Bionic Turtle’s Week in Risk (April 28, 2019)

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Welcome to our Week in Risk blog! This week’s new FRM practice questions, written by David Harper, discuss predicting sovereign default (Damodaran- Topic 4) and collateral and the margin period of risk (Gregory – Topic 6). David recorded new YouTube videos covering gross versus net realized return and bond spread. We’ve also included helpful discussions from our FRM forum. Enjoy and have a great week!

week in risk FRM practice questions

1. Valuation & Risk Models: P1.T4.916. Predicting sovereign default (Damodaran) https://trtl.bz/2V5E0ZV We are proud of the final set of our newest FRM practice questions for Damodaran’s updated country risk survey. Sovereign default risk is extremely multivariate, including factors that are difficult to quantify; e.g., political risk. In the first question, David generated four hypothetical countries as a way to test these multivariate dimensions. At a minimum, we hope it gets you thinking!

sovereign default

2. Credit Risk Measurement & Management: P2.T6.907. Collateral and the margin period of risk (Gregory Ch.6) https://trtl.bz/2UYVh7b This completes a new series of questions for Gregory’s xVA Chapter 6 (Collateral). GARP assigns nine learning objectives (LOs) to this chapter, although that understates the assignment given the second LO wants candidates to be familiar with threshold, initial margin, minimum transfer amount and rounding, haircuts, credit quality, and credit support amount. The first question has a precedent in the actual exam; candidates have seen a variation on this type of question; i.e., the impact of “hedging” an exposure with collateral on the net position’s volatility.

FRM youtube videos

1. Valuation & Risk Models: Fixed Income: Gross versus net realized return (FRM T4-27) https://trtl.bz/2Vvsc2B I’ve spent years studying Tuckman (over both editions) and my appreciation of his text grows each year. Gross versus net (i.e., funded) realized returns is fundamental but we need these basic definitions to cope with later chapters. Over the years, I’ve answered hundreds of questions about Tuckman’s later chapters, and many of them are explained in his earlier Part One.

2. Valuation & Risk Models: Fixed income: bond spread (FRM T4-28) https://trtl.bz/2vzK2mF It was fun to share Tuckman’s approach to calculating bond spread. This is the simplest breakdown of bond risk, into one spread that is compensation for credit risk, which is added to the risk-free term structure. This encapsulates the interplay between market and credit risk: market risk is adverse movement in the term structure, while credit risk is widening in the credit spread.

FRM YouTube

FRM forum
1. Par yields in Tuckman’s key rate shift technique. We were glad to see forum member, ankit4685, dig into our key rate spreadsheet here https://trtl.bz/2V3q1ni. As Part 2 candidates know, the key rate technique is flexible to different interest rate types. While forward rates are common in practice, Tuckman’s uses par yields, probably as a continuation following their convenient usage in hedge applications. However, the shock on par yields has a counterintuitive impact on spot rates. But it’s a great excuse to master the calculation of par rates because our spreadsheet needs to solve for the discount function given the shocked par yield key rates.

Tuckman's key rate shift technique

2. ROA versus NIM: Thank you to forum member, evelyn.peng, for noticing, by way of our question set on foreign exchange (FX) hedge exercises, that there is a difference between the bank’s return on investment, ROI, and its net interest margin (NIM). The FRM relies on Saunders for the hedged balance sheet application such that we are often solving for ROI as given by the difference between return on assets (ROA) and cost of funds (COF): https://trtl.bz/2V3qkys

3. Economic value added (EVA): In our view, forum member, nansverma, is totally correct to point out syllabus imprecisions (if not inconsistencies) in its reference to economic value added (EVA); i.e., Crouhy versus Giacomo. CEO, David Harper, actually consulted to several EVA implementations at large companies, and wrote Investopedia’s EVA tutorial. Although there are different, valid flavors, EVA has two essential characteristics: one, accounting reports are translated into economic reality, and two, the cost of capital (include equity) is explicitly charged to the economic earnings base. Also, as usual, we prefer ratio consistency. See https://www.bionicturtle.com/forum/threads/economic-value-added-eva.22329/

Risk news

1. Simulations are the future. The hypergrowth of data science is enabling a shift away from analytic solutions and toward simulations and experiments. In option pricing, the Black-Scholes (BSM) and its variants are analytical; the binomial is a simulation. Despite the elegance of the BSM, it’s just easier and more powerful to run simulations with the binomial. But that’s just option pricing, which is a minor use case in the ocean of possible use cases. GARP’s Risk Intelligence has this interesting article: From Theory to Practice with Agent-Based Modeling https://trtl.bz/2GJHs2e. Speaking of simulations, this is a delightful 2-part post (Part 1 https://trtl.bz/2GDEIUe and Part 2  https://trtl.bz/2GFqC4T) on the Probability of winning a best-of-7-series. When I read the title, I expected a dull calculation, but notice how simulations open up new perspectives!

Probability of winning a best-of-7-series

2. Compensation Committee Guide. The FRM explores governance but not really the role of the board’s compensation committee. In my previous life as a management consultant, I helped design dozens of executive incentive plans. So I’m very biased in favor of believing compensation is a valuable governance artifact. As an investor, I read every proxy statement submitted to the SEC in order to understand how management gets paid; e.g., what are the incentive metrics. Personally, I think governance is the most important soft (non-quantitative) signal for investors, and compensation is part of the mix. In any case, Wachtell Limtpon’s published their 138-page 2019 Compensation Committee Guide  https://trtl.bz/2GFjg16. Its objective is “to describe the duties of public company compensation committee members and to provide information to enable compensation committee members to function most effectively. Like prior versions, the Guide begins with an overview of key responsibilities and subsequently addresses more specific substantive issues.

3. Managing a list of risks is not risk management. This short post (A board that would fail any test of its governance practices https://trtl.bz/2GJEx9S ) by Norman Marks had me shaking my head in vigorous agreement. He says, “managing a list of risks is not risk management.” Bingo! How many articles have we read that start with the premise that risk management is itemization of the risk typology? (I’m guilty of this myself, ooops … ). He explains that is not the board’s job. Their job is more meta. No wonder so many companies fail to anticipate their urgent and important risks: if both management and the board are concerned with the right list, you know they’ll miss something. The board’s focus should be on their meta-role of “obtaining assurance that management is effectively managing risk (what might happen) and making informed and intelligent decisions every day.” That shift in focus, in my opinion, is more profound than subtle: it implies that the board is evaluating the processes, organization, responsibilities, incentives (etcetera) that enable, sustain and improve the risk management function itself.

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