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Welcome to

PRMIAs
Associate PRM Webinar Series

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PRMIA 2016
Welcome to Session A of the Associate PRM Webinar Series

Dr. Bob Mark, Presenter Anne Jones, Host


Black Diamond Risk Enterprises Webcast Manager
PRMIA

This material is the intellectual property of PRMIA and shall not be reproduced or used without the express written permission of PRMIA.
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PRMIA 2016
Audio and Questions
Your Participation
Open and hide your control panel

Join audio:
Choose Mic & Speakers to
use VoIP
Choose Telephone and dial
using the information
provided

Submit questions and comments


via the Questions panel

Note: Todays presentation is


being recorded and will be
available within 48 hours using
the recording link provided in the
syllabus.

This material is the intellectual property of PRMIA and shall not be reproduced or used without the express written permission of PRMIA.
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PRMIA 2016
This material is the intellectual property of PRMIA and shall not be reproduced or used without the express written permission of PRMIA.
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PRMIA 2016
Attentiveness
An attendee will appear as "inattentive"
during a session if that the attendee no
longer has GoToWebinar as the "active"
window on their computer.

This is monitored during the poll


questions. If you are shown as
inattentive and you do not answer a poll
question, you will not receive CPE
credit.

The correct answer is not required to


receive credit.

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PRMIA 2016
How Poll Questions Work

1. Click circle
next to your
answer

2. Click
Submit

This material is the intellectual property of PRMIA and shall not be reproduced or used without the express written permission of PRMIA.
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PRMIA 2016
Book:
Essentials of Risk Management (EoRM)
Second Edition

Please keep the EoRM book at hand during the webinar


sessions to facilitate the learning experience.
Key boxes, figures and tables from the EoRM book will be
referred to during each of the webinar presentations.
It is very helpful to open the book to the specified page
when indicated on a slide.

This material is the intellectual property of PRMIA and shall not be reproduced or used without the express written permission of PRMIA.
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PRMIA 2016
Slide Deck:
Please print the slide deck prior to each session for note
taking.
Check the webpage (link provided in syllabus) prior to
each session for possible updates.

Updates will be indicated here.

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PRMIA 2016
Bookmark the syllabus link:

Please bookmark the syllabus link. You will find links to:
The live webinar sessions
The reading assignments
The presentations
The recorded sessions with access instructions

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PRMIA 2016
Welcome to Session A

Overview, Corporate Risk Management


and the
Theory of Risk and Return

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PRMIA 2016
Introduction to the Associate PRM
Intended for staff entering risk management, who interface
with the discipline, or who need a broader understanding of
financial risk practices
A practical exam that does not require mathematical
knowledge and includes limited theory
Syllabus material includes:
Selected chapters from the 2nd edition of The Essentials of
Risk Management (EoRM) by Michel Crouhy, Dan Galai and
Bob Mark
Excerpts from the PRMIA Guide to Financial Markets
Risk Management Practices two abridged chapters from the
PRMIA PRM Handbook Risk Theory and Best Practice
The PRMIA Standards of Best Practice, Conduct and Ethics,
PRMIA Bylaws, and PRMIA Governance Principles
PRMIA Case Studies

(All except the EoRM are available from the PRMIA website.)

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PRMIA 2016
Overall Associate PRM Learning Objectives
Gain a familiarity with:
The concept of risk management and its place in the business
An overall understanding of the concepts of risk management
techniques in a non-quantitative framework
The structure and workings of various financial markets and the
financial instruments used in risk management
Understand:
How governance fits into the concept of risk management
The concepts of risk and return, interest rate risk and hedging,
asset-liability management market, credit, operational and
enterprise risk management
How performance can be measured
Industry standards and best practices
The positive role that risk management can play
The goal of the series is a general, widespread understanding
and the ability to develop skills; not becoming an expert in
any one area

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PRMIA 2016
Associate PRM Logistics
An automated exam taken in a controlled test centre
A calculator is not required nor allowed any simple maths needed
can be done on a scrap sheet
90 questions in 180 minutes (2 minutes/question)
All questions are narrative and multiple choice with four options
and only one right answer
Exam is in 8 sections (A-H) each with 8-12 questions
Sections are taken in sequence, questions within a section are
random
The candidate can return to questions, or mark an answer to revisit
later
The result is given within 15 working days
The exam cannot be repeated in less than 90 days
If an exam is repeated, the candidate will not get the same
questions

