2009/2010 FINANCIAL RISK MANAGER

(FRM) LEVEL I HANDBOOK
































Alan Anderson, Ph.D.
Western Connecticut State University
ECI Risk Training
http://www.frmtraining.com






CHAPTER 1: FUNDAMENTAL RISK CONCEPTS

1.1 RISK

Risk refers to uncertainty over future events, such as stock prices, the level of interest
rates, GDP growth, the repayment of loans by a borrower, etc. that can impact the
solvency of an organization.

1.2 TYPES OF RISK

Risk can be classified as follows:

• market risk
o interest rate risk
o commodity price risk
o foreign exchange risk
o equity price risk
• credit risk
• operational risk

1.2.1 MARKET RISK

Market risk refers to the possibility of losses due changes in economic variables such as
interest rates, commodity prices, exchange rates and equity prices.

1.2.1.1 INTEREST RATE RISK

Interest rate risk refers to the possibility that financial assets will decline in value due to
an adverse change in interest rates. For example, the prices of bonds and interest rates
are inversely related; therefore, rising interest rates lead to capital losses for bondholders.

1.2.1.2 COMMODITY PRICE RISK

A commodity is a good that has highly standardized properties; some examples are:

• oil
• gold
• copper
• sugar
• salt

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• wheat
• orange juice
• pork bellies

Commodities can be classified as hard (non-perishable) commodities and soft

(perishable) commodities. Precious metals and industrial metals are examples of hard
commodities, while agricultural products and energy are examples of soft commodities.

Commodity price risk refers to the possibility that losses will occur due to adverse
changes in commodity prices; for example, costs of production rise when oil prices rise,
leading to reduced profits for a corporation.

1.2.1.3 FOREIGN EXCHANGE RISK

Foreign exchange risk refers to the possibility that losses will occur due to changes in
the strength of a currency. For example, if a U.S. firm earns profits denominated in
British pounds, the dollar value of these profits will decline if the dollar strengthens
(appreciates) against the pound.

1.2.1.4 EQUITY PRICE RISK

Equity price risk refers to the possibility that losses could result from changes in equity
(stock) prices. For example, if an insurance company holds a broad-based portfolio of
common stocks, a decline in stock prices could make it difficult for the company to honor
its obligations to its policyholders.

1.2.2 CREDIT RISK

Credit risk refers to the possibility that losses will occur due to deterioration in the
ability of the obligor (borrower) to make promised interest and principal payments in a
timely manner. For example, if a bank holds corporate bonds in its investment portfolio,
the possibility of default by these bonds is classified as credit risk.

1.2.3 OPERATIONAL RISK

Operational risk refers to the possibility of losses due to a failure of internal processes,
people, systems and external events. Sources of operational risk include fraud, human
error, computer system failures, power failures, property damage due to fires or natural
disasters, etc.

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1.2.4 ENTERPRISE RISK MANAGEMENT (ERM)

Enterprise risk management (ERM) refers to the integration of market, credit and
operational risk into a coherent framework. The objective of ERM is to explicitly
consider the interaction among these types of risk, instead of considering each type of
risk in isolation.

1.3 OTHER TYPES OF RISK

Other important types of risks include:

• liquidity risk
• legal (regulatory) risk
• business risk
• strategic risk
• reputation risk

1.3.1 LIQUIDITY RISK

The liquidity of an asset refers to the ease of exchanging it for other goods or assets. For
example, money is the most liquid asset; checking deposits are also highly liquid. Stocks
and bonds are less liquid, since they must be sold through specialized brokers; this entails
transactions costs, such as bid-ask spreads. In addition, selling stocks and bonds is
relatively time-consuming compared with more liquid assets such as money. Examples
of highly illiquid assets are: real estate, art, jewelry and gold coins. Valuing these assets
can be difficult, since they have unique characteristics and are bought and sold
infrequently. Further, the time required to sell these assets can be significant.

