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FoundationsofFinancialRisk

Management
FRMLevel1Part1

SourceMaterial https://www.garp.org/#!/frm
LO25

EnterpriseRiskManagement

WhatisERMandhowdoesitrelatetoriskmetricsand
hedging?AnoverviewofERMdefinitions,components,and
process.
LO25

EnterpriseRiskManagement Definition

RiskManagement:Thesequenceofactivitiesaimedtoreduceoreliminateanentitysfinancialriskand
uncertainty

DefinitionsofEnterpriseRiskManagement(ERM):
Processtomakeconsistentandconscientiousriskmanagementdecisionsattheentityratherthan
anysubunitlevel.Thisprocessmust,ataminimum,involveattemptstoidentify,measure,and
addressrisksinamannerconsistentwiththeboardand/ormanagementspreconceivedarticulations
ofdesiredriskappetiteandculture. Integratedfrombelowdefinitions
Integratedapproachtoriskmanagementthatevaluatesexposuresattheentityratherthanunit
level.Attemptstocoordinateriskmanagementdutiestomaximizeefficiencyandvalueaddedwhile
reducinghedgingandothertransactioncosts. GARP
Enterpriseriskmanagement(ERM)istheprocessofplanning,organizing,leading,andcontrollingthe
activitiesofanorganizationinordertominimizetheeffectsofriskonanorganization'scapitaland
earnings. Investopedia

Costs
Identifyingandaggregating
Benefits
Increasedorganizationaleffectiveness
Moreeffectiverisktransferandreporting
Improvesbusinessefficiencyandperformance
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EnterpriseRiskManagement Participants

ParticipantsintheEMRprocesstypicallyincludetheBoardofDirectors,Senior
Management,TradingRoomManagement,Operations,Finance,andRiskManagement.

BoardofDirectors

Boardofdirectors:Agroupofindividualsthatareelectedasrepresentativesofthe
stockholderstoestablishcorporatemanagementrelatedpoliciesandtomakedecisionson
majorcompanyissues.
StrongboardswatchoutforshareholdersinterestsandproactivelyaddressAgencyRisk
by:
Maintainingmajorityindependencefrommanagementhavingstrongrepresentation
fromshareholdersandgenerallynotallowingtheCEOtoalsobeChairmanoftheboard
LimitingmanagementsabilitytoassumerisksbyreviewingtheRiskAppetite
Frameworks(RAF)
EstablishCompensationCommitteewithgoalofaligningcompensationwithRAF
EstablishAuditCommitteewithgoalofensuringfinancialstatementsreflecteconomic
reality
Approveallmajortransactions
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EnterpriseRiskManagement Participants

ParticipantsintheEMRprocessareinterdependent

BoardofDirectors

SeniorManagement TradingRoomManagement
Approvesbusinessplansandtargets Establishes&managesriskexposure
Setsrisktolerance Responsiblefordealcapture
Establishespolicy SignsoffonofficialP&L
Responsibleforperformance

RiskManagement Interdependent Operations


Developsriskpolicies Booksandsettlestrades
Monitorscompliancetolimits ReconcilesFront/Backoffice
Managesriskcommittee positions
process PreparesdailyP&LviaMtM
Validatesmodels
Finance
valuationofpositions
Developsvaluationand
Providesindependentviewof
financepolicy
risks
EnsuresintegrityofP&L
Managesbusinessplanning
process
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EnterpriseRiskManagement Components
Components BestPractices Challenges
CorporateGovernance Boardandseniormanagementsucceedin ConnectionRAFwithculture(realactions).
(includingrisk communicating ameaningfulRAFand havea Buildingprocessesandcultureneededtoclearly
appetite) clearunderstandingoftheentitysrisks. communicatematerialrisks.
Boardisindependentfrommanagement with Conflictofinterestbetweendebtholders&shareholders
strongrepresentationfromshareholders.
Boardriskcommitteeindependentfromaudit.
ProductLine Linemanagersareabletomakeindependentrisk Appropriately applyingtheRAFtonewrisksand/or
Management managementdecisionsconsistentwithRAF changingriskprofiles.Clearlineofresponsibilityand
(Accountability) accountability
PortfolioManagement Quantification processandstrategyappliedtake Appropriatelymodelingand/oraccountingforhedging
(holisticviewofrisks) interactionsacrossrisksintoaccount and riskcorrelations
RiskStrategy Strategiesareevaluatedusingcost/benefit Accountingfortheopportunitycostandoperationalrisks
analysistodeterminewhichismosteffective associated withhedgingandothermorecomplex
strategies
RiskAnalytics Approachesareconsistentwithpurposeand Identifyingallmaterialrisks,particularlythosethatare
(Quantification) appropriatelyacknowledgeandcommunicate noteasilyquantifiable.
nonquantifiablerisks Determiningappropriateapproach(ex.VaR vsExpected
Shortfall.whatconfidencelevel)
DataTechnology Fullyintegratedandstandardizeddata Buildingandmaintainingthetechnologicalinfrastructure
warehouses tosupportriskquantification(i.e. measurement)
Stakeholder Effectiveandtransparentcommunicationofrisk Lackofconnectionbetweenstakeholderbusiness
management(market managementpracticestoallinternalandexternal planningandrisk appetite
discipline) stakeholders
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EnterpriseRiskManagement Process
Keychallenges:
EstablishRiskAppetite
Step1 Framework(RAF) Clearlyarticulating
acceptablerisklimits
Continuingprocess Communicatingallmaterial
Identify riskstoriskmanagement
Step2 IndividualRisks
Applyingappropriate
approachgivenobjective