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PRMIA 2016
Study Comments

There is a lot to read work out how much there is to read


and spread that over the time to the exam allow a week
(or even two) spare before the exam for review

Look at the syllabus percentages and plan your study


accordingly

Read around the subject if necessary but not too much


everything in the syllabus is in the reading material you
do not need to read external reference material

Do not skip the detail question writers are attracted to


detail check footnotes

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PRMIA 2016
Further Sources of Information

These are websites that can be used for further clarification


of subjects:

www.investorwords.com
www.investopedia.com/?viewed=1
www.businessdictionary.com
www.answers.com
www.useconomy.about.com

Also, confer with work colleagues, professors, etc.

Note: Everyone has their own favourites. One cannot always depend on these
services. Many of them are highly opinionated and may only put forward one side
of any view. Some simply can be wrong! From the exams point of view, the
syllabus material is always right!

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PRMIA 2016
Exam Comments

Check the exam centre location, arrive in time, have your


identification ready

You cannot take anything into the exam centre secure


storage will be provided for bags, phones, calculators, etc.

Pace yourself 90 questions in 2 hours is 90 seconds per


question then move on to the next question. This gives
you another 30 minutes spare to return to check answers
or complete unfinished questions, and a further 15 minutes
contingency

Use all of time allowed relax and answer every


question!

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PRMIA 2016
Session A

Helicopter view of risk management


A primer in corporate risk management
A non-quantitative guide to risk and return

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PRMIA 2016
Learning Objectives
After completing this session, participants will be able to:
Define financial risk and risk types
Define the risk management process
Define the role of the risk manager
Identify the balance between risk and reward
Implement a financial risk management program
Define hedge accounting and diversification
Define the efficient portfolio and other methods
Identify basic concepts of a call options value
Define the concept of risk-adjusted returns

Reading material includes Chapters 1, 2 and 5 from the 2nd edition of EoRM

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PRMIA 2016
The Global Financial Crisis of 2007-2009
Have the events of 2007-9 changed the focus of risk
management?
The importance of risk governance (e.g. of boards and senior
management understanding of the risks)

Avoiding risk concentrations and understanding the tendency for


things to go wrong together (e.g. correlations tend to migrate toward
1 in extreme markets)

Organisations with a poor risk management and risk governance


culture sometimes allow powerful business groups to exaggerate the
potential returns while diminishing the perceived potential risks

People tend to poorly diagnose probabilities of extreme events

VaR tends to be a very poor and a misleading measure of risk in


abnormal markets, over longer time periods, or for illiquid portfolios

The role of a risk manager is not to try to read a crystal ball, but to
uncover the sources of risk and to make them visible (transparent)
to key decision makers in both normal and stress markets

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PRMIA 2016
Risk in Stress Markets :Dodd-Frank Act Stress Test (DFAST)

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What is Risk?
The future cannot be predicted (you can never predict the future)
Predicted costs result in expected losses (cost of business)
unpredicted costs give unexpected losses
Risks are unpredicted costs a variability in cost that can be
quantified in terms of probability
Losses can be predicted for large, well diversified portfolios with
unlinked risks such as credit cards
Lumpy corporate loan portfolios (fewer larger value loans) have:
Linked risk factors covariance statistics
That can all go wrong together correlation risk
Probability that varies with time (stochastic covariance)
Variability that can be quantified in terms of probability = risk, variability that
cannot be quantified at all = uncertainty (Frank H Knight, Risk Uncertainty and
Profit, 1921)

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PRMIA 2016
Lumpy or Non-Lumpy?
A typical corporate
lending portfolio
Number of assets

Number of assets
Value of assets

A typical credit
card portfolio
Value of assets
Glossary of Risk Types
Appendix 1.1, page 23

Market Losses arising from changes in market factors: foreign


Risk exchange rates, interest rates, commodity prices and equity
prices. The value of an asset changes because of changes in
the price of these individual market factors or their costs.
Credit Changes in the credit quality of an asset. An asset loses
Risk value because its ability to redeem that value (repay)
declines. This can be because it is downgraded (credit
rating) or, in extreme cases, because it defaults.
Liquidity Funding Liquidity Risk the inability to raise the liquid
Risk cash to meet collateral obligations
Market (Trading) Liquidity Risk the inability to execute
a transaction at the current market price

* These descriptions are key areas and should be given priority in studies.

