Q.

(i) Potential downside risks faced by PlainSailingCargo (PSC) as a result of renegotiation:

 It could be that PSC may not be able to continue its business in S-land anymore
 So, it may have to sell its business setups there
 And this liquidation might be at a disadvantaged prices
 The financial position might be hurt as PSC may need to downsize its operations rapidly
 Its operations may also get the support from S-Land facilities
 So, a renegotiation might result in this support to be withdrawn and PSC may not find an
immediate alternative
 It may not be able to recover the credits given to the debtors/ receivables based in S-Land
 The exchange rate between PFX and SFX might deteriorate such that SFX depreciates in values
 So, if PSC has a net income being generated from S-Land, its net income will be hurt while
remitting back to P-Land
 So, on an average, PSC might get lower returns generated from its business in S-Land
 However, the currency movement depends on which country has more influence to the world’s
economy
 If S-Land has more influence, SFX might be expected to appreciate in relation to PFX
 In that case, PSC might have to buy its fuels (needed to run its transport cargo ships) at a higher
price
 Also, if PFX depreciates in value with respect to SFX and if PSC imports most of its products in
SFX, PSC might need to import its necessities at a higher import price
 The shipping transaction might be restricted through higher port barriers like tariff
 Also, it could restrict which products PSC can actually transport.

Potential upside risks:

 If SFX appreciates with respect to PFX, PSC will be able to get more net incomes while being
remitted to P-Lans/ translated in PFX.
 PSC would see that a lot of cheaper alternatives emerge because of these new trading
restrictions
 It could be that some other countries have bad relationship with S-Land governments and so P-
Land government might be forming better ties with these countries
 So, new markets might develop and PSC might be the one who will get the first mover
advantage in that respect
 However, if SFX depreciates because of the world’s perception that S-Land is trying to run its
economy on a standalone basis and should not be expected to influence the world economy in
future, PSC would be able to get fuel at a lower price
 So, a depreciation in SFX would give PSC an import advantage
 Also it could be that P-Land and S-Land will be liberalizing the trading agreements in other fronts
  Depending on whether this happens, this might give PSC an upper hand if it has a business
expansion plan in other areas of business.

(ii) Advantages of hiring a consultancy firm:

 PlainSailingCargo (PSC) may not have the expertise to generate all possible scenarios emerging
from the trading renegotiations
 So, hiring a consultancy firm would result in better scenario generation and analysis
 The consultancy forms might already have had experience in dealing with such projects with
other similar firms in similar situations
 Also, the consultancy form might have had economists and financial analysts who will be able to
track world economies and exchange rate movement better than PSC
 So, PSC will be able to tap into these expertise and experience of the consultancy firm
 PSC will be able to focus on its core business
 PSC will not need to do any in-house analysis which might be influenced by bias

Disadvantages:

 PSC is operating a very niche type of business (e.g., shipping) which has a very specific category
of risks and so the risk profile could be very different
 So, the consultancy firm may not be able to understand the risk profiles and business lpans well
 So, the result of the consultancy might not be accurate
 Will be a costly option
 PSC will need time to locate an experienced consultancy firm
 Will also need to share the confidential business plans
 Will also need to employ staff to understand how the consultancy firm works

(iii) Comment on CEO’s response:

 CEO of PSC wants to omit a scenario which has a 5% chance of occurring

 It could be that because the scenario has a very low probability, the CEO does not want to
include it in the analysis
 Or it could be that CEO does not foresee that the trading negotiations will be unsuccessful,
leading to a hike in the tariff on shipping for an indefinite period.
 However, whatever the case, the CEO should be cautious of dealing with highly-unlikely but
nevertheless high-impact events
 These events might be considered outlier events
 But if they take place, these will have huge repercussions on PlainSailingCargo’s (PSC) future
financial position
 So, the scenario should be included fir further investigation
  Also, the consultancy form should be asked how they have come up with this chance being 5%
 It could be that the consultancy firm has been able to gather lots of public information and
market judgments
 CEO should analyze those rationale points further before jumping to a conclusion
 It could also be that the CEO is biased from a behavioral perspective
 He could be showing overconfidence bias in that he is confident that only his views will
materialize in reality
 This overconfidence could be resulting from his having successfully run the business for many
years
 The CEO should be aware of such behavioral biases and should make an informed decision with
respect to PSC’s exposure to the trading negotiations
 The CEO should also understand that the consultancy firm might be having more expertise in
dealing with such situations

