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HENRY LIANG’SFRM GUIDE I

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HENRY L IANG, CQF

Algo trader/quant

Golden Future Education: senior FRM/CFA lecturer

CATTI Certified Interpreter – Level II

Member of the Translators Association of China

Practitioner of Kyokushin Karate

iii

Last update: 8 Oct, 2017

Painter: Lin Fengmian

FOUNDATIONS OF RISK MANAGEMENT

1

4

A. Is Risk Management Useful?

Risk management: how firms actively select the type and level of risk that it is appropriate for them to assume.

Blames for Risk Management• Fail to prevent market disruptions or

accounting scandals.• Derivative markets make it easier to

take on large amount of risk and increase market volatility.

• Sophisticated financial engineering lead to the violent implosion of firms.

• Only transfer risks to other firms as a counterparty.

• Work to the short-term benefit of one group of stakeholders while destroying long-term value for another group.

B. What is Risk?

EL And UL• Expected loss: predictable, incurred

in normal times, and already priced into the products.

• Unexpected loss: risks are lumpy, appear unexpectedly, big enough to upset business plans. Correlation risk is a major factor.

• Risk management doesn’t aim to controlling and reducing EL but to understanding, costing, and managing UL.

Old Treatment Of Risk Vs Stress Testing• Risk managers: move from a

historical-statistical treatments of risk to scenario analysis and stress testing.

• Scenarios: are chosen not on the basis of statistical analysis, because it is both plausible and suitably severe.

• But the statistical models can also help in pricing risk, eliminate or mitigate the risks.

A Risk Manager’ JobNO: control and reduce EL.YES: understand, cost, and efficiently manage unexpected levels of variability for a business.

- Measure the UL;- Set sufficient capital to protect

against potential UL;

RISK MANAGEMENT: A HELICOPTER VIEW

SECTION 1

5

- Achieve appropriate return from the risky activities;

- Clear communication with stakeholders about the company’s target risk profile.

C. The Conflict of Risk and Reward

Higher rate of return ⇒ assume more risk

Risk: variability that can be quantified in terms of probabilities.Uncertainty: variability that cannot be quantified.

A Tradeoff between Risks and Rewards• Organisations with a poor risk

management and risk governance culture sometimes allow powerful business leaders to exaggerate returns while diminishing risks.

• Management might leave gaps in risk measurement that, if mended, would disturb the reported profitability.

• Risk management failure can be exacerbated by the compensation incentive schemes (bonuses are paid today; costs are pushed into the future).

• Trading institutions move revenues forward through either a “mark-to-market” or a “market-to-model” process.

• Risk can be artificially reduced by applying poor or deliberately distorted risk measurement techniques.

• Industry regulators can also be drawn into the deception.

D. The Danger of Names

• The classification of risk creates the potential for missed risks and gaps in responsibilities.

• The management of risk within silos is efficient but won’t work together efficiently to manage the risks as a whole.

• VaR/Economic capital/worst-case scenario analysis have facilitated integrated measurement and management of the various risks and business lines.

• Enterprise-wide risk management (ERM) breaks through risk management silos and allows for enterprise-wide risks.

E. Numbers are Dangerous too

• Only some kinds of numbers are truly comparable.

• Introducing sophisticated models has its own dangers.

• The VaR measure works well only for:

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- Markets operating under normal conditions;

- Over a short period;- For liquid portfolios.

• A trader might falsify transaction details, use fictitious trades, or tamper with the inputs to risk models.

• Risk report readers seldom ask tough questions.

• All statistical estimation is subject to estimation errors and economic environment changes.

• Human psychology: people tend to be risk-averse in the domain of gains and risk-seeking in the domain of losses.

F. The Risk Manager’s Job

A Risk Manager’s Role• Uncover the sources of risk and

measure its impact: help make risk management decision.

• Balance risk and reward.• Make risk transparent to key decision

makers and stakeholders in terms of probability.

• Find the right relationship between business leaders and the specialist risk management functions.

G. Typology of Risk Exposures

Market Risk

• Definition: market risk is the risk that changes in financial market prices and rates will reduce the value of a security or a portfolio.

• Interest rate risk: an increase in market interest rates ⇒ value of a fixed-income security falls.

• Equity price risk: associated with volatility in stock prices.

- General market risk: the sensitivity of an instrument value to a change in the level of broad stock market indices.

- Idiosyncratic risk: portion of a stock’s price volatility determined by characteristics specific to the firm.

- General market risk cannot be eliminated through portfolio diversification, while specific risk can be diversified away.

• Foreign exchange risk: fluctuations in profits or values as measured in a local currency.

- Major drivers: imperfect correlations in the movement of currency prices and fluctuations in international interest rates.

• Commodity price risk- Concentrated in the hands of a few

suppliers.- Must consider the cost of storage.- Higher volatility and larger price

discontinuities.

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Credit Risk

• Definition: credit risk is the risk of an economic loss from the failure of a counterparty to fulfil its contractual obligations, or from the increased risk of default during the term of the transaction.

• Default risk: the debtor’s incapacity or refusal to meet his debt obligations.

• Bankruptcy risk: the risk of actually taking over the collateralised assets of a defaulted borrower.

• Downgrade risk.• Settlement risk: due to the exchange

of cash flows when a transaction is settled.

Credit Risk at the Portfolio Level• Charge the appropriate interest rate to

each borrower so that the lender is compensated for the risk it undertakes.

• Concentration risk: the extent to which the obligors are diversified in terms of exposures, geography, and industry.

• During the good times: the frequency of default falls sharply.

• During the economic downturn: customers tend to default together.

• Time diversification: banks build portfolios that are not concentrated in particular maturities.

Liquidity Risk

1. Funding Liquidity Risk• Definition: a firm’s ability to raise the

necessary cash to roll over its debt; to meet the cash, margin, and collateral requirements; and to satisfy capital withdrawals.

• Can be managed through holding cash, setting credit lines in place, and monitoring buying power.

2. Trading Liquidity Risk• Definition: an institution will not be

able to execute a transaction at the prevailing market price because there is temporarily no appetite for the deal on the other side of the market.

• Size and immediacy: the faster or larger the transaction, the greater the potential for loss.

Operational Risk• Definition: OP risk refers to potential

losses resulting from a range of operational weaknesses including failed internal processes, people, and systems, or from external events.

• OP risk includes human factor risk, fraud, technology risk, etc.

Legal And Regulatory Risk• Classified as OP risk.• Such as change in tax law.

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Business Risk• In the Basel II Capital Accord,

“business risk” was excluded from OP risk.

Strategic Risk• Strategic risk refers to the risk of

significant investments for which there is a high uncertainty about success and profitability.

Reputation RiskTwo Main Classes• The belief that an enterprise can and

will fulfil its promises to counterparties and creditors.

• The belief that the enterprise is a fair dealer and follows ethical practices.

Systemic Risk• Systemic risk concerns the potential

for the failure of one institution to create a chain reaction on other institutions and consequently threaten the stability of financial markets and even the global economy.

• Such as: flight to quality, panicked margin call requests.

The Dodd-Frank Act• Focus on systemic risk.

• To move the market for OTC derivatives onto centralised clearing platforms.

• Counterparty risk inherent in OTC derivative transactions will be transferred to a central counterparty.

[END OF THIS CHAPTER]

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A. Why Not to Manage Risk in Theory

• Franco Modigliani and Merton Miller (M&M): the value of a firm cannot be changed merely by means of financial transactions. Firms should therefore not engage in any risk reduction activity that individual investors can execute on their own.

• MM’s assumption: the capital markets are perfect (highly competitive; participants are not subject to transaction costs, commissions, or taxes).

• CAPM: in a world with perfect capital markets, firms only base their investment decisions on systematic risks.

• Using hedging tools cannot increase the value of the firm. Self-insurance is a more efficient strategy.

• Active hedging may distract management from its core business.

• A careless risk management strategy can drag a firm down even more quickly than the underlying risk.

• Risk management strategy has compliance costs, including disclosure.

• Hedging could increase the firm’s earnings variability due to the gap between accounting earnings and economic cash flows.

B. Reasons for Managing Risk in Practice

• The assumption that capital markets operate with perfect efficiency does not reflect market realities: the high fixed costs associated with financial distress and bankruptcy.

• Managers have an interest in reducing risks to show to boards and investors their skills of management.

• By employing risk management tools, management can better achieve the board’s objectives.

• Hedging reduces the cost of capital and enhances the ability to finance growth.

• Hedging increases the debt capacity of companies ⇒ increase interest tax deductions.

• A firm can stabilise its costs through hedging ⇒ a competitive advantage.

• Purchasing insurance is expensive.

CORPORATE RISK MANAGEMENT: A PRIMER

SECTION 2

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C. Hedging Operations Versus Hedging Financial Positions

Whether a Particular Corporation should Hedge its Risks?• Companies should concentrate on

business areas in which they have comparative advantages and avoid areas where they cannot add value.

• Reducing risk in the production process and in selling activities is advisable.

• Whether or not the financial markets are perfect, the firm may gain some advantage (at least no harm) from hedging its balance sheet.

A Twofold Conclusion• Firms should risk-manage their

operations.• Firms may also hedge their assets and

liabilities, so long as they disclose their hedging policy.

D. Putting Risk Management into Practice

1. Determining The Objective

Risk Appetite• The board defines it.

• Set out the types of risk that the firm is willing to tolerate and which risks should be hedged or to assume.

• Indicate the maximum losses the organisation is willing to incur.

The Board Should• Direct management to mitigate or

insure against extreme losses.• Accept projects with positive

risk-adjusted NPV (can enhance the welfare of all stakeholders).

• Balance the benefit of both debt-holders and shareholders.

• Consider which risk to hedge, and which risk to assume.

• Declare whether the aim is to hedge accounting profits or economic profits, and short-term profits or long-term profits.

• Decide whether to smooth out the ups and downs of accounting profits.

• Make clear the time horizon for any of the risk management objectives set for management.

• Make clear risk limits to allow management to be exposed to the risk within the zone, but to disallow risk exposure beyond those limits.

2. Mapping The Risks

1. Map the specific risks likely to arise from some risk factors (such as exchange rate fluctuation).

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2. Make a record of all assets and liabilities with values that are sensitive to that risk factor.

3. All expected expenses over the coming year that are concerned with that risk factor should be traced.

4. The timing of cash inflows and outflows for that risk factor can then be matched.

5. Prepare a list of risks: each risk on the list should be characterised in terms of its potential damage and the probability of its occurrence.

6. Differentiate between risks that can be insured against, risks that can be hedged, and risks that are non-insurable and non-hedgeable.

3. Instruments For Risk Management• Identify instruments that can be used to

risk-manage the exposures. Some of the instruments can be naturally hedged.

• Compare competing ways to manage the risks: transferable? insurable? not insurable? self-insure?

• Many large companies opt to self-insure their property.

• Hedge with OTC instruments or exchange-traded instruments?

4. Constructing And Implementing A Strategy

Static Hedging Strategies• A hedging instrument is purchased to

match the risky position as exactly as possible and is maintained for as long as the risky position exists.

• Easy to implement and monitor.

