Study session 14 in the Level III CFA Program curriculum begins the readings on Risk Management with two readings (34-35). The Level 3 exam puts a lot of emphasis on the topic area and it is extremely testable. There is typically a question in the morning essay section, in fact last year was the first time since 2007 that there was no risk management essay. REVIEW THOSE PAST ESSAY QUESTIONS.
The reading starts of with some basic concepts and is important but secondary to the later material. Understand the advantages and disadvantages of both a centralized risk management system versus a decentralized system. A centralized system is led by a senior management employee within its own department and benefits from economies of scale and can provide an integrated picture of the company’s risks. In a decentralized system, each department handles their own risks and allows people closer to the actual risk to directly manage it.
Understand the different categories of risk: financial, non-financial, and sovereign and the risks within each category:
Financial risks: market, credit, and liquidity
Non-financial risks: operational, model, regulatory and settlement
The measures of market risk are the more important material. You must understand standard deviation and value at risk, and the three methods of calculating value at risk.
Analytical– VAR = E® – z value (StDev)
Remember, you may need to adjust the standard deviation and expected return depending on the data provided and the question. Daily StDev =Annual StDev/(square root of 250)
Historical Method– uses actual historical returns ranking in decending order and picks out corresponding return for the % probability. For example, if there are 100 observations and we want a 5% probability, then we would select the fifth worst return (or the average of the two closest).
Monte Carlo Simulation – generates random outcomes according to assumed probability distribution and a set of parameters to estimate the VAR.
Understand the extensions/supplements to VAR like stress testing and scenario analysis, as well as the performance measures like the Sharpe and Sortino ratios.
Currency Risk Management
The reading can get pretty detailed and quantitatively intense but you need to be able to work through all the hedging exercises. Pay attention to whether the question asks for the return in the local or domestic currency and whether the expected future value is hedged or only the principal.
Understand the differences between hedging with futures and using options. Futures are less expensive and appropriate when the investor risks volatility in rates but has a clear view of the direction of change. Options may be more expensive but provide more precision and are appropriate when exposures are uncertain with respect to timing and magnitude of exchange rate changes.
Understand the concepts behind strategic and tactical currency risk management. The three types of approaches are strategic management with a balanced mandate, currency overlay (tactical management), and treating the currency as a separate asset class.
Study session 15 in the Level III CFA Program curriculum concludes the readings on risk management with three readings on applications of derivatives.
‘til next time, happy studyin’
Joseph Hogue, CFA