Liquidity risk can be classified as:

• funding liquidity risk

• asset liquidity risk



Funding liquidity risk refers to the possibility that sources of short-term funding will be
restricted in the future, making it difficult or costly for a firm to meet its liabilities in a
timely manner. For example, a corporation may find that its bank has restricted its lines
of credit, making it difficult to meet short-term obligations such as payroll.

Asset liquidity risk refers to the possibility that it will be difficult to carry out a financial
transaction without incurring a significant cost. For example, if a bank holds a risky

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corporate bond in its portfolio, it could be difficult to sell the bond without incurring
significant transactions costs due to the thin market for the bond.




1.3.2 LEGAL (REGULATORY) RISK

All financial transactions take place within a given country’s regulatory environment.
The risk that this environment will change in an adverse way is known as legal or
regulatory risk. An example of this would be unfavorable changes in tax laws.

1.3.3 BUSINESS RISK

Business risk refers to the different types of uncertainties confronting a corporation, such
as the quantity of a product to produce, the amount of advertising to use, the type of
funding to use, etc.

1.3.4 STRATEGIC RISK

Strategic risk refers to the possibility of losses due to poor decision-making, faulty
implementation of business decisions, etc. For example, if a corporation decides to
compete in a new market, the possibility of failure would be classified as strategic risk.

1.3.5 REPUTATION RISK

Reputation risk refers to the chance that losses will occur as a result of damage to a
firm’s public image. For example, a product recall could reduce consumer confidence in
a firm, leading to a reduction in its sales.

1.4 ASSET PRICING MODELS: THE CAPM

The Capital Asset Pricing Model (CAPM) explains the relationship between risk and
expected returns for equities. The CAPM classifies all risk as:

• systematic (market) risk

• non-systematic (firm-specific) risk

One of the key insights of the CAPM is that a security’s expected return does not reflect
non-systematic risk, since this can be eliminated in a well-diversified portfolio. In a
well-diversified portfolio, non-systematic risks will partially or totally offset each other.
As a result, in an efficient market, no investor can expect to be rewarded for bearing non-
systematic risk. Therefore, the expected return to a security depends only on systematic
risk.

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The CAPM is based on several restrictive assumptions:

• investors are risk averse and seek to maximize the expected utility of their wealth
• all information is costless and available simultaneously to all investors
• all investors have an identical investment horizon
• investors may borrow or lend unlimited amounts at the risk-free rate of interest
• there are no taxes or transactions costs; all assets trade and are infinitely divisible
• all investors have identical expectations

According to the CAPM, there is a linear relationship between the expected return to a
stock and its risk. Risk is defined by the CAPM as the uncertainty of a stock’s returns
relative to those of the market portfolio.

The market portfolio is defined as a portfolio containing all assets in the economy,
weighted by their market capitalization. In order to implement the CAPM model, the
returns to the market portfolio can be estimated with a proxy, such as the Standard and
Poor’s 500 index. According to the CAPM, a security’s expected return is a function of
its contribution to the risk of a well-diversified portfolio. This contribution is measured
by the security’s sensitivity to systematic or market risk, as indicated by its beta:

Cov(ri ,rM )
βi =
Var(rM )

where:
Var(rM) = the variance of the excess returns to the market portfolio

Cov(ri, rM) = the covariance between the excess returns to stock i and the
market portfolio

The excess return to a stock is the difference between the return to the stock and the
risk-free rate of interest; i.e., the yield on Treasury securities. Excess return is also
known as a risk premium. A risk premium is the compensation investors require in
order to buy a risky asset instead of the risk-free asset. Since the risk-free rate is a
known constant, its covariance with the market portfolio is zero. Therefore, its beta is
also zero. The beta of the market portfolio equals one, since beta measures the risk of an
asset relative to the market portfolio.

Based on the CAPM assumptions, the model predicts that all investors will choose to
hold a combination of the market portfolio (M) and the risk-free asset. Investors will
allocate their portfolio to the market portfolio and the risk-free asset based on their degree
of risk aversion. A risk-averse investor requires compensation for bearing risk; a risk-

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neutral investor requires no compensation for bearing risk, while a risk-seeking investor
would accept a lower return in exchange for bearing risk.

