Hi David,

I am finding this reading very tough.What is the author trying to convey here.Can you explain it in much softer terms than the study notes.There you mention about hedging qualifying somewhere and somewhere it doesnt.

Besides,can I omit core reading for Operational risk as there is very little time left and one needs to revise the previous portions too.In other words is Bionic sufficient here ??

Thanks
Sipani

Hi Sipani,

Broadly, I agree this reading (ERM) is difficult (as are Stulz Chapter 2 & 3). But, with 15 pages, it has density (AIMs per page) that is among the higher. Reading this source is highly recommended, even grappling with it has an intellectual payoff (IMO).

page 12 today’s screencast has this AIM:
http://www.bionicturtle.com/images/forum/slide12_oprisk_thumb.png

Specifically, at the risk of omission, today’s screencast (page 12) does try to boil down this AIM to a simple idea:

mgmt should be concerned with both (economics and accounting), but should prioritize firm value (firm value = PV of future cash flows) and such a focus inevitably means accounting earnings (which do matter per ratios and credit rating) to be more volatile. There is a tradeoff: higher PV of cash flows sacrifices smooth accounting earnings.

So I hope this page 12 reduces it…

David

Hi David,

When will you be publishing investment study notes and rest of the Qbank ?

Thanks
Sipani

Hi Sipani,

The investments note will go up soon, i don’t have definitive timing on the Qbank: they will continue to go up on a rolling basis - David

Hi David,

Page no. 42 study notes operational risk.....
I quote from your previous post “mgmt should be concerned with both (economics and accounting), but should prioritize firm value (firm value = PV of future cash flows) and such a focus inevitably means accounting earnings (which do matter per ratios and credit rating) to be more volatile.”

How can focusing more on cash flow leads to higher volatility in accounting earning .....can you also explain the example given in the study notes.....

Thanks
Sipani

Hi David,

In Schweser in the same reading it is mentioned that a firm with economic values in excess of accounting values may be penalized and may habe to maintain higher amounts in liquid asset to cover the short fall. What does this mean ??

Thanks
Sipani

Hi Sipani,

The example generically refers (per FAS 133 derivatives accounting) to any situation where the asset/exposure is hedged with a hedging instrument and their accounting treatments are different (the hedge is mark to market but the underlying is not). Under this, economics (cash flow) may be stable but the accounting could be volatile.

e.g., a bank has loan with floating rate. Bank decides to hedge with interest rate swap (pay floating, receive fixed). Before hedge, cash flows are floating (volatile). After hedge, cash flows are predictable (receive fixed). But if per derivatives accounting, the loan was not market to market and the hedge (the swap) is M-to-M, then the accounting is volatile because only the hedge instrument is being updated to “fair value.” This is a giant bruhaha currently. Current issue of CFO has something on the “fair value revoluation”: http://www.cfo.com/article.cfm/11957243?f=search

In short, an example

1. Start with floating-rate loan by itself:
cash flow (economics) volatile, and
(perhaps) accounting is stable

2. Now add hedge with int rate swap:
net cash flows stable (i.e., converted to fixed rate), but
(if only swap is mark-to-market) now accounting is volatile

Re schweser, I am not totally sure. Best guess is: such a firm has prioritized economic values (which is the more important priority) but at the cost of volatile accounting earnings. But the accounting cannot be ignored; e.g., regulatory capital (Basel) is “typically defined in standard accounting terms”. So, this bank may have high/stable economic value (per the priority) but, in suffering a trade-off, may have lower/less stable regulatory capital (accounting defs) and may be penalized to hold more regulatory capital.

David