Reading 37: Risk Management －LOS b management, justify, system

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 12: Risk Management
Reading 37: Risk Management
LOS b: Recommend and justify the risk exposures an analyst should report as part of an enterprise risk management system.

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When describing the risk exposures that an analyst should examine as part of an enterprise risk management system, what terms describe the risks pertaining to the factors that directly affect firm or portfolio values and the risks associated with external capital markets?

Firm/Portfolio Value

External Capital Market

A) Systematic risk Factor risk

B) Market risk Factor risk

C) Market risk Financial risk

D) Systematic risk Financial risk

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Answer and Explanation

Financial and non-financial risk factors are general terms. Financial risk factors are those associated with external capital markets and the transactions within external markets. Non-financial risk factors capture other types of risk. Financial risk factors include market risk, liquidity risk, credit risk, and sovereign risk. Market risk pertains to the factors that affect firm or portfolio values (e.g. interest rates, exchange rates, equity prices, commodity prices, etc.). Non-financial risk factors include settlement (Herstatt) risk, operations risk, model risk, sovereign risk, regulatory risk, and other miscellaneous risk factors. Note that sovereign risk has both financial and non-financial risk components.

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BigBank engages in foreign exchange transactions. They have just provided a forward contract to a major multinational corporation that allows the corporation to sell Swiss francs in 90 days. They have also entered into a currency swap that allows them to receive Japanese yen in exchange for paying U.S. dollars. Furthermore, they are in the process of selling a large position in Canadian dollars in the spot market. Which of the following risks is NOT explicitly mentioned in these series of transactions by BigBank?

A) Operations risk.

B) Herstatt risk.

C) Liquidity risk.

D) Credit risk.

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Answer and Explanation

Operations risk is the potential for failures in the firms operating systems due to personnel, technological, mechanical, or other problems. Although BigBank is sure to have exposure to operations risk, it is not explicitly described in these transactions. Credit risk is the potential for default, which is certainly a possibility in BigBanks forward contract. Herstatt risk or settlement risk is the possibility that one party could default on a contract while the other is settling. This has been a problem in foreign exchange markets due to time differences and is certainly possible in BigBanks currency swap. Liquidity risk refers to the potential for sustaining losses due to the inability to sell or buy a position quickly. BigBanks sale of the Canadian dollars is subject to liquidity risk.

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The LDC Bank specializes in foreign exchange transactions and lending to emerging market countries. They have provided a loan to the country of Tinia so that Tinia can install a water irrigation system in the interior of the country. The LDC Bank is very careful with their lending practices, calculating the probability of a countrys default through the use of simulation. They have also entered into a currency swap that allows them to receive Mexican pesos in exchange for paying U.S. dollars. Which of the following risk is NOT explicitly mentioned in these series of transactions by the LDC Bank?

A) Herstatt risk.

B) Regulatory risk.

C) Model risk.

D) Sovereign risk.

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Answer and Explanation

Regulatory risk is due to the fact that different securities in a firms portfolio are subject to regulation by different regulatory bodies. Although the LDC Bank is sure to have exposure to regulatory risk, it is not explicitly described in these transactions. Sovereign risk refers to the willingness and ability of a country to repay its debt, which is certainly present in the loan to Tinia. Model risk refers to the risk that models may fail due to poor inputs or construction. The banks use of simulation to predict country default is subject to model risk. Herstatt risk or settlement risk is the possibility that one party could default on a contract while the other is settling. This has been a problem in foreign exchange markets due to time differences and is certainly possible in the LDC Banks currency swap.