Quantify Correctlyaccountingfor
Step3 Riskexposure jointeffects(eg.correlation)
Efficientmitigationor
transferofrisks
Strategy:
Step4 Avoid Transfer Mitigate Assume
Mitigationinstruments(eg.
derivative)maybackfire.

Strategygrowsstale
Step5 MonitorPerformance:
Amendasneeded
EstablishRiskAppetite
Framework(RAF)
Step1:ERMProcess RAF

RAFspecifiestheamountandtypeofoverallriskanorganizationiswillingtoaccepttoobtainobjectives

Challenges indeterminingRAF
QualitativevsQuantitativearticulationofriskappetite
Qualitativearticulationrequirescontinualreviewbasedonnatureoftherisks,potentiallysupportedby
stresstestingorotheranalysis
Quantitativethreshold(ex.entitysetsmaximumVaR)
Accountingvseconomicexposures
Timehorizon(ex.isthehedgingstrategyfocusedonshortorlongtermprofits)
Considerationoftheexistingprofile,riskcapacity,risktolerance,attitudetowardrisk
Flexibleenoughtoapplytofullbreadthofriskswhilealsoprovidingclearguidanceonwhichstrategy
toemploygiventhenatureoftherisk.

BestpracticesforimplementingRAF
Clearstatementofriskappetite FirststepoftheBoardinconstructingtheRAF.
Communicationinplainlanguage VisibleparticipationfromexecutivesinsettingandenforcingRAF
Communicationoflimits Determininghowlimitsareset(ex.notionalsizevsVaR)and
communicatingbackgroundandreasonsforlimits.
ResponsibilityforRisk Cleardelegationofrisktobusinessunitmanagers
Transactionapproval Individualstaskedwithtransactionapprovalshouldclearlycommunicatehow
eachtransactionisconsistentwiththeRAF
EstablishRiskAppetite
Framework(RAF)
Step1:ERMProcess RAF

RiskCultureisthesystemofvaluesandbehaviorsinemployees
thatimpactanalysisandinformationpertainingtorisk.

TheabilityofanentitytoexecutetheRAF isdirectlyimpactedby
theRiskCultureoftheentity,andviceversa.

ACEOmustnotdelegateriskcontrol.Itssimplytooimportant
WarrenBuffet(2009)
Identify
IndividualRisks
Step2:ERMProcess IdentifyIndividualRisks

QuantifiableRisks:
CreditRisk Thepossibilityofdefaultbythecounterpartytoafinancialtransaction.Subclasses
includetheriskofdefault,bankruptcy,downgrade,andsettlement
InterestRateRisk Riskofunfavorablemovementsininterestratestobothassetsandliabilities
(closelyrelatedtoforeignexchangerisk)
LiquidityRisk Possibilityofsustainingsignificantlossesduetotheinabilitytotakeorliquidatea
positionatafairprice.Subclassesincludefundingliquidityriskandtradingliquidityrisk
MarketRisk Riskoflossfrompriceorvolatilitymovementinfinancialmarkets.Subclassesinclude
interestrate,equity,foreignexchange,andcommodity.

