Kingpin804

Tom Andrews is in charge of the risk management committee for Sigma Portfolio Managers. Interest rates have recently increased and the firm’s model has predicted a substantial decline in the value of the firm’s 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) revise the model in light of its shortcomings.

B) take no action at all.

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

---

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.

Kingpin804

Frank Meinrod is in charge of the risk management committee for Alpha Portfolio Managers. Recently, the value of one of the company’s 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) take no action at all.

B) hedge the position by selling interest rate futures.

C) hedge the position by buying interest rate futures.

---

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.

Kingpin804

Which of the following would NOT be a characteristic of an effective enterprise risk management system?

A) Allocating capital according to the returns generated.

B) Using a model that accounts for changing risk factor sensitivities.

C) Identifying all relevant external and internal risk factors.

---

An effective enterprise risk management system would allocate capital on a risk-adjusted basis. Capital should not be allocated solely according to returns without accounting for risk. Both remaining responses above are all components of an effective enterprise risk management system.

Kingpin804

Which of the following would NOT be a characteristic of an effective enterprise risk management system?

A) Allowance for all potential combinations of risk factors facing the firm.

B) Allocation of capital on a risk-adjusted basis.

C) Decentralization of risk monitoring and control procedures.

---

An effective enterprise risk management system should provide for performance monitoring by a risk management committee that reports directly to upper management. Both remaining responses above are all components of an effective enterprise risk management system.

Kingpin804

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

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

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

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

---

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. Both remaining responses are correct.

Kingpin804

A manager wishes to lower the financial risk of a portfolio. She looks at the risks of her portfolio associated with currencies and commodities. In attempting to lower the financial risk associated with her portfolio, she should hedge:

A) the risk of neither currencies nor commodities because neither are associated with financial risk.

B) the risk associated with currencies, but not commodities since commodities are unrelated to financial risk.

C) the risk associated with both currencies and commodities.

---

Market risk is a subset of financial risk. Market risk includes commodities, currencies, equity prices, and interest rates.

Kingpin804

A company has a portfolio composed of several securities with large bid/ask spreads. This is an indication that the portfolio has:

A) low liquidity risk, but the financial risk is not affected.

B) high liquidity risk, which means high financial risk.

C) high liquidity risk, but the financial risk is not affected.

---

The bid/ask spread is a good measure of liquidity. The larger the spread the greater the liquidity risk. Liquidity risk is a subset of financial risk—the larger the liquidity risk, the larger the financial risk.

Kingpin804

Increasing the relative weight on OTC derivatives relative to the weight on exchange-traded derivatives in a portfolio will:

A) have no affect on credit risk or financial risk.

B) increase credit risk but decrease financial risk.

C) increase credit risk and financial risk.

---

OTC derivatives have much more credit risk than exchange-traded derivatives, so the credit risk will increase. Credit risk is a part of financial risk; therefore, financial risk increases too.

Kingpin804

All of the following are sources of non-financial risk EXCEPT:

A) regulations.

B) accounting practices.

C) commodity prices.

---

Commodity prices are a source of financial risk.

