Institute of Financial Markets of Pakistan

Risk Management

Certification

Study and Reference Guide

Copyright © 2017

Institute of Financial Markets of Pakistan (Formerly Institute of Capital Markets) Karachi, Pakistan All rights reserved

This is document is for educational purposes only and the Institute of Financial Markets of Pakistan (IFMP) (Formerly Institute of Capital Markets) accepts no responsibility for persons undertaking trading or investments in whatever form.

While every effort has been made to ensure its accuracy, no responsibility for loss occasioned to any person acting or refraining from actions as a result of any material in this publication can be accepted by the IFMP or its members.

IFMP has prepared its study guides with the best intent for educational reference purposes only and the documents shall not be considered as an ultimate authority on the subject or to pass the IFMP qualifications. Readers are encouraged to study additional relevant material and as recommended by IFMP.

The IFMP's training materials are solely for the purpose of referencing and the matter provided may not be taken as any empirical theory on the subject which is dynamic and evolving with latest research and developments. While some of the content has been taken from third-party sources, their efforts and work on the topic are highly acknowledged.

For any comments, suggestions and information, you may reach IFMP at info@ifmp.org.pk

TABLE OF CONTENTS

Objective of the Study Guide 3

Examination Specifications 5

Summary of the Syllabus 6

Recommended Readings 17

Study Material 18

Acronyms 19

Element 1: Introduction to Risk Management 20

Element 2: Introduction to Financial Markets 53

Element 3: Regulatory Framework 59

Element 4: Risk Measurement Models 78

Element 5: Management of Risks 98

Element 6: Operational Risk 107

Element 7: Derivatives & Risk Management 116

Element 8: Introduction to Surveillance 134

Element 9: Operational Scope of Surveillance 141

OBJECTIVE OF THE STUDY GUIDE

The objective of this study guide is to provide in-depth knowledge of risk management and surveillance in capital markets to candidates wishing to take Institute of Financial Markets of Pakistan (IFMP) Risk Management and Surveillance certification. The candidates are expected to gain risk management and surveillance knowledge for capital market with some knowledge of banking system and regulations governing the banking system. Significance of various risks is different for banking sector and capital markets and therefore our emphasize will remain on market, operational and liquidity risks, which are of more concern to institutions in capital markets instead of credit risk, which has greater significance for banking sector. At the end of this course, the candidate should be able to;

Explain risk, history of risk management, development in risk management, Holistic risk management, ways to identify, measure and classify risks, the management process of risk, various sources from which risk emanates and risks that participants of capital markets are exposed to.

Explain nature of various financial markets in Pakistan, liquidity drivers in the market, various products that are being traded in those markets specifically with respect to Pakistani markets, risks associated with those products and dependency of financial markets on each other that all together forms a systemic risk.

Understand the importance of capital in financial institutions, Basel I & Basel II with their pros and cons, economic and regulatory capital, three pillars of Basel II, regulations that govern capital markets in Pakistan.

Understand credit ratings and their meanings, concepts in measuring credit risk including probability of default, loss given default, recovery rates, default rates, KMV-Merton approach to credit risk. Candidates should be able to understand key concepts of VaR, measurement of market risk using all three methodologies of VaR and limitations of VaR model. Candidates should be able to calculate and interpret interest rate risk using duration gap methodology. Understanding of stress test and scenario analysis, quantification of liquidity risk.

Understand the management of credit, market and liquidity risks. Various steps that needs to be taken in management of these risks at board and senior management level as well as on operational levels. Should understand fund managers’ hedging strategies for market risk.

Understand the procedure of formulation and implementation of operational risk framework. Identification, assessment and monitoring of operational risk. Management of operational risk, supervisory guidelines on operational risk and operational risk under Basel II.

Understand the nature of derivatives, understanding forward, future, swaps and options with their use in hedging as external technique for managing risks, pricing and revaluation of forwards and swap contracts.

Understand surveillance and its importance for the systemic risk, the requirements for effective surveillance and operational structure of surveillance departments with its functions in capital markets of Pakistan.

Understand techniques that are being used for surveillance in Pakistan, market manipulation, investigating market manipulation, insider trading, its significance and regulations governing insider trading in Pakistan, surveillance procedure to identify insider trading and investigation of insider trading.

TARGET AUDIENCE

This exam is by and large mandated for the people working at Risk Management Companies.