QuasiQuantifiableRisks:
OperationalRisk Riskoflossduetoinadequatemonitoringsystems,managementfailure,defective
controls,fraud,orhumanerror.Mayalsoincludetechnologyfailuresandnaturaldisasters
ModelRisk Riskthatmodelsusedbytheentityaremisspecifiedorusedinappropriately
LegalandRegulatoryRisk Riskoflawsuitsorachangeinlawsorspecificregulations
BusinessRisk Riskofunexpecteddropsinrevenueorincreasesincostsduetoexternalfactorssuch
asshiftingsupply/demandordisruptionsinthesupplychain.
StrategicRisk Riskoflossesduetochangesinbusinessmodeland/ordirectionascausedbyinternal
executiveleadership.
ReputationRisk Riskthatthepublicwilllosetrustintheentity.Trustinthiscontextreferstothe
beliefthattheentitywillboth1)beabletofulfillitsobligationstocreditorsandcounterpartiesand2)
isethicalinitsbusinessdealings
Quantify
Riskexposure
Step3:ERMProcess QuantifyRiskExposure

KeydiscussiontopicfornexttwoLunchand
Learns:
Part2:IntroductiontoRiskMetrics
September10
Part3:ValueatRiskvsExpected
Shortfall September24

CommonRiskMetrics
Standarddeviation(Volatility)
Valueatrisk(VaR)
Expectedshortfall (ES,CVAR)

Keydecisionsinconstructingthemeasure
Trade
Timeperiod
ConfidenceLevel Risk
Estimationmethod Factor
Trade Portfolio

Aggregationtotheportfoliolevel Risk
Mappingofrisktocommonriskfactors Factor
inordertoaggregatetoentitylevel Trade
Strategy:

Step4:ERMProcess Strategy Avoid Transfer Mitigate Assume

Avoid Transfer Mitigate Assume


Abstain fromthe Contractualshiftingof Systematicreductionin Accepttheriskand
market,counterparty, apureriskfromone theextentofexposure holdsufficient
Description orpractice partytoanother toariskand/orthe capital/liquidity
likelihoodofits commensuratewith
occurrence therisk
Board rejects Entitytransfersrisk of Hedge interestraterisk Boardaccepts
managementrequests counterpartyAto usingderivatives. managementrequests
Example(s) torelaxunderwriting counterpartyBviaa torelaxunderwriting
standardtoallowloan creditdefaultswap Blockingemailssent to standards.Forecastsof
underwritingwithout (CDS). external email futurelossesareused
proofofstatedincome. addresses tocalculateincreasein
capitalbuffers.
Mayprevententity Maynotremoveall Derivativesare Capitalcanbecostly to
Limitations fromenteringinto risk.Inexample,entity complex(operational hold.Criticalthat
profitablemarkets, hasexchangedriskof risk)andcanbecostly estimatesofexpected
counterparty counterpartyAdefault lossesfromriskare
relationships,or withcounterpartyB Moreonthistopic adequate.
practices andmayhavebasis duringnext
riskifusingaproxy
CDS
MonitorPerformance:
Amendasneeded
Step5:ERMProcess Monitor

RiskManagementisnotastaticprocess
Mustbeinitiallyset,continuallymonitored,andupdatedasneeded
Monitoringdeterminesifriskmanagementactivitiesareconsistent
withriskappetite
Deviationsinmonitoringsuggestthatriskappetiteorriskmitigation
processneedstobereviewed.

Monitoringmethods
Backtesting andconfidenceintervals
Stresstesting

CausesofRiskManagementFailure
Ignoringknownrisk
Improperincorporationofrisk
Unidentifiedrisk
LO6
FinancialDisasters MisleadingReportingCases
Case Cause Lesson

