Temp_store

LO 38.3: Describe the development and implementation of an ERM system, as well as challenges to the implementation of an ERM system.
In developing an ERM, management should follow this framework: Determine the firm s acceptable level o f risk. The critical component of this determination
is selecting the probability of financial distress that maximizes the value of the firm. Financial distress in this context means any time the firm must forego projects with positive net present values, due to inadequate resources. The likelihood of financial distress could be minimized by investing all funds into U.S. Treasury securities, but this should not be the firms objective. The objective should be maximizing firm value by selecting an appropriate probability of distress. For many firms, the proxy used for measuring the probability of distress is the firms credit rating assigned by external agencies. Thus, the firm may determine that the objective under ERM is to avoid a minimum credit rating below BBB. If the firm is currently rated AA, for example, the likelihood of falling below BBB can be estimated by average data supplied by the rating agency.
Based on the firm s target debt rating, estimate the capital (i.e., buffer) required to support
the current level o f risk in the firm s operations. In other words, how much capital does the firm need to have (on hand or available externally) to ensure that it can avoid financial distress. A company with liquid assets sufficient to fund all of its positive NPV projects would not be exposed to the underinvestment problem when it encountered cash flow deficits. Thus, risk management can be viewed as a substitute for investing equity capital in liquid assets. Keeping a large amount of equity in the form of liquid assets is costly. Instead of maintaining a large liquid asset buffer, a company can institute a risk management program to ensure (at some level of statistical significance) that its operating cash flow will not fall below the level needed to fund valuable projects. That is, the firm can take actions to limit the probability of financial distress to a level that maximizes firm value. The goal of ERM is to optimize (not eliminate) total risk by trading off the expected returns from taking risks with the expected costs of financial distress.
Determine the ideal mix o f capital and risk that will achieve the appropriate debt rating. At this level of capital, the firm will be indifferent between increasing capital and decreasing risk.
Decentralize the risk/capital tradeoff by giving individual managers the information and the
incentive they need to make decisions appropriate to maintain the risk/capital tradeoff.
The implementation steps of ERM are as follows: Step 1: Identify the risks o f the firm. For many banks, risks are classified as falling into one of three categories: market, credit, or operational. Other financial institutions broaden the list to include asset, liability, liquidity, and strategic risks. Identification of risks should be performed both top-down (by senior management) and bottom-up (by individual managers of business units or other functional areas).
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Step 2: Develop a consistent method to evaluate the firm s exposure to the risks identified above. If the methodology is not consistent, the ERM system will fail because capital will be mis-allocated across business units.
Implementation of an ERM system is challenging, and it is important that the entire organization supports the system. Thus, it is critical for all levels of the organization to understand how the system is designed and how it can create value. Monitoring the ERM system may be neglected due to its time-consuming nature. However, the inability to identify relevant risks on a regular basis could lead to corporate failures.
E c o n o m i c V a l u e v s . A c c o u n t i n g V a l u e
Credit ratings are typically based on accounting data, combined with some level of subjective assessment by analysts. Economic value, as determined by management, may very well be a more accurate reflection of the true value of the firm.
In determining whether accounting value or economic value is more relevant, the firm must consider its objective. If the objective is to manage the probability of default, the question of how default is determined becomes important. If default is determined by failure to meet certain accounting measures (e.g., debt ratio, interest coverage), then accounting measures will be a critical component of meeting the objectives.
If the objective is to manage the present value of future cash flows, then economic measures may be more appropriate than accounting measurements that do not accurately capture economic reality. Management must consider that managing economic value may lead to more volatile accounting earnings, which may ultimately affect economic value as well.
R i s k A g g r e g a t i o n

LO 38.2: Explain how a company can determine its optimal amount of risk through the use of credit rating targets.

LO 38.1: Define enterprise risk management (ERM) and explain how implementing ERM practices and policies can create shareholder value, both at the macro and the micro level.
A business can manage its risks separately, one at a time, or all together in a cohesive framework. Enterprise risk management (ERM) is the process of managing all of a corporations risks within an integrated framework.
The benefit of ERM is that a comprehensive program for managing risk allows the business to achieve its ideal balance of risk and return.
Macro Level
At the macro level, ERM allows management to optimize the firms risk/return tradeoff. This optimization assures access to the capital needed to execute the firms strategic plan.
The perfect markets view of finance implies that a companys cost of capital is unrelated to its diversifiable risk. Rather, the cost of capital is determined by the firms systematic risk (also referred to as nondiversifiable, market, or beta risk). According to this view, efforts to hedge diversifiable risk provide no benefit to shareholders, who can eliminate this risk by diversifying their portfolios.
However, reducing diversifiable risk can be beneficial when markets are imperfect. Suppose a firm experiences a large and unexpected drop in its operating cash flow and does not have
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funds sufficient to fund valuable investment opportunities. In perfect markets, the firm would be able to raise funds on fair terms to fund all of its value-creating projects. When markets are not perfect (i.e., investors information about project values is incomplete), the firm may not be able to raise the needed funds on fair terms. This can lead to the underinvestment problem, where the company passes up valuable strategic investments rather than raise equity on onerous terms. The inability to fund strategic investments on a timely basis can result in a permanent reduction in shareholder value, even if the cash shortfall is temporary. By hedging diversifiable risks, the company reduces the likelihood of facing the underinvestment problem. Thus, the primary function of corporate risk management is to protect the companys strategic plan by ensuring timely investment. The ability to carry out the strategic plan in a timely manner confers an advantage over competitors who are unable to do so.
Micro Level
In order for ERM to achieve the objective of optimizing the risk/return tradeoff, each project must be evaluated not only for the inherent risk of the project but also for the effect on the overall risk of the firm. Thus, ERM requires that managers throughout the firm be aware of the ERM program. This decentralization of evaluating the risk/return tradeoff has two components: Any managers evaluating new projects must consider the risks of the project in the
context of how the project will affect the firms total risk.
Business units must be evaluated on how each unit contributes to the total risk of the
firm. This gives the individual managers an incentive to monitor the effect of individual projects on overall firm risk.
There are three reasons why decentralizing the risk-return tradeoff in a company is important: 1. Transformation o f the risk management culture: A consistent, systematic assessment of risks by all business units ensures that managers consider the impact of all important risks.
2. Every risk is owned: Because performance evaluations are based on risk, managers have
an incentive to consider important risks in their decision making.
3. Risk assessment by those closest to the risk: Managers in the individual business units have the knowledge and expertise needed to assess and manage the risks of the business unit.
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D e v e l o p m e n t a n d I m p l e m e n t a t i o n

LO 37.6: Explain the Basel Committees suggestions for managing technology risk and outsourcing risk.
Technology can be used to mitigate operational risks. For example, automated procedures are generally less prone to error than manual procedures. However, technology introduces its own risks. The Basel Committee recommends an integrated approach to identifying, measuring, monitoring, and managing technology risks.
Technology risk management tools are similar to those suggested for operational risk management and include: Governance and oversight controls. Policies and procedures in place to identify and assess technology risks. Written risk appetite and tolerance statements.
Establish risk transfer strategies to mitigate technology risks. Monitor technology risks and violations of thresholds and risk limits. Create a sound technology infrastructure (i.e., the hardware and software components,
Implement a risk control environment.
data and operating environments).
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Outsourcing involves the use of third parties to perform activities or functions for the firm. 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. 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.
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Ke y C o n c e pt s
LO 37.1 The Basel Committee on Banking Supervision defines operational risk as, the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events.
The Basel Committee recognizes three common lines of defense used to control operational risks. These lines of defense are: (1) business line management, (2) independent operational risk management function, and (3) independent reviews of operational risks and risk management.
LO 37.2 The 11 fundamental principles of operational risk management suggested by the Basel Committee are: 1. The maintenance of a strong risk management culture led by the banks board of
directors and senior management.
2. The operational risk framework (i.e., the Framework) must be developed and fully
integrated in the overall risk management processes of the bank.
3. The board should approve and periodically review the Framework. The board should also oversee senior management to ensure that appropriate risk management decisions are implemented at all levels of the firm.
4. The board must identify the types and levels of operational risks the bank is willing to
assume as well as approve risk appetite and risk tolerance statements.
3. Consistent with the banks risk appetite and risk tolerance, senior management must
develop a well-defined governance structure within the bank.
6. Operational risks must be identified and assessed by managers. Senior management must understand the risks, and the incentives related to those risks, inherent in the banks business lines and processes.
7. New lines of business, products, processes, and systems should require an approval
process that assesses the potential operational risks.
8. A process for monitoring operational risks and material exposures to losses should be
put in place by senior management and supported by senior management, the board of directors, and business line employees.
9. Banks must put strong internal controls and risk mitigation and risk transfer strategies
in place to manage operational risks.
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10. Banks must have plans in place to survive in the event of a major business disruption.
Business operations must be resilient.
11. Banks should make disclosures that are clear enough that outside stakeholders can assess
the banks approach to operational risk management.
LO 37.3 The board of directors and senior management must be engaged with operational risk assessment related to all 11 of the fundamental principles of operational risk management. The operational risk management framework must define, describe, and classify operational risk and operational loss exposure. The Framework must be documented in the board of directors approved policies.
LO 37.4 There are several tools that may be used to identify and assess operational risk. The tools include business process mappings, risk and performance indicators, scenario analysis, using risk assessment outputs as inputs for operational risk exposure models, audit findings, analyzing internal and external operational loss data, risk assessments, and comparative analysis.
LO 37.3 An effective control environment should include the following five components: (1) a control environment, (2) risk assessment, (3) control activities, (4) information and communication, and (3) monitoring activities.
LO 37.6 Technology can be used to mitigate operational risks but it introduces its own risks. The Basel Committee recommends an integrated approach to identifying, measuring, monitoring, and managing technology risks. Technology risk management tools are similar to those suggested for operational risk management.
Outsourcing involves the use of third parties to perform activities or functions for the firm. 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.
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C o n c e pt Ch e c k e r s
1.
2.
3.
Griffin Riehl is a risk manager at Bluegrass Bank and Trust, a small, independent commercial bank in Kentucky. Riehl has recently read the Basel Committee on Banking Supervisions recommendations for sound operational risk management and would like to put several controls in place. He would like to start with the three lines of defense suggested by the committee. Which of the following is not one of the three common lines of defense suggested by the Basel Committee for operational risk governance? A. Business line management. B. Board of directors and senior management risk training programs. C. Creating an independent operational risk management function in the bank. D. Conducting independent reviews of operational risks and risk management
operations.
Garrett Bridgewater, a trader at a large commercial bank, has continued to increase his bonus each year by producing more and more profit for the bank. In order to increase profits, Bridgewater has been forced to increase the riskiness of his positions, despite the written risk appetite and tolerance statements provided to all employees of the bank. The bank seems happy with his performance so Bridgewater takes that as a sign of approval of his methods for improving profitability. Which of the following pairs of the 11 fundamental principles of risk management has the bank most clearly violated in this situation? A. Principle 1 (a strong risk management culture) and Principle 11 (the bank
should make clear disclosures of operational risks to stakeholders).
B. Principle 2 (develop an integrated approach to operational risk management) and Principle 7 (establish a rigorous approval process for new lines of business). C. Principle 3 (approve and review the operational risk framework) and Principle 4
(develop risk appetite and tolerance statements).
D. Principle 3 (develop a well-defined governance structure) and Principle 6
(understand the risk and incentives related to risk inherent in the banks business lines and processes).
Gary Hampton is providing descriptions of the operational risk management assessment tools, reporting lines, and accountabilities to the board of directors. Hampton is most likely working on: A. Framework documentation. B. A corporate operational risk function (CORF) handbook of operations. C. An outline of the fundamental principles of operational risk management. D. An open group operational framework diagram.
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4.
3.
George Mathis works in risk analysis and management at a large commercial bank. He uses several tools to identify and assess operational risk. He has asked several business line managers to identify some risk events that would disrupt business. Each manager has also provided their thoughts on what would happen given worst case operational failures. The risk assessment tool Mathis is most likely using in this case is (are): A. risk indicators. B. comparative analysis. C. scenario analysis. D. business process mappings.
A risk management officer at a small commercial bank is trying to institute strong operational risk controls, despite little support from the board of directors. The manager is considering several elements as potentially critical components of a strong control environment. Which of the following is not a required component of an effective risk control environment as suggested by the Basel Committee on Banking Supervision? A. Information and communication. B. Monitoring activities. C. A functionally independent corporate operational risk function. D. Risk assessment.
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C o n c e pt Ch e c k e r A n s w e r s
1. B The three common lines of defense suggested by the Basel Committee on Banking
Supervision and employed by firms to control operational risks are: (1) business line management, (2) an independent operational risk management function, and (3) independent reviews of operational risks and risk management.
2. D Based on the choices provided, the best match for the scenario is a violation of Principles 5
and 6. It is clear that the bank has not considered the incentives that are related to risk taking in the bank. Bridgewater has been given the risk appetite and tolerance statements but senior managers keep rewarding Bridgewater for high returns and seem to be ignoring the fact that they are the result of higher risks. Thus, there are incentives linked to increasing risk. The governance structure may or may not be well defined, but regardless, is not being adhered to.
3. A The operational risk management framework (i.e., the Framework) must define, describe, and classify operational risk and operational loss exposure. Hampton is likely working on Framework documentation. Framework documentation is overseen by the board of directors and senior management.
4. C Mathis is asking for managers to identify potential risk events, which he will use to assess
potential outcomes of these risks. This is an example of scenario analysis. Scenario analysis is a subjective process where business line managers and risk managers identify potential risk events and then assess potential outcomes of those risks.
5. C A functionally independent corporate operational risk function is desirable in a bank but is not necessary for an effective control environment. This is especially true for a small bank, which might roll all risk management activities into one risk management group (i.e., not segregated by type of risk). An effective control environment should include the following five components: (1) a control environment, (2) risk assessment, (3) control activities, (4) information and communication, and (5) monitoring activities.
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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:
En t e r pr i se Ri s k Ma n a g e me n t : Th e o r y a n d Pr a c t i c e
Topic 38
E x a m F o c u s
Enterprise risk management (ERM) is the process of managing all of a corporations risks within an integrated framework. This topic describes how ERM can be implemented in a way that enables a company to manage its total risk-return tradeoff in order to better carry out its strategic plan, gain competitive advantage, and create shareholder value. Key issues include why it may be optimal to hedge diversifiable risk and how to differentiate between core risks the firm should retain and noncore risks the firm should layoff. Also discussed is the determination of the optimal amount of corporate risk and the importance of ensuring that managers at all levels take proper account of the risk-return tradeoff. For the exam, understand the framework for developing and implementing ERM.
C r e a t i n g V a l u e W i t h ERM

