Management Question

‫المملكة العربية السعودية‬
‫وزارة التعليم‬
‫الجامعة السعودية اإللكترونية‬

Kingdom of Saudi Arabia
Ministry of Education
Saudi Electronic University

College of Administrative and Financial Sciences

Assignment 3

Portfolio Management
Due Date: 15/11/2025 @ 23:59

Course Name: Portfolio Management

Student’s Name:

Course Code: FIN 424

Student’s ID Number:

Semester: First

CRN:
Academic Year: 2025-26th

For Instructor’s Use only
Instructor’s Name:
Students’ Grade:

/10

Level of Marks: High/Middle/Low

General Instructions – PLEASE READ THEM CAREFULLY
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Restricted ‫مقيد‬

The Assignment must be submitted on Blackboard (WORD format only) via allocated
folder.
Assignments submitted through email will not be accepted.
Students are advised to make their work clear and well presented, marks may be reduced
for poor presentation. This includes filling your information on the cover page.
Students must mention question number clearly in their answer.
Late submission will NOT be accepted.
Avoid plagiarism, the work should be in your own words, copying from students or
other resources without proper referencing will result in ZERO marks. No exceptions.
All answered must be typed using Times New Roman (size 12, double-spaced) font.
No pictures containing text will be accepted and will be considered plagiarism).
Submissions without this cover page will NOT be accepted.

Activity -Question:
Group Assignment:
Objective
To apply the concepts of risk identification, measurement, and management discussed in
Chapter 9 – Risk Management to a real-world organization and analyze how effectively it
implements enterprise risk management (ERM) practices.
Instructions
1. Group Composition
o

Each group must consist of a minimum of four members.

o

The assignment is to be done collaboratively as a group, but each member
must present individually.

o

Group members should divide the work equally — each member is
responsible for writing and presenting one section.

2. Part
1:
Written
Report
(20
Marks
–
Group
Grade)
Prepare a detailed report (1,500–2,000 words) addressing the following sections:
Part 1 – Identification of Risks
o

Identify at least three financial and two non-financial risks relevant to your
chosen company (e.g., market, credit, operational, regulatory, or model risk).

o

Explain how each risk affects the company’s performance and stability.

Part 2 – Measurement and Management of Risk
o

Describe how the company measures and manages these risks.

o

Apply concepts such as Value at Risk (VaR), stress testing, or risk budgeting
as discussed in the chapter.

o

Highlight any risk governance or enterprise-level frameworks used.

Part 3 – Evaluation of Risk Management Practices

Restricted ‫مقيد‬

o

Critically evaluate the strengths and weaknesses of the company’s risk
management process.

o

Discuss whether it follows centralized or decentralized risk governance.

Part 4 – Recommendations and Reflection
o

Suggest improvements or alternative strategies for managing the identified
risks.

o

Reflect on how ERM supports financial stability and decision-making.

Part 2: Presentation (Individual Grade)
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Each group must prepare a PowerPoint presentation (10–12 slides) summarizing the
key points from the report.

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Each student must present their assigned section (e.g., one student presents Part 1,
another presents Part 2, etc.).

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Presentation marks will be awarded individually based on the following criteria:

Presentation
Criteria

Description

Marks

Content Understanding

Clarity of concepts and accuracy of explanation

3

Communication & Delivery

Confidence, clarity,
presentation

3

Visual Presentation

Quality of slides, structure, and design

2

Response to Questions

Ability to answer questions confidently

2

Total Marks

Restricted ‫مقيد‬

Evaluation

and

engagement

during

10

Risk Management
By Don M. Chance, CFA
Kenneth Grant
John Marsland, CFA

Key Learning Outcomes
• Compare and contrast the main features of the risk
management process, risk governance, risk reduction,
and an enterprise risk management system
• Recommend and justify the risk exposures an analyst
should report as part of an enterprise risk management
system, given a description of the company’s business
• Evaluate the strengths and weaknesses of a company’s
risk management processes
• Evaluate possible responses to a risk management
problem

Learning Outcomes
• Interpret Value at Risk (VAR) and its role in measuring overall and
individual position market risk
• Compare and contrast the analytical (variance-covariance),
historical, and Monte Carlo methods for estimating VAR and discuss
the advantages and disadvantages of each
• Discuss the advantages and limitations of VaR and extension and
supplements to it (e.g., cash flow at risk, earnings at risk, tail value
at risk)
• Compare and contrast the various types of stress testing and
discuss the advantages and disadvantages of each
• Evaluate the results pf stress tests

