Temp_store

LO 62.2: Describe the capital asset pricing model (CAPM) including its assumptions, and explain how factor risk is addressed in the CAPM.
The capital asset pricing model (CAPM) describes how an asset behaves not in isolation, but in relation to other assets and to the market. The CAPM views not the assets own volatility as the relevant measure, but its covariance with the market portfolio, as measured by the assets beta.
The CAPM assumes that the only relevant factor is the market portfolio, and risk premiums are determined solely by beta. As mentioned, risk premiums are important because they compensate investors for losses during bad times. Risk here is determined by the assets movements relative to each other, and not by the assets in isolation.

LO 62.1: Provide examples of factors that impact asset prices, and explain the theory of factor risk premiums.
In the context of factor investing, it is easiest to think of assets as bundles of factor risks, where exposure to the different factor risks earns risk premiums. The underlying factors may include the market (which is a tradable investment factor), interest rates, or investing styles (including value/growth, low volatility, or momentum). Factors may also be classified as fundamental macroeconomic factors, such as inflation and economic growth.
Factor theory is based on an analysis of factor risks. Factor risks represent exposures to bad times, where these exposures are rewarded with risk premiums. Factor theory is based on three primary principles: 1. Factors are important, not assets. It is not exposure to the specific asset that matters, rather the exposure to the underlying risk factors. As a result, investors must look through assets and understand the underlying factor risks.
2. Assets represent bundles o f factors. Assets typically represent bundles of risk factors,
although some assets, like equities and government bonds, can be thought of as factors themselves. Other assets, including corporate bonds, private equity, and hedge funds, contain many factors, such as equity risk, interest rate risk, volatility risk, and default risk. Assets risk premiums reflect these risk factors.
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Topic 62 Cross Reference to GARP Assigned Reading – Ang, Chapter 6
3.
Investors have differing optimal risk exposures. Investors each have different optimal exposures to risk factors. One of the important factors is volatility. Higher volatility results in higher asset risks during bad times. One important recent example of bad times was the 20072009 financial crisis. In return for bearing factor risks, investors require compensation through a risk premium (e.g., a volatility premium for volatility risk) during normal times. Economic growth represents another factor to which investors want different exposures.
Bad times could represent economic bad times, including high inflation and low economic growth. They could also represent bad times for investing, including poorly performing investments or markets. Factors are all unique and each represents exposure to a different set of bad times.
Ca pit a l As s e t Pr ic in g M o d e l

LO 61.4: Explain policies and procedures a bank should use to manage ML/FT risks in situations where it uses a third party to perform customer due diligence and when engaging in correspondent banking.
In some countries banks may rely on third parties to perform CDD. These third parties may be other financial institutions or designated non-financial businesses and professionals who are supervised or monitored for AML/CFT purposes. The FATF standards allow banks to rely on third parties for: 1. Identifying the customer and verifying the customers identity using reliable, Identifying the customer and verifying the customers identity using reliable, independent information.
2.
Identifying and verifying the identity of the beneficial owner.
3. Understanding and obtaining information on the purpose of the intended nature of the
business relationship.
The bank, relying on a third party to perform these functions, should immediately obtain the information concerning the CDD.
Banks may outsource CDD obligations, and generally fewer restrictions apply in terms of who can act as the agent of the bank. The lower level of restrictions is offset by record keeping requirements.
Reliance on a Third Party
Reliance on a third party does not relieve the bank of its responsibilities in terms of CDD and other AML/CFT requirements on customers. Relevant criteria for assessing reliance on a third party include: The third party should be as comprehensively regulated and supervised as the bank.
Alternatively, national laws may require the use of compensating controls where these standards are not met.
There should be a written agreement between the parties acknowledging the banks
reliance on the third party for its CDD.
The banks policies and procedures must acknowledge this arrangement and establish
adequate controls and review processes for the third party arrangement.
The third party should implement the banks AML program, and may be required to
certify that it has done so and that it performs CDD equivalent to the banks obligations and requirements.
The bank should be aware of adverse publicity regarding the third party, such as
enforcement actions for AML deficiencies or violations.
The bank should identify and mitigate risks posed by relying on a third party for CDD
rather than maintaining a direct relationship with the customer.
The banks risk assessment should acknowledge the potential risk factors produced by
relying on a third party for CDD.
The bank should periodically review the third partys CDD and should obtain
documentation from the third party that it relies upon and assesses the due diligence processes and procedures, ensuring that the third party is complying with local regulatory requirements by screening against local databases.
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The bank should terminate the relationship with a third party that does not apply
adequate CDD on their customers or fails in some way to meet the banks requirements or expectations.
If a bank relies on another financial institution in the group to introduce it to customers in other countries, the institution must ensure that the customer identification by the introducer complies with the previously listed criteria.
O ut so urcing/Agency
Banks may engage in CDD directly or outsource the activity, sometimes in an agent relationship. If outsourced, it does not relieve the bank of its compliance responsibilities, which still lie with the bank. Banks that work more over the phone or internet and/or have few brick and mortar branches tend to use third parties to a greater extent. Banks often use retail deposit brokers, mortgage brokers, and solicitors to apply and meet their customer identification obligations. A written agreement between the parties should set forth the AML/CFT obligations of the bank and explain how they will be executed by the third party. The written agreement should include the following requirements that the: Banks customer identification and CDD requirements be applied by the agent.
.Agent use original identification documents to identify the customer when the customer .Agent use original identification documents to identify the customer when the customer is present in person.
Third party adheres to the banks policies when the customer is not present at the time of
customer identification.
Customers information remains confidential. In addition, the bank should: Ensure that the agent or third party determines the identity of beneficial owners or PEPs. Ensure that the agent or third party provides the bank with customer identification
information in the required time frame.
Review and audit the quality of the customer information that is gathered and
documented.
duties.
Clearly identify instances the bank would consider failures to perform the contracted
Ensure that data provided by the third party is complete, accurate, and timely. An agent, under the law of agent and principal, is generally considered a legal extension of the bank. This means the customer is legally dealing with the bank itself and the agent is, therefore, obligated to apply the banks policies and procedures regarding customer identification, verification, and CDD.
The third party must have technical expertise, knowledge, and training regarding customer identification and CDD. In some cases, the third party is not subject to AML/CFT obligations itself. Even if the agent does not have AML/CFT obligations, it must apply the principals identification and CDD requirements, and conform to the principals legal requirements.
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Correspondent Banking – A Risk Based Approach
Correspondent banking relationships allow the respondent bank to provide services that it could not otherwise provide. According to the FATF, a correspondent banking relationship is ongoing and repetitive in nature. Cross-border correspondent banking involving the execution of third party payments is higher risk and, according to FATF Recommendation 13, should prompt additional CDD measures. Cross-border correspondent relationships allow respondent banks without international presence or cross- border payment systems to operate in jurisdictions to which they would otherwise not have access.
The correspondent bank does not generally have a direct relationship with the respondent banks customers. They are in fact the customers of the respondent bank and, thus, the correspondent bank must conduct due diligence on the respondent bank, but not on the respondent banks customers. The respondent bank must conduct CDD. Flowever, this also means the correspondent bank may be exposed to greater ML/FT risks because of limited information regarding the nature and purpose of the underlying transactions of the respondent banks customers.
Risk indicators arising from cross-border correspondent banking include: The inherent risks resulting from the nature of the services provided by the The purpose of the services provided (e.g., foreign exchange services for proprietary correspondent bank including:
The purpose of the services provided (e.g., foreign exchange services for proprietary
trading, securities trading on exchanges, and so on may indicate lower risk).
Whether the services will be used via nested (downstream) correspondent banking
by bank affiliates or third parties, and the risks that doing business with these parties entail. Nested (or downstream) refers to the use of correspondent banking services by a number of respondent banks through the relationship with the correspondent banks direct respondent bank to conduct financial transactions and gain access to services. Whether services will be used via payable-through account(s) activity by the
Whether services will be used via payable-through account(s) activity by the
respondent banks affiliates or third parties and the risks these parties introduce.
The characteristics of the respondent bank, including the respondent banks: Major business activities (e.g., target markets, types of customers served, key business
Major business activities (e.g., target markets, types of customers served, key business
lines).
CDD processes. Management and ownership.
Management and ownership.
Money laundering prevention and protection policies and procedures such as the History, including whether any sanctions, criminal, civil, or administrative actions
History, including whether any sanctions, criminal, civil, or administrative actions
have occurred and how it was addressed by the respondent bank. The environment in which the respondent bank operates, including: The jurisdiction of the respondent bank and its parent.The quality and effectiveness of bank regulation and supervision in the respondent
The jurisdiction of the respondent bank and its parent.
The jurisdiction of the subsidiaries and branches of the group.
The quality and effectiveness of bank regulation and supervision in the respondent
banks country.
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Nested (Downstream) Correspondent Banking
Nested or downstream correspondent banking is necessary and generally legitimate. Regional banks can assist small, local banks in the respondents region to gain access to the international financial system. However, these foreign institutions are not customers of the correspondent bank and, as they are not known, may increase ML/FT risks. The respondent bank should, therefore, disclose whether accounts include nested relationships. The correspondent bank should assess the risks on a case-by-case basis. Correspondent banks should consider: The number and types of financial institutions the respondent bank serves. The jurisdiction of the nested institutions and whether those jurisdictions have adequate
AML/CFT policies according to available public information.
The types of services the respondent bank offers the nested institutions. The length of the relationship between the correspondent and respondent banks. The adequacy of the due diligence processes and procedures of the respondent bank. The correspondent bank should gather information about the respondent bank before entering a business relationship. Information about the respondent banks AML/CFT policies is essential and can be gathered from the respondent bank. The correspondent bank may use third-party databases (referred to as know your customer or KYC utilities) at account opening and must update this information over time. Correspondent banks may also use public sources to gather information. The correspondent bank should also consider relevant information on the jurisdiction in which the respondent resides before entering into a banking relationship.
The level of due diligence should be commensurate with the respondent banks risk profile. The correspondent bank should assess the risk and the respondent banks AML/CFT controls by gathering information, checking the functioning of the internal audit, and so on. Correspondent banks should not engage in a relationship with a shell bank (i.e., one that has no physical presence in a jurisdiction and no affiliation with a regulated financial
Banks should engage in ongoing monitoring activities of respondent banks. If a transaction is suspicious, the correspondent bank can issue a request for information on the transaction.
In cross-border wire transfers, the Committee encourages all banks to apply high transparency. Payment messages must be in the correct form and must identify the originator and the beneficiary of the payment, and then must be monitored by those in the payment chain. The respondent bank, acting as the ordering financial institution, remains responsible for performing CDD. It is essential that the information in payment messages unambiguously identifies the originator and the beneficiary of the payment.
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Topic 61 Cross Reference to GARP Assigned Reading – Basel Committee on Banking Superversion
Professors Note: Payment messages are the written instructions that go along with payments. There are messages when a paym ent is due, issued, canceled, and so on. Payment messages also contain information on the originator o f the paym ent and the beneficiary. The Committee requires that everyone in the paym ent chain m onitor the paym ents they process based on the inform ation in the paym ent messages. This should in turn increase transparency and lower the ML/FT risk.
