15. Foundations of Risk Global Topic Review Questions

In January 2016, Basel (BCBS) published new capital requirements for market risk. The requirements included revised internal models approach (IMA) which replaces two value at risk metrics (ie, VaR and stressed VaR) with a single expected shortfall (ES). In terms of horizon and confidence level, the shift is from a 10-day 99.0% VaR to a 10-day 97.5%. According to Basel, "a shift from Value-at-Risk (VaR) to an Expected Shortfall (ES) measure of risk under stress. Use of ES will help to ensure a more prudent capture of 'tail risk' and capital adequacy during periods of significant financial market stress." Specifically, the new requirements specify the following minimum standards: "181. Banks will have flexibility in devising the precise nature of their models, but the following minimum standards will apply for the purpose of calculating their capital charge. Individual banks or their supervisory authorities will have discretion to apply stricter standards. (a) 'Expected shortfall' must be computed on a daily basis for the bank-wide internal model for regulatory capital purposes. Expected shortfall must also be computed on a daily basis for each trading desk that a bank wishes to include within the scope for the internal model for regulatory capital purposes. (b) In calculating the expected shortfall, a 97.5th percentile, one-tailed confidence level is to be used." In regard to value at risk (VaR) and expected shortfall (ES), each of the following is true EXCEPT which is not necessarily true? It is more difficult to backtest ES than to backtest VaR which is a disadvantage of ES Both VaR and ES are necessarily increasing with longer horizon and/or higher confidence level Given the same distribution, on a L(+)/P(-) scale where losses are positives, a 97.5% ES must be less than (ie, imply less capital required) than a 99.0% VaR In theory (ie, without regard to the new BCBS requirements), the calculation of either VaR or ES can be validly approached in any of the three methods: variance/covariance (aka, delta normal), historical simulation, or Monte Carlo

C. FALSE: Given the same distribution, on a L(+)/P(-) scale where losses are positives, a 97.5% ES must be less than (ie, imply less capital required) than a 99.0% VaR Expected shorfall is a conditional average. High loss amounts in the extreme tail (e.g., outliers) may not influence the VaR, which is a quantile, but will increase the expected shortfall. This reflects on a weakness of VaR: VaR does not incorporate information about losses in the extreme tail beyond the quantile. This is a key motivation for Basel's switch from VaR to ES. In regard to (A), (B) and (D), each is necessarily TRUE. In regard to true (A), ES is non-trivial to backtest, while VaR is rather easily tested by a binomial distribution due to the fact that actual exceptions (exceedences) are Bernoulli variables In regard to true (B), both VaR and ES are special cases of the general risk function. In regard to true (D), any approach that produces a probability distribution can be applied to VaR or ES because mathematically both are features of a probability distribution.

When approaching financial derivatives--e.g., stock options--which are common hedging instruments, there is a thematic distinction between valuation (a.k.a, pricing) and risk measurement. While the approaches to pricing and risk measurement often share much in common (e.g., risk factors), there are some key differences. Each of the following is true about a difference between valuation and risk measurement approaches EXCEPT which is NOT true? a) Risk measurement tends to estimate a distribution of future values, which derivatives valuation tends to compute a discounted expected present value (PV) b) Risk measurement is focused on distributional tails (and second or higher moments), while derivatives valuation is focused on the center of the distribution c) Risk measurement requires high precision, while derivatives valuation is satisfied with approximations d) Risk measurement prefers actual (aka, physical) distributions, while derivatives valuation prefers risk-neutral distributions

C. False, the reverse is true: derivatives valuation wants high precision for pricing purposes, while risk measurement is satisfied with approximations (consistent with the study of future distributional tails, we cannot expect precision!) In regard to (A), (B) and (D), each is TRUE.

I. The types and amount of risk, on a broad level, an organization is willing to accept in pursuit of value II. The maximum amount of risk that an entity is able to absorb in the pursuit of strategy and business objectives III. A process, effected by an entity's board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting, and compliance. IV. A composite view of the risk assumed at a particular level of the entity, or aspect of the business model that positions management to consider the types, severity, and interdependencies of risks, and how they may affect performance relative to its strategy and business objectives. V. The culture, capabilities, and practices, integrated with strategy-setting and its execution, that organizations rely on to manage risk in creating, preserving, and realizing value. Which sequence of terms correctly matches each term to its definition above? I. Risk Profile, II. is Enterprise Risk, III. is Inherent Risk, IV. is Risk Appetite, V. is Residual Risk I. is Enterprise Risk, II. is Residual Risk, III. is Risk Appetite, IV. is Risk Capacity, V. is Inherent Risk I. is Risk Appetite, II. is Risk Capacity, III. is Internal Control, IV. is Risk Profile, V. is Enterprise Risk I. is Internal Control, II. is Inherent Risk, III. is Risk Profile, IV. is Enterprise Risk, V. is Risk Appetite

C. I. is Risk Appetite, II. is Risk Capacity, III. is Internal Control, IV. is Risk Profile, V. is Enterprise Risk While not currently assigned in the FRM, COSO's draft ERM Framework is useful overview. The Executive Summary (14 pp) is here http://trtl.bz/1Y3hhZi and the full draft report (132 pp) is here http://trtl.bz/21ufutT. Key definitions include: Risk Appetite: The types and amount of risk, on a broad level, an organization is willing to accept in pursuit of value Risk Capacity: The maximum amount of risk that an entity is able to absorb in the pursuit of strategy and business objectives Internal Control: A process, effected by an entity's board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting, and compliance. Risk Profile: A composite view of the risk assumed at a particular level of the entity, or aspect of the business model that positions management to consider the types, severity, and interdependencies of risks, and how they may affect performance relative to its strategy and business objectives. Enterprise Risk: The culture, capabilities, and practices, integrated with strategy-setting and its execution, that organizations rely on to manage risk in creating, preserving, and realizing value. Also of potential interest is the oft-cited difference between inherent and residual risk: Inherent risk is the risk to an entity in the absence of any direct or focused actions by management to alter its severity. Target residual risk is the amount of risk that an entity prefers to assume in the pursuit of its strategy and business objectives, knowing that management will implement, or has implemented, direct or focused actions by management to alter risk severity Actual residual risk is the risk remaining after management has taken action to alter its severity. Actual residual risk should be equal to or less than the target residual risk, as is illustrated in Figure 8.5. Where actual residual risk exceeds target risk, additional actions should be identified that allow management to alter risk severity further.

After its first three years of earning almost 40% in annualized returns, Long-term Capital Management (LTCM) experienced a rapid downfall in August and September of 1998 triggered by the 1998 Russian financial crisis (which included Russia's default on its domestic debt and a moratorium on repayment of foreign debt). LTCM teetered on bankruptcy before it was rescued in a bailout. According to Steven Allen, which of the following is critical lesson learned from LTCM? Because it was a rescue of management and investors by the U.S. government, LTCM contributed to the perilous attitude that some firms are "too big to fail" (TBTF) The lack of transparency (information sharing) and tendency to promote key decisionmaking by individuals rather than groups enabled the emergence of rogue traders A simple calculation of LTCM's balance sheet leverage (assets to equity) would have demonstrated it was much too risky, especially in comparison to investment banks in 1998 LTCM should have relied on forward-looking stress tests (rather than backward-looking convergence patterns) that included a flight-to-quality scenario which might widen credit spreads and spikes in equity option implied volatility