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PRMIA 2016
Glossary of Risk Types
(continued Appendix 1.1)
Operational Losses from breakdowns in operations caused by people
Risk processes, technology

Systems failure, management errors, faulty controls,


internal or external fraud, human error, inadequate
processes, etc.
Legal and Contract not executable as the counterparty did not have
Regulatory the authority, changes in laws or regulations (legal and
Risk regulatory risks are typically classified as operational risk)

Business Making the wrong business decisions miscalculating


Risk demand, pricing, technology, channels, marketing

Strategic Incorrect strategies


Risk
Reputation Loss of reputation for fair dealing, loss of belief that a
Risk firm is successful, legal execution of the business, dealing
in disreputable activities

These descriptions are key areas and should be given priority in studies.

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PRMIA 2016
Schematic Presentation, by Categories of Financial Risks
Figure 1A-2, Page 24

Equity price General


risk market risk
Trading risk
Interest rate
Specific risk
risk
Financial risk

Market risk Gap risk


Foreign
exchange risk
Commodity
price risk
Transaction Issue risk
risk
Credit risk
Portfolio Issuer risk
concentration
Counterparty
credit risk

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PRMIA 2016
Question #1
Q There are four major types of market risk. These are:

a) Equity & commodity prices, credit ratings, interest


rates
b) FX, interest rates, loan default rates, volatility rates
c) Interest rates, equity prices, FX rates, commodity
prices
d) Interest rates, credit ratings, stochastic (time)
variance, equity prices

The answer is:

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PRMIA 2016
Answer for Question #1

Q There are four major types of market risk. These are:

a) Credit ratings are a measurement used in credit risk


b) Loan default rates are used in credit risk, volatility
rates are a tool used in market risk
c) Interest rates, equity prices, FX rates,
commodity prices
d) Credit ratings, stochastic (time) variance is a tool
used in market risk

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PRMIA 2016
The Risk Managers Job
The risk manager identifies sources of risk, estimates probabilities
(likelihood) and impacts (severity)

The risk manager provides reports to business units, senior


management risk committees and the board, as well as recommends
mitigation actions that fit the corporate risk culture

The risk manager is not a prophet nor does he typically execute


business decisions

The risk manager has to balance the needs of the business to


generate revenue against the risk factors, as well as deliver reports
that the business can understand

There is no single perfect measure of risk, but quantification should


be attempted

VaR (Value at Risk) has shortcomings and is best used for short
periods in normal markets

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PRMIA 2016
The Risk Management Process
Figure 1-1, page 2
Identify risk exposures

Find instruments and


Measure and estimate
facilities to shift or
risk exposures
trade risks

Assess effects of Assess costs and


exposures benefits of instruments

Form a risk mitigation


strategy: Avoid, Transfer,
Mitigate, Keep

Evaluate performance
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PRMIA 2016
Risk Culture Questions
(note: Full actual survey available)

Poll Question

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Financial Risk Management
Statutory requirement in the U.S. (Sarbanes-Oxley, 2002) made
managers liable if they exposed their firm to undue risk through
poor practices

Today we have Dodd Frank (e.g. Dodd Frank Stress Test


requirements) and Basel III

Deploying sophisticated hedging techniques is now standard


practice in reducing financial risk derivatives are commonly
used: swaps, forwards, futures, options or combinations of these

A poor risk management strategy using hedging can, when it


goes wrong (e.g. low correlations between the hedge and the
asset being hedged), drag down a firm faster than the underlying
risk it was trying to protect

Hedging can be operational (e.g. storing raw materials), or


financial (i.e. using derivatives to reduce the risk of an interest
rate sensitivity mismatch between assets and liabilities)

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The purpose of Basel III is to prevent a
financial crisis from happening again in the
future by imposing:

More, and better quality, loss-absorbing capital


Better protection against some risks, such as market risk in general,
securitization, counterparty credit risk, and liquidity risk
Better treatment of cyclicality in the economy and financial markets
Better risk governance in financial institutions
Some argue that Basel III is too complex and should be replaced by a
simple leverage ratio (Tier 1 Capital/Exposure).

