[products ids="58240,60502"]FRM AIM: Differentiate between an open outcry system and electronic trading
FRM AIM: Differentiate between an open outcry system and electronic trading
| Properties |
Open Outcry System |
Electronic Trading |
| Definition |
Trading done through actual shouting and hand signals |
Trading done via computers |
| Physical Exchange location |
Yes |
No |
| Example |
CBOT |
NASDAQ |
FRM AIM; Within operational risk (a)describe the potential relationships between operational, market and credit risk (b)describe model risk and its sources (c)describe people risk (d)describe legal risk and its sources
Relationship between operational, market and credit risk:
Operational risk occurs because of poor management decisions, poor management control, rogue traders, wrong model usage in analyzing risk
Because of losses arising out of operational risk credit ratings of the firm may be hit that causes credit risk
Because of the credit risk for the firm its value of the securities in the market will decrease resulting in market risk
Model Risk:
Arises because of application of wrong models in assessing risk
Ex: Prices used in assessing risk in a model may be wrong which might lead to an indication of lower risk for a particular security where the actual risk of security performance is quite low
People Risk:
Risk because of rogue traders who may have falsified reports about the financial status of the company during audit
Risk because of powerful people in the company using their position to sufficiently expose the firm by buying underperforming derivatives
Legal Risk:
Loss in value of the firm caused by fighting lawsuits, penalties/damage claims etc
Ex: Samsung payment of more than 1 billion dollar for infringing the patent held by apple
Drug companies settlement to patients because of the drug introduced by these companies causing side effects to the patients
FRM AIM: Within market risk: (a)Describe and differentiate between absolute and relative risk (b)Describe and differentiate between directional and non- directional market risk (c)Describe basis risk and its sources (d)Describe volatility risk and its sources
Absolute vs Relative Risk:
| Properties |
Absolute Risk |
Relative Risk |
| Definition |
Focus on Volatility of Total Returns |
Focus on volatility of returns relative to portfolio or a benchmark index |
| Advantages |
Gives total losses |
Gives relative losses and there is risk comparison to other risk (Tracking error relative to benchmark index) |
| Disadvantages |
There is no risk comparison to other risk |
Tells nothing about actual risk |
Directional vs Non Directional Risk:
| Properties |
Directional Risk |
Non-Directional Risk |
| Definition |
Linear exposure to economic or financial variables |
Non-Linear exposures to economic or financial variables |
| Example |
Interest rates |
Basis Risk, Volatilities |
Basis Risk:
- Arises because of the imperfect correlation between the price of the hedging instrument and the assets being hedged
- Ex: Hedging of bonds against treasury bills
Volatility Risk:
- Risk of loss arising from actual or implied volatility of market prices
- Ex: Political instability, investor uncertainty, interest rate changes
FRM AIM: Compare and Contrast valuation and risk management, using VAR as an example
PropertiesValuationVARPurposeDetermine current price of assetDetermine possible future distributions of assetLooks atCurrent PriceFuture PriceFocus in distributionMean of distributionTail end of distributionsWhat Type of Distribution is usedCurrentHistoricalIs the Analysis preciseYesNo (As long as the model is not biased errors tend to offset each other)
No
NoYesYesCorrelation between risk factors
No
NoNoYesQuantify Risk Factors
No
NoNoYesEase of Calculation and Explanation
Yes
YesNoNoCan it be applied across assets
Yes
NoNoYes
FRM AIM: Define Value at Risk (VAR) and how it is used in risk management
Value at Risk (VAR) is defined as:
• Measure of loss over a defined period of time at a particular confidence level in normal market conditions
• VAR is used in financial control, financial reporting, regulatory capital
Methods of Calculating VAR:
• Historical Method
• Variance-Covariance Method
• Monte Carlo Simulation","FRM AIM: Define Value at Risk (VAR) and how it is used in risk management
FRM AIM: Explain how expected return and returns variance are used to describe the return distribution for a security or portfolio of securities - Part I
FRM AIM : Within operational risk (a)describe the potential relationships between operational, market and credit risk (b)describe model risk and its sources (c)describe people risk (d)describe legal risk and its sources:
Exposure vs Recovery Rate:
| Properties |
Exposure |
Recovery Rate |
| Definition |
Size or value of loss that would happen when credit event occurred |
Recovery of partial losses through sale of assets after loss has occurred |
| Value |
This will include full value of losses |
Fraction of the losses |
Credit Event:
- Changes in the counterparty ability to fulfill financial obligations that was previously agreed upon
- Credit Event can occur because of market or credit risk
- Sovereign risk that occur because of country specific actions can lead to credit event
- Ratings agencies like Moody’s, Standard & Poor have ratings that issues guidelines on companies performance and position to meet the financial obligations from time to time
Settlement Risk:
- Counterparty fails to deliver its obligation after opposite party has made the delivery as agreed upon
- Risk of full losses because of settlement risk
- Pre settlement risk can mitigate the effects of the settlement risk because of payment before delivery
FRM AIM: Within credit risk (a) Describe and differentiate between exposure and recovery rate (b)describe credit event and how it may relate to market risk (c)describe sovereign risk and its sources (d) describe settlement risk and its sources:
Exposure vs Recovery Rate:
| Properties |
Exposure |
Recovery Rate |
| Definition |
Size or value of loss that would happen when credit event occurred |
Recovery of partial losses through sale of assets after loss has occurred |
| Value |
This will include full value of losses |
Fraction of the losses |
Credit Event:
- Changes in the counterparty ability to fulfill financial obligations that was previously agreed upon
- Credit Event can occur because of market or credit risk
- Sovereign risk that occur because of country specific actions can lead to credit event
- Ratings agencies like Moody’s, Standard & Poor have ratings that issues guidelines on companies performance and position to meet the financial obligations from time to time
Settlement Risk:
- Counterparty fails to deliver its obligation after opposite party has made the delivery as agreed upon
- Risk of full losses because of settlement risk
- Pre settlement risk can mitigate the effects of the settlement risk because of payment before delivery
FRM AIM: Within liquidity risk, describe and differentiate between asset and funding liquidity risk:
Asset vs Funding Liquidity Risk:
| Properties |
Asset Liquidity Risk |
Funding Liquidity Risk |
| Definition |
Large size of transactions influence the price of securities |
Firms unable to raise cash to meet its debt requirements |
| Other Names of this type of risk |
Market or trading liquidity risk |
Cash Flow Risk |
| Mitigation Efforts |
Limiting the size of the transactions |
Rules/Regulations can be put in place to have sufficient cash deposit as a guarantee to mitigate this type of risk |