Kingpin804

Shilton Capital, owned by flamboyant billionaire Travis Shilton, has a reputation for managing risk well. The firm operates several hedge funds and partnerships, generating huge returns with risky strategies that always seem to pay off. Shilton hires the most creative portfolio managers he can find, then jets off to Switzerland or Brazil to be seen in the presence of the world's glitziest people. Paul Miller, as staid as Shilton is flighty, handles the day-to-day operations at Shilton Capital.
The bulk of Shilton Capital's assets are invested in five portfolio strategies: a hedge fund that seeks to profit from currency fluctuations, a market-neutral hedge fund, a real estate partnership, an enhanced index hedge fund, and a partnership that buys bonds of companies in financial distress. All five strategies have generated excellent returns over the last year.
The following discusses one hour at Shilton Capital:
Charlene Hatchett manages a hedge fund focusing on foreign currencies. She buys currencies she considers undervalued, mostly those in countries whose economic growth potential is not reflected in the global market, and sells overvalued currencies in forward contracts in an effort to cash in on the fluctuations. During her first hour at work, Hatchett has been buying up the drang, a currency used in Extralatia, a small African country with a booming economy and an increasingly talented and educated workforce she believes is not acknowledged by the global business community. At 5 p.m. Extralatian time, or 10 a.m. Eastern time, a military coup in Extralatia's neighboring country, Warmongaria, sends a flood of refugees running toward the Extralatian border. The new military governor of Warmongaria immediately threatens to invade Extralatia's capital if the country allows in the refugees, many of whom are of Extralatian descent. With a few quick phone calls, Hatchett learns that two multinationals near to announcing large development projects in Extralatia are rethinking their plans because of the unrest. The political situation in Extralatia is dodgy at the best of times, and Hatchett is concerned that recent developments will wreak havoc with the currency.
Mitchell Stone runs a market-neutral sector hedge fund that takes long positions in securities Stone considers undervalued and short offsetting positions in expensive stocks in a couple of key industry groups within the industrial sector. Stone expects the stock market to decline, so he wants to seek alpha through stock selection and wash out market returns. Most of the long positions represent companies with increasing market share and strong finances, while the short positions generally represent companies with weak balance sheets, which have been punished by a choppy, volatile market in recent weeks. Today, the market opens up strong on higher-than-expected growth of the gross domestic product and optimistic news about industrial activity from the Federal Reserve. The entire industrial sector rallies, with the weakest companies -- those most heavily punished in recent weeks -- leading the way. Stone's long positions are doing well, but his short positions are getting killed, more than offsetting gains in the long positions.
Carter Wainwright's real-estate partnership owns a mix of industrial and retail properties across the Eastern Seaboard. Vacancy is low, and rental rates are rising. But at 10 a.m., Wainwright learns that the state legislature just passed a new inventory tax that will make it more expensive to store goods in Massachusetts. Several large industrial concerns immediately start trying to back out of contracts to use a half-dozen huge, newly constructed warehouses in Boston, properties expected to provide the bulk of the partnership's revenue growth over the next year.
Lisa Cline's partnership owns bonds issued by a number of troubled industrial and consumer companies, all of which pay yields well above the market average. At 10 a.m., Canton Metals files for bankruptcy, and Cline's preliminary analysis suggests the company will default on its bonds, which represent about 10 percent of the partnership's holdings.
Max Campbell is having a fine day. He attempts to beat market returns by using leverage during periods when he expects the market to rise, and using futures contracts to hedge market risk during periods when he expects the market to fall. He targets a return of 150 percent of the index in up markets. Campbell is bullish at the moment and highly leveraged, and the solid economic news has sent the market soaring.
Hatchett, Stone, Wainwright, and Cline arrive at Miller's door at roughly the same time, panicking because they do not know how to address the risks. He meets with each one and recommends the following, in turn:

• To Hatchett: Since trading in Extralatian currency has been temporarily suspended, she should buy the currencies of neighboring countries in the region in an effort to hedge her risk.
• To Stone: He should sell some of his long positions and use the proceeds to cover the worst of the short positions.
• To Wainwright: He should do nothing.
• To Cline: She should liquidate her Canton bond position immediately for whatever price she can get before demand dries up altogether.

In attempting to fix the problems in Shilton Capital's risk-management system, which issue warrants the least attention?

A) Inadequate stress testing.

B) Shilton's absentee ownership.

C) Failure to hedge away risks.

---

As long as Shilton has a man he believes is competent in charge and a comprehensive plan in place, his presence at the office is not required. Many people own businesses and let others run them. The issue here is the process, not the company owner. Good ERM systems will select the best possible risk models and decide in advance which risks to ignore and which to hedge. The Shilton Capital system did neither. A good risk-management system will have a committee to oversee the process and ensure that proper stress testing is performed on all risky investments. (Study Session 14, LOS 34.b)

---

All of the risky events discussed above could recur. Current mitigation efforts aside, going forward, which analyst's risk would be most difficult for Shilton Capital to hedge away?

