Risk Management and Ethics
Domain 4 tests whether you can identify, measure and control derivatives risk and apply ethical standards under Pakistani market rules.
Core rules
- Market risk includes delta, gamma, vega and theta; use limits, VaR and stress tests. Credit risk is counterparty default; CCP novation reduces but does not eliminate it. Liquidity risk covers funding and market liquidity. Operational risk covers systems, settlement and fraud.
- VaR is a loss threshold at a confidence level over a horizon, not a maximum loss. Stress tests capture tail events.
- Ethics require client priority, suitability, confidentiality, conflicts management, best execution, and no insider trading or manipulation. SECP conduct rules and the AML Act, 2010 apply.
- Hedging reduces risk but introduces basis risk and margin calls.
Worked example
A portfolio has PKR 10 million exposure and 2% daily volatility. Parametric 1-day 95% VaR = 1.65 × 2% × 10,000,000 = PKR 330,000. This means a 5% chance of a loss greater than PKR 330,000 over one day under normal assumptions, not a cap. If a stress scenario implies a 6% move, the stress loss is PKR 600,000, which must be reported and covered by capital or liquidity buffers. A trader who hides the stress result to avoid a margin call breaches risk and conduct rules.
Traps
- Treating VaR as worst-case loss.
- Ignoring liquidity horizons and basis risk in hedges.
- Disclosing a client's order flow to another desk.
- Assuming no client loss means no ethics breach; manipulation and unauthorised trading are breaches even with profit.