D. TRUE: LTCM should have relied on forward-looking stress tests (rather than backward-looking convergence patterns) that included a flight-to-quality scenario which might widen credit spreads and spikes in equity option implied volatility. Allen: "A lesson that all market participants have learned from the LTCM incident is that a stress scenario is needed to look at the impact of a competitor holding similar positions exiting the market, as when Salomon decided to cut back on proprietary trading. However, even by best practice standards of the time, LTCM should have constructed a stress test based on common economic factors that could cause impacts across its positions, such as a flight to quality by investors, which would widen all credit spreads, including swap spreads, and increase premiums on buying protection against stock market crashes, hence increasing option volatility." In regard to (A), (B) and (C), each is FALSE. In regard to false (A), Allen writes "Please note that the bailout was not primarily a rescue of LTCM's investors or management, but a rescue of LTCM's creditors by a concerted action of these creditors. Even recently, I continue to encounter the [incorrect] view that the bailout involved the use of U.S. government funds, helped the LTCM investors and management avoid the consequences of their mistakes, and therefore contributed to an attitude that some firms are too-big-to-fail and so can afford to take extra risks because they can count on the government absorbing some of their losses. I do not think evidence is available to support any of these claims. " In regard to false (B), Allen writes "Within the firm, however, the management style favored sharing information openly, and essentially every investment decision was made by all the partners acting together, an approach that virtually eliminates the possibility of a rogue trader making decisions based on information concealed from other members of the firm. Although it is true that outside investors in the fund did not have access to much information beyond the month-end valuation of its assets and the track record of its performance, it is equally true that the investors knew these rules prior to their decision to invest. Since the partners who managed the fund were such strong believers in the fund that they had invested most of their net worth in it (several even borrowed to invest more than their net worth), their incentives were closely aligned with investors (in other words, there was little room for moral hazard). If anything, the concentration of partner assets in the fund should have led to more risk-averse decision making than might have been optimal for outside investors, who invested only a small portion of their wealth in the fund, with the exception of UBS, discussed in Section 4.1.5. " In regard to false (C), Allen counters the criticism that LTCM was excessively leveraged and counters the criticism that LTCM's managers placed excessive faith in their models: "Two other criticisms have been made of LTCM's management of risk with which I disagree. One is that a simple computation of leverage would have shown that LTCM's positions were too risky. However, as will be seen in Section 13.2.4, leverage by itself is not an adequate measure of risk of default. It must be multiplied by volatility of the firm's assets. But this just gets us back to testing through VaR or stress scenarios. The second criticism is that LTCM showed unreasonable faith in the outcome of models. I see no evidence to support this claim. Major positions LTCM entered into— U.S. swap spreads to narrow, equity volatilities to decline— were ones that many proprietary position takers had entered into. For example, the bias in equity implied volatilities due to demand for downside protection by shareholders had long been widely recognized as a fairly certain profit opportunity for investors with long-enough time horizons. That some firms made more use of models to inform their trading judgments while others relied more on trader experience tells me nothing about the relative quality of their decision making."

Silvercore Financial Services purchases credit protection on an underlying bond issued by Lanehigh Corporation by purchasing a credit default swap (CDS). Each of the following is true about the CDS EXCEPT which is false? Bankruptcy and failure to pay by Lanehigh are credit events If the underlying bond is downgraded and the bond's price reacts by dropping, the markto- market value of the CDS will increase The CDS generally provides a hedge against market risk as defined by a shift in risk-free rate curve; e.g., the theoretical spot rate for US Treasury securities A credit agency downgrade of the bond is not a credit event; and a restructuring by Lanehigh may or may not be a credit event depending on the restructuring clause

C: False. The CDS does not hedge against interest rate risk (market risk) In regard to (A), (B) and (C), each is TRUE. In regard to true (A), a CDS contract will define credit events as some subset (depending on geography and debt type) of the credit events defined by ISDA: (i) bankruptcy, (ii) payment default, (iii) default, (iv) an acceleration, (v) a repudiation or moratorium, (vi) a restructuring, and (vii) a governmental intervention. However, bankruptcy and failure to pay are typically included and constitute essential credit events. In regard to true (B), credit deterioration will increase the mark-to-market CDS premium which increases the value of the CDS; note that the (long) CDS buyer who buys credit protection is short the underlying reference such that this (synthetically) short position should profit if the underlying experiences credit deterioration. In regard to true (D), the status of restructuring has a colorful history including, as Crouhy writes "In May 2001, following this episode [the Conseco restructuring that triggered a $2.0 billion CDS payout], ISDA issued a Restructuring Supplement to its 1999 definitions concerning credit derivative contractual terminology. Among other things, this document requires that to qualify as a credit event, a restructuring event must occur to an obligation that has at least three holders, and at least two-thirds of the holders must agree to the restructuring. The ISDA document also imposes a maturity limitation on deliverables— the protection buyer can only deliver securities with a maturity of less than 30 months following the restructuring date or the extended maturity of the restructured loan— and it requires that the delivered security be fully transferable. " The upshot is that restructuring depends on the contract because after Conseco there are four different contract versions including "No-R" which deletes restructuring as a credit event and American modified restructuring clause ("Mod-R") and the European modified-modified clause ("Mod-Mod-R").

Peter Parker is comparing the single-factor capital asset pricing model (CAPM) to the arbitrage pricing theory (APT) model. Which statement is true? a) Both CAPM and APT require a mean-variance efficient market portfolio b) Both CAPM and APT assume normally distributed security returns c) Both CAPM and APT recognize multiple systemic risk factors d) Both CAPM and APT predict a security market line (SML)

D. True: Both CAPM and APT predict a security market line (SML) (A) is false: APT does not require a mean-variance efficient market portfolio (although CAPM does) (B) is false: APT does not assume normal returns (although CAPM does) (C) is false: CAPM assumes a single factor, whereas the key difference of APT is its assumption of multiple factors

Your colleague Peter is drafting a proposed operational risk (OpRisk) taxonomy to be presented to the board. The risk taxonomy will categorize OpRisk in different risk types. He expresses the following four opinions about operational risk. Which of his following statements about operational risk is TRUE? If a risk is not already defined as either a credit, market or liquidity risk, then by definition it is an operational risk In many firms, "operational risk" can be safely renamed "technology risk" because they have increasingly become synonyms In order to measured risks within the firm's control, operational risk should exclude external events such as terrorism or criminal hackers breaching the firm's computer systems Although it includes legal risk, operational risk concerns many activities and factors that are not contractual, in contrast to credit and market risk which are based mostly on financial contracts

D. TRUE: Although it includes legal risk, operational risk concerns many activities and factors that are not contractual, in contrast to credit and market risk which are based mostly on financial contracts. In regard to (A), (B) and (C), each is FALSE. In regard to false (A), operational risk is not an "all other category" nor do the sum of market, credit and operational risk equal all of the firm's risks. The classic FRM examples here are business risk, strategic risk and reputational risk. In regard to false (B), while technology risk is an increasing component of operational risk, operational risk includes several non-technology risks. In particular, operational risk includes people and processes. For example, says Crouhy "Human factor risk is a special form of operational risk. It relates to the losses that may result from human errors such as pushing the wrong button on a computer, inadvertently destroying a file, or entering the wrong value for the parameter input of a model. Operational risk also includes fraud— for example, when a trader or other employee intentionally falsifies and misrepresents the risks incurred in a transaction. Technology risk, principally computer systems risk, also falls into the operational risk category. " In regard to false (C), operational risk definitely includes external events such as thirdparty fraud (in Basel typology, external fraud); or natural disasters and terrorism (in Basel typology, Damage to Physical Assets)

The financial disasters at Metallgesellschaft in 1993 and Long-term Capital Management (LTCM) in 1998, although very different, shared in common that no rogue trader was involved. According to Steven Allen, which of the following best summarizes briefly the key dynamic shared in common between the LTCM and Metallgesellschaft disasters? Both were disasters due to large and unanticipated market moves exposed a lack of liquidity management Both were disasters due misleading reporting in particular exacerbated by atypical and outdated accounting systems Both were disaster due to the conduct of customer business, specifically they did not adequately explain their strategy's risks to their clients Both were disaster due to the conduct of customer business, specifically they hid the magnitude of their exposure from their clients