If a respondent bank has a relationship with several entities in the same group, then risk assessments by different entities must be consistent with the group-wide risk assessment policy. The groups head office should coordinate the monitoring of the relationship with the respondent bank. This is especially important in the case of high-risk relationships. If the relationship is with the same group but in different host countries, the correspondent bank must assess the ML/FT risks presented in each business relationship.
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Ke y C o n c e pt s
LO 61.1 To assess money laundering and the financing of terrorism (ML/FT) risks, the bank must know the identities of its customers and must have policies and procedures for: Customer identification. Customer due diligence (CDD). Customer acceptance. Monitoring of business relationships. Monitoring of business operations. To mitigate ML/FT risks, the first line of defense is the business units (e.g., the front office and customer facing activities). They identify, assess and control ML/FT risks through policies and procedures that should be specified in writing and communicated to bank personnel. The second line of defense is the chief officer in charge of anti-money laundering and countering financing of terrorism (AML/CFT). The officer should engage in ongoing monitoring and the fulfillment of AML/CFT duties. The third line of defense is internal audits. The bank should establish policies for conducting internal audits of the banks AML/CFT policies.
LO 61.2 Banks must determine which customers pose a high risk of ML/FT. Factors the bank should consider include the customers background, occupation, sources of income and wealth, the country of origin and the country of residence, the choice and use of the banks products and services, the nature and purpose of the bank account, and any linked accounts. Banks must, according to the Financial Action Task Force (FATF) standards, identify customers and verify their identities. Banks must establish a systematic procedure for identifying and verifying customers. In some cases, the bank must identify and verify a person acting on behalf of a beneficial owner(s). Customer identification documentation may include passports, identity cards, driving licenses, and account files such as financial transaction records and business correspondence.
LO 61.3 Banks involved in cross-border activities should:
Integrate information on the customer, beneficial owners of the customer (if one exists), and the funds involved in the transaction(s).
Monitor significant customer relationships, balances, and activity on a consolidated basis whether the account is on- or off-balance sheet, as assets under management (AUM) or on a fiduciary basis.
Appoint a chief AML/CFT officer for the whole group (the group of banks and branches
that are part of one financial organization) who must ensure group-wide compliance (across borders) of AML/CFT requirements.
Oversee the coordination of group-wide information sharing. The head office should be informed of information regarding high-risk customers. Local data protection and privacy laws must be considered.
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Topic 61 Cross Reference to GARP Assigned Reading – Basel Committee on Banking Superversion
Bank supervisors must comply with FATF Recommendation 26 and apply the Core Principles fo r Effective Banking Supervision as it relates to the supervision of AML/CFT risks. FATF states the principles that are relevant to money laundering and financing of terrorism. They must also set out supervisory expectations governing banks AML/CFT policies and procedures and should adopt a risk-based approach to supervising banks ML/FT risk management systems.
LO 61.4 In some cases, banks rely on third parties to perform CDD. The FATF standards allow banks to rely on third parties to (1) identify the customer and verify the customers identity using reliable, independent information, (2) identify and verify the identity of the beneficial owner, and (3) understand and obtain information on the purpose and the intended nature of the business relationship with the customer. Ffowever, reliance on a third party does not relieve the bank of its responsibilities in terms of CDD and other AML/CFT requirements on customers.
Banks may engage in CDD directly or outsource the activity, sometimes in an agent relationship. If outsourced, it does not relieve the bank of its compliance responsibilities, which still lie with the bank.
Correspondent banking relationships allow the respondent bank to provide services that it could not provide otherwise. Risk indicators arising from cross-border correspondent banking include the inherent risks resulting from the nature of the services provided by the correspondent bank including the characteristics of the respondent bank, which involve the respondent banks major business activities and the environment in which the respondent bank operates.
Nested (or downstream) refers to the use of correspondent banking services by a number of respondent banks through the relationship with the correspondent banks direct respondent bank to conduct financial transactions and gain access to services. The foreign institutions (respondent banks) are not customers of the correspondent bank and, as they are not known, may increase ML/FT risks. The respondent bank should, therefore, disclose whether accounts include nested relationships and monitor accordingly. In cross-border wire transfers, the Committee encourages all banks to apply high transparency. Payment messages must be in the correct form and must identify the originator and the beneficiary of the payment, and then must be monitored by those in the payment chain.
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Topic 61 Cross Reference to GARP Assigned Reading – Basel Committee on Banking Supervision
C o n c e pt C h e c k e r s
1.
2.
3.
4.
Which of the following is an example of external data that the chief Anti-Money Laundering and Countering Financing of Terrorism (AML/CFT) officer should analyze and understand in order to manage and mitigate money laundering and the financing of terrorism (ML/FT) risks? A. Transaction data. B. Payment message streams. C. Country reports. D. Customer passports and identity card.
With respect to managing and mitigating money laundering and the financing of terrorism (ML/FT) risks in a bank, bank tellers and branch managers are examples of: A. B. C. the most important line of defense. D. lower level bank employees that have little to do with financial crimes risk
the first line of defense. the second line of defense.
management.
The risk manager of a large U.S. multi-national bank is attempting to put in greater risk controls. In keeping with recommendations from the Basel Committee on the sound management of risks related to money laundering and the financing of terrorism (ML/FT) she requires enhanced customer due diligence (CDD) for: A. all accounts from customers initiated in countries outside the United States. B. accounts with regular cross-border wire transfers. C. individual accounts with balances less than the $230,000 Federal Deposit individual accounts with balances less than the $230,000 Federal Deposit Insurance Corporation (FDIC) insurance limit.
D. accounts of persons who reside in countries other than their countries of birth.
Which of the following is the role of a bank supervisor, acting in its role regarding the supervision of Anti-Money Laundering and Countering Financing of Terrorism (AML/CFT) risks? A. Require all banks to use the same global payment systems to make detection of
irregularities simpler.
B. Make sure all banks have a chief AML/CFT risk manager that reports directly to
C. Require all banks to provide daily documentation to the supervisor on any cross-
D. Make sure the stricter of the two jurisdictions rules regarding ML/FT risks are
the board of directors.
border wire transfers.
applied by banks.
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5.
When a correspondent bank provides products or services to a respondent bank that then offers these services to other banks, it is known as: A. nested correspondent bankingit is legal but can increase the risks of money
laundering and the financing of terrorism.
B. upstream correspondent bankingit is illegal and will increase the risks of
money laundering and the financing of terrorism.
C. diversified correspondent bankingit is legal and does not increase the risks of
money laundering and the financing of terrorism.
D. downstream correspondent bankingit is illegal and will increase the risks of
money laundering and the financing of terrorism.
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C o n c e pt C h e c k e r An s w e r s
1. C The banks understanding of inherent money laundering and the financing of terrorism (ML/FT) risks is based on both internal and external data sources including operational and transaction data (internal) and national risk assessments and country reports from international organizations (external).
2. A To mitigate ML/FT risks, the first line of defense is the business units (e.g., the front office
and customer facing activities). They identify, assess, and control ML/FT risks through policies and procedures that should be specified in writing and communicated to bank personnel. The second line of defense is the chief officer in charge of AML/CFT. The third line of defense is internal audits.
3. B Banks must determine which customers pose a high risk of ML/FT. Factors the bank
should consider include the customers background, occupation, business activities, sources of income and wealth, country of origin, country of residence, if different from country of origin, choice and use of bank products and services, nature and purpose of the bank account, and any linked accounts. For lower-risk customers, simplified assessment procedures may be used (e.g., a customer with low balances who uses the account for routine banking needs). Enhanced due diligence may be required for: Accounts with large balances and regular cross-border wire transfers. A politically exposed person (PEP), especially foreign PEPs.
4. D Bank supervisors have many jobs in conjunction with ML/FT risks, including complying
with FATF Recommendation 26 and applying the Core Principles for Effective Banking Supervision as it relates to the supervision of AML/CFT risks. Supervisors should make sure the stricter of two jurisdictions requirements is applied. They do not, however, require banks to use the same payment systems, require daily documentation of cross-border wire transfers be submitted to the supervisor, or require banks to have a chief AML/CFT officer that reports to the board (although it is recommended that banks have an officer that reports to the board and/or senior management).
5. A Nested (or downstream) refers to the use of correspondent banking services by a number of respondent banks through the relationship with the correspondent banks direct respondent bank to conduct financial transactions and gain access to services. Nested or downstream correspondent banking is necessary, legal, and generally legitimate. However, the foreign institutions are not customers of the correspondent bank and, as they are not known, may increase money laundering and the financing of terrorism (ML/FT) risks.
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Se l f -Te s t : O pe r a t i o n a l a n d In t e g r a t e d Ri s k Ma n a g e me n t
10 Questions: 30 Minutes
1.
2.
3.
Outsourcing may reduce costs, provide expertise, expand bank offerings, and/or improve bank services. The board of directors and senior management must understand the operational risks that are introduced as a result of outsourcing. Which of the following actions is (are) suggested by the Basel Committee for controlling risks related to outsourcing? I. An agreement detailing termination rights and other rights and responsibilities
II. Established policies for restitution in the event of failure on the part of an
of the two parties involved.
outside service provider.
A. I only. B. II only. C. Both I and II. D. Neither I nor II.
There are five major factors that could lead to a poor or fragmented IT infrastructure at an organization. Which of the following factors is least likely to result in a poor or fragmented IT infrastructure? A. Moderate turnover of key IT staff. B. Participating in merger and acquisition activities. C. Management of a firm that is focused primarily on long-term projects. D. Allowing each business line the autonomy to upgrade their IT systems based on
the best available resources.
The generalized Pareto distribution is used for modeling extreme losses. The model requires the choice of a threshold. Which of the following best describes the tradeoffs in setting the threshold level? A. The threshold must be high enough so that the tail index indicates a heavy tail. B. The threshold must be high enough so that the tail index indicates a light tail. C. The threshold must be high enough so that convergence to the generalized
D. The threshold must be high enough so that there are enough observations to
Pareto distribution occurs.
estimate the parameters.
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Book 3 Self-Test: Operational and Integrated Risk Management
4.
Given the following data for a project, which of the following statements is most accurate regarding the use of the risk-adjusted return on capital (RAROC)?
Equity beta: Market return: Variance of returns: RAROC: Risk-free rate:
1.2 13% 5% 16% 4%
3.
6.
7.
I. Using the adjusted RAROC, the project should be rejected because the
RAROC is less than the market return plus the risk-free rate.
II. Using the adjusted RAROC, the project should be accepted because its
adjusted RAROC is higher than the risk-free rate.