(iv) Reducing the direct currency exposures:

 Direct currency exposures would be impacting the remittances being sent from S-Land in future
years
 In that case, PlainSailingCargo (PSC) can go for currency derivatives (e.g., currency options,
futures, forwards, and swaps) to hedge exchange rate exposures on its future SFX cash-flows
from the business from S-Land
 While currency options will protect from PSC from a downside movement in SFX, it will protect
the upside
 However, it will be more expensive for PSC
 Also, to minimize the number of derivative contracts, PSC could be watching carefully when its
revenues and expenses in SFX are going to take place
 So, it can go for cash-flow matching in SFX
 This would be resulting in a netting impact
 Also, it can resort to leading and lagging of cash-flows such that it can sometimes remit back
cash-flows earlier and sometimes later
 This will also minimize the number of derivative contracts

Reducing the indirect currency exposures:

 PSC can see how the currency movement will affect its other export and import businesses (e.g.,
fuel price)
 So, it can likewise enter into derivative contracts in those particular commodities
 In most cases, forward contracts with an investment bank can be entered
 PSC can see if PlainBank can offer such contracts

Reducing the tail risk exposure:

  Tail risk means how SFX and PFX will move at the lower or upper tail of their join distribution
 Currencies should be having very low lower and upper tail dependence
 So, PSC would leave these risk exposures unhedged

(v) Additional risks and mitigation techniques

 Counterparty risks:
o PSC will be exposed to PlainBank in that PlainBank may not honor the contracts in time
o This can be minimized if there is a central clearing house who will act as a counterparty
for all forward transactions between PlainBank and PSC
o PSC could enter into contracts with multiple counterparties
 Settlement risk
o The settlement from PlainBank might fail on the settlement date
o PSC could go for early warnings to PlainBank on the day of settlement
o It could notify PlainBank beforehand
o Or it could introduce a penalty on PlanBank in case of failing a settlement
 Liquidity risk
o If the forward contracts are traded, these might be illiquid when PSC need to sell them
o PSC could enter into contracts with multiple counterparties
o Also PSC could enter into futures contracts so that it can exit through more liquid future
contracts in future
o However, in that case, it will lose the customization that PlainBank might be offering it
through different forward contracts
 Aggregation risk
o PSC is entering contracts for all currencies; so, aggregation might not be appropriate
o PSC can hire consultants or risk experts who can aggregate the risk exposures posed by
these different contracts
 Concentration risk
o PSC could be overly entering contracts which are not needed
o PSC can hire risk experts who will set trading and exposure limits on each currency such
that PSC’s employees will not enter into unwanted currency derivative contracts
 Legal risk
o The contracts might be prepared in shallow forms such that future litigations might arise
o Also, PSC might be violating certain local regulations
o This can be avoided if PSC follows globally accepted derivative agreements like advised
by ISDA (International Swaps and Derivatives Association) contracts
 Reputational risk
o PSC might be running the risk of breaching derivative guidelines and might be exposed
to more earnings volatility, leading to poor stakeholder management
o A limit on currency contracts would minimize this risk
 Regulatory risk
o PSC would be running the risk of violating regulatory limits and constraints
 o A strong compliance and risk management team who will oversee the daily derivative
positions and number of contracts will minimize this risk
 Operational risk
o Operational risk might emerge from inadequate people, processes, and system, and also
from external events concerning the currency movements
o Details operational risk management policies, guidelines, procedures, methodologies,
and models would help PSC minimize this risk

(vi) Benefits of own risk function in structuring and overseeing the derivative contracts

