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Week in Risk Week in Risk (May 5th)

David Harper CFA FRM

David Harper CFA FRM
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New Practice Questions
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In the Forum

1. How wide is the operational risk bucket? @Stuart D Moncrieff raised a good question about whether unanticipated costs associated with a reorganization should be counted as an operational loss type(s). Does it matter if it's a restructuring as opposed to a mere reorganization? What about incentive plan impacts? The impetus is my question about a sales reorg gone awry. Operational risk can be defined in different ways but the FRM starts with Basel's well-defined categories (e.g., execution, delivery, and process management, EDPM). It's important to note that there are many types of risk that are not among our major financial risk buckets and that operational risk is not a catch-up for miscellaneous risks. See https://trtl.bz/2PQthgi

2. Taylor Series. @Maxim Rastorguev asked about the apparent difference in application of the Taylor series to options as opposed to bonds. The Taylor expansion is easily one of the most discussed concepts in our forum over the last decade. It governs risk approximation in bonds, options, end even portfolio VaR. See https://trtl.bz/2PQtqjQ.

3. Prior Practice Papers. As the exam is only two weeks away, members are discussing some of GARP's prior exam questions. We've recommended avoiding prior year's practice exams due to their alarmingly high error rate (in any case, the recent batch are mostly recycled corrections such that the 2019 practice exam is your updated resource anyhow). A classic confusion *again* arose this week around inconsistent default probability applications (https://trtl.bz/2PM2bXA) but even the latest paper contains imprecisions; e.g., here the VaR backtest trade-off is imprecisely explained https://trtl.bz/2PPSAin. On the other hand, to include a positive note, here is a good question about the total gain achievable by a swap in a comparative advantage situation (this is the sort-of Hull-based question that will be difficult unless you are prepared. If prepared, finding the answer is straightforward and relatively quick): https://trtl.bz/2PMpdgU

4. Options are interesting. We had some interesting threads on options. @abhinavkhanna asked why the put is naturally better suited (than the call) to early exercise https://trtl.bz/2PSYZJO. @Jaskarn asked a great question: how is delta impacted by the volatility smile, if we develop what Hull has said about it already https://trtl.bz/2vAWpyK. And @Maxim Rastorguev makes a delightful observation that the sum of call delta and put delta must be one (cool!), except under a specific circumstance, but we can conveniently quantify the difference https://trtl.bz/2J1vaWy

External

1. LIBOR. It's been over a decade since the LIBOR scandal first began with the earliest reports of its manipulation, but the transition to an alternative rate(s)--in particular the Secured Overnight Financing Rate (SOFR)-- is finally underway. The SOFR is the subject of an FRM Part 2 Current Issues reading, What is SOFR? The transition is marked by Hull's 10th edition (as opposed to his 9th edition) where alternative risk-free rates, such as are incorporated into valuations, such as the overnight indexed swap (OIS) rate. Here is PIMCO on The Future Without Libor, Part 1 (Transition Framework for Derivatives) https://trtl.bz/2vDEjMn and Part 2 (How Will Non‑Derivative Markets Transition to Alternative Rates?) https://trtl.bz/2vG6VEV. Also, This Man Wants to Mend, Not End, Libor (WSJ) https://trtl.bz/2vFM58C

2. Climate Risk. Climate risk--in particular as an environmental, social and governance (ESG) factor--seems to be gaining traction with institutional investors; it appears on my reading list with increasing frequency. Here is BlackRock: Four charts depicting climate risks to portfolios https://trtl.bz/2PQwe0m. WSJ: Climate Changes as Firms Heed Investors on Social Issues https://trtl.bz/2PQwDQq. Wired: Companies can predict climate catastrophes for you as a service https://trtl.bz/2PKoZXJ ("Jupiter explicitly incorporates climate change into its models for catastrophe risk, both proprietary and public, and then offers that knowledge to the kind of people who might lose money when the floods, fires, storms, and heat waves really kick in ... they come down to this: Hedge. Understand the price of the risk, and aggregate it, maybe into a financial instrument of some sort.") Finally from WaPo: As seas rise, Indonesia is moving its capital city. Other cities should take note https://trtl.bz/2PMJVgI And, Jakarta is Sinking (Wired) https://trtl.bz/2PNRVOD

3. Decision science: I think risk managers need to be aware of developments in data science, which includes decision science and its inevitable impact on risk management. Isn't part of the job helping the company to make better decisions? Here is McKinsey: Three keys to faster, better decisions https://trtl.bz/2PM4aLz. They distinguish between Big-bet decisions (infrequent but high-risk), cross-cutting decisions such as pricing (frequent, high-risk and cross-functional), and delegated decisions (frequent but low-risk). Here is a16z (the top VC firm who hosts a great podcast): The Future of Decision-Making: 3 Startup Opportunities (a16z) https://trtl.bz/2PPXqMD

4. Other: Carol Williams on The Board's Role in Risk Oversight and Why it's Important https://trtl.bz/2PMFVwE. I mentioned last week a recent forum discussion about economic value added (EVA). According to the Harvard Law School Forum, Institutional Shareholder Services (ISS) is adding EVA metrics to its proxy research reports: Economic Value Added: What Companies Should Know https://trtl.bz/2PQbEx1 (here is ISS' EVA page https://www.issgovernance.com/solutions/iss-analytics/eva/). Finally, I've mentioned him before, but this week's Axios Edge by Felix Salmon is great, again, especially if you are interested in the upcoming IPO frenzy https://trtl.bz/2PMrAAk.
 
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