See page 113

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PRMIA 2016
Financial Hedging in Practice
Determine the objectives
Manage volatility in accounting profits vs. managing economic
profits, over what term?

Map the risks


Currencies, interest rates, operational costs, etc.

Select the instruments


From simple futures to OTC exotic derivatives

Construct a hedging strategy


What models? Static or dynamic? Over what time?

Implement the strategy


Responsibilities, measurement, tax monitoring, etc.

Evaluate performance
When? Transaction and disclosure costs changes of plans

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PRMIA 2016
The +/- of Financial Risk Management Hedging
Against For
In practice, markets are not Excessive and unprotected
perfect losses can cause financial
distress and bankruptcy
Complex instruments can
distract management Hedging can protect firms
Financial risk management that use commodities
requires specialist skills Hedging reduces volatility and
... and specialist systems subsequent tax liability peaks
and processes Shareholders need to be
Gearing accelerates volatility protected against excessive
down as well as up risk taking

Disclosure rules can be Risk management can reduce


complex the cost of, and free up
capital

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PRMIA 2016
Risk vs. Reward
Safe (risk free) investments yield lower yields because they are
safe (assumed free from default)

Riskier investments pay higher yields (because the potential


default is built in to the yield calculation)

Investors decide how much risk to accept (e.g. balancing


expected return versus risk)

The balance between risk and return is not a simple


mathematical one

The market can be irrational in pricing instruments, but it does


price them

Many investments are not easy to evaluate including Residential


Mortgage Backed Securities (RMBS), complex exotic trading
instruments, etc.

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PRMIA 2016
Risk Can be Difficult to Price
The risk for transactions that are NOT market-traded is
harder to price it can be distorted by:

The desire to complete the transaction

The personal reward for the transaction

Inaccurate timing of the risk

The pricing of the transaction (e.g. Mark-to-Model)

If the risk or price is hard to estimate then there is the


potential that rewards will be overestimated and risk
underestimated a risk itself

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PRMIA 2016
Question #2

Q Which of the following financial transactions is not


used by a risk manager in the management of
financial risk?

a) Insurance
b) Secondary share flotations
c) Currency swaps
d) Collateralized debt obligations

The answer is:

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PRMIA 2016
Answer to Question #2
Q Which of the following financial transactions is not
used by a risk manager in the management of
financial risk?

a) Insurance can be used as mitigation, although not


overly common for financial risks as expensive
b) Secondary share flotations are not used in
financial risk management
c) Currency swaps are a hedging tool used in risk
management
d) Collateralized debt obligations are another hedging
tool used in risk management

Note that not questions are not uncommon in the exam. Read carefully,
however, you should not find double negative questions.

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PRMIA 2016
Theories on Risk and Return
A basic understanding of the underlying models and
principles is important as it helps one understand the rest of
the syllabus, and to understand and interact with other risk
professionals, especially the quantitative analysts.
Examples of basic theories are:
The beginnings of Modern Portfolio Theory (MPT)
(Harry Markowitz, 1952)

The Capital Asset Pricing Model (CAPM)


(William Sharpe and John Linter, 1964-65)

Pricing options in a portfolio the Black-Scholes Model


(Fischer Black and Myron Scholes, 1973)

Calculating Probability of Default (PD)


(Robert Merton, 1974)

and to a lesser extent


The zero value impact of a firms capital structure
(Franco Modigliani and Merton Miller, 1958)

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PRMIA 2016
Efficient Portfolio Theory
Figure 5-1, page 185

Efficient-portfolios.com
Harry Markowitz, The Principles of Portfolio Selection
University of Chicago, 1952 (Nobel Prize 1990)
Investors select their portfolio based on profit (average return) and risk
(variance on this return)
Diversification reduces risk as individual returns can move in different
directions
For every level of risk an investor wishes to take on there is an efficient
(optimal) asset diversification

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PRMIA 2016
Capital Asset Pricing Model (CAPM)
Builds on Markowitzs Portfolio Theory
Decomposed risk into two portions:
Risk that can be reduced to zero through diversification
(diversifiable or specific risk)
Risk that cannot be eliminated through diversification
(systematic risk)
Calculates the market risk premium (what investors get for
taking on the risk) by subtracting the interest rate of default-
free assets (e.g. treasury bonds) from the market return
Beta for an asset which has zero correlation with the market
portfolio = 0
Beta for the market portfolio (i.e. all possible assets) = 1
A single asset will therefore have a beta which ranges either
side of 1

