FRM Exam Preparation AIM Series 1

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

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FRM AIM: Describe the mechanism of delivery process and contrast with cash settlement

FRM AIM: Describe the mechanism of delivery process and contrast with cash settlement

Delivery

Refers to closing out f contract where the trader who has short position in the contracts sells the agreed upon asset and the trader who has the long position in the contract buys the asset
For cash settlement delivery is not an option and position marked to market based on price on the last settlement price
Delivery can take on the floor of the exchange and also away from the clearinghouse where the two parties contact privately and close out the deal. After the trade is closed out the parties have to inform the clearinghouse about the transaction
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Relate Significant market events of the past several decades to the growth of risk management industry I :
Several significant events have occurred in the past that has affected the common man, financial institutions and business that has led to huge financial loses.

Some of the significant events in the past are as follows:

Black Monday of 1987 that saw a sharp decline in U.S stock price for a single day
Asian equity markets decimation of 1997
Russian default of 1998
2001 September world trade attack
Sub mortgage crisis that started on 2007 and whose impact is felt even today
These events remind us that it is even more important to use financial risk management policies and practices to insulate ourselves from future financial losses.
Calculate an arbitrage payoff and describe how arbitrage opportunities are ephemeral (i.e., short lived):

Arbitrage is a kind of hedging technique used in investment management.
In general simultaneous selling and buying of stocks to offset losses is referred to as arbitrage. sometimes it helps us achieve profit with less risk.

FRM AIM: Calculate an arbitrage payoff and describe how arbitrage opportunities are ephemeral (i.e., short lived)

Speculators

  • Take positions in the market to profit from the positions
  • There might be large gain/loss when speculators use futures as a hedge against the underlying securitys
  • The maximum loss when speculators use options as hedging strategy is limited to the cost of the option itself

Arbitrageurs

  • Use derivatives to earn risk free profit in excess of risk free rate by manipulation of mispriced securities
  • Riskless profit is earned by entering into equivalent and offsetting positions in markets
  • Opportunities do not last long since supply and demand will quickly eliminate the arbitrage situation

Risk from Derivatives

FRM AIM: Describe some of the risks that can arise from the (mis) use of derivatives

  • Traders use to speculative instead of hedging the derivatives (Operational Risk)
  • Loses suffered using hedging, speculation, arbitrage is high
  • Control mechanism needed to monitor risk that arises out of hedging, speculation, arbitrage opportunities

FRM AIM Define:

  1. Derivatives
  2. Market Maker
  3. Spot, Forward, Future contract
  4. Call, Put option
  5. American, European option
  6. Long, Short position
  7. Exercise (strike) price
  8. Expiration(Maturity) date
  9. Bid, Offer price
  10. Bid-Offer spread
  11. Hedgers, Speculators, Arbitrageurs

 

Derivative

  • Derives its value from underlying security value
  • Ex: Options, Forward, futures contract

Market Maker

  • Individual who acts as a middleman between exchange and end user
  • Buys and sells security
  • Charges fees based on the services offered

Spot Contract

  • Agreement to buy/sell asset today
  • No legal binding agreement in the contract

Forward Contract

  • Contract to buy/sell asset at a predetermined prices and at predetermined date in the future
  • No legally binding agreement in the contract

Future Contract

  • Legally binding agreement to buy/sell asset at a predetermined price at a predetermined date in the future
  • Ex: Buy/Sell of commodities in the future like jet fuel

Call Option

  • Buy a specified number of shares of an underlying security on/or before the expiration date at a given strike price
  • Used for hedging, speculative, arbitrage purposes

Put Option

  • Sell a specified number of shares of an underlying security on/or before the expiration date at a given strike price
  • Used for hedging, speculative, arbitrage purposes

American Styled Option

  • Similar to call/put option except that the option can be exercised anytime between issue date and expiration date
  • Valuable at times when right to exercise early will bring in profit

European Styled Option

  • Similar to call/put option except that the option can be exercised only at expiration date
  • Valuable when right to exercise early doesn’t bring in any profit

Long Position

  • Individual who has long positions owns/buys the security in the near future
  • Investor who owns long position anticipates increase in the value of the security in the near future

Short Position

  • Individual who has short positions sells the security in the near future
  • Investor who owns short position anticipates decrease in the value of the security in the near future

Strike Price

  • Price at which the underlying security may be bought/sold

Expiration Date

  • Date at which the option may be exercised (bought/sold)

Bid/Quoted price

  • Price at which the buyer is willing to pay for the security

 

Offer/Asking price

  • Price at which the seller is willing to sell the security

Bid-Ask Spread = Asking Price – Bid Price

 Hedgers

  • Use forward, futures, option to reduce their risk of the financial security that they have
  • Usage of forward contracts, the hedgers neutralizes risk by paying the price of the underlying security
  • Usage of options is used as an insurance policy

Arbitrageurs

Take offsetting positions in financial markets to lock in a risk less profit
FRM AIM: Define and Describe key features of futures contract

Futures Contract

  • Highly standardized contract specified by exchange
  • The person who buys/sells futures contract is obligated to buy/sell the assets at agreed upon time and at agreed upon price
  • Futures contract is used by speculators who take advantage of price fluctuations of the underlying asset to get a profit
  • Futures contract is used by hedgers to reduce the risk of the underlying asset

Characteristics of Futures Contract

  • Price quotation
  • Contract Size
  • Quality of asset
  • Delivery Time
  • Delivery Location
  • Position Limits
  • Daily Price Limits

FRM AIM: Describe the over the counter market and how it differs from trading on an exchange, including advantages and disadvantages :

FRM AIM: Describe the over the counter market and how it differs from trading on an exchange, including advantages and disadvantages

Properties Over the Counter Market Traditional Exchange
Definition Uses telephone and computers to make trade Uses shouting and hand signals to make trade
Size Bigger than traditional exchange Smaller than OTC market
Terms of contract Not specified by exchange Specified by exchange
Can participant negotiate contract Yes No
Any type of risk involved Credit Risk No Credit Risk
How issues are resolved Calls are recorded during transactions which serves as a reference in any disputes  

Issues are resolved based on contractual terms agreed during trading

FRM AIM: Describe, contrast and calculate the payoffs from hedging strategies involving forward contracts and options :

FRM AIM: Describe, contrast and calculate the payoffs from hedging strategies involving forward contracts and options 

Properties Forward Contracts Options
Purpose Eliminate or reduce financial exposure Eliminate or reduce financial exposure
Investor with Long exposure to asset Hedge the exposure by entering into short futures contract Hedge the exposure by buying a put option
Investor with Short exposure to asset Hedge the exposure by entering into long futures contract Hedge the exposure by buying a call option
Advantages No initial investment in executing these contracts Initial premium to purchase options
Disadvantages Hedgers give up price movements that has a positive effect in event the position is left un hedged The price movement that has a positive effect on the options is used by the hedgers to earn a profit