 Will be able to understand any hidden diversification benefits posed by other areas of business
 Will be cost effective
 The risk management team might already have the expertise and the team to manage such risks
 So, managing the contracts will not be an added burden
 Also, the risk function will be better able to understand the business rationale
 So, entering the contracts for the sake of entering the contracts will not be there
 Also, the risk management function will have the objective of having a higher risk-adjusted
return
 So, this objective will lead to minimal contracts needed for hedging currency risks in a sufficient
manner so that the purpose of minimal currency volatility and stable returns is served well
Q.2

(i) Similarities between Solvency ii and Basel ii/ iii framework

 Both are risk-based frameworks

 Both have 3 pillars of framework.
o In case of Basel ii/ iii, they are regulatory capital requirement, supervisory review, and
disclosure.
o In case of solvency ii, these are quantitative requirements, qualitative requirements, and
supervisory requirement and disclosure
 Both focus on market, credit, and operational risks. Solvency ii also focuses on the insurance/
underwriting risk as it is applicable for the insurance companies
 Both apply some risk measures based on VaR (value at risk).
o For example, Basel ii says that market risk can be determined at 10-day 99% VaR
threshold
o Solvency ii also says that its solvency capital requirement (SCR) under the first pillar of
quantitative requirements can be set at 99.5% VaR threshold over the one-year time
horizon
 Both apply to multinational companies
 Both have the objective of unifying the solvency/ capital regulations for financial institutions
across the world. While Basel ii/ iii apply for banks worldwide, solvency ii is yet to be
implemented by many countries around the world.

(ii) Solvency ii approach to risk management:

 Solvency ii has 3 pillars:

o Quantitative requirements:
 This is a twin peak approach. It mandates to satisfy two types of capital
requirements – solvency capital requirement (SCR) and minimum capital
requirement (MCR)
 SCR says that a company has to maintain its capital at 99.5% VaR (value at risk
level) over a one-year time horizon
 SCR sets the boundary for the regulatory to action against the insurance
company
 MCR is more liberal as it’s related to the insurance companies’ licensing
 It’s set at 80-90% confidence level over one year
 Also it’s set at 3 million euros plus a margin based in business activity
o Qualitative requirements:
 These requirements focus on the internal capacity of the insurance companies
 The companies perform tests according to ORSA (Own Risk and Solvency
Assessment) and then determine if its capital position is adequate
 And whether it has the ongoing ability to continue the business
 And whether it would be able to maintain its financial viability over a longer
horizon than needed by the regulators
 o Disclosure:
 These mostly relate to the disclosure to the public and potential investors on a
periodic basis

(iii) Impact of the last quarter’s results on solvency capital requirement:

 Liability-side Risk identification:

o First, the risks facing LongLife can be outlined.

o In this case, the company is selling savings products and so is exposed to a general
movement in the interest rate in the market
o It’s also impacted by the other forms of market risk – equity price shock
o If the savings products are short-term in nature, the company is impacted by a change in
the short-term interest rate more

o It also sells life insurance policies

o These policies can be assumed to long-duration products
o So, these are going to be impacted by the long-range variables e.g., long-term interest
rates, duration of the assets, duration of the liabilities etc.
o If some of the life insurance policies are unit-linked, these will also be impacted by the
equity price movement in the market
o Also, if the life insurance policies offer guarantees, these will an additional source of risk
in that LongLife would have to earn the minimum investment return from its
investments over the longer term
o Also, depending on the with-profit and without-profit nature of life insurance policies,
the company will be able to see if some of the market risks can be shared with the
policyholders or not
o Also, not all life insurance policies will be long-term. Some policies can be short-term as
well e.g., some short-term term insurance policies
o Also, if LongLife sells life insurance products to different groups businesses, it will have a
different risk characteristic than the other businesses – group business, in most cases,
will be yearly renewable term contracts

