Reading 37: Risk Management －LOS c, (Part 2) problem, possible, management

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 12: Risk Management
Reading 37: Risk Management
LOS c, (Part 2): Evaluate the possible responses to a risk management problem.

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Frank Meinrod is in charge of the risk management committee for Alpha Portfolio Managers. Recently, the value of one of the companys bond positions has decreased due to a potential steep rate hike by the Federal Reserve. Meinrod believes that the rate hike will be moderate and that the decline in the bond portfolio value is temporary. Which of the following is the best action for Meinrod to take? Meinrod should advise the risk management committee that they should:

A) sell the position.

B) take no action at all.

C) hedge the position by buying interest rate futures.

D) hedge the position by selling interest rate futures.

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Answer and Explanation

Meinrod should advise the risk management committee that they should take no action at all. In most cases, when there is a risk management problem that is viewed as temporary, the best course of action is often to take no action at all.

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Tom Andrews is in charge of the risk management committee for Sigma Portfolio Managers. Interest rates have recently increased and the firms model has predicted a substantial decline in the value of the firms bond portfolio. However, the actual value of the bond portfolio has not decreased as much as expected because the firm has large holdings of callable bonds. Which of the following is the best action for Andrews to take? Andrews should advise the risk management committee that they should:

A) take no action at all.

B) hedge the position by buying a series of interest rate call options (caps).

C) hedge the position by selling a series of interest rate puts (floors).

D) revise the model in light of its shortcomings.

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Answer and Explanation

Andrews should advise the risk management committee that they should revise the model. Recall that callables will outperform noncallables when interest rates rise and the callable bonds were previously priced to call. In this case, Sigma should revise their model so it accounts for the option-like features of their bonds and provides a more realistic assessment of bond performance in various interest rate scenarios.

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Which of the following regarding an effective risk management model is FALSE?

A) When a risk management problem is viewed as temporary, the best course of action is often to take no action at all.

B) When a risk management problem is viewed as a long-run change in fundamentals, corrective action is required.

C) Management must consider how the correlations of assets affect the risk of the firm.

D) Duration and delta are sufficient for modeling the risk of bonds and options.

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Answer and Explanation

Duration and delta by themselves are not sufficient measures of bond and option risk. Second order effects (convexity and gamma) must also be considered. Risk managers should consider asset sensitivities to factors as well as how those sensitivities change. The other responses are correct.