1.4.1 THE CAPM EQUATION

According to the CAPM, the expected return to a stock is:

E(ri) = rf + βi[E(rM) – rf]

where:

E(ri) = expected return to stock i

rf = risk-free rate of interest
βi = beta of stock i
E(rM) = expected return to market portfolio

EXAMPLE

Suppose that the risk-free rate is 3%, while the expected return to the market portfolio is
10%. Assume that Ford stock has a beta of 2.1, IBM stock has a beta of 1.4 and GM
stock has a beta of 0.9. According to the CAPM, the expected return to each stock is
determined as follows:

FORD: E(ri) = rf + βi[E(rM) – rf] =.03 + (2.1)[.10 - .03] =.177= 17.7%

IBM: E(ri) = rf + βi[E(rM) – rf] =.03 + (1.4 )[.10 - .03] =.128 = 12.8%
GM: E(ri) = rf + βi[E(rM) – rf] =.03 + (0.9 )[.10 - .03] =.093 = 9.3%

1.4.2 THE CAPITAL MARKET LINE (CML)

The capital market line (CML) shows the relationship between the expected return to a
stock and the risk of the stock, measured by the standard deviation of its returns. The
Capital Market Line is tangent to the efficient frontier, which represents the set of all
assets where the expected return is maximized for a given level of risk. The intercept of
the Capital Market Line is the risk-free rate since its standard deviation is zero. The
Capital Market Line is illustrated in the following diagram:

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The slope of the CML represents the gain in expected return that can be achieved by
bearing more risk. The steeper the CML, the more favorable is the tradeoff between
expected return and risk. The Capital Market Line touches the efficient frontier at a
single point: the market portfolio (M). The equation of the CML is:

⎡ E(rM ) − rf ⎤
E(ri ) = rf + σ i ⎢ ⎥
⎣ σM ⎦



Choosing to invest on the CML gives investors the highest possible return per unit of
risk; therefore, one of the implications of the CAPM is that all investors will choose a
combination of the market portfolio and the risk-free asset. The allocation between the
two assets will be determined by an investor’s degree of risk aversion. Highly risk-
averse investors will place most or all of their funds in the risk-free asset; less risk-averse
investors will place a larger proportion of their funds in the market portfolio. Investors
can achieve positions that are riskier than the market portfolio by short-selling the risk-
free asset (i.e., borrowing) to invest more in the market portfolio.

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1.4.3 THE SECURITY MARKET LINE (SML)

The security market line (SML) shows the relationship between the expected return to a
stock and its beta (i.e., systematic risk). The SML is a graph of the CAPM equation.
Using the data from the previous example (Ford, IBM and GM stock), the following
SML can be constructed:













In equilibrium, all stocks will be on the SML; any stock that is not on the SML is
considered to be mispriced. In an efficient market, the prices of these stocks will adjust
quickly until they return to the SML. Any stock that is above the SML is underpriced
relative to the CAPM, since its expected return exceeds the value predicted by the
CAPM. As a result, investors will buy the stock, which raises its price and reduces its
expected return. Similarly, any stock that is below the SML is overpriced. Investors will
sell the stock, reducing its price and raising its expected return.

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EXAMPLE

If the stock of the XYZ corporation has a beta of 2.1, it should have an expected return
equal to that of Ford (17.7%). Suppose instead that its expected return is 20%; this
indicates that the price of the stock is too low. In an efficient market, investors will buy
XYZ stock, which will raise its price and lower its expected return until it returns to the
SML.

EXAMPLE

If the stock of the ABC corporation has a beta of 2.1, it should have an expected return
equal to that of Ford (17.7%). Suppose instead that its expected return is 16.0%; this
indicates that the price of the stock is too high. In an efficient market, investors will sell
ABC stock, which will lower its price and raise its expected return until it returns to the
SML.