A. TRUE: Both were disasters due to large and unanticipated market moves exposed a lack of liquidity management Allen: "4.2 DISASTERS DUE TO LARGE MARKET MOVES: We will now look at financial disasters [i.e., Long-term Capital Management and Metallgesellschaft] that were not caused by incorrect position information, but were caused by unanticipated market moves. The first question that should be asked is: How is a disaster possible if positions are known? No matter what strategy is chosen, as losses start to mount beyond acceptable bounds, why aren't the positions closed out? The answer is lack of liquidity. We will focus on this aspect of these disasters. ... [4.2.1 Long-term Capital Management] Another point on which LTCM's risk management could be criticized is a failure to account for the illiquidity of its largest positions in its VaR or stress runs. LTCM knew that the position valuations it was receiving from dealers did not reflect the concentration of some of LTCM's positions, either because dealers were not taking liquidity into account in their marks or because each dealer knew only a small part of LTCM's total size in its largest positions. ... [4.2.2 Metallgesellschaft (MG)] The disaster at Metallgesellschaft (MG) reveals another aspect of liquidity management. 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. Although some controversy exists about how effective this hedging strategy was from a P& L standpoint, as we'll discuss in just a moment, the fundamental consequence of this strategy for liquidity management is certain. The futures being used to hedge were exchange-traded instruments requiring daily cash settlement, as explained in Section 10.1.4. 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 regard to (B), (C) and (D), each is FALSE.

Which of the following is LEAST likely to be a key function of members of the board of directors? a) Build risk-adjusted valuations for each business unit in order to verify management's models b) Review corporate strategy and oversee major capital transactions, including expenditures, acquisitions and divestitures. c) Align key executive and board compensation (renumeration) with the longer term interests of the company and its shareholders d) Ensure integrity of financial (and accounting) reporting systems and monitor risk management systems

A. The board typically neither builds valuation models nor directly verifies. However, key functions of the board do typically include (B), (C) and (D). According to the OECD Principles of Corporate Governance, functions of a board member include: 1. Reviewing and guiding corporate strategy, major plans of action, risk policy, annual budgets and business plans; setting performance objectives; monitoring implementation and corporate performance; and overseeing major capital expenditures, acquisitions and divestitures 2. Monitoring the effectiveness of the company's governance practices and making changes as needed 3. Selecting, compensating, monitoring and, when necessary, replacing key executives and overseeing succession planning 4. Aligning key executive and board remuneration with the longer term interests of the company and its shareholders 5. Ensuring a formal and transparent board nomination and election process 6. Monitoring and managing potential conflicts of interest of management, board members and shareholders, including misuse of corporate assets and abuse in related party transactions 7. Ensuring the integrity of the corporation's accounting and financial reporting systems, including the independent audit, and that appropriate systems of control are in place, in particular, systems for risk management, financial and operational control, and compliance with the law and relevant standards 8. Overseeing the process of disclosure and communications According to the NACD, board responsibilities include: Mitigating Risk (The goal of a risk program is mitigation of risks in strategy implementation. The board should encourage through written policies and actions a "tone at the top" that shows ethical integrity, legal compliance, strong controls and strong financial reporting) Strategy and Risk Appetite (To fully assess an enterprise's risk appetite, the board must engage in reviewing the enterprises strengths, weaknesses, opportunities, and threats. A fully developed risk profile encompasses the impact on stakeholders including employees, customers, and suppliers) Risk Identification (Directors should probe the legitimacy and scope of management's risk assessments. They must help identify potential risks and provide scenarios that the managers may not have considered. Unforeseen risks cause the most problems for companies) Monitoring Risk (The board should continually monitor the financial health of the firm, ensuring accurate accounting and safekeeping of corporate assets. An important element of risk identification and monitoring is ensuring the information relied upon is high quality, dependable, and timely); and Crisis Response (The board is responsible for ensuring that sound crisis planning has occurred. During a crisis it should remain informed and the board or a committee of the board should remain in contact during the period in which the situation is most critical).

According to Bodie, Kane, Marcus, each of the following statements is true about arbitrage pricing theory (APT) EXCEPT which is false? Price relationships that satisfy the no-arbitrage condition are important because we do expect them to hold in real-world markets In a well-diversified portfolio, the proportion held of any individual security is small enough that a reasonable change in that security's rate of return will have a negligible effect on the portfolio's rate of return The arbitrage pricing theory (APT) model is inferior to the capital asset pricing model (CAPM) because APT cannot predict a security market line linking expected return to risk due to the reality that idiosyncratic risk is not diversified away in the APT The arbitrage pricing theory (APT) does not require the restrictive assumptions of the capital asset pricing model (CAPM) and its unobservable market portfolio, but the price of this generality is that the APT does not guarantee this relationship for all securities at all times.

C. FALSE. The APT not inferior to the CAPM, it does link expected returns to risk, and it does assume idiosyncratic risk is diversified away. In regard to (A), (B) and (D) each is TRUE Here are Bodie's SUMMARY points: 1) "Multifactor models seek to improve the explanatory power of single-factor models by explicitly accounting for the various systematic components of security risk. These models use indicators intended to capture a wide range of macroeconomic risk factors. 2) Once we allow for multiple risk factors, we conclude that the security market line also ought to be multidimensional, with exposure to each risk factor contributing to the total risk premium of the security. 3) A (risk-free) arbitrage opportunity arises when two or more security prices enable investors to construct a zero-net-investment portfolio that will yield a sure profit. The presence of arbitrage opportunities will generate a large volume of trades that puts pressure on security prices. This pressure will continue until prices reach levels that preclude such arbitrage. 4) When securities are priced so that there are no risk-free arbitrage opportunities, we say that they satisfy the no-arbitrage condition. Price relationships that satisfy the noarbitrage condition are important because we expect them to hold in real-world markets. 5) Portfolios are called "well-diversified" if they include a large number of securities and the investment proportion in each is sufficiently small. The proportion of a security in a welldiversified portfolio is small enough so that for all practical purposes a reasonable change in that security's rate of return will have a negligible effect on the portfolio's rate of return. 6) In a single-factor security market, all well-diversified portfolios have to satisfy the expected return-beta relationship of the CAPM to satisfy the no-arbitrage condition. If all well-diversified portfolios satisfy the expected return-beta relationship, then individual securities also must satisfy this relationship, at least approximately. 7) The APT does not require the restrictive assumptions of the CAPM and its (unobservable) market portfolio. The price of this generality is that the APT does not guarantee this relationship for all securities at all times. 8) A multifactor APT generalizes the single-factor model to accommodate several sources of systematic risk. The multidimensional security market line predicts that exposure to each risk factor contributes to the security's total risk premium by an amount equal to the factor beta times the risk premium of the factor portfolio that tracks that source of risk. 9) A multifactor extension of the single-factor CAPM, the ICAPM, is a model of the risk- return trade-off that predicts the same multidimensional security market line as the APT. The ICAPM suggests that priced risk factors will be those sources of risk that lead to significant hedging demand by a substantial fraction of investors."

Each of the following is an obvious, blatant failure of risk management EXCEPT which of the following by itself does not necessarily imply a risk management failure? a) The firm realizes a loss of more than 20% of its capital in the period of only a single year b) Risk models assume positions are independent, but in reality the firm's positions are highly correlated c) Market, credit, and operational risks are measured, but liquidity risk is forgotten (and therefore inadvertently omitted) due to this three-bucket typology d) The firm's risk managers correctly specify the firm's risk profile but they fail to successfully and timely communicate these risks to the firm's executives and the board of directors.

A. According to Stulz, a realized loss by itself does not implicate a risk management failure; his specific example is LTCM's 70% loss in capital ("the returns of LTCM do not tell us anything about whether its risk management failed.") In regard to (B), (C) and (D), each is TRUE. According to Stulz, there are six types of risk management failures: 1. Mismeasurement of known risks. 2. Failure to take risks into account. 3. Failure in communicating the risks to top management. 4. Failure in monitoring risks. 5. Failure in managing risks. 6. Failure to use appropriate risk metrics.

