Revision
We will cover following topics
Key Takeaways
LO 1.a: Explain the concept of risk and compare risk management with risk taking.
Risk involves the unpredictability of outcomes. The risk management process consists of steps aimed at minimizing or eliminating potential losses. Risk-taking includes consciously accepting additional risk to achieve greater gains.
The risk management process is a structured approach to evaluating whether the anticipated rewards outweigh the expected risks. It comprises several key components, including:
- Identifying risks.
- Measuring and managing risks.
- Differentiating between anticipated and unanticipated risks.
- Examining the interrelationships among risks.
- Formulating a risk mitigation strategy.
- Continuously monitoring and adjusting the risk mitigation strategy as necessary.
LO 1.b: Evaluate, compare, and apply tools and procedures used to measure and manage risk, including quantitative measures, qualitative risk assessment techniques, and enterprise risk management.
To asses risk, both quantitative measures (such as VaR and economic capital) and qualitative measures (such as stress testing and scenario analusis) are used. Additionally, qualitative methods like scenario analysis and stress testing are also employed. It’s crucial for risk managers to understand that enterprise-level risk cannot be simplified to a single metric. Risk is a multifaceted concept, necessitating a dynamic process to effectively identify, measure, mitigate, and monitor pertinent risks.
LO 1.c: Distinguish between expected loss and unexpected loss and provide examples of each.
Expected losses refer to the average amount of loss anticipated over a specific time period. These losses depend on three key factors:
- the likelihood of the risk event occurring,
- the monetary exposure to the risk, and
- the anticipated severity of the loss if the risk event takes place.
Unexpected losses, on the other hand, are those that exceed the average expected loss. When these unexpected losses are correlated, they can be somewhat more straightforward to model.
LO 1.d: Interpret the relationship between risk and reward and explain how conflicts of interest can impact risk management.
A trade-off is observed between risk and reward, implying that riskier opportunities offer higher returns and vice-versa. Risk managers must evaluate not only the potential impact of a particular risk but also the detailed factors contributing to that risk. At times, the objectives of corporate insiders might clash with those of shareholders, leading to risk-taking that serves hidden agendas. This misalignment can result in significant issues if an extreme and unforeseen loss (i.e., tail risk) occurs. Implementing multiple layers of oversight along with regular and independent internal audits can help mitigate these conflicts of interest.
LO 1.e: 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.
The term “risk” encompasses several categories, including market risks, credit risks, liquidity risks, operational risks, legal and regulatory risks, business and strategic risks, and reputation risks.
- Market risk involves potential losses due to changes in financial market levels or volatility.
- Credit risk pertains to the possibility of a loan default or rating downgrade.
- Liquidity risk arises from a lack of sufficient funds to meet business needs (funding liquidity risk) or the inability to quickly convert a financial asset into cash in the market at a reasonable value (market liquidity risk).
- Operational risk covers potential losses resulting from inadequate or failed internal processes, human errors, or external events.
- Legal and regulatory risks are associated with potential litigation or adverse government actions.
- Business risk involves fluctuations in revenue or costs that affect the business’s viability.
- Strategic risk deals with uncertainties related to long-term business strategies.
- Reputation risk involves a loss of sales due to a negative shift in public perception of the company’s products or fairness.
LO 1.f: Explain how risk factors can interact with each other and describe challenges in aggregating risk exposures.
Interconnected risks can trigger a chain reaction where one risk directly causes another, and amplify the overall risk exposure. Risk aggregation involves assessing risk at the enterprise level. Increased complexity of underlying risks reduces the reliability of risk assumptions.
VaR, economic capital, and RAROC collectively aid risk managers in gaining a comprehensive understanding of a firm’s total risk exposure. For comparison purposes, RAROC can be used. However, VaR should not be used in isolation as a risk metric because it relies on specific assumptions, can be influenced by input parameters, and exists in various forms.
Practice Questions
1) A portfolio manager is assessing the risk profiles of various portfolios with same market value but different asset classes. During a sharp, widespread downturn in financial markets, which portfolio is likely to experience the highest potential unexpected loss?
A. A portfolio of US T-notes with 2 to 5 years to maturity.
B. A portfolio of long stock positions in an international large-cap stock index combined with long put options on the same index.