1976 Drysdale Securitiesborrows Drysdale misledChase byexploiting 1.Understandtransactionrisks


$300millioninunsecuredfunds aflawinthesystemforcomputing 2.Buildaccuratevaluationmodels
fromChaseManhatten thevalueofcollateral 3.Employ ariskcontrolfunction
1992: KidderPeabodys headof JettmisledKP byexploitingaflawin 1.Understandtradingstrategies
govtbondtradingdesk,Joseph systemregardingPVofforward 2.Buildaccuratevaluationsystems
Jett,reportedlargeartificialprofits contractsongovtbonds.
1994:NickLeesonatBaringsBank Lackofoperationaloversight&dual 1.Employoperationaloversight
switchedfromhedged tospecula roleastrader&settlementofficer 2.Separateroleoftraderand
tive strategytorecouplosses allowedconcealmentoflosses settlement officer
1997:JohnRusnak atAlliedIrish Rusnak createdfaketradestooffset 1.Requireimmediate cash
Bankhidlossesbybullying theback realtradesinordertohidelarge settlementinOTCmarkets
officeintonotconfirmingtrades currencypositions 2.SameasBaringsBank
1997:UnionBankofSwitzerland Inadequateactionfromfirmsrisk 1.Double checkhedgingstrategies
lostmillionsfromequity derivatives controllers. DualroleofSeniorrisk 2.Buildaccuratevaluationmodels
positionsandexposuretoLTCM managerasheadofquantanalytics. 3.Independentriskcontrolteam
2008:JeromeKerviel atSociete Kerviel hidunauthorizedtradesby 1.Buildrobustvaluationsystems
Generale lostbillionsfrom creatingfakehedgesthathehideby thatkeephistoryofrecords
unauthorizedtradingactivity cancelingjustbeforereview
LO6
FinancialDisasters LargeMarketMovementCases
Case Cause Lesson

1991 Metallgesellschafts failed Cashflowtimingdifferences 1.Hedgingpriceriskcanstillleave


stachandrollstrategycaused cash betweenlongdatedshortsand fundingliquidityrisk(LR)
shortagerequiringanunwind. shortdatedfuturesusedtohedge 2.Largepositionshave tradingLR.
1998 LTCMsextreme leverage, LTCMsrelativevalue,creditspread 1.Requirepost &collectIM
lackofdiversification&inadequate &equityvolatilitystrategiesfailed 2.Incorporateliquidationcostsinto
riskmodelsputLTCMinacashflow toconsiderextremescenarioslike pricesincase ofadverseevents
crisiswhenRussiandefaultcreated Russiandefaultwhichtriggered 3.SupplementVaR with stress
intolerablemarkettomarketand concernwithothercountries.LTCM testingwhen evaluatingfinancial
margincalls oftendidnotpostIMforOTCtrades risk(ex.creditrisk)

FinancialDisasters CustomerConductCases
Case Cause Lesson
1991 BankersTrust(BT)provided PG failedtofullyinvestigatethe 1.Tightercontrolsondealingwith
Proctor&Gamblewithintentionally strategywhichBTstaffbragged clientsandvendors
complex strategyforreducing aboutbeingmisleading(callswere 2. Recordcallswithcaution
fundingcostsusingderivatives. recorded) 3.Matchtradeswithclientneeds
2001 Enronwas abletosecretly Itwasrevealed thatJPM & Citi 1.Failure toperformduediligence
borrowfrom JPM & Citibyshorting understoodEnronsintent, but canresultisreputationrisk
oil forfuturedeliveryinexchange participatedinthetransactions 2.Avoidparticipatingin
forcash.Onceuncovered,JMPand anywaysotheywouldnotbe inappropriateactionsonthepartof
Citipaidheftyfines. recognizedasloansontheBS. customers.
LO7&LO8
TheCreditCrisis&RiskManagementFailures

SkippedAllExceptForTerms:
HeisenburgPrinciplesaysthatincreasingthe
certainlyforonevariablemayintroduce
uncertaintyforanothervariable
PredatoryTradingoccurswhenotherfirmsin
amarketseethatalargeplayerisintrouble.
Otherfirmsattempttopushthepriceagainst
thelargeplayerknowingthelargeplayerhas
toacceptthepriceorexitandacceptheavy
losses.
LO9

CapitalAssetPricingModel

Topic9
LO9
CapitalMarketLine EfficientFrontier

EfficientFrontieristheupperboundaryofthesetofallpossibleportfolio
risk/returncombinations
LO9
CapitalMarketLine AddingRiskFreeAsset
LO9
CapitalMarketLine

CMLModelexpressestheexpected
returnofaportfolio,i,asalinear
functionofitsstandarddeviation,market
portfolioreturnandstandarddeviation

Assumesallinvestorshavethesame
expectationsincludingrisk,return,and
thereforetheyallderivethesame
optimalriskyportfolio(M).