o LongLife also sells critical illness policies

o Depending on the term of the policies, the company can see if it’s exposed more to the
short-term market variables or the long-term ones
o Also, it has a severe morbidity risk component
o Unlike the life insurance policies, the critical illness policies might only be paying claims
for a certain illness and may not be providing any benefit in case of natural death
o However, there could be some positive correlation in between the life insurance policies
and the critical illness policies
 Asset-side risk identification:
o Corporate bond investments are mostly affected by the movement in the risk-free rate
in the market, the associated credit spreads for each term and rating, and also other
factors like liquidity and marketability risks

o Equity investments are exposed in general to market movements in the equity prices
o In this case, the likelihood of a market contagion is more likely than ever evidenced by
the more recent market crash incidents

o Corporate property investments are mostly illiquid and so are mostly influenced by
broad market and economic movements
o It can be assumed that property investments offer real returns
o However, this argument cannot be validated always
o Property investments might face severe economic stagnation in future out of any
market crash

 Possible diversification:
o In the liability side, life insurance and critical illness products may be assumed to be
more positively correlated. However, this depends on the product benefits.
o The savings products can be assumed to be less correlated as it is mostly exposed to
market and interest rate risk

o In the asset side, corporate bond, equity, and property returns should be less correlated
in normal market conditions
o However, if the market moves in an extreme way, these relationships will break-down
and the correlations between different investments may rise.

 Risk quantification through approximate calculations:

o The last quarter’s economic summary report with respect to L-Island shows promising
results in terms of higher employment, higher GDP growth, higher government
investment, higher equity and property prices, higher inflation, and lower credit spread.
o This overall shows that the demand in the economy has been very high over some time
o And so the overall economy has been benefited from this higher demand

o Also, these higher returns from different segments would result in a positive correlation
in between certain asset classes. For example, equity and property price indices have
both risen by a significant %.
o So, they tend to be more correlated in case of significant market movements.
 o Now, certain risk exposure movements can be calculated

o First, the overall interest rate movement can be determined from the inflation rate
movement and the credit spread movement
o The inflation rate has been higher than the target by 50 basis points
o On the other hand, the credit spread has gone down on an average by 100 basis points
o Assuming that there are no other risks exposures have moved in between, the market
yield rates across all tenors and ratings of corporate bond can be assumed to go down
by 50 basis points
o If LongLife has an average asset duration on its corporate bond portfolio of 10, this 50
basis points downward movement would result in an increase in the market value of its
assets by 5% = 10 times 50 basis points.
o If the corresponding liability duration is only 5, the liability market value would move by
only 2.5%.
o So, on a net basis, LongLife would have a higher available economic capital (which is the
market value of its assets minus the market value of its liabilities) by 2.5%
o However, this all depends on the asset and liability duration profile that LongLife has

o Second, the equity price index rise by 15% should also result in an approximately 15%
increase in LongLife’s equity investment portfolio assuming that LongLife maintains a
passive equity investment portfolio
o So, the market value of equity has arisen by 15% leading to higher available economic
capital
o However, this depends on whether LongLife large blocks of with-profits life insurance
policies where the equity returns will be shared with the policyholders.
o So, any increase in the available capital might be less pronounced

o Likewise, the property price movement can also be captured.

o All these movements will have a favorable movement in the available economic capital
depending on the asset-liability duration, with-profits characteristics
o The impact on required capital might be influenced by how the risk characteristics have
changed in between different risk exposures.

(iv) Adverse selection and moral hazard example:

 Adverse selection:
 o Adverse selection means that if the insurance company had more information about the
policyholders/ customers, the insurance company would not be selling any policy to the
customer or might be selling the policy with a higher premium rate.
o For example, if an insurance company offers the same premium rates for smokers and
non-smokers, it could be that the non-smokers will get policies from other companies
(who differentiate between the premium rates for smokers and non-smokers) at a
cheaper rate and the company might only be having customers from the smokers’
group. So, in this case, the company is adversely selected against the smokers.