LO 37.3: Describe features of an effective control environment and identify specific controls that should be in place to address operational risk.
An effective control environment must include the following five components: 1. A control environment.
2. Risk assessment.
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3. Control activities.
4.
Information and communication.
3. Monitoring activities. Senior managers should conduct top-level reviews of progress toward stated risk objectives, verify compliance of standards and controls, review instances of non-compliance, evaluate the approval system to ensure accountability, and track reports of exceptions to risk limits and management overrides and deviations from risk policies and controls. Managers should also ensure that duties are segregated and conflicts of interest are identified and minimized.
Specific controls that should be in place in the organization to address operational risk include: Clearly established lines of authority and approval processes for everything from new
products to risk limits.
Safeguards to limit access to and protect bank assets and records. Careful monitoring of risk thresholds and limits.
An appropriately sized staff to manage risks. An appropriately trained staff to manage risks. A system to monitor returns and identify returns that are out of line with expectations
(e.g., a product that is generating high returns but is supposed to be low risk may indicate that the performance is a result of a breach of internal controls).
Confirmation and reconciliation of bank transactions and accounts. A vacation policy that requires officers and employees to be absent for a period not less
than two consecutive weeks.
Ma n a g in g Te c h n o l o g y Ris k a n d O u t s o u r c in g Ris k

LO 37.4: Describe tools and processes that can be used to identify and assess operational risk.
Tools that may be used to identify and assess operational risk include: Business process mappings, which do exactly that, map the banks business processes.
Maps can reveal risks, interdependencies among risks, and weaknesses in risk management systems.
Risk and performance indicators are measures that help managers understand the banks risk exposure. There are Key Risk Indicators (KRIs) and Key Performance Indicators (KPIs). KRIs are measures of drivers of risk and exposures to risk. KPIs provide insight into operational processes and weaknesses. Escalation triggers are often paired with KRIs and KPIs to warn when risk is approaching or exceeding risk thresholds. Scenario analysis is a subjective process where business line managers and risk managers identify potential risk events and then assess potential outcomes of those risks. Measurement involves the use of outputs of risk assessment tools as inputs for operational risk exposure models. The bank can then use the models to allocate economic capital to various business units based on return and risk.

Audit findings identify weaknesses but may also provide insights into inherent

operational risks. .Analysis of internal operational loss data. Analysis can provide insight into the causes of large losses. Data may also reveal if problems are isolated or systemic.
Analysis of external operational loss data including gross loss amounts, dates, amount of
recoveries and losses at other firms.
Risk assessments, or risk self assessments (RSAs), address potential threats. Assessments
consider the banks processes and possible defenses relative to the firms threats and vulnerabilities. Risk Control Self-Assessments (RCSA) evaluate risks before risk controls are considered (i.e., inherent risks). Scorecards translate RCSA output into metrics that help the bank better understand the control environment.
Comparative analysis combines all described risk analysis tools into a comprehensive
picture of the banks operational risk profile. For example, the bank might combine audit findings with internal operational loss data to better understand the weaknesses of the operational risk framework.
Fe a t u r e s o f a n Ef f e c t iv e C o n t r o l En v ir o n me n t

LO 37.3: Explain guidelines for strong governance of operational risk, and evaluate the role of the board of directors and senior management in implementing an effective operational risk framework.
The attitudes and expectations of the board of directors and senior management are critical to an effective operational risk management program.
With respect to Principle 1, the board of directors and/or senior management should: Provide a sound foundation for a strong risk management culture within the bank. A strong risk management culture will generally mitigate the likelihood of damaging operational risk events.
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Establish a code of conduct (or ethics policy) for all employees that outlines
expectations for ethical behavior. The board of directors should support senior managers in producing a code of conduct. Risk management activities should reinforce the code of conduct. The code should be reflected in training and compensation as well as risk management. There should be a balance between risks and rewards. Compensation should be aligned not just with performance, but also with the banks risk appetite, strategic direction, financial goals, and overall soundness.
Provide risk training throughout all levels of the bank. Senior management should
ensure training reflects the responsibilities of the person being trained.
With respect to Principle 2, the board of directors and/or senior management should: Thoroughly understand both the nature and complexity of the risks inherent in the products, lines of business, processes, and systems in the bank. Operational risks are inherent in all aspects of the bank.
Ensure that the Framework is fully integrated in the banks overall risk management
plan across all levels of the firm (i.e., business lines, new business lines, products, processes, and/or systems). Risk assessment should be a part of the business strategy of the bank.
With respect to Principle 3, the board of directors and/or senior management should: Establish a culture and processes that help bank managers and employees understand
and manage operational risks. The board must develop comprehensive and dynamic oversight and control mechanisms that are integrated into risk management processes across the bank.
Regularly review the Framework. Provide senior management with guidance regarding operational risk management and
approve policies developed by senior management aimed at managing operational risk.
Ensure that the Framework is subject to independent review. Ensure that management is following best practices in the field with respect to
operational risk identification and management.
Establish clear lines of management responsibility and establish strong internal
controls.
With respect to Principle 4, the board of directors and/or senior management should: Consider all relevant risks when approving the banks risk appetite and tolerance statements. The board must also consider the banks strategic direction. The board should approve risk limits and thresholds.
Periodically review the risk appetite and tolerance statements. The review should Changes in the market and external environment.Effectiveness of risk management strategies.The nature of, frequency of, and volume of breaches to risk limits. specifically focus on:
Changes in the market and external environment.
Changes in business or activity volume.
Effectiveness of risk management strategies.
The quality of the control environment.
The nature of, frequency of, and volume of breaches to risk limits.
With respect to Principle 3, the board of directors and/or senior management should: Establish systems to report and track operational risks and maintain an effective
mechanism for resolving problems. Banks should demonstrate the effective use of the three lines of defense to manage operational risk, as outlined by the Basel Committee.
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Translate the Framework approved by the board into specific policies and procedures used to manage risk. Senior managers should clearly assign areas of responsibility and should ensure a proper management oversight system to monitor risks inherent in the business unit.
Ensure that operational risk managers communicate clearly with personnel responsible
for market, credit, liquidity, interest rate, and other risks and with those procuring outside services, such as insurance or outsourcing.
Ensure that CORF managers should have sufficient stature in the bank, commensurate
with market, credit, liquidity, interest rate, and other risk managers.
Ensure that the staff is well trained in operational risk management. Risk managers
should have independent authority relative to the operations they oversee. Committee structure’, for large, complex banks, a board-created firm level risk Develop a governance structure of the bank that is commensurate with the size and complexity of the firm. Regarding the governance structure, the bank should consider: Committee structure’, for large, complex banks, a board-created firm level risk
committee should oversee all risks. The management-level operational risk committee would report to the enterprise level risk committee.
Committee composition’, committee members should have business experience,
financial experience, and independent risk management experience. Independent, non-executive board members may also be included.
Committee operation’, committees should meet frequently enough to be productive
and effective. The committee should keep complete records of committee meetings.
With respect to Principle 6, the board of directors and/or senior management should: Consider both internal and external factors to identify and assess operational risk.
Examples of tools that may be used to identify and assess risk are described in LO 37.4.
With respect to Principle 7, the board of directors and/or senior management should: Maintain a rigorous approval process for new products and processes. The bank should make sure that risk management operations are in place from the inception of new activities because operational risks typically increase when a bank engages in new activities, new product lines, enters unfamiliar markets, implements new business processes, puts into operation new technology, and/or engages in activities that are geographically distant from the main office.
Thoroughly review new activities and product lines, reviewing inherent risks, potential changes in the banks risk appetite or risk limits, necessary controls required to mitigate risks, residual risks, and the procedures used to monitor and manage operational risks.
With respect to Principle 8, the board of directors and/or senior management should: Continuously improve the operational risk reporting. Reports should be manageable in
scope but comprehensive and accurate in nature.
Ensure that operational risk reports are timely. Banks should have sufficient resources to
produce reports during both stressed and normal market conditions. Reports should be provided to the board and senior management.
Ensure that operational risk reports include: Breaches of the banks risk appetite and tolerance statement.Details of recent operational risk events and/or losses.Both internal and external factors that may affect operational risk.
Breaches of the banks risk appetite and tolerance statement.
Breaches of the banks thresholds and risk limits.
Details of recent operational risk events and/or losses.
External events that may impact the banks operational risk capital.
Both internal and external factors that may affect operational risk.
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With respect to Principle 9, the board of directors and/or senior management should have a sound internal control system as described in LO 37.3 (an effective control environment) and LO 37.6 (managing technology and outsourcing risks).
Banks may need to transfer risk (e.g., via insurance contracts) if it cannot be adequately managed within the bank. However, sound risk management controls must be in place and thus risk transfer should be seen as a complement to, rather than a replacement for, risk management controls. New risks, such as counterparty risks, may be introduced when the bank transfers risk. These additional risks must also be identified and managed.
With respect to Principle 10, the board of directors and/or senior management should: Establish continuity plans to handle unforeseen disruptive events (e.g., disruptions in
technology, damaged facilities, pandemic illnesses that affect personnel, and so on). Plans should include impact analysis and plans for recovery. Continuity plans should identify key facilities, people, and processes necessary for the business to operate. The plan must also identify external dependencies such as utilities, vendors, and other third party providers.
Periodically review continuity plans. Personnel must be trained to handle emergencies
and, where possible, the bank should perform disaster recovery and continuity tests. With respect to Principle 11, the board of directors and/or senior management should: Write public disclosures such that stakeholders can assess the banks operational risk
management strategies.
Write public disclosures that are consistent with risk management procedures. The
disclosure policy should be established by the board of directors and senior management and approved by the board of directors. The bank should also be able to verify disclosures.
O pe r a t io n a l Ris k Ma n a g e me n t Fr a me w o r k
The operational risk management framework (i.e., the Framework) must define, describe, and classify operational risk and operational loss exposure. The Framework helps the board and managers understand the nature and complexities of operational risks inherent in the banks products and services. The components of the Framework should be fully integrated into the banks overall risk management plan. The Framework must be documented in the board of directors approved policies. Framework documentation, which is overseen by the board of directors and senior management, should: Describe reporting lines and accountabilities within the governance structure used to
manage operational risks.
Describe risk assessment tools. Describe the banks risk appetite and tolerance. Describe risk limits. Describe the approved risk mitigation strategies (and instruments). With respect to inherent and residual risk exposures, describe the banks methods for
establishing risk limits and monitoring risk limits.
Establish risk reporting processes and management information systems. Establish a common language or taxonomy of operational risk terms to create
consistency of risk identification and management.
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Establish a process for independent review of operational risk. Require review of established policies and procedures.
To o l s f o r Id e n t if y in g a n d A s s e s s in g O pe r a t io n a l Ris k