A. I only. B. II only. C. Both I and II. D. Neither I nor II.
You are holding 100 SkyTrek Company shares with a current price of $30. The daily mean and volatility of the stock return are 2% and 3%, respectively. VaR should be measured relative to initial wealth. The bid-ask spread of the stock varies over time, and the daily mean and volatility of this spread are 0.3% and 1%, respectively. Both the return and spread are normally distributed. What is the daily liquidity-adj listed VaR (LVaR) at a 99% confidence level assuming the confidence parameter of the spread is equal to 3? A. $103.50. B. $172.62. C. $193.15. D. $202.20.
A recently published article on issues with value at risk (VaR) estimates included the following statements. Statement 1: Differences in the use of confidence intervals and time horizon
can cause significant variability in VaR estimates as there is lack of uniformity in practice.
Statement 2: Standardization of confidence interval and time horizon would
eliminate most of the variability in VaR estimates. This articles statements are most likely correct with regard to: A. Statement 1 only. B. Statement 2 only. C. Both statements. D. Neither statement.
Global Transportation, Inc., recently traded at an ask price of $45 and a bid price of $44.50. The sample standard deviation of the bid-ask spread was 0.0001. The 99% spread risk factor for a purchase of Global Transportation is closest to: A. 0.0057. B. 0.2541. C. 25.41. D. 0.1111.
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Book 3 Self-Test: Operational and Integrated Risk Management
8.
9.
10.
The standardized model for market risk charges differs from the internal model- based approach in that the standardized model: A. sums up market risks across market risk categories, whereas the internal model-
based approach uses a multiplicative factor on the average VaR.
B. sums up market risks across market risk categories, whereas the internal model-
based approach focuses solely on specific risk charges.
C. focuses solely on specific risk charges, whereas the internal model-based
approach sums up market risks across market-risk categories.
D. uses a multiplicative factor on the average VaR, whereas the internal model-
based approach sums up market risks across market risk categories.
Fligh-quality liquid assets: Required amount of stable funding: Cash outflows over the next 30 days: Given the following information, what is Bank Xs net stable funding ratio (NSFR)

Net cash outflows over the next 30 days: Available amount of stable funding: A. 63%. B. 89%. C. 103%. D. 125%.
$100 $200 $130 $90 $210
Global Bank has been unwilling to appoint a chief Anti-Money Laundering and Countering Financing of Terrorism (AML/CFT) officer. As a result, the bank has had several incidents involving money laundering, some of which have been reported on in the press. Which of the following is not a key risk associated with weak money laundering and the financing of terrorism (ML/FT) risk management practices? A. Market risk. B. Operational risk. C. Compliance risk. D. Concentration risk.
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Se l f -Te st An s w e r s: O pe r a t i o n a l a n d In t e g r a t e d Ri s k Ma n a g e me n t
1. A Outsourcing policies should include:
Processes and procedures for determining which activities can be outsourced and
how the activities will be outsourced.
Processes for selecting service providers (e.g., due diligence).
Structuring the outsourcing agreement to describe termination rights, ownership of data, and confidentiality requirements.
Monitor risks of the arrangement including the financial health of the service
provider. Implement a risk control environment and assess the control environment at the service provider.

Develop contingency plans. Clearly define responsibilities of the bank and the service provider.
The Basel Committee does not explicitly suggest establishing policies for restitution in the event of failure on the part of the outside service provider although this could be detailed in the outsourcing agreement.
(See Topic 37)
2. C Management of a firm that is focused less on short-term financial issues and more on
long-term survival is much less likely to encounter problems with poor or fragmented IT infrastructures. Moderate turnover in IT staff, especially key staff, will likely contribute to the problem. Merger and acquisition activity will often result in multiple systems running at the same time so that data aggregation across products and business lines becomes a significant new challenge. Allowing autonomy to each business line will likely result in inconsistency across business lines and could be costly if the systems end up being incompatible due to the inconsistency.
(See Topic 39)
3. C The threshold must be high enough so that convergence to the generalized Pareto
distribution occurs. Choices A and B are incorrect because the tail index is chosen by the researcher. Heavy tails are indicated by a tail index greater than zero. Choice D is incorrect because the threshold must be low enough so that there are enough observations to estimate the parameters.
(See Topic 45)
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Book 3 Self-Test Answers: Operational and Integrated Risk Management
4. B The adjusted RAROC (ARAROC) compares the adjusted RAROC to the risk-free rate. So
Statement I is incorrect.
The project should be accepted because the ARAROC of 5.2% is greater than the risk-free rate of 4%. So Statement II is correct. ARAROC = 0.16 – 1.2(0.13 – 0.04) = 0.052. (See Topic 48)
5. D At the 99% confidence level, you would use an alpha statistic of 2.33 since VaR is a one-
tailed test. The liquidity-adjusted VaR = normal VaR + adjustment for liquidity. Normal VaR = portfolio value x (mean – 2.33 x standard deviation) Normal VaR = 100 x $30 x (2% – 2.33 x 3%) Normal VaR = $149.70 (Note that a negative sign is implied here since we are dealing with the value at risk.) Liquidity adjustment = 0.5 x portfolio value (spread mean + 3 x spread volatility) Liquidity adjustment = 0.5 x $3,000 x (0.5% + 3 x 1%) = $52.5 LVaR = $149.70 + $52.5 = $202.20
(See Topic 52)
6. A Statement 1 is correct as variability in risk measures, including lack of uniformity in the use of confidence intervals and time horizons, can lead to variability in VaR estimates. Statement 2 is incorrect as other factors can also cause variability, including length of the time series under analysis, ways of estimating moments, mapping techniques, decay factors, and number of simulations.
(See Topic 53)
7. A The formula for the expected transactions cost confidence interval is:
+/- P x V2(s + 2.33cr) where: P = an estimate of the next day asset midprice, usually set to P, the most recent price
observation.
s = expected or typical bid-ask spread calculated as (ask price – bid price) / midprice as = sample standard deviation of the spread
The I/2(s + 2.33cts) component of the confidence interval is referred to as the 99% spread risk factor. Midprice = (45 + 44.50) / 2 = 44.75 s = (45 -44.5)/ 44.75 = 0.0112 spread risk factor = ^[0.0112 + 2.33(0.0001)] = 0.0057
(See Topic 54)
8. A The standardized model approach simply sums the market risks across the market-risk
categories. The internal model-based approach applies a multiplicative factor to the average VaR.
(See Topic 58)
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Book 3 Self-Test Answers: Operational and Integrated Risk Management
9. C The longer-term funding ratio is equal to the available amount of stable funding divided
by the required amount of stable funding. Under Basel III, this ratio must equal or exceed 100%. Bank As net stable funding ratio = $210 / $200 = 105%.
(See Topic 59)
10. A Banks without sound ML/FT risk management practices are exposed to serious risks
including reputational, operational, compliance, and concentration risks.
(See Topic 61)
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Fo r m u l a s
Topic 43 basic indicator approach:
x a
\
/
Operational and Integrated Risk Management
where: GI = annual (positive) gross income over the previous three years n = number of years in which gross income was positive a =15% (set by Basel Committee)
the standardized approach:
3 Years
3
where: GIj 8 = annual gross income in a given year for each of the eight business lines Pj_g = beta factors (fixed percentages for each business line)
Topic 44
business indicator:
BI = ILDC + SC + FC
avg
avg
avg
where: ILDC = interest, lease, dividend component SC = services component FC = financial component
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2018 Kaplan, Inc.
Book 3 Formulas
internal loss multiplier:
internal loss multiplier =
loss component BI component
where: loss component = 7 x average total annual loss only including loss events above 10 million 7 x average total annual loss + 7 x average total annual loss only including loss events above 10 million + 3 x average total annual loss only including loss events above 100 million
Topic 43
generalized extreme value (GEV) distribution:
F ( X | ,p ,,c r) = e x p
.
>
( – 1 / t X LX
l + ^ x ——- l cr
J
i f f
F(X | f.p.a) = exp

exp
( x [i
{
Y
y
if , = 0
generalized Pareto distribution: exp 1 exp
Topic 48
economic capital:
economic capital = risk capital + strategic risk capital
RAROC:
RAROC =
after-tax expected risk-adjusted net income
economic capital
RAROC = taxes + return on economic capital transfers exp ected revenues cos ts exp ected losses
taxes + return on economic capital transfers
economic capital
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Book 3 Formulas
hurdle rate:
(CE x R c e ) + (PE x R pe )
(CE + PE)
where: CE = market value of common equity PE = market value of preferred equity Rc e = cost of common equity [could be derived from the capital asset pricing model (CAPM)] ^PE = cost of preferred equity (yield on preferred shares)
adjusted RAROC:
Adjusted RAROC = RAROC |3p (Rj^ Rp)
Topic 32
(ask price bid price) (ask price + bid price) / 2
liquidity-adjusted VaR (constant spread):
LVaR = (V x z x a) + [0.5 x V x spread] V _A /
LVaR = VaR + LC
where: V = asset (or portfolio) value z = confidence parameter a = standard deviation of returns
lognormal VaR: VaR = [1 exp(p a x z )] x V
1 +
=

VaR
—————————^
2 x [l exp(a x z a )] ———————————
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Book 3 Formulas
elasticity: E = AP/P AN/N
where: AN/N = size of the trade relative to the entire market
LVaR = VaR x
API 1——- p E x —– = VaRx f ^ AN) E x —– 1 N J
LVaR VaR combined
LVaR VaR
exogenous
x
LVaR VaR endogenous
Topic 34
i D , leverage ratio: L = = ———– = H —— E
(E + D)
A E
E
.