 Moral hazard:
o This means that the customers behave in a different way (after having an insurance)
from how they would behave if they were exposed to the risk exposures they are now
insured against.
o For example, if a customer has a building insurance and after securing the insurance, if
he behaves in a more casual manner with respect to taking care of his building, this
would be an example of a moral hazard.
o In many cases, this results from an information asymmetry.

(v) How the genetic tests can impact LongLife:

 Policyholders are not obliged to share the results of their genetic tests
 And these genetics tests show that some people are more vulnerable to critical illnesses some
of which are covered by LongLife
 So, it could happen that some customer who have recently gone through a genetic test would
be more interested in buying an insurance cover from LongLife if they can see that their tests
reveal that they are more prone to critical illnesses
 However, as LongLife cannot force these customers to reveal this information, LongLife would
not be able to charge higher on these customers, leading to an adverse selection risk

(vi) Risk mitigation actions and secondary risks

 It could be that LongLife would be honoring some premium waivers for those customers who
show the genetic tests and the tests reveal that they are not prone to critical illnesses
 However, the regulator may not allow this type of premium waivers which would encourage
voluntary submissions of genetic test reports by the less vulnerable people
 So, the secondary risk would be a potential regulatory repercussion

 LongLife would be able to reprice its existing critical illness product to cater for adverse
selection risks (through building in more buffers in the premium table) and it could apply the
same premium tables for all its customers
  However, this would be disadvantageous for the policyholders/ customers who have gone
through a genetic test and have found themselves to be less prone to the critical illnesses
 So, there will be a risk of adverse selection being more pronounced and good customers going
away
 There could be regulatory implications as the regulator might ask why LongLife has revised the
pricing for its critical illness product and the most extreme response could be not approving the
repriced product.

 Using published data on the genetic testing, LongLife can get an idea of how this is correlated
with the critical illness
 LongLife can also have an idea of approximately how much of the tested population are prone
to critical illness
 LongLife can then hold higher reserves and higher capitals to cover for adverse selection risks in
the light of this new information
 This will lead to lower risk adjusted return

(vii) How ERM adds value to the business of LongLife

 ERM considers all risks

 So, it does not apply a silo based risk management approach
 And so, all quantitative and qualitative risks are identified and brought under the umbrella of
ERM framework
 Also, ERM considers all upside and downside risks
 So, as long as all the risks considered, ERM would lead to better risk identification and
assessment in part of LongLife

 Also, ERM focuses more on a consistent risk taxonomy

 So, any silo-based, line-manager, function-specific risk definition will be discarded
 And LongLife will get the value from a consistent risk definition ad taxonomy across all its
businesses whereby risk management in future will be possible

 ERM also focuses on diversification and the interaction between different risk exposures
 So, LongLife will be able to get the benefit of natural hedging and diversification
 This will result in lower capital held by LongLife

 Also, because of a consistent risk identification, assessment, and measurement, its function
responsibilities will be aligned
 So, pricing, reserving, investments, fund transfer, capital and asset allocation, treasury – all of
these functions would go in a coherent and consistent manner

 Better risk reporting

 Better risk education, training, and understanding
 Buy-in from the top/ Board of LongLife in setting the risk management policies, procedures etc
 Line management will take the responsibility to implement as the top/ Board has asked
 More transparent risk culture in LongLife
 Asset allocation to different functions would be made in a consistent manner
 Risk can be aggregated in a consistent manner such that LongLife would be able to secure the
diversification benefits
 LongLife would be able to have better organizational effectiveness and better business
alignment
 Incentives and performance objectives of different functions can be set such that LongLife can
have a higher risk-adjusted return
Q.3

(i) Using options to take a long position in equity volatility:

 Diagram C would be the most available and most cost-effective option to trade to have a long
position in equity volatility
 It shows that for further stock price rises, ActuarInvest will be realizing profit
 And it also shows that for a fall in stock price after some threshold, ActuarInvest will also be
realizing profit
 So, ActuarInvest is actually implementing a long call plus a long put strategy
 In between the strike prices of the two individual positions (e.g., call and put), ActuarInvest is
expecting that the market will be stable and so there will be no need to enter any option within
that range
 Diagram C ensures that extreme sharp falls in the equity price from an increased volatility can
be protected against.
 Diagram A would also earn the same objective; however, trading call and put options at the
same strike prices might be more costly.

