Sep 13

Movie: Operational Risk, Part 2

by David Harper, CFA, FRM, CIPM

FRM |

opRiskIntro

For members, we just published Part 2 of the operational risk tutorial for the 2007 FRM. This includes seven groups of learning outcomes:

  • Case studies, including Amaranth (LO 60-61)
  • Enterprise risk management (ERM, LO 62)
  • The CRMGP II report and the PWG report on private capital pools (LO 63-64)
  • Risk-adjusted return on capital (RAROC, LO 65)
  • Strategic capital allocation (LO 66)

Normal Backwardation versus backwardation

The first case study is Metallgesellschaft (MG) and we can connect this case to two ideas in derivatives. MG aimed to profit on the continuation of a normal backwardation market; but the market shifted to contango. Normal backwardation (and normal contango) refer to the relationship between the spot price and the expected future spot price. Note this does not refer to the slop of the futures curve. That's contango or backwardation (inversion).

image

 

Amaranth

This year's curriculum devotes several learning outcomes to Amaranth's stunning loss of one-third of its value during one short month in September 2006. We take another look at the unique futures curve of natural gas contracts ("a sine-like wave of altering contango and backward segments").

 image

 

ERM

The ERM reading is anchored in a concept familiar to the FRM: the capital asset pricing model (CAPM). The traditional view of CAPM holds that investors won't pay for a company's diversifiable (non-systematic) risk. They can diversify themselves.

image

But Nocco and Stulz point to a flaw in the traditional view: deadweight costs. A firm does not have unfettered access to unlimited borrowing. The consequence? The firm may be forced to forgo investments in growth opportunities.

Instructively, the firm is then balancing tensions:

  • A low-leverage (low debt-to-equity) firm has lots of "buffer" equity capital. This lowers the probability of default (PD). However, equity is expensive
  • Instead of equity to reduce/maintain its probability of default, the firm can employ active risk management. Again, active risk management reduces the reliance on equity capital.
  • However, the firm cannot take this too far: a riskless firm is not useful to investors (investor can buy Treasuries themselves). The firm must assume risk to pursue growth opportunities.

image

 

Market Shocks

The CRMPG II report distinguishes between "mere" market disturbances and market shocks. It says there have been only three market shocks...

image

...and shocks have three characteristics:

  1. The LDC debt and banking crisis of the early to mid 1980s;
  2. The stock market crash of 1987; and
  3. The Asian, Russian and LTCM crises that culminated in the late summer and early fall of 1998.

 

RAROC and strategic capital

We look at three traditional ways to allocate economic capital to market, credit and operational risk (not regulatory capital, that refers to Basel II).

image

 

And finally, you need high-level familiarity with six approaches to allocating economic capital to business units:

strategicCapital

Comments

  1. Be the first to leave a comment!

Leave a Comment