Dynamic Hedging Strategies• Involve an ongoing series of trades.• Call for greater managerial effort.• Posses sophisticated and reliable

models.• Incur higher transaction costs.

Planning horizon: investment horizons should be made consistent with performance evaluations.

Accounting issues: derivatives used for hedging must be perfectly matched to an underlying position. They can then be reported together with the underlying risky positions, and no accounting profit or loss needs to be reported.

Potential tax effects are considered.

5. Performance EvaluationWhether• Risk is eliminated?• Reduce earnings volatility?• Well manage the transaction costs of

hedging?


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A. Introduction

Sarbanes-Oxley Act (SOX)1. Penalise inattention and

incompetence as much as deliberate malfeasance.

2. Ensure the accuracy of company reports filed with the SEC.

3. Disclose to the audit committee any deficiencies and material weaknesses in internal controls and fraud.

4. The board of the company must include financial experts.

5. Require U.S. National securities exchanges to make sure that their securities listing standards conform to the SEC rules.• The board must have a majority of

independent directors.• Establish a corporate governance

committee.• A compensation committee and an

audit committee in place.

Key Post-Crisis Corporate Governance Concerns• Depositors, debt holders, and taxpayers

have a much stronger interest in minimising the risk of bank failure than do most shareholders. The usual

solution to corporate governance issues (empowering shareholders) may not be the complete solution in banking.

• Board composition: bank boards contain the right balance of independence, engagement, and financial industry expertise.

• Boards need to become much more actively involved in risk oversight.

• Risk appetite: regulators have pushed banks to set out a risk appetite that defines the firm’s willingness to take risk and to tolerate threats to solvency.

• Compensation: making bonuses a smaller part of the compensation package; bonus clawback and deferred payments.

B. Setting the Scene: Corporate Governance and Risk Management

The Board Should• Look after the interests of shareholders.• Be sensitive to the concerns of other

stakeholders.• Alert for any conflict between the

interests of management and the company’s longer-term stakeholders.

CORPORATE GOVERNANCE AND RISK MANAGEMENT

SECTION 3

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• Separate the role of the CEO and the chairman of the board.

CRO• Act as a senior member of the

management committee and attend board meetings regularly.

• Have a direct reporting line to the board or its risk committees in addition to reporting to the executive team.

C. True Risk Governance

Risk Appetite• The board characterise a risk appetite

for the firm.• The risk appetite should clearly be

connected to its overall business strategy and capital plan.

• Clear communication throughout the firm of the firm’s risk appetite and risk position.

Four Basic Choices in Risk Management1. Avoid risk.2. Transfer risk to third parties through

insurance, hedging, and outsourcing.3. Mitigate risk through preventive and

detectives control measures.4. Accept risk: undertaking certain risky

activities should generate shareholder value.

The Board Should

• Ensure that business and risk management strategies are directed at economic rather than accounting performance.

• Set up ethics committees: make sure that “soft” risks don’t slip through the “hard” risk-reporting framework.

• Make sure that the way staff are rewarded is based on risk-adjusted performance and is aligned with shareholders’ interests.

• Ensure that any major transactions the bank enters into are consistent with the risk authorised.

• Ensure that the information it obtains about risk management is accurate and reliable.

• Directors should demonstrate healthy skepticism and ask tough questions.

Board Members Should• Be given the means to explore and

determine the risk appetite of the organisation.

• Board members of the risk committee need some technical sophistication and solid business experience.

• The risk committee of the board should remain separate from the audit committee (as different skills are needed).

D. Committees and Risk Limits

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1. Risk Management Committee• The risk management committee helps

to translate the overall risk appetite of the bank into a set of limits.

• Independently review the identification, measurement, monitoring, and controlling of credit, market, and liquidity risks.

• Report back to the board on a variety of items, such as all loans and credits over a specified dollar limit.

• Senior risk committees oversee risk management practices and detailed reporting.

• Junior risk committees look after specific types of risk and often report to this senior risk committee.

2. Audit Committee Of The Board• The audit committee’s duties involve

checking for infringements, overseeing the quality of the processes that underpin financial reporting, regulatory compliance, internal controls, and risk management.

• But it only confines to verification function.

• Audit committee members are required to be financially literate.

• The audit committee needs to establish an appropriate interaction with management.

3. Risk Advisory Director• Specialist risk advisory director is a

member of the board who specialises in risk matters.

• Work to improve the overall efficiency and effectiveness of the senior risk committees and the audit committee.

• Provide independent commentary on executive risk reporting.

• Meet regularly with key members of management.

• Observe the conduct of business.

4. Compensation Committee• Determine the compensation of top

executives.• Incentive compensation should be

aligned with the long-term interests of stakeholders, and with risk-adjusted return on capital.

• International cooperation to prevent financial firms from arbitraging the market for human capital through their choice of jurisdiction.

• Removal of guaranteed bonuses. Replace with compensation deferral, clawbacks, cap bonus.

• Stock-based compensation can encourage risk-taking.

• Solutions:- Make employees creditors of the

company by including restricted bonds as part of their compensation package.

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- Contingent debt: converts into equity if the capital ratio falls below 5%.

E. Roles and Responsibilities in Practice

Key Lessons from the Financial Crisis• CROs should not just be after-the-fact

risk managers but also risk strategists.• Engage directly with the risk committee

of the board and also report regularly to the full board.

• Be independent of line business management.

• Have a strong enough voice.• Must evaluate all new financial

products to verify that the expected return is consistent with the risks undertaken.

F. Limits and Limit Standards Policies

• An appropriate set of limits and authorities must be developed for each portfolio of business and for each type of risk.

• Limits should be related to VaR, scenario and stress testing to make sure the bank can survive worst-case scenarios.

• Limit setting needs to take into account an assessment of the business unit’s historical usage of limits.

G. Standards for Monitoring Risk

How Should a Bank Monitor Those Limits?• All market risk positions should be

valued daily.• All the assumptions used in the models

should be independently verified.• Timely and meaningful reports to

measure the compliance of the trading team.

• The variance between the actual volatility of the value of a portfolio and that predicted by means of the bank’s risk methodology should be evaluated.

Data Used in Limit Monitoring Must be• Independent of the front office.• Reconciled with the official books of the

bank.• Derived from consolidated data feeds.• In a data format that allows risk to be

properly measured.

What Happens if the Limit is Breached?• The risk management function should

immediately put any excess on a daily

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“limit type A or limit type B exception report”.

• The head of risk management may authorise the use of a reserve.

• The risk managers should then report all limit excesses across the bank in an exception report.

Type A limits: include a single overall limit for each asset class as well as a single overall stress test limit and a cumulative loss from peak limit.• Limit type A excesses must be cleared

or corrected immediately.• May authorise use of a reserve.• Can petition the senior risk committee

for a type A excess.

Type B limits: are more general and cover authorised business and concentration limits.• Limit type B excesses should be cleared

or approved within a relatively short time frame.

• Either approves type B excesses or orders them to be cleared.

H. What Is the Role of the Audit Function?

A Key Role of the Audit Function• Provide an independent assessment of

the design and implementation of the bank’s risk management.

• Examine the integrity of the management information system and the independence, accuracy, and completeness of position data.

• Evaluate the design and conceptual soundness of the risk measures.

• Verify the accuracy of models through back-testing.

• Evaluate the soundness of elements of the risk management information system.

• Provide assurance as to the design and soundness of the financial rates database that is used to generate parameters.

• Examine the documentation relating to compliance.

Conclusion• A joint approach to corporate

governance and risk management has become a critical component of a globally integrated best-practice institution.


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Delegation Process for AuthoritiesDelegation Process for Authorities

Risk Committee of the BoardApprove the bank’s risk appetite.

Risk Committee of the Board Review the identification, measurement, monitoring, and controlling of all risks.

Delegate authority to Senior Risk CommitteeDelegate authority to Senior Risk Committee

Senior Risk Committee(including CEO, CRO, CFO, head of compliance, heads of the business

units)

Determine the amount of financial risk and non-financial risk to be assumed.Senior Risk Committee

(including CEO, CRO, CFO, head of compliance, heads of the business

units)

Establish, document and enforce all policies that involve risk.

Senior Risk Committee(including CEO, CRO, CFO, head of compliance, heads of the business

units) Review and approve each business unit mandate in terms of risk limits.

Delegate authority to CRODelegate authority to CRO

CROA member of the management

Design the risk management strategy.


Responsible for the risk policies and corporate risk governance.


Inform the board and senior risk committee about the risk appetite across the bank.


Communicate the views of the board and senior management down through the organisation.


Monitor the limits.

Delegate authority to Heads of Business UnitsDelegate authority to Heads of Business Units

Heads of Business Units

Make sure that risks are managed appropriately at the business line level.

Heads of Business UnitsAnd business decisions are in line with the firms’ risk/reward trade-offs.

Delegate to Business Unit ManagerDelegate to Business Unit Manager

Business Unit Manager Responsible for the risk management and performance of the business.

A. ERM Definitions

COSOERM is a process, effected by an entity's board of directors, management, and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its appetite, to provide reasonable assurance regarding the achievement of entity objectives.

ISO 31000Risk is the “effect of uncertainty on objectives” and risk management refers to “coordinated activities to direct and control an organisation with regard to risk.”

The Book Author’s DefinitionRisk is a variable that can cause deviation from an expected outcome. ERM is a comprehensive and integrated framework for managing key risks in order to achieve business objectives, minimise unexpected earnings volatility, and maximise firm value.

TRADITION ERM

Companies manage risk in a solo approach.

An integrated approach.

Risks are broken into separate components and managed independently.

Risks cannot be segmented and managed by entirely independent units.

Risks can fall through the cracks. Risk interdependencies and portfolio effects may not be captured.

Establish firm-wide policies and standards and provide overall risk monitoring.

Individual risk functions measure and report their specific risks using different methodologies and formats.

Senior management and the board get the whole picture, not pieces of the puzzle.

B. The Benefits of ERM

ERM Is All About Integration

• ERM requires an integrated risk organisation.

- The CRO reports to the CEO and the Board in support of their risk oversight responsibilities.

WHAT IS ERM?

SECTION 4

19

- CRO is responsible for overseeing all aspects of risk within the organisation.

• ERM requires the integration of risk transfer strategies.

- Take a portfolio view of all types of risk within a company.

- Use derivatives, insurance, and alternative risk transfer products to hedge only the residual risk.

• ERM requires the integration of risk management into the business processes of a company.

- Optimise business performance by supporting and influencing pricing, resource allocation, and other business decisions.

Three Benefits To ERM

1. Organisational Effectiveness• Various functions work cohesively and

efficiently: an integrated team can better address not only the individual risks facing the company, but also the interdependencies between these risks.

2. Risk Reporting• Produce timely and relevant risk

reporting for the senior management and board of directors.

• Increase risk transparency throughout an organisation.

3. Business Performance

• Market value improvement.• Lower earnings volatility.• Early warning of risks.• Loss reduction.• Regulatory capital relief.• Risk transfer rationalisation.• Insurance premium reduction.

C. The Chief Risk Officer

A CRO Is Responsible For1. Providing the overall leadership for

enterprise risk management.2. Establishing an integrated risk

management framework for all aspects of risks across the organisation.

