RISK MANAGEMENT PRACTICES RISK FRAMEWORKS MARKET RISK OPERATIONAL RISK CREDIT RISK LIQUIDITY RISK, ALM & FTP

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1 T H E P RO F E SS I O N A L R I S K M A N AG E R ( P R M ) D E S I G N AT I O N P RO G R A M PRM TM SELF STUDY GUIDE EXAM III RISK MANAGEMENT PRACTICES RISK FRAMEWORKS MARKET RISK OPERATIONAL RISK CREDIT RISK LIQUIDITY RISK, ALM & FTP 2015 EDITI ON TH R EE OF FOUR

2 PRMT M OVERVIEW SELF-STUDY GUIDE EXAM III RISK MANAGEMENT FRAMEWORKS AND OPERATIONAL RISK, CREDIT RISK AND COUNTERPARTY CREDIT RISK, ASSET LIABILITY MANAGEMENT AND FUNDS TRANSFER PRICING Exam III of the PRM designation tests a candidate s knowledge and understanding of the modern risk management theory and practices. The curriculum was designed by industry leaders and PRMIA members holding senior positions in the industry who felt there was a gap in the market, with special focus on the risk management practices required by active risk practitioners. Exam III is split into six parts covering: Risk Management Frameworks Operational Risk Credit Risk Counterparty Credit Risk Market Risk Asset Liability Management and Funds Transfer Pricing. Asset Liability Management Liquidity Risk Management Funds Transfer Pricing Risk Management Frameworks 23% These are the six main components of the risk management function, Counterparty Credit Risk borne by any organization. You can use this Self-Study Guide to focus your study on the key s from each chapter. These s form the basis for the questions asked during the examination that you would take as Exam III of the PRM designation program. We recommend that you first read the chapter, then review the s, then re-read the chapter with particular emphasis on these points. We recommend strongly that you do not simply read the s and then try to find the information about each in the books as a short-cut way of preparing for the exam. Real-life risk management requires your ability to assemble information from many simultaneous inputs, and you can expect that some exam questions will draw from multiple s. After studying the book for this section (PRM Handbook Volume III) and the seven additional supplemental papers and becoming comfortable with your knowledge and understanding of each Learning Outcome Statement you will have read the materials necessary for passing Exam III of the PRM Designation program. Taking the PRM qualification, as well as working as a risk officer, requires a certain amount of mathematical expertise. This is not excessive. Anyone who was passed mathematics studies at advanced high school level, or who has completed the first year of a university degree in a mathematical-based qualification (physics, economics, engineering, etc.) should have no problem with the requirements. For others, we recommend that they take tuition in the mathematics required and that they focus on this as the first part of their studies for the PRM. Please remember that the exams of the PRM designation are very challenging. There is no guarantee that using the Self-Study Guide, in combination with the reading materials will give you a passing score. But, they should all provide you with assistance in doing your best. We wish you much success in your effort to become certified as a Professional Risk Manager! 1 PRM SELF-STUDY GUIDE EXAM III 18% 11% Market Risk 8% 16% 29% Operational Risk Credit Risk

3 CONTENTS 1 OVERVIEW 4 RISK MANAGEMENT FRAMEWORKS AND OPERATIONAL RISK 6 CREDIT RISK AND COUNTERPARTY CREDIT RISK 8 MARKET RISK, ASSET LIABILITY MANAGEMENT AND FUNDS TRANSFER PRICING WORD DEFINITIONS In this guide, we use Command Words. These are similar to those used by the CFA Institute, with a few additional words, and indicate levels of ability expected from successful candidates on each. Calculate Characterize Compare Construct Contrast Deconstruct Define Demonstrate Derive Describe Differentiate Discuss Draw Explain Identify List Show State To ascertain or determine by mathematical processes. To describe the essential character or quality of. To examine the character or qualities of, for the primary purpose of discovering resemblances. To create by organizing ideas or concepts logically and coherently. To compare in respect to differences. To disassemble the key elements of ideas or concepts. To set forth the meaning of; specifically, to formulate a definition of. To prove or make clear by reasoning or evidence; to illustrate and explain, especially with examples. To obtain by reasoning To transmit a mental image, an impression, or an understanding of the nature and characteristics of. To mark or show a difference in; to develop different characteristics in. To discourse about through reasoning or argument; to present in detail. To express graphically in words; to delineate. To give the meaning or significance of; to provide an understanding of; to give the reason for or cause of. To establish the identity of; to show or prove the sameness of. To enumerate. To set forth in a statement, account, or description; to make evident or clear. To express in words. FINANCE THEORY, FINANCIAL INSTRUMENTS, FINANCIAL MARKETS 2

