Reading 37: Risk Management －LOS j limits, methods, position, managing, budgeting

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 12: Risk Management
Reading 37: Risk Management
LOS j: Demonstrate the use of risk budgeting, position limits, and other methods for managing market risk.

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For a firm that uses enterprise risk management, what type of limit should be used to ensure firm diversification?

A) Liquidity limit.

B) Risk factor limit.

C) Position limit.

D) Performance stopout.

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Answer and Explanation

A position limit places a dollar nominal cap on a given position. By placing a maximum dollar amount on each position, the firm will diversify its capital across a greater number of sectors. A liquidity limit is a position limit that is based on trading volume so that liquidity risk is minimized. A performance stopout sets a dollar limit for losses over a specified time period. Risk factor limits restrict the exposure of the portfolio to individual risk factors.

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For a firm that uses enterprise risk management, how should a deviation from a risk budget be dealt with?

A) Each portfolio manager should have the discretion to determine the correct response.

B) The portfolio manager should immediately close out the position that caused the violation.

C) The deviation should be reported immediately to upper management.

D) The manager should take steps to hedge the position that caused the violation of the risk budget.

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Answer and Explanation

Using risk budgeting in enterprise risk management, a firm will allocate capital and the associated VAR to each manager depending upon managements desired exposure to each sector. An effective enterprise risk management system should monitor violations of a risk budget so that any violations are immediately reported to upper management.

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Using the following information from a firm that uses enterprise risk management, which portfolio manager has superior performance and why?

	Manager A	Manager B
Capital	$150,000,000	$590,000,000
VAR	$7,500,000	$21,000,000
Profit	$2,000,000	$7,000,000

A) Manager A because they had a higher return on capital.

B) Manager A because they used less VAR.

C) Manager B because they had a higher profit.

D) Manager B because their return is higher in a risk budgeting context.

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Answer and Explanation

Using risk budgeting in enterprise risk management, we would divide the profit by the VAR allowed to generate a risk-adjusted performance measure. For manager A it is 26.7% (2,000,000/7,500,000). For Manager B it is 33.3% (7,000,000/21,000,000). Thus Manager B has better risk-adjusted performance. Note that the return on capital for each manager tells a different story. For manager A it is 1.3% (2,000,000/150,000,000) and it is 1.2% (7,000,000/590,000,000) for Manager B. So although the percentage return generated is higher for Manager A, we would conclude that Manager B has better performance when risk is considered.