1.4.4 MARKET EFFICIENCY

The CAPM model is based on the assumption of efficient capital markets. The three
basic forms of market efficiency are:

• weak
• semi-strong
• strong

If markets are weakly efficient, then all securities prices reflect their own past values.
With the semi-strong form of market efficiency, securities prices reflect all publicly
available information, including past prices. With the strong form of market efficiency,
securities prices reflect all information, both public and private. The CAPM is based on
the assumption of strong market efficiency.

1.5 MEASURES OF PERFORMANCE

Several measures of the relationship between risk and return for an asset or portfolio are
commonly used, including:

• the Sharpe Ratio

• the Treynor Ratio
• Jensen’s Alpha
• the Information Ratio
• the Sortino Ratio

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1.5.1 THE SHARPE RATIO

The Sharpe Ratio is defined as:

E(rp ) − rf
σp
where:

E(rp) = expected portfolio return

rf = risk-free rate
σP = portfolio standard deviation

The Sharpe Ratio indicates the expected excess return to an asset per unit of total risk, as
measured by the standard deviation of returns.

1.5.2 THE TREYNOR RATIO

The Treynor Ratio is defined as:

E(rp ) − rf
βp

where:

βP = portfolio beta

The Treynor Ratio indicates the expected excess return to an asset per unit of systematic
risk, as measured by beta. This measure works best for diversified portfolios.

1.5.3 JENSEN’S ALPHA

Jensen’s alpha is defined as:

αi = E(ri) - rf - βi[E(rM) – rf]

This represents deviations from the expected returns predicted by the CAPM model. In
equilibrium, Jensen's alpha equals zero. Jensen’s alpha is used to determine if a portfolio
manager is adding value relative to the returns from a passive investment strategy.
Jensen’s alpha can be generalized as follows: α = E(rP) - E(rB)

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where:

E(rP) = expected return to a portfolio

E(rB) = the expected return to a benchmark asset or portfolio

Jensen's alpha provides a measure of an investment manager's skill, as follows:

α > 0: superior return

α = 0: normal return
α < 0: inferior return

Since alpha can be zero by pure chance, a hypothesis test can be performed to determine
if alpha is significantly different from zero. In this case, the null hypothesis is that alpha
equals zero; the alternative hypothesis is that alpha is different from zero:

H0 : α = 0
H1 : α ≠ 0

The test statistic is:

α−0
t=
Sα
where:

sα = the standard error of alpha

As a rule of thumb, if the test statistic exceeds 2, then the null hypothesis is rejected in
favor of the alternative hypothesis that alpha is positive. If the test statistic is less than -2,
then the null hypothesis is rejected in favor of the alternative hypothesis that alpha is
negative. Otherwise, the null hypothesis that alpha equals zero cannot be rejected.

1.5.4 THE INFORMATION RATIO

The information ratio equals the difference between the expected return to a portfolio
and the expected return to a benchmark, (portfolio active return), divided by the tracking
error:
E(rP ) − E(rB )
IR =
σ (rP − rB )

The information ratio measures the expected return of an active portfolio manager
relative to a benchmark divided by the risk taken. The information ratio can be used to

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compare the performances of two portfolio managers; a higher the value of the
information ratio indicates a superior performance. The statistical significance of the
information ratio can be tested with the following test statistic:

IR
t=
SIR

where:

IR = information ratio
SIR = standard error of information ratio

1
SIR ≈
t

where: t = number of years

1.5.5 THE SORTINO RATIO

The Sortino Ratio is defined as:

E(rP ) − rmin
SVmin

where:

rmin = minimum acceptable return (target return)

SVmin = the semi-variance of the returns below rmin

The semi-variance is computed in the same way as the variance except that returns
greater than or equal to rmin are discarded.

