Board of Directors: Operational risk strategy question

[monsieuruzairo3]

Dear David Harper, CFA, FRM, CIPM ShaktiRathore

I cam across an interesting question with a rather uninteresting answer. I am sure you could throw some light to it.

1. Your Board of Directors wants a comprehensive review of each business units’ operational risk activities. As the head of the corporate operational risk unit, you know that little has been done to implement an operational risk process at the business unit level and that you need to immediately come up with a framework. Which of the following statements offers the best strategy?
   1. The audit committee of the Board should first define its objectives to ensure that all the firm’s business units’ operational risk programs are providing required information
   2. The auditing department is to be charged with developing an operational risk program for each business unit, with the business unit being made clearly aware that they will be held accountable for its implementation
   3. That your department immediately assess the operational risk for each business unit using independent data feeds to ensure the information fed into the assessment cannot be manipulated
   4. A senior manager from each profit center is to be charged with developing their own operational risk self assessment program based on guidelines you provide.

A. I only
B. I and IV only
C. I and III only

D. IV only

Now the answer given is D(IV only). To me I,II,III look correct and IV looks incorrect because there could be a bias in reporting if the power is vested with individual managers as it would be more of a self correcting exercise which may not be correctly reported by managers(out of fear, ignorance etc)


What do you think about it?

Best Uzi

 

[ShaktiRathore]

Hi,
at first site the 2 options rules out as the work of audit committee is to oversee financial reporting and disclosure http://www.investopedia.com/terms/a/audit-committee.asp and they play no role in operational risk.
The third option i think the operational risk of each unit can be better assess using the data at each unit level rather than using the independent data feeds, assessing risk level for each unit at centralized level is not that feasible but in a decentralized risk assessment each unit develop their own risk self assessment program they know better about their unit than anybody else so based on their unit risk they are in better position to form risk assessment program for respective units and guidelines discharged from central unit assures uniformity across all units. Relying on independent feeds and forming risk assessment for units you know is not that much feasible. So Option D seems more correct than option C.
thanks

 

[monsieuruzairo3]

Thanks Shakti
There is a question which actually looks simple but if I go by the calculation gives me an incorrect answer. Please read below
Assuming the 92 day and 274 day interest rate is 8% (act/360, money market yield) compute the 182 day forward rate starting in 92 days (act/360, money market yield).
A. 7.8%
B. 8.0%
C. 8.2%
D. 8.4%
Going by calculations; [1+0.08*92/360]*[1+r*182/360] = [1+0.08*274/360]
This returns an answer of 7.8%.But the answer should be 8%. I don't understand this.

Thanks for your help in advance

KR
Uzi

 

[ShaktiRathore]

Hi ,
I think the question assumes continues compounding rather than discrete compounding, so going by this
e^0.08*92/360*e^r*182/360=e^0.08*274/360
=>e^(0.08*92/360+r*182/360)=e^0.08*274/360
equating powers on both sides or taking natural logs on both sides,
=>0.08*92/360+r*182/360=0.08*274/360
=>r*182/360=0.08*274/360-0.08*92/360 , multiplying both sides by 360
=>r*182=0.08*274-0.08*92
=>r=0.08*274-0.08*92/182 , dividing both sides by 182
=>r=.08*(274-92)/182, take .08 common in numerator
=>r=.08*(182)/182
=>r=.08 or 8%

Alternatively you can directly apply the formula
Rf=R2T2-R1T1/T2-T1
Rf=8*274-92*8/182=8%
thanks

 

[monsieuruzairo3]

Hi ShaktiRathore

Thanks for the prompt response.
As you know the FRM is approaching, so I am asking a lot of questions. Hope your don't mind

On another note, I think the solution to the problem is flawed.

The 6-month interest rates in Switzerland and the United States are 6% and 8% respectively. Current exchange rate between Switzerland and US is 1 Swiss Franc = 0.79 US$. Suppose the 6-month forward exchange rate is 0.81 US$ per Swiss Franc. Determine the possible profit through arbitrage opportunity if upto $1,000,000 is available as loan.
Choose one answer.
a. $253,000 Incorrect
b. $262,000 Correct
c. $313,000 Incorrect
d. $341,000 Incorrect
The correct answer is B
Sol

6-month forward exchange rate should be = 0.79 e(0.08 – 0.06)*0.5 = 0.798. As 0.81 > 0.798, borrow US$ and sell the forward contract in Swiss Franc. Borrow $ 1000,000 at 8% per annum for 6 months, convert to 1,000,000/0.79 = 1,265,000 Swiss Franc and invest the $ 1,265,000 Swiss Franc at 6% which will grow to 1,303,500 Swiss Franc after 6 months. Enter into a forward contract to sell 1,303,000 Swiss Franc for 1,303,000*0.81 = $1,055,835. The amount needed to pay off the US$ borrowing is 1000e0.08*0.5 = 1,040,810 US$. Profit = 1,303,000-1,040,810 = $262,190

Now my point is that in the Last line they have subtracted CHF denominated value(1,303,000) and the USD denominated(1,040,810 ) . The correct answer should be 1,055,835-1,040,810

What do you think?

Best
Uzi

 

[David Harper CFA FRM]

Hi monsieuruzairo3 I agree, if the source is GARP, can you please share the details? Like you, if continuous compound frequency:

• I get future t=0.5 CHF 1,304,373 converted by the forward contract into CHF 1,304,373 * USD 0.810 / 1 CHF = USD $1,056,541.99 which can fund the loan payoff:
• payoff of loan @ 8% continuous = USD $1,040,810.77
• For future riskless profit of USD $1,056,541.99 - USD $1,040,810.77 = USD $15,731. Thanks,

 

[flex]

Hi,
at first site the 2 options rules out as the work of audit committee is to oversee financial reporting and disclosure http://www.investopedia.com/terms/a/audit-committee.asp and they play no role in operational risk.
The third option i think the operational risk of each unit can be better assess using the data at each unit level rather than using the independent data feeds, assessing risk level for each unit at centralized level is not that feasible but in a decentralized risk assessment each unit develop their own risk self assessment program they know better about their unit than anybody else so based on their unit risk they are in better position to form risk assessment program for respective units and guidelines discharged from central unit assures uniformity across all units. Relying on independent feeds and forming risk assessment for units you know is not that much feasible. So Option D seems more correct than option C.
thanks

Hi, @ShaktiRathore

i support U view concern there's no direct responsibility of Audit (committee or unit) amid OR internal reporting, however, think - regulatory requirments (reporting) in case inconsistent OR assesment/info can be violated that relate to committee responsibility.

And also should to hear @David Harper CFA FRM view, thx