3. Developing risk management policies including the firm’s risk appetite.

4. Implementing a set of risk indicators and reports.

5. Allocating economic capital to business activities based on risk, and optimising the company's risk portfolio.

6. Communicating the company's risk profile to key stakeholders.

7. Developing the analytical, systems, and data management capabilities to support the risk management program.

Reporting

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• The heads of credit risk, market risk, operational risk, insurance, and portfolio management typically report to the CRO.

• The CRO reports to the CFO or CEO.• A dotted-line reporting relationship

between the CRO and the board:- Under extreme circumstances, the

CRO can go directly to the board without fear for his job security or compensation.

- Risk management must have an independent voice.

- Establish and document the ground rules.

Some Problems In ERM• If audit committees were responsible

for risk management, audit committees are already working at maximum capacity just handling audit matters, and are unable to properly oversee ERM as well.

• The lack of an ERM standard is also a significant barrier to the positive development of the CRO role: firms from different industries should tailor their approaches to risk management.

The CRO Role Has Elevated The Risk Management Profession• The appointment of executive

managers whose primary focus is risk

management has improved the visibility and organisational effectiveness of that function at many companies.

• The CRO position provides an attractive career path for risk professionals.

An Ideal CRO’s Superb Skills1. The leadership skills to hire and

retain talented risk professionals and establish the overall vision for ERM.

2. The evangelical skills to convert skeptics into believers.

3. The stewardship to safeguard the company's financial and repetitional assets.

4. Having the technical skills in strategic, business, credit, market, and operational risks.

5. Having consulting skills in educating the board and senior management, as well as helping business units implement risk management at the enterprise level.

D. Components of ERM

1. Corporate Governance• Ensure that the board of directors and

management have established the appropriate organisational processes and corporate controls to measure and manage risk across the company.

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2. Line Management• Align business strategy with corporate

risk policy when pursuing new business and growth opportunities.

• The risks of business transactions should be fully assessed and incorporated into pricing and profitability targets in the execution of business strategy.

3. Portfolio Management• Set portfolio targets and risk limits.• Ensure optimal portfolio returns.• Aggregate risk exposures.• Incorporate diversification effects.• Monitor risk concentrations.

4. Risk Transfer• Lower the cost of transferring out

undesirable risks.• Mitigate risk exposures that are

deemed too high.• Risk transfer strategies: through credit

derivatives or securitisation.• Natural hedges.• Purchase desirable risks or swap

undesirable risk exposures.

5. Risk Analytics• Provide the risk measurement, analysis,

and reporting tools to quantify the company’s risk exposures as well as track external drivers.

6. Data and Technology Resources

• Aggregate underlying business and market data.

• Improve the quality of data that is fed into the risk systems.

7. Stakeholder Management• Communicate and report the

company’s risk information to its key stakeholders (eg. the Board, regulators, analysts, rating agencies).

THE RESPONSIBILITIES OF THE BOARD OF DIRECTORS AND SENIOR

MANAGEMENT

Defining the organisation's risk appetite.

Ensuring that the organisation has the risk management skills and risk absorption capability to support its business strategy.

Establishing the organisational structure of the ERM framework and defining the roles and responsibilities for risk management.

Implementing an integrated risk measurement and management framework.

Establishing risk assessment and audit processes.

Shaping the organisation's risk culture.

Providing appropriate opportunities for organisational learning.


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A. How Does Risk Management Add Value?

Attitudes Toward Risk• Good risk: risks that have a positive

expected payoff or reward on a stand-alone basis.

• Bad risk: risks that can be expected to destroy value on a stand-alone basis.

• Banks cannot succeed without taking risks that are profitable.

Modigliani-Miller Theorem• The value of companies would not be

affected by corporate efforts to manage financial risks.

• But in the real world:- Taxes and transaction costs exist.- Bad outcomes can lead to costly

financial distress.- Companies in distress may lose the

ability to carry out their strategies.- Difficult to conduct their business.- The value of a company’s equity is

reduced.

Risk management: reduce these distress costs, and increase the value of the firm.

The Goal of Risk Management for Banks• Not to eliminate or minimise risk, but

to determine the optimal level of risk – the level that maximises bank value subject to the constraints imposed by regulators, laws, and regulations.

A Tradeoff between Return and Risk• A bank should take any project that

increases its value.• The cost of taking on a new risk < the

gain from taking that risk.• Risk-taking decisions must be assessed

in terms of their impact on the overall risk.

• Major challenge: the tradeoff can not be made in real time.

• Countermeasure: unit of the bank focuses on individual risks separately; while at the same time manage the bank’s overall risk by imposing limits on each unit.

Two Ways that Risk Management can Destroy Value• Fail to ensure that the bank has the

right amount of risk.

RISK MANAGEMENT AND RISK TAKING IN BANKS

SECTION 5

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- Fail to uncover bad risks that should be eliminated.

- Mis-measure good risks.- Fail to measure the bank’s total

risk.• Fail to exercise the right amount of

flexibility.- It prevents the taking of valuable

risks.- Risk managers become “policemen”

rather than partners in creating value.

- It is critical to strike the balance.

B. Determining a Bank’s Risk Appetite

Banks Cannot Operate with too much Risk• Constrained by laws and regulations.• Market can reduce a bank’s value by

limiting its ability to attract deposits.• Derivatives counterparties will be

reluctant to deal with the bank.• Difficult to hire potential employees.

Banks have to Take Some Risks• To create wealth for their shareholders.• By targeting a certain credit rating, a

bank’s management is also targeting a specific probability of default and a desired level of risk.

A Bank’s Optimal Credit Rating

• Depending on its business model and investment opportunities.

• Banks with more of doing traditional activities (such as deposit) prefer a higher rating and a low-risk profile (amount of capital > that required).

• Banks with less reliance on deposit-gathering activities target a less restrictive credit posture.

Taking Social Costs into Account• The difference between banks and less

regulated industrial companies is the potential for bank failures to have system-wide effects.

• The activities of banks that aim to maximise value for their shareholders could generate an amount of systemic risk that is excessive to society.

• Regulators therefore impose restrictions on banks’ ability to take risks and require banks to satisfy minimal capital requirements.

• Therefore, banks choose their level of risk subject to external constraints.

C. Governance and Risk Taking

A Good Governance• A well-governed bank should make

value-maximising trade-offs between risk and reward, all while operating within the constraints imposed by regulation.

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• The board has to ensure that the firm has a risk management organisation so that the actual level of risk taken is consistent with the firm’s risk appetite.

• Risk audits could be valuable tools in helping boards ensure that management is managing a bank’s risk properly.

Better Risk Governance ≠ Less Risk• Effective risk governance does not

mean eliminating or even reducing risk-taking.

• Because the optimal amount of risk from the perspective of the shareholders need not be the optimal amount for society.

• Better governance means taking risks that were expected to be rewarding for shareholders, given that bank managers and their shareholders generally viewed the possibility of a crisis as an exceedingly low-probability event.

• Effective governance can make banks more valuable but also riskier.

• Empirical evidence: better governance did not enable banks to perform better during the crisis.

D. The Organisation of Risk Management

Real-world Banks cannot Control Risk for Three Reasons

1. Limitations in risk measurement technology:• Real-time risk measures do not

exist for banks as a whole.• Risk measurement can be highly

imprecise.• Risk measurement can be affected

by behavioural biases.2. Limitations of hedging:

• Some risks cannot be hedged, and hedges may not work out as planned.

3. Limitations of control resulting from incentives:• Risk-takers can often gain from

taking risks that destroy value for the bank.

Risk must be Managed throughout the Organisation• If a bank’s value is insensitive to its

overall level of risk, there is little room for risk management to add much value.

• If too much risk-taking results in a sharp drop in a bank’s value, a risk management function has the potential to create a lot of value.

The Right Degree of Independence for Risk Managers• Risk management is not an audit.

- Auditors only have a verification function.

- But risk managers should help employees increase firm value.

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• If risk managers are viewed as a police, they will face obstacles in gathering information ⇒ may not learn of model weaknesses.

• The reporting lines of risk managers should be completely separate from the businesses whose risks they are monitoring.

- Where business lines have a weak commitment to managing risk, business lines may retaliate against the risk managers.

- Where business lines have a strong commitment to managing risk, business lines collaborate with risk managers.

E. Using VaR to Target Risk

Process of Using VaR• Translate a bank’s risk appetite into a

targeted probability of experiencing losses that are expected to result in financial distress.

• The bank-wide VaR is a function of the VaRs of various units as well as their correlations.

• VaR can assess how each unit contributes to the risk of the bank.

• Risk management can target the bank’s VaR by setting limits on the VaRs of all the units.

F. The Limits of Risk Measurement

Difficulties in Using VaR to Measure Risk at the Firm Level• Aggregating VaR to obtain a firm-wide

risk measure has problems.- A firm-wide VaR that is obtained by

aggregating market, credit, and operational risks will not reflect all risks.

- VaR does not capture all risks (such as some business risks).

• VaR has substantial model risk.- Mistakes in correlation estimates.- Different types of risk have

different statistical distributions.- No sufficient history to reliably

assess whether the VaR is unbiased.• Black swans.• Stress testing: to simulate what the

performance of the bank would be if historical crises were to repeat themselves.

- If bank is not able to survive past crises, its VaR is likely biased.

G. Incentives, Culture, and Risk Management

Risk Management is not Auditing• Risk managers must understand the

bank's businesses and personnel well

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enough to know when limit exceedances should be allowed.

• Risk managers also have to determine when limits or risk appetite have to be changed.

• A risk management organisation might make incorrect risk assessments without having a dialogue with business units.

• But having such a dialogue is difficult if the risk management function is viewed as a compliance unit rather than an essential part of the firm.

Risk Management Key Points• If many people make sure that the

institution takes risks that increase firm value, risk management becomes a resource.

• Executives within the firm must care about the firm as a whole (as risk managers face potential conflicts with unit managers).

• Set correct incentives for risk taking.

Corporate Culture of Risk• It is impossible to set up an incentive

plan that is so precisely calibrated that it leads executives to take the right actions in every situation.

• Not all risks can be quantified ⇒ there is an incentive for employees to take risks that are not quantified and monitored.

• The ability of a firm to manage risk properly depends on its corporate culture.

• Companies where managers are viewed by their employees as trustworthy are more profitable.

• However, shareholders gain initially from the better governance, but these gains are partly offset over time because of the change in the culture of the firm.

• A bank’s culture can provide a more flexible way that leads to better outcomes.


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A. Disasters due to Misleading Reporting

Chase Manhattan Bank/Drysdale SecuritiesChase Manhattan Bank/Drysdale Securities

Incident

Result

Arose

Why not detected?

How detected?

Lessons

Drysdale obtained unsecured borrowing of $300 million by exploiting a flaw in computing the value of U.S. government bond collateral.

Drysdale had only $20 million in capital.

Drysdale lost the borrowed money in bond markets.

Chase Manhattan absorbed these losses because it had brokered most of Drysdale's securities borrowings.

The losses severely damaged Chase’s reputation.

The inexperienced managers in Chase were convinced they were simply acting as intermediaries.

Drysdale took systematic advantage of a computational shortcut in determining the value of borrowed securities.

