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FRM Part1: Foundation of Risk Management > Foundation of Risk Management Topic 1 - 4 > Flashcards

Foundation of Risk Management Topic 1 - 4 Flashcards

1
Q

What is the definition of risk in an investing context?

A

Uncertainty surrounding outcomes
the potential for negative outcomes like unexpected investment losses

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2
Q

What is the trade-off between risk and return?

A

There is a natural trade-off between risk and return, where opportunities with high risk have the potential for high returns and those with lower risk offer lower return potential.

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3
Q

What is the primary purpose of risk management?

A

The primary purpose of risk management is to reduce or eliminate the potential for expected losses and manage the variability of unexpected losses

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4
Q

How does risk taking differ from risk management?

A

Risk taking involves the active acceptance of additional risk in pursuit of greater gains, whereas risk management focuses on mitigating, reducing, or eliminating risks.

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5
Q

What are the key steps in the risk management process?

A

The key steps include
1. identifying risks,
2. measuring and managing risks,
3. differentiating expected from unexpected risks,
4. developing and monitoring a risk mitigation strategy.

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6
Q

What are some common techniques for identifying risks?

A

Common techniques include brainstorming with business leaders, analyzing loss data, scenario analysis, and consulting industry resources.

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7
Q

What are the strategic decisions involved in risk management?

A

Strategic decisions can include
1. avoiding
2. retaining
3. mitigating
4. transferring risks,
depending on the perceived rewards relative to risks.

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8
Q

What are major challenges faced in risk management?

A

Major challenges include managing the dispersion of risks, avoiding concentration of risk, preventing market disruptions, and handling the misuse of derivatives.

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9
Q

What are the main categories of risk?

A
  1. Market risks
  2. Credit risks
  3. Liquidity risks
  4. Operational risks
  5. Legal and regulatory risks
  6. Business and strategic risks
  7. Reputation risks
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10
Q

What is Market Risk and its subtypes?

A

Market risk refers to losses due to changes in market prices and rates. Subtypes include:
1. Interest rate risk
2. Equity price risk
3. Foreign exchange risk
4. Commodity price risk.

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11
Q

Define Interest Rate Risk and provide an example.

A

Interest rate risk is the risk of losses resulting from changes in interest rates. Example: If interest rates rise, the value of bonds typically decreases.

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12
Q

What is Equity Price Risk?

A

Equity price risk involves the volatility of stock prices due to general market movements or specific company-related factors.

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13
Q

Explain Foreign Exchange Risk with an example.

A

Foreign exchange risk occurs from changes in currency exchange rates. Example: A U.S. company may face losses on its European sales if the euro weakens against the dollar.

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14
Q

What causes Commodity Price Risk?

A

Commodity price risk stems from the volatility in commodity prices due to market concentration and limited trading liquidity.

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15
Q

Describe Credit Risk and its four subtypes.

A

Credit risk is the potential for a loss when a counterparty fails to meet its obligations. Subtypes include:
1. Default risk
2. Bankruptcy risk
3. Downgrade risk
4. Settlement risk.

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16
Q

What is Default Risk?

A

Default risk is the potential non-payment of scheduled interest or principal on a debt obligation by the borrower.

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17
Q

Explain Liquidity Risk and its two divisions.

A

Liquidity risk is the risk of not being able to meet cash needs or convert assets into cash. It is divided into
1. Funding liquidity risk
2. Market liquidity risk (also known as trading liquidity risk).

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18
Q

What is Operational Risk? Give examples.

A

Operational risk refers to losses from failed internal processes, human errors, or external events. Examples include technology failures, data entry errors, and natural disasters.

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19
Q

Define Legal and Regulatory Risk.

A

Legal risk involves losses from litigation, while regulatory risk involves losses from changes in laws or regulations affecting business practices.

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20
Q

What are Business and Strategic Risks?

A

Business risk relates to the variability in operational factors affecting profits, and strategic risk involves decisions impacting long-term business goals.

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21
Q

What is Reputation Risk and how can it arise?

A

Reputation risk is the risk of damage to a firm’s reputation, potentially leading to financial losses. It can arise from financial issues or unethical practices.

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22
Q

How do risk factors interact in risk management?

A

Risk factors can interact and correlate with each other, complicating risk management and assessment processes.

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23
Q

What is the Value at Risk (VaR) and its importance?

A

VaR is a statistical measure used to estimate the potential loss in value of risky assets over a defined period. It is crucial for assessing the risk exposure of portfolios.

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24
Q

Explain Risk-Adjusted Return on Capital (RAROC).

A

RAROC is a measure of return adjusted for the risk taken, used to assess whether the returns from an investment justify the risks involved.

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25
Q

What are the four main risk management strategies?

A

Accept the Risk
Avoid the Risk
Mitigate the Risk
Transfer the Risk

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26
Q

Under what circumstances might a firm decide to accept a risk?

A

A firm might accept a risk if the impact is small and the cost of managing it exceeds the potential benefit, or if the risk is integral to the business model, such as direct exposure to market price movements in a gold mining company.

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27
Q

What does avoiding risk involve, and can you give an example?