SYLLABUS STRUCTURE

The unit is divided into elements. These are broken down into a series of learning objectives. Each learning objective begins with one of the following prefixes: know, understand, be able to calculate and also be able to apply. These words indicate the different levels of skill to be tested. Learning objectives prefixed:

know require the candidate to recall information such as facts, rules and principles

understand require the candidate to demonstrate comprehension of an issue, fact, rule or principle

be able to calculate require the candidate to be able to use formulae to perform calculations

be able to apply require the candidate to be able to apply their knowledge to a given set of circumstances in order to present a clear and detailed explanation of a situation, rule or principle

EXAMINATION SPECIFICATIONS

Each examination paper is constructed from a specification that determines the weightings that will be given to each element. The specification is given below.

It is important to note that the numbers quoted may vary slightly from examination to examination as there is some flexibility to ensure that each examination has a consistent level of difficulty. However, the number of questions tested in each element will not change by more than plus or minus 2.

Examination Specification

100 multiple choice questions

Element No. Elements Questions

1 Introduction to Risk Management 20

2 Introduction to Financial Markets 5

3 Regulatory Framework 15

4 Risk Management Models 15

5 Management of Risks 10

6 Operational Risks 10

7 Derivatives and Risk Management 10

8 Introduction to Surveillance 5

9 Operational Scope of Surveillance 10

Total 100

ASSESSMENT STRUCTURE

This will be a 150 minutes examination of 100 Multiple Choice Questions (MCQs).

All questions will carry equal marks.

There will be no negative marking.