1.6 TRACKING ERROR

Tracking error is the standard deviation of the difference between the returns to a
portfolio and the returns to a benchmark:

TE = σ(rP - rB)

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where:

TE = tracking error
rP = portfolio returns
rB = benchmark portfolio returns

Tracking error may be thought of as the standard deviation of Jensen’s alpha over time; it
shows how closely a portfolio’s returns match a benchmark portfolio. Tracking error is
typically higher for actively managed portfolios than for passively managed portfolios.

1.7 ASSET PRICING MODELS: MULTFACTOR MODELS

Newer models have extended the CAPM to include multiple risk factors; these are known
as multifactor models. With a multifactor model, the expected return to a stock is
decomposed into several risk factors and the sensitivities of the stock’s returns to these
factors: E(ri) = αi + βi1f1 + βi2f2 + βi3f3 + .... + βiKfK + εi

where:

fk = risk factor k
αi = a constant
βik = the sensitivity of stock i’s returns to factor k
εi = non-systematic risk

1.7.1 ARBITRAGE PRICING THEORY (APT)

Arbitrage pricing theory (APT) is a multifactor version of the CAPM. The APT model
can be written as:
K
E(ri ) − rf = ∑ βik fk
k =1

The risk factors are macroeconomic factors that apply to all assets in the economy, such
as GDP, inflation rates, exchange rates, commodity prices, etc.

A closely related type of multifactor model is known as the empirical model, where the
risk factors are specific to an individual asset, such as its dividend yield, market
capitalization, earnings, leverage, etc.

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1.7.2 EXPLICIT VS. IMPLICIT MODELS

With an explicit multifactor model, the factors are identified in advance; the sensitivities
are estimated from historical data. With an implicit multifactor model, both the identity
of the factors and the sensitivities are taken from historical data; the factors are
determined through a statistical procedure known as factor analysis.

1.8 RISK MANAGEMENT FAILURES

One of the main objectives of risk management is to correctly measure the risks faced by
an organization. This process can lead to errors if risks are not measured correctly or if
they are not measured at all. Another key objective of risk management is to properly
communicate results to senior management. Risk management is also charged with
ensuring that the risks taken by an organization are consistent with the risk appetite of
senior management. This includes making decisions about which projects to accept and
reject as well as hedging strategies.

Overall, the six basic types of risk management failures are:

1) incorrect measurement of known risks

2) failure to take relevant risks into account
3) failure to communicate risks to senior management
4) failure to properly monitor risk
5) failure to properly manage risk
6) failure to properly measure risk

1.9 CASE STUDIES

Over the past twenty years there have been several well-publicized cases of huge losses
due to the failure to follow proper risk management procedures. These include:

• Metallgesellschaft
• Sumitomo
• Long-Term Capital Management
• Barings

1.9.1 METALLGESELLSCHAFT (MGRM)

In 1993, Metallgesellschaft (MGRM) admitted that its energy group had lost $1.5 billion
from forward contracts on oil. MGRM was originally a metals producer; later, it became
involved in risk management services. MGRM committed to sell oil (at prices set in

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1992) every month for up to ten years through forward contracts on 160 million barrels.
These contracts contained an embedded option in which the counterparty could terminate
early if the shortest term New York Mercantile Exchange (NYMEX) oil futures contract
was greater than the price of the forward contract. MGRM would then be required to pay
one-half of the difference to the counterparty. This was beneficial to buyers who were in
financial trouble or no longer needed the oil.

MGRM used “stacked” futures to hedge their risk; all contracts were short-dated, not
spread across maturities. MGRM took long positions in these futures contracts and
entered into energy swaps as the payer of fixed energy prices and receiver of floating
energy prices. The massive volume of trading relative to the size of the market ensured
that it would be difficult to unwind their positions; the positions left MGRM vulnerable
to liquidity risk. When oil prices fell, the short-dated futures contracts required large
margin calls that MGRM couldn’t meet.

The market was originally in normal backwardation, which occurs when the spot price
is greater than the futures price. The futures curve is downward-sloping; i.e., futures
prices decline as their maturity increases. It then switched to contango, which occurs
when the futures price is greater than the spot price. The futures curve is upward-sloping;
i.e., futures prices rise as their maturity increases. This causes “rollover” losses for the
long futures position as short-dated hedges mature and are replaced with progressively
more expensive contracts. Ultimately, the failure to anticipate this funding risk is what
brought down MGRM.