LO 37.2: Summarize the fundamental principles of operational risk management as suggested by the Basel committee.
Operational risks must be proactively managed by a banks board of directors and senior managers as well as its business line managers and employees. The 11 fundamental principles of operational risk management suggested by the Basel Committee are: 1. The maintenance of a strong risk management culture led by the banks board of
directors and senior managers. This means that both individual and corporate values and attitudes should support the banks commitment to managing operational risks.
2. The operational risk framework (referred to as the Framework in this topic) must
be developed and fully integrated into the overall risk management processes of the bank.
3. The board should approve and periodically review the Framework. The board should also oversee senior management to ensure that appropriate risk management decisions are implemented at all levels of the firm.
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4. The board must identify the types and levels of operational risks the bank is willing to
assume as well as approve risk appetite and risk tolerance statements.
3. Consistent with the banks risk appetite and risk tolerance, senior management must
develop a well-defined governance structure within the bank. The structure must be implemented and maintained throughout the banks various lines of business, its processes, and its systems. The board of directors should approve this governance structure.
6. Senior management must understand the risks, and the incentives related to those
risks, inherent in the banks business lines and processes. These operational risks must be identified and assessed by managers.
7. New lines of business, products, processes, and systems should require an approval
process that assesses the potential operational risks. Senior management must make certain this approval process is in place.
8. A process for monitoring operational risks and material exposures to losses should be put in place by senior management and supported by senior management, the board of directors and business line employees.
9. Banks must put strong internal controls, risk mitigation, and risk transfer strategies in
place to manage operational risks.
10. Banks must have plans in place to survive in the event of a major business disruption.
Business operations must be resilient.
11. Banks should make disclosures that are clear enough that outside stakeholders can
assess the banks approach to operational risk management.
The Role of the Board and Senior Management

LO 37.1: Describe the three lines of defense in the Basel model for operational risk governance.
The Basel Committee on Banking Supervision defines operational risk as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. The committee states that the definition excludes strategic and reputational risks but includes legal risks. Operational risk is inherent in banking activities. Risks range from those arising from national disasters, such as hurricanes, to the risk of fraud. The committee intends to improve operational risk management throughout the banking system.
Sound operational risk management practices cover governance, the risk management environment, and the role of disclosure. Operational risk management must be fully integrated into the overall risk management processes of the bank.
The three common lines of defense employed by firms to control operational risks are: 1. Business line management. Business line management is the first line of defense.
Banks now, more than ever, have multiple lines of business, all with varying degrees of operational risk. Risks must be identified and managed within the various products, activities, and processes of the bank.
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Topic 37 Cross Reference to GARP Assigned Reading – Basel Committee on Banking Supervision
2. An independent operational risk management function. This is the second line of
defense and is discussed in the next section.
3. Independent reviews of operational risks and risk management. The review may
be conducted internally with personnel independent of the process under review or externally.
C o r po r a t e O pe r a t io n a l Ris k Fu n c t i o n (CORF)
The banks specific business lines monitor, measure, report, and manage operational and other risks. The corporate operational risk function (CORF), also known as the corporate operational risk management function, is a functionally independent group that complements the business lines risk management operations. The CORF is responsible for designing, implementing, and maintaining the banks operational risk framework. Responsibilities of the CORF may include: Measurement of operational risks. Establishing reporting processes for operational risks. Establishing risk committees to measure and monitor operational risks. Reporting operational risk issues to the board of directors. In general, the CORF must assess and challenge each business lines contributions to risk measurement, management, and reporting processes.
Larger, more complex banking institutions will typically have a more formalized approach to the implementation of the lines of defense against operational risks, including the implementation of the CORF. For example, a large bank may have a fully staffed group skilled specifically in operational risk management, while a smaller bank may simply fold operational risk management into the broader risk management function of the bank.
Pr in c ipl e s o f O pe r a t io n a l Ris k Ma n a g e me n t

LO 36.8: Com pare predatory lending and borrowing.
Predatory lending results in the borrower becoming worse off after the loan than before. This may happen because the rates are deceptively high, the appraisals are inflated allowing the borrower to extract equity and then cannot refinance, and prepayment penalties are extreme, steering borrowers unnecessarily to subprime products and similar ruses. Predatory lending may also include outright fraudulent activity in addition to deception.
Predatory borrowing is misrepresentation in the mortgage application from the borrower side. The temptation is driven by increasing housing prices whereby the borrower feels that he cannot catch up with housing prices. Therefore, lying on the mortgage application allows the borrower to the buy the house with the expectation that continued appreciation will allow a favorable refinancing. The fraud may be perpetrated by the buyer alone or in concert with lawyers, broker, and appraisers.
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Topic 36 Cross Reference to GARP Assigned Reading – Ashcroft & Schuermann
K e y C o n c e p t s
LO 36.1
The recent past has witnessed about 73% of subprime mortgages securitized.
LO 36.2
Frictions involve the borrower, originator, arranger, asset manager, investor, and rating agency. The frictions are based on adverse selection and moral hazard problems.
Ultimately, the lack of due diligence on the asset manager and arranger led to even looser underwriting standards. The credit rating agencies issued ratings that lacked this key information.
LO 36.3
Subprime mortgages are mainly hybrid arms (2/28 and 3/27) where the term denotes fixed and floating, respectively. Hence, the borrower retains the vast majority of the interest rate risk.
The capital structure of a pool places the safest securities on top (senior notes), junior securities in the middle (mezzanine) and riskiest on the bottom (equity).
Subordination, excess spread, and shifting interest provide protection for the senior tranches.
LO 36.4
Credit ratings are determined by the amount of collateralization in the structure. If the projected cash flows are insufficient to warrant a desired rating, the originator can supply additional enhancement.
LO 36.3
Credit ratings for ABSs are more complex than corporate ratings because of the underlying portfolio nature and correlation between assets, dependence on economic forecasts, and static nature of the collateral pool.
LO 36.6
Credit ratings are designed to rate through-the-cycle so that there are not excessive upgrades (downgrades) during housing booms (busts). However, changing required enhancements amplify the impact on housing markets by reducing credit in down markets and increasing credit in up markets for the lowest rated borrowers.
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LO 36.7
Rating agencies collectively monitor approximately 10,000 mortgage pools. Its impractical to monitor each pool on a monthly basis in detail, so annual reviews are preferred.
LO 36.8
Predatory lending is when the borrowers welfare is reduced after undertaking the loan. The key characteristic is that the borrower has entered into an agreement with unfavorable terms. Predatory borrowing is when the borrower knowingly misrepresents his financial condition to secure a loan that he otherwise would not qualify for.
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C o n c e p t C h e c k e r s
1.
2.
3.
4.
3.
Which of the following is not a friction in the subprime securitization market? A. Investor and rating agency. B. Servicer and mortgagor. C. Mortgagor and arranger. D. Asset manager and investor.
Which of the following frictions represents an adverse selection problem? A. Investor and mortgagor. B. Originator and arranger. C. Servicer and rating agency. D. Servicer and mortgagor.
Which of the following statements about subprime mortgages is true? Subprime mortgages: A. are typically fixed rate obligations. B. often use the 2/28 or 3/27 hybrid structure. C. force the lender to bear most of the interest rate risk. D. are simpler to analyze than corporate bonds.
Which of the following is true about predatory lending and predatory borrowing? A. Both underprovide credit. B. Both overprovide credit. C. Predatory lending underprovides credit and predatory borrowing overprovides
credit.
D. Predatory lending overprovides credit and predatory borrowing underprovides
credit.
Which of the following subprime characteristics provide direct protection for senior tranches? A. Subordination, excess spread, and shifting interest. B. Subordination, prepayments, and shifting interest. C. Overcollateralization, excess spread, and timing of losses. D. Overcollateralization, excess spread, and prepayments.
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C o n c e p t C h e c k e r An s w e r s
1. C The mortgagor and arranger have no direct contact so there is no friction.
2. B The originator has better information about the quality of the borrowers so the arranger
is subject to an adverse selection problem. That is, if the originator keeps the high quality mortgages, the arranger will receive lemons.
3. B Most subprimes are 2/28 or 3/27 structures where the fixed component is for two or three
years. Hence, the remainder of the term (27 or 28 years) is variable and bears the majority of the interest rate risk.
4. B Predatory borrowing is when the borrower misrepresents themselves to obtain credit they
otherwise would be denied. Predatory lending is providing credit that is welfare decreasing and should not be provided.
5. A Subordination, excess spread, and shifting interest provide protection for senior tranches.
Overcollateralization also provides protection for senior tranches. Timing of losses impacts excess spreads. Prepayments can accelerate or decelerate the cash flows to senior tranches.
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10 Questions: 30 M inutes
1.
2.
3.
A firm is experiencing financial difficulties. Using a contingent claims approach, which of the following best describes the valuation of their senior and subordinated debt? A. Both the senior debt and subordinated debt have positive exposures to debt
maturity, firm volatility, and interest rates (i.e., the debt value increases as these factors increase).
B. The senior debt has negative exposures to debt maturity, firm volatility, and
interest rates (i.e., the senior debt value decreases as these factors increase). The subordinated debt has positive exposures to debt maturity, firm volatility, and interest rates (i.e., the subordinated debt value increases as these factors increase).
C. The senior debt has positive exposures to debt maturity, firm volatility, and
interest rates (i.e., the senior debt value increases as these factors increase). The subordinated debt has negative exposures to debt maturity, firm volatility, and interest rates (i.e., the subordinated debt value decreases as these factors increase).
D. Both the senior debt and subordinated debt have negative exposures to debt
maturity, firm volatility, and interest rates (i.e., the debt value decreases as these factors increase).
Suppose a portfolio has a value of $ 1,000,000 with 50 independent credit positions. Each of the credits has a default probability of 2% and a recovery rate of 0%. The credit portfolio has a default correlation equal to 0. The number of defaults is binomially distributed and the 95th percentile of the number of defaults is 3. What is the credit value at risk at the 95% confidence level for this credit portfolio? A. $20,000. B. $40,000. C. $60,000. D. $980,000. Continuously increasing default probability (while holding default correlation constant) will most likely have what effect on the credit VaR of mezzanine and equity tranches? Equitv VaR Increase A. B. Increase C. Decrease D. Decrease
Mezzanine VaR Increase then decrease Decrease then increase Increase then decrease Decrease then increase
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Book 2 Self-Test: Credit Risk Measurement and Management
4.
5.
6 .
7.
Which of the following statements regarding counterparty risk and lending risk is correct? A. For an interest-rate swap, counterparty risk exists because default may occur at
the end of the contract term.
B. With counterparty risk, there is uncertainty as to which counterparty will have a
negative mark-to-market value.
C. Lending risk involves bilateral risks. D. With lending risk, the principal amount at risk is known with absolute certainty
at the outset.
Netting refers to the combining of cash flows from different contracts with a counterparty into a single net amount. This method of mitigating counterparty risk has enabled explosive growth in credit exposures. Which of the following statements is incorrect regarding the advantages and disadvantages of netting? A. Netted exposures can be volatile, which may result in difficulty in controlling
exposure.
B. Netting removes risks by executing a reverse position with a counterparty,
removing both default and operational risk, but not market risk.
C. Without netting, entities trading with insolvent or troubled counterparties
would be motivated to cease trading and terminate existing contracts.
D. By offsetting exposures with parties managing net positions only, netting reduces
risk and improves operational efficiency.
Counterparty Y is attempting to transfer posted collateral to another counterparty as collateral through a process of rehypothecation. Assuming that Counterparty X pledges collateral to Counterparty Y, and then Counterparty Y rehypothecates this collateral to Counterparty Z, what will happen if Counterparty Z defaults? A. Counterparty X will receive its original collateral back from Counterparty Z. B. Counterparty Y will have a liability to Counterparty X for not returning its
collateral.
C. Counterparty Y will profit from not receiving the collateral from Counterparty
Z given that a credit event has occurred.
D. Counterparty Y will accept a haircut on the value of the pledged collateral in
order to reclaim a portion of the collateral.
Teresa Harrison, a junior portfolio manager, is considering the purchase of super senior tranches for her client portfolios. The typical client is fairly conservative and concerned more with downside risk than upside potential. Harrison based her recommendation on the following observations:
Senior tranches have large attachment points and hence a low probability of Senior tranches have large attachment points and hence a low probability of credit losses.
Mezzanine tranches represent the first loss piece of the capital structure.
Synthetic CD Os have standardized tranche widths similar to index tranches.
How many of these observations support Harrisons view of tranches? A. 0. 1. B. C. 2. D. 3.
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Book 2 Self-Test: Credit Risk Measurement and Management
8.
9.
A portfolio consists of two bonds, Bonds A and B. The credit VaR for the portfolio is defined as the maximum loss due to defaults at a confidence level of 98% over a one-year horizon. The probability of joint default of the two bonds is 1.32%, and the default correlation is 33%. The bond value, default probability, and recovery rate are USD 1.2 million, 4%, and 60%, respectively for Bond A, and USD $800,000, 3%, and 35%, respectively for Bond B. What is the expected credit loss for the portfolio? A. $45,200. B. $15,820. C. $42,800. D. $26,400.
High Flying Hedge Fund will enter into a $100 million total return swap on the S&P 500 Index as the index receiver (i.e., total return receiver). The counterparty (i.e., total return payer) will receive 1-year LIBOR + 400bp. The contract will last two years and will exchange cash flows annually.