(ii) Likely objectives behind the risk manager’s proposal

 Protect against any sharp fall in the equity prices

 The market values of the equity investments are currently higher than the level of guarantee
that ActuarInvest has provided for within its products
 The risk manager is concerned that any sharp fall in the equity price will significantly impact its
market valuation of its equity investments
 Also, 60% of its investments are in global equities
 So, the asset allocation to equities is very high
 The risk manager thus wants to be protected against any near-term fall in the equity markets
given that the market has been at an all-time high level
 Also, the equity volatility is been low over a 10-year time horizon
 It could be that the risk manager believes that the market is just waiting to go burst
 It could be the case that there has been an asset bubble until this time
 So, the risk manager wants to be protected against any extreme events occurring in the market
in near future
 This is the reason why the risk manager also believes that high values in equity volatilities are
also related with extreme falls in the equity values
 It could also be that the risk manager has identified a potential risk arbitrage opportunity
between the options traded on underlying stocks and the options traded on underlying stocks’
volatility
 And so, the risk manager wants to take that advantage
 Also, the current option limits may not be permitting the risk manager holding more positions
on options where the underlying is the stock
  So, the risk manager might be willing to trade on options on stock volatility instead

(iii) Factors that will determine the hedging strategy

 Whether ActuarInvest trading/ investment guidelines support such volatility option trades
 Whether there has been any restriction set by the regulator
 Whether the current system supports such trades
 Whether there have been detailed trading, settlement, monitoring, and position guidelines with
respect to such trades
 Whether ActuarInvest can see that other similar companies employ similar options trades
 The capacity of the traders, market makers, and the risk managers
 The reporting framework – how these volatility options trades will be reported and what would
be the key performance indicators and key risk indicators
 A buy-in from the Board/ Top management within ActuarInvest
 A legal framework to decide on the contractual terms and conditions
 Basis risk – equity volatility is not an observable security; so, depending on what volatility index,
the options will be traded on, there could be significant basis risks.
 Taxation advantages
 Liquidity and marketability of such options in the market
 Historical index price correlation with the fixed income and cash securities – these are important
as ActuarInvest also has 30% assets invested in fixed income and 10% in cash.

(iv) Advantages of having a variable exposure based on the equity market levels

 Variable exposure could be obtained by buying more put options at a lower strike price as the
market falls further
 So that the return could be augmented further
 And as the market price goes up, more put options can be bought at a higher strike price so that
in case of future market fall, this can be protected against
 In both cases, the previous put positions can be exited
 This variable exposure maintenance would ensure that ActuarInvest will always be protected
against a market fall from its current level
 So, any gain until the current market level would be protected
 And if until the current market level, ActuarInvest is able to maintain the benefit guarantee
level, it can be well protected to honor such guarantees
 Also, trading the options on broad market levels will be more cost effective than stock options
 And these options will be more liquid that individual stock options
 There could be trackable indices available for entering such contracts and so liquidity and cost
advantage can improve further
Disadvantages:

 At times of market fall, the put options become more costlier

 So, even if ActuarInvest would want to maintain a variable exposure, it may not always be
possible as market participants may not want to sell/ offer such options
 Basis risk will prevail as ActuarInvest will have an exposure on the broad market level
 So, if its individual stock positions significantly differ from the market level, its objectives of
downward market protection through variable exposure may not be achieved
 More options mean more cost and time involved
 Counterparty risk is there as these will be offered as over-the-counter options
 The system may not be capable enough to maintain such trades

(v) Incorporating equity volatility risk in the ERM framework including the economic capital model