1.9.2 SUMITOMO

In June 1996, Sumitomo Corp. announced that it had lost over $2 billion due to
unauthorized copper trading by Yasuo Hamanaka. Yasuo Hamanaka was the firm’s chief
copper trader; his strategy involved illegal manipulations of the copper market through
extremely large purchases or sales. Hamakana kept two sets of records of his trades, so
that he could show profits to Sumitomo’s accountants while racking up huge losses.
Since Hamanaka appeared to be making sizable profits for Sumitomo, his actions were
not closely scrutinized, making Sumitomo management at least partially responsible for
this debacle.

1.9.3 LONG-TERM CAPITAL MANAGEMENT (LTCM)

John Meriwether, Myron Scholes and Robert Merton were the principals of LTCM.
LTCM was able to use the reputation of its principals to borrow 100% of any collateral
that it posted, then use the proceeds to borrow more; this enabled LTCM to leverage its
investments to a level of 25-1. Bets were placed on “convergence trades.”

In 1998, LTCM bet that the spread between U.S. Treasuries and emerging markets bonds
would narrow as investors sought higher yields. Losses started in August 1998 following

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the Russian debt moratorium; as the spread between U.S. Treasuries and other securities
widened, more collateral was required to cover mounting losses. By September 1998,
LTCM’s capital was down to $4 billion, but their total notional exposure was about $1
trillion. Although LTCM had stress-tested its portfolios, the change in correlations was
so dramatic that their models did not predict what actually happened. Ultimately, LTCM
was bailed out by a consortium of banks arranged by the Fed.

The major problems at LTCM included:

1) Not enough attention was paid to stress-testing, gap risk and liquidity risk;
insufficient attention paid to size of notional positions, despite relatively small net
positions was still risky since the price of notional principal can change in
unpredictable ways.

2) Counterparties were too generous with their funding to LTCM

3) Supervision – the SEC and the New York Stock Exchange underestimated the risk
of LTCM

1.9.4 BARINGS

Barings Bank became insolvent in 1995 as a result of the activities of a rogue trader
named Nick Leeson. Leeson was the head derivatives trader at the bank’s newly-formed
Singapore office. Leeson was also in charge of the back office; as a result, he was able to
hide his losses in the phantom client account #88888. He also used falsified records to
cover up his losses. Due to mounting margin calls, the scheme unraveled, forcing Leeson
to confess to losses of about $1.3 billion.

The strategies employed by Nick Leeson consisted mainly of long futures positions on
the Japanese stock market and Japanese government bonds, which were partially funded
by short options positions. Nick Leeson held a sizeable long position in Nikkei 225
futures; the Nikkei 225 is the most widely-followed index of the Japanese stock market.
This position was held in anticipation of a recovery by the Japanese stock market;
instead, partially due to the Kobe earthquake in January 1995, the Japanese stock market
continued to slump. This triggered massive margin calls, requiring progressively more
funding from London.

One of the strategies employed by Nick Leeson was to set up short straddles on Nikkei
225 futures and use the premiums to partially offset the mounting margin calls from his
rapidly increasing long Nikkei 225 futures position. A short straddle consists of a written
call and a written put on the same asset with the same maturity and the same strike price.
This position is profitable only if the price of the underlying asset remains within a
narrow range.

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Combining a short straddle with a long position in the underlying asset creates a position
equivalent to a short put with more risk on the downside. In Nick Leeson’s case, his need
for more funding led him to write multiple straddles for each long futures contract that he
held. This led to the creation of an “iceberg”, a riskier version of a short straddle; as a
result, the position would only be profitable if the Nikkei 225 remained within a very
narrow range of prices. Any movement outside of this range would lead to extremely
large losses.