Chase believed they were only acting as agents on these transactions.

They also believed that Drysdale’s capital was not at risk.

The size of the losses exceeded the amount of unauthorised borrowings Drysdale could raise and the firm had to declare bankruptcy.

Make the methods for computing collateral value on bond borrowings more precise.

New product offerings must receive prior approval from the risk control functions.

FINANCIAL DISASTERS

SECTION 6

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Kidder PeabodyKidder Peabody

Incident

Result

Arose

Lessons

Kidder Peabody entered into a series of trades that were artificially inflating the firm’s reported profits.

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

It had not resulted in any actual loss of cash.

But triggered a substantial loss of confidence in the competence of the firm's management.

A flaw in accounting for forward transactions in the computer system for government bond trading.

Always investigate a stream of large unexpected profits and make sure you completely understand the source.

Periodically review models and systems.

Barings BankBarings BankIncident

Result

Arose

Why not detected?

Lessons

A loss of $1.25 billion due to the unauthorised trading of a trader Nick Leeson.

Forced Barings into bankruptcy.

Leeson disguised his speculative position taking by reporting that he was taking the positions on behalf of fictitious customers. He manufactured substantial reported profits for his own accounts.

Incompetence of Barings' management: ignored control rule and failed to act on indications of something being wrong.

Allowing Leeson to function as head of trading and the back office => depriving the firm of an independent check on his activities.

Management failed to inquire how a low-risk trading strategy was generating such a large profit.

Poor structuring of management information: different risk control areas looked at reports that did not tie together.

The absolute necessity of an independent trading back office.

The need to make thorough inquiries about unexpected sources of profit or loss.

The need to make thorough inquiries about any large unanticipated movement of cash.

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Allied Irish BankAllied Irish Bank

Incident

Result

Arose

Why not detected?

Lessons

John Rusnak, a currency option trader, entered into massive unauthorised trades, resulting in $691 million in losses.

A major blow to AlB's reputation and stock price.

Rusnak was actually running large outright positions and disguising them from management.

Rusnak 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.

He was extremely modest in the amount of false profit he claimed.

He booked imaginary trades with counterparties in the Asian time zone, making confirmation task difficult.

He also relied on arguments that costs should be cut by weakening or eliminating key controls.

Rusnak's managers was inexperienced in FX options and trusted Rusnak's supposedly excellent character.

Avoid engaging in small ventures in which the firm lacks any depth of expertise.

Union Bank of SwitzerlandUnion Bank of Switzerland

Incident

Result

Arose

Lessons

Losses of $400 million ~ $700 million in equity derivatives during 1997.

Another loss of $700 million during 1998 due to a large position in LTCM.

The 1997 losses forced UBS into a merger with Swiss Bank Corporation. The 1998 losses came after that merger.

Less is known about the UBS disaster.

The equity derivatives business was being run without a proper management oversight.

The person with senior risk management authority for the department doubled as head of quantitative analytics. His compensation tied to trading results.

The need for independent risk oversight.

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Societe GeneraleSociete Generale

Incident

Result

Arose

Why not detected?

Lessons

In January 2008, Societe Generale reported trading losses of $7.1 billion caused by unauthorised activity of a trader, Jerome Kerviel.

Severely damaged Societe Generale's reputation and required it to raise capital.

Kerviel took very large unauthorised positions in equities and exchange-traded futures from 2005 to 2008.

He concealed these unauthorised positions by entering fictitious transactions that offset the risk and P&L of his true trades.

He constantly replaced canceled fictitious transactions with new ones, totalling 947 transactions.

There was no red-flagging for an unusual level of trade cancellations.

Day-to-day supervision of Kerviel by a new manager was weak.

Kerviel’s trading assistant may have been operating in collusion with Kerviel.

The normal precaution of forcing a trader to take vacation was not followed.

There were no limits or other monitoring of Kerviel's gross positions, only his net positions.

Societe Generale's cash and collateral procedures lacked sufficient granularity to detect unusual movements at the level of a single trader.

Kerviel was reporting trading gains in excess of levels his authorised position permitted. But these warning signs were apparently not pursued.

Flag any trader who is using an unusually high number of cancellations.

Control personnel should be aware of situations in which traders are being supervised by temporary or new managers.

Don’t trust the independence of the trading assistant too much.

Rules for mandatory vacation should be enforced.

Unusually high ratios of gross to net positions are a warning sign of unauthorised activities.

Better monitoring of cash and credit flows.

Any unusual P&L need to be identified and investigated.

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Other Cases Concerning Unauthorised Positions

• Toshihida Iguchi of Daiwa Bank's New York office lost $1.1 billion trading Treasury bonds. He hid his losses and made his operation appear to be profitable by forging trading slips. He was the head of both trading and the back-office support function.

• The Sumitomo Corporation of Japan lost $ 2.6 billion in a failed attempt by Yasuo Hamanaka to corner the world's copper market (to drive up prices by controlling a large portion of the available supply). Hamanaka had employed fraudulent means in hiding the size of his positions.

• Askin Capital Management and Granite Capital went bankrupt in 1994 with losses of $600 million. The manager of the funds was valuing positions with his own marks substituted for dealer quotes and using these position values in marketing materials to attract new clients.

• Merrill Lynch lost $350 million in trading mortgage securities in 1987, due to risk reporting that used an incorrect duration for all securities created from a pool of 30-year mortgages.

• National Westminster Bank in 1997 reported a loss on interest rate caps and swaptions of about $140 million. Traders deliberately used

incorrect volatility inputs by checking only a sample of volatility marks against market sources.

• The large Swiss bank UBS in 2011 reported a loss of $2.3 billion due to unauthorised trading by a relatively junior equity trader.

B. Disasters due to Large Market Moves

1. Long-Term Capital Management

Key Point• No one at LTCM provided misleading

information about positions taken. The near failure was due to some of the largest market moves in recent memory.

Before the Failure• LTCM was highly secretive about the

particulars of their investment portfolio.

• Inside LTCM, information was shared openly, and essentially every investment decision was made by all the partners acting together.

• The partners had invested most of their net worth in it. Their incentives were closely aligned with investors.

• Investors were locked into their investments for extended time periods.

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• As LTCM was 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.

LTCM’s Presumed Positions• LTCM was long U.S. interest rate swaps

and short U.S. government bonds at a time when these spreads were at historically high levels. Over the life of the trade, this position will make money as long as the average spread between the LIBOR at which swaps are reset and the repurchase agreement rates at which government bonds are funded narrows.

• LTCM sold equity options at historically high implied volatilities. Over the life of the trade, this position will make money if the actual volatility is lower than the implied volatility.

LTCM’s Funding Sources• LTCM wanted to deal in

over-the-counter markets as well as on futures exchanges.

• LTCM almost always negotiated terms that avoided posting the initial margin. But lenders retained the option of demanding initial margin if fund equity fell too much.

• 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.

The Crisis• The triggers: Russian debt default in

1998; Salomon Brothers decided 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, and it was reluctant to cut positions in a turbulent market.

• Rumours of LTCM's predicament caused competitors to drive market prices even further against what they guessed were LTCM's positions.

• 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 unfavorables to LTCM intensified.

The Fall of LTCM• 14 of the largest creditors contributed a

fresh $3.65 billion in equity investment into the LTCM fund to allow for a substantial time period in which to close out positions.

• In return, the creditors received substantial control over fund management.

• The existing investors had only a 10 percent share in the positions of the fund.

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• By 2000, LTCM had been wound down. 14 creditors recovered all of the equity they had invested and avoided any losses on the LTCM positions.

• Two propositions: LTCM was largely right about the long-term values underlying its positions; the creditors were right to see the primary problem as liquidity, which required patience to ride out.

Lessons• LTCM failed to supplement VaR

measures with a full set of stress test scenarios.

• A stress scenario is needed to look at the impact of a competitor holding similar positions exiting the market.

• LTCM failed to account for the illiquidity of its largest positions in its VaR or stress runs.

• The author disagreed with two other criticisms: LTCM’s high leverage by itself is not an adequate measure of risk of default. No evidence supports that LTCM showed unreasonable faith in the outcome of models.

Some Suggestions for Improved Practices• A greater reluctance to allow trading

without initial margin for counterparties whose principal business is investing and trading.

• Factoring the potential costs of liquidating positions in an adverse

market environment into estimates of the price at which trades can be unwound.

• A push for greater disclosure by counterparties of their trading strategies and positions.

• Better use of stress tests in assessing credit risk.

2. Metallgesellschaft

Background• 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 were exchange-traded instruments requiring daily cash settlement. The long-term contracts with customers involved no such cash settlement.

• A large downward move in gas and oil prices ⇒ MGRM needs 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.

The Crisis• In 1993, a large decrease in gas and oil

prices had resulted in funding needs of around $900 million.

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• The MG parent responded by closing down the futures positions, leaving unhedged exposure to gas and oil price increases through the customer contracts.

• Faced with this open exposure, MG negotiated unwinds of these contracts at unfavourable terms.

Lessons• When using shorter-term hedges against longer-term contracts, this can be

successfully carried out only if proper risk controls are applied.• The uncertainty of roll cost requires the use of valuation reserves.• A firm running short-term hedges against longer-term risk requires the flexibility to

choose the shorter-term hedge that offers the best tradeoff between risk and reward.

C. Disasters due to the Conduct of Customer Business

Bankers TrustBankers Trust

Incident

Result

Arose

How detected?

Lessons

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.

It was severely damaging BT's reputation for fair business dealing. BT was forced into an acquisition by Deutsche Bank.

BT offered P&G and Gibson a probable but small reduction in funding expenses in exchange for a potentially large loss under some less probable circumstances.

The exact nature of the structures hadn't been tailored to meet client needs.

The structures were designed to be complex enough to make it difficult for clients to comparison shop the pricing to competitor firms.

Evidence showed that BT staff boasting of that they had fooled the clients.

The internal BT recordings showed that price quotes to P&G and Gibson were being manipulated to mislead them.

Banks should match the degree of complexity of trades to the degree of financial sophistication of customers.

Be cautious about how to use any form of communication.

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JPMorgan, Citigroup, and EnronJPMorgan, Citigroup, and Enron

Incident

Result

Arose

Enron had been engaging in dubious accounting practices to hide the size of its borrowings from investors and lender.

Enron had disguised a borrowing as an oil futures contract.

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 fine of $286 million for "helping to commit a fraud".

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. This was in fact a loan.

Enron did not have to report this as a loan, making the firm appear more desirable as an investment and as a borrower.


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A. Banking Industry Trends

Trend 1: Securitisation

Instead of holding loans on banks’ balance sheets, banks moved to an “originate and distribute” model. Banks repackaged loans and passed them on to various other financial investors.

Collateralised Debt Obligations (CDOs)• Step 1: CDO forms diversified portfolios

of mortgages and loans.• Step 2: Slice these portfolios into

different tranches.• Step 3: Sold tranches to investor groups

with different appetites for risk.

Tranches• Senior tranche: offers low interest rate;

the first to be paid; AAA rating.• Equity tranche: be paid only after all

other tranches have been paid; usually held by the issuing bank.

• Mezzanine tranches: between these extremes.