Current LIBOR = 3%. Current S&P 500 value = 2,000. S&P 500 in one year = 2,200. S&P 500 in two years = 1,760.
Given this information, what are the cash flows to High Flying in one year and in two years, respectively? Assume LIBOR remains flat. Year 1 Year
A. +3 million B. +3 million C. + 13 million D. + 13 million
2 Years
-13 million -27 million -13 million -27 million
10.
Five tranches of auto loan asset-backed securities (ABSs) are issued with a face value of $6,000,000 and pay an average coupon of 5.2 %. The value of the auto loans is $6,800,000, and they have an average interest rate of 5.4%. The fee for servicing the ABS is 0.2%. Which of the following credit enhancements are involved with this transaction? A. Excess spread. B. Margin step-up. C. Subordinating note classes. D. Overcollateralization.
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1. B
If a firm is in financial distress, the subordinated debt behaves more like equity and a call option. It will increase in value as time to maturity increases, volatility increases, and interest rates increase. The senior debt will have negative exposures to these factors.
If the firm is not in distress, both the senior debt and subordinated debt have negative exposures to these factors because the subordinated debt behaves more like senior debt than equity. In this case, choice D would be correct.
(See Topic 20)
2. B The loss given default is $60,000 [3 x ($1,000,000 / 50)]. The expected loss is equal to the
portfolio value times it and is $20,000 (0.02 x $1,000,000). The credit VaR is defined as the quantile of the credit loss less the expected loss of the portfolio. At the 95% confidence level, the credit VaR is equal to $40,000 ($60,000 minus the expected loss of $20,000).
(See Topic 22)
3. C
Increasing the probability of default decreases equity VaR as defaults are more likely, and the equity tranche will suffer writedowns. However, the writedowns are bounded by the thin level of subordination so the variation in losses becomes smaller. Mezzanine tranches behave more like senior bonds at low default levels (increasing VaR) but more like the equity tranche at higher default levels (decreasing VaR).
(See Topic 23)
4. B With counterparty risk, there is uncertainty regarding which counterparty will have a
negative MtM value. For an interest-rate swap, there is no counterparty risk at the end of the contract term because all payments required by the contract would have been made by then. With lending risk, only one party (unilateral) takes on risk. In addition, the principal amount at risk is known only with reasonable certainty at the outset because changes in interest rates, for example, will lead to some uncertainty.
(See Topic 24)
5. B
If an entity wishes to exit a less liquid OTC trade with one counterparty by entering into an offsetting position with another counterparty, the entity will remove market risk; however, it will be exposed to counterparty and operational risk. Netting removes these risks through executing a reverse position with the initial counterparty, removing both market and counterparty risk.
(See Topic 25)
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Book 2 Self-Test Answers: Credit Risk Measurement and Management
6. B
In rehypothecation, party X may pledge collateral to party Y and party Y may rehypothecate this collateral to party Z. If party Z defaults, then party Y will not only have a loss from not receiving the collateral from party Z, it will also have a liability to party X for not returning its collateral.
(See Topic 26)
7. B Only recommendation 1 is correct. Senior tranches have a low probability of default because their attachment points are much higher in the capital structure. Equity tranches represent the first loss position. Index tranches, not synthetic CDOs, have standardized tranche widths.
(See Topic 29)
8. A The joint expected credit loss is the sum of the two individual expected credit losses.
EL
= PD x exposure x LGD
ELgondA = $1 >200,000 x 0.04 x 0.40 = $19,200
ELfiondB = $800,000 x 0.05 x 0.65 = $26,000
Total EL = $45,200
Note that expected credit loss does not depend on the correlation between the bonds.
(See Topic 32)
9. B Over the next year, the S&P 500 Index will increase by 10%. Hence, the index receiver
(High Flying) will receive $10 million from the index payer and will pay $7 million (LIBOR = 3% + 400bp) to the counterparty. Therefore, the net cash flow will be +$3 million to High Flying.
Between years 1 and 2, the S&P 500 Index will drop 20%. Now, High Flying as the total return receiver must pay 20% to the counterparty in addition to the 7% floating rate. Hence, the total outflow from High Flying to the counterparty is $27 million.
(See Topic 34)
10. D This ABS is supported by overcollateralization because the value of the asset pool is greater
than the value of the securities. There is no excess spread involved because there is no difference between the cash inflows from the underlying assets and the cash outflows in the form of interest payments on the ABS issues.
(See Topic 35)
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F o r m u l a s
Topic 16
expected loss: PD x LGD x EAD
Topic 18
Credit Risk Measurement and Management
exposure at default: EAD = drawn amount + (limit – drawn amount) x loan equivalency factor p o r t f o l i o marginal risk contribution: (3j = ———– p o r t f o l i o
U
L
economic value added: EVA = (RARORAC Ke) x economic capital
risk-adjusted return on risk-adjusted capital:
RARORAC =
spread + fees EL cost of capital cost of operations
economic capital
defaulted]: ^
names
Topic 19
probability of default: PD^
where: PD = probability of default defaulted = number of issuer names that have defaulted in the applicable time horizon names = number of issuers k = time horizon
i=t+k
cumulative probability of default: p y ) c u m u l a t i v e _
_ i =
defaulted j t – – – – – – – – – – – – – – – – – – names
marginal probability of default: pDargina^ = PD c u m u l a t i v e
t+ k
PDjc u m u l a t i v e
annualized default rate: discrete: ADRt = 1 1/(1 PD]:c u m u l a t i v e
i
continuous: ADRt =
In 1 PDj:c u m u l a t i v e
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ln(I-) ln(V.\) -|iT
\
Book 2 Formulas
Merton model PD: PD = N
ffA Vt
where: In = the natural logarithm F = debt face value VA = firm asset value (market value of equity and net debt) 1 = expected return in the risky world 1 T = time to maturity remaining oA = volatility (standard deviation of asset values) N = cumulated normal distribution operator
distance to default: DtD
ln(VA) ln(F) +
‘risky
M V
/

