mouse123

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 their return is higher in a risk budgeting context.

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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.

mouse123

Which of the following is the most widely accepted definition of market risk?

A) Duration.

B) The potential loss from investing in stocks and bonds.

C) The potential change of value in an asset or derivative in response to a change in some basic source of uncertainty.

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Risk is generally equated with uncertainty, which includes both positive and negative changes in value.

mouse123

Which of the following is a type of market risk?

A) Interest rate risk.

B) Operations risk.

C) Accounting risk.

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There are three types of market risk: interest rates, exchange rates, and equity prices.

mouse123

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

A) Risk factor limit.

B) Liquidity limit.

C) Position limit.

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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. Risk factor limits restrict the exposure of the portfolio to individual risk factors.

mouse123

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

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

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

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

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Using risk budgeting in enterprise risk management, a firm will allocate capital and the associated VAR to each manager depending upon management’s 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.

mouse123

Which of the following is a source of market risk?

A) Taxes.

B) Equity prices.

C) Operations.

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There are three types of market risk: interest rates, exchange rates, and equity prices.

mouse123

When two counterparties have obligations to each other, the process that potentially reduces the credit risk of one counterparty to zero and lowers the credit risk of the other is known as:

A) netting.

B) marking to market.

C) collateralizing.

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Netting is the process of consolidating the exposures between two parties to a single net exposure that one party bears. Marking to market would not apply to a case where two parties have obligations to each other.

mouse123

A subsidiary of a parent company that is capitalized in a way that results in a high credit rating, with the objective of allowing the subsidiary to engage in activities where a high credit rating is an advantage would be called:

A) collateralization.

B) a special purpose vehicle.

C) a collateral mortgage obligation.

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Special purpose vehicles are subsidiaries set up by a parent company to engage in certain transactions. Generally, they are separate from the parent organization and not liable for the debt of the parent company. They are capitalized in a way that results in a high credit rating, and can, therefore, engage in transactions that the parent cannot.

mouse123

The practice that imposes current credit risk on a periodic basis to lower potential credit risk is called:

A) netting.

B) marking to market.

C) potentiality.

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Marking to market is the best answer. This reduces potential credit risk by converting what would otherwise be potential credit risk to current credit risk. The credit risk becomes current insofar as the counterparty is required to provide additional collateral immediately (rather than in the future).

mouse123

Jenny Rouse has been a portfolio manager for Theta Advisors for the last five years. The performance of her portfolio has had few returns below its benchmarks since its inception. Which of the following risk measures best measures Rouse’s performance?

A) Standard Deviation.

B) Sortino ratio.

C) Sharpe ratio.

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The Sortino ratio examines the downside risk of returns. It is calculated as the portfolio return minus the minimum acceptable return (MAR) divided by a standard deviation that only uses returns below the MAR. It is similar to the target semivariance. Since Rouse’s portfolio has had consistently higher returns, she should not be penalized for any variability on the upside. Standard deviation and the Sharpe ratio (which uses the standard deviation in the denominator) examine all returns, whether they correspond to positive or negative alphas. The use of these measures would result in risk measurements that are unfairly high in Rouse’s case.