SUMMARY OF THE SYLLABUS

RISK MANAGEMENT CERTIFICATION

ELEMENT 1: INTRODUCTION TO RISK MANAGEMENT

1.1 What is Risk

1.1.1 Difference between Risk and Uncertainty

1.1 Attitudes towards Risk

1.2 The Classification of Risks

1.3.1 Calculating Objective Risk

1.3.2 Subjective Risk

1.3.3 Other Classifications of Risk

1.3 Sources of Risk

1.4.1 Economic Risk

1.4.2 Political Risk

1.4.3 Technology Risk

1.4.4 Legal Risk

1.4.5 Model Risk

1.4.6 Natural Disasters

1.4 The Perception of Risk

1.5 Role of Risk Management

1.6.1 Historical Views of Risk Management

1.6.2 Problems with Traditional Views of Risk Management

1.6.3 The Development of Risk Management in the 1980s

1.6.4 Risk Management for the 1990s and 'Organizational Risk Management'

1.6 The Risk Management Process

1.7.1 Mission identification

1.7.2 Risk and uncertainty assessment

1.7.3 Risk control

1.7.4 Risk financing/transfer

1.7.5 Program implementation/ administration

1.7.6 Evaluation/feedback

1.7 Risk Management and Corporate Governance

1.8 Risk Identification

1.9.1 The Scientific Approach

1.9.2 The Socio-Technical Approach

1.9.3 Risk Identification – Practical Approaches

1.9 Risk Measurement

1.10.1 The Benefits of Risk Measurement

1.10.2 Objective versus Subjective Approaches

1.10 Issues in Risk Measurement

1.11.1 How tangible are the consequences of a risk?

1.11.2 The 'Risk Map'

1.11.3 Ranking Risks

1.11.4 The Stakeholder Approach

1.11 Risk Control

1.12.1 Why Control Risk?

1.12.2 Risk Control Methods

1.12.3 Disaster Recovery and Business Continuity

1.12 Risks in Capital Markets

1.13.1 Market Risk

1.13.1.1 Interest Rate Risk

1.13.1.2 Foreign Exchange Risk

1.13.1.2 Equity Price Risk

1.13.1.3 Credit Risk

1.13.2 Operational Risk

1.13.3 Liquidity Risk

1.13.3.1 Interest Rate Risk and Liquidity Risk

1.13.3.2 Price Risk and Liquidity Risk

1.13.3.3 Other Risks

1.13.3.4 Regulatory Risk

1.13.3.5 Legal Risk

1.13.3.6 Technology Risk

Element 2: Introduction to Financial Markets

2.1 Liquidity Drivers in Market

2.1.1 Liquidity and Financial Risk Management

2.2 Different Types of Market

2.3 The Money Market

2.3.1 Treasury Bills and Pakistan Investment Bonds (PIBs) 2.3.2 Repo and Reverse Repos

2.3.3 Call/Clean Money

2.3.4 Certificate of Deposits

2.3.5 Letter of Placement

2.3.6 Capital Markets

2.3.7 Stock Market

2.3.8 Term Finance Certificates (TFCs)

2.3.9 Forex Market

2.3.10 Commodity Market

Element 3: Regulatory Framework

3.1 Financial Regulations in Financial Industry

3.2 Role of Regulatory Capital

3.2.1 Pillar I – Capital Adequacy

3.2.2 Pillar II – Supervisory Process

3.2.3 Pillar III – Market Discipline

3.3 Regulations in Capital Market

3.3.1 Base Minimum Capital & Capital Adequacy

3.3.2 Exposure and Netting

3.3.2.2 Netting within Ready Market

3.3.2.3 Netting within Deliverable Futures Market

3.3.2.4 Netting within CSF (Cash-Settled Futures) Market

3.3.2.5 Netting within Stock Index Futures Contract Market

3.3.2.6 Netting within Mt Transaction

3.3.2.7 Netting within Index Options Market

3.3.2.8 Restriction/Prohibition

3.3.3 Exposure Margins

3.3.3.1 Margin Requirements

3.3.3.2 Var Based Margins

3.3.3.3 Fixed Margins

3.3.3.4 Deposit of Exposure Margins

3.3.3.5 Conditions Applicable To All Margin Deposits

3.3.3.6 Value of Margin Deposit to Be Maintained

3.3.3.7 Pre-Trade Margin

3.3.3.8 Post-Trade Margin

3.3.4 Mark-To-Market Losses

3.3.4.1 Determination of MtM Losses

3.3.4.2 Netting

3.3.4.3 MtM Losses Deposit

3.3.5 Special Margins

3.3.5.1 Determination of Special Margin

3.3.5.2 Special Margin Deposit

3.3.5.3 Obligation In Addition To Other Margin Obligations

3.3.5.4 Form of Special Margin Deposits

3.3.6 Source and Utilization of Margins and Mtm Losses

3.3.7 General

3.3.7.1 Circuit Breaker

3.3.7.2 Deposits to Be Held By The Exchange

3.3.7.3 Lien on Deposits

3.3.7.4 Obligation of Members To Collect Margins From Their Clients

3.3.7.5 Disciplinary Actions on Non-Compliance

3.3.7.6 Evasion of Requirements Prohibited

3.3.7.7 Restriction/ Prohibition

3.3.7.8 Force Majeure

3.3.8 Repeal

Element 4: Risk Measurement Models

4.1 Measurement of Credit Risk

4.1.1 Credit Ratings

4.1.2 Key Concepts in Credit Risk Measurement

4.1.2.1 Default Rates

4.1.2.2 Recovery Rates

4.1.2.3 Probability of Default

4.1.2.4 Loss Given Default (Lgd)

4.1.3 Kmv-Merton Model

4.2 Measurement of Market Risk

4.2.1 Value-At-Risk

4.2.1.1 Var Methodologies

4.2.2 Duration Gap Analysis

4.2.3 Scenario Analysis and Stress Testing

4.3 Quantification of Liquidity Risk

4.3.1 Gap Analysis of Maturing Assets and Liabilities