Keyconclusions:
Marketportfolioconsistsofallassets CML
weightedbyproportionofmarket
capitalizationduetohomogenous
investors
Allinvestorswillholdsome
combinationofriskfreeassetandM
dependingontheirriskaversion.
LO9
SingleFactorSecurityMarketLine

SMLexpressestheexpectedreturnofa
portfolio,i,asalinearfunctionofits

systemicriskasmeasuredbyBeta
CalculatingofassetI>
Assumesthatsecurityreturnscanbe
explainedbyasinglefactor,thewell
diversifiedportfolioscanbecreated,and
thatnoarbitrageopportunitiesexist.

Keyconclusions: SML
Doesnotrelyonthestringent
assumptionsoftheCMLandCAPM
(nextslide)wherethesamemean
variancemarketportfolio,M,isheld
byallinvestors.
Investorsarenotcompensatedfor
holdingunsystematicrisk
LO9
CapitalAssetPricingModel(CAPM)

CAPMisexpressedusingthesameformula
atSML

CalculatingofassetI>
Assumptions
1. Investorsusemeanvariance
framework CAPMvsCML
2. UnlimitedlendingandborrowingatRf CMLisonlyusefulforcomputing
3. Homogenousexpectations expectedreturnsforanefficient
(diversified)portfolio
4. Oneperiodtimehorizon
5. Divisibleassets
CAPMvsSML
6. Frictionlessmarkets
Sameformulabutformulaisderivedfrom
7. Noinflationandunchanginginterest
constructingmeanvarianceportfolio(an
rates
unobservableportfolioconsistingofall
8. Capitalmarketsareinequilibrium marketassets).
LO9
CapitalAssetPricingModel Examples

CalculateExpectedReturn
Marketriskpremiumof5% 11.5%=4%+1.5[(5%+4%)4%]
Riskfreerateof4%
StockBetaof1.5 MarketRisk
Premium
CalculateExpectedMarketReturn
StockBetaof.75 13%=4%+.75[(Rmkt) 4%]
StockExpectedReturnof13% 12%=.75(Rmkt)
Riskfreerateof4% 16%=Rmkt

CalculateMarketRiskPremium Premium =E(Rmkt) Rf


Premium=16% 4%=12%
LO9
CapitalAssetPricingModel Examples

Sell
Buy
Indifferent
LO9
CapitalAssetPricingModel Examples
LO10

ApplyingCAPMtoPerformance
Measurement
Topic10
LO10

RiskAdjustedReturnMeasures
Treynor measure=riskpremiumoversystemicrisk
Appropriateforcomparingdiversifiedportfolios

Sharpemeasure=riskpremiumovertotalrisk
Alwaysapplicablebecauseitusestotalrisk

Jensensalpha=assetsexcessreturnoverCAPM CAPM
Appropriateforcomparingportfolioswithsamebeta

Sortino ratio=variationofthesharpe ratiothatis


moreappropriateforasymmetricreturns.
ReplacesRf withRmin,aminimumacceptablereturn
Replacestotalriskwithsquarerootofmeansquared Semistandard
deviation(MSD)fromRmin
deviation
LO10

TrackingErrorandInformationRatio
TrackingErroristhestandarddeviationofthedifferencebetweenthe
portfolioreturnandthebenchmarkreturn
InformationRatio(IR)(i.e.appraisalratio)isthealphaofthemanaged
portfoliorelativetoitsbenchmarkdividedbythetrackingerror.
Usedtodetermineifthemanagersdeviationfromthebenchmarkhas
reapedanappropriatereturn.
Intuitively,theratioprovidestheresidualreturnovertheresidualrisknot
explainedbybenchmark
Resultsfromchoicesmadebythemanagertooverweightsecuritiesinthe
hopeofachievingareturngreaterthanthebenchmark

Residualreturn

Residualrisk
LO11

ArbitragePricingTheoryand
MultifactorModelsofRiskand
Return
Topic11
LO11

MultifactorModelofRiskandReturn
LO11
TheLawofOnePriceandArbitrage

TheLawofOnePrice:Identicalassetssellingin
differentlocationsshouldbepricedidentically
Arbitrage istheactionofbuyinganassetinthe
cheapermarketandsimultaneouslysellingthatassetin
themoreexpensivemarket.
Simultaneoustradesshouldcontinueuntiltheassettrades
atonepriceinbothmarkets(i.e.arbitrageopportunityis
fullyexploited)
Netinvestmentmustbezero(longpaidforwithshort)
Riskfree(BetasonlongareoffsetbyBetasonshort)
Returnmayequalorexceedriskfreerate
ArbitragePricingTheory(APT)assumesthat:
Returnisderivedfromamultifactormodel
Unsystematicriskiscompletelydiversifiedaway
Noarbitrageopportunitiesexist.
LO11