_
&
leverage effect: ROE = (leverage ratio x ROA) [(leverage ratio 1) x cost of debt] transactions cost confidence interval: +/ P x V^(s + 2.33ct )
where: P = an estimate of the next day asset midprice, usually set to P, the most recent price
observation
s = expected or typical bid-ask spread a s = sample standard deviation of the spread
spread risk factor: l/i{s + 2.33cts)
Topic 58 credit equivalent amount:
max(V, 0) + a x L
where: V = current value of the derivative to the bank a = add-on factor L = principal amount
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Book 3 Formulas
market risk capital requirement:
max(VaRt_1, mc x VaRavg) + SRC multiplicative factor where: VaRt l = previous days VaR VaRavg = the average VaR over the past 60 trading days mc = multiplicative factor SRC = specific risk charge
expected loss:
EL = ^ 2 EAD; x LGD; x PD;
1
required capital = EAD x LGD x (WCDR PD) x MA
where: MA = maturity adjustment = (1 + (M 2.3) x b)/( 1 – 1.5 x ^) M = maturity of the exposure b [0.11832-0.03478 x In (PD)]2 = [0.11832-0.03478 x In (PD)]2
total capital = 0.08 x (credit risk RWA + market risk RWA + operational risk RWA)
Topic 59 stressed VaR:
max(VaRt_1, mc x VaRavg) + max(SVaRt l , mg x SVaRavg) avg’
where: VaRt – 1 VaRavg
S VaRt _ J SVaRavg previous days VaR, 10-day time horizon, 99% confidence levelmultiplicative factor, determined by supervisor, minimum value of threethe average stressed VaR over the past 60 days, 10-day time horizon, 99% = previous days VaR, 10-day time horizon, 99% confidence level the average VaR over the past 60 days, 10-day time horizon, 99% confidence = level = multiplicative factor, determined by supervisor, minimum value of three = previous days stressed VaR, 10-day time horizon, 99% confidence level the average stressed VaR over the past 60 days, 10-day time horizon, 99% = confidence level = stressed VaR multiplicative factor, determined by supervisor, minimum of three
liquidity coverage ratio:
high quality liquid assets / net cash outflows in a 30-day period > 100%
net stable funding ratio:
amount of available stable funding / amount of required stable funding > 100%
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2018 Kaplan, Inc.
alibration test 283 capital adequacy process 165,166 capital asset pricing model 135, 340 capital conservation buffer 295 Capital Plan Rule 164
2018 Kaplan, Inc.
Page 343
acktesting 273 balance sheet risk 216 bank holding companies 164 banking book 311 bank run 243 base-level metric 38 Basel I 268 basic indicator approach 74, 280 basis risk 209 Bear Stearns 183 beta factors 75 bid-ask spread 192 binomial test 111 Bureau of Financial Protection 301 burned-out capital 131 Business Disruption and System Failures 45 business environment and internal control fac
tors 50
business indicator 86 business line management 1 business process mappings 7
B b
c c
cash 231 cash flow at risk 199 cash flow mapping 208 cash management 180 chi-square test 111 Clients, Products, and Business Practices 45 coherence 250 coherent risk measure 146 collateral markets 220 comparative advantage 20 comparative analysis 7 complex metric 38 compliance risk 259 comprehensive approach 275 Comprehensive Capital Analysis and Review
250
comprehensive risk measure 292 concentration risk 259 conditional VaR 99 confidence bias 52 consortium data 63 constant level of risk 292 constant spread approach 194 context bias 52 contingent convertible bonds 299 contract provisions 261 control environment 7 conversion factor 269 convertible arbitrage hedge funds 219 convolution 81 Cooke ratio 268 copula correlation 276 core capital 271,294 corporate operational risk function 2 correspondent banking 324 countercyclical buffer 296 counterparty credit risk 153 counterparty risk 181 country risk 259 CrashMetrics 200 credit equivalent amount 269 credit risk capital requirements 274 credit spread risk 312 crisis-scenario analyses 201 cross-margin agreements 221 customer due diligence 316 customer identification 319 customer verification 319
BCP conduits 218 acceptable data 36 add-on amount 269 adjusted RAROC 136 advanced IRB approach 278 advanced measurement approach 78, 280 adverse price impact 228 adverse selection 228 alternative standardized approach 77 anchoring bias 52 anxiety bias 52 asset-liability management 217 audit findings 7 availability bias 52 available stable funding 297
A A
In d e x
aming 52 general collateral 184 generalized extreme value (GEV) distribution
97
generalized Pareto distribution 98 goodwill 131 gross leverage 226 gross loss 92
aircut 181, 220 huddle bias 52 human error 119 hurdle rate 135 hybrid approach 82
H h
ncremental default risk 312 incremental default risk charge 292 incremental risk charge 292, 312 independent operational risk management func
tion 2
independent reviews 2 inexpert opinion 52 insurance 82 internal audits 318 Internal Fraud 46 internal loss data 7 internal loss multiplier 89 internal models approach (market risk) 272 internal models approach (Solvency II) 283 internal ratings-based approach 276 intrinsic value 226 inventory management 228 IT infrastructure 29 IT risk management policy 28
ey performance indicators 7 key risk indicators 7, 49
K k
egal risk 259 Lehman Brothers 182 lending technology 110 leveraged buyouts 219
L l
PMorgan Chase 120 jump-to-default risk 312
J J
G g
I i
conomic capital 19, 128, 131, 146 :dded leverage 224 omies of scope 240 icity 198 edded leverage 224 :dded leverage 224 ioyment Practices and Workplace Safety 46 genous liquidity 193 prise risk management 15 -driven strategies 209 tion 273 tion 44 ition, Delivery, and Process
E e
exogenous liquidity 193 exogenous spread approach 196 expected losses 131 expected revenues 131 expected shortfall 99, 147, 308 exposure at default 277 external audits 318 External Fraud 46 external loss data 7, 61 extreme value theory 96
ederal Insurance Office 300 fed funds-GC spread 184 Financial Stability Oversight Council 300 financing of terrorism 316 firm-wide VaR 18 foundation IRB approach 278 fractional-reserve bank 217 fully diversified capital 137 funding liquidity 216
F F
amage to Physical Assets 46
data aggregation 30 data quality 33 data quality inspection 38 data quality scorecard 38 data validation 38 dealer banks 237 delivery 44 Delphi technique 52 delta-gamma approximation 200 depth 230 diseconomies of scope 240 Dodd-Frank 300 due diligence 260 duration-convexity mapping 208 dynamic strategies 209
D D
Book 3 Index
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Book 3 Index
ffice of Credit Ratings 301
Office of Financial Research 300 off-the-run 185 on-the-run 185 open repos 181 operational data governance 38 operational risk 1, 207, 259 operational risk capital requirements 73, 280 Operational Riskdata eXchange Association 50,
o O
63
operational risk governance 1 operational risk management framework 6 operational risk profiles 53 OpRisk taxonomy 43 OTC derivatives market 237 outsourcing 9 overnight repos 180
payment messages 325 peaks-over-threshold 98 pillar 1: minimum capital requirements 281 pillar 2: supervisory review 281 pillar 3: market discipline 281 point-in-time 134 Poisson distribution 80 positive homogeneity 146 presentation bias 52 prime broker 238 probability of default 276
ebate 221 recoveries 47 regulatory capital 19,128 rehypothecation 220 remargining 220 repledging 220 repo market 238 repurchase agreement 178, 221, 239 reputational risk 259 required stable funding 298 resecuritizations 293 resiliency 230 reverse repo 178 revised standardized approach 310 risk-adjusted return on capital 130 risk aggregation 148
R r
ualitative validation 104 quantitative validation 104
Q q
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Page 345
leverage effect 222 leverage ratio 222, 296 liquidity 216 liquidity-adjusted VaR 193 liquidity at risk 199 liquidity coverage ratio 297 liquidity horizon 309 liquidity management 180 liquidity risk 181, 192, 208, 216 lognormal distribution 80 lognormal VaR 195 London Whale 122 Long-Term Capital Management 120 loss component 89 loss distribution approach 79 loss events 43 loss given default 277 loss provisions 48 loss threshold 47
mapping 208 marginal capital 137 margin loans 221 market risk 207 market risk capital 307 market risk capital requirement 271 mark-to-market 271 maturity adjustment 278 maturity mismatch 216 merger arbitrage hedge funds 219 minimum capital requirement 282 modeling frequency 79 modeling severity 80 model risk 116, 206 model validation 104 money laundering 316 money market mutual fund 219 monotonicity 146 Monte Carlo simulation 81 multivariate EVT 100
ested correspondent banking 325 net leverage 226 net present value 131 net stable funding ratio 297 normal test 111 novation 241
N n
Supervisory Capital Assessment Program 249 supplementary capital 271,294 suspicious transaction reports 318 systematic funding risks 219 systematic risk 15 systemically important financial institutions 300 systemic risk 217
echnology risk 8 through-the-cycle 134 Tier 1 capital 271, 294 Tier 2 capital 271, 294 tightness 230 timeframe for recoveries 47 time value 226 total return swaps 221 toxic assets 244 trade processing costs 228 trading book 311 traffic lights approach 111 transactions cost 229 transactions liquidity 216 translation invariance 146 Troubled Asset Relief Program 244
orst case probability of default 276
w w
alue at risk 99, 147, 307 Volcker Rule 300
V v
nderwriting risk 283 unexpected losses 131 unpledged assets 231 use test 283
T t
u u
cenario analysis 7, 51, 81 securities lending 221 Sharpe ratio 131 simple approach 275 slippage 228 Societe Generate 66 solvency capital requirement 282 Solvency II 282 special collateral 184 special purpose entity 240 special rate 184 special spread 185 specials trade 184 specific risk charge 272, 292 spread risk factor 229 stand-alone capital 137 standard deviation 147 standardized approach (credit risk) 274 standardized approach (operational risk) 75 standardized approach (Solvency II) 282 standardized measurement approach 86 standardized measurement method (market risk)
272
statistical quality test 283 strategic risk capital 131 stressed value at risk (VaR) 291 stress testing 248 structured credit products 218 structured investment vehicle 218, 240 subadditivity 146 subscription databases 62
s s
risk and performance indicators 7 risk appetite framework 25 risk assessments 7, 260 risk capital 128 risk control self-assessment 7, 48 risk data infrastructure 28 risk-weighted assets 252, 268 rollover risk 217
Book 3 Index
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2018 Kaplan, Inc.
Notes
Notes
Notes
Notes
Notes
Notes
Notes
Required Disclaimers:
CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by Kaplan. CFA Institute, CFA, and Chartered Financial Analyst are trademarks owned by CFA Institute.
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Kaplan is a review course provider for the CFP Certification Examination administered by Certified Financial Planner Board of Standards Inc. CFP Board does not endorse any review course or receive financial remuneration from review course providers.
GARP does not endorse, promote, review, or warrant the accuracy of the products or services offered by Kaplan of FRM related information, nor does it endorse any pass rates claimed by the provider. Further, GARP is not responsible for any fees or costs paid by the user to Kaplan, nor is GARP responsible for any fees or costs of any person or entity providing any services to Kaplan. FRM, GARP, and Global Association of Risk Professionals are trademarks owned by the Global Association of Risk Professionals, Inc.
CAIAA does not endorse, promote, review or warrant the accuracy of the products or services offered by Kaplan, nor does it endorse any pass rates claimed by the provider. CAIAA is not responsible for any fees or costs paid by the user to Kaplan nor is CAIAA responsible for any fees or costs of any person or entity providing any services to Kaplan. GAIA, CAIA Association, Chartered Alternative Investment Analyst, and Chartered Alternative Investment Analyst Association are service marks and trademarks owned by CHARTERED ALTERNATIVE INVESTMENT ANALYST ASSOCIATION, INC., a Massachusetts non-profit corporation with its principal place of business at Amherst, Massachusetts, and are used by permission.
2018 SchweserNotes
Part
FRMExam Prep
Risk Management and Investment Management; Current Issues in Financial Markets
eBook 4
Getting Started FRM Exam Part II Welcome As the VP of Advanced Designations at Kaplan Schweser, I am pleased to have the opportunity to help you prepare for the 2018 FRM Exam. Getting an early start on your study program is important for you to sufficiently prepare, practice, and perform on exam day. Proper planning will allow you to set aside enough time to master the learning objectives in the Part II curriculum. Now that you’ve received your SchweserNotes, here’s how to get started:
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Attend our Live Online Weekly Class or review the on-demand archives as often as you like. Our expert faculty will guide you through the FRM curriculum with a structured approach to help you prepare for the exam. (See our instruction packages to the right. Visit www.schweser.com/frm to order.)
