FRM 1. The Building Blocks of Risk Management
Introduction
This chapter provides an overview of fundamental risk management concepts. It highlights the importance of general risk management process, potential shortcomings, and the relationship between risk and reward. Key areas covered include:
1) Concept of Risk: Risk in investments is the uncertainty of outcomes, with a focus on potential losses. The trade-off between risk and return is fundamental, where higher risks often come with the potential for higher returns.
2) Risk Management Process: This involves identifying, measuring, and managing risks, distinguishing between expected and unexpected risks, addressing risk relationships, developing mitigation strategies, and monitoring and adjusting these strategies as needed.
3) Risk Identification: Methods include brainstorming, industry resources, loss data analysis, and scenario analysis. Risks can be categorized from known (expected) to unknown (unexpected).
4) Risk Management Decisions: Companies can avoid, retain, mitigate, or transfer risks. Effective risk management disperses risk among willing participants to prevent concentration, which was a failure seen in the 2007-2009 financial crisis.
5) Quantitative Risk Measures: Value at Risk (VaR) and economic capital are discussed as tools to quantify potential losses and the capital needed to cover them.
6) Qualitative Risk Assessment: Scenario analysis and stress testing help understand potential impacts of various risk factors under different scenarios.
7) Enterprise Risk Management (ERM): ERM integrates risk management across an organization, considering risks holistically and their impact on strategic planning.
8) Expected vs. Unexpected Loss: Expected losses are predictable and can be planned for, whereas unexpected losses are harder to predict and manage.
9) Risk and Reward Relationship: There is a natural trade-off between risk and reward. Proper risk management involves understanding and monitoring relevant risks to align with the organization’s risk tolerance.
10) Conflicts of Interest: Addressing conflicts of interest in risk management is crucial to prevent issues like rogue trading or misleading information impacting risk assessments.
This chapter sets the stage for more detailed discussions on risk management principles throughout the FRM curriculum.
Learning Objectives
1) Explain the concept of risk and compare risk management with risk taking.
2) Evaluate, compare and apply tools and procedures used to measure and manage risk, including quantitative measures, qualitative risk assessment techniques, and enterprise risk management.
3) Distinguish between expected loss and unexpected loss and provide examples of each.
4) Interpret the relationship between risk and reward and explain how conflicts of interest can impact risk management.
5) Describe and differentiate between the key classes of risks, explain how each type of risk can arise, and assess the potential impact of each type of risk on an organization.
6) Explain how risk factors can interact with each other and describe challenges in aggregating risk exposures.