A classic concept in risk management is that a firm cannot and should not attempt to eliminate risk. If an enterprise were somehow theoretically risk-free, then it would not be able to create value. This is an important premise in establishing the principle that risk management is more than a compliance and risk-avoidance function. Rather, risk management aspires to be an ally in value creation. More specifically, and with respect to financial risks, there is a classic trade-off in finance between expected return and risk: higher expected returns are compensation for assuming greater risk. However, which of the following risks is the most notable general EXCEPTION to this rule? Operational risk Funding liquidity risk Trading liquidity risk Concentration risk (in credit risk at the portfolio level)

A. Although arguably not the only exception to the classic risk-return trade-off, operational risk is the notable exception because (unless you are an insurance company) there is little compensation in most cases for the assumption of typical operational risks. Market risk and credit risks, on the other hand, are generally associated with contracts (e.g., long or short position in an asset or derivative, which is by definition a contract; loan obligation) such that the trade-off is more plainly inherent. In regard to (B) and (C), liquidity risk a market risk and we tend to assume there is compensation of illiquidity risk. In regard to (D), concentration risk is a type of credit risk and we similarly tend to assume there is compensation for credit risk. Although, this is not a bad choice due to the argument that concentration is a lack of diversification and diversification is a rare exception to the trade-off. Operational risk has some unique features: As mentioned, unlike market and credit risk, operational risk involves many risks that are not associated with contracts Because operational risk is embedded in the firm and often highly interrelated with market and credit risks, it can be difficult to isolate and measure. It many cases, it arises from a process that touches on various activities in the firm. Operational risk and its sub-types are the most common exposures among the various case studies. As a practical tip, if you have to guess about the causes in a case study, guess operational risk! As Crouhy writes, "Many of the failures in risk management we have discussed in this book so far, including the key failures of the financial crisis of 2007- 2009— control failures, credit risk management failures, model risk failures, failures of risk communication, fraud, the overlooking of liquidity risks and risk interactions, and so on— could in some sense be attributed to operational risk. While the traditional approach to operational risk has been to manage it informally, it is getting much more focus and continues to evolve. As James Lam writes in Enterprise Risk Management, "Although operational risk management may be new relative to other risk management disciplines, one can safely make three comments about its development thus far. First, it has already been widely accepted that all companies face operational risks and should develop systematic programs to measure and manage them. Second, given the complexity of operational risks, a comprehensive approach should be used. As we will see later in this chapter, such an approach will ideally incorporate both process-oriented methods such as total quality management and statistical methods such as economic capital and extreme value theory. Lastly, the focus of operational risk programs should be on management, not measurement, which includes the integration of operational risk with market and credit risks.

Sallly Smith is developing an economic capital model for her bank. Her economic capital model will determine the target level of equity (i.e., on the balance sheet) at the firm based on a risk appetite articulated by the board of directors and capital at risk across the business units. Each of the following is a financial risk that directly determines her model's output EXCEPT among these which is the LEAST likely to directly impact her economic capital model? The $1.5 million loss that is expected on a $100.0 million bond portfolio with a default probability (PD) of 1.5% The $2.0 in value at risk (VaR) of certain operational processes that Sally has quantified; e.g., model risk, transaction risk The value at risk (VaR) of the bank's portfolio of public securities and debt instruments, 70% of which are actively managed The high exposure of the bank's credit portfolio to macroeconomic conditions; i.e., asset correlation of 20% to systemic risk factor

A. Expected loss (EL) is the least likely because "financial risk" primarily concerns unexpected losses (UL). Further, expected credit losses will be priced into loan products rather than buffered by capital cushions In regard to (B), (C) and (D), each is TRUE as a typical component of the overall capital at risk.

The Enron scandal led to the largest bankruptcy in U.S. history at the time (November 2001. it was surpassed by WorldComm's bankruptcy the next year). According to Allen, each of the following is true about the Enron scandal EXCEPT which is false? Enron's stack-and-roll strategy was profitable until the oil futures market shifted from backwardation to contango Just as Greece entered an off-market currency swap in 2001 to disguise debt, Enron used oil futures contracts to disguise debt Enron used hundreds of special purpose entities (SPE) to limit transparency, overstate equity, hide debt and to misrepresent risk by asserting that certain SPE were hedges when they did not mitigate risk Enron's dubious accounting practices (e.g., aggressive revenue recognition) were enabled by its auditor, Arthur Anderson, whose failure to fulfill its professional responsibilities led to the break-up of the accounting firm

A. FALSE: the shift to oil futures contango is a key element in the Metallgesellschaft case. Steven Allen writes, "4.3.2 JPMorgan, Citigroup, and Enron: Following the Bankers Trust incident, investment banks put in controls to guard against exploitation of customers. But it was not seen as part of a bank's responsibility to safeguard others from actions by the customer. This has changed as part of the fallout from Enron's 2001 bankruptcy. As part of the process leading up to the bankruptcy, it was revealed that Enron had for years been engaging in dubious accounting practices to hide the size of its borrowings from investors and lenders (it was their part in these shenanigans that brought an end to the major accounting firm Arthur Andersen). One of the ploys that Enron had used was to disguise a borrowing as an oil futures contract. As a major player in the energy markets, it was to be expected that Enron would be heavily engaged in futures contracts on oil. But these particular futures contracts did not involve taking any position on oil price movements. 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."

In contrast to managers at non-financial firms (according to Stulz), risk managers at FINANCIAL firms encounter which of the following special challenges? a) Financial firms hold many derivative positions and their risk properties can change very rapidly with no trading whatsoever; e.g., due to extreme sensitivity to market conditions b) In financial firms, operational risk tends to uniquely transcend business unit delineations such that bottom-up approaches tend to omit key operational risks c) Due to their inherent complexity, financial firms are more naturally prone to communication failures especially communications flows that are sent up the management chain d) Due to their uniquely competitive context, financial firms must "move move faster and with more flexibility, and this agility requires risk management that is structured to know everything at all times."

A. Financial firms hold many derivative positions and their risk properties can change very rapidly with no trading whatsoever; e.g., due to extreme sensitivity to market conditions Stulz on Failures in monitoring and managing risks: "We have already discussed the problem that a firm may be taking risks that it does not know about. When we discussed that problem, we focused on it as an inventory issue. However, there is a different perspective on this problem which is particularly relevant in financial firms. For the typical non-financial firm, risks often change slowly. Not so for financial firms. For a financial firm, risks can change sharply even if the firm does not take new positions. The problem arises from the fact that financial firms have many derivatives positions and positions with embedded derivatives. Over time, these positions have become more complex. The risk properties of portfolios of derivatives can change very rapidly with no trading whatsoever. This is because complex derivatives often have exposures to risk factors that are extremely sensitive to market conditions. Strikingly, it is perfectly possible with some products to see changes such that, during the same day, a security could have an exposure to interest rates so that it gains substantially if interest rates increase and later in the day have an exposure such that it loses substantially if interest rates increase. For such a product, hedges adjusted daily could end up creating large losses because the hedge that is optimal at the start of the day could end up aggravating the risk exposure at the end of the day." In regard to (B), (C) and (D), each is FALSE.