 Consistent risk definition

o A consistent risk definition for equity volatility should be introduced
o This can be done through a team effort inviting the related trading, risk manager, and
other functional leads (e.g., audit, compliance etc.)
o The risk definition should be aligned with the market definitions as well
o The definitions should be easily understandable and communicable
o The Board should be informed of such a risk definition
 Risk exposure determination
o Given that ActuarInvest invests 60% of its portfolios in global equity, it can be
determined how much will be the exposure coming out of equity volatility
o The maximum exposure is the current equity market value itself
o However, not all equities can be assumed to be go down to zero in future
o So, the exposure can be determined in a realistic manner
 Risk identification
o At this stage, the sources of such equity volatility can be determined
o Sources can be high and unsustainable P/E (price earnings) ratios in the market
 Risk assessment
o Risk can be assessed at this stage
o The likelihood and severity of equity volatilities can be set under certain bands
o For example, what is the probability of observing an increase in equity volatility by 5% in
the course of next one month, what is the probability of an increase in equity volatility
by 10% in the course of next one month, and so on
 Interaction with other risks
o How equity volatility risks interact with other risk variables (e.g., interest rates in the
market) can also be measured
o This is needed before ActuarInvest can do a rough capital calculation
o As capital needs to consider the interactions ad diversifications in between different
risks, this is something that ActuarInvest should spend more time
 o As higher equity volatility is also associated with lower interest rates (as more people
now go for safer fixed income securities), this should be validated with historical time
series data
o If needed, expert opinion can also be taken
 Illustrative capital calculations
o ActuarInvest can then calculate some illustrative capital figures based on the points
made above
o A multivariate loss distribution considering all risks can be formed (including the equity
volatility risk) and a certain tail level threshold can be taken as the capital level
o Or AcuarInvest can model the marginal distributions of different risk exposures
(including the equity volatility risk) and then join then through a copula
 Setting the risk appetite statement and risk tolerance limits
o Based on the impact on the economic capital under different scenario, sensitivity, and
stress testing, suitable limits and tolerance levels for equity volatility can be determined
 Communication across the ERM stakeholders
o All of the above outputs can be documented and then shared with key ERM
stakeholders before the next Board/ Risk-subcommittee meeting
o The outputs should be in a summarized and understandable format
o The outputs should clearly show the difference between the cases – one with the equity
volatility risk and one without
 Buy-in from the Board, CRO, and functional leads
o The Board/ Risk sub-committee members may approve the decision to include the
equity volatility in the ERM framework
 Adding the risk to the existing ERM framework
o Once the decision, the steps above will be documented and then the equity volatility
risk will be finally added to the ERM framework
 Implementing the new framework
o The new framework can be implemented effective immediately
 Possible other routes
o The steps above are more/ less like a bottom-up approach
o It could be that the central risk function first gets the approval from the Board/ risk sub-
committee to proceed with including the equity volatility to the ERM framework
o And then the other steps can be done

(vi) Implications on the hedging strategy

 As soon as the equity volatility becomes a part of ActuarInvest’s ERM framework, it will
influence how ActuarInvest will control its delta, gamma, and vega hedging involving other
options
 If ActuarInvest has current option positions involving the underlying stocks, it could be that in
future it may not need to be concerned about periodic vega hedging for these options
 This is because vega hedging of stock options would protect the company from increased
volatility of the underlying stocks
 And the same objective of getting protection from the increased volatility of the underlying
stocks can be obtained through equity volatility options
 So, number of stock option rebalancing to achieve vega hedging might go down
 However, vega hedging for individual stock options might still be needed because equity
volatility options would normally be traded against the whole market level
 So, there could be significant basis risk as equity volatility options may not be achieving the
individual stock options’ vega hedging
 Also, the number of stock derivatives can also go down is ActuarInvest’s risk manager identifies
a potential risk arbitrage opportunity between stock options and equity volatility options
 So, depending on the price of the volatility options, this can give ActuarInvest an added
advantage
 Also, the trading/ hedging limits might be modified such that some trading is allocated to equity
volatility while reducing the existing limits for stock options
 This will be done to achieve the protection of ActuarInvest from running unnecessary and undue
option exposures