4.3.2 Liquidity Ratios

4.3.3 Funding Sources

4.3.4 Early Warning / Key Risk Indicators (Kris)

4.5.5 Liquidity Stress Testing

4.4 Problems in Risk Quantification and Forecasting

Element 5: Management of Risks

5.1 What Does Exposure Management Aim To Achieve?

5.2 Management of Credit Risk

5.2.1 Components of Credit Risk Management

5.3 Management of Market Risk

5.3.1 Hedge Selectively

5.3.2 Momentary Hedging

5.3.3 Managing For a Risk-Adjusted Performance Target

5.3.4 Capital Protection

5.3.5 Compliance and Accountability

5.4 Management of Liquidity Risk

5.4.1 Roles & Responsibilities of Board of Directors

5.4.2 Roles & Responsibilities of Senior Management

5.4.3 Liquidity Risk Management Strategy

Element 6: Operational Risk

6.1 Operational Risk Strategy

6.2 Operational Risk Identification and Assessment

6.3 Operational Risk Monitoring and Mitigation

6.3.1 Operational Risk Monitoring

6.3.2 Operational Risk Management

6.4 Operational Risk and Supervisory Guidelines

6.4.1 Basel II Operational Risk Types & Business Lines

6.5 Final Thoughts on Operational Risk

Element 7: Derivatives and Risk Management

7.1 Introduction

7.1.1 Growth in Derivatives Market

7.2 Uses of Derivatives

7.2.1 Hedging

7.2.2 Speculation

7.2.3 Arbitrage

7.3 Types of Derivative Contracts

7.3.1 Forwards

7.3.1.1 Forward Price

7.3.1.2 Revaluation of Forward Contract

7.3.2 Futures

7.3.2.1 Collateralization in Futures

7.3.2.2 Hedging Strategies Using Futures

7.3.2.3 Basis Risk

7.3.3 Swaps

7.3.3.1 Hedging Using Swaps

7.3.3.2 Revaluation of Swaps

7.3.4 Options

7.3.4.1 Hedging Using Options

7.3.4.2 Option Pricing

7.4 Closing Thoughts on Derivatives

Element 8: Introduction to Surveillance

8.1 Why surveillance is required at stock Exchange level

8.2 Know the structure of surveillance organization

Element 9: Operational Scope of Surveillance 9.1.1 Function and operations

9.1.2 Approach to Supervision

9.1.3 Market replay

9.1.4 Trading Rule breaches 9.2 Market Manipulation

9.2.1 What is market manipulation?

9.2.2 Why Manipulation is bad for market? 9.2.2.1 Examine the Hype

9.2.2.2 Examining the issuers

9.3 INSIDER TRADING

9.3.1 Regulatory framework

9.3.2 Why is it bad?

9.3.3 Classical Insider Trading Theory

9.3.3.1 Elements of Classical Insider Trading

9.3.4 Investigative Steps

9.3.4.1 Identify the Material Non-Public Information

9.3.4.2 Evaluating Trading Record

9.3.4.3 Maintain a Time-Line of Events

9.3.4.4 Question the Traders

9.3.4.5 Request a Chronology

9.3.4.6 Brokerage Record

9.3.4.7 Phone Records

9.3.4.8 Corporate Records

9.3.4.9 Bank Records

9.3.4.10 Recognition Letter

9.3.4.11 Taking Statement and Testimony

RECOMMENDED READINGS

The next section of this study guide covers a brief extract from some of the below mentioned documents. Candidates are advised to study the respective documents (in detail and original) which are available free-to-download from ICM's website and / or the respective organization's websites.

1. Anti-Money Laundering Act, 2010 2. Anti-Money Laundering Ordinance, 2009 3. Anti-Money Laundering Regulations, 2008 4. Anti-Money Laundering Rules, 2008 5. Bond Automated Trading System (BATS) Regulations, 2009 6. Broker Agents Registration Rules, 2001 7. CDC Act, 1997 8. CDC Regulations 9. Code of Corporate Governance, 2012 10. Companies Ordinance, 1984 11. Debt Securities Trustee Regulations, 2012 12. Directive to Brokers on Conduct of Business (February 7, 2003) 13. Income Tax Ordinance, 2001 14. ISE/ KSE/ LSE Listing Regulations 15. KSE Investor Protection Fund Regulations 16. KSE Cash Settled Future Contract Regulations (October, 2008) 17. KSE Members Default Management Regulations (September, 2009) 18. KSE Deliverable Future Contract Regulations (April, 2009) 19. General Regulations of KSE Amended (August 20, 2009) 20. Karachi Automated Trading System (KATS) Regulations (March, 1998) 21. KSE Investor Protection Fund Regulations 22. NCCPL Procedure, 2003 23. NCCPL Regulations, 2003 24. NCEL General Regulations (May, 2007) 25. Commodity Exchange and Futures Contracts Rules (March, 2005) 26. Regulations Governing Over the Counter Market (September, 2009) 27. Regulations Governing Risk Management of KSE Ltd. (March, 2013) 28. Regulations Governing System Audit of Brokers of Exchanges, 2004 29. SECP Act, 1997 30. Securities (Leveraged Market and Pledging) Rules, 2011 31. Securities Act, 2015 32. Securities and Exchange Rules, 1971 33. Short Selling Regulations, 2002 34. Stock Exchange Members (Inspection of Books and Record) Rules, 2001