CFA Level 3 Risk Management

Below, you’ll find my personal CFA level 3 risk management notes…

You can find a list of the other categories here: CFA Level 3 Notes, Formulas, and Weights.

Enterprise Risk Management (ERM) looks at firm-wide risk both in isolation and together.

Risk Management Process (in order)

  1. Set Policies and Procedures
  2. Define Risk Tolerance
  3. Identify Risks
  4. Measure Risks
  5. Adjust Risk Level

Corporate Governance uses a system of internal controls to reduce risk.

Front Office is trading and sales. Back Office is transaction processing, compliance and admin work.

Straight-Through-Processing (STP) systems are streamlining Trade Settlement processes and reducing the need for Global Custodians.

Financial Risks

  • Credit Risk (Sovereign and Political Risk)
  • Commodity Prices
  • Exchange Rates
  • Equity Prices
  • Interest Rates
  • Liquidity Risk (Bid-Ask Indicator)

Non-Financial Risks

  • Model
  • Operations
  • Accounting
  • Taxes
  • Settlement (Herstatt Risk)
  • Legal (Contract Risk)
  • Regulations

Performance Netting Risk occurs when firms use asymmetric incentive fees (gains rewarded and losses not penalized). For example, the firm could break-even on two portfolio managers’ returns but still have to pay out an incentive to one of them. Settlement Netting Risk is similar but occurs during liquidation.

Duration is to Delta as Convexity is to Gamma.

Option Greeks

  • Delta is the sensitivity to price
  • Gamma is the sensitive to Delta
  • Vega is the sensitivity to volatility
  • Theta is the sensitivity to time decay

Value at Risk (VaR) is not stated as maximum loss but as a threshold with probability and time factors. For example, the VaR for the portfolio is $3 million for one day with a probability of 5%.

VaR as a Minimum Example: There is a 5% chance that the portfolio will lose at least $3 million in a single day.

VaR as a Maximum Example: There is a 95% chance that the portfolio will lose no more than $3 million in a single day.

Time-frame and VaR have a positive correlation. The reported timeframe usually depends on the firm’s operations… banks regulators tend to want two-week VaR time-frames… some companies report quarterly VaR… dealers, hedge funds, and investment banks often use daily VaR due to higher turnover.

Three VaR Methods

1. Variance-Covariance (aka Analytical Method or Delta-Normal Method)

  • Assumes normally distributed returns (no options in portfolio)
  • Z-scores… [(x – mean) / standard deviation]
Two Assets Portfolio Variance Formula
  • 90% within ±1.65 standard deviations (use for 5% VaR)
  • 95% within ±1.96 standard deviations
  • 98% within ±2.33 standard deviations (use for 1% VaR)
  • 99% within ±2.58 standard deviations
  • Daily deviation = annual deviation / sqrt(250)

2. Historical Method (aka Historical Simulation Method)

  • Not constrained by normal distribution (nonparametric)
  • Disadvantage is that historical returns might not accurately predict future return patterns (a problem with all VaR models)

3. Monte Carlo Simulation

  • Doesn’t require normal distribution
  • Complex and can give false sense of security
  • Use Backtesting to improve modeling

Incremental VaR can measure the effect of single assets on a portfolio.

Risk Budgeting can help to determine operations, allocation, and portfolio strategies.

Equity markets have more frequent large declines than normal distribution predicts.

Stress Testing is used in tandem with VaR modeling… two types: Scenario Analysis and Stress Models (factor pushes)

Swaps and Forward Contracts have Bilateral Credit Risk… although only one side ends up making a payment. Options have Unilateral Credit Risk (credit risk to option buyer).

Swap Credit Risk is largest during middle period (for interest and equity swaps). Credit ratings could have changed with material payments remaining. Currency Swaps have largest credit risk towards the end of the contract.

Marking-to-Market is a way to reduce credit risk. At set times before expiration, the party with a loss pays up and the contract is recalculated. This can help prevent big payouts from piling up.

A Cross-Default Provision states that when a company defaults on one payment, all of its payments are in default.

Long-Term Capital Management (LTCM) 1998… leveraged 25x and underestimated liquidity risk of unwinding positions.

Enhanced Derivatives Products Companies (EDPCs) aka Special Purpose Vehicles (SPVs)… try to have higher credit ratings to lower borrowing/hedging costs.


Please comment below if you have any suggestions or questions. Also, the next category in my CFA level 3 study list is Application of Derivatives.

Invest mindfully,

Brian Kehm

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