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FRM Pa r t II Bo o k 4: Ri s k M a n a g e m e n t a n d In v e s t m e n t M a n a g e m e n t ; C u r r e n t Is s u e s i n Fi n a n c i a l M a r k e t s
Re a d in g As s ig n m e n t s a n d Le a r n in g O b j e c t iv e s Ris k M a n a g e m e n t a n d In v e s t m e n t M a n a g e m e n t
62: Factor Theory 63: Factors 64: Alpha (and the Low-Risk .Anomaly) 63: Illiquid Assets 66: Portfolio Construction 67: Portfolio Risk: Analytical Methods 68: VaR and Risk Budgeting in Investment Management 69: Risk Monitoring and Performance Measurement 70: Portfolio Performance Evaluation 71: Hedge Funds 72: Performing Due Diligence on Specific Managers and Funds
C u r r e n t Is s u e s in Fin a n c ia l M a r k e t s
v
1 13 31 47 61 73 90 106 117 139 151
73: The New Era of Expected Credit Loss Provisioning 165 74: Big Data: New Tricks for Econometrics 172 75: Machine Learning: A Revolution in Risk Management and Compliance? 182 76: Central Clearing and Risk Transformation 191 77: The Bank/Capital Markets Nexus Goes Global 201 78: FinTech Credit: Market Structure, Business Models
and Financial Stability Implications
209
79: The Gordon Gekko Effect: The Role of Culture in the
Financial Industry
Se l f -Te s t : Ris k M a n a g e m e n t a n d In v e s t m e n t M a n a g e m e n t ; C u r r e n t Is s u e s in Fin a n c ia l M a r k e t s Fo r m u l a s Ap p e n d ix In d e x
227
242 248 251 255
2018 Kaplan, Inc.
Page iii
FRM 2018 PART II BOOK 4: RISK MANAGEMENT AND INVESTMENT MANAGEMENT; CURRENT ISSUES IN FINANCIAL MARKETS 2018 Kaplan, Inc. All rights reserved. Published in 2018 by Kaplan, Inc. Printed in the United States of America. ISBN: 978-1-4754-7035-2
Required Disclaimer: GARP does not endorse, promote, review, or warrant the accuracy of the products or services offered by Kaplan of FRM related information, nor does it endorse any pass rates claimed by the provider. Further, GARP is not responsible for any fees or costs paid by the user to Kaplan, nor is GARP responsible for any fees or costs of any person or entity providing any services to Kaplan. FRM, GARP, and Global Association of Risk Professionals are trademarks owned by the Global Association of Risk Professionals, Inc. These materials may not be copied without written permission from the author. The unauthorized duplication of these notes is a violation of global copyright laws. Your assistance in pursuing potential violators of this law is greatly appreciated. Disclaimer: The SchweserNotes should be used in conjunction with the original readings as set forth by GARP. The information contained in these books is based on the original readings and is believed to be accurate. However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success.
Page iv
2018 Kaplan, Inc.
Re a d i n g A s s i g n m e n t s a n d Le a r n i n g O b j e c t i v e s
The following material is a review o f the Risk Management and Investment Management, and Current Issues in Financial Markets principles designed to address the learning objectives set forth by the Global Association o f Risk Professionals.
Re a d in g As s ig n m e n t s
Risk Management and Investment Management
.Andrew Ang, Asset Management: A Systematic Approach to Factor Investing (New York, NY: Oxford University Press, 2014).
62. Factor Theory, Chapter 6
63. Factors, Chapter 7
64. Alpha (and the Low-Risk Anomaly), Chapter 10
63. Illiquid Assets, Chapter 13
(page 1)
(page 13)
(page 31)
(page 47)
Richard Grinold and Ronald Kahn, Active Por folio Management: A Quantitative Approach for Producing Superior Returns and Controlling Risk, 2nd Edition (New York, NY: McGraw-Hill, 2000).
66. Portfolio Construction, Chapter 14
(page 61)
Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd Edition (New York, NY: McGraw-Hill, 2007).
67. Portfolio Risk: Analytical Methods, Chapter 7
(page 73)
68. VaR and Risk Budgeting in Investment Management, Chapter 17
(page 90)
Robert Litterman and the Quantitative Resources Group, Modern Investment Management: An Equilibrium Approach (Hoboken, NJ: John Wiley & Sons, 2003).
69. Risk Monitoring and Performance Measurement, Chapter 17
(page 106)
Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments, 10th Edition (New York, NY: McGraw-Hill, 2013).
70. Portfolio Performance Evaluation, Chapter 24
(page 117)
2018 Kaplan, Inc.
Page v
Book 4 Reading Assignments and Learning Objectives
George M. Constantinides, Milton Harris, and Rene M. Stulz, eds., Handbook o f the Economics o f Finance, Volume 2 B (Oxford, UK: Elsevier, 2013).
71. Hedge Funds, Chapter 17
(page 139)
Kevin R. Mirabile, Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance, 2nd Edition (Hoboken, NJ: Wiley Finance, 2016).
72. Performing Due Diligence on Specific Managers and Funds, Chapter 12
(page 131)
Current Issues in Financial Markets
73. Benjamin H. Cohen and Gerald A. Edwards, Jr., The New Era of Expected Credit Loss Provisioning, BIS Quarterly Review, March 2017. (page 163)
74. Hal Varian, Big Data: New Tricks for Econometrics, Journal o f Economic Perspectives 28, no. 2 (Spring 2014).
(page 172)
73. Bart van Liebergen, Machine Learning: A Revolution in Risk Management and Compliance? Institute of International Finance, April 2017.
(page 182)
76. Rama Cont, Central Clearing and Risk Transformation, Norges Bank Research, March 2017. (page 191)
77. Hyun Song Shin, The Bank/Capital Markets Nexus Goes Global, BIS Quarterly Review, November 2016. (page 201)
78. FinTech Credit: Market Structure, Business Models and Financial Stability Implications. BIS Committee on Global Financial Systems, May 2017.
(page 209)
79. Andrew W. Lo, The Gordon Gekko Effect: The Role of Culture in the Financial Industry, Federal Reserve Bank of New York Economic Policy Review 22, no. 1 (August 2016).
(page 227)
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2018 Kaplan, Inc.
Le a r n in g O b j e c t iv e s
62. Factor Theory
Book 4 Reading Assignments and Learning Objectives
After completing this reading, you should be able to: 1. Provide examples of factors that impact asset prices, and explain the theory of factor
risk premiums, (page 1)
2. Describe the capital asset pricing model (CAPM) including its assumptions, and
explain how factor risk is addressed in the CAPM. (page 2)
3. Explain implications of using the CAPM to value assets, including equilibrium and
optimal holdings, exposure to factor risk, its treatment of diversification benefits, and shortcomings of the CAPM. (page 2)
4. Describe multifactor models, and compare and contrast multifactor models to the
3. Explain how stochastic discount factors are created and apply them in the valuation
6. Describe efficient market theory and explain how markets can be inefficient.
CAPM. (page 6)
of assets, (page 6)
(page 8)
63. Factors
.After completing this reading, you should be able to: 1. Describe the process of value investing, and explain reasons why a value premium
may exist, (page 13)
2. Explain how different macroeconomic risk factors, including economic growth,
inflation, and volatility affect risk premiums and asset returns, (page 16)
3. Assess methods of mitigating volatility risk in a portfolio, and describe challenges
that arise when managing volatility risk, (page 19)
4. Explain how dynamic risk factors can be used in a multifactor model of asset
returns, using the Fama-French model as an example, (page 20)
5. Compare value and momentum investment strategies, including their risk and
return profiles, (page 22)
64. Alpha (and the Low-Risk Anomaly)
After completing this reading, you should be able to: 1. Describe and evaluate the low-risk anomaly of asset returns, (page 31) 2. Define and calculate alpha, tracking error, the information ratio, and the Sharpe
ratio, (page 31)
3. Explain the impact of benchmark choice on alpha, and describe characteristics of an
effective benchmark to measure alpha, (page 33)
4. Describe Grinolds fundamental law of active management, including its
assumptions and limitations, and calculate the information ratio using this law. (page 34)
5. Apply a factor regression to construct a benchmark with multiple factors, measure a portfolio s sensitivity to those factors, and measure alpha against that benchmark, (page 35)
6. Explain how to measure time-varying factor exposures and their use in style
7. Describe issues that arise when measuring alphas for nonlinear strategies, (page 39) 8. Compare the volatility anomaly and beta anomaly, and analyze evidence of each
analysis, (page 38)
anomaly, (page 40)
9. Describe potential explanations for the risk anomaly, (page 41)
2018 Kaplan, Inc.
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Book 4 Reading Assignments and Learning Objectives
65. Illiquid Assets
After completing this reading, you should be able to: 1. Evaluate the characteristics of illiquid markets, (page 47) 2. Examine the relationship between market imperfections and illiquidity, (page 48) 3. Assess the impact of biases on reported returns for illiquid assets, (page 49) 4. Describe the unsmoothing of returns and its properties, (page 49) 5. Compare illiquidity risk premiums across and within asset categories, (page 51) 6. Evaluate portfolio choice decisions on the inclusion of illiquid assets, (page 55)
66. Portfolio Construction
After completing this reading, you should be able to: 1. Distinguish among the inputs to the portfolio construction process, (page 61) 2. Evaluate the methods and motivation for refining alphas in the implementation
process, (page 61)
3. Describe neutralization and methods for refining alphas to be neutral, (page 62) 4. Describe the implications of transaction costs on portfolio construction, (page 63) 5. Assess the impact of practical issues in portfolio construction, such as determination
of risk aversion, incorporation of specific risk aversion, and proper alpha coverage. (page 64)
6. Describe portfolio revisions and rebalancing, and evaluate the tradeoffs between
alpha, risk, transaction costs, and time horizon, (page 65)
7. Determine the optimal no-trade region for rebalancing with transaction costs.
(page 65)
8. Evaluate the strengths and weaknesses of the following portfolio construction
techniques, screens, stratification, linear programming, and quadratic programming, (page 66)
9. Describe dispersion, explain its causes, and describe methods for controlling forms
of dispersion, (page 68)
67. Portfolio Risk: Analytical Methods
After completing this reading, you should be able to: 1. Define, calculate, and distinguish between the following portfolio VaR measures, individual VaR, incremental VaR, marginal VaR, component VaR, undiversified portfolio VaR, and diversified portfolio VaR. (page 73)
2. Explain the role of correlation on portfolio risk, (page 74) 3. Describe the challenges associated with VaR measurement as portfolio size increases,
(page 78)
(page 82)
a portfolio, (page 82)
4. Apply the concept of marginal VaR to guide decisions about portfolio VaR.
5. Explain the risk-minimizing position and the risk and return-optimizing position of
6. Explain the difference between risk management and portfolio management, and
describe how to use marginal VaR in portfolio management, (page 83)
68. VaR and Risk Budgeting in Investment Management
After completing this reading, you should be able to: 1. Define risk budgeting, (page 90) 2. Describe the impact of horizon, turnover, and leverage on the risk management
process in the investment management industry, (page 90)
3. Describe the investment process of large investors such as pension funds, (page 91)
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2018 Kaplan, Inc.