4 STUDY TIME Preparation time will vary greatly according to your knowledge and understanding of the subject matter prior to your self-study, your ability to commit dedicated and uninterrupted time to your study and other factors. In general, candidates who prepare for the exams of the PRM TM designation program allocate about three months to preparation for each exam. You may spend three hours each week in study, or as much as ten or more, each week to ready yourself. Follow the suggestions above regarding the use of the s. Once you are comfortable with your readiness, it s time to register for the exam. TESTING STRATEGIES All questions are multiple-choice, and there are no penalties for incorrect answers. Bear in mind that it is vitally important to finish the exam in the time allotted. Do not linger over questions longer than is sensible. For example, if the exam has 30 questions in 90 minutes, do not spend longer than three minutes per question. If at the end of three minutes you have not answered the question, decide on the best answer you can (ignoring the obviously wrong), mark your answer and move on. If you do have any spare time at the end of the exam you can always go back and review the answer. However, make absolutely sure that you have an answer for every question at the end of the exam! Another strategy would be to go through all the questions, answering the ones you find easier first. Then after a first pass, divide the remaining questions by the time remaining and proceed as above. USAGE OF THE CALCULATOR At the exam center you will have access to an on-line Texas Instrument TI308XS calculator. No other materials may be brought into the exam room with you. It is suggested that candidates purchase the hand-held version (TI-30XS) to fully familiarize themselves with the calculator. User guide for the calculator can be found at this link: n/62522eb25d fdb8a46f90740/30x_ mv_tg TI308XS Calculator Download Instructions For system requirements please click on system requirements and download instructions Note: The practice exam is not accessible on Mac computers. 1. Download the Pearson Vue Tutorial & Practice Exam by clicking here if the link does not work, cut and paste this in your browser: uetutorialdemo.msi 2. Click "run" if you have that option; otherwise, click "save file" 3. Open the saved file. (If you clicked "Run" skip this step) 4. Follow the Software Installation prompts 5. Run the installed software 6. Check the box for the Practice Exam 7. Click on the "next" button until you get to the screen with the calculator icon in the upper left hand corner of the screen. 8. Click on the calculator icon to practice with the TI308XS calculator. 3 PRM SELF-STUDY GUIDE EXAM III

5 RISK MANAGEMENT FRAMEWORKS AND OPERATIONAL RISK Chapter 1 Foreword Embed Good Practice in a Changed Regulatory Environment Understand the context in which we operate Understand good risk management practices versus best practices Chapter 2 Risk Governance Understand concepts of governing and governance Understand key people in the governance structure and their roles and responsibilities Understand the risk governance process Understand the new developments and the horizons of risk governance Chapter 3 The Risk Management Framework Define and explain the differences between risk capacity and risk appetite Understand a Risk Appetite Statement Understand and define risk policy and the roles of risk policies in an organization Understand Risk Pricing Define risk culture and the role of leadership and the risk management function in risk culture Chapter 4 Risk Assessment Understand the risk assessment lifecycle Define the functional versus the process approach Understand top down risk identification Compare top-down and bottom-up approaches Define the role of process review Explain the role of control assessment Identify issues and design action plans Describe issue management and resolution Discuss residual risk Understand the management validation process Understand the importance of risk assessment of new and expanded products and services Understand the importance of risk assessment of third party service providers RISK MANAGEMENT FRAMEWORKS AND OPERATIONAL RISK 4

6 Chapter 5 Risk Information Define risk appetite Understand risk profile Define unexpected loss Understand the loss investigation process Explain the collecting loss data Understand quantifying losses Define loss data fields Understand boundary issues Define external loss data Derive Key Risk Indicators Understand the selection of appropriate KRIs Implement a KRI Framework Discuss the toolsets and reporting process Chapter 7 Insurance Mitigation Understand insurance mitigation basics Discuss risk taxonomy and mapping Understand the qualification criteria of insurance mitigation Calculate capital relief Chapter 6 Risk Modeling Form basic to advanced approaches Understand Operational risk data Define units of measure Demonstrate frequency modeling Derive the statistical foundations of severity fitting Understand ILD Severity Model Understand fitting algorithms Discuss scenario based models Combine the ILD and scenario models Combine the ILD model with scenario assessment Understand ELD model Combine ILD with ELD models Discuss dependency modeling and risk aggregation Understand capital allocation 5 PRM SELF-STUDY GUIDE EXAM III