Hedgingexposurestomultiplefactors
Investorsmaywishtoonlybeexposedtoa
subsetofriskfactors.Ifso,theyshouldhedge
exposuresforwhichtheydonotwant
exposure
LO11

ModelingReturns
CAPM ArbitragePricingTheory Fama French3xFactor

RiskPremium

Describesexpectedreturnsasa Describesexpectedreturnsasa Describesexcessreturnsabovethe


functionoftheassetslevelof linearfunctionofexposuresto riskfreeassetasafunctionofthree
systemicrisk() common(i.e.macro)factors factors:
1. Marketreturn
SpecialcaseofAPTwheretheonly Macroeconomicfactorsare 2. SMB(i.e.Size)=Smallfirm
factorissystemicrisk. determinedbythemodeler returnsMinusBigfirmreturns
3. HML(i.e.Booktomarket)=
Stepstoderive: Stepstoderive: HighBtM firmsMinusLowBtM
1. Recognizethatinvestorsare 1. CreateFactorPortfolios(FP)
onlycompensatedforBeta Welldiversifiedwithexposure RationalforSMBandHMListhat
2. Returnisalinearfunctionof toonlyonefactor bothtendtohavehigherE(R)
becauseE(Return)and are 2. DerivereturnsforeachFP
weightedaveragesofassets E(R1)correspondstoF1etc SpecialcaseofAPTwherespecific
3. Useriskfreeassetandmarket 3. Deriveriskpremiums(F) factorsaregiven.
portfolio(fromSML)tosolve WhereF1 =E(R1) RF
forslopeofCAPM StepstoderiveissimilartoAPT
LO12

InformationRiskandData
QualityManagement
Topic12
LO11
Impactsanddimensionsofdataquality
Impactsfrompoordataquality
1. Financial:Lowerrevenues,higherexpenses
2. Confidencebased:Managersmakingincorrectbusinessdecisions
3. Satisfactionimpacts:Customerandemployeedissatisfaction
4. Productivityimpacts:Reducedproductionoutput;delays
5. Riskimpacts:Underestimationofrisk
6. Complianceimpacts:Maynotbeincompliance(ex.SarbanesOxley)
Dimensionsofdataquality(acceptabledata)
1. Accuracy:Degreetowhichdatareflectsrealworld
2. Completeness:Extenttowhichexpectedattributesateprovided
3. Consistency:Reasonablecomparisonofvaluesacrossdatasets.Threetypes:
1. RecordLevel Consistencybetweenonesetofvalueswithinsamerecord
2. CrossRecordLevel Consistencyinvaluesacrossrecords
3. TemporalLevel Recordlevelconsistencyacrosstime
4. Reasonableness:Conformitywithconsistencyexpectations
5. Currency:Lifespanofdata,isthedatastillconsideredusefulorisitstale?
6. Uniqueness:Maynotbeincompliance(ex.SarbanesOxley)
LO11
OperationalDataGovernance
Operationaldatagovernancereferstothecollectivesetofrulesand
processes(i.e.program)regardingdatathatallowanorganizationtohave
sufficientconfidenceinthequalityofitsdata
DataQualityScorecardmayhelpmonitor thesuccessofsaidprogram
Processesforcreatingscorecard
1. BaselLevelMetricisanysinglequantitativemeasureusingclearcriteria
2. ComplexMetricisanycombinedscorepotentiallyusingweightsofmultiplescores
andmaybecustomizedtoincorporatequalitativereporting.Scorecardcould
reportmetricby1.dataqualityissue,2.businessprocess,or3.businessimpact.
Motivation:Canprovidemanagementwithwarningsignsandleadtocorrectiveactions
Mechanics:Canimproveaccountabilitybytyingintohierarchyoforganization
DataValidationvsDataQualityInspection:
DataValidationisaonetime steptodetermineifdataconfirmstodefinedbusiness
specifications
DataQualityInspectionisongoing setofstepsaimedto:
Reducenumberoferrortoatolerablelevel
Spotdataflawsandmakeappropriateadjustments
Quicklysolvethecauseoferrorsandflaws
LO13