John has regressed three years of monthly excess portfolio returns (n = 36) against the excess returns for a broad-based market index which represents a proxy for CAPM's theoretical market portfolio. Where R(i) is the predicted portfolio return, Rf is the risk-free rate, β(0) and β(1) are the generated regression coefficients, and e(i) is the regression residual, his singlefactor regression model is given by the form: R(i) - Rf = β(0) + β(1)*[R(M) - Rf] + e(i). His regression results are given by: R(i) - Rf = 0.40% + 0.732*[R(M) - Rf]. John is asked by his manager, "Did the manager of this portfolio generate positive ex post alpha?" Which of the following answers is BEST? Alpha is the regression intercept, in this case β(0) which is +0.0040; therefore, yes, the portfolio did generate positive alpha Alpha is the average regression residual which has a mean value of zero; therefore, no, the portfolio did not generate positive alpha Alpha is the slope coefficient, in this case β(1) which is +0.732; therefore, yes, the portfolio did generate positive alpha but this +0.732 is actually "beta disguised as alpha" Alpha is the difference between the average portfolio return and the average market return; because we are not given these average return values, we do not have enough information to determine alpha

A. TRUE: Alpha is the regression intercept, in this case β(0) which is +0.0040; therefore, yes, the portfolio did generate positive alpha Each of (B), (C) and (D) is FALSE. In regard to false (B), the regression, by definition of the OLS method, ensures that the mean residual is equal to zero. Each monthly return will vary from its predicted return, but these differences are not portfolio alpha. In regard to false (C), the slope coefficient is the portfolio's so-called beta; in the case, of CAPM, this is its measure of systematic risk In regard to false (D), there is an important and necessarily true relationship given by the OLS regression equation: [average Y] = β(0) + β(1)*[average X]. That is, the regression line must pass through the point corresponding to [average X, average Y]. Notice the imprecision in the false statement (it omits beta). In this case, this implies β(0) = average[R(i) - Rf] - β(1)*average[R(M) - Rf]. So we do know that the portfolio alpha equals the average portfolio excess return minus the product of beta and the average market excess return, which is re-statement of the same assertion that alpha is the regression intercept.

Which of following statements is TRUE about the information ratio (IR)? The information ration generalizes the Sharpe ratio by replacing the riskfree rate with the benchmark rate of return The monthly information ratio (IR) is the same as its annualized IR because both numerator and denominator are multiplied by 12 If a portfolio underperforms the benchmark (e.g., portfolio return is 7% versus market index return of 8%) then the information ratio must be negative Because t-stat = IR*N, where N is number of years, N = t/IR, such that demonstration of alpha-type skill typically requires N = 2/IR years of out-performance

A. The information ratio generalizes the Sharpe ratio by replacing the riskfree rate with the benchmark rate of return In regard to (B), (C) and (D), each is FALSE. In regard to false (B), annualization is more likely to be * 12/SQRT(12) as the denominator's volatility scales per the square root rule In regard to false (C), the sign of the IR depends on the numerator (as the denominator must be positive). In this case, if active returns are measures (i.e., active return divided by tracking error), then the IR will be negative; however, if residual return is measured, the IR can be positive. In regard to false (D), Amenc's function is given by IR ≈ t-stat/sqrt(N) such that N = (tstat/ IR)^2

What do these incidents have in common: Chase Manhattan Bank/Drysdale Securities, Kidder Peabody, Barings, Allied Irish Bank, and Union Bank of Switzerland (UBS) in 1997-1998? a) They are cases in which the firm or its investors and lenders were seriously misled about the size and nature of the positions it had (Disasters due to misleading reporting) b) They are cases in which the firm and its investors and lenders had reasonable knowledge of its positions, but had losses result from unexpectedly large market moves (Disasters due to large market moves) c) They are cases in which losses did not result from positions held by the firm, but instead resulted from fiduciary or reputational exposure to positions held by the firm's customers (Disasters due to the conduct of customer business) d) None of the above

A. They are cases in which the firm or its investors and lenders were seriously misled about the size and nature of the positions it had (Disasters due to misleading reporting)

In Appendix 1.1., Crouhy's high-level typology of risk exposures includes the following list of risks: Market risk: the risk that changes in financial market prices and rates will reduce the value of a security or a portfolio, Credit risk: the risk of an economic loss from the failure of a counterparty to fulfill its contractual obligations, or from the increased risk of default during the term of the transaction, Liquidity risk: this is most often but not always classified as a sub-type of market risk, Operational risk: the risk of loss resulting from inadequate or failed processes, people and systems or from external events, Legal and regulatory risk: these are always classified as operational risks in the FRM, Business risk: the inherent risks which the firm willingly assumes to create competitive advantage and add shareholder value, Strategic risk: traditionally in the FRM, this is a firmwide business risk, but NOT an operational risk which is a non-business financial risk! Reputation risk: traditionally in the FRM, this is a firmwide non-business, non-financial risk (also NOT an operational risk) however there is some debate and evolution. Each of the following is a true statement EXCEPT which is false? While all four are sub-types of market risks, commodity price risk is uniquely different from equity price risk, interest rate risk and foreign exchange risk Value at risk (VaR) is optimal for market risk but is poorly designed for credit and operational risk; and VaR cannot realistically play a role in enterprise risk and economic capital metrics, where elliptical properties are desirable Systemic risk was a focus of the Dodd-Frank Act and refers to the potential for the failure of one institution to create a chain reaction or domino effect on other institutions and consequently threaten the stability of financial markets Liquidity has two versions: (i) funding liquidity risk which increases with balance sheet leverage and can be exploited by variation margin; and (ii) trading liquidity risk (aka, asset liquidity risk) which is measured by tightness (e.g., bid-ask spread), market depth/breadth, and/or resiliency/immediacy.

B. FALSE: Value at risk (VaR) is optimal for market risk but is poorly designed for credit and operational risk; and VaR cannot realistically play a role in enterprise risk and economic capital metrics, where elliptical properties are desirable. In regard to (A), (C) and (D), each is TRUE. In regard to true (A), "Commodity Price Risk: The price risk of commodities differs considerably from interest rate and foreign exchange risk, since most commodities are traded in markets in which the concentration of supply is in the hands of a few suppliers who can magnify price volatility. For most commodities, the number of market players having direct exposure to the particular commodity is quite limited, hence affecting trading liquidity which in turn can generate high levels of price volatility. Other fundamentals affecting a commodity price include the ease and cost of storage, which varies considerably across the commodity markets (e.g., from gold to electricity to wheat). As a result of these factors, commodity prices generally have higher volatilities and larger price discontinuities (i.e., moments when prices leap from one level to another) than most traded financial securities. Commodities can be classified according to their characteristics as follows: hard commodities, or nonperishable commodities, the markets for which are further divided into precious metals (e.g., gold, silver, and platinum), which have a high price/ weight value, and base metals (e.g., copper, zinc, and tin); soft commodities, or commodities with a short shelf life that are hard to store, mainly agricultural products (e.g., grains, coffee, and sugar); and energy commodities, which consist of oil, gas, electricity, and other energy products. "

Each of the following is true about Long Term Capital Management (LTCM), according to Allen, EXCEPT which is false? a) LTCM is classified as a disaster due to large market moves rather than a disaster due to misleading reporting b) LTCM strategy was not to hold any long-term positions; instead, they were "essentially similar to modern-day high-frequency traders" c) LTCM was bailed out by its creditors who feared the adverse impact to themselves, and their financing clients, of closing out such large positions in such illiquid markets d) A key lesson from the LTCM incident is that a stress scenario is needed to look at the impact of a competitor holding similar positions exiting the market

B. False, LTCM held long term positions; in fact, their problem was arguably a lack of short-term liquidity which did not afford the patience they sought Allen: "[LTCM Investors] were locked into their investments for extended time periods (generally, 3 years). This reflected the basic investment philosophy of LTCM, which was to locate trading opportunities that represented what they 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." In regard to (A), (C) and (D), each is TRUE.

GARP Members agree to uphold and implement Rules of Conduct, which includes each of the following EXCEPT for: a) Shall exercise reasonable judgment in the provision of risk services while maintaining independence of thought and direction. b) Shall be knowledgeable about probable future regulations in order to ensure their recommendations can endure future developments c) Shall be diligent about not overstating the accuracy or certainty of results or conclusions and shall clearly disclose the relevant limits of their specific knowledge and expertise concerning risk assessment, industry practices and applicable laws and regulations d) Shall endeavor to be mindful of cultural differences regarding ethical behavior and customs, and to avoid any actions that are, or may have the appearance of being unethical according to local customs.

