Key steps in a process to develop risk responses
See Module 26 Section “Developing a Response to Each Risk”
4 steps process to developing risk responses
6 ways of transferring risk
5 fundamental concepts in portfolio management
Ways in which risks may be reduced without transfer
Factors that should be considered when deciding whether to transfer a risk
Reasons a company may decide to retain a risk
Quanlities of good risk response
ART Products
See Module 26 Section “Summary of ART Products”
See links to the notes appendix 1 and 2
Questions that should be asked when considering an ART product in order to:
Understand the product
Assess the seller
Design of a CDS’ credit events trigger
List the possible credit events that could be listed in the agreement
See Module 28 Section “Credit Derivatives” \(\rightarrow\) “Types of Credit Events”
Attributes of the counterparty and the economic environment that will impact the likelihood of the credit events
See Module 23 Section “Qualitative Credit Models”
Counterparty charateristics:
Profitability and stability of profit
Industry it operates in (better if profits are immune to business cycle)
Level of operational and financial gearing
Competitiveness of the industry
Quality of management
Ability to generate cash
Commitment of shareholders (to growth)
General economic outlook over the terms of the CDS
Considering between 2 CLNs, single reference bond vs reference of 20 credits
Assuming all the underlying have equal credit worthiness, then the portfolio option has the effect of reducing the credit risk dramatically
If it’s a portfolio of junk, it is likely to be worst:
Assessing credit worthiness:
Looking at the external ratings
Calculating the average income cover and asset cover
Assessing the correlation between the defaul risk
Looking at the restrictions for further borrowing for the reference bonds
Compare CDS cost and use
Single reference bond
Hedge the credit exposure on a particular bond
Cost depends on the credit rating of the reference entity and seniority of the reference bond
First to default on 20 bonds
Expensive due to the likelihood
If uncorrelated, chance of 1 defaul will increase, more expensive
Use by cautious investors to hedge against any credit risk in a bond portfolio
Third to default on 20 bonds
Inexpensive due to low chance
More expensive if correlated
Use as cat insurance for an institution who was willing to cope with a couple of defaults
Advantages and disadvantages of ART
Explain the following terms in the context of MVPT:
Efficient portfolio
Combination of one or more investments that gives the highest expected rate of return for a given level of risks
Efficient frontier
Line that joins the points in expected return-s.d. space that represent efficient portfolios
indifference curves
Join together points representing all the portfolios that give the investor equal levels of expected utility, given the risk-return preferences of that investor
They slope upwards for a risk-averse investors
Optimal portfolio
Portfolio on the efficient frontier that gives the highest possible level of expected utility
Represented by the point where the efficient frontier is tangential to the highest attainable indifference curve
Describe the use of CDS and the TRORS to manage credit risk
Potential responses to risk identified as part of a risk planning process
See Module 26 Section “Risk Responses”
Details on the 4 main responses
Benefits of portfolio management in ERM
Live cattle futures to hedge a decrease (on 240 cows each 1,000 lb) and the futures is on 40,000 pounds
\(\sigma_s = 0.1\) s.d. of change in spot prices of Angus per pound
\(\sigma_F = 0.08\) s.d. of movement in the live cattle futures per pount
Correlation between the two \(\rho = 0.92\)
Optimal hedge ratio:
\(h = \rho \dfrac{\sigma_s}{\sigma_f} = 0.92 \times \dfrac{0.1}{0.08} = 1.15\)
Number of contracts needed = \(dfrac{240 \times 1,00}{40,000}\)
And then scale by 1.15 we get 6.9, so 7 contracts