CFA Level 3 - Derivatives Session 14 - Reading 34

CFA Level 3 – Derivatives
Session 14 – Reading 34
(Notes, Practice Questions, Sample Questions)

1. Risk management has evolved into:

A)a series of small sets of independent activities.
B)a government mandated set of standards.
C)a broad set of interrelated activities.

Explanation: Risk management was once simply thought as hedging risk. Now managers must look at it from several perspectives. Various types of risks must be defined, measured and selectively managed. A desired level of risk must be selected and the actual risk monitored to see if it is in line with that selected level

2. Each of the following is a step in the risk management process EXCEPT:

A)setting a target level of risk.
B)identifying the current level of risk.
C)filing taxes

Explanation: There are five parts of the process: identify the desired level of risk, determine the current level of risk, bring the current level in line with the desired level, monitor the risk exposure to keep it line with the desired level, and alter the process to reflect new information, policies and preferences
3. The final step in the implementation phase of the risk management process is to:

A)identify and price the appropriate tools for achieving the objectives.
B)conduct a Monte Carlo simulation.
C)determine the optimal time to wait for addressing risk again

Explanation: After setting goals and assessing the current level of risk, the firm needs to see if the goals can be achieved cost-effectively. There is no “waiting” in risk management because it is an ongoing procedure.

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The Monte Carlo simulation may be involved in risk management, but it is certainly not the final step
4. Yoshi Chu and Ryan Dobson have been tasked with creating an enterprise-wide risk management (ERM) system for Reliant Financial Services. After creating a centralized data warehousing facility, their next step is creating a useful analytics system. Which of the following features would be least likely included in their system?

A)Derivative valuation models.
B)Legal risk analysis.
C)Monte Carlo simulations

Explanation: A useful analytics system for an ERM is used for assessing risk, not valuing individual assets. The useful system would include several VAR methodologies including historical VAR and Monte Carlo simulation, credit risk analysis, liquidity risk analysis, operational risk analysis, and legal risk analysis

5. Risk management is best addressed:

A)monthly.
B)daily.
C)quarterly.

Explanation: Risk management is a continuous process; therefore addressing it more frequently is better
6. One goal of all risk management systems should be to:

A)make the risk level equal to the prevailing level in the market.
B)bring the level of risk to a desired level of risk, which may exceed zero.
C)eliminate all risk, i.e., reduce risk to zero

Explanation: Since return and risk go together, risk managers should determine the appropriate level of risk that is acceptable. The acceptable level should be based upon the nature of the firm and the risk tolerance of the stakeholders. Those that manage risk should be separate from those that take the risks
7. Which of the following is the most difficult step in establishing an enterprise-wide risk management (ERM) system for a large firm?

A)Establishing a monitoring and evaluation system.
B)Creating a centralized data warehousing system.
C)Developing an analytics system

Explanation: Establishing a centralized data warehousing system is the most difficult step in an ERM system because it involves coordinating an enormous amount of information from potentially different data systems requiring the output to be standardized and comparable across the institution
8. Which of the following operations applies to the monitoring and evaluation systems of an enterprise-wide risk management (ERM) system?

A)Computing stress testing to complement traditional value at risk (VAR) based risk measures.
B)Performing diagnostics on the pricing, value at risk (VAR) computations, and data quality.
C)Computing value at risk (VAR) metrics for all risks across the firm

Explanation: Monitoring and evaluation includes the ability to easily identify data problems, identify position limit violations, perform diagnostics on pricing and VAR measures computed by the analytics system, and allow for risk adjustments and performance evaluation
9. Which of the following is the final step in the risk management process?

A)Monitoring the process and taking any necessary corrective actions.
B)Identifying and measuring specific risk exposures.
C)Reporting risk exposures (deemed appropriate) to stakeholders

Explanation: The risk management process is a continual process of:
Identifying and measuring specific risk exposures.
Setting specific tolerance levels.
Reporting risk exposures (deemed appropriate) to stakeholders.
Monitoring the process and taking any necessary corrective actions
10. Peter Weatherford and Paul Washington are discussing the characteristics of an effective enterprise risk management system for their firm, Supra Portfolio Managers. Weatherford states that Supra should have a committee in place to respond to violations of risk management guidelines. Washington adds that each asset Supra holds must be investigated thoroughly in isolation so that management can better understand the asset’s risk and return characteristics. Which of the following regarding Weatherford’s and Washington’s statements is CORRECT?

A)Weatherford is incorrect; Washington is incorrect.
B)Weatherford is correct; Washington is correct.
C)Weatherford is correct; Washington is incorrect

Explanation: Weatherford is correct. There should be a committee or team at the highest reaches of management to respond quickly to violations of risk guidelines.
Washington is incorrect because, although each asset’s risk and return characteristics should be investigated thoroughly, each asset should be examined from a portfolio perspective, not in isolation. The correlations between assets should be examined in order to determine the risk of the firm as a whole
11. 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).

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
12. 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

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