Credit Default Swaps (CDS)

• Buyers of these tranches can protect themselves by purchasing CDS contracts insuring against the default of a particular bond or tranche.

• The CDS buyer pays a periodic fixed fee in exchange for a contingent payment in the event of credit default.

Trend 2: Shortening The Maturity Structure

Maturity Mismatch• Most investors prefer assets with short

maturities.- Allowing them to withdraw funds at

short notice.- Signalling a fund’s confidence in his

ability to perform.• But most investment projects and

mortgages have maturities measured in years or even decades.

• As a result, banks increasingly financed their asset holdings with shorter maturity instruments.

Off-balance-sheet Investment Vehicles (Shadow Banks)• Raise funds by selling short-term

asset-backed commercial paper with an average maturity of 90 days.

DECIPHERING THE LIQUIDITY AND CREDIT CRUNCH 2007—2008

SECTION 7

37

• The short-term assets are backed by a pool of mortgages or other loans as collateral.

• In the case of default, owners of the asset-backed commercial paper have the power to seize and sell the underlying collateral assets.

• The strategy of off-balance-sheet vehicles—investing in long-term assets and borrowing with short-term paper—exposes the banks to funding liquidity risk.

• To ensure funding liquidity for the vehicle, the sponsoring bank grants a credit line to the vehicle, called a liquidity backstop.

• The banking system still bears the liquidity risk even though it does not appear on the banks’ balance sheets.

Short-term Repurchase Agreements (repos)• Repo: A firm borrows funds by selling a

collateral asset today and promising to repurchase it at a later date.

- Overnight repos.- Term repos: maturity of up to three

months.• This greater reliance on overnight

financing required investment banks to roll over a large part of their funding on a daily basis.

Conclusion• Leading up to the crisis, banks were

heavily exposed to maturity mismatch

both through granting liquidity backstops to their off-balance sheet vehicles and through their increased reliance on repo financing.

• Any reduction in funding liquidity could thus lead to significant stress for the financial system.

Rise In Popularity Of Structured Products

Reasons• Lowering interest rates.• Allowing certain institutional investors

to hold assets that they were previously prevented from holding.

• Regulatory and ratings arbitrage:- Banks were able to reduce their

capital charges by pooling loans in off-balance-sheet vehicles.

• Credit-rating agencies provided overly optimistic forecasts about structured finance products.

- These models were based on historically low mortgage default rates.

- The United States had not experienced a nationwide decline in housing prices recently.

- Assumed a low cross-regional correlation of house prices ⇒ a diversification benefit ⇒ boosted the valuations of AAA-rated tranches.

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• Structured products have received more favourable ratings.

- Rating agencies collected higher fees for structured products.

- Banks worked closely with the rating agencies to ensure that AAA tranches reach the AAA rating.

- Structured products offered high expected returns.

- Structured products trade so infrequently ⇒ making monthly returns appear attractively smooth over time.

Consequences

Cheap Credit and Low Lending Standards• Rise in popularity of securitised

products ⇒ a flood of cheap credit, and lending standards fell.

• Banks faced only the “pipeline risk”: holding a loan for some months until the risks were passed on.

• Banks had little incentive to take particular care in approving loan applications.

- Teaser rates;- No-documentation mortgages;- Piggyback mortgages (a

combination of two mortgages that eliminates the need for a down payment);

- NINJA (no income, no job or assets) loans.

• A borrower could thus always refinance a loan using the increased value of the house.

Housing Boom• This combination of cheap credit and

low lending standards resulted in the housing frenzy.

• Many observers were reluctant to bet against the bubble.

• Nevertheless, there was a widespread feeling that the day of reckoning would eventually come.

B. The Unfolding of the Crisis

The Subprime Mortgage Crisis• The trigger for the liquidity crisis was

an increase in subprime mortgage defaults: February 2007.

• The cost of insuring a basket of mortgages against default increased.

• Rating downgrades of other tranches unnerved the credit markets in June and July 2007.

• House prices and sales continued to drop.

Asset-Backed Commercial Paper

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• In July 2007, the market for short-term ABCP began to dry up.

• Money market participants had become reluctant to lend to each other ⇒ high interest rate on ABCP.

The LIBOR, Repo, And Federal Funds Markets• The U.S. federal funds rate: the

overnight interest rate at which banks lend reserves to each other to meet the central bank’s reserve requirements.

• LIBOR rate: banks make unsecured, short-term loans to each other.

• Credit spreads: surge upward in the summer of 2007.

• TED spread (LIBOR rate – the risk-free U.S. Treasury bill rate): widened in times of crises.

Central Banks Step Forward• August 1–9, 2007: many quantitative

hedge funds, which use trading strategies based on statistical models, suffered large losses, triggering margin calls and fire sales.

• August 9: the perceived default and liquidity risks of banks rose.

• To alleviate the liquidity crunch, the Federal Reserve reduced the discount rate, broadened the type of collateral that banks could post, and lengthened the lending horizon.

• However, banks are reluctant to borrow at the Fed’s discount window.

• They fear that discount window borrowing might signal a lack of credit-worthiness on the interbank market.

Continuing Write-downs Of Mortgage-related Securities• October 2007: major international

banks seemed to have cleaned their books.

• But matters worsened again in November 2007: an earlier estimate of the total loss in the mortgage markets had to be revised upward.

• Many banks were forced to take additional, larger write-downs.

• At this point, the Federal Reserve had discerned that broad cuts in the federal funds rate and the discount rate were not reaching the banks caught in the liquidity crunch.

• Therefore, the Fed announced the creation of the Term Auction Facility (TAF), through which commercial banks could bid anonymously for 28-day loans against a broad set of collateral.

• Banks could borrow anonymously!

The Monoline Insurers• Monoline insurers: focus completely on

one product, insuring municipal bonds

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against default, or insuring structured finance products.

• The investment community’s primary worry: the potential downgrading of the monoline insurers.

• As a matter of fact, the monoline insurers were on the verge of being downgraded by all three major rating agencies, resulting in a sweeping rating downgrade.

• Consequently, a rating downgrade would have triggered a huge sell-off of the assets by money market funds.

Bear Sterns

Fact 1• March 2008: the credit spreads

between agency bonds (issued by Freddie Mac and Fannie Mae) and Treasury bonds started to widen again.

• The widening spreads hurt Carlyle Capital.

• When Carlyle could not meet its margin calls, its collateral assets were seized and partially liquidated.

• This action depressed the price of agency bonds further.

• Bear Stearns held large amounts of agency paper on its own, it was also one of the creditors to Carlyle.

Fact 2• March 11, 2008: the Federal Reserve

announced its $200 billion Term

Securities Lending Facility: allowed investment banks to swap mortgage-related bonds for Treasury bonds for up to 28 days.

• This move was interpreted as a sign that the Fed knew that some investment bank might be in difficulty.

• Naturally, people pointed to the smallest, most leveraged investment bank with large mortgage exposure: Bear Stearns.

Fact 3• March 11, 2008: Goldman’s late

acceptance in relation to Bear Sterns was wrongly interpreted as a refusal ⇒ causing unease among Bear Stearns’s hedge fund clients ⇒ run on Bear by its hedge fund clients ⇒ Bear’s liquidity situation worsened dramatically as it was suddenly unable to secure funding on the repo market.

Consequence• JPMorgan Chase would acquire Bear

Stearns for $236 million.• The Fed cut the discount rate further.• For the first time, the Fed opened the

discount window to investment banks ⇒ temporarily eased the liquidity problems of the other investment banks.

Government-Sponsored Enterprises

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• Government-sponsored enterprises: Fannie Mae and Freddie Mac.

• By mid-June 2008, the interest rate spread between agency bonds and Treasury bonds had widened again.

• Problems at Fannie and Freddie flared up ⇒ Treasury Secretary Henry Paulson announced plans to make their implicit government guarantee explicit ⇒ government officials put them in federal conservatorship ⇒ this step constituted a “credit event” for CDS ⇒ triggering large payments.

• And Ginnie Mae always enjoyed full government guarantee.

Lehman Brothers, Merrill Lynch• Lehman Brothers made heavy use of

the Fed’s new Primary Dealer Credit Facility, but did not issue new equity to strengthen its balance sheet.

• The state-controlled Korea Development Bank would not buy the firm ⇒ Lehman’s shares plunged.

• No banks agreed to take over Lehman without a government guarantee.

• Eventually, Treasury and Fed officials decided not to offer a guarantee.

• Lehman had to declare bankruptcy.• Merrill Lynch sold itself to Bank of

America.

The Ripple Effects of Lehman’s Demise

• Lehman had counterparties across the globe ⇒ many money market funds suffered losses ⇒ the U.S. Treasury had to guarantee the money market funds.

• The CDS prices soared.• Financial non-asset-backed commercial

paper experienced a sharp fall.

AIG• AIG faced a serious liquidity shortage.• AIG was active in the credit derivatives

business.• September 16, 2008: AIG’s stock price

fell more than 90%.• Owing to AIG’s interconnectedness in

the credit derivatives business, the Federal Reserve quickly bailout AIG.

Coordinated Bailout, Stock Market Decline, Washington Mutual, Wachovia, And Citibank• Washington Mutual: customers and

fund managers withdrew funds electronically.

• Washington Mutual was then sold to JPMorgan Chase.

• Wachovia ultimately fell into the hands of Wells Fargo.

• The overall stock market fell off a cliff, losing about $8 trillion in the year.

• Credit for firms and local and state governments tightened, infecting the global economy.

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• The Treasury Secretary proposed a $700 billion bailout plan.

• On December 16, 2008, the Fed set its target interest rate between 0 and 0.25%.

C. Amplifying Mechanisms and Recurring Themes

Liquidity Risk

Funding Liquidity Risk• Funding liquidity describes the ease

with which expert investors and arbitrageurs can obtain funding from financiers.

• Funding liquidity is high when it is easy to raise money.

• Funding liquidity risk can take three forms:

- Margin/haircut funding risk: margins and haircuts will change;

- Rollover risk: impossible to roll over short-term borrowing;

- Redemption risk: demand depositors of banks withdraw funds.

Market Liquidity Risk• Market liquidity is low when it is

difficult to raise money by selling the asset.

• Three sub-forms of market liquidity:- The bid-ask spread;

- Market depth: how many units traders can sell or buy at the current bid or ask price without moving the price;

- Market resiliency: how long it will take for prices that have temporarily fallen to bounce back.

Loss Spiral And Margin Spiral

Loss Spiral• A loss spiral arises for leveraged

investors because a decline in the value of assets erodes the investors’ net worth much faster than their gross worth and the amount that they can borrow falls.

• These sales depress the price further, inducing more selling.

Margin/haircut Spiral• As margins or haircuts rise, the investor

has to sell even more because the investor needs to reduce its leverage ratio (which was held constant in the loss spiral).

• Margins and haircuts spike in times of large price drops ⇒ tightening of lending.

• Higher margins and haircuts force de-leveraging and more sales ⇒ increasing margins further and forcing more sales.

43

Why Margins Increase when Prices Drop Suddenly?• Unexpected price shocks ⇒ higher

future volatility ⇒ margins and haircuts increase.