PrinciplesforEffectiveData
AggregationandRiskReporting
Topic13

RiskDataAggregationandReporting
(RDARR) BCBS239
LO13
RiskDataAggregation
Benefits:
AnticipateProblems byunderstandingrisksholistically
Identifyroutestoreturntofinancialhealthintimesofstress
Improvesresolvabilityintheeventofbankstressorfailure
Increaseefficiency,reducechanceofloss,andultimatelyimproveprofitability
Principals
1. Governance
2. DataarchitectureandITinfrastructure
3. AccuracyandIntegrity
4. Completeness
5. Timeliness
6. Adaptability
7. Accuracy
8. Comprehensiveness
9. Clarityandusefulness
10. Frequency
11. Distribution
LO13
Overarchinggovernanceandinfrastructure
1.Governance Abanksriskdataaggregationcapabilitiesandriskreporting
practicesshouldbesubjecttostronggovernancearrangementsconsistent
withotherprinciplesandguidanceestablishedbytheBaselCommittee.

2.DataarchitectureandITinfrastructure Abankshoulddesign,buildand
maintaindataarchitectureandITinfrastructurewhichfullysupportsitsrisk
dataaggregationcapabilitiesandriskreportingpracticesnotonlyinnormal
timesbutalsoduringtimesofstressorcrisis,whilestillmeetingtheother
Principles.
LO13
Riskdataaggregationcapabilities
3.AccuracyandIntegrity Abankshouldbeabletogenerateaccurateandreliableriskdatato
meetnormalandstress/crisisreportingaccuracyrequirements.Datashouldbeaggregatedona
largelyautomatedbasissoastominimizetheprobabilityoferrors.

4.Completeness Abankshouldbeabletocaptureandaggregateallmaterialriskdataacross
thebankinggroup.Datashouldbeavailablebybusinessline,legalentity,assettype,industry,
regionandothergroupings,asrelevantfortheriskinquestion,thatpermitidentifyingand
reportingriskexposures,concentrationsandemergingrisks.

5.Timeliness Abankshouldbeabletogenerateaggregateanduptodateriskdatainatimely
mannerwhilealsomeetingtheprinciplesrelatingtoaccuracyandintegrity,completenessand
adaptability.Theprecisetimingwilldependuponthenatureandpotentialvolatilityoftherisk
beingmeasuredaswellasitscriticalitytotheoverallriskprofileofthebank.Theprecisetiming
willalsodependonthebankspecificfrequencyrequirementsforriskmanagementreporting,
underbothnormalandstress/crisissituations,setbasedonthecharacteristicsandoverallrisk
profileofthebank.

6.Adaptability Abankshouldbeabletogenerateaggregateriskdatatomeetabroadrangeof
ondemand,adhocriskmanagementreportingrequests,includingrequestsduringstress/crisis
situations,requestsduetochanginginternalneedsandrequeststomeetsupervisoryqueries.
LO13
Riskreportingpractices
7.Accuracy Riskmanagementreportsshouldaccuratelyandpreciselyconveyaggregatedriskdata
andreflectriskinanexactmanner.Reportsshouldbereconciledandvalidated.

8.Comprehensiveness Riskmanagementreportsshouldcoverallmaterialriskareaswithinthe
organization.Thedepthandscopeofthesereportsshouldbeconsistentwiththesizeandcomplexity
ofthebanksoperationsandriskprofile,aswellastherequirementsoftherecipients.

9.Clarityandusefulness Riskmanagementreportsshouldcommunicateinformationinaclearand
concisemanner.Reportsshouldbeeasytounderstandyetcomprehensiveenoughtofacilitate
informeddecisionmaking.Reportsshouldincludeanappropriatebalancebetweenriskdata,analysis
andinterpretation,andqualitativeexplanations.Reportsshouldincludemeaningfulinformation
tailoredtotheneedsoftherecipients.

10.Frequency Theboardandseniormanagement(orotherrecipientsasappropriate)shouldsetthe
frequencyofriskmanagementreportproductionanddistribution.Frequencyrequirementsshould
reflecttheneedsoftherecipients,thenatureoftheriskreported,andthespeedatwhichtheriskcan
change,aswellastheimportanceofreportsincontributingtosoundriskmanagementandeffective
andefficientdecisionmakingacrossthebank.Thefrequencyofreportsshouldbeincreasedduring
timesofstress/crisis.