A) Wainwright's.

B) Cline's.

C) Hatchett's.

---

While political risks cannot be hedged directly, Shilton Capital could address Hatchett's issues through insurance, currency swaps, or a combination of both. It is impossible to know exactly what could happen, but trouble comes when the currency falls for whatever reason, so the key is creating a hedge in the event that the currency falls, rather than trying to predict which disasters to prepare for. Cline's risks could be hedged with swaps, though this technique would eat into the profitability of the strategy. Wainwright's political risks would be extremely difficult to hedge away. It is very difficult to hedge away the risks of political change or a change in customers' perceptions of the market. (Study Session 14, LOS 34.d)

---

To best prepare for events like those faced by Hatchett, Shilton Capital should have:

A) addressed sovereign risk through credit derivatives.

B) set up a currency swap.

C) calculated an incremental VAR.

---

Nonfinancial risks are difficult to measure, and a VAR is only as good as the estimates used to derive it. Sovereign risk is not relevant here because it reflects only the government's willingness to make good on its debts. The best option among those presented would be a currency swap, which could be used to hedge against declines in the value of Extralatian currency. (Study Session 14, LOS 34.i)

---

Which of Miller's proposed solutions makes the least sense? Miller's instructions for:

A) Wainwright.

B) Hatchett.

C) Stone.

---

Miller's instructions for Stone are a blunt but effective way of controlling the damage. The actions may seem drastic, but they will go a long way toward mitigating the risk. Wainwright's problem cannot be easily hedged away. Doing nothing may be the best option, particularly considering these are not problems the company can address without a lot of time and negotiation. However, the advice to Hatchett was bad. If Extralatian currency falls, currency in neighboring countries is unlikely to rise, and may fall in sympathy, or be affected by the same political issues. As such, a better hedge would be to attempt to sell those neighbors' currencies forward before they fall. The strategy isn't perfect, but it could counteract some of the risk. As the instructions currently stand, Hatchett would be doubling down on her bet, which exacerbates the risk rather than mitigating it. (Study Session 14, LOS 34.d)

---

Stone isn't happy with Miller's advice on how to manage the increased risk of his portfolio, and he has several ideas of his own regarding how to manage such risks in the future. Which of Stone's proposed solutions would be least effective?

A) Doing nothing, because the company's risk is already partially hedged.

B) Purchasing out-of-the-money call options on the shorted stocks.

C) Establishing notional position limits for each security in the portfolio.

---

Purchasing out-of-the-money call options would presumably allow Stone to cover his short positions at below-market rates in the event of a major rally. Doing nothing is a counterintuitive solution, but it has merit because of Campbell's investment strategy. In the event that unusual increases in stock prices overwhelm Stone's market-neutral model, Campbell's investments are likely to rise. Campbell's portfolio is not as concentrated as Stone's, but it does have some risk-reduction features in the context of Stone's portfolio. However, notional position limits on securities would be unlikely to help, because Stone's portfolio is concentrated in one sector, and in the situation portrayed above, all of the stocks moved in the same direction. When all of the stocks tend to move in the same direction, assigning limits to the size of each stock position will have little effect on the overall risk of the portfolio. (Study Session 14, LOS 34.m)

---

Wainwright's current problems are best explained as:

A) active risk.

B) model risk.

C) sovereign risk.

---

Active risk is a measure of market risk relative to a benchmark, which is not applicable here. Sovereign risk reflects the chance that a foreign government will not honor its obligations, while credit risk reflects the possibility of default, neither of which gets to the heart of Wainwright's problems. The trouble here is model risk, because Wainwright's model apparently did not consider the political risks of a tax change. (Study Session 14, LOS 34.d)