Book 4 Reading Assignments and Learning Objectives
4. Describe the risk management challenges associated with investments in hedge
funds, (page 92)
5. Distinguish among the following types of risk: absolute risk, relative risk, policy-
mix risk, active management risk, funding risk, and sponsor risk, (page 92)
6. Apply VaR to check compliance, monitor risk budgets, and reverse engineer sources
7. Explain how VaR can be used in the investment process and the development of
8. Describe the risk budgeting process and calculate risk budgets across asset classes
of risk, (page 95)
investment guidelines, (page 97)
and active managers, (page 98)
69. Risk Monitoring and Performance Measurement
After completing this reading, you should be able to: 1. Define, compare, and contrast VaR and tracking error as risk measures, (page 106) 2. Describe risk planning, including its objectives, effects, and the participants in its
development, (page 107)
(page 108)
3. Describe risk budgeting and the role of quantitative methods in risk budgeting.
4. Describe risk monitoring and its role in an internal control environment.
(page 108) Identify sources of risk consciousness within an organization, (page 108)
5. 6. Describe the objectives and actions of a risk management unit in an investment
7. Describe how risk monitoring can confirm that investment activities are consistent
management firm, (page 109)
with expectations, (page 110)
8. Explain the importance of liquidity considerations for a portfolio, (page 110) 9. Describe the use of alpha, benchmark, and peer group as inputs in performance
measurement tools, (page 112)
10. Describe the objectives of performance measurement, (page 111)
70. Portfolio Performance Evaluation
After completing this reading, you should be able to: 1. Differentiate between time-weighted and dollar-weighted returns of a portfolio and
describe their appropriate uses, (page 117)
2. Describe and distinguish between risk-adjusted performance measures, such as Sharpes measure, Treynors measure, Jensens measure (Jensens alpha), and information ratio, (page 120)
3. Describe the uses for the Modigliani-squared and Treynors measure in comparing
two portfolios, and the graphical representation of these measures, (page 120)
4. Determine the statistical significance of a performance measure using standard error
and the t-statistic. (page 127)
5. Explain the difficulties in measuring the performance of hedge funds, (page 128) 6. Explain how changes in portfolio risk levels can affect the use of the Sharpe ratio to
measure performance, (page 128)
7. Describe techniques to measure the market timing ability of fund managers with a regression and with a call option model, and compute return due to market timing. (page 129)
8. Describe style analysis, (page 131) 9. Describe and apply performance attribution procedures, including the asset allocation decision, sector and security selection decision, and the aggregate contribution, (page 131)
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71. Hedge Funds
After completing this reading, you should be able to: 1. Describe the characteristics of hedge funds and the hedge fund industry, and
compare hedge funds with mutual funds, (page 139)
2. Explain biases that are commonly found in databases of hedge funds, (page 139) 3. Explain the evolution of the hedge fund industry and describe landmark events that
precipitated major changes in the development of the industry, (page 139)
4. Evaluate the role of investors in shaping the hedge fund industry, (page 139) 3. Explain the relationship between risk and alpha in hedge funds, (page 140) 6. Compare and contrast the different hedge fund strategies, describe their return
characteristics, and describe the inherent risks of each strategy, (page 141)
7. Describe the historical portfolio construction and performance trend of hedge
funds compared to equity indices, (page 144)
8. Describe market events that resulted in a convergence of risk factors for different hedge fund strategies, and explain the impact of such a convergence on portfolio diversification strategies, (page 143)
9. Describe the problem of risk sharing asymmetry between principals and agents in
the hedge fund industry, (page 145)
10. Explain the impact of institutional investors on the hedge fund industry and assess reasons for the growing concentration of assets under management (AUM) in the industry, (page 146)
72. Performing Due Diligence on Specific Managers and Funds
After completing this reading, you should be able to: 1. 2. Explain elements of the due diligence process used to assess investment managers,
Identify reasons for the failures of funds in the past, (page 151)
(page 152) Identify themes and questions investors can consider when evaluating a manager, (page 153)
3.
4. Describe criteria that can be evaluated in assessing a funds risk management
5. Explain how due diligence can be performed on a funds operational environment,
process, (page 155)
(page 156)
(page 158)
(page 159)
6. Explain how a funds business model risk and its fraud risk can be assessed.
7. Describe elements that can be included as part of a due diligence questionnaire,
73. The New Era of Expected Credit Loss Provisioning After completing this reading, you should be able to: 1. Describe the reasons to provision for expected credit losses, (page 165) 2. Compare and contrast the key aspects of the IASB (IFRS 9) and FASB (CECL)
standards, (page 166)
(page 167)
3. Assess the progress banks have made in the implementation of the standards.
4. Examine the impact on the financial system posed by the standards, (page 168)
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74. Big Data: New Tricks for Econometrics
Book 4 Reading Assignments and Learning Objectives
After completing this reading, you should be able to: 1. Describe the issues unique to big datasets, (page 172) 2. Explain and assess different tools and techniques for manipulating and analyzing
3. Examine the areas for collaboration between econometrics and machine learning,
big data, (page 173)
(page 177)
73. Machine Learning: A Revolution in Risk Management and Compliance?
After completing this reading, you should be able to: 1. Describe the process of machine learning and compare machine learning
approaches, (page 182)
2. Describe the application of machine learning approaches within the financial
services sector and the types of problems to which they can be applied, (page 184)
3. Analyze the application of machine learning in three use cases:)
Credit risk and revenue modeling)
Fraud) Fraud) Surveillance of conduct and market abuse in trading (page 184)
76. Central Clearing and Risk Transformation
After completing this reading, you should be able to: 1. Examine how the clearing of over-the-counter transactions through central
counterparties has affected risks in the financial system, (page 191)
2. Assess whether central clearing has enhanced financial stability and reduced
systemic risk, (page 192)
3. Describe the transformation of counterparty risk into liquidity risk, (page 193) 4. Explain how liquidity of clearing members and liquidity resources of CCPs affect
risk management and financial stability, (page 193)
3. Compare and assess methods a CCP can use to help recover capital when a member
defaults or when a liquidity crisis occurs, (page 196)
77. The Bank/Capital Markets Nexus Goes Global
After completing this reading, you should be able to: 1. Describe the links between banks and capital markets, (page 201) 2. Explain the effects of forced deleveraging and the failure of covered interest rate
3. Discuss the US dollars role as the measure of the appetite for leverage, (page 203) 4. Describe the implications of a stronger US dollar on financial stability and the real
parity, (page 201)
economy, (page 204)
78. FinTech Credit: Market Structure, Business Models and Financial Stability
Implications After completing this reading, you should be able to: 1. Describe how FinTech credit markets are likely to develop and how they will affect
the nature of credit provision and the traditional banking sector, (page 209)
2. Analyze the functioning of FinTech credit markets and activities, and assess the
potential microfinancial benefits and risks of these activities, (page 211)
3. Examine the implications for financial stability in the event that FinTech credit
grows to account for a significant share of overall credit, (page 219)
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Book 4 Reading Assignments and Learning Objectives
79. The Gordon Gekko Effect: The Role of Culture in the Financial Industry
After completing this reading, you should be able to: 1. Explain how different factors can influence the culture of a corporation in both
positive and negative ways, (page 227)
2. Examine the role of culture in the context of financial risk management, (page 230) 3. Describe the framework for analyzing culture in the context of financial practices
and institutions, (page 231)
4. Analyze the importance of culture and a framework that can be used to change or
improve a corporate culture, (page 234)
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The following is a review of the Risk Management and Investment Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
Fa c t o r Th e o r y
Topic 62
Ex a m Fo c u s
In this topic, we introduce factor theory and factor risk. A key point is that it is not the exposure to an asset that is rewarded, but the exposure to the underlying factors. The risk of these factors is being rewarded with risk premiums. Several factor theories are introduced, including the capital asset pricing model (CAPM) and multifactor models. For the exam, understand the key assumptions of the CAPM while recognizing the models limitations in a real-world setting, and be able to contrast the CAPM with the assumptions of multifactor models. Through multifactor models, we introduce the concept of a stochastic discount factor, which is a random variable used in pricing an asset. Finally, be familiar with the efficient market hypothesis, since it identifies areas of market inefficiencies that can be exploited through active management.
Fa c t o r s Th a t Im pa c t As s e t P r ic e s

LO 61.3: Explain practices for managing ML/FT risks in a group-wide and cross-border context, and describe the roles and responsibilities of supervisors in managing these risks.
ML/FT Risk Management for Cross-Border Banks
When a bank operates in multiple jurisdictions, it is subject to numerous country regulations. Each banking group {group refers to an organizations one or more banks and the branches and subsidiaries of the bank(s)] should develop group-wide AML/ CFT policies and procedures and consistently apply those policies across the groups international operations. Policies should be consistently applied (and supportive of the groups broader policies and procedures regarding ML/FT risks) even if requirements differ across jurisdictions. If the host jurisdictions requirements are stricter than the groups home country, the branch or subsidiary should adopt the host jurisdiction requirements.
If a host country does not permit the proper implementation of FATF standards, then the chief AML/CFT officer should inform home supervisors. In some instances, the bank may need to close operations in the host country.
In a cross-border context, AML/CFT procedures are more challenging than other risk management processes because some jurisdictions restrict a banks ability to transmit customer names and balances across national borders. However, for risk management purposes, it is essential that banks be able to, subject to legal protections, share information about customers with head offices or the parent bank.
Risk assessment and management activities, such as customer risk assessments, group-wide risk assessments, and internal and external audits, apply to multi-national banks. When business is being referred to a bank, the banks own AML/CFT standards must be used in place of the jurisdiction of the referring bank, unless the introducer is in a jurisdiction with equal or stricter standards and requirements.
Banks involved in cross-border activities should:
Integrate information on the customer, beneficial owners of the customer, and the funds involved in the transaction(s).
Monitor significant customer relationships, balances, and activity on a consolidated basis whether the account is on- or off-balance sheet, as assets under management (AUM), or on a fiduciary basis.
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Appoint a chief AML/CFT officer for the whole group who must ensure group-wide
compliance (across borders) of AML/CFT requirements.
Oversee the coordination of group-wide information sharing. The head office should be informed of information regarding high-risk customers. Local data protection and privacy laws must be considered.
For larger banks, the ability to centralize bank processing systems and databases may allow for more effective and efficient risk management.
Role of Supervisors
Bank supervisors are expected to: Comply with FATF Recommendation 26 and apply the Core Principles fo r Effective
Banking Supervision as it relates to the supervision of AML/CFT risks. FATF states the principles that are relevant to money laundering and the financing of terrorism. Set out supervisory expectations governing banks AML/CFT policies and procedures.
