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Definition: unexpected variability&danger&opportunity

1.1Absolute/1.2Relative Risk

1.1 Initial value and volatility of total returns (SD);

1.2 Benchmark (Tracking error e=Rp-Rb)

1.1 Directional/1.2 Non-directional Risk

Market Risk

Basis Risk

1.1 first order or linear approximations

1.2 non-linear exposures

different time or product: different price (hedging and asset being hedged)

Volatility Risk
Probability of Default (PD)

Financial Risk Types

Credit Risk

Source

Credit Exposure (CE)

Loss Given Default (LGD or LR)

Expected credit loss=PDxCExLGD

Model Risk
Operational Risk

Risk

People Risk

Legal Risk
Asset liquidity Risk

Liquidity Risk
Risk types, measurement
and management tools

Funding Liquidity Risk (cash flow risk)

daily operations

Business Risk

business decisions and environment

Risk Profile: list, categorizing

Risk Appetite: amount, broad level, willing to accept
authorize, optimize, monitor: Directors;

Risk Governance

risk oversight: Entire board

comprehensive, holistic;
COSO: compliance objectives, operational, strategic, reporting

Enterprise Risk Management

CSA framework: hazard, financial, strategic, operational risks

Identification
Assessment: analysis (identification+risk estimation) & evaluation

http://www.lesleywang.com/
AIRMIC risk management process

Treatment: avoidance, transfer (hedging), reduction (diversification), retention (acceptable)

Monitoring

Risk-adjusted performance measurement

NPV
WACC

Sensitivity analysis, Scenario Analysis, Decision Trees, Simulation, Value at Risk(VaR)

Risk management tools

Expected return and volatility of a two-asset portfolio

Assumption: E(R) as return, Vega as risk; Utility maximization; Risk aversion
Return, Risk: Single asset/Two-asset portfolio

Markowitz Portfolio Theory

Efficient Frontier: minimum variance portfolio & Highest sharpe ratio / Combine the risk-free rate
Capital Market Line (CML): systematic risk & unsystematic risk
Security Market Line (SML)
Portfolio Beta:
Sharpe ratio (absolute risk)
Portfolio Construction

Portfolio Management Theory

Performance

Capital Asset Pricing Model (CAPM)

Treynor ratio (systematic risk)

Information ratio (tracking error volatility)
Jensen's alpha

Foundations

Assumptions
Multifactor Models of Risk and Return

no transaction costs, no taxes, price takers, unlimited short-selling is

allowed, one-period horizon, homogeneous, marketable

Single-Factor Model
Multifactor Model

Arbitrage Pricing Theory (APT)

Financial Risk Manager I

. Creating value with risk management

maximize returns and increase the company's value

Short straddles on Nikkei 225 (selling calls and puts)
Strategy

Barings "Nick Leeson"

Arbitraging: taking long futures with low price and hedging with an
offsetting short position with high price
A head of trading & the back office

Lessons

Poor structuring of management information

Political power struggles & senior management's lack of understanding

As the head of both trading and the back-office

Daiwa

Union Bank of Switzerland: doubled as the head of senior risk manager and the quantitative analytics
Strategy
Sumitomo
Lessons

A dominant long position in futures contracts and simultaneously purchased large

quantities of physical copper
Sold put options
Lack of supervision allowed hime keep two sets of trading books
Large transactions need approvals by senior management
Offered customer contracts to buy fixed amounts...and gave MGRM a
long position in long-term forward contracts

Strategy

Stack-and-roll hedging strategy

Used short-term futures to hedge

Financial disasters and failures

Market shifted to contango exploited basis risk

Metallgesellschaft

Stack-and-roll hedge exposes to basis risk

Reasons

Shift to contango
Greatly increased the cost of hedge

http://www.lesleywang.com/
Led to cash flow risks

Relative value
Strategy

Credit spreads
Equity volatility

Long-term Capital Management

Insufficient of equity and cash flow crisis

Reasons

Models are flawed

Require initial margin, need stress tests, underestimated
manitude of liquidity risk, limit reporting

Allied Irish Bank: hide trading activities, had not dual role
Generale

. Data quality management

Reasons: fake transactions, incorrect handling of trade cancellations, lack supervision,

policy, reporting system...
Lessons: a large trade cancellations should be flagged; tighter controls; collateral and cash reports

Accuracy, Completeness, Consistency, Reasonableness, Currency, Uniqueness

Confidentiality
Principles

. Ethics and GARP Code

Conflicts of interest
Professional integrity and ethical conduct

Professional Standards

Fundamental responsibilities
Best practices