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PRMIA 2016
Question #3

Q According to the CAPM, the expected rate of return on


an asset equals?

a) Expected rate of return on the market portfolio (


risk-free interest rate)
b) Risk-free interest rate - (expected rate of return on
the market portfolio)
c) Expected rate of return on the market portfolio + (
risk-free interest rate expected rate of return on the market
portfolio)
d) Risk-free interest rate + (expected rate of return on
the market portfolio risk-free interest rate)

The answer is:

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PRMIA 2016
Answer to Question #3

Q According to the CAPM, the expected rate of return on


an asset equals?

a) The CAPM definition is the risk free rate plus the beta
times the risk premium
b) The CAPM definition adds a premium to the risk free rate
c) The CAPM definition adds the risk free rate with the beta
times the market risk premium
d) Risk-free interest rate + (expected rate of
return on the market portfolio risk-free interest rate)
correct by definition

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PRMIA 2016
The Greeks

Beta A measurement of the variation


between an assets return multiplied by its
correlation with the return on the market
portfolio divided by the variance of the
market portfolio. A beta above 1 moves up
more than the market, a beta of less than
1 moves less than the market. A beta of zero
implies a return equal to the risk free rate.

Delta, Gamma, Vega, Theta and Rho all


come in Session E of this series

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PRMIA 2016
Beta Risk
Figure 5-2, page 189
Expected
Return D

C
RM
B

A
Expected ROR Risk-free ROR
RF
(BETA) = Market ROR Risk-free ROR

(ROR = Rate of return)

0 1
(Beta Risk)

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PRMIA 2016
Question #4

Q The market risk premium in the Capital Asset Pricing


Model (CAPM) is:

a) The expected rate of return on the market portfolio


minus the risk-free interest rate
b) The premium that investors demand for taking on the
risk of the market portfolio, as opposed to investing in
the risk-free asset
c) The premium that investors must pay in order to get a
higher expected rate of return
d) A and B

The answer is:

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PRMIA 2016
Answer to Question #4

Q The market risk premium in the Capital Asset Pricing


Model (CAPM) is:

a) The expected rate of return on the market portfolio


minus the risk-free interest rate
b) The premium that investors demand for taking on the
risk of the market portfolio, as opposed to investing in
the risk-free asset
c) The premium that investors must pay in order to get a
higher expected rate of return
d) A and B correct because both a and b identify
the risk premium as in the CAPM definition as
the market portfolio expected return minus the
risk free rate

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PRMIA 2016
Option-Pricing Theory
Black-Scholes in 1973

Options = puts (an option, i.e. not an obligation, to sell an


asset) and calls (an option to buy)

A buyer of a call option pays a small amount at the start of


the contract and the rest on maturity if chosen to execute

A call is insurance against price going up, a put against it


going down

But how to price? The Black-Scholes Model uses the price of


the asset, the strike price agreed on execution of the contract,
the current risk-free interest rate, the expected volatility of
the asset, and the time until expiration

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PRMIA 2016
The Math
The Black-Scholes formula is: C0 = S0N(d1) - Xe-rTN(d2)
Where:
d1 = [ln(S0/X) + (r + 2/2)T]/ T and d2 = d1 - T, and C0 =
current option value, S0 = current stock price, N(d) = the probability
that a random draw from a standard normal distribution will be less
than (d), X = exercise price, e = 2.71828, the base of the natural log
function, r = risk-free interest rate, T = time to option's maturity, in
years, ln = natural logarithm function, and = standard deviation of
the annualized continuously compounded rate of return on the stock

And, modified by Bob Merton to take dividends into consideration,


is: C0 = Se-dTN(d1) - Xe-rTN(d2)
Where:
d1 = [ln(S0/X) + (r - d + 2/2)T]/ T, and d2 = d1 - T

And you dont have to remember any of this as it is not in the syllabus!

