Risk taking: corporate governance perspective

[williamhsu]

I have questions regarding your note for Risk taking: corporate governance perspective:
1) Explain the role played by risk in value creation?(I cant find the answer from your note)
2) strengths and weaknesses of risk adjusted discount rate approach?
3) The formula you state in your note to translate expected future cash flow into it certainty equivalent. You wrote CE(CF(n))=E(CF(n))*(1+r(WACC))^n/(1+r(f))^n. I doubt this formula is correct. I believe the correct formula should be CE(CF(n))=E(CF(n))*(1+r(f))^n/(1+r(WACC))^n

Thanks

William

 

[David Harper CFA FRM]

Hi William - I moved this to Foundations (can I ask you not to throw specific topic question into About).

Re 3) The formula indeed is a typo, apologies, yours is correct; I need to fix/reissue.

I will bookmark and look at (1) and (2) as soon as I can (sorry, I am quite busy on the T2 and T6 updates; so I can't follow up everything in detail immediately). Thanks,

 

[williamhsu]

Thanks David. I apologize for that.

 

[Thomas Stump]

Dear David,
In the FRM 2013 Study Notes, Part 1.Topic1 (p 3) you reference Jorion in the "Classification of risk" session instead of the IFCs classification system. Why? Does the FRM 2013 Exam not relay to the FRM Study Notes 2013?
Thanks for your clarification,
Thomas

 

[Thomas Stump]

Dear David,
May I coming back to the formula for calculating the Certainty-Equivalent = CE(CF(n))=E(CF(n))*(1+r(f))^n/(1+r(WACC))^n. I could not figure out why this formula has been chosen to estimate the certainty-equivalent, i.e. tried to get more on this searching the internet. Is this formula a well-known and accepted standard, to be known and stated in the FRM exam?
Thanks
Thomas

 

[David Harper CFA FRM]

Hi Thomas,

These are both excellent observations!

• Indeed I did invoke Jorion's classification, because it is a classic, defensible, and traditional (years) to the FRM.
  The AIM is "... identify the classifications of risks..." and the associated IFC reading is flexible (indecisive) on a risk typology:
  IFC reading: "Note that there are many equally valid classifications, and firms can develop their own lists suitable to their particular circumstances. The most important thing is that decision makers must understand the risks relevant to their enterprises as they are making decisions"
  ... then the IFC proceeds to illustrate with two examples, neither of which are informative with respect to the FRM curriculum (e.g., #1 has 1. operational, 2. financial, and 3. market-based. This typology #1 is counterproductive to an FRM candidate because our study concerns primarily non-business [e.g., strategy] financial risks which primarily includes market, credit and operational risks. We don't parse out "financial:" it is the umbrella over all of our risks, the F in FRM). The only real "controversy" in the Jorion typology is whether liquidity is sibling to the other three or a sub-class of market risk.
  So of course the IFC is correct w.r.t to a real-world perspective but the Jorion is more useful, in my opinion.
• Of the three methods, I have never encountered this formula approach (please note that IFC specifically recommends it). Further, it makes no sense to me. In my humble opinion, the point of the certainty-equivalent is to implicitly "tease out" the investors' (subjective) risk aversion by starting with the investor's articulation of the acceptable riskfree cash flow stream. By using the NPV to solve for a risk-free cash flow, it seems to me that, at best, CE produces a "test" CE cash flow for yes/no/iterate. The problem with the formula is that it assumes NPV (which is based on an "objectively" derived discount rate: note it contains no individual risk aversion but rather a single market consensus); whereas the point of CE is to solve for NPV given the CE cash flows as inputs (because they do reflect the individual investor's risk preference).

The first issue happens often in the anthology approach to the FRM, with brand new reading (the IFC replaced Jorion Chapter 1 in Topic 1). So, what I will do, as soon as i have time, is draft a post for GARP and collect the observation ("Dear GARP, I think this AIM has a potential defect ....") into a forum like we did last year here, b/c thankfully they receive feedback. The lack of IFC classification is not an "error" but at the same time, I would argue it's a weakness. With respect to the second issue (CE cash flows), I won't create a feedback for GARP because the CE has never been introduced before, I may disagree but there is no conflict with the body of the FRM. I hope that's helpful, great observations!

 

[Thomas Stump]

Dear David,

Thanks a lot for your intense and exhaustive feedback to my two questions.

As I have only the GARP FRM 2013 Study Books, do you have a hint or link to Jorion's paper towards his Risk Classification Scheme? It would be of great interest to me to get this explanations studies in more detail.

Greetings from Switzerland
Thomas

 

[David Harper CFA FRM]

Hi Thomas,

Sure thing, here is the chapter (this reading was the first reading in the FRM since 2009, at least, before it was replaced by the IFC paper): http://www.garpdigitallibrary.org/display/product.asp?pid=2129 (I would share if i were allowed but I'm not!)

but, i have two typos to fix anyway in the T1 Study Notes, so what I wanted to do anyway was attach our previous notes on this chapter as an Appendix, because it is still relevant to the FRM, so please look for an updated T1 within a week or so, thanks,

 

[Thomas Stump]

Hi David,
Thanks .. I stay tuned to get the new T1 Study Notes.
Have a good afternoon
Thomas

 

[williamhsu]

Hi William - I moved this to Foundations (can I ask you not to throw specific topic question into About).

Re 3) The formula indeed is a typo, apologies, yours is correct; I need to fix/reissue.

I will bookmark and look at (1) and (2) as soon as I can (sorry, I am quite busy on the T2 and T6 updates; so I can't follow up everything in detail immediately). Thanks,

Hi David,

I found both answer from CFA level 2 notes. You can ignore my questions. Thanks for your help.

William Hsu

 

[David Harper CFA FRM]

williamhsu okay, sorry ... that's interesting, I will check the CFA L2 notes to see if there is anything worth adding on the questions you raised, because I realized that w.r.t. your (1) and (2), the notes are short because the IFC reading doesn't really address them (imo), thanks,

 

[williamhsu]

williamhsu okay, sorry ... that's interesting, I will check the CFA L2 notes to see if there is anything worth adding on the questions you raised, because I realized that w.r.t. your (1) and (2), the notes are short because the IFC reading doesn't really address them (imo), thanks,

Hi David,
More specificially, it is LOS 31 e CFA Level II Describe strengths and weakness of methods used to estimate the required return on an equity investment. What a coincidence!! To be honest to you, I am more prefer CFA material that CFA institute clearly presents than GARP. I dont really know whether it is GARP intention to make the material so hard to understand especially statistic and some of AIM statements is so vague. I delayed my exam and spent six two months to study only statistic but am not sure whether I get it . Is there any supplementary material that is easilier to understand.