Nick Leeson also employed a strategy of “doubling.” Each time the Nikkei 225 fell,
Nick doubled his long exposure on the theory that he would make up past losses as soon
as the Nikkei 225 recovered. He also hoped that massive purchases of Nikkei 225 futures
would drive up the Japanese stock market. This type of strategy is also known as the
“gambler’s ruin” strategy, since capital can be wiped out very quickly.

Ultimately, the inability to finance growing margin calls put an end to Nick Leeson’s
trading in early 1995. Nick Leeson lost over $1 billion, causing the collapse of Barings
bank. This earned him a jail sentence of six and a half years, while Barings was sold to
the Dutch bank ING for one pound.

1.10 GARP CODE OF CONDUCT

The GARP Code of Conduct consists of several principles of professional conduct and
ethical standards for the risk management profession. GARP members are expected to
display professional integrity and ethical conduct, avoid conflicts of interest and respect
confidentiality. GARP members are also expected to exhibit the highest possible
standards of professional skills and engage in best risk management practices.

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CHAPTER 1 KEY CONCEPTS





1) Risk can be broadly classified as market risk, credit risk and operational risk. Market
risk can be further subdivided into: interest rate risk, commodity price risk, foreign
exchange risk and equity price risk.

2) The Capital Asset Pricing Model (CAPM) postulates that the expected return to a
stock depends on the risk-free rate of interest, the expected return to the market
portfolio and the risk of the stock, as measured by beta. Beta is defined as:

Cov(ri ,rM )
βi =
Var(rM )

This is the covariance between the excess returns to the stock and the market portfolio
divided by the variance of the excess returns to the market portfolio. The excess return to
a stock equals its actual return minus the risk-free rate of interest.

The CAPM equation is E(ri) = rf + βi[E(rM) – rf].

3) According to the CAPM, all non-systematic (firm-specific) risk can be eliminated in a

well-diversified portfolio; therefore, investors can only expect to be compensated for
bearing systematic (market) risk.

4) One of the implications of the CAPM is that all investors will choose to invest their
wealth in a combination of the market portfolio and the risk-free asset.

5) The Capital Market Line (CML) shows the relationship between the expected return
to a stock and its risk, as measured by the standard deviation of its returns. The CML is
tangent to the efficient frontier, which shows all stocks that offer the highest rate of
return for a given level of risk.

6) The Security Market Line (SML) shows the relationship between the expected return
to a stock and its risk, as measured by beta. The SML is linear and represents the
equilibrium expected return for all stocks based on their betas.

7) Several measures of portfolio performance have been developed. These include the
Sharpe Ratio, the Treynor Ratio, Jensen's Alpha, the Information Ratio and the Sortino
Ratio.

The Sharpe Ratio equals:

E(rp ) − rf
σp

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This is the expected excess return to a stock divided by its risk, as measured by the
standard deviation of its returns.

The Treynor Ratio is:

E(rp ) − rf
βp

This is the expected excess return to a stock divided by its risk, as measured by beta.

Jensen's Alpha is defined as:

αi = E(ri) - rf - βi[E(rM) – rf]

This equals the deviation from the predictions of the CAPM model. It can be interpreted
as a measure of the value added by a portfolio manager.

The Information Ratio equals

E(rP ) − E(rB )
IR =
σ (rP − rB )

This represents the expected return to an active portfolio manager relative to the risk of
the portfolio as measured by the standard deviation of the returns in excess of a
benchmark.

The Sortino Ratio equals

E(rP ) − rmin
SVmin

This represents the expected return to an active portfolio manager relative to a minimum
acceptable return divided by risk as defined by the semivariance of returns below the
minimum acceptable level.

8) Tracking error is a measure of the standard deviation of excess returns relative to a

benchmark. This is used to determine how closely a portfolio replicates a benchmark.

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9) Multifactor models, such as Arbitrage Pricing Theory (APT) have been developed to
extend the CAPM to include multiple sources of risk.