• Financiers become especially careful about accepting assets as collateral if they fear receiving a particularly bad selection of assets.

• If lenders naively estimate future volatility using past data, then a large price drop leads to higher volatility estimates and higher margins.

Loss Spiral for Low-liquidity Stocks• For many structured finance products,

market liquidity is so low that no reliable price exists.

• Selling some of these assets in a financial crisis would establish a low price and force the holder to mark down remaining holdings.

Lending Channel

Moral Hazard• Most lending is intermediated by banks

that have expertise in monitoring a borrower’s investment decisions.

• The net worth of the intermediaries’ stake falls ⇒ intermediaries may then reduce their monitoring effort ⇒ forcing the market to fall back to direct lending without monitoring ⇒ moral hazard arises.

Precautionary Hoarding• Lenders are afraid that they might

suffer from interim shocks and that they will need funds for their own projects and trading strategies ⇒ precautionary hoarding arises.

• Precautionary hoarding increases when:

- The likelihood of interim shocks increases;

- Outside funds are expected to be difficult to obtain.

• Each bank became more uncertain whether banks could tap into the interbank market after a potential interim shock ⇒ sharp spikes in the interbank market interest rate, LIBOR.

Runs On Financial Institutions• Everybody had an incentive to be the

first to withdraw funds from a possibly troubled bank.

• Late movers receive less.• Runs can occur on many financial

institutions:- a run on the ABCP;- a run on Bear Stearns;- a run on AIG;- a run by investors in a hedge fund

or mutual funds.

Network Effects

44

Counterparty Credit Risk• Most financial institutions are lenders

and borrowers at the same time.• An increase in perceived counterparty

credit risk can be self-fulfilling and create additional funding needs.

Gridlock Risk• A multilateral netting arrangement

could eliminate all exposures.• However, because all parties are aware

only of their own contractual agreements, they may not know the full situation.

• Therefore each party become concerned about counterparty credit risk and has to insure each other against that risk.

• This can be overcome by a clearinghouse.

• Multilateral netting agreements can stabilise the system.


45

A. Overview and Timeline of the Crisis

The Financial Crisis of 2007-2009 began in early August.

Bernanke’s Testimony• Losses on subprime mortgages were a

trigger for the crisis.• But subprime losses were not large

enough for the magnitude of the crisis.• The prospective losses were amplified

to generate the crisis.• Changes that had occurred in the

financial sector ⇒ systemic vulnerabilities.

- Many financial institutions became shadow banks.

- Shadow banks served as intermediaries to channel savings into investment.

- Shadow banking was also the source of key vulnerabilities.

Vulnerabilities in Shadow Banks• Short-term debt: repurchase

agreements, and commercial paper.• These markets are large, but

unregulated.

A Repo Transaction• The depositor or lender puts money in

the bank for a short-term, usually overnight.

• The bank promises to pay the overnight repo rate on the deposited money.

• To ensure the safety of the deposit, the bank provides collateral to the depositor.

• If the bank fails, then the depositor can sell the collateral to recover the value of the deposit.

• Haircut: deposit = $90 million, collateral = $100 million ⇒ a 10% haircut.

The Progress of the Crisis• Disruptions in the U.S. short-term debt

markets created a shortage of U.S. dollars in global markets.

• The shortage in U.S. dollars also affected the foreign exchange swap market.

• The failure of Lehman ⇒ run on money market mutual funds.

• The U.S. Treasury then announced a temporary guarantee of money market mutual funds.

GETTING UP TO SPEED ON THE FINANCIAL CRISIS

SECTION 8

46

• The U.S. Congress eventually passed the Troubled Asset Relief Program (TARP).

• There was a coordinated reduction in policy rates by six major central banks.

• The resulting turmoil led to banks hoarding liquidity ⇒ transmitting the crisis to the real sector and internationally.

• The prospective losses in the subprime market were amplified.

B. Historical Background

An acceleration of debt from both governments and financial intermediaries are the most important antecedents.

Reinhart And Rogoff’s Paper

Banking Crisis• Bank runs led to the closure, merging,

or takeover by the public sector of one or more financial institutions.

• If there are no runs, the closure, merging, takeover, or large-scale government assistance of an important financial institution, that marks the start of a string of similar outcomes for other financial institutions.

Findings

• External debt increases sharply in advance of banking crises.

• Banking crises tend to lead sovereign-debt crises.

Schularick And Taylor’s Paper• After WWII, credit started to decouple

from broad money and grew rapidly, via a combination of increased leverage and augmented funding via the nonmonetary liabilities of banks.

• Changes in credit supply (bank loans) are a strong predictor of financial crises.

• But broad money aggregates do not have the same predictive power.

C. The Crisis Build-Up

Securitisation

An increase of the issuance of asset-backed securities, particularly mortgage-backed securities ⇒ credit boom.

Why were Shadow Banks Growing?• The traditional banking model became

less profitable in the face of competition from money market mutual funds and junk bonds.

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• And securitisation was an important response.

• Institutional cash pools have a demand for insured deposit alternatives.

• However, their demand for insured deposit alternatives exceeded the outstanding amount of short-term government guaranteed instruments.

• Therefore the shadow banking system rose to fill this gap.

Credit Boom (Foreign Factors)• In the US: national saving < U.S. capital

investment.• This shortfall is made up by foreign net

borrowing – large and persistent capital inflows from foreigners seeking U.S. assets.

• Institutional cash pools had to find substitutes such as:

- Short-term bank debt-like products, such as repurchase agreements and asset-backed commercial paper.

- Indirect holdings of unsecured private money market instruments through money market mutual funds.

Credit Boom (Domestic Factors)• The increase in the production of

asset-backed securities appears to be a credit boom.

• House prices were rising during the credit boom.

• Furthermore, house price run-ups prior to crises are common.

D. The Panics

Briefings• Two panic periods of the financial

crisis: August 2007 and September–October 2008.

• The crisis was exacerbated by panics in the banking system, where various types of short-term debt suddenly became subject to runs.

• Runs also took place in the newly evolving “shadow banking” system: money market mutual funds, commercial paper, securitised bonds, and repurchase agreements.

• The crisis eventually spread to the real economy.

Asset-backed Commercial Paper

What is ABCP?• In the traditional CP market, highly

rated firms can quickly issue debt with minimal transactions costs.

• They can cover the risk that investors will suddenly disappear by obtaining a backup line of credit from a commercial bank.

• Demand for CP is high enough that financial intermediaries have

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increasingly made use of the market to finance long-term financial assets.

Why ABCP Becoming Prevalent?• ABCP can be more transparent than full

bank balance sheets ⇒ lowering funding costs.

• ABCP can be used to move assets off balance sheets, allowing banks to save on regulatory capital.

ABCP Run• An ABCP program would suffer a “run”

if lenders are unwilling to refinance CP when it comes due.

• If a firm is unable to issue new paper, then it must either rely on backup support from the program sponsor, or it is forced to sell assets.

• Programs were more likely to experience a run if they had high credit risk (from holdings of subprime-related securities) or high liquidity risk (from a missing or incomplete liquidity support from the plan sponsor).

Money Market Mutual Funds

A Chain Effect• As the main holders of ABCP, MMFs

saw the values of their stakes decline when ABCP yields rose ⇒ shrinking ABCP programs were forced to sell their underlying assets ⇒ placing

further downward pressure on asset classes held by many MMFs.

• 43 MMFs were bailed out by the banks or fund families that managed them.

The Side Effects• The sponsor-based rescue of MMFs

may have also solidified the expectation that MMFs would always be bailed out by their sponsors.

• Such expectations add to the belief that MMFs are safe instruments that require no due diligence by investors.

Lehman Bankruptcy: a Major Shock to MMFs• The Lehman bankruptcy was a major

shock to MMFs.• It led to run on many MMFs.• Sharp outflow from prime MMFs ⇒

transfer into government-only funds.• Prime MMFs are a crucial supplier of

funds to corporations and to financial intermediaries. When these investors moved to government-only MMFs, this liquidity supply was lost.

• ABCP and MMFs are linked ⇒ contagion in these markets can spread.

• Conclusion: the initial ABCP panic was driven by a weakness in subprime mortgages, whereas the eventual run on MMFs was triggered by the bankruptcy of Lehman.

Repo

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• Repo is the shadow-banking equivalent of a deposit market.

• Large institutional money pools can lend short-term to a financial institution and receive collateral as protection.

• For every $100 of collateral, an institution can receive $(100-x) in loans. $x represents the haircut.

• At the beginning of 2007, average haircuts were near zero on most types of collateral.

• Haircuts get their first shock at the time of the ABCP panic, and continue a steady rise throughout the next year.

• Following the Lehman failure, the haircut rose by an additional 20% to 100% (for some assets).

Subprime Crisis Turned Into The Collapse Of Global Financial Institutions• The subprime failure had a direct effect

on many ABCP programs.• These runs and related price drops in

other subprime-related securities caused unprecedented problems for MMFs.

• After the initial panic of August 2007, interbank markets were slow to recover.

• In repo markets, haircuts grew steadily ⇒ adding to the funding pressure on financial intermediaries.

• When Lehman Brothers became a victim, the stressed interbank markets nearly collapsed.

E. Policy Responses

• Beginning in August 2007, governments of all advanced nations took a variety of actions to mitigate the financial crisis.

• Liquidity support was effective at calming interbank credit markets during the pre-Lehman period.

• After the fall of Lehman, liquidity support did not have reliable effects.

• In these later stages, capital injections were the most effective policy.

F. Real Effects of the Financial Crisis

• The run on short-term debt created fear across the financial intermediary sector.

• The widespread loss of confidence reached the real sector of the economy when intermediaries began to hoard cash and stop lending.

• Banks cut back on credit supply ⇒ having significant impacts on the real economy:

- Firms cut back on expenditure and dividend payments.

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- Cash holdings and the number of employees decline.

- Less access to credit.- Problems with lines of credit.


51

A. A Typology of Risk Management Failures

A large loss is not evidence of a risk management failure because a large loss can happen even if risk management is flawless.

Six Types of Risk Management Failures1. Mis-measurement 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.

1. Mis-measurement Of Known Risks

Risk Managers could Make a Mistake in• Assessing the probability of a loss or the

size of the loss.• Using the wrong distribution.• Correlations may be mis-measured.

• A known risk may not manifest itself in the past.

• With such cases, statistical risk measurement reaches its limits and risk management goes from science to art.

2. Mis-measurement Due To Ignored Risks

1. Ignored known risks2. Mistakes in information

collection- Somebody knew about the risk but

it did not enter the relevant risk models.

- The division of risk into market, credit and operational risk may ignore large chunks of risk.

- Incomplete risk aggregation leads to large losses from risks that were not accounted for (such as business risk).

3. Unknown risks- Most unknown risks do not create

risk management problems.- Most unknown risks have a trivially

low probability.

3. Communication Failures

RISK MANAGEMENT FAILURES

SECTION 9

52

• Risk management has to provide timely information to the board and top management that enables them to make decisions concerning the firm's risk.

• Get the right information, at the right time, to the right people, such that those people can make the most informed judgments possible.

• Hierarchical structures sometimes are filters when information was sent up the management chain, leading to delays or distortions.