C. A portfolio of mezzanine tranche MBS structured by a large regional bank.
D. A short position in futures for industrial commodities such as copper and steel.
C is correct. The portfolio of MBS is expected to have the highest unexpected loss due to the securities’ potentially high correlation (covariance) and greater risk of simultaneous downward movement in a crisis scenario.
A is incorrect. US T-notes are backed by the government and have very low risk of default. Thus, they provide the constant promised return regardless of market movement.
B is incorrect. It is an example of protective put strategy (long stock + short put) where the losses are limited in case of falling stock proces.
D is incorrect. Since it is a short position in futures, the prices of futures will rise with a fall in thr price of underlying stocks’ prices and the portfolio will benefit.
2) A risk manager explains to his junior analyst that unexpected losses can arise from unknown or uncertain risks, or risks that are difficult to quantify. Which of the following statements is accurate for the manager to make about risk measurement?
A. Unknown risks can be estimated but are generally unmanageable.
B. Unknown risks may occur across different risk categories but are usually minor and insignificant.
C. Risk managers should handle unknown risks the same way as quantifiable risks.
D. A risk manager’s confidence in the estimate of a risk measure should influence how that estimate is used in decision-making.
A is correct. A risk manager’s confidence in a risk measure impacts how the estimate should be integrated into decision-making.
A is incorrect. Unknown risks, such as Knightian uncertainties, involve scenarios where it is impossible to know all information necessary to model a probability distribution of outcomes. However, these risks can sometimes be managed by avoiding the risk and other risk management strategies.
B is incorrect. Certain unknown risks, like Knightian uncertainties, can be significant and severe.
C is incorrect. Unknown risks can be treated in the same manner as if they are known quantities.
3) Which of the following statements is most appropriate regarding the RAROC risk metric?
A. RAROC facilitates the comparison of profitability across business divisions with varying capital requirements.
B. RAROC enables the firm to benchmark its performance against operational targets set by industry peers.
C. RAROC serves as an effective forward-looking tool for modeling potential extreme losses during stress scenarios.
D. An activity is creating value for the bank’s shareholders if its cost of equity capital exceeds its RAROC.
A is correct. RAROC allows firms to compare the profitability of business lines that require different amounts of economic capital.
B is incorrect. RAROC does not serve as a benchmark against peers. Instead, it is used to assess whether internal projects or business units provide value by delivering risk-adjusted returns that exceed the firm’s cost of equity capital.
C is incorrect. RAROC is based on expected returns and does not quantify losses during stress scenarios. Other metrics, such as expected loss or scenario analysis, are more suitable for assessing potential extreme losses.
D is incorrect. An activity is creating value if its RAROC is higher than the cost of equity capital.
4) A treasury risk analyst is assigned with providing assistance in the management of liquidity risk of a bank. Which of the following is most likely part of the treasury risk analyst’s job duties?
A. Developing VaR models.
B. Buying CDS instruments.
C. Executing asset-liability management.
D. Calculating loss given defaultRAROC facilitates the comparison of profitability across business divisions with varying capital requirements.
C is correct. Asset-liability management is crucial for handling banks’ funding liquidity risk. This involves techniques such as gap and duration analysis. Managing the mismatches between the maturities of assets and liabilities (e.g., using short-term deposits to fund longer-term loans) is essential to mitigate risk, especially if short-term interest rates rise more quickly than long-term rates.
A is incorrect. Developing VaR models is typically done by model risk managers or developers and is related to managing market risk.
B is incorrect. Purchasing CDS instruments is a strategy used to hedge against counterparty risk, which is a type of credit risk.
D is incorrect. Estimation of loss given default is a task associated with credit risk.
5) Bank Alpha enters into a trade with Bank Beta? However, bank Beta is concerned that bank Alpha will fail to deliver its obligation. Which type of risk is used to correctly describe the concern of bank Beta?
A. Model risk.
B. Settlement risk.
C. Market risk.
D. Business risk.
B is correct. Settlement risk refers to the danger that a counterparty will not meet its obligation.
A is incorrect. Model risk refers to the risk of error due to inadequacies in financial risk measurement and valuation models.
C is incorrect. Market risk is the potential for losses due to factors impacting the overall performance of investments in the financial markets.
D is incorrect. Business risks refers to the possibility of making inadequate profits in the business due to uncertainties.