The Professional Risk Manager Exam Handbook

Exam 1

Jaffar Mohammed Ahmed

• Editorial: Harriman House
• Año: 2015
• ISBN:
  9780857194794
• Edición: 1

Risk management is no longer merely a passive cost-center in financial and non-financial organizations. Regulators, shareholders, executive management and investors look to risk managers for advice on risk budgeting. Since the financial crisis erupted in 2007, risk managers are expected more than before to make a thorough internal assessment of their organization's risk management frameworks and advise the board of directors and investors on their findings.Through its Professional Risk Manager (PRM) examination and qualification, the Professional Risk Managers' International Association (PRMIA) offers an outstanding tool of education for risk managers at all institutions.To be awarded the PRM designation, candidates must successfully pass four exams. The Professional Risk Manager (PRM) Exam Handbook - Exam 1 covers the Learning Outcome Statements (LOS) issued by PRMIA for Exam 1. The topics dealt with in this exam are: finance theory, financial instruments and financial markets.Due to the limited number of study manuals available for the PRM exams, candidates have previously had to rely on a wide range of resources on finance and financial instruments to learn the information they need. This approach is time-consuming and does not leave the candidate feeling confident about their readiness for the exams. The Professional Risk Manager (PRM) Exam Handbook is designed to address this problem and help PRM candidates prepare for the the PRM exams. The intention is to remove the need to refer to many different reference works and to make the obscure concepts comprehensible.The Handbook has been designed to cover everything you will need to know for PRM Exam 1. Information is presented in a clear, organized way, and demand very little previous knowledge of risk and finance. PRM candidates coming from a non-financial background should face no difficulty using this book as a reference to the intricacies of financial markets and risk management.

Chapter 1. Corporate Finance

This chapter includes the following sections:

1. Risk, utility and interest rate.
2. Capital allocation.
3. Capital structure.

1.1 Risk, Utility and Interest Rate

In this section we will address the LOSs related to the following topics:

• Continuous and discrete compounding.
• Nominal and effective interest rate.
• Utility maximization and function.
• Risk aversion.
• Mean-variance criterion.
• Risk adjusted performance measurements (RAPM):
  1. Sharpe ratio.
  2. Jensen alpha.
  3. Treynor ratio.
  4. Information ratio.
  5. Risk adjusted return on capital (RAROC).
  6. Return over value at risk (RoVaR).
  7. Sortino ratio.
  8. Omega index.

LOS. Differentiate between continuous and discrete compounding

As the name implies, in discrete compounding interest is compounded in a discrete number of periods during the year. With quarterly compounding, for instance, interest is compounded four times per year, and with monthly compounding, interest is compounded 12 times a year.

On the other hand, in continuous compounding money generates income every second. So the period is infinitesimally small in continuous compounding. In mathematical terms, when a variable value (the time per year in this context) reduces to a smaller amount, it goes to infinity. This is called continuous compounding.

Therefore, for an investment with a given present value, the future value of the investment is larger with continuous compounding than with discrete compounding. Similarly, for an investment with a given future value, the present value of the investment is smaller with continuous compounding than with discrete compounding.

For example, the future value (FV) of $100 invested today for six months at an interest rate of 7%, if compounded on a continuous basis, is:

FV = $100 × e(0.07 × 0.5) = $103.562

But if discretely compounded annually:

FV = $100 × (10.07)0.5 = $103.441

LOS. Differentiate between the nominal interest rate and effective yield

The nominal intere...