4. Failures In Monitoring And Managing Risks• For a financial firm, risks can change

sharply because of derivatives positions.

• Hedges adjusted daily could create large losses.

• Risk managers may fail to measure risks or hedge risks simply because risk characteristics of securities may change too quickly.

• When liquidity dries up in the markets, many risk-mitigating options can no longer be used.

• MtM accounting makes it harder for risk managers to estimate risk.

• In large complex firms, individuals may take risks that remain hidden for a while.

• Too strict risk management would stifle innovation or risk monitoring might become costly.

• The effectiveness of risk monitoring and control depends on an institution’s culture and incentives.

5. Risk Measures And Risk Management Failures• Focusing on metrics that are too

narrow may make it harder for management to achieve its objectives.

• VaR does not capture catastrophic losses that have a small probability of occurring.

• If a firm sits on a portfolio that cannot be traded, a daily VaR measure is not a measure of the risk of the portfolio.

• When we consider years, crises are not extremely rare events.

• Existing risk models are generally not designed to capture risks associated with crises.

• During crisis periods, firms will make multiple losses that exceed their daily VaRs.

• Statistical risk models typically take returns to be exogenous to the firm and ignore risk concentrations across institutions.

• A large institution can be exposed to predatory trading.

• A firm has to augment these models with scenario analysis: how crises will affect it under various assumptions.

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B. Was the Collapse of LTCM a Risk Management Failure?

1. Managers of Long-Term Capital Management knew the distribution of possible outcomes of the fund.

2. Risk management could not have been improved in this case.

3. The managers knew exactly the risks they faced, and they decided to take them.- Deciding whether to take a known

risk is not a decision for risk managers. It depends on the risk appetite.

4. LTCM’s loss came with no additional deadweight costs.- No losing employees, no losing

customers, or facing increased scrutiny.

5. The partner of LTCM knew the risks and the rewards from using leverage.

6. The partner of LTCM collectively had $2 billion invested in the fund ⇒ incentivising managers to make the right decisions for their shareholders.

7. In summary, risk management doesn’t prevent losses.


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A. The Assumptions

1. No transaction costs.2. Assets are infinitely divisible.3. The absence of personal income tax.4. An individual cannot affect the price

of a stock.5. Investors make decisions solely in

terms of expected values and standard deviations of the returns on their portfolios.

6. Unlimited short sales are allowed.7. Unlimited lending and borrowing at

the riskless rate.8. The homogeneity of expectations

(mean, variance of returns, and correlation).

9. All assets are marketable.

B. Deriving the CAPM

You Need to Know• Efficient frontier.• Minimum variance portfolio.

The Market Portfolio• The portfolio of risky assets M held by

any investor will be identical to the one held by any other investor.

• If all investors hold the same risky portfolio, then it must be the market portfolio.

• The market portfolio M is a portfolio comprised of all risky assets.

• Each asset is held in the proportion that the market value of that asset represents of the total market value of all risky assets.

• All investors will hold combinations of only two portfolios: the market portfolio (M) and a riskless security.

Capital Market Line

E(Re) = RF + E(RM) − RF

σMσe

• e: an efficient portfolio.

•E(RM) − RF

σM: market price of risk for all

efficient portfolios.• All investors will end up with portfolios

somewhere along the CML.• All efficient portfolios would lie along

the CML.• Except these, all the other portfolios lie

below the CML.

THE STANDARD CAPITAL ASSET PRICING MODEL

SECTION 10

55

• But this equation does not describe equilibrium returns on non-efficient portfolios or on individual securities.

Beta• For very well-diversified portfolios,

nonsystematic risk tends to go to zero and the only relevant risk is systematic risk measured by Beta.

• Since the investor will hold a very well-diversified portfolio M, the only things concerned are expected return and Beta.

• The market portfolio’s Beta = 1.• Riskless asset’s Beta = 0.

Security Market Line

The CAPM Model

E(Ri) = RF + βi [E(RM) − RF]or E(Ri) = RF + [ E(RM) − RF

σM ] σiM

σM

βi = ρiMσi

σM

• The expected return on any asset, or portfolio, whether it is efficient or not, can be determined from CAPM.

• The risk of any stock could be divided into systematic and unsystematic risk. Beta was the index of systematic risk.

• Systematic risk is the only important ingredient in determining expected

returns and that nonsystematic risk plays no role.

C. Prices and the CAPM

Pi = 11 + RF [E(Yi) − [E(YM) − (1 + RF)PM] cov(YiYM)

σ2(YM) ]• Pi: the present price of asset i.• PM: the present price of the market

portfolio.• Yi: the dollar value of the asset one

period hence.• YM: the dollar value of the market

portfolio one period hence.• RF: risk-free rate.


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A. The Treynor Measure

Treynor Ratio =E(Rp) − RF

βp

• Based on the systematic risk (beta).• Limited to well-diversified portfolios.• More suitable for anticipating future

performance.• Roll’s criticism: the result depends on

the choice of reference index to estimate the beta.

B. The Sharpe Measure

Sharpe Ratio =E(Rp) − RF

σ(Rp)

• Based on the total risk (sigma).• Can be used for all portfolios.• Give a better evaluation of the past

performance.• Not subject to Roll’s criticism.

C. The Jensen Measure

Jensen′ �s Alpha = E(Rp) − {RF + βp[E(RM) − RF}

• Limited to the relative study of portfolios with the same beta.

• Also subject to Roll’s criticism.

D. Relationships between the Different Indicators

Treynor and Jensen

TRP = αP

βP+ [E(RM) − RF]

Sharpe and JensenFor a well-diversified portfolio,

SRP ≈ αP

σP+ E(RM) − RF

σM

Treynor and SharpeFor a well-diversified portfolio,

SRP ≈ TRP

σM

E. The Information Ratio

Tracking Error = σ(Rp − RB)

APPLYING THE CAPM TO PERFORMANCE MEASUREMENT

SECTION 11

57

Information Ratio =E(Rp) − E(RB)

σ(Rp − RB)

• Managers seek to maximise the IR.

IR and the Significance Test• T: the length of the period expressed in

years.• During T years we observed the returns.• The number of years T required for

alpha to be significant, with a given level of probability is:

T = [ tstat

IR ]2

• The higher the manager's IR, the more the number of years decreases.

F. The Sortino Ratio

Sortino Ratio =E(Rp) − Rmin

semi σ

• More appropriate for asymmetrical return distributions.

• Rmin: minimum acceptable return (MAR), the return below which the investor does not wish to drop.

• semi σ: standard deviation of the returns that are below the Rmin.

G. Recently Developed Risk-adjusted Return Measures

The Morningstar Rating System

RARPi = RRPi − RRiskPi

• RAR: risk-adjusted rating.• RRPi: the relative return for fund Pi.• RRiskPi: the relative risk for fund Pi.

Measure Taking The Management Style Into Account

RAPP = σM

σP(RP − RF) + RF

Relative RAP = RAP(Fund ) − RAP(Market)

• RAP: risk-adjusted performance.• σM: the annualised standard deviation

of the market returns.• σP: the annualised standard deviation of

the returns of fund P.• RP: the annualised return of fund P.• RF: the risk-free rate.

Application of RAP• RAP is useful to compare management

results with a benchmark that

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accurately represents the manager's style.

• Choose the fund with the highest RAP.• Calculate the difference between the

RAP for the fund and the RAP for the benchmark.

• The benchmark's RAP = its return.

Risk-adjusted Performance Measure In Multi-management

The Muralidhar Model• Objective: to compare the performance

of different managers within a group of funds with the same objectives.

• Steps: construct portfolios that are split optimally between a risk-free asset, a benchmark and several managers, while taking the investors' objectives into account.

• Principle: reduce the portfolios to those with the same risk in order to be able to compare their performance.

• Benefits:- SR and IR measure don’t allow

investors to rank different funds and to construct their optimal portfolio.

- SR and IR don’t indicate how to construct portfolios in order to produce the objective tracking error.

- The Muralidhar model provides a more appropriate risk-adjusted

performance measure because it takes into account both the differences in standard deviation and the differences in correlations between the portfolios.

- It also provides the composition of the portfolios that satisfy the investors' objectives.

- It can solve the problem of an institutional investor's optimal allocation between active and passive management.


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A. Multi-factor Models: an Overview

Factor Models Of Security Returns

Single-factor Model

Ri = E(Ri) + βiF + ei

• F: the deviation of the common factor from its expected value. E(F)=0.

• βi: the sensitivity of firm i to that factor.• ei: the firm-specific disturbance: zero

expected value, uncorrelated among themselves and uncorrelated with the factor F.

Multi-factor Model

Ri = E(Ri) + βi1F1 + βi2F2 + ei

• An investor who wishes to hedge a source of risk can establish an opposite factor exposure to offset that particular source of risk.

• F1 and F2 are not their real value but the risk premiums for each factor.

• F1 and F2 have zero expected value because each measures the surprise in the systematic variable rather than the level of the variable.

B. Arbitrage Pricing Theory

Key Propositions• Security returns can be described by a

factor model.• There are sufficient securities to

diversify away idiosyncratic risk.• Well-functioning security markets do

not allow for the persistence of arbitrage opportunities.

Arbitrage, Risk Arbitrage, And Equilibrium

Law of One Price• An arbitrage opportunity arises when

an investor can earn riskless profits without making a net investment.

• The Law of One Price: if two assets are equivalent in all economically relevant respects, then they should have the same market price.

• Arbitrage activity: simultaneously buying the asset where it is cheap and

ARBITRAGE PRICING THEORY

SECTION 12

60

selling where it is expensive until the arbitrage opportunity is eliminated.

Difference between Arbitrage and Equilibrium Price

APT CAPM

When arbitrage opportunities exist,

each investor wants to take as large a position

as possible.

Many investors will make small and limited portfolio

changes.

It will not take many investors to bring

about the price pressures.

Aggregation of these limited portfolio

changes can create a large volume of buying

and selling.

They will mobilise large dollar amounts and quickly restore

equilibrium.

Restores equilibrium prices.

Well-Diversified Portfolios• When the portfolio gets large in the

sense that n is large, its nonsystematic variance approaches zero.

• A well-diversified portfolio: diversified over a large enough number of securities, with each weight small enough.

• Diversification can eliminate risk even in very unbalanced portfolios, if the investment universe is large enough.

The No-Arbitrage Equation Of The APT

• The alpha of any well-diversified portfolio must also be zero.

• Well-diversified portfolios with equal betas must have equal expected returns in market equilibrium, or arbitrage opportunities exist.

C. The APT, the CAPM, and the Index Model

The APT And The CAPM

APT• The APT is built on the foundation of

well-diversified portfolios.• APT is sufficient as long as a small

number of arbitrageurs scour the market for arbitrage opportunities.

• Replacing the unobserved market portfolio of the CAPM with an observed, broad index portfolio.

• This relationship holds for all but perhaps a small number of securities.

CAPM• Requiring that all investors be

mean-variance optimisers.• Relying on an unobserved market

portfolio.

D. A Multi-factor APT

Multi-factor SML

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E(Ri) = rf + β1 [E(r1) − rf] + β2 [E(r2) − rf]= rf + β1E(R1) + β2E(R2)

The risk premiums on the two factor portfolios are E(R1) and E(R2).

