Risk Management and Treasury Operations
What the exam tests
Risk Management and Treasury Operations tests how firms measure and control market, credit, liquidity and operational risk, and how treasury manages cash, collateral and settlement. Expect sensitivity calculations, margining and settlement-risk questions.
Core concepts
- Market risk. VaR summarises potential loss at a confidence level over a horizon but says nothing about tail size; stress testing complements it. DV01 measures value change per basis point; duration measures percentage price sensitivity.
- Credit and settlement risk. Counterparty risk is replacement cost; settlement risk is the risk of paying away value before receiving it (Herstatt risk). Collateral and netting reduce exposure.
- Liquidity risk. Funding liquidity is the ability to meet obligations; market liquidity is the ability to trade without moving prices. The LCR compares high-quality liquid assets with net stressed outflows.
- Operational risk. Failed settlements, reconciliation breaks, payment errors and cyber events. Treasury controls include nostro/vostro reconciliation and payment authorisation.
- Margining. Initial margin covers potential future exposure; variation margin settles current exposure. Haircuts and thresholds shape collateral calls.
Worked example
A bond portfolio has a DV01 of GBP 25,000 per basis point. A futures contract has a DV01 of GBP 80. The risk manager wants a DV01-neutral hedge.
Reasoning: number of contracts = 25,000 / 80 = 312.5, rounded to 313. If yields rise by one basis point, the cash portfolio loses about GBP 25,000 while 313 futures gain 313 x 80 = GBP 25,040. The small residual is rounding. DV01 hedging is a linear approximation: it works well for small yield changes but not for large moves or changes in curve shape.
Traps
- Confusing the VaR confidence level with the horizon; both must be stated.
- Getting the DV01 hedge sign or direction wrong.
- Assuming collateral eliminates counterparty risk; it mitigates but does not remove it.
- Confusing settlement risk with pre-settlement credit exposure.
Regulation, Compliance and Market Integrity
What the exam tests
Regulation, Compliance and Market Integrity tests the rulebook and conduct expectations: client classification, market abuse, transaction reporting, clearing, AML and sanctions. The exam favours applied questions about breaches and controls rather than rote recitation.
Core concepts
- Conduct rules. MiFID II/MiFIR set client categorisation, best execution, appropriateness and transparency for EU markets. Similar regimes exist elsewhere.
- Market abuse. MAR prohibits insider dealing, unlawful disclosure and manipulation, including spoofing, layering and wash trades. Intent and market impact matter.
- Derivatives reform. EMIR requires central clearing, risk mitigation and reporting for OTC derivatives; Dodd-Frank performs a similar role in the US. Basel standards set capital and liquidity minima.
- Benchmarks. The IOSCO Principles and the EU Benchmarks Regulation impose governance, input-data and control requirements on administrators and contributors.
- Financial crime. KYC, ongoing monitoring, sanctions screening and suspicious activity reporting are core compliance controls.
- Reporting. MiFID II transaction reports are due by the end of the next working day (T+1); EMIR reports are also T+1. Accuracy, not just timeliness, is tested.
Worked example
A trader places several large buy orders in a stock, cancelling them before execution, while selling the stock on another venue. The buy orders create apparent demand and lift the price.
Reasoning: this is layering, a form of spoofing and market manipulation. The cancelled orders were not genuine; they were designed to mislead other participants. MAR prohibits this, and surveillance systems flag high cancellation ratios and order-to-trade ratios. A defence that the orders were 'part of normal market making' would fail if there was no genuine intent to execute and the pattern was repeated.
Traps
- Confusing best execution with suitability; they are different obligations.
- Treating 'accepted market practice' as an automatic defence to manipulation.
- Ignoring the extra-territorial reach of regimes such as MAR and Dodd-Frank.
- Treating reporting as a back-office detail; late or inaccurate reports are breaches.