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PRMIA 2016
Question #5

Q The historical rate of return of the market is 13%. The


return on a treasury bond is 6%. An asset has a beta of
1.5. What is its required rate of return?

a) 6%
b) 9%
c) 16.5%
d) 20.5%

The answer is:

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PRMIA 2016
Answer to Question #5

Q The historical rate of return of the market is 13%. The


return on a treasury bond is 6%. An asset has a beta
of 1.5. What is its required rate of return?

a) 6% - incorrect as the CAPM model yields a different


result
b) 9% - incorrect as the CAPM model yields a different
result
c) 16.5% - correct as the CAPM model yields this
required rate of return
d) 20.5% - incorrect as the CAPM model yields a
different result

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PRMIA 2016
Explanation for Question #5

The treasury bond rate (a government supported asset) is the


risk-free rate = 6%
The average market risk premium is the average rate of return for
the market (13%) less the risk-free rate (6%): so 13-6 = 7%
The beta of the particular asset is 1.5; so its market premium would
be the average market risk premium times 1.5: so 7 x 1.5 = 10.5%
The rate of return of that particular asset is therefore the risk-free
rate plus the risk premium of that asset: so 6 + 10.5 = 16.5%

So a beta of zero would be the same as the underlying risk-free rate (6% + 7x0 =
6%), a beta of 1 would be the same as the average historic rate (6% + 7x1 = 13%).
A negative beta means the return is less than the risk-free rate.

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PRMIA 2016
Thank you for viewing this session!

The next session will be


Session B
The Role of Governance in Risk Management

The reading assignment for Session B is Chapter 4 from the 2nd edition of
EoRM plus the PRMIA Standards of Best Practice, Conduct and Ethics, as
well as the PRMIA Governance Principles and the PRMIA Bylaws
found at:
http://www.prmia.org/sites/default/files/references/AssociatePRMReading.pdf

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PRMIA 2016
Dr. Robert M. Mark
Dr. Robert M. Mark is a Founding Partner of Black Diamond Risk which provides corporate governance, risk management consulting, risk
software tools and transaction services. Dr. Mark is also the Founding Executive Director of the Masters of Financial Engineering Program
at the UCLA Anderson School of Management. He serves on several boards as well as on Checkpoints Investment Committee. In 1998, he
was awarded the Financial Risk Manager of the Year by the Global Association of Risk Professionals (GARP). He is on the Executive
Committee of the Board of the Professional Risk Managers International Association (PRMIA).

Prior to his current position, he was the Senior Executive Vice-President and Chief Risk Officer (CRO) at the Canadian Imperial Bank of
Commerce (CIBC). Dr. Mark was a member of the Management Committee. His global responsibility covered all credit, market, and
operating risks for all of CIBC as well as for its subsidiaries. Prior to his CRO position, Dr. Mark was the Corporate Treasurer at CIBC.

Prior to CIBC, he was the partner in charge of the Financial Risk Management Consulting practice at Coopers & Lybrand (C&L). The Risk
Management Practice and C&L advised clients on risk management issues and were directed toward financial institutions and multi-
national corporations. This specialty area also coordinated the delivery of the firms accounting, tax, control, and litigation services to
provide clients with integrated and comprehensive risk management solutions and opportunities.

Prior to his position at C&L, he was a managing director in the Asia, Europe, and Capital Markets Group (AECM) at Chemical Bank. His
responsibilities within AECM encompassed risk management, asset/liability management, research (quantitative analysis), strategic
planning and analytical systems. He served on the Senior Credit Committee of the Bank. Before he joined Chemical Bank, he was a senior
officer at Marine Midland Bank/Hong Kong Shanghai Bank (HKSB) where he headed the technical analysis trading group within the Capital
Markets Sector.

He earned his Ph.D., with a dissertation in options pricing, from New York Universitys Graduate School of Engineering and Science,
graduating first in his class. Subsequently, he received an Advanced Professional Certificate (APC) in accounting from NYUs Stern
Graduate School of Business, and is a graduate of the Harvard Business School Advanced Management Program. He is an Adjunct
Professor and co-author of Risk Management (McGraw-Hill), published in October 2000, as well as a co author of The Essentials of Risk
Management (McGraw Hill) published in December 2005. Dr. Mark served on the board of ISDA as well as the Chairperson of the National
Asset/Liability Management Association (NALMA). Dr. Mark is also currently a lecturer on Risk Management at the University of California,
Berkeley.

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PRMIA 2016
Text References

The Essentials of Risk The 2nd Edition Risk Management


Management Essentials of Risk (2001)
(2006) Management
(2015)

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PRMIA 2016