7 CREDIT RISK AND COUNTERPARTY CREDIT RISK Chapter 1 Classic Credit Instruments Understand the credit risk taxonomy Understand important credit instruments Understand credit markets Understand structuring considerations Chapter 4 Credit Derivatives and Securitization Discuss structured credit as a funding tool Define linear credit risk transfer Discuss structured credit as a risk management tool Understand bespoke structured credit Chapter 2 Classic Credit Life Cycle Characterize the origination phase Discuss the analysis and approval process Discuss the credit monitoring phase Understand credit repayment Demonstrate workout phase Chapter 5 Modern Credit Risk Modeling Define credit risk parameters Explain credit VaR models Understand the implementation of credit models Discuss modeling credit risk mitigation Discuss risk allocation and performance management Chapter 3 Classic Credit Risk Methodology Understand the fundamentals of credit analysis Analyze wholesale credit Analyze retail credit Compare classic vs. modern credit analysis methodologies Chapter 6 Credit Portfolio Management, CPM Understand CPM goals and philosophy Understand CPM instruments Understand CPM analytics Understand CPM in practice CREDIT RISK AND COUNTERPARTY CREDIT RISK 6

8 Chapter 7 Contextual Considerations Discuss the available analytical tools Understand strategic alignment Understand taxonomies Discuss conduct risk Chapter 10 Credit Valuation Adjustment, CVA Define CVA Calculate CVA Define DVA Understand Wrong-Way risk Understand organizational challenges Chapter 8 Basics of Counterparty Risk Understand the historical perspective of counterparty risk Understand the OTC derivative market Discuss exposure measurement Understand risk appetite Chapter 11 CVA Related Aspects Towards XVA Define FVA Calculate capital requirements Understand leverage ratio Calculate liquidity ratios Chapter 9 Risk Mitigation Discuss the documentation process and its importance Understand netting Understand collateral Understand clearing Understand guarantees, intermediation, and credit insurance Chapter 12 Managing Counterparty Risk and CVA Understand hedging CVA Central Clearing Counterparties (CCP) Manage distressed names and defaults 7 PRM SELF-STUDY GUIDE EXAM III

9 MARKET RISK, ASSET LIABILITY MANAGEMENT AND FUNDS TRANSFER PRICING Chapter 1 Introduction Understand the typology of market risk exposures Understand the basics of Asset Liability Management Understand the basics of Funds Transfer Pricing Discuss industry best practices Chapter 2 Market Risk Governance Understand the current market risk environment Understand the impact of the recent crisis Discuss the post crisis risk regulatory framework Understand the roles of the different committees Define roles and responsibilities in practice Discuss limit setting and limit policies Understand the different risk management systems Define risk management data Monitor market risk Understand the role of the audit function Discuss model risk governance Discuss model risk mitigating strategies Chapter 3 Market Risk Measurement Understand the Basics of Value at Risk (VaR) Define VaR Understand the basic concepts and definitions Discuss the different VaR methods Calculate simulations of interest rates Discuss weaknesses and limitations of the Value-at-Risk model Understand the regulatory impetus on model development Define the univariate advanced VaR models Understand backtesting Discuss the extreme value theory Calculate expected shortfall Define multivariate advanced VaR models Calculate joint distribution of risk factors MARKET RISK, ASSET LIABILITY MANAGEMENT AND FUNDS TRANSFER PRICING 8

10 Chapter 4 Market Risk in the Trading Book: Business-Specific Context Understand the historical considerations Understand the Fixed Income considerations Discuss Fixed Income trading activities and hedging strategies Understand the Fixed Income markets Define Swaps & Swap products Discuss trading activities and hedging strategies Define interest rate options products Understand FX and rates trading Understand Equity markets trading Compare retail client and wholesale client (delta one desk clients) Chapter 6 Stress Testing Understand stress testing beyond the VaR threshold Define the dangerous unknowns Discuss the static versus dynamic models Understand stress testing beyond comparative statistic analysis Discuss systemic risk lessons from beyond finance Understand stress testing beyond VaR Discuss the practical and organizational considerations Discuss the challenges of stress testing Chapter 5 Commodity Markets Risk Management Define market participants Discuss the key products and instruments Discuss the risk implication of physical nature of commodities Understand price risk management Discuss stress testing for commodity markets 7 PRM SELF-STUDY GUIDE EXAM III

11 Chapter 7 Asset Liability Management (ALM) & Liquidity Risk Define Asset Liability Management Define Liquidity risk Understand the implications of the recent crisis on ALM and liquidity Understand Gaps Compare banking book practices versus trading book practices Define the different roles within ALM Understand the components of interest rate risk Compare measurement versus management of interest rates Discuss different balance sheet management techniques Understand the fundamentals of liquidity risk Discuss liquidity versus solvency Compare the measurement versus management of ratios, liquidity gaps and liquidity risk Discuss recent liquidity markets developments Understand the implementation of BCBS principles Understand the basics of balance sheet management Define the role of the ALCO Chapter 8 Bank Funds Transfer Pricing (FTP) Understand the contextual considerations of FTP Understand the basics of FTP Understand the governance and management of FTP Discuss different FTP methods and understand the historical developments Discuss challenges of FTP MARKET RISK, ASSET LIABILITY MANAGEMENT AND FUNDS TRANSFER PRICING 10

12 The Professional Risk Managers International Association