B. False. The Rules require compliance with (current) "applicable laws, rules, and regulations governing professional activities ... and [Members] shall not knowingly participate or assist in any violation of such laws, rules, or regulations." However, the rules say nothing about expecting Members to anticipate the future! In regard to (A), (C) and (D), each is TRUE.

About the Fama-French (FF) three-factor model, each of the following is true, EXCEPT which is false? a) One factor is High Minus Low (HML); i.e., the excess relative return of so-called "value" stocks with a low price-to-book (P/B) ratio b) One factor is Industrial Production (IP); i.e., the real output in manufacturing, mining, and electric, and gas utilities c) As a possible type of arbitrage pricing theory (APT) model, Fama-French may contain a firm-specific risk term d) Fama-French is an empirical model where the firm-specific are meant to be proxies for exposure to extramarket or systemic risks which are not themselves identified

B. False. The three FF factors are the market's risk premium (similar to CAPM or single-index model), Small Minus Big (SMB: a small capitalization premium), and High Minus Low (HML: a value premium).

In January 2008, Société Générale reported trading losses of €4.9 billion (~ $7.1 billion) that the firm attributed to fraudulent and unauthorized activity by a junior trader, Jérôme Kerviel. According to Steve Allen, each of the following is a "lesson to be learned" from the crisis EXCEPT which is NOT a direct lesson to be learned from the crisis? Vacation policy: Rules for mandatory time away from work should be enforced. Dealing risk; aka, endogenous liquidity risk: Because huge positions (measured as a percentage of the total trading activity) can take too long to liquidate, impose concentration limits so any position does not represent more than 40% of a market's total trading activity Trade cancellation: Institute systems for monitoring patterns of trade cancellation. Flag any trader who appears to be using an unusually high number of such cancellations. Any trader flagged should have a reasonably large sample of the cancellations checked to make sure that they represent real trades by checking details of the transaction with the counterparty. Gross positions: Gross positions must be monitored and highlighted in control reports. This is particularly important since unusually high ratios of gross to net positions are a warning sign of potentially inadequately measured basis risk as well as a possible flag for unauthorized activities. The Kidder Peabody and Allied Irish Bank frauds could also have been uncovered by investigating unusually high ratios of gross to net trading.

B. False: although Kerviel took massive (and unauthorized) positions, they were positions in equities and exchange-traded futures. According to Wikipedia (see http://trtl.bz/societe-generale), "It is estimated that over the period the total trading in futures and the cash market for the Euro Stoxx 50 was €544 billion. This would make the unwinding of Kerviel's position account for five per cent or less of overall activity.[9] Société Générale's investment banking chief, Jean Pierre Mustier, acknowledged that the three days of forced selling played a role in the market's overall decline, but characterized that impact as minimal." In regard to (A), (C) and (D), each is a lesson learned according to Allen. Allen: "4.1.6 Société Générale > 4.1.6.6 Lessons to Be Learned: What new lessons can we draw from this control failure? From one point of view, the answer is not much— Kerviel's methods for eluding scrutiny of his positions were close to those used in previous incidents such as those of Kidder Peabody, Barings, and Allied Irish Bank. But, from another viewpoint, we can learn quite a bit, since clear patterns are emerging when we look across episodes. The obvious lessons for control personnel are to tighten procedures that may lead to detection of fictitious trade entries. Corresponding to the points raised in Section 4.1.6.4, the specific lessons follow. Trade Cancellation: Institute systems for monitoring patterns of trade cancellation. Flag any trader who appears to be using an unusually high number of such cancellations. Any trader flagged should have a reasonably large sample of the cancellations checked to make sure that they represent real trades by checking details of the transaction with the counterparty. Supervision: Control personnel should be aware of situations in which traders are being supervised by temporary or new managers. Tightened control procedures should be employed. Trading Assistant: Control personnel must remember that even in situations where there is no suspicion of dishonesty, trading assistants are often under intense pressure from the traders with whom they work closely. Their job performance ratings and future career paths often depend on the trader, regardless of official reporting lines. The greater prestige, experience, and possible bullying tactics of a trader can often convince a trading assistant to see things from the trader's viewpoint. Other control personnel must be cognizant of these realities and not place too much reliance on the presumed independence of the trading assistant. Vacation Policy: Rules for mandatory time away from work should be enforced. Gross Positions: Gross positions must be monitored and highlighted in control reports. This is particularly important since unusually high ratios of gross to net positions are a warning sign of potentially inadequately measured basis risk as well as a possible flag for unauthorized activities. The Kidder Peabody and Allied Irish Bank frauds could also have been uncovered by investigating unusually high ratios of gross to net trading. Cash and Collateral: Cash and collateral requirements should be monitored down to the individual trader level. Better monitoring of cash and credit flows would have also been instrumental in uncovering the Barings and Allied Irish Bank frauds. P&L: Any patterns of P& L that are unusual relative to expectations need to be identified and investigated by both management and the control functions. Identification of unusual patterns can be comparisons to historical experience, to budgeted targets, and to the performance of traders with similar levels of authority. Investigation of suspicious earnings patterns could also have led to earlier discovery of the Kidder Peabody and Barings frauds."

In reaction to certain stakeholder concerns and several risk event "near-misses," International Thrift Bank--which is a publicly-traded bank with $40.0 billion in assets--just redesigned its approach to corporate risk governance in order to better comply with so-called best practices, including accountabilities, processes and policies. Each of the following is an element of their new risk governance program EXCEPT which is the LEAST LIKELY to be included? The formation of an enterprise-wise Risk Committee of the board of directors A new policy prohibiting directors from owning stock, or being paid in the bank's stock, in order to avoid actual and perceived conflicts of interest A new requirement that the board must have at least one director who has expertise in risk; ie, who has experience identifying, assessing, and managing risk exposures of large, complex firms A new requirement for a written Corporate Risk Policy that is updated periodically and includes, among other items, an articulation of the organization's risk appetite and an identification of roles and responsibilities

B. HIGHLY UNLIKELY for a company to prohibit board ownership of stock. The trend is the opposite: to encourage and/or require stock ownership by directors. In regard to (A), (C) and (D), each is typical "best practice." In regard to (A), Dodd-Frank requires a bank holding company with more than $10 billion in total consolidated assets ("Public Mid-size BHCs") to establish a risk committee of the board of directors to oversee its risk management framework. In regard to (C) and (D), these are best practice

According to COSO, which of the following risks is defined as "the acceptable level of variation relative to achievement of a specific objective, and often is best measured in the same units as those used to measure the related objective?" a) Risk appetite b) Risk tolerance c) Risk profile d) Risk capacity

B. Risk tolerance The COSO paper has a focus on the relationship between risk appetite and its "tactical and operational" expression in the form of risk tolerances: "Risk appetite is the amount of risk, on a broad level, an organization is willing to accept in pursuit of value. Each organization pursues various objectives to add value and should broadly understand the risk it is willing to undertake in doing so ... Risk tolerances The acceptable level of variation relative to achievement of a specific objective, and often is best measured in the same units as those used to measure the related objective. In setting risk tolerance, management considers the relative importance of the related objective and aligns risk tolerances with risk appetite. Operating within risk tolerances helps ensure that the entity remains within its risk appetite and, in turn, that the entity will achieve its objectives. Risk tolerances guide operating units as they implement risk appetite within their sphere of operation. Risk tolerances communicate a degree of flexibility, while risk appetite sets a limit beyond which additional risk should not be taken."