Learning Outcomes
• Evaluate a company’s or a portfolio’s exposures to
market risk
• Evaluate the credit risk of a position, including forward
contract, swap, and option positions
• Evaluate a company’s or a portfolio’s exposures to
nonfinancial risk
• Demonstrate the use of risk budgeting, position limits,
and other methods for managing market risk

Learning Outcomes
• Demonstrate the use of the following methods of
managing credit risk: limiting exposure, marking to
market, using collateral, using netting arrangements,
setting credit standards, and using credit derivatives
• Compare and contrast the Sharpe ratio, risk-adjusted
return on capital, return over maximum drawdown, and
the Sortino ratio as measures of risk-adjusted
performance
• Demonstrate the use of VaR and stress testing in setting
capital requirements

The Risk Management Process
• Risk management subject to continuous
evaluation and revision by:
– Identifying risk exposures
– Establishing appropriate ranges of exposure
– Continually measuring the exposures
– Executing appropriate adjustments when
exposures fall outside target ranges
– May require alterations to reflect new policies,
preferences and information

Risk Governance
• Specific processes used to put risk management
into practice
• Choices related to:
– Governance structure

• Centralized offers economies of scale and offsetting of risks
across business units
• Decentralized allows risk management by people most
familiar with specific risks

– Infrastructure (data warehouses, etc)
– Reporting
– Methodology

Enterprise Risk Management
• Centralized risk management at senior
management level
• Takes a firm-wide perspective
• Considers risks both in isolation and interplay
• Should control sensitivity of earnings to stock
market fluctuations, interest rates, exchange
rates and commodity prices
• Should also control exposures to credit and
default risk, asset/liability management,
operational systems, fraud and other factors

Steps to Effective Enterprise Risk
Management
• Identify each risk factor to which the company is
exposed
• Quantify each exposure’s size in money terms
• Map the inputs into a risk estimation calculation
• Identify overall risk exposures and the contribution to
overall risk derived from each risk factor
• Set up a process for periodic reports to management,
who will determine capital allocations, risk limits and risk
management policies
• Monitor compliance with policies and risk limits

Identifying Financial Risk
Exposures
• Market risk

– Interest rates, exchange rates, stock and commodity
prices
– How will these affect asset/liability management

• Credit risk

– Loss caused by missed payment from debtor or
counterparty
– Can be managed using credit derivatives or traditional
credit analysis

• Liquidity risk

– Inability to efficiently buy and sell
– Can change during investment horizon

Identifying Nonfinancial Risk
Exposures
• Operational risk – loss from failures in systems and
procedures or external events
• Model risk – incorrect or misspecified valuation models
• Settlement (Herstatt) risk – one counterparty in process of
settling account while other is declaring bankruptcy
• Regulatory risk – uncertainty regarding regulation of
transactions
• Legal/Contract risk – Potential loss from legal system failing to
enforce a contract
• Tax risk – uncertainty associated with tax laws
• Accounting risk – uncertainty regarding how to record
transactions and potential rule changes
• Sovereign and Political Risks – regime changes or risk that
sovereign borrower defaults

Value at Risk (VaR)
• Financial industry’s premier risk management technique
• Probability based measure of loss potential from the
level of a transaction up to the total enterprise
• Estimated loss (in money terms) that could be exceeded
(minimum loss) at a given level of probability
• Lower probability will equate to higher potential loss, all
else equal
• $1 million daily VaR at 5% means 5% chance of losing at
least $1 million in one day (or 95% chance that one
day’s losses will be lower than $1 million

Estimating VaR Using Analytical
(Variance-Covariance) Method
• Assumes normal distribution of portfolio returns
• Must estimate expected return and standard
deviation of returns
• As number of portfolio instruments increases,
calculations can become unwieldy
• Expected return of zero generally appropriate for
daily VaR, but not for longer-term measures of
VaR
• Advantage of analytical method is simplicity
• Disadvantage is reliance on assumptions,
particularly that of normal distribution of returns

Estimating VaR Using the Historical
Method
• Graphs actual daily returns from user-specified
past period in a histogram
• If have 1,000 observations, the 1% and 5%
probabilities would be of a loss greater than the
10th or 50th-worst, respectively
• Reflects historical results, not future
• Should adjust for moving investment horizon
• Advantage is that it is nonparametric (doesn’t
need probability distribution assumptions)
• Disadvantage is that future could differ greatly
from past

