
Centralized vs decentralized risk system
 centralized: identifies, quantifies, reports and monitors firmwide risks; preferred
 decentralized: each unit manages own risk, does not consider correlations

Six Financial Risks
 interest rate
 exchange rate
 equity prices
 commodity prices
 credit
 liquidity
first four are market risks

Eight nonfinancial risks
 operational
 model
 settlement
 regulatory
 legal/contract
 tax
 accounting
 sovereign

VAR
 estimate of loss at a specified probability over a specified time
 ex. 5% VAR: E(r)  1.645*stnd dev = VAR (amount below 0)
 ignore E(r) for 1 day VAR
 1% is 2.33

Three VAR methods
 1. Analytical: variance and covariance; easy to apply; relies on normality (which is probably not true)
 2. Historical: uses actual historic returns; ex if have 100 returns, take the 5th lowest and thats the 95% VAR
 3. Monte Carlo: same as historic, but use simulation to determine set of returns

Three ways to stress models
 factor push: push factors in direction that will hurt the firm
 maximum loss optimization: optimize mathematically to find the risk variables that will cause the maximum loss
 worst case scenario: guess at what the worst case would be

Current vs potential credit risk
 current: payment is currently due
 potential: payment may be due or is due in the future

Calculate option credit risk
 trading price of option * number of shares (usually number of contracts*100)
 not dependent on amount in the money


Calculate return and standard deviation to domestic investor
 Return = Rdc = (1+Rfc)(1+Rfx)  1
 Rfc = return of asset in foreign currency
 Rfx = relative change in foreign currency value
Var(Rdc) = Var(Rfc) + Var(Rfx) + 2*std(Rfc)*std(Rfx)*corr(Rfc,Rfx)
If asset is risk free, std(Rdc) = std(Rfx)(1+Rfc)

Four types of currency management
 passive: match benchmark's exposure
 discretionary: small deviations, but primary goal is still risk reduction
 active: try to earn alpha on currency
 overlay: separate currency exposure management from asset management

Deviations from benchmark currency determined using
 1. economic fundamentals
 2. technical rules
 3. carry trade
 4. volatility trading
 1. assume purchasing power parity holds in longrun and short run deviations can be exploited. Increase in relative currency value associated with low value relative to longterm, low inflation, higher real rates, decreasing currency risk premium
 2. assumes past prices predict future prices; not trusted by CFAI
 3. borrow at low interest rate and lend at high interest rate; assumes currency lent in will not depreciate as dictated by IRP; usually works, but very bad when goes wrong
 4. if volatility will be high, buy put and call; if low, sell put and call. ATM called straddle, OTM called strangle

Calculate roll yield
 (Ft  Fo)  (St  So)
 Since Ft = St at expiration, roll yield at expiration = (So  Fo)/So

Currency cross hedge
hedge currency exposure with another, highly correlated currency

Currency macro hedge
 ex. portfolio is long multiple currencies, hedge with basket instead of each one individually
 cheaper, but less perfect hedge

Minimum variance hedge ratios
 MVHR uses regression to determine hedge ratio that will minimize risk
 regress asset returns against currency returns, and multiple the slope coefficient and amount invested to determine amount of currency hedge to obtain

Nondeliverable Forward
Forward contract in an illiquid currency, so calculate gain/loss and settle in another currency

