18/01/2025 10:38:02
FRM Part 1 – FRM
1 Risk Management Process and Problems
1. Identify risks
2. Quantify and estimate risk exposures
3. Determine effects of risk exposures
4. Design a risk mitigation strategy
5. Assess performance and improve strategy if needed
Problems
- identifying the correct risks
- Finding efficient method of risk transfer
1 VaR
used to provide a loss and its probability of occurring over a specified time
period
1 Expected vs Unexpected Loss
- how much a company expects to lose over the normal course of business
and is generally easy to quantify due to certainty
- how much a company may lose outside of normal operations and is more
difficult to predict due to higher uncertainty (correlation risk can occur)
1 Liquidity Risks: Funding vs Trading
- occurs when an entity is unable to pay down or refinance debt, satisfy cash
obligations, or fund any capital withdrawals
- entity is unable to buy/sell a security at market price due to inability to
find counterparty to transact with
1 Business Risk
Uncertainty around a firm's I/S regarding revenues or production costs
1 Credit Risks: Default, Bankruptcy, Downgrade, Settlement
- non-payment of interest and/or principal on a loan by borrow to lender
- taking possession of collateral, risk that liquidation value of collateral is
insufficient to cover loss
- decreased creditworthiness of a counterparty, may lead to default
- derivatives transaction settlement where one party is in a "losing" position
and one is "winning", losing position could refuse to pay and fulfill its
obligations
2 Pricing Risk
Risk of input costs, can hedge with futures/forwards, type of operational risk
2 Static vs Dynamic Hedging Strategy
, 18/01/2025 10:38:02
- static is matching position as closely as possible with single position
- dynamic is the continuous matching of a changing position which
increases transaction costs and takes time to monitor the risks
2 Exchange-Traded vs OTC
- exchange-traded instruments cover certain underlying assets and are
standardized to promote liquidity
- OTC are privately traded between banks and firms and are more
customizable for the firm, less liquid, difficult to price, and have some
default risk
3 Interdependence of Functional Units (bank)
- Senior Management - approves plans and sets targets
- Risk Management - develops risk policies and monitors risks
- Trading Room Management - manages risk exposures and signs off on
P&L
- Operations - generates and maintains data to manage risk
- Finance - valuation and finance policies and ensures integrity of P&L
4 What is ERM?
"Risk is a variable that can cause deviation from an expected outcome. ERM
is a comprehensive and integrated framework for managing risks in order to
achieve business objectives, minimize unexpected earnings volatility, and
maximize firm value"
4 Three Motivations of ERM
1. Integration of Risk Organization
2. Integration of Risk Transfer
3. Integration of Business Processes
5 Limitations of VaR
- different risks lead to different distributions (market uses normal while
credit/ops use log-normal)
- does not account for correlations between risks
6 Chase Manhattan Bank and Drysdale Securities
Facts: Drysdale obtained $300M in unsecured funds from Chase Manhattan
by exploiting a flaw in the system for computing the value of US gov't bond
collateral despite only having $20M in capital
Key Factors: Inexperienced managers, Chase failed to detect the
unauthorized positions
Lessons: Need for more precise methods for computing the value of
collateral and better process control
FRM Part 1 – FRM
1 Risk Management Process and Problems
1. Identify risks
2. Quantify and estimate risk exposures
3. Determine effects of risk exposures
4. Design a risk mitigation strategy
5. Assess performance and improve strategy if needed
Problems
- identifying the correct risks
- Finding efficient method of risk transfer
1 VaR
used to provide a loss and its probability of occurring over a specified time
period
1 Expected vs Unexpected Loss
- how much a company expects to lose over the normal course of business
and is generally easy to quantify due to certainty
- how much a company may lose outside of normal operations and is more
difficult to predict due to higher uncertainty (correlation risk can occur)
1 Liquidity Risks: Funding vs Trading
- occurs when an entity is unable to pay down or refinance debt, satisfy cash
obligations, or fund any capital withdrawals
- entity is unable to buy/sell a security at market price due to inability to
find counterparty to transact with
1 Business Risk
Uncertainty around a firm's I/S regarding revenues or production costs
1 Credit Risks: Default, Bankruptcy, Downgrade, Settlement
- non-payment of interest and/or principal on a loan by borrow to lender
- taking possession of collateral, risk that liquidation value of collateral is
insufficient to cover loss
- decreased creditworthiness of a counterparty, may lead to default
- derivatives transaction settlement where one party is in a "losing" position
and one is "winning", losing position could refuse to pay and fulfill its
obligations
2 Pricing Risk
Risk of input costs, can hedge with futures/forwards, type of operational risk
2 Static vs Dynamic Hedging Strategy
, 18/01/2025 10:38:02
- static is matching position as closely as possible with single position
- dynamic is the continuous matching of a changing position which
increases transaction costs and takes time to monitor the risks
2 Exchange-Traded vs OTC
- exchange-traded instruments cover certain underlying assets and are
standardized to promote liquidity
- OTC are privately traded between banks and firms and are more
customizable for the firm, less liquid, difficult to price, and have some
default risk
3 Interdependence of Functional Units (bank)
- Senior Management - approves plans and sets targets
- Risk Management - develops risk policies and monitors risks
- Trading Room Management - manages risk exposures and signs off on
P&L
- Operations - generates and maintains data to manage risk
- Finance - valuation and finance policies and ensures integrity of P&L
4 What is ERM?
"Risk is a variable that can cause deviation from an expected outcome. ERM
is a comprehensive and integrated framework for managing risks in order to
achieve business objectives, minimize unexpected earnings volatility, and
maximize firm value"
4 Three Motivations of ERM
1. Integration of Risk Organization
2. Integration of Risk Transfer
3. Integration of Business Processes
5 Limitations of VaR
- different risks lead to different distributions (market uses normal while
credit/ops use log-normal)
- does not account for correlations between risks
6 Chase Manhattan Bank and Drysdale Securities
Facts: Drysdale obtained $300M in unsecured funds from Chase Manhattan
by exploiting a flaw in the system for computing the value of US gov't bond
collateral despite only having $20M in capital
Key Factors: Inexperienced managers, Chase failed to detect the
unauthorized positions
Lessons: Need for more precise methods for computing the value of
collateral and better process control