11.Distribution Riskmanagementreportsshouldbedistributedtotherelevantpartiesandwhile
ensuringconfidentialityismaintained.
NOTONEXAM
Supervisoryreview,toolsandcooperation

Principle12
Review Supervisorsshouldperiodicallyreviewandevaluateabankscompliance
withtheelevenPrinciplesabove.

Principle13
Remedialactionsandsupervisorymeasures Supervisorsshouldhaveandusethe
appropriatetoolsandresourcestorequireeffectiveandtimelyremedialactionby
abanktoaddressdeficienciesinitsriskdataaggregationcapabilitiesandrisk
reportingpractices.Supervisorsshouldhavetheabilitytousearangeoftools,
includingPillar2.

Principle14
Home/hostcooperation Supervisorsshouldcooperatewithrelevantsupervisors
inotherjurisdictionsregardingthesupervisionandreviewofthePrinciples,and
theimplementationofanyremedialactionifnecessary.
LO14
GARPCodeofConduct
GARPCodeofConductcontainssetofkeyprincipalsdesignedtosupport
financialriskmanagementpractices.
DevelopedforFRMandotherGARPcertifications.
Whenencounteringsituationnotspecificallyaddressedincode,actethically
Principals
1. ProfessionalIntegrity&EthicalConduct:Actethicallyeveryone,maintainappearance
ofindependence(ex.avoidgifts),dontbedeceptive,dontcompromiseGARPorFRM
(ex.cheatingonexam)
2. Conflictsofinterest:Actfairlyanddiscloseconflictsofinterest
3. Confidentiality:Allworkisconfidentialunlessgivenpermissionbyemployer/client
ProfessionalStandards
1. FundamentalResponsibilities:Donotknowinglydisobeyrules.Cantdelegateethical
responsibilities,provideriskmanagementadvicethatsuitstheemployer/client.Dont
overstateaccuracyorcertaintyofresults
2. Adherencetogenerallyaccepted(Best)practicesinriskmanagement: Performall
workinamannerthatisindependentfrominterestedparties(beobjective).Keepup
withbestpracticesandclearlystateanydeparturefrombestpractices,distinguish
betweenfactandopinion
Part3

Hedging

Whatishedgingandhowdoesitrelatetotherisk
managementprocess?
Hedging:ARiskMitigationStrategy Definition

Definition:Ariskmitigationstrategyusedtoneutralizeriskbyenteringintoan
offsettingpositiontoanexistinginvestment.

Hedgingisoftenaccomplishedusingderivatives.

Advantages
Lowerearningsvolatility Thisimprovesmarketcapitalizationandinturncanreducecostsof
capital
Increasecertaintyofoperationalcostssuchascommodityprices(alsorelatedtoearnings
volatility)

Disadvantages
Complexity Failedstrategiescanresultinworseoutcomesthanassumingtheunderlying
risks(i.e.higheroperationalrisks)
Costs Hedgingstrategiescanbecostlytoimplement,monitorandmaintain.

Keyquestions:
Aretherisksofhedgingconsistentwithriskappetite(i.e.RAF)?
Whatarethecounterpartyriskexposuresandassociatedcapitalcosts?
Whataretheliquidityandtaximplications?
Hedging:CommonApproaches

PricingRisks
Forwards/futurescanreduceinput/outputprice
fluctuations

ForeignCurrentRisk
FXSwapscanreduceeffectsofcurrencyexchangerateson
balancesheetearningsvolatility

InterestRateRisk
IRSwapscanreducevolatilityinfundingcostsaswellas
ratesofreturnoninvestments
Hedging:StaticvsDynamic

BasisRisk Theriskthatthevalueofafuturescontract
(oranoverthecounter(OTC)hedge)willnotmovein
linewiththatoftheunderlyingexposure.Alternatively,
itistheriskthatthecashfuturesspreadwillwidenor
narrowbetweenthetimesatwhichahedgepositionis
implementedandliquidated.

StaticvsDynamicHedging
Timehorizonandcost/benefittradeof
Statichaslowercost,buthigherbasisrisk
Dynamichashighercost,butreducesbasisrisk