“other payouts”
\
/
In V In F
A
Altmans Z-score: Z = 1.21×1 + 1.40×2 + 3.30×3 + 0.6×4 + 0.999×5
where: x1 = working capital / total assets x2 = accrued capital reserves / total assets x3 = EBIT / total assets x4 = equity market value / face value of term debt x5 = sales / total assets TV: LOGIT model: LOGIT(Tq) = log— – 1 TV:
Topic 20
credit spread =
1
(cid:31)
where: (T – t) = remaining maturity = current value of debt D F = face value of debt = risk-free rate
r
f
vulnerable option = [(1 PD) x c] + (PD x RR x c)
= value of the option without default
where: c PD = probability of default RR = recovery rate
Topic 21
cumulative PD: 1 e
default probability: \ T RR 1 RR
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Book 2 Formulas
Topic 22
correlation with default probabilities: p12
7ti2 – ^ 2
Topic 27
7n + n (n -l)p
netting factor = where: n = number of exposures p = average correlation
Topic 29
risk-neutral default probability = liquidity premium + default risk premium +
real-world default probability
cumulative default probability: F(u) = 1 exp
spread recovery 1 recovery
x u
number of defaults = n
X% recovery / 1 recovery /
Topic 30
m
credit value adjustment: CVA = LGD x ^ x E E (q ) x PD (t^ j, q )
i= l
where: LGD = loss given default or how much of the exposure one expects to lose in the event
of a counterparty default; equal to 1 minus the recovery rate (1 RR)
EE PD
= discount expected exposure for future dates = marginal default probability
CVA as a spread:
CVA(t,T)
CDS p r e m i u m (t>T)
X CDSx EPE
where: CDSpremium(t, T) = unit premium value of a credit default swap XCDS
= CDS premium at maturity date T; this amount can be thought of as
a credit spread
EPE
= expected positive exposure that is the average of the expected
exposure over a preset time period, typically from the present to the maturity date of the transaction
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Book 2 Formulas
bilateral credit value adjustment: BCVA = CVA + DVA
CVA = +L G D C x
EE(t;) x PDC (t;_i, t;)
m
i= l m
DVA = LGDj x NEE(t;) x PDj (tH , t;)
i= l
where: NEE = negative expected exposure (EE from the counterpartys perspective)
BCVA as spread:
BCVA(t,T)
C D S premium (* T )
X g DS x EPE – X f DS x ENE
p r \ r where : X j 3 = the institution5 s own CDS spread ENE = expected negative exposure (the opposite of EPE)
Topic 32
r
N
loan portfolio expected loss: EL = X PD i x EAD; x LGD}
i= l
N
deriatives portfolio expected loss: EL = Z PD i x (EPEj x a ) x LGDj
i= i
Topic 35 weighted average life (WAL): WAL =
(a / 365) x PF(t)
constant prepayment rate: CPR = 1 (1SM M )12
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U s in g t h e C u m u l a t iv e Z-Ta b l e
Probability Example
Assume that the annual earnings per share (EPS) for a large sample of firms is normally distributed with a mean of $5.00 and a standard deviation of $1.50. What is the approximate probability of an observed EPS value falling between $3.00 and $7.25?
If EPS = x = $7.25, then z = (x – p)/a = ($7.25 – $5.00)/$1.50 = +1.50
If EPS = x = $3.00, then z = (x – p)/a = ($3.00 – $5.00)/$1.50 = -1.33
For z-value of 1.50: Use the row headed 1.5 and the column headed 0 to find the value 0.9332. This represents the area under the curve to the left of the critical value 1.50.
For z-value of1.33: Use the row headed 1.3 and the column headed 3 to find the value 0.9082. This represents the area under the curve to the left of the critical value +1.33. The area to the left o f1.33 is 1 0.9082 = 0.0918.
The area between these critical values is 0.9332 0.0918 = 0.8414, or 84.14%.
Hypothesis Testing One-Tailed Test Example
A sample of a stocks returns on 36 non-consecutive days results in a mean return of 2.0%. Assume the population standard deviation is 20.0%. Can we say with 95% confidence that the mean return is greater than 0%?
H q: p < 0.0%, Ha : p > 0.0%. The test statistic = ^-statistic = = (2.0 – 0.0) / ( 20.0 / 6) = 0.60.
The significance level = 1.0 0.95 = 0.05, or 5%.
Since this is a one-tailed test with an alpha of 0.05, we need to find the value 0.95 in the cumulative stable. The closest value is 0.9505, with a corresponding critical .z-value of 1.65. Since the test statistic is less than the critical value, we fail to reject H Q.
Hypothesis Testing Two-Tailed Test Example
Using the same assumptions as before, suppose that the analyst now wants to determine if he can say with 99% confidence that the stocks return is not equal to 0.0%.
H q: p = 0.0%, Ha : p ^ 0.0%. The test statistic (.z-value) = (2.0 0.0) / (20.0 / 6) = 0.60. The significance level = 1.0 0.99 = 0.01, or 1%.
Since this is a two-tailed test with an alpha of 0.01, there is a 0.005 rejection region in both tails. Thus, we need to find the value 0.995 (1.0 0.005) in the table. The closest value is 0.9951, which corresponds to a critical .z-value of 2.58. Since the test statistic is less than the critical value, we fail to reject H Q and conclude that the stocks return equals 0.0%.
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C u m u l a t iv e Ta b l e P(Z < z) = N(z) for z > 0 P(Z < -z) = 1 - N(z) z 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3 0 0.5000 0.5398 0.5793 0.6179 0.6554 0.6915 0.7257 0.7580 0.7881 0.8159 0.8413 0.8643 0.8849 0.9032 0.9192 0.9332 0.9452 0.9554 0.9641 0.9713 0.9772 0.9821 0.9861 0.9893 0.9918 0.9938 0.9953 0.9965 0.9974 0.9981 0.01 0.5040 0.5438 0.5832 0.6217 0.6591 0.6950 0.7291 0.7611 0.7910 0.8186 0.8438 0.8665 0.8869 0.9049 0.9207 0.9345 0.9463 0.9564 0.9649 0.9719 0.9778 0.9826 0.9864 0.9896 0.9920 0.994 0.9955 0.9966 0.9975 0.9982 0.02 0.5080 0.5478 0.5871 0.6255 0.6628 0.6985 0.7324 0.7642 0.7939 0.8212 0.8461 0.8686 0.8888 0.9066 0.9222 0.9357 0.9474 0.9573 0.9656 0.9726 0.9783 0.983 0.9868 0.9898 0.9922 0.9941 0.9956 0.9967 0.9976 0.9982 0.03 0.5120 0.5517 0.5910 0.6293 0.6664 0.7019 0.7357 0.7673 0.7967 0.8238 0.8485 0.8708 0.8907 0.9082 0.9236 0.937 0.9484 0.9582 0.9664 0.9732 0.9788 0.9834 0.9871 0.9901 0.9925 0.9943 0.9957 0.9968 0.9977 0.9983 0.04 0.5160 0.5557 0.5948 0.6331 0.6700 0.7054 0.7389 0.7704 0.7995 0.8264 0.8508 0.8729 0.8925 0.9099 0.9251 0.9382 0.9495 0.9591 0.9671 0.9738 0.9793 0.9838 0.9875 0.9904 0.9927 0.9945 0.9959 0.9969 0.9977 0.9984 0.05 0.5199 0.5596 0.5987 0.6368 0.6736 0.7088 0.7422 0.7734 0.8023 0.8289 0.8531 0.8749 0.8944 0.9115 0.9265 0.9394 0.9505 0.9599 0.9678 0.9744 0.9798 0.9842 0.9878 0.9906 0.9929 0.9946 0.9960 0.9970 0.9978 0.9984 0.06 0.5239 0.5636 0.6026 0.6406 0.6772 0.7123 0.7454 0.7764 0.8051 0.8315 0.8554 0.8770 0.8962 0.9131 0.9279 0.9406 0.9515 0.9608 0.9686 0.9750 0.9803 0.9846 0.9881 0.9909 0.9931 0.9948 0.9961 0.9971 0.9979 0.9985 0.07 0.5279 0.5675 0.6064 0.6443 0.6808 0.7157 0.7486 0.7794 0.8078 0.8340 0.8577 0.8790 0.8980 0.9147 0.9292 0.9418 0.9525 0.9616 0.9693 0.9756 0.9808 0.985 0.9884 0.9911 0.9932 0.9949 0.9962 0.9972 0.9979 0.9985 0.08 0.5319 0.5714 0.6103 0.6480 0.6844 0.7190 0.7517 0.7823 0.8106 0.8365 0.8599 0.8810 0.8997 0.9162 0.9306 0.9429 0.9535 0.9625 0.9699 0.9761 0.9812 0.9854 0.9887 0.9913 0.9934 0.9951 0.9963 0.9973 0.9980 0.9986 0.09 0.5359 0.5753 0.6141 0.6517 0.6879 0.7224 0.7549 0.7852 0.8133 0.8389 0.8621 0.8830 0.9015 0.9177 0.9319 0.9441 0.9545 0.9633 0.9706 0.9767 0.9817 0.9857 0.989 0.9916 0.9936 0.9952 0.9964 0.9974 0.9981 0.9986 0.9987 0.9987 0.9987 0.9988 0.9988 0.9989 0.9989 0.9989 0.9990 0.9990 2018 Kaplan, Inc. Page 321 A l t e r n a t iv e .Z-Ta b l e P(Z < z) = N(z) for z > 0 P(Z < -z) = 1 - N(z) z 0.0 0.1 0.2 0.3 0.4 0.3 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3.0 0.00 0.0000 0.0398 0.0793 0.1179 0.1554 0.1915 0.2257 0.2580 0.2881 0.3159 0.3413 0.3643 0.3849 0.4032 0.4192 0.4332 0.4452 0.4554 0.4641 0.4713 0.4772 0.4821 0.4861 0.4893 0.4918 0.4939 0.4953 0.4965 0.4974 0.4981 0.01 0.0040 0.0438 0.0832 0.1217 0.1591 0.1950 0.2291 0.2611 0.2910 0.3186 0.3438 0.3665 0.3869 0.4049 0.4207 0.4345 0.4463 0.4564 0.4649 0.4719 0.4778 0.4826 0.4864 0.4896 0.4920 0.4940 0.4955 0.4966 0.4975 0.4982 0.02 0.0080 0.0478 0.0871 0.1255 0.1628 0.1985 0.2324 0.2642 0.2939 0.3212 0.3461 0.3686 0.3888 0.4066 0.4222 0.4357 0.4474 0.4573 0.4656 0.4726 0.4783 0.4830 0.4868 0.4898 0.4922 0.4941 0.4956 0.4967 0.4976 0.4982 0.03 0.0120 0.0517 0.0910 0.1293 0.1664 0.2019 0.2357 0.2673 0.2967 0.3238 0.3485 0.3708 0.3907 0.4082 0.4236 0.4370 0.4484 0.4582 0.4664 0.4732 0.4788 0.4834 0.4871 0.4901 0.4925 0.4943 0.4957 0.4968 0.4977 0.4983 0.04 0.0160 0.0557 0.0948 0.1331 0.1700 0.2054 0.2389 0.2704 0.2995 0.3264 0.3508 0.3729 0.3925 0.4099 0.4251 0.4382 0.4495 0.4591 0.4671 0.4738 0.4793 0.4838 0.4875 0.4904 0.4927 0.4945 0.4959 0.4969 0.4977 0.4984 0.05 0.0199 0.0596 0.0987 0.1368 0.1736 0.2088 0.2422 0.2734 0.3023 0.3289 0.3531 0.3749 0.3944 0.4115 0.4265 0.4394 0.4505 0.4599 0.4678 0.4744 0.4798 0.4842 0.4878 0.4906 0.4929 0.4946 0.4960 0.4970 0.4978 0.4984 0.06 0.0239 0.0636 0.1026 0.1406 0.1772 0.2123 0.2454 0.2764 0.3051 0.3315 0.3554 0.3770 0.3962 0.4131 0.4279 0.4406 0.4515 0.4608 0.4686 0.4750 0.4803 0.4846 0.4881 0.4909 0.4931 0.4948 0.4961 0.4971 0.4979 0.4985 0.07 0.0279 0.0675 0.1064 0.1443 0.1808 0.2157 0.2486 0.2794 0.3078 0.3340 0.3577 0.3790 0.3980 0.4147 0.4292 0.4418 0.4525 0.4616 0.4693 0.4756 0.4808 0.4850 0.4884 0.4911 0.4932 0.4949 0.4962 0.4972 0.4979 0.4985 0.08 0.0319 0.0714 0.1103 0.1480 0.1844 0.2190 0.2517 0.2823 0.3106 0.3356 0.3599 0.3810 0.3997 0.4162 0.4306 0.4429 0.4535 0.4625 0.4699 0.4761 0.4812 0.4854 0.4887 0.4913 0.4934 0.4951 0.4963 0.4973 0.4980 0.4986 0.09 0.0359 0.0753 0.1141 0.1517 0.1879 0.2224 0.2549 0.2852 0.3133 0.3389 0.3621 0.3830 0.4015 0.4177 0.4319 0.4441 0.4545 0.4633 0.4706 0.4767 0.4817 0.4857 0.4890 0.4916 0.4936 0.4952 0.4964 0.4974 0.4981 0.4986 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990 Page 322 2018 Kaplan, Inc. 2018 Kaplan, Inc. Page 323 collateralized debt obligation 213, 273 collateralized loan obligation 274 collateralized mortgage obligations 122 collateral management 161 collateral volatility 184 concentration risk 31 constant prepayment rate 293 consumer credit analyst 15 Consumer Financial Protection Act 256 corporate credit analyst 16 corporate credit risk 255 counterparty credit analyst 16 counterparty risk 143, 242 covered bonds 122 credit 1 credit analysts at rating agencies 16 credit bureau scores 256 credit card debt 289 credit crunch 275, 296 credit default put 80 credit default swap 81, 144, 210, 270 credit derivatives 269 credit enhancement 124, 287 credit events 80 credit exposure 146 credit exposure metrics 173 CreditGrades 208 credit-linked note 272 CreditMetrics 76 credit migration 146 credit modeling analyst 16 CreditPortfolioView 79 credit quality 162 credit rating agencies 127, 282, 296 credit ratings 28 credit risk 1, 28, 254 CreditRisk+ 75 credit risk mitigation 267 credit risk model 31 credit scoring models 256 credit spread curve 211 credit support amount 162 credit support annex (CSA) 161 credit value adjustment (CVA) 148, 200, 219, 243 credit value at risk 109 cross-product netting 147 cumulative accuracy profile 258 bility to repay 256 absolute prepayment speed 289 acceleration clause 154 accuracy rati o 258 additional termination events 156 adverse selection 200, 302 Altmans Z-score 45 amortizing structure 284 annualized default rate 41 annual report 22 asset-backed credit-linked notes 272 asset-backed securities 123 asset valuation risk 255 asset value correlation 31 auditors report 22 auto loans 289 A a ank credit function 268 bank examiners 16 bank failure 9 bank insolvency 9 Bernoulli trial 92 bifurcations 200 bilateral CVA 224, 246 bilateral netting 155 binomial distribution 92 bond insurance 267 break clause 157 business risks 254 B b alibration 46 canonical correlation method 52 capital value adjustment (KVA) 201 cash flow simulation model 52 cash waterfall 283 central counterparty (CCP) 148, 195 close-out 147 close-out clauses 155 close-out netting 153 cluster analysis 49 collateral agreements 163 collateral disputes 163 collateralization 147, 148, 161, 267 c c In d e x fixed-income analysts 16 foreign exchange forwards 144 foreign exchange risk 168 funding liquidity risk 167 funding value adjustment (FVA) 200 G Geske compound option model 70 aircut 164, 165 hazard rate 93 hazard rate curves 97 hedging 148 heuristic methods 53 hierarchical clustering 49 high-quality counterparties 147 historical data approach 207 H h mplied correlation 135 incremental CVA 222 independent amount 162 index tranches 212 initial margin 162,164,186 interest-rate risks 255 internal credit enhancement 124 investment selection 17 ISDA Master Agreement 153 i-spread 90 issuer 281 I i MV model 78, 208 K K egal and operational efficiency 200 lending risk 143 linear discriminant analysis 45 liquidity 200 liquidity premium 206 liquidity risk 29, 167 loan syndication 267 loan-to-value (LTV) ratio 254, 257 logistic regression models 48 LOGIT model 48 loss coverage ratio 306 loss curve 289 loss given default 8, 29, 74, 146 loss mutualization 200 L l cumulative probability of default 41, 205 current exposure 242 custodian 282 customer relationship cycle 259 cutoff scores 46, 257 D debt service coverage ratio 290 debt-to-income ratio 257 debt value adjustment (DVA) 224, 248 decision support system 54 default correlation 31 default management 200 default probability 146 default ratio 289 default risk 28, 29, 168 default risk premium 206 delinquency ratio 289 delivery squeeze 210 derivative product company (DPC) 194 derivatives players 145 distance to default 44, 208 divisive clustering 50 conomic capital 32 economic value added 33 effective EE 175 effective EPE 175 eigenvalue 50 equity-based approaches 208 equity piece 283 equity tranche 123, 283, 304 excess spread 124, 285, 288, 304 expected exposure 173, 184, 243 expected loss 8, 30, 245 expected mark to market 173 expected positive exposure 174, 243 experts-based approach 39 expert system 53 exponential distribution 93 exposure at default 8, 30 exposure risk 28, 30 external credit enhancement 124 E e actor analysis 51 FICO score 257 financial guarantor 282, 286 financial obligation 2 first-loss piece 283 first-to-default put 271 F f Book 2 Index Page 324 2018 Kaplan, Inc. Book 2 Index ualified mortgages 256 qualitative credit analysis techniques 4 qualitative skills 21 quantitative credit analysis techniques 5 quantitative skills 21 Q q ating agency 17 real-world default probabilities 206 reassignment 267 recovery 146 recovery rate 209 recovery risk 28, 29 recovery swaps 209 reduced form model 43 rehypothecation 165 remargin period 183,186 replacement cost 146 repos 144 reputation risks 254 research skills 21 reset agreement 156 retail banking 254 retail credit risk 255 revolving structures 285 right-way risk 231 risk-adjusted return on capital 33 risk-adjusted return on risk-adjusted capital 33 risk-based pricing 260 RiskCalc model 46 risk management 17 risk-neutral approach 208 risk-neutral default probabilities 206 risk-neutral parameter 186 rounding 164, 165, 186 R r primary research 17 principal component analysis 50 probability of default 29, 40, 74 procyclicality 200 Public Securities Association 293 put-call parity 67 corecard 258 secondary research 17 securities financing transactions 144 securitization 128, 265, 281 senior debt 71 senior tranches 123 settlement risk 2 shadow banking system 296 shifting interest 304 s s arginal CVA 222 marginal probability of default 41, 205 marginal VaR 32 margin step-up 288 margin value adjustment (MVA) 201 market risk 167 marking to market 146, 267 master trust structure 285 maximum PFE 174 MBS performance tools 290 Merton model 44, 63, 208 mezzanine tranche 124 migration matrix 40 migration risk 29 minimum transfer amount 164, 165, 