10) Several risk management failures have occurred in recent years, including
Metallgesellschaft (MGRM), Sumitomo, Barings and Long-Term Capital
Management (LTCM). MGRM adopted a hedging strategy based on the assumption
that markets would remain in normal backwardation; when markets switched to
contango, massive losses resulted for MGRM. Sumitomo lost over $2 billion in
unauthorized copper trading due to a rogue trader who was able to hide his losses.
Similarly, Barings Bank became insolvent due to massive losses by Nick Leeson, who
both traded and ran the back office in Singapore for Barings. Long-Term Capital
Management (LTCM) suffered catastrophic losses due to an unanticipated emerging
markets crisis coupled with an inability to liquidate its positions in a timely fashion.

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CHAPTER 1 PROBLEMS

1. The Capital Asset Pricing Model

a. postulates a linear relationship between a stock’s expected return and standard
deviation
b. shows that the expected return to a stock depends on non-systematic risk
c. defines beta as the covariance between the excess returns to a stock and the market
portfolio relative to the standard deviation of the market portfolio
d. none of the above

2. According to the CAPM, if the risk-free rate of interest is 3% and the expected return
to the market portfolio is 5% and the expected return to the stock is 8%,
a. the beta is 1.0
b. the beta is 2.0
c. the beta is 2.5
d. the beta is 0

3. The Sharpe ratio equals:

a. the expected excess return to an asset divided by its beta
b. the expected return to an asset divided by its beta
c. the expected excess return to an asset divided by its standard deviation
d. the beta divided by the expected return to an asset

4. Which of the following is true?

I. The Sortino ratio is defined in terms of the semivariance of the returns to an asset
II. A positive value of Jensen’s alpha indicates that a portfolio manager has
underperformed the market
III. The Information Ratio equals the expected return to a portfolio divided by its tracking
error

a. I and II
b. I only
c. II only
d. I and III only

5. Metallgesellschaft
a. used “stacked” forward contracts to hedge their risk
b. used payer swaptions to hedge their risk
c. used energy swaps as the fixed rate payer to hedge their risk
d. used energy swaps as the floating rate payer to hedge their risk

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6. Which of the following is true?

a. if the spot price exceeds the futures price of a commodity, the market is in contango
b. if the spot price exceeds the futures price of a commodity, the market is in normal
backwardation
c. if the spot price exceeds the futures price of a commodity, the market is in inverted
backwardation
d. none of the above

7. One of the strategies pursued by Nick Leeson at Barings was:

a. taking short futures positions on the Nikkei 225
b. setting up short strangles on Nikkei 225 futures contracts
b. setting up long straddles on Nikkei 225 futures contracts
d. none of the above

8. The Treynor ratio is:

a. the expected excess return to an asset divided by its beta
b. the expected return to an asset divided by its beta
c. the expected excess return to an asset divided by its standard deviation
d. the beta divided by the expected return to an asset

9. Long-Term Capital Management

a. bet that the spread between Treasury yields and emerging markets yields would widen
b. suffered massive losses as a result of the 1997 Asian crisis
c. was bought out by Goldman Sachs
d. none of the above

10. Arbitrage pricing theory (APT)

a. is a special case of the CAPM
b. can be used to predict future arbitrage opportunities
c. is one of the earliest option pricing models
d. none of the above

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CHAPTER 1 SOLUTIONS

1. D

2. C

The CAPM model is: E(ri) = rf + βi[E(rM) – rf]

Rearranging algebraically, βi = [E(ri) - rf ] / [E(rM) – rf]

rf = 0.03
E(rM) = 0.05
E(ri) = 0.08

βi = [E(ri) - rf ] / [E(rM) – rf] = (0.08 - 0.03) / (0.05 - 0.03) = 0.05/0.02 = 2.5

3. C

4. B

5. C

6. B

Normal backwardation occurs when the spot price is greater than the futures price, and
futures prices decline with maturity. Contango occurs when the spot price is less than the
futures price, and futures prices rise with maturity.

7. D

8. A

9. D

10. D

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