Hey everyone! Hope everybody had awesome Christmas and New Year holidays! I have not posted in a while due to laziness and focus on other responsibilities....Hubby had to nudge me to write an entry..lol! I guess you must be wondering about my title for today's blog entry. 'Foundations of Risk Management? Is she starting risk management classes on her blog?' Nope. In fact, I need the world's best financial risk management instructor to conduct 100s of classes for me to pass level 1. Despite the farfetched hope, I am making an attempt on the FRM exam and hubby suggested that I include in my blog a summary of what I have covered at each stage. So that's what today's article is about. You might find it dry and boring but I'll make a sincere attempt at putting it down in simple terms.
For the level 1 exam, there are 4 main areas in the syllabus which are Foundations of Risk Management, Quantitative Analysis, Valuation and Risk Models and Financial Markets and Products. I am now in Foundations and there are 12 chapters. I have only covered 4 chapters...the content is heavy and me being an amateur, am taking lots of time to understand the material. Ok let's get started!
Chapter 1
What is Risk?
Risk according to Schweser, is the unexpected variability of asset prices or earnings. There are 2 types of risks: business & financial.
Business risk: Risks arising from daily operations, including risks that result from business decisions & environment
Financial Risk: Risks resulting from a firm's financial market activities.
Financial risk is what our focus is on.
2 major factors that have increased sensitivity to financial factors are - Deregulation & Globalization
Deregulation has led to increases in interest rate sensitivity in banks. Deregulation is when government reduces its role and allows industry greater freedom in how it operates.
Globalization refers to firms doing business outside borders, leading to more exposure to currency changes.
What is a derivative contract?
A derivative contract is a contract that derives it value from an underlying security. It has a finite, predefined life, predefined reference rate and predefined notional amount. Eg. forward contract
FRM is the process of detecting, assessing, and managing financial risks. The use of tools to measure and manage these risks is hence very important. A major tool that is used for many risks is Value-At-Risk (VAR) measure.
VAR is defined as the maximum loss over a defined period of time at a stated level of confidence, given normal market conditions. Other risk management tools are stop-loss limit, notional limit, and exposure limit.
There are mainly 4 types of risks - Market risk, Liquidity risk, Credit risk and Operational risk
Market risk - Risk that declining prices or volatility of prices will result in a loss
Liquidity risk - sustaining significant losses due to inability to liquidate a position at a fair price
Credit risk - possibility of a default on payment by a counterparty
Operational risk - Risk of loss due to inadequate monitoring systems, management failure, defective controls, fraud and human errors
Chapter 2
Investors and Risk Management
Mean and variance of a distribution shows the probability distribution of normally distributed security returns.
Diversifiable risk - Part of the volatility of a security's return that is not related to the volatility of the market portfolio
Systematic risk - Part of a security's risk that arises because of the positive covariance of the security's return with overall market returns
Market portfolio - a bundle of investments that includes every type of asset available in the world financial market
Positive covariance - a measure of the degree to which returns on 2 risky assets move in tandem. For eg if return on security A goes up, then the return on security B goes up too.
Negative covariance - Same meaning as positive covariance but if return on security A goes up, the return on security B goes down.
Risk of portfolio decreases as correlation of returns between 2 securities goes down which goes to show that lower correlation results in greater diversification benefits.
Risk of a portfolio of Risky Assets depends on
1. Volatility of the risky asset returns
2. Proportion of portfolio invested in each asset
3. Covariance of each asset with all other assets in the portfolio
CAPM equation - Expected return on any security or portfolio is determined by its systematic risk (beta)
Reducing a firm's diversifiable risk will reduce the firm's value
Reducing a firm's systematic risk will not increase firm value
Low cost operating strategies to reduce beta of a firm's equity might increase a firm's value
Chapter 3
Creating Value with Risk Management
Bankruptcy and financial distress are costly and reducing risk can increase the value of a firm.
Reducing volatility of taxable income can reduce a firm's tax liability and increase firm value.
Optimal amount of debt in the firm's target capital structure can be increased by risk reduction strategies, leading to lower funding costs and increased firm value.
Large shareholder increases firm value due to his greater incentive to monitor management and influence management decisions. This prevents managers from taking decisions that will benefit management but do not increase firm value.
Risk management clarifies relation between managerial decisions and firm value leading to more efficient management incentive compensation schemes.
Debt overhang refers to the situation where amount of debt prevents equityholders from investing in positive net present value projects because the benefit to debtholders reduces the value created for equityholders.
Risk management can increase firm value by reducing the potential for conflicts between the interests of debtholders and the interests of equityholders and managers. It also increases firm value by reducing the problem of asymmetric information, thereby reducing the firm's cost of capital.
Chapter 4
Delineating Efficient Portfolios
Perfect positive correlation (p=1): The portfolio standard deviation reduces to this simple weighted average of the individual standard deviations. The portfolio possibilities curve for 2 perfectly correlated assets is a straight line, indicating that there are no benefits from diversifying from a 1-asset to a 2-asset portfolio is the assets are perfectly correlated.
Perfect negative correlation (p= -1): Greatest diversification is achieved when 2 assets are negatively correlated. The portfolio possibilities curve is 2 lines segments and it is possible to construct a portfolio with zero standard deviation.
Zero correlation: When the correlation between 2 assets is zero, the covariance term in the portfolio standard deviation expression is eliminated. The portfolio possibilities curve is non-linear in this case.
Moderate correlation: Most equities are positively correlated (i.e. 0<p<1). The portfolio possibilities curve is non-linear in this case.
The portfolio possibilities curve is concave above the minimum variance portfolio and convex below the minimum variance portfolio.
The minimum variance portfolio is the portfolio with the smallest variance among all the possible portfolios on a portfolio possibilities curve.
The efficient frontier is a plot of the expected return and risk combinations of all efficient portfolios on the portfolios combinations curve. An efficient portfolio has the highest return for all portfolios with equal volatility and the lowest volatility for all portfolios with equal return.
When short sale are allowed, the efficient frontier expands up and to the right (i.e. higher return and higher volatility portfolio combinations become feasible).
When risk free lending and borrowing are available, the efficient frontier becomes a straight line. A risk free asset is the security that has a return known ahead of time, so the variance of the return is zero.
No comments:
Post a Comment