IFC Risk Management 5 — Questions and Answers
Question 1: The Sharpe ratio measures a fund's risk-adjusted return by comparing excess return to:
- The fund's beta
- The fund's standard deviation (total risk) (Correct answer)
- The benchmark's return
- The fund's maximum drawdown
Correct answer: The fund's standard deviation (total risk)
The Sharpe ratio divides the fund's excess return (above the risk-free rate) by its standard deviation, providing a measure of return earned per unit of total risk.
Question 2: A fund manager executes a currency hedge to protect a Canadian fund's exposure to euro-denominated assets. The hedge is likely implemented using:
- Equity futures on European stocks
- Forward currency contracts selling euros for Canadian dollars (Correct answer)
- Credit default swaps on European bonds
- Interest rate swaps linked to European rates
Correct answer: Forward currency contracts selling euros for Canadian dollars
Currency hedging for euro exposure is typically achieved using forward contracts to sell euros (and buy Canadian dollars) at a fixed future rate, locking in the exchange rate.
Question 3: A mutual fund's risk rating of 'High' as required by Canadian securities regulators is based primarily on:
- The fund manager's years of experience
- The fund's 10-year standard deviation of returns (Correct answer)
- The number of securities held in the portfolio
- The fund's expense ratio
Correct answer: The fund's 10-year standard deviation of returns
Canadian securities regulations require fund risk ratings to be based on the fund's historical 10-year standard deviation of returns, classifying funds from Low to High risk.
Question 4: Which of the following is an example of a 'tail risk' event for a mutual fund?
- A 0.5% daily fluctuation in the fund's NAV
- A rare but severe market crash causing losses far exceeding normal VaR estimates (Correct answer)
- Gradual erosion of returns due to management fees
- A minor credit rating downgrade of one portfolio holding
Correct answer: A rare but severe market crash causing losses far exceeding normal VaR estimates
Tail risk refers to extreme, low-probability events that cause losses far beyond what normal risk models (like VaR) predict, such as a severe financial crisis or market crash.
Question 5: Tracking error in a fund context measures:
- The fund manager's errors in executing trades
- The variability of a fund's returns relative to its benchmark (Correct answer)
- The difference between NAV and market price
- The fund's exposure to unsystematic risk
Correct answer: The variability of a fund's returns relative to its benchmark
Tracking error is the standard deviation of the difference between a fund's returns and its benchmark's returns, indicating how closely the fund follows the benchmark.
Question 6: A fund manager applies a 'stop-loss' strategy by automatically selling a security if it falls more than 15% from its purchase price. This is primarily a technique to manage:
- Liquidity risk
- Downside risk by limiting maximum losses on individual positions (Correct answer)
- Credit risk on bond holdings
- Currency risk on foreign securities
Correct answer: Downside risk by limiting maximum losses on individual positions
A stop-loss rule automatically exits a position at a predetermined loss threshold, limiting the fund's downside exposure on any individual security.
Question 7: Under Canadian securities regulations, which body has primary oversight responsibility for ensuring mutual funds comply with risk management and disclosure requirements?
- The Bank of Canada
- The Canadian Investment Regulatory Organization (CIRO) (Correct answer)
- The Office of the Superintendent of Financial Institutions (OSFI)
- The Canada Deposit Insurance Corporation (CDIC)
Correct answer: The Canadian Investment Regulatory Organization (CIRO)
CIRO (formerly MFDA and IIROC) is the self-regulatory organization overseeing mutual fund dealers and their compliance with securities regulations including risk disclosure requirements.
IFC Risk Management 5
The Sharpe ratio measures a fund's risk-adjusted return by comparing excess return to: