Notes of CFA Level1 READING 41 & 42: Introduction to Risk Management

The major components of an IPS（investment policy statement） typically address the following:

• Description of Client circumstances, situation, and investment objectives.
• Statement of the Purpose of the IPS.
• Statement of Duties and Responsibilities of investment manager, custodian of assets, and the client.
• Procedures to update IPS and to respond to various possible situations.
• Investment Objectives derived from communications with the client.
• Investment Constraints that must be considered in the plan.
• Investment Guidelines such as how the policy will be executed, asset types permitted, and leverage to be used.
• Evaluation of Performance, the benchmark portfolio for evaluating investment performance, and other information on evaluation of investment results.
• Appendices containing information on strategic (baseline) asset allocation and permitted deviations from policy portfolio allocations, as well as how and when the portfolio allocations should be rebalanced. 

Investment constraints include the investor’s liquidity needs, time horizon, tax considerations, legal and regulatory constraints, and unique needs and preferences.

Financial risks are those that arise from exposure to financial markets. Examples are:

• Credit risk. This is the uncertainty about whether the counterparty to a transaction will fulfill its contractual obligations。
• Liquidity risk. This is the risk of loss when selling an asset at a time when market conditions make the sales price less than the underlying fair value of the asset.
• Market risk. This is the uncertainty about market prices of assets (stocks, commodities, and currencies) and interest rates.

Non-financial risks arise from the operations of the organization and from sources external to the organization. Examples are:

• Operational risk. This is the risk that human error or faulty organizational processes will result in losses.
• Solvency risk. This is the risk that the organization will be unable to continue to operate because it has run out of cash.
• Regulatory risk. This is the risk that the regulatory environment will change, imposing costs on the firm or restricting its activities.
• Governmental or political risk (including tax risk). This is the risk that political actions outside a specific regulatory framework, such as increases in tax rates, will impose significant costs on an organization.
• Legal risk. This is the uncertainty about the organization’s exposure to future legal action.
• Model risk. This is the risk that asset valuations based on the organization’s analytical models are incorrect.
• Tail risk. This is the risk that extreme events (those in the tails of the distribution of outcomes) are more likely than the organization’s analysis indicates, especially from incorrectly concluding that the distribution of outcomes is normal
• Accounting risk. This is the risk that the organization’s accounting policies and estimates are judged to be incorrect. 

Measures of risk for specific asset types include standard deviation, beta, and duration.

• Standard deviation is a measure of the volatility of asset prices and interest rates. Standard deviation may not be the appropriate measure of risk for non-normal probability distributions, especially those with negative skew or positive excess kurtosis (fat tails).
• Beta measures the market risk of equity securities and portfolios of equity securities. This measure considers the risk reduction benefits of diversification and is appropriate for securities held in a well-diversified portfolio, whereas standard deviation is a measure of risk on a stand-alone basis.
• Duration is a measure of the price sensitivity of debt securities to changes in interest rates.

Derivatives risks (sometimes referred to as “the Greeks”) include:

• Delta. This is the sensitivity of derivatives values to the price of the underlying asset.
• Gamma. This is the sensitivity of delta to changes in the price of the underlying asset.
• Vega. This is the sensitivity of derivatives values to the volatility of the price of the underlying asset.
• Rho. This is the sensitivity of derivatives values to changes in the risk-free rate. 

Value at risk (VaR) is the minimum loss over a period that will occur with a specific probability. Consider a bank that has a one-month VaR of $1 million with a probability of 5%. That means that a one-week loss of at least $1 million is expected to occur 5% of the time. Note that this is not the maximum one-month loss the bank will experience; it is the minimum loss that will occur 5% of the time. VaR does not provide a maximum loss for a period. VaR has become accepted as a risk measure for banks and is used in establishing minimum capital requirements.

Conditional VaR (CVaR) is the expected value of a loss, given that the loss exceeds a minimum amount. Relating this to the VaR measure presented above, the CVaR would be the expected loss, given that the loss was at least $1 million. It is calculated as the probability-weighted average loss for all losses expected to be at least $1 million. CVaR is similar to the measure of loss given default that is used in estimating risk for debt securities.