Factor Portfolio• A well-diversified portfolio.• Beta=1 on one of the factors and

Beta=0 on any other factor.• Serving as the benchmark portfolios.

E. The Fama-French Three-Factor Model

Ri = αi + βMRM + βSMBSMB + βHMLHML + ei

• SMB = Small Minus Big. The return of a portfolio of small stocks – the return on a portfolio of large stocks.

• HML = High Minus Low. The return of a portfolio of stocks with a high book-to-market ratio – the return on a portfolio of stocks with a low book-to-market ratio.

Criticisms• None of the factors in the FF models

can be clearly identified as hedging a significant source of uncertainty.

• Data-snooping: when researchers scan and rescan the database of security returns in search of explanatory factors,

they may eventually uncover past patterns that are due purely to chance.


62

A. Introduction

A Lesson Learned from the Global Financial CrisisBanks’ IT and data architectures were inadequate to support the broad management of financial risks because of weak risk data aggregation capabilities and risk reporting practices.

BenefitsImproving risk data aggregation will:• Help banks and supervisors anticipate

problems ahead.• Improve the prospects of finding

alternative options to restore financial strength and viability.

• Gain in efficiency.• Reduce probability of losses.• Enhance strategic decision-making.• Increase profitability.

B. Definition

• 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.

• This includes sorting, merging or breaking down sets of data.

C. Objectives

• Effective implementation of the Principles should increase the value of the bank.

• For bank supervisors, these Principles will improve the intensity and effectiveness of bank supervision.

• For resolution authorities, improved risk data aggregation should reduce the potential recourse to taxpayers.

D. The Principles Cover Four Closely Related Topics

Part 1. Overarching Governance and Infrastructure

Principle 1Governance – A bank’s risk data aggregation capabilities and risk

EFFECTIVE DATA AGGREGATION AND RISK REPORTING

SECTION 13

63

reporting practices should be subject to strong governance arrangements consistent with other principles and guidance established by the Basel Committee.

• A bank’s board and senior management should review and approve the bank’s group risk data aggregation and risk reporting framework.

• Should be fully aware of and understand the limitations that prevent full risk data aggregation.

Principle 2Data architecture and IT infrastructure – A bank should design, build and maintain data architecture and IT infrastructure which fully supports its risk data aggregation capabilities and risk reporting practices not only in normal times but also during times of stress or crisis, while still meeting the other Principles.

• A bank should establish integrated data taxonomies and architecture across the banking group.

Part 2. Risk Data Aggregation Capabilities

Principle 3

Accuracy and Integrity – A bank should be able to generate accurate and reliable risk data to meet normal and stress/crisis reporting accuracy requirements. Data should be aggregated on a largely automated basis so as to minimise the probability of errors.

• Risk data should be reconciled with bank’s sources to ensure that the risk data is accurate.

• A bank should strive towards a single authoritative source for risk data.

• A bank’s risk personnel should have sufficient access to risk data.

• A bank should have a “dictionary” of the concepts used.

• A higher degree of automation is desirable to reduce the risk of errors.

Principle 4Completeness – A bank should be able to capture and aggregate all material risk data across the banking group. Data should be available by business line, legal entity, asset type, industry, region and other groupings, as relevant for the risk in question, that permit identifying and reporting risk exposures, concentrations and emerging risks.

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• A bank’s risk data aggregation capabilities should include on/off-balance sheet exposures.

• Risk data aggregation capabilities should be the same regardless of the choice of risk aggregation systems implemented.

Principle 5Timeliness – A bank should be able to generate aggregate and up-to-date risk data in a timely manner while also meeting the principles relating to accuracy and integrity, completeness and adaptability. The precise timing will depend upon the nature and potential volatility of the risk being measured as well as its criticality to the overall risk profile of the bank. The precise timing will also depend on the bank-specific frequency requirements for risk management reporting, under both normal and stress/crisis situations, set based on the characteristics and overall risk profile of the bank.

Principle 6Adaptability – A bank should be able to generate aggregate risk data to meet a broad range of on-demand, ad hoc risk management reporting requests, including requests during stress/crisis situations, requests due to changing internal needs and requests to meet supervisory queries.

Adaptability Includes• Data aggregation processes that are

flexible.• Customisation to users’ needs.• Capabilities to incorporate new

developments on the organisation of the business.

• Capabilities to incorporate changes in the regulatory framework.

Part 3. Risk Reporting Practices

Principle 7Accuracy – Risk management reports should accurately and precisely convey aggregated risk data and reflect risk in an exact manner. Reports should be reconciled and validated.

A Bank should Maintain• Defined requirements and processes to

reconcile reports to risk data.• Automated and manual edit and

reasonableness checks.• Integrated procedures for identifying,

reporting and explaining data errors.

Principle 8Comprehensiveness – Risk management reports should cover all material risk areas within the

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organisation. The depth and scope of these reports should be consistent with the size and complexity of the bank’s operations and risk profile, as well as the requirements of the recipients.

• Risk management reports should include exposure and position information for all significant risk areas (eg credit risk, market risk, liquidity risk, operational risk).

• Provide a forward-looking assessment of risk and should not just rely on current and past data.

Principle 9Clarity and usefulness – Risk management reports should communicate information in a clear and concise manner. Reports should be easy to understand yet comprehensive enough to facilitate informed decision-making. Reports should include meaningful information tailored to the needs of the recipients.

• Reports should reflect an appropriate balance between detailed data, qualitative discussion, explanation and recommended conclusions.

Principle 10Frequency – The board and senior management (or other recipients as appropriate) should set the frequency of

risk management report production and distribution. Frequency requirements should reflect the needs of the recipients, the nature of the risk reported, and the speed at which the risk can change, as well as the importance of reports in contributing to sound risk management and effective and efficient decision-making across the bank. The frequency of reports should be increased during times of stress/crisis.

• In times of stress, all relevant and critical credit, market and liquidity position reports are available within a very short period of time.

Principle 11Distribution – Risk management reports should be distributed to the relevant parties and while ensuring confidentiality is maintained.

Part 4. Supervisory Review, Tools and Cooperation

Principle 12Review – Supervisors should periodically review and evaluate a bank’s compliance with the eleven Principles above.

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Principle 13Remedial actions and supervisory measures – Supervisors should have and use the appropriate tools and resources to require effective and timely remedial action by a bank to address deficiencies in its risk data aggregation capabilities and risk reporting practices.

Principle 14Home/host cooperation – Supervisors should cooperate with relevant supervisors in other jurisdictions regarding the supervision and review of the Principles, and the implementation of any remedial action if necessary.


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A. Code of Conduct

1. Principles

Professional Integrity and Ethical Conduct• GARP Members shall act with honesty,

integrity, and competence to fulfil the risk professional’s responsibilities and to uphold the reputation of the risk management profession.

Conflicts of Interest• GARP Members will not knowingly

perform risk management services involving a conflict of interest unless full disclosure has been provided to all affected parties.

Confidentiality• GARP Members will prevent

intentional and unintentional disclosure of confidential information.

2. Professional Standards

Fundamental Responsibilities

• GARP members must encourage others to operate at the highest level of professional skills.

• Continue to perfect their expertise.• Cannot delegate personal ethical

responsibility to others.

Best Practices• GARP Members will promote and

adhere to applicable “best practice standards,” and will ensure that risk management activities performed under his direct supervision satisfies these applicable standards.

• GARP Members commit to considering the wider impact of their assessments and actions on their colleagues and the wider community and environment.

Communication and Disclosure• GARP Members issuing any

communications on behalf of their firm will ensure that the communications are clear, appropriate to the circumstances and their intended audience, and satisfy applicable standards of conduct.

B. Rules of Conduct

GAPR CODE OF CONDUCT

SECTION 14

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1. Professional Integrity And Ethical Conduct• GARP Members shall act

professionally, ethically and with integrity in all dealings.

• Maintain independence, and must not solicit any gift that could compromise their independence.

• Ensure that the Member’s services are not used for improper, fraudulent or illegal purposes.

• Not knowingly misrepresent details.• Not engage in any professional conduct

involving dishonesty or deception.• Shall not compromise the integrity of

GARP, the FRM designation.• Be mindful of cultural differences

regarding ethical customs.• If their is a conflict of standards, the

member should seek to apply the higher standard.

2. Conflict Of Interest• GARP Members shall act fairly and

fully disclose any conflict to all affected parties.

• Make disclosure of all matters that could impair their independence and objectivity.

3. Confidentiality• GARP Members shall maintain the

confidentiality of their work, their employer or client.

• Must not use confidential information to benefit personally.

4. Fundamental Responsibilities• GARP Members shall comply with all

applicable laws governing the GARP Members’ professional activities.

• Cannot delegate ethical responsibilities to others.

• Provide suitable risk management services and advices.

• Not overstate the accuracy or certainty of results.

• Disclose the limits of their knowledge and expertise concerning risk assessment.

5. General Accepted Practices• GARP Members shall perform all work

in a manner that is independent from interested parties.

• Distribute risk information with objectivity.

• Be familiar with current risk management practices and indicate any departure from their use.

• Ensure that communications do not contain false information.

• Make a distinction between fact and opinion.

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C. Applicability and Enforcement

• Local laws and regulations may also impose obligations on GARP Members.

• Where local requirements conflict with the Code, such requirements will have precedence.

• Violation of this Code may result in the temporary suspension or permanent removal of the GARP Member from GARP’s Membership roles or the FRM designation.


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1. Michel Crouhy, Dan Galai, and Robert Mark, The Essentials of Risk Management, 2nd Edition (New York: McGraw-Hill, 2014).

2. James Lam, Enterprise Risk Management: From Incentives to Controls, 2nd Edition (Hoboken, NJ: John Wiley & Sons, 2014).

3. René Stulz, “Risk Management, Governance, Culture and Risk Taking in Banks,” FRBNY Economic Policy Review, (August 2016): 43-59.

4. Steve Allen, Financial Risk Management: A Practitioner’s Guide to Managing Market and Credit Risk, 2nd Edition (New York: John Wiley & Sons, 2013).

5. Markus K. Brunnermeier, 2009. “Deciphering the Liquidity and Credit Crunch 2007—2008,” Journal of Economic Perspectives 23:1, 77—100.

6. Gary Gorton and Andrew Metrick, 2012. “Getting Up to Speed on the Financial Crisis: A One-Weekend-Reader’s Guide,” Journal of Economic Literature 50:1, 128—150.

7. René Stulz, “Risk Management Failures: What Are They and When Do They Happen?” Fisher College of Business Working Paper Series, October 2008.

8. 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).

9. Noel Amenc and Veronique Le Sourd, Portfolio Theory and Performance Analysis (West Sussex, England: John Wiley & Sons, 2003).

10. Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments, 10th Edition (New York: McGraw-Hill, 2013).

REFERENCE

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11. “Principles for Effective Data Aggregation and Risk Reporting,” (Basel Committee on Banking Supervision Publication, January 2013).

12. GARP Code of Conduct.

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Faithful to the Official FRM Books

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henry liang s frm guide i · henry liang’s frm guide %) ... old treatment of risk vs stress...

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