benchmark, is

sufficiently rewarded. It is given as αp/ Te

6. Sortino Ratio: It is same as Sharpe ratio except that we replace Rf with some other minimum return Rmin. It is

given as E(Rp) – Rmin) / σp (σp only includes those values which are below the minimum return level)

APT

Reading: Arbitrage Pricing Theory and Multifactor Models of Risk and Return (Chapter 10, Zvi Bodie, Alex Kane, and Alan

J. Marcus, Investments, 9th Edition (New York: McGraw-Hill, 2010))

1. Multifactor Models: In CAPM, β summarized all the systematic risk due to all macro/micro variables. We can

decompose this into multiple factors, where β for each factor will measure specific factor risk. A general form of

multifactor models is given as:

a. E(Rp) = Rf + βpn (Factorn) + βpj (Factorj)+…

2. Law of One Price: It states that if two assets are equivalent in all economically relevant respects, then they

should have the same market price. The Law of One Price is enforced by arbitrageurs.

3. APT(Arbitrage Pricing Theory): APT is a multifactor model, wherein we use different portfolios and their

sensitivity to market returns i.e. it is based on arbitrage theory

a. E(Rp) = Rf + βpn (E(Rn) - Rf) + βpj (E(Rj) - Rf) + …

Where E(Rn) – Rf is the risk premium of that factor and βin is the sensitivity of i to that portfolio factor

4. Relationship between CAPM and APT: CAPM can be considered a special case of APT with just one factor i.e.

the Market Risk variable encapsulates all other factors.

5. Issues with APT: APT does not mention which factors are to be chose to approximate the systematic risk. Also,

it assumes that no arbitrage opportunities exist. It also makes other assumptions like CAPM that Unsystematic

risk can be completely diversified.

6. Passive and Active Investment Management:

a. Passive: It attempts to track an index as closely as possible by holding only a fraction of all securities in

the index. Fine tuning factors in APT can help achieve this

b. Active: It attempts to beat the benchmark by speculating on the future values of different factors in APT

and constructing portfolio accordingly

7. Fama-Fench Three Factor Model: One famous multifactor model is the Fama-Fench model. The model is stated

as Rp = Rf + βpm Rm + βpSMB SMB + βpHML HML

a. Where SMB is Small Minus Big (the return of a portfolio of small stocks in excess of the return

on a portfolio of large stocks. ) and HML is High Minus Low (the return of a portfolio of stocks

with a high book-to-market ratio in excess of the return on a portfolio of stocks with a low

book-to-market ratio)

EFFECTIVE DATA AGGREGATION AND RISK REPORTING

Reading: Principles for effective data aggregation and risk reporting (Basel Committee on Banking Supervision

Publication, January 2015)

1. Definitions:

a. Risk Data Aggregation: Defining, gathering and processing risk data according to the bank’s risk reporting requirements to enable the bank to measure its performance against its risk tolerance/ appetite.

2. Benefits of Data Aggregation

a. Increased ability to anticipate problems b. Enhanced ability to identify alternatives c. Improved resolvability in event of stress or failure d. Enhanced ability to make strategic decisions

3. Governance Principle (Principle 1): Risk data aggregation should be a part of banks overall risk management

framework.

4. Data Architecture and IT (Principle 2): Bank should design, build, and maintain data architecture and IT infrastructure which fully supports its risk data aggregation capabilities and risk reporting practices

5. Principles 3-6 specify standards and requirements for effective risk data aggregation. Banks should ensure that the data is accurate and has integrity (Principle 3), is complete (Principle 4), is timely (Principle 5), and is adaptable to the end user (Principle 6)

6. Principles 7-11 specify standards and requirements for effective risk reporting practices. Risk reports should be accurate (Principle 7), comprehensive (Principle 8), and clear and useful (Principle 9). Principle 10 states that reports should be “appropriately frequent” (i.e., frequency depends on the role of the recipient—board members need reports less frequently than risk committee members). Reports should be distributed to relevant parties in a timely fashion while maintaining confidentially (Principle 11)

GARP CODE OF CONDUCT

Reading: GARP Code of Conduct, 2010

1. Code of Conduct:

a. Integrity and Ethical Standards: Act

professionally, ethically and with Integrity in all

dealings. Maintain independence of thought and

direction. Do not knowingly misrepresent facts,

details relating to analysis etc. Be mindful of

cultural differences regarding ethical behavior and

customs

b. Conflict of Interest: Disclose actual or potential

conflict of interest to all affected parties

c. Confidentiality: Do not use confidential

information for personal benefit

d. Responsibilities: No overstating the accuracy or

certainty of results or conclusions. Disclose limits

of specific knowledge and expertise

e. Adherence to best practices: Execute work in a manner that is independent from interested parties.

Make distinction between fact and opinion.

2. Violations of Code: Violation(s) of this Code by may result in, among other things, the temporary suspension or

permanent removal of the GARP Member from GARP’s Membership roles, and may also include temporarily or

permanently removing from the violator the right to use or refer to having earned the FRM designation or any

other GARP granted designation, following a formal determination that such a violation has occurred.

Principles

Integrity

Ethical Standards

Conflicts of Interest

Confidentiality

Standards

Responsibilities

Adherence