186 monoline insurance company 194 monthly payment rate 289 moral hazard 200, 301 mortgage credit assessment 257 mortgage pass-through securities 122 multilateral netting 155,199 M m ame lending 4 negative expected exposure 248 negative exposure 175 netting 148, 181, 267 netting effectiveness 156 netting factor 182 neural network 54 novation 196 numerical approach 39, 53 N n ne-way CSA 166 operational risk 167, 254 originate-to-distribute model 265, 268 originator 127, 273, 281 OTC derivatives 144 overcollateralization 124, 164, 283, 288 o o ayment netting 153 peak exposure 242 performance triggers 304 Poisson random variable 93 pooled model 257 pool insurance 288 portfolio credit VaR 114 potential future exposure 173, 177, 184 predatory borrowing 306 predatory lending 306 P p 2018 Kaplan, Inc. Page 325 nderwriter 127 unexpected loss 30 unilateral CVA 246 U u aluation agent 162 value at risk 31, 176 varimax method 52 Vasicek model 72 vulnerable option 82 V v alkaway feature 147,157 waterfall structure 124 weighted average coupon 291 weighted average life 292 weighted average maturity 291 wrong-way risk 179, 231, 243 w w ield spread 90 Y y Z-score cut-off 46 z-spread 90 Book 2 Index single-factor model 111 single monthly mortality (SMM) 293 single-tranche CDO 275 sovereign risk ratings 4 special purpose vehicle 193, 273, 281, 284 spread01 91 spread conventions 90 spread risk 29, 100 statistical-based classification 39 stressed CVA 247 stressed expected loss 245 structural approach 43 structured credit products 123 structured finance securities 213 structured investment vehicles 266 structuring agent 282 subordinate debt 71 subordinating note classes 288 subordination 304 substitution 165 super-senior tranche 212 synthetic CDO 213, 275 systemically important financial institutions (SIFIs) 193 termination 267 termination features 156 threshold 162, 164, 186 total return swap 81, 272 trade compression 157 tranches 273, 283 transparency 199 true sale 281 trustee 282 two-way CSA 166 Page 326 2018 Kaplan, Inc. Notes Notes Notes R e q u i r e d D i s c l a i m e r s : C F A I n s t i t u t e d o e s n o t e n d o r s e , p r o m o t e , o r w a r r a n t t h e a c c u r a c y o r q u a l i t y o f t h e p r o d u c t s o r s e r v i c e s o f f e r e d b y K a p l a n . C F A I n s t i t u t e , C F A , a n d C h a r t e r e d F i n a n c i a l A n a ly s t a r e t r a d e m a r k s o w n e d b y C F A I n s t i t u t e . C e r t i f i e d F i n a n c i a l P l a n n e r B o a r d o f S t a n d a r d s I n c . o w n s t h e c e r t i f i c a t i o n m a r k s C F P , C E R T I F I E D F I N A N C I A L P L A N N E R , a n d f e d e r a l l y r e g i s t e r e d C F P ( w it h f l a m e d e s i g n ) i n t h e U . S . , w h i c h i t a w a r d s t o i n d i v i d u a l s w h o s u c c e s s f u l l y c o m p l e t e i n i t i a l a n d o n g o i n g c e r t i f i c a t i o n r e q u i r e m e n t s . K a p l a n d o e s n o t c e r t i f y i n d i v i d u a l s t o u s e t h e C F P , C E R T I F I E D F I N A N C I A L P L A N N E R 1" , a n d C F P ( w it h f l a m e d e s i g n ) c e r t i f i c a t i o n m a r k s . C F P c e r t i f i c a t i o n is g r a n t e d o n l y b y C e r t i f i e d F i n a n c i a l P l a n n e r B o a r d o f S t a n d a r d s I n c . t o t h o s e p e r s o n s w h o , i n a d d i t i o n t o c o m p l e t i n g a n e d u c a t i o n a l r e q u i r e m e n t s u c h a s t h i s C F P B o a r d - R e g i s t e r e d P r o g r a m , h a v e m e t i t s e t h i c s , e x p e r i e n c e , a n d e x a m i n a t i o n r e q u i r e m e n t s . K a p l a n i s a r e v ie w c o u r s e p r o v i d e r f o r t h e C F P C e r t i f i c a t i o n E x a m i n a t i o n a d m i n i s t e r e d b y C e r t i f i e d F i n a n c i a l P l a n n e r B o a r d o f S t a n d a r d s I n c . C F P B o a r d d o e s n o t e n d o r s e a n y r e v ie w c o u r s e o r r e c e i v e f i n a n c i a l r e m u n e r a t i o n f r o m r e v ie w c o u r s e p r o v i d e r s . G A R P d o e s n o t e n d o r s e , p r o m o t e , r e v ie w , o r w a r r a n t t h e a c c u r a c y o f t h e p r o d u c t s o r s e r v i c e s o f f e r e d b y K a p l a n o f F R M r e l a t e d i n f o r m a t i o n , n o r d o e s i t e n d o r s e a n y p a s s r a t e s c l a i m e d b y t h e p r o v i d e r . F u r t h e r , G A R P i s n o t r e s p o n s i b l e f o r a n y f e e s o r c o s t s p a i d b y t h e u s e r t o K a p l a n , n o r is G A R P r e s p o n s i b l e f o r a n y f e e s o r c o s t s o f a n y p e r s o n o r e n t i t y p r o v i d i n g a n y s e r v i c e s t o K a p l a n . F R M , G A R P , a n d G l o b a l A s s o c i a t i o n o f R i s k P r o f e s s i o n a l s a r e t r a d e m a r k s o w n e d b y t h e G l o b a l A s s o c i a t i o n o f R i s k P r o f e s s i o n a l s , I n c . C A I A A d o e s n o t e n d o r s e , p r o m o t e , r e v ie w o r w a r r a n t t h e a c c u r a c y o f t h e p r o d u c t s o r s e r v i c e s o f f e r e d b y K a p l a n , n o r d o e s i t e n d o r s e a n y p a s s r a t e s c l a i m e d b y t h e p r o v i d e r . C A I A A i s n o t r e s p o n s i b l e f o r a n y f e e s o r c o s t s p a i d b y t h e u s e r t o K a p l a n n o r is C A I A A r e s p o n s i b l e f o r a n y f e e s o r c o s t s o f a n y p e r s o n o r e n t i t y p r o v i d i n g a n y s e r v i c e s t o K a p l a n . G A I A , C A I A A s s o c i a t i o n , C h a r t e r e d A l t e r n a t i v e I n v e s t m e n t A n a l y s t , a n d C h a r t e r e d A l t e r n a t i v e I n v e s t m e n t A n a l y s t A s s o c i a t i o n a r e s e r v i c e m a r k s a n d t r a d e m a r k s o w n e d b y C H A R T E R E D A L T E R N A T I V E I N V E S T M E N T A N A L Y S T A S S O C I A T I O N , I N C . , a M a s s a c h u s e t t s n o n - p r o f i t c o r p o r a t i o n w i t h i t s p r i n c i p a l p l a c e o f b u s i n e s s a t A m h e r s t , M a s s a c h u s e t t s , a n d a r e u s e d b y p e r m i s s i o n . 2018 SchweserNotes TM FRM Exam Prep Part Operational and Integrated Risk Management eBook 3 K A P L A N ') S C H W E S E R 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: Step 1: Access Your Online Tools Visit www.schweser.com/frm and log in to your online account using the button located in the top navigation bar. After logging in, select the appropriate part and proceed to the dashboard where you can access your online products.
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Create a study plan with the Schweser Study Calendar (located on the Schweser dashboard). Then view the Candidate Resource Library on-demand videos for an introduction to core concepts.
Step 3: Prepare and Practice
Read your SchweserNotes
Our clear, concise study notes will help you prepare for the exam. At the end of each reading, you can answer the Concept Checker questions for better understanding of the curriculum.
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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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Derek Burkett, CFA, FRM, CAIA VP, Advanced Designations, Kaplan Schweser
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FRM Pa r t II Bo o k 3: 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
Re a d in g A s s ig n me n t s a n d Le a r n in g O b j e c t iv e s
O pe r a t io n a l a n d In t e g r a t e d Ris k Ma n a g e me n t
37: Principles for the Sound Management of Operational Risk 38: Enterprise Risk Management: Theory and Practice 39: Observations on Developments in Risk Appetite Frameworks and IT
Infrastructure
40: Information Risk and Data Quality Management 41: OpRisk Data and Governance 42: External Loss Data 43: Capital Modeling 44: Standardized Measurement Approach for Operational Risk 45: Parametric Approaches (II): Extreme Value 46: Validating Rating Models 47: Model Risk 48: Risk Capital Attribution and Risk-Adjusted Performance Measurement 49: Range of Practices and Issues in Economic Capital Frameworks 50: Capital Planning at Large Bank Holding Companies: Supervisory
Expectations and Range of Current Practice
51: Repurchase Agreements and Financing 52: Estimating Liquidity Risks 53: Assessing the Quality of Risk Measures 54: Liquidity and Leverage 55: The Failure Mechanics of Dealer Banks 56: Stress Testing Banks 57: Guidance on Managing Outsourcing Risk 58: Basel I, Basel II, and Solvency II 59: Basel II.5, Basel III, and Other Post-Crisis Changes 60: Fundamental Review of the Trading Book 61: Sound Management of Risks Related to Money Laundering
and Financing of Terrorism
Se l f -Te s t : O pe r a t io n a l a n d In t e g r a t e d Ris k Ma n a g e me n t
Fo r mu l a s
In d e x
v
1 15
25 35 43 61 73 86 96 104 116 128 146
164 178 192 206 216 237 248 259 267 290 307
316
332
338
343
2018 Kaplan, Inc.
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FRM 2018 PART II BOOK 3: OPERATIONAL AND INTEGRATED RISK MANAGEMENT 2018 Kaplan, Inc. All rights reserved. Published in 2018 by Kaplan, Inc. Printed in the United States of America. ISBN: 978-1-4754-7033-8
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.
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2018 Kaplan, Inc.
Re a d i n g A ssi g n me 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 Operational and Integrated Risk Management principles designed to address the learning objectives set forth by the Global Association o f Risk Professionals.
Re a d in g A s s ig n me n t s
37. Principles for the Sound Management of Operational Risk, (Basel Committee on
Banking Supervision Publication, June 2011).
(page 1)
38. Brian Nocco and Rene Stulz, Enterprise Risk Management: Theory and Practice,
Journal of Applied Corporate Finance 18, No. 4 (2006): 8-20.
(page 15)
39. Observations on Developments in Risk Appetite Frameworks and IT Infrastructure, (page 23)
Senior Supervisors Group, December 2010.
Anthony Tarantino and Deborah Cernauskas, Risk Management in Finance: Six Sigma and Other Next Generation Techniques (Hoboken, NJ: John Wiley & Sons, 2009).
40. Information Risk and Data Quality Management, Chapter 3
(page 33)
Marcelo G. Cruz, Gareth W. Peters, and Pavel V. Shevchenko, Fundamental Aspects o f Operational Risk and Insurance Analytics: A Handbook o f Operational Risk (Hoboken, NJ: John Wiley & Sons, 2015).
41. OpRisk Data and Governance, Chapter 2
(page 43)
Philippa X. Girling, Operational Risk Management: A Complete Guide to a Successful Operational Risk Framework (Hoboken, NJ: John Wiley & Sons, 2013).
42. External Loss Data, Chapter 8
43. Capital Modeling, Chapter 12
(page 61)
(page 73)
44. Standardized Measurement Approach for Operational RiskConsultative Document,
(Basel Committee on Banking Supervision Publication, March 2016).
(page 86)
Kevin Dowd, Measuring Market Risk, 2nd Edition (West Sussex, UK: John Wiley & Sons, 2005).
45. Parametric Approaches (II): Extreme Value, Chapter 7
(page 96)
Giacomo De Laurentis, Renato Maino, and Luca Molteni, Developing, Validating and Using Internal Ratings (Hoboken, NJ: John Wiley & Sons, 2010).
46. Validating Rating Models, Chapter 5
(page 104)
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Book 3 Reading Assignments and Learning Objectives
Michel Crouhy, Dan Galai and Robert Mark, The Essentials o f Risk Management, 2nd Edition (New York, NY: McGraw-Hill, 2014).
47. Model Risk, Chapter 13
48. Risk Capital Attribution and Risk-Adjusted Performance Measurement,
Chapter 17
(page 116)
(page 128)
49. Range of Practices and Issues in Economic Capital Frameworks, (Basel Committee on
Banking Supervision Publication, March 2009).
(page 146)
30. Capital Planning at Large Bank Holding Companies: Supervisory Expectations
and Range of Current Practice, Board of Governors of the Federal Reserve System, August 2013.
(page 164)
Bruce Tuckman and Angel Serrat, Fixed Income Securities: Tools for Today s Markets, 3rd Edition (Hoboken, NJ: John Wiley & Sons, 2011)
51. Repurchase Agreements and Financing, Chapter 12
(page 178)
Kevin Dowd, Measuring Market Risk, 2nd Edition (West Sussex, UK: John Wiley & Sons, 2005).
52. Estimating Liquidity Risks, Chapter 14
(page 192)
Allan Malz, Financial Risk Management: Models, History, and Institutions (Hoboken, NJ: John Wiley & Sons, 2011).
53. Assessing the Quality of Risk Measures, Chapter 11
54. Liquidity and Leverage, Chapter 12
(page 206)
(page 216)
55. Darrell Duffie, 2010. The Failure Mechanics of Dealer Banks, Journal of Economic
Perspectives 24:1, 5172.
56. Til Schuermann, Stress Testing Banks, prepared for the Committee on Capital Market (page 248)
Regulation, Wharton Financial Institutions Center (April 2012).
(page 237)
(page 259)
57: Guidance on Managing Outsourcing Risk, Board of Governors of the Federal Reserve
System, December 2013.
John C. Hull, Risk Management and Financial Institutions, 4th Edition (Hoboken, NJ: John Wiley & Sons, 2015).
58. Basel I, Basel II, and Solvency II, Chapter 15
(page 267)
59. Basel II.5, Basel III, and Other Post-Crisis Changes, Chapter 16
60. Fundamental Review of the Trading Book, Chapter 17
(page 290)
(page 307)
61. Sound Management of Risks Related to Money Laundering and Financing of
Terrorism, (Basel Committee on Banking Supervision, June 2017).
(page 316)
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Le a r n in g O b j e c t iv e s
37. Principles for the Sound Management of Operational Risk
After completing this reading, you should be able to: 1. Describe the three lines of defense in the Basel model for operational risk
2. Summarize the fundamental principles of operational risk management as suggested
governance, (page 1)
by the Basel committee, (page 2)
3. Explain guidelines for strong governance of operational risk, and evaluate the role
of the board of directors and senior management in implementing an effective operational risk framework, (page 3)
4. Describe tools and processes that can be used to identify and assess operational risk,
(page 7)
3. Describe features of an effective control environment and identify specific controls
that should be in place to address operational risk, (page 7)
6. Explain the Basel Committees suggestions for managing technology risk and
outsourcing risk, (page 8)
38. Enterprise Risk Management: Theory and Practice After completing this reading, you should be able to: 1. Define enterprise risk management (ERM) and explain how implementing ERM
practices and policies can create shareholder value, both at the macro and the micro level, (page 13)
2. Explain how a company can determine its optimal amount of risk through the use
of credit rating targets, (page 17)
3. Describe the development and implementation of an ERM system, as well as
challenges to the implementation of an ERM system, (page 17)
4. Describe the role of and issues with correlation in risk aggregation, and describe
typical properties of a firms market risk, credit risk, and operational risk distributions, (page 18)
5. Distinguish between regulatory and economic capital, and explain the use of
economic capital in the corporate decision making process, (page 19)
39. Observations on Developments in Risk Appetite Frameworks and IT Infrastructure
After completing this reading, you should be able to: 1. Describe the concept of a risk appetite framework (RAF), identify the elements
of an RAF, and explain the benefits to a firm of having a well-developed RAF. (page 25)
2. Describe best practices for a firms Chief Risk Officer (CRO), Chief Executive
Officer (CEO), and its board of directors in the development and implementation of an effective RAF. (page 26)