Estimating VaR Using the Monte
Carlo Method
• Produces random outcomes to examine effects
of particular set of risks
• Uses a probability distribution for each variable
of interest
• Can use normal or nonnormal distributions
• Often the only practical means of generating
needed risk management information
• Can require extensive commitments of computer
resources with large portfolios

Advantages and Limitations of VaR
• Advantages

– Quantifies potential loss in simple terms
– Widely accepted by regulators
– Versatile

• Limitations

– Can be difficult to estimate, and estimation methods
can lead to significant differences
– Can create false sense of security
– Often underestimates severity of worst-case returns
– Position VaR does not translate well to portfolio VaR
– Fails to incorporate positive results (incomplete
picture)

Extensions and Supplements to
VaR
• Cash flow at risk or earnings at risk

– Measure risk to cash flow or earnings rather
than market value
– Used when assets generate cash flows but
cannot be readily valued, or to test sensitivity
of valuation model

• Tail value at risk

– VaR plus expected loss in excess of VaR
– For a given 5% VaR would be calculated as
the average of the worst 5% of outcomes

Stress Testing
• Seeks to identify unusual circumstances that
could lead to larger than expected losses
• Scenario analysis
– Stylized scenarios from modest to extreme
– Standard sets can facilitate comparisons
– Does not account for correlation of exposures
(scenarios performed sequentially)

• Actual or hypothetical extreme events

– Simulate portfolio under extreme conditions
– Useful if extreme breaks considered more likely than
given by the model in use

Credit Risk of Forward Contracts
• Forward contracts require commitments
from each counterparty, from which the
party owing the larger amount could
potentially renege
• Prior to expiration, credit risk is only
potential since no money is due
• Risk borne by party that will benefit from
the contract (the one with a positive claim)

Credit Risk of Swaps
• Swaps are similar to a series of forward
agreements, with credit risk arising at a
series of points
• Default risk largest during the middle
period of the contract

– Credit checks mitigate initial risk
– In later stages most cash flows already paid

• If notional principal payment is required,
risk is very high at end of contract

Credit Risk of Options
• Unilateral credit risk – only seller is
obligated, so only buyer is exposed after
premium is paid
• With European option, credit risk is
potential until expiration
• With American option, credit risk exists
throughout option term

Risk Budgeting
• Where should risks be taken and how can they be
allocated efficiently?
• Establishes objectives for individuals, groups and
divisions to allocate risk
• Limits should be carefully monitored and managed
• Allows comparison of unit profits according to the capital
and risk employed
• Sum of individual risk budgets typically exceeds
organization budget due to diversification benefits
• Can also be used to allocate funds among managers

Managing Credit Risk
• Position limits – limit exposure to a given party
• Marking to market – periodically marking forward
contracts to market can reduce credit risk by
making smaller interim payments
• Collateral – margin requirements to cover
expected losses
• Netting – only one party (with larger obligation)
pays (the difference)
• Credit standards – Dealing only with qualified
counterparties
• Credit derivatives – transfer risk to another party

Measuring Risk Adjusted Return
Using the Sharpe Ratio
• Industry standard measure
• Sharpe ratio = (Mean portfolio return – risk
free rate)/Standard deviation of portfolio
return)
• Mean excess return for unit of volatility
• Can be inaccurate when applied to
portfolios with nonlinear risk (such as
option exposure)

Measuring Risk Adjusted Return
Using the Sortino Ratio
• Managers should not be penalized for excess positive
volatility
• Numerator is difference between mean portfolio return
and minimum acceptable return (MAR)
• Denominator is downside deviation using MAR as target
return
• Downside deviation computes volatility using only points
below MAR
• If risk-free rate is used as MAR, the only difference from
the Sharpe ratio is use of downside deviation
• Used with Sharpe ratio, provides an understanding of
risk adjusted performance attributable to outperformance

Other Measures of Risk Adjusted
Return
• Risk adjusted return on capital

– Divides expected return by capital at risk
– Capital at risk defined in many ways
– Some companies use a hurdle rate to justify capital
allocations

• Return over maximum drawdown (RoMAD)

– Drawdown is difference between high water mark and
any subsequent low point
– RoMAD is the average return expressed as a
percentage of the maximum drawdown
– Investors can evaluate their tolerance for an
occasional drawdown of X% in exchange for an
average return of Y%

Using VaR to Allocate Capital
• Can assign a VaR limit as a proxy for allocated
capital
• Allocating capital in units of exposure acts in
greater harmony with overall risk management
process
• Limits only as effective as VaR calculations
• Relationship between overall VaR and that of
individual positions is complex and may be
counterintuitive

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