Adopt a risk-based approach to supervising banks ML/FT risk management systems. To Understand the risks present in other jurisdictions and the impact on the supervised that end, supervisors must:
Understand the risks present in other jurisdictions and the impact on the supervised Evaluate the adequacy of the banks risk assessment based on the jurisdictions
Evaluate the adequacy of the banks risk assessment based on the jurisdictions
banks.
national risk assessments. Assess the banks risks in terms of the customer base, products and services, and
Assess the banks risks in terms of the customer base, products and services, and
geographical locations in which the bank and its customers do business. Evaluate the effectiveness in implementation of the controls (e.g., CDD) designed
Evaluate the effectiveness in implementation of the controls (e.g., CDD) designed
by the bank to meet AML/CFT obligations. Allocate resources to conduct effective reviews of the identified risks.
Allocate resources to conduct effective reviews of the identified risks.
Protect the integrity of the financial system by protecting the safety and soundness
of banks relative to ML/FT risk management. This means making it clear that supervisors will take action, action that may be severe and public, against banks and their officers who fail to follow their own internal procedures and regulatory requirements. Make sure the stricter of two jurisdictions requirements is applied.
Make sure the stricter of two jurisdictions requirements is applied.
Verify a banks compliance with group-wide AML/CFT policies and procedures
during on-site inspections.
Extend full cooperation and assistance to home-country supervisors who need
to assess a banks overseas compliance with group-wide AML/CFT policies and procedures. Ensure there is a group audit and determine the scope and frequency of audits of the
Ensure there is a group audit and determine the scope and frequency of audits of the
groups AML/CFT risk management procedures. Ensure the confidentiality of customer information provided to supervisors.
Ensure the confidentiality of customer information provided to supervisors.
Make sure that supervisors are not classified as third parties in countries where there are restrictions on the disclosure of customer information to third parties.
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Topic 61 Cross Reference to GARP Assigned Reading – Basel Committee on Banking Superversion

LO 61.2: Describe recommended practices for the acceptance, verification, and identification of customers at a bank.
Customer Acceptance
Sources of income and wealth. Banks must determine which customers pose a high risk of ML/FT. Factors the bank should consider include the customers: Background. Occupation including public and/or high profile figures. Business activities.
Country of origin. Country of residence, if different from country of origin. Choice and use of bank products and services. Nature and purpose of the bank account. Linked accounts. For lower-risk customers, simplified assessment procedures may be used (e.g., a customer with low balances who uses the account for routine banking needs). Also, the customer acceptance standards must not be so restrictive that they deny access to the general public, especially financially or socially disadvantaged persons.
Enhanced due diligence may be required for: Accounts with large balances and regular cross-border wire transfers. A politically exposed person (PEP), especially foreign PEPs.
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Banks must determine the risks they are willing to accept in order to do business with higher-risk customers. The bank must also determine the circumstances under which it will not accept a new business relationship or will terminate an existing relationship.
Customer Verification
The Financial Action Task Force (FATF) Recommendation 10 defines a customer as any person entering into a business relationship with a bank or carrying out an occasional financial transaction with a bank. Banks must, according to FATF standards, identify customers and verify their identity. Banks must establish a systematic procedure for identifying and verifying customers. In some cases, the bank must identify and verify a person acting on behalf of a beneficial owner(s).
In terms of verification of a persons identity, the bank must be aware that the best documentation is that which is difficult to forge or to obtain illicitly. A bank may require a written declaration of the identity of a beneficial owner but should not rely solely on such a declaration. A bank must not forgo identification and verification simply because the customer cannot be present for an interview. The bank should pay particular attention to customers from jurisdictions that are known to have AML/CFT deficiencies. Enhanced due diligence is called for in these circumstances.
Customer Identification
Size of the transactions of the customer. In order to develop customer risk profiles (or categories of customers), the bank should collect data pertaining to the: Purpose of the relationship or of the occasional banking transaction. Level of assets.
Regularity or duration of the banking relationship. Expected level of activity. Types of transactions.
The bank should identify normal behavior for particular customers or categories of customers and activities that deviate from normal and might be labeled unusual or suspicious.
Sources of customer funds, income, or wealth (if necessary).
Identity cards. Customer identification documentation may include: Passports.
Driving licenses. Account files such as financial transaction records. Business correspondence. If the bank cannot perform CDD, it should not open the account or perform a transaction. If the bank must, so as to not interrupt the normal conduct of business, engage in a business transaction prior to verification, and ultimately cannot verify the customers identity, then the bank should consider filing an STR. The customer should not be informed that the STR has been or will be filed, either directly or indirectly.
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If the bank believes a customer has been refused banking services from another bank due to concerns about illicit activities, the bank should consider classifying the customer as high risk and engage in enhanced CDD or reject the customer altogether. If the customer insists on anonymity (or gives an obviously fictitious name), the bank should refuse to accept the customer. Numbered accounts may provide a level of confidentiality for a customer, but the bank must still verify the identity of the account holder.
Ongoing monitoring of customer accounts and vigilant record-keeping are necessary to ML/FT risk management.

LO 61.1: Explain best practices recommended by the Basel Committee for the assessment, management, mitigation, and monitoring of money laundering and financial terrorism (ML/FT) risks.
The Basel committee (referred to as the Committee) is committed to combating money laundering (ML) and the financing of terrorism (FT) as part of its mandate to enhance worldwide financial stability via a strengthening of regulation, supervision, and bank practices. The Committee has a long-standing commitment to sound Anti-Money Laundering and Countering Financing of Terrorism (AML/CFT) policies and procedures in banks. Banks without sound ML/FT risk management practices are exposed to serious risks including, but not limited to: reputational, operational, compliance, and concentration risks. Costs associated with these risks include fines and sanctions by regulators, the termination of wholesale funding and facilities, claims against the bank, loan losses, asset seizures, asset freezes, and investigative costs.
Risk Assessment
The Committees Core Principles fo r Effective Banking Supervision was updated in 2012 and requires that all banks, have adequate policies and processes, including strict customer due diligence (CDD) rules to promote high ethical and professional standards in the banking sector and prevent the bank from being used, intentionally or unintentionally, for criminal activities. Sound risk management means the bank must identify and manage
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Topic 61 Cross Reference to GARP Assigned Reading – Basel Committee on Banking Supervision
ML/FT risks, designing and implementing policies and procedures corresponding to the identified risks. These risks must be assessed at the country, sector, bank, and business relationship levels. The bank must have policies and procedures for: Customer identification. Customer due diligence. Customer acceptance. Monitoring of business relationships. Monitoring of business operations. The bank must develop a thorough understanding of ML/FT risks present in: The customer base. The banks products and services. The delivery channels for products and services, including products and services in the
development stage.
The jurisdictions within which the bank and the banks customers do business. The banks understanding of inherent ML/FT risks is based on both internal and external data sources, including operational and transaction data (internal) and national risk assessments and country reports from international organizations (external).
Risk Management
Proper governance arrangements are necessary for the management of ML/FT risks. Prior publications from the Committee (specifically, The Internal Audit Function in Banks, June 2012, Principles fo r Enhancing Corporate Governance, October 2010, and Compliance and the Compliance Function in Banks, April 2005) describe proper governance arrangements. In particular, these publications require the board of directors to approve and oversee risk policies, risk management activities, and compliance. These functions are critical to the management and mitigation of ML/FT risks. ML/FT risk assessments must be communicated to the board of directors in a timely, complete, accurate, and understandable manner.
The board of directors and senior management should appoint a qualified chief AML/ CFT officer with the stature and authority to garner the attention of the board, senior management, and business lines when ML/FT issues arise.
Risk Mitigation
First line o f defense. The business units (e.g., the front office and customer facing activities) are the first line of defense in identifying, assessing, and controlling ML/FT risks. Policies and procedures should be specified in writing and communicated to bank personnel. Employees should know what they are supposed to do and how to comply with regulations. There should be procedures in place for detecting and reporting suspicious transactions. High ethical and professional standards are essential. The bank should carry out employee training on how to identify and report suspicious transactions.
Second line o f defense. The chief officer in charge of AML/CFT is the second line of defense. The officer should engage in ongoing monitoring and the fulfillment of AML/CFT duties. The officer should be the contact person for .AML/CFT issues both internally and externally
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[e.g., supervisory authorities and financial intelligence units (FIUs)]. To avoid conflicts of interest, the officer should not have business line responsibilities or be responsible for data protection or internal audits. The officer may also be the chief risk officer and should have a direct reporting line to senior management and/or the board of directors.
Third line o f defense. The third line of defense is internal audits. The bank should establish policies for conducting internal audits of the banks AML/CFT policies. External audits may also play a role in evaluating a banks policies and procedures with respect to the AML/CFT function.
Risk Monitoring
The banks risk monitoring systems should be commensurate with the banks size, activities, and complexity. For most banks, and especially for banks that are internationally active, some of the monitoring activities will be automated. A bank must document its decision to forgo information technology (IT) monitoring and demonstrate an effective alternative. Monitoring systems should be able to provide accurate information to senior management on issues such as changes in the transactional profiles of bank customers. The IT system should also enable a bank to determine its own criteria for monitoring and filing suspicious transaction reports (STR) or taking other steps to minimize ML/FT risks. Internal audits should evaluate the effectiveness of IT monitoring systems.

LO 60.3: Explain proposed modifications to Basel regulations in the following areas: Classification of positions in the trading book compared to the banking book Treatment of credit spread and jump-to-default risk, including the incremental
default risk charge
The FRTB also addressed regulatory modifications. One modification is to clarify if a risk asset should be considered part of the trading book or the banking book. Historically, the trading book consisted of risk assets that the bank intended to trade. Trading book assets have been periodically marked-to-market. The banking book has consisted of assets that are intended to be held until maturity, and they are held on the books at cost. Banking book assets are subject to more stringent credit risk capital rules, while trading book assets are subject to market risk capital rules. Using different rules has enabled a form of regulatory arbitrage where banks will hold credit-dependent assets in the trading book to relax capital requirements.
In an attempt to mitigate this regulatory arbitrage, the FRTB makes a specific distinction between assets held in the trading book and those held in the banking book. To be allocated to the trading book, the bank must prove more than an intent to trade. They must meet dual criteria of: (1) being able to trade the asset, and (2) physically managing the associated risks of the underlying asset on the trading desk. If these two criteria are met, then an asset can be allocated to the trading book, but the day-to-day price fluctuations must also affect the banks equity position and pose a risk to bank solvency.
.Another important distinction was made in terms of reclassification between a banking book asset and a trading book asset. Once an asset has been acquired and initially assigned to either the trading book or the banking book, it cannot be reclassified except for extraordinary circumstances. This roadblock has been established to minimize the act of switching between categories at will, based on how capital requirements are calculated.
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An example of an extraordinary circumstance is if the bank changes accounting practices that is a firm-wide shift. Another caveat is that any benefit derived from calculating capital requirements under a post-shift category is disallowed. The capital requirement of the original method must be retained.