Which is true of the Professional Standards which GARP Members agree to uphold and implement? a) Members can delegate their ethical responsibility to others; are not responsible for the wider impact of their assessments and actions; and cannot be expected to achieve "perfection" in their expertise b) Members can delegate their ethical responsibility to others; are responsible for the wider impact of their assessments and actions; but cannot be expected to achieve "perfection" in their expertise c) Members cannot out-source or delegate their ethical responsibility to others; should consider the wider impact of their assessments and actions; and should always continue to perfect their expertise d) Members cannot out-source or delegate their ethical responsibility to others; but they are not responsible for the wider impact of their assessments and actions; and cannot be expected to achieve "perfection" in their expertise

C. Members cannot out-source or delegate their ethical responsibility to others; should consider the wider impact of their assessments and actions; and should always continue to perfect their expertise The (2.) Professional Standards include (2.1) Fundamental Responsibilities, (2.2) Best Practices, and (2.3) Communication and Disclosure. Fundamental Responsibilities include "GARP Members should always continue to perfect their expertise; GARP Members have a personal ethical responsibility and cannot out-source or delegate that responsibility to others." Best Practices include "GARP Members recognize that risk management does not exist in a vacuum. GARP Members commit to considering the wider impact of their assessments and actions on their colleagues and the wider community and environment in which they work."

Stulz has argued for the Risk Management Irrelevance Proposition which holds that it is difficult for risk management to add value when markets are financial markets are perfect. According to this proposition, many of the opportunities for risk management to add value are genuinely present because markets, in fact, contain several imperfections. According to Stulz's logic, each of the following is an viable opportunity for the risk manager to increase (or add to) the firm's value EXCEPT which is the LEAST LIKELY to add value? Reduce the implicit and explicit costs of financial distress to the firm Modify the management's pay incentives to better align compensation Reduce the firm's relatively high beta by shorting S&P 500 futures contracts Encourage the firm to undertake new project(s) that are positive in net present value but undesirable due to debt overhang

C. Reduce the firm's relatively high beta by shorting S&P 500 futures contracts. This is the LEAST LIKELY to add value because shareholders can already calibrate their desired exposure to systematic risk (beta) in capital markets. Put more simply, the firm has no comparative advantage in beta exposure. The other choices each rely on a market IMPERFECTION that creates an opportunity for risk management to add value. Specifically: In regard to (A), as Stulz explains, the cost of financial distress are "the costs firms incur because of a poor financial situation ... costs of financial distress can occur even if the firm never files for bankruptcy or never defaults. Manager have to think about finding ways to conserve cash to pay off debtholders. They might cut investment, which means the loss of future profits. Potential customers may become reluctant to deal with the firm, leading to losses in sales. Any time costs of financial distress divert cash flow away from the firm's claimholders, they reduce firm value. Reducing firm risk by minimizing the present value of costs of financial distress naturally increases firm value." In regard to (B), agency costs can theoretically be reduced by better alignment between shareholders and managers by way of compensation. In regard to (D), debt overhang can prevent the undertaking of positive net present value projects if they dilute current shareholders

Which of the following most accurately reflects a key risk that was realized in the Metallgesellschaft case study? a) Eventually interest rate spreads are likely to revert to mean b) Value at risk (VaR) is not necessarily reliable without scenario analysis complements c) Roll return (roll yield) for a long futures position is negative in contango d) A firm which does not choose the theoretical minimum variance hedge is economically speculating

C. Roll return (roll yield) for a long futures position is negative in contango This is a fundamental concept explored further in Topic 3. If the futures curve is in backwardation (i.e., inverted), then F(2) < (F(1) < S(0). Under such a scenario, the roll return is profitable to long positions as they are entered at lower prices then they are exited. Conversely, the long position in contango produces a negative roll yield. In the same way, a short futures position profits from the roll return in contango and loses from the roll return in backwardation; just as the long position loses from the roll in contango and profits from the roll in backwardation.

Consider two very different financial disasters the both happened in 1994: Proctor & Gamble's (P&G's) $150+ million loss and a much bigger loss by the city of Orange County. In the case of Orange County, a $1.5 billion investment loss forced the city to file bankruptcy in December 1994. Until Jefferson County went bankrupt seventeen years later in 2001, this had been the largest municipal bankruptcy in U.S. history. Orange County treasurer Robert Citron had entered into reverse repurchase agreements, collateralized mortgage obligations, indexed amortizing notes, and structured notes, including inverse floaters. Citron's strategies at Orange Country where highly profitable in the early 1990s, but unraveled into massive losses in 1994. Although the Proctor & Gamble (P&G) differs from the Orange County case study, among the following which do the disasters most have in common? The managers at P&G and Orange County falsified trading activity in order to fabricate artificial profits, which were ultimately discovered by accountants In both cases, unanticipated regulation prompted an abrupt shift in the stock market, and an increase in equity volatility, that could have been managed with additional derivatives hedges Both P&G and Orange County entered highly complex derivative positions than neither suited their objectives, nor were deeply understood by them, such that the client's banks were blamed Both P&G and Orange County entered positions that were profitable during an environment of increasing interest rates (e.g., inverse floater) but experienced losses when interest rates dropped

C. TRUE: Both P&G and Orange County entered highly complex derivative positions than neither suited their objectives, nor were deeply understood by them, such that the client's banks were blamed Steven Allen classifies the Bankers Trust/P&G case study as a "Disaster Due to the Conduct of Customer Business," (4.3) and he writes about the role of complexity in the case: "One element that established some prima facie suspicion of BT [Banker's Trust] was the sheer complexity of the structures. It was hard to believe that BT's clients [including Procter & Gamble] started out with any particular belief about whether there was a small enough probability of loss in such a structure to be comfortable entering into it. BT would have had to carefully explain all the intricacies of the payoffs to the clients for them to be fully informed. Since 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. " In regard to (A), (B) and (D), each is FALSE.

Risk measurement tends to employ so-called downside risk metrics such as value at risk and expected shortfall (ES). With respect to these measures, each of the requirements below is important; each is either somewhat important or very important. HOWEVER, among the following which is the LEAST important requirement for an effective risk measurement approach? Minimal model error: Minimization of model error and incorrect model implementation Loss tail accuracy: accurate specification of the distributional tail Precise output metrics: A high degree of precision in calculated downside risk measures Future-oriented distribution: Characterization of a future (as opposed to current or historical) distribution

C. Unlike valuation (pricing) where precision is important, risk measurement neither requires nor realistically expects a high degree of precision. See this discussion of accuracy versus precision https://en.wikipedia.org/wiki/Accuracy)and_precision. Classically, as expressed by Jorion (in Value at Risk, 3rd edition), risk measurement can be contrasted with derivatives valuation (pricing) in the following ways: Focus (focus of risk is the tail): Valuation is focused on the center of the distribution (distributional mean) while risk measurement is focused on the tails of the distribution Horizon (horizon of risk is the future): Valuation discounts to the expected present value, but risk measurement is preoccupied with an estimate of the future Precision (precision in risk is not essential): Valuation requires a high degree of precision for purposes of pricing, but risk measurement only needs accurate approximations Distribution (distribution is actual/physical): Derivatives valuation utilizes risk-neutral assumption (e.g., Black-Scholes Merton) but risk measurement utilizes an actual (aka, physical) distribution (e.g., Merton model)

Betacare Bank is a United States (U.S.) commercial bank that primarily invests in longterm projects. It is a market leader in commercial real estate loans and business loans. For its sources of funds, the bank mostly issues short-term liabilities, including short-term repurchase agreements (repos), six-month commercial paper and certificates of deposit (CDs) with maturities of less than one year. Each of the following correctly specifies a financial risk to which the bank is exposed EXCEPT which is incorrectly specified? Credit risk due to unexpected losses (UL) in credit assets Liquidity risk due to sudden surge of withdrawals from repo counterparties Market risk due maturity mismatch between long-term assets and short-term liabilities Off-balance-sheet risk due to loans made to companies in the United Kingdom that are denominated in pounds sterling

D. FALSE. Loans made by a US bank to companies in the United Kingdom that are denominated in pounds sterling is foreign exchange (FX) risk. Off-balance-sheet risk is generally risk due to contingent assets or contingent liabilities. In regard to (A), (B) and (C), each is TRUE. In regard to true (C), the specific market risk due to the maturity mismatch is interest rate risk: if interest rates increase, they impact will be greater on long-duration assets than on short-duration liabilities.

