(55) Risk Management: An Introduction

Question 1

LOS 41. a: Define risk management.

Answer 1

Risk management is the process of:

• identifying and measuring the risks an organization (or portfolio manager or individual) faces
• determining an acceptable level of overall risk (establishing risk tolerance)
• deciding which risks should be taken and which risks should be reduced or avoided
• putting the structure in place to maintain the bundle of risks that is expected to best achieve the goals of the organization.

Question 2

LOS 41. b: Describe features of a risk management framework.

Answer 2

An overall risk management framework should address the following activities:

• Identifying and measuring existing risks
• Determining the organization’s overall risk tolerance
• Establishing the processes and policies for risk governance
• Managing and mitigating risks to achieve the optimal bundle of risks
• Monitoring risk exposures over time
• Communicating across the organization
• Performing strategic risk analysis

Question 3

LOS 41. b: Describe features of a risk management framework. What would effective risk management most likely attempt to do?

Answer 3

Risk management requires establishment of a risk tolerance (maximum acceptable level of risk) for the organization and will attempt to maximize expected returns for that level of risk. Some significant risks the firm is exposed to may be borne by the firm or even increased as a result of risk management.

Question 4

LOS 41. c: Define risk governance and describe elements of effective risk governance.

Answer 4

Risk governance refers to:

• senior management’s determination of the risk tolerance of the organization
• the elements of its optimal risk exposure strategy
• the framework for oversight of the risk management functions.

Question 5

LOS 41. d: Explain how risk tolerance affects risk management.

Answer 5

The risk tolerance for an organization is the overall amount of risk it will take in pursuing its goals and is determined by top management.

Question 6

LOS 41. e: Describe risk budgeting and its role in risk governance

Answer 6

Risk budgeting is the process of allocating the total risk the firm will take (risk tolerance) to assets or investments by considering the risk characteristics of each and how they can be combined to best meet the organization’s goals. The budget can be a single risk measure or the sum of various risk factors.

Question 7

LOS 41. e: Describe risk budgeting and its role in risk governance. How can risk budgeting can be best described?

Answer 7

Risk budgeting refers to selecting assets or securities by their risk characteristics up to the maximum allowable amount of risk. The maximum amount of risk to be taken is established through risk governance.

Question 8

LOS 41. f: Identify financial and non-financial sources of risk and describe how they may interact.

Answer 8

Financial risks are those that arise from exposure to financial markets, including:

• credit risk
• liquidity risk
• market risk.

Question 9

LOS 41. f: Identify financial and non-financial sources of risk and describe how they may interact. (what risks do individuals face as well?)

Answer 9

Non-financial risks are the risks from the operation of the organization and from sources external to the organization. Individuals face mortality and longevity risk, in addition to financial risk.

Question 10

LOS 41. f: Identify financial and non-financial sources of risk and describe how they may interact.

Answer 10

Interactions among risks are frequent and can be especially significant during periods of stress in financial markets.

Question 11

LOS 41. g: Describe methods for measuring and modifying risk exposures and factors to consider in choosing among the methods. What is the risk of assets measured by?

Answer 11

Risk of assets is measured by:

• standard deviation
• beta
• duration

Question 12

LOS 41. g: Describe methods for measuring and modifying risk exposures and factors to consider in choosing among the methods. What do derivative risk measures include?

Answer 12

Derivatives risk measures include:

• delta
• gamma
• vega
• rho

Question 13

LOS 41. g: Describe methods for measuring and modifying risk exposures and factors to consider in choosing among the methods. How is tail risk measured?

Answer 13

Tail risk is measured with value at risk (VaR) or Conditional VaR.

Question 14

LOS 41. g: Describe methods for measuring and modifying risk exposures and factors to consider in choosing among the methods. How may some risks be measured where there is lack of data?

Answer 14

Some risks must be measured subjectively.

Question 15

LOS 41. g: Describe methods for measuring and modifying risk exposures and factors to consider in choosing among the methods. What are the various ways an organization may decide deal with risks?

Answer 15

An organization may decide to:

• bear a risk (self-insurance)
• avoid or take steps to prevent a risk
• efficiently manage a risk through diversification
• transfer a risk with insurance or a surety bond
• shift a risk (change the distribution of uncertain outcomes) with derivatives

Question 16

LOS 41. g: Describe methods for measuring and modifying risk exposures and factors to consider in choosing among the methods. What is the end result of addressing risk exposures?

Answer 16

Organizations may use multiple methods of risk modification after considering the costs and benefits of the various methods. The end result is a risk profile that matches the organization’s risk tolerance and includes the risks that top management has determined match the organization’s goals.