Basel II. 5 also introduced the incremental risk charge (IRC) to further mitigate this regulatory arbitrage. The IRC recognizes two different types of risk created by credit- dependent risk assets: (1) credit spread risk, and (2) jump-to-default risk.
Credit spread risk is the risk that a credit risk assets credit spread might change and thus cause the mark-to-market value of the asset to change. This risk can be addressed by using the expected shortfall calculation process discussed earlier. The IRC process allows banks to assume a constant level of risk. This means that it is assumed that positions that deteriorate are replaced with other risk assets. For example, if a bank has an A-rated bond with a three- month liquidity horizon that suffers a credit-related loss, then it is assumed that the bank replaces this risk asset with another A-rated bond at the end of the three-month liquidity horizon. This is clearly a simplifying assumption, which is being replaced with incremental marking-to-market without assuming replacement under the FRTB proposals.
Jump-to-default risk is the risk that there will be a default by the issuing company of the risk asset. A default would lead to an immediate and potentially significant loss for the bank that holds the defaulted issuers risk asset. This risk is subject to an incremental default risk (IDR) charge. The IDR calculation applies to all risk assets (including equities) that are subject to default. It is calculated based on a 99.9% VaR with a one-year time horizon.
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K e y C o n c e p t s
LO 60.1 The Fundamental Review of the Trading Book (FRTB) is changing the historical reliance on 10-day value at risk (VaR) with a 99% confidence interval combined with a 250-day stressed VaR. The new calculation will require the use of expected shortfall with a 97.5% confidence interval. This switch will better capture the value of capital at risk below a certain confidence interval.
LO 60.2 The FRTB is establishing various liquidity horizons, which are the length of time required to execute transactions that extinguish an exposure to a risk factor, without moving the price of the hedging instruments, in stressed market conditions. The expected shortfall will then be calculated by structuring risk assets into categories and solving for an overall value of expected shortfall for a banks risk assets.
LO 60.3 Some banks have engaged in regulatory arbitrage by actively switching assets between the trading book and the banking book depending on which category would show their capital requirements in a more favorable light. The FRTB is mitigating this arbitrage opportunity by deploying a rules-based standard for classification into these categories and a roadblock for easily switching between them.
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C o n c e p t C h e c k e r s
1.
2.
3.
4.
5.
Which of the following statements regarding the differences between Basel I, Basel II. 5, and the Fundamental Review of the Trading Book (FRTB) for market risk capital calculations is incorrect? A. Both Basel I and Basel II. 5 require calculation of VaR with a 99% confidence
B. FRTB requires the calculation of expected shortfall with a 97.5% confidence
C. FRTB requires adding a stressed VaR measure to complement the expected
interval.
interval.
shortfall calculation.
D. The 10-day time horizon for market risk capital proposed under Basel I
incorporates a recent period of time, which typically ranges from one to four years.
What is the difference between using a 95% value at risk (VaR) and a 95% expected shortfall (ES) for a bond portfolio with $825 million in assets and a probability of default of 3%? A. Both measures will show the same result. B. The VaR shows a loss of $495 million while the expected shortfall shows no loss. C. The VaR shows no loss while the expected shortfall shows a $495 million loss. D. The VaR shows no loss while the expected shortfall shows a $395 million loss.
Which of the following statements best describe how the internal models-based approach (IMA) incorporates various liquidity horizons into the expected shortfall calculation? A. A rolling 10-day approach is used over a 250-day window of time. B. Smaller time periods are used to extrapolate into larger time periods. C. A series of weights are applied to the various liquidity horizons along with a
correlation factor determined by the Basel Committee.
D. The expected shortfall is based on a waterfall of the liquidity horizon categories and is then scaled to the square root of the difference in the horizon lengths of the nested risk factors.
Which of the following statements represents a criteria for classifying an asset into the trading book? I. The bank must be able to physically trade the asset. II. The risk of the asset must be managed by the banks trading desk. A. I only. B. II only. C. Both I and II. D. Neither I nor II.
Which of the following risks is specifically recognized by the incremental risk charge (IRC)? A. Expected shortfall risk, because it is important to understand the amount of loss
B. Jump-to-default risk, as measured by 99% VaR, because a default could cause a
potential in the tail.
significant loss for the bank.
C. Equity price risk, because a change in market prices could materially impact
mark-to-market accounting for risk.
D. Interest rate risk, as measured by 97.5% expected shortfall, because an increase
in interest rates could cause a significant loss for the bank.
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C o n c e pt C h e c k e r An s w e r s
1. C Basel I and Basel II. 5 use VaR with a 99% confidence interval and the FRTB uses the
expected shortfall with a 97.5% confidence interval. Basel I market risk capital requirements produced a very current result because the 10-day horizon incorporated a recent period of time. The FRTB does not require adding a stressed VaR to the expected shortfall calculation. It was Basel II.5 that required the addition of a stressed VaR.
2. C The VaR measure would show a $0 loss because the probability of default is less than 5%. Having a 3% probability means that three out of five times, in the tail, the portfolio will experience a total loss. The potential loss is $495 million (=3/5 x $825 million).
3. D The expected shortfall is based on a waterfall of the liquidity horizon categories and is then scaled to the square root of the difference in the horizon lengths of the nested risk factors.
4. C The criteria for classification as a trading book asset are: (1) the bank must be able to
physically trade the asset, and (2) the bank must manage the associated risks on the trading desk.
5. B The two types of risk recognized by the incremental risk charge are: (1) credit spread risk,
and (2) jump-to-default risk. Jump-to-default risk is measured by 99% VaR and not 97.5% expected shortfall.
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The following is a review of the Operational and Integrated Risk Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
So u n d Ma n a g e me n t o f Ri s k s Re l a t e d t o M o n e y La u n d e r i n g a n d Fi n a n c i n g o f Te r r o r i s m
Topic 61
E x a m F o c u s
This topic focuses on the Basel Committees recommendations for identifying, assessing, and managing the risks associated with money laundering and the financing of terrorism (ML/FT) through banks. The concept of customer due diligence (CDD) is important and focuses on the precautionary steps a bank must take to ensure it knows the true identities of the customers with which it is dealing. Because many of the higher risk situations arise out of international, cross-border transactions, much of the recommendations focus on the risks associated with these activities. For the exam, understand who bears the ultimate responsibility for customer identification and verification, even if a third party is hired to carry out CDD. Also, know the responsibilities of both the correspondent and respondent banks in a correspondent banking relationship.
B e s t P r a c t
i c e s

LO 60.2: Compare the various liquidity horizons proposed by the Fundamental Review of the Trading Book (FRTB) for different asset classes and explain how a bank can calculate its expected shortfall using the various horizons.
According to the Basel Committee, a liquidity horizon (LH) is the time required to execute transactions that extinguish an exposure to a risk factor, without moving the price of the hedging instruments, in stressed market conditions. The standard 10-day LH was not deemed appropriate given the actual variations in liquidity of the underlying transactions. Five different liquidity horizons are now in use: 10 days, 20 days, 60 days, 120 days, and 250 days. Consider the 60-day horizon, which is essentially three months worth of trading days. The calculation of regulatory capital for a 60-day horizon is intended to shelter a bank from significant risks while waiting three months to recover from underlying price volatility.
Under FRTB proposals, every risk factor is assigned a liquidity horizon for capital calculations. For example, investment grade sovereign credit spreads are assigned a 20- day horizon, while non-investment grade corporate credit spreads are assigned a 120-day horizon and structured products have a 250-day horizon. See Figure 2 for a sample listing of liquidity horizons.
Figure 2: Allocation of Risk Factors to Liquidity Horizons
Risk Factors
Horizon (in Days)
Interest rate (EUR, USD, GBP, AUD, JPY, SEK, and CAD) Interest rate (other) Interest rate at-the-money (ATM) volatility Credit spread: sovereign, investment grade Credit spread: sovereign, non-investment grade Credit spread: corporate, investment grade Credit spread: corporate, non-investment grade Credit spread: structured products Equity price: large cap Equity price: small cap Equity price: large cap ATM volatility Equity price: small cap ATM volatility FX rate (liquid currency pairs) FX rate (other currency pairs) FX volatility Energy price Precious metal price Energy price ATM volatility Precious metal ATM volatility
10 20 60 20 60 60 120 250 10 20 20 120 10 20 60 20 20 60 60
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Topic 60 Cross Reference to GARP Assigned Reading – Hull, Chapter 17
The Basel committees original idea was to utilize overlapping time periods for stress testing. They initially wanted to find a time periods expected shortfall (ES) by scaling smaller time periods up to longer time periods using a series of trials. Consider a bank that has a 10- day risk asset, like large-cap equity, and a 120-day risk asset, like a non-investment grade corporate credit spread. In the first trial, they would measure the stressed P&L changes from Day 0 to Day 10 for the large-cap equity and also the value change from Day 0 to Day 120 for the non-investment grade corporate credit spread. The next trial would measure the change from Day 1 to Day 11 on the large-cap equity and from Day 1 to Day 121 for the credit spread. The final simulated trial would measure Day 249 to Day 259 for the large- cap equity and Day 249 to Day 369 for the credit spread. The ES used would then be the average loss in the lower 2.5% tail of the distribution of the 250 trials.
After the initial idea was submitted for comments, it was revised in December 2014 to incorporate five categories. The rationale was to reduce implementation costs. The updated categories are as follows: Category 1 is for risk factors with 10-day horizons. Category 2 is for risk factors with 20-day horizons. Category 3 is for risk factors with 60-day horizons. Category 4 is for risk factors with 120-day horizons. Category 5 is for risk factors with 250-day horizons. Using this revised, categorical process attempts to account for the fact that risk factor shocks might not be correlated across liquidity horizons.
This proposed new process is formally known as the internal models-based approach (IMA). In the internal models-based approach, expected shortfall is measured over a base horizon of 10 days. The expected shortfall is measured through five successive shocks to the categories in a nested pairing scheme using ES15. ESj is calculated as a 10-day shock with intense volatility in all variables from category 15. ES2 is calculated as a 10-day shock in categories 25, holding category 1 constant. ES3 is calculated as a 10-day shock in categories 35, holding category 1 and 2 constant. ES4 is calculated as a 10-day shock in categories 45, holding categories 13 constant. The final trial, ES5, is calculated as a 10-day shock in category 5, holding categories 14 constant. The idea is to measure the hit to the banks P&L for ES15. The overall ES is based on a waterfall of the categories, as described above, and is scaled to the square root of the difference in the horizon lengths of the nested risk factors. This relationship is shown in the following formula:
Until the internal models-based approach has been formally approved, banks must continue to use what is known as the revised standardized approach. This process groups risk assets with similar risk characteristics into buckets, which are essentially just organized around
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Topic 60 Cross Reference to GARP Assigned Reading – Hull, Chapter 17
liquidity horizons. The standardized risk measure for each bucket is then calculated using the following formula:
+ 2 ^ y ^ p ijw iw jv iv j
i
i
j