Each of the following is true about the traditional risk-adjusted performance measures (i.e., Treynor, Sharpe, Jensen's alpha, information ratio and Sortino) EXCEPT which statement is false? a) Unlike the Treynor and Jensen measures, the Sharpe ratio is not subject to Roll's criticism b) While Jensen's alpha is useful for ranking portfolios with the same beta, the Sharpe ratio is better for ranking portfolios with different levels of risk c) If a portfolio's excess returns are regressed against its benchmark's excess returns, and the regression intercept is assumed to be the portfolio's alpha, then the correct denominator for its information ratio is the residual risk d) If the minimum acceptable return (MAR) is set to equal the risk-free rate, then the Sortino ratio is equal to the Sharpe ratio

D. False. If MAR = risk_free_rate, then only the numerator will be the same (although it is good to realize this!); but the Sortino denominator is the downside deviation and it will still differ from the plain old standard deviation in the denominator of the Sharpe ratio. In regard to (A), (B), and (C), each is TRUE. In regard to (A), about the Treynor measure Amenc writes "Calculating [the Treynor measure] requires a reference index to be chosen to estimate the beta of the portfolio. The results can then depend heavily on that choice, a fact that has been criticized by Roll ... [The Sharpe measure] does not refer to a market index and is not therefore subject to Roll's criticism."

Each of the following is a key dimension of data quality EXCEPT which is not? a) Accuracy measures the degree to which data instances compare to the real-life entities they are intended to model. b) Completeness specifies expectations regarding the population of data attributes, according to varying levels of constraint: mandatory attributes that require a value; data elements with conditionally optional values; and inapplicable attribute values. c) Reasonableness measures conformance to consistency expectations relevant within specific operational contexts. For example, one might expect that the total sales value of all the transactions each day is not expected to exceed 105 percent of the running average total sales for the previous 30 days. d) Uniqueness is measured in terms of agreement with an identified reference source of correct information such as a system of record

D. False. Uniqueness measures the number of inadvertent duplicate records that exist within a data set or across data sets. Asserting uniqueness of the entities within a data set implies that no entity exists more than once within the data set and that there is a key that can be used to uniquely access each entity (and only that specific entity) within the data set. In regard to (A), (B) and (C), each is TRUE.

In regard to Conflicts of Interest, which is true in principle about the responsibility of members: a) Members will not knowingly perform risk management services directly or indirectly involving an actual (but not potential) conflict of interest, under any conditions b) Members will not knowingly perform risk management services directly or indirectly involving an actual or potential conflict of interest, under any conditions c) Members will not knowingly perform risk management services directly or indirectly involving an actual or potential conflict of interest, unless full disclosure has been provided to GARP d) Members will not knowingly perform risk management services directly or indirectly involving an actual or potential conflict of interest, unless full disclosure has been provided to all affected parties of any actual or apparent conflict of interest

D. Members will not knowingly perform risk management services directly or indirectly involving an actual or potential conflict of interest unless full disclosure has been provided to all affected parties of any actual or apparent conflict of interest

Consider the following four financial services firms and their associated financial disasters: Morgan Grenfell: In 1995, a fund manager at Morgan Grenfell Asset Management directed mutual fund investments into highly speculative stocks JPMorgan and Citigroup: JPMorgan and Citigroup agreed to pay a combined $286 million and to put new controls in place, in one outcome of the Enron scandal Prudential-Bache Securities: after a long investigation by the SEC, Prudential-Bache Securities had to pay over $1.0 billion in fined and settlements due to limited liability partnerships Investment banks during the dot-com bubble and crash: Prior to the large fall in the value of technology stocks in 2001 and 2002, some widely following stock market analysts working at investment banks issued favorable recommendations for companies Which of the following is TRUE about all four of these financial services firms; i.e., what do they have in common? In each, investors and/or lenders were seriously misled about the size and nature of the positions it had In each, a rogue trader started with a garden variety position and gradually accumulated in an unauthorized position In each, the firm and its investors and lenders had reasonable knowledge of its positions, but had losses resulting from unexpectedly large market moves In each, losses did not result from positions held by the firm, but instead resulted from fiduciary or reputational exposure to positions held by the firm's customers

D. TRUE. In each, losses did not result from positions held by the firm, but instead resulted from fiduciary or reputational exposure to positions held by the firm's customers These four are all classified by Allen as Disasters Due to the Conduct of Customer Business (4.3). About Enron, Allen writes (emphasis ours), "When this was finally disclosed, JPMorgan Chase and Citigroup, Enron's principal counterparties on these trades, justified their activities by saying that they had not harmed Enron, their client, in any way, and that they had no part in determining how Enron had accounted for the transactions on its books; that was an issue between Enron and Arthur Andersen. JPMorgan and Citigroup had treated these transaction as loans in their own accounting and reporting to regulators, so they had not deceived their own investors or lenders. But both JPMorgan and Citigroup clearly knew what Enron's intent was in entering into the transaction. In the end, they agreed to pay a combined $ 286 million for "helping to commit a fraud" on Enron's shareholders. They also agreed to put new controls in place to ascertain that their clients were accounting for derivative transactions with them in ways that were transparent to investors." Allen: "4.3.3 Other Cases: The following are some examples of other cases in which firms damaged their reputations by the manner in which they dealt with customers: Prudential-Bache Securities was found to have seriously misled thousands of customers concerning the risk of proposed investments in limited partnerships. In addition to damaging its reputation, Prudential-Bache had to pay more than $ 1 billion in fines and settlements. An account of this incident can be found in Eichenwald (1995). In 1995, a fund manager at Morgan Grenfell Asset Management directed mutual fund investments into highly speculative stocks, utilizing shell companies to evade legal restrictions on the percentage of a firm's stock that could be owned by a single fund. In addition to damage to its reputation, Morgan Grenfell had to pay roughly $ 600 million to compensate investors for resulting losses. A brief case account can be found in Garfield (1998). JPMorgan's reputation was damaged by allegations that it misled a group of South Korean corporate investors as to the risk in derivative trades that lost hundreds of millions of dollars based on the precipitous decline in the Thai baht exchange rate against the dollar in 1997. An account of these trades and the ensuing lawsuits can be found in Gillen, Lee, and Austin (1999). Many investment banks had their reputations damaged in the events leading up to the large fall in value of technology stocks in 2001 and 2002. Evidence showed that some widely followed stock market analysts working at investment banks had issued favorable recommendations for companies as a quid pro quo for underwriting business, with analyst bonuses tied to underwriting business generated. Regulators responded with fines for firms, bans from the industry for some analysts, and requirements for separation of the stock analysis function from the underwriting business. A summary account with references can be found in Lowenstein (2004, 212- 213)."

Which of the following statements is TRUE about the capital asset pricing model (CAPM)? CAPM implies that expected return increases with higher volatility Portfolio beta is equal to the value-weighted average beta of its components CAPM is premised on a relaxed set of real-world assumptions, as a model it is rather easily tested, and it has generally passed these empirical tests Because volatilities must be positive, CAPM beta must be positive and therefore a portfolio's expected excess return (excess = net of the risk free rate) must be positive

TRUE. Portfolio beta is equal to the value-weighted average beta of its components Each of (A), (C) and (D) is FALSE. In regard to false (A), CAPM implies that expected return increases with systemic risk, beta, not total risk (ie, volatility) In regard to false (C), as covariance or correlation can be negative, so too can beta and therefore the expected excess return can be negative; realistically, this occurs in a net short portfolio. In regard to false (D), the assumptions are stringent and unrealistic, the CAPM is almost impossible to test by definition (see Bodie), and it has failed many empirical tests. Still, it is useful!