3. Explain the role of an RAF in managing the risk of individual business lines within a firm, and describe best practices for monitoring a firms risk profile for adherence to the RAF. (page 27)
4. Explain the benefits to a firm from having a robust risk data infrastructure, and
describe key elements of an effective IT risk management policy at a firm, (page 28)
5. Describe factors that can lead to poor or fragmented IT infrastructure at an
6. Explain the challenges and best practices related to data aggregation at an
organization, (page 29)
organization, (page 30)
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40. Information Risk and Data Quality Management
After completing this reading, you should be able to: 1. 2. Explain how a firm can set expectations for its data quality and describe some key
Identify the most common issues that result in data errors, (page 36)
dimensions of data quality used in this process, (page 36)
3. Describe the operational data governance process, including the use of scorecards in
managing information risk, (page 38)
41. OpRisk Data and Governance
After completing this reading, you should be able to: 1. Describe the seven Basel II event risk categories and identify examples of
operational risk events in each category, (page 43)
2. Summarize the process of collecting and reporting internal operational loss data, including the selection of thresholds, the timeframe for recoveries, and reporting expected operational losses, (page 46)
3. Explain the use of a Risk Control Self-Assessment (RCSA) and key risk indicators
(KRIs) in identifying, controlling, and assessing operational risk exposures. (page 48)
4. Describe and assess the use of scenario analysis in managing operational risk, and identify biases and challenges that can arise when using scenario analysis, (page 31) 3. Compare the typical operational risk profiles of firms in different financial sectors,
(page 53)
6. Explain the role of operational risk governance and explain how a firms
organizational structure can impact risk governance, (page 56)
42. External Loss Data
After completing this reading, you should be able to: 1. Explain the motivations for using external operational loss data and common
sources of external data, (page 61)
2. Explain ways in which data from different external sources may differ, (page 64) 3. Describe the challenges that can arise through the use of external data, (page 65) 4. Describe the Societe Generale operational loss event and explain the lessons learned
from the event, (page 66)
43. Capital Modeling
After completing this reading, you should be able to: 1. Compare the basic indicator approach, the standardized approach, and the
alternative standardized approach for calculating the operational risk capital charge, and calculate the Basel operational risk charge using each approach, (page 73)
2. Describe the modeling requirements for a bank to use the Advanced Measurement
3. Describe the loss distribution approach to modeling operational risk capital.
Approach (AMA). (page 78)
(page 79)
4. Explain how frequency and severity distributions of operational losses are obtained,
including commonly used distributions and suitability guidelines for probability distributions, (page 79)
5. Explain how Monte Carlo simulation can be used to generate additional data points
to estimate the 99.9th percentile of an operational loss distribution, (page 81)
6. Explain the use of scenario analysis and the hybrid approach in modeling
operational risk capital, (page 81)
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44. Standardized Measurement Approach for Operational Risk
Book 3 Reading Assignments and Learning Objectives
After completing this reading, you should be able to: 1. Explain the elements of the proposed Standardized Measurement Approach (SMA),
including the business indicator, internal loss multiplier and loss component, and calculate the operational risk capital requirement for a bank using the SMA. (page 86)
2. Compare the SMA to earlier methods of calculating operational risk capital, including the Alternative Measurement Approaches (AMA), and explain the rationale for the proposal to replace them, (page 90)
3. Describe general and specific criteria recommended by the Basel Committee for the
identification, collection, and treatment of operational loss data, (page 91)
43. Parametric Approaches (II): Extreme Value
.After completing this reading, you should be able to: 1. Explain the importance and challenges of extreme values in risk management.
(page 96)
2. Describe extreme value theory (EVT) and its use in risk management, (page 96) 3. Describe the peaks-over-threshold (POT) approach, (page 98) 4. Compare and contrast generalized extreme value and POT. (page 100) 3. Evaluate the tradeoffs involved in setting the threshold level when applying the GP
distribution, (page 98)
6. Explain the importance of multivariate EVT for risk management, (page 100)
46. Validating Rating Models
After completing this reading, you should be able to: 1. Explain the process of model validation and describe best practices for the roles of
internal organizational units in the validation process, (page 104)
2. Compare qualitative and quantitative processes to validate internal ratings, and
describe elements of each process, (page 107)
3. Describe challenges related to data quality and explain steps that can be taken to
validate a models data quality, (page 109)
4. Explain how to validate the calibration and the discriminatory power of a rating
model, (page 111)
47. Model Risk
After completing this reading, you should be able to: 1.
Identify and explain errors in modeling assumptions that can introduce model risk. (page 116)
2. Explain how model risk can arise in the implementation of a model, (page 118) 3. Explain methods and procedures risk managers can use to mitigate model risk.
(page 119)
4. Explain the impact of model risk and poor risk governance in the 2012 London
Whale trading loss and the 1998 collapse of Long Term Capital Management. (page 120)
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48. Risk Capital Attribution and Risk-Adjusted Performance Measurement
After completing this reading, you should be able to: 1. Define, compare, and contrast risk capital, economic capital, and regulatory capital,
and explain methods and motivations for using economic capital approaches to allocate risk capital, (page 128)
2. Describe the RAROC (risk-adjusted return on capital) methodology and its use in
capital budgeting, (page 130)
3. Compute and interpret the RAROC for a project, loan, or loan portfolio, and use
RAROC to compare business unit performance, (page 130)
4. Explain challenges that arise when using RAROC for performance measurement, including choosing a time horizon, measuring default probability, and choosing a confidence level, (page 133)
3. Calculate the hurdle rate and apply this rate in making business decisions using
RAROC. (page 133)
6. Compute the adjusted RAROC for a project to determine its viability, (page 136) 7. Explain challenges in modeling diversification benefits, including aggregating a firms risk capital and allocating economic capital to different business lines. (page 136)
8. Explain best practices in implementing an approach that uses RAROC to allocate
economic capital, (page 138)
49. Range of Practices and Issues in Economic Capital Frameworks
After completing this reading, you should be able to: 1. Within the economic capital implementation framework describe the challenges
that appear in: Defining and calculating risk measures Risk aggregation Validation of models Dependency modeling in credit risk Evaluating counterparty credit risk Assessing interest rate risk in the banking book (page 146)
2. Describe the BIS recommendations that supervisors should consider to make effective use of internal risk measures, such as economic capital, that are not designed for regulatory purposes, (page 156)
3. Explain benefits and impacts of using an economic capital framework within the
following areas: Credit portfolio management Risk based pricing Customer profitability analysis Management incentives (page 157)
capital framework, (page 158)
4. Describe best practices and assess key concerns for the governance of an economic
50. Capital Planning at Large Bank Holding Companies: Supervisory Expectations and
Range of Current Practice .After completing this reading, you should be able to: 1. Describe the Federal Reserves Capital Plan Rule and explain the seven principles of an effective capital adequacy process for bank holding companies (BHCs) subject to the Capital Plan Rule, (page 164)
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Book 3 Reading Assignments and Learning Objectives
2. Describe practices that can result in a strong and effective capital adequacy process
Internal controls, including model review and valuation for a BHC in the following areas: Risk identification
Corporate governance Capital policy, including setting of goals and targets and contingency planning
Estimating losses, revenues, and expenses, including quantitative and qualitative
Stress testing and stress scenario design
methodologies
Assessing the impact of capital adequacy, including risk-weighted asset (RWA)
and balance sheet projections (page 166)
31. Repurchase Agreements and Financing
After completing this reading, you should be able to: 1. Describe the mechanics of repurchase agreements (repos) and calculate the
settlement for a repo transaction, (page 178)
2. Explain common motivations for entering into repos, including their use in cash
management and liquidity management, (page 179)
3. Explain how counterparty risk and liquidity risk can arise through the use of repo
transactions, (page 181)
4. Assess the role of repo transactions in the collapses of Lehman Brothers and Bear
Stearns during the (2007-2009) credit crisis, (page 182)
3. Compare the use of general and special collateral in repo transactions, (page 183) 6. Describe the characteristics of special spreads and explain the typical behavior of
US Treasury special spreads over an auction cycle, (page 185)
7. Calculate the financing advantage of a bond trading special when used in a repo
transaction, (page 186)
52. Estimating Liquidity Risks
After completing this reading, you should be able to: 1. Define liquidity risk and describe factors that influence liquidity, including the bid-
ask spread, (page 192)
2. Differentiate between exogenous and endogenous liquidity, (page 193) 3. Describe the challenges of estimating liquidity-adjusted VaR (LVaR). (page 193) 4. Describe and calculate LVaR using the constant spread approach and the exogenous
spread approach, (page 194)
5. Describe endogenous price approaches to LVaR, their motivation and limitations,
and calculate the elasticity-based liquidity adjustment to VaR. (page 197)
6. Describe liquidity at risk (LaR) and compare it to LVaR and VaR, describe the factors that affect future cash flows, and explain challenges in estimating and modeling LaR. (page 199)
7. Describe approaches to estimate liquidity risk during crisis situations and challenges
which can arise during this process, (page 200)
53. Assessing the Quality of Risk Measures
After completing this reading, you should be able to: 1. Describe ways that errors can be introduced into models, (page 206) 2. Explain how model risk and variability can arise through the implementation of
VaR models and the mapping of risk factors to portfolio positions, (page 207)
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Book 3 Reading Assignments and Learning Objectives
3.
Identify reasons for the failure of the long-equity tranche, short-mezzanine credit trade in 2003 and describe how such modeling errors could have been avoided. (page 209)
4. Explain major defects in model assumptions that led to the underestimation of
systematic risk for residential mortgage backed securities (RMBS) during the 2007 2009 financial downturn, (page 211)
34. Liquidity and Leverage
After completing this reading, you should be able to: 1. Differentiate between sources of liquidity risk, including balance sheet/funding
liquidity risk, systematic funding liquidity risk, and transactions liquidity risk, and explain how each of these risks can arise for financial institutions, (page 216)
2. Summarize the asset-liability management process at a fractional reserve bank,
including the process of liquidity transformation, (page 217)
3. Describe specific liquidity challenges faced by money market mutual funds and by
hedge funds, particularly in stress situations, (page 219)
4. Compare transactions used in the collateral market and explain risks that can arise
through collateral market transactions, (page 220)
5. Describe the relationship between leverage and a firms return profile, calculate the
leverage ratio, and explain the leverage effect, (page 222)
6. Explain the impact on a firms leverage and its balance sheet of the following
transactions: purchasing long equity positions on margin, entering into short sales, and trading in derivatives, (page 224)
7. Explain methods to measure and manage funding liquidity risk and transactions
liquidity risk, (page 228)
8. Calculate the expected transactions cost and the spread risk factor for a transaction, and calculate the liquidity adjustment to VaR for a position to be liquidated over a number of trading days, (page 229)
9. Explain interactions between different types of liquidity risk and explain how
liquidity risk events can increase systemic risk, (page 216)
55. The Failure Mechanics of Dealer Banks
After completing this reading, you should be able to: 1. Describe the major lines of business in which dealer banks operate and the risk
factors they face in each line of business, (page 237) Identify situations that can cause a liquidity crisis at a dealer bank and explain responses that can mitigate these risks, (page 241)
2.
3. Describe policy measures that can alleviate firm-specific and systemic risks related to
large dealer banks, (page 244)
56. Stress Testing Banks
After completing this reading, you should be able to: 1. Describe the historical evolution of the stress testing process and compare methodologies of historical EBA, CCAR and SCAP stress tests, (page 249)
2. Explain challenges in designing stress test scenarios, including the problem of
coherence in modeling risk factors, (page 250)
3. Explain challenges in modeling a banks revenues, losses, and its balance sheet over a
stress test horizon period, (page 251)
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37. Guidance on Managing Outsourcing Risk
Book 3 Reading Assignments and Learning Objectives
After completing this reading, you should be able to: 1. Explain how risks can arise through outsourcing activities to third-party service providers, and describe elements of an effective program to manage outsourcing risk, (page 239)
2. Explain how financial institutions should perform due diligence on third-party
3. Describe topics and provisions that should be addressed in a contract with a third-
service providers, (page 260)
party service provider, (page 261)
58. Basel I, Basel II, and Solvency II
After completing this reading, you should be able to: 1. Explain the motivations for introducing the Basel regulations, including key risk
exposures addressed, and explain the reasons for revisions to Basel regulations over time, (page 267)
2. Explain the calculation of risk-weighted assets and the capital requirement per the
original Basel I guidelines, (page 268)
3. Describe and contrast the major elementsincluding a description of the risks coveredof the two options available for the calculation of market risk capital:

Standardized Measurement Method Internal Models Approach (page 271)
4. Calculate VaR and the capital charge using the internal models approach, and
explain the guidelines for backtesting VaR. (page 272)
5. Describe and contrast the major elements of the three options available for the
Standardized Approach calculation of credit risk capital:
Foundation IRB Approach Advanced IRB Approach (page 274)
6. Describe and contrast the major elements of the three options available for the
calculation of operational risk capital: basic indicator approach, standardized approach, and the Advanced Measurement Approach, (page 280)
7. Describe the key elements of the three pillars of Basel II: minimum capital
requirements, supervisory review, and market discipline, (page 280)
8. Define in the context of Basel II and calculate the worst-case default rate (WCDR).
(page 274)
9. Differentiate between solvency capital requirements (SCR) and minimum capital requirements (MCR) in the Solvency II framework, and describe the repercussions to an insurance company for breaching the SCR and MCR. (page 282)
10. Compare the standardized approach and the Internal Models Approach for
calculating the SCR in Solvency II. (page 282)
59. Basel II.5, Basel III, and Other Post-Crisis Changes After completing this reading, you should be able to: 1. Describe and calculate the stressed VaR measure introduced in Basel 2.5, and
calculate the market risk capital charge, (page 290)
2. Explain the process of calculating the incremental risk capital charge for positions
held in a banks trading book, (page 292)
3. Describe the comprehensive risk measure (CRM) for positions that are sensitive to
correlations between default risks, (page 292)
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4. Define in the context of Basel III and calculate where appropriate.
Tier 1 capital and its components Tier 2 capital and its components Required Tier 1 equity capital, total Tier 1 capital, and total capital (page 294) 3. Describe the motivations for and calculate the capital conservation buffer and the
countercyclical buffer introduced in Basel III. (page 293)
6. Describe and calculate ratios intended to improve the management of liquidity risk, including the required leverage ratio, the liquidity coverage ratio, and the net stable funding ratio, (page 296)
7. Describe the mechanics of contingent convertible bonds (CoCos) and explain the
motivations for banks to issue them, (page 299)
8. Explain the major changes to the US financial market regulations as a result of
Dodd-Frank, (page 300)
60. Fundamental Review of the Trading Book
After completing this reading, you should be able to: 1. Describe the proposed changes to the Basel market risk capital calculation and
the motivations for these changes, and calculate the market risk capital under this method, (page 307)
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, (page 309)
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 (page 311)
61. Sound Management of Risks Related to Money Laundering and Financing
of Terrorism After completing this reading, you should be able to: 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, (page 316)
2. Describe recommended practices for the acceptance, verification, and identification
of customers at a bank, (page 318)
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, (page 320)
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, (page 322)
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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:
Pr i n c i pl e s f o r t h e So u n d Ma n a g e me n t o f O pe r a t i o n a l Ri s k
Topic 37
Ex a m Fo c u s
This is a descriptive topic that addresses the principles of sound operational risk management as proposed by the Basel Committee on Banking Supervision. The committee describes a three lines of defense approach, which includes business line management, independent operational risk management, and independent reviews. The committee suggests that a bank should have a corporate operational risk function (CORF) that is commensurate with the size and complexity of the banking organization. For the exam, understand the 11 principles of operational risk management as outlined by the Basel Committee. Know the specific responsibilities of the board of directors and senior managers as they relate to the 11 principles of operational risk management. Be able to explain the critical components of the banks operational risk management framework documentation, and know the features of an effective control environment. Lastly, understand the committees recommendations for managing technology and outsourcing risk.
O pe r a t io n a l Ris k G o v e r n a n c e