A

Avoiding risk involves eliminating activities that pose unnecessary risks. Example: A company might stop operations in a business unit if its risk is unnecessary for the overall function of the business, such as during a financial crisis.

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28
Q

How can a firm mitigate risk, and provide an example?

A

A firm can mitigate risk by reducing the likelihood or impact of the risk through various strategies. Example: A bank might offer loans at higher interest rates with enhanced collateral requirements to mitigate credit risk.

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29
Q

What does transferring risk entail, and what are the associated risks?

A

Transferring risk involves shifting the risk to another party, usually through insurance or derivatives. This introduces counterparty risk, where the other party may not fulfill their obligations.

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30
Q

What is risk appetite and how does it influence risk management decisions?

A

Risk appetite is the level and types of risk a firm is willing to retain. It guides risk management decisions, ensuring they align with the firm’s willingness and ability to handle risk, influenced by internal controls and regulatory constraints.

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31
Q

Describe the process of risk mapping.

A

Risk mapping involves creating an inventory of all known and potential risks, analyzing their magnitude, timing, and impact, and understanding how different risks interact with each other.

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32
Q

What are some advantages of hedging risk exposures?

A

Advantages include stabilizing cash flows, reducing earnings volatility, lowering the cost of capital, and signaling financial stability to stakeholders.

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33
Q

What are some disadvantages of hedging risk exposures?

A

Disadvantages include high costs, complexity, potential mismatches between hedging strategies and actual risks, and the risk of management becoming complacent about other risk management practices.

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34
Q

How does a firm’s risk appetite relate to its risk management process?

A

The firm’s risk appetite defines the maximum level of risk it is willing to accept, shaping its risk management strategy, from identifying potential risks to implementing and adjusting the risk management plan.

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35
Q

What is operational risk in a business context?

A

Risks associated with a firm’s day-to-day operations which impact the income statement, like production and sales, which can fluctuate expenses and revenues.

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36
Q

What is financial risk in a business context?

A

Risks related to a firm’s balance sheet, including assets and liabilities, influenced by market conditions such as interest rates and exchange rates.

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37
Q

How can a company hedge operational risks?

A

By using derivatives like futures to lock in prices for raw materials, thus stabilizing production costs regardless of market volatility.

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38
Q

How can financial risks be hedged?

A

Through instruments like interest rate swaps, which allow firms to manage fluctuations in interest rates affecting their debt.

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39
Q

Define pricing risk and a method to hedge it.

A

Pricing risk involves potential changes in input costs. It can be hedged using forward contracts to fix input costs at a predetermined rate.

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40
Q

What is foreign currency risk and how can it be managed?

A

This risk arises from fluctuations in exchange rates affecting revenues and assets. Hedging strategies include using forward contracts and currency options to stabilize exchange rates.

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41
Q

Explain interest rate risk and its hedging approach.

A

Interest rate risk refers to the potential negative impact of interest rate fluctuations. It can be managed using interest rate swaps or swaptions.

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42
Q

Describe a forward contract and its purpose.

A

A forward contract is a customized agreement between two parties to buy or sell an asset at a predetermined future date and price, used to hedge against price changes.

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43
Q

What are futures contracts?

A

Futures are standardized forward contracts traded on exchanges that facilitate the buying and selling of assets at agreed-upon prices in the future, minimizing counterparty risk.

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44
Q

What is the function of options in financial markets?

A

Options provide the right, not the obligation, to buy (call) or sell (put) an underlying asset at a specific price before a certain date, allowing for strategic risk management.

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45
Q

What is a swap contract?

A

Swap contracts involve two parties exchanging cash flows or financial obligations to manage various risks, such as interest rate or currency risk.

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46
Q

What are stop loss limits?

A

These limits prevent losses from escalating beyond a predetermined price, aiming to minimize immediate financial damage.

47
Q

Define notional limits.

A

Notional limits set the maximum level of exposure a firm can have based on the nominal value of investments, which might not always align with actual risk.

48
Q

Explain Greek limits in risk management.

A

Greek limits are set based on the sensitivity of derivatives’ prices to factors like market movements (delta, gamma) and time decay (theta).

49
Q

What is Value at Risk (VaR)?

A

VaR quantifies the maximum expected loss over a specific period within a given confidence interval, under normal market conditions.

50
Q

What is stress testing in risk management?

A

Stress testing involves evaluating financial resilience under extreme market conditions to understand potential impacts on the firm’s finances.

51
Q

What is corporate governance?

A

Corporate governance refers to the way firms are run, outlining the roles and responsibilities of shareholders, the board of directors, and senior management.

52
Q

What is the significance of the relationship between corporate governance and risk since the 2007-2009 financial crisis?

A

The relationship between corporate governance and risk has become fundamental, highlighted by the crisis, emphasizing the importance of effective risk management practices within governance structures.

53
Q

What are some leading causes of corporate failures in the 2001-03 and 2007-09 periods?

A

Leading causes include lack of transparency, insufficient information about economic risks, and breakdowns in transmitting relevant information to the board of directors, leading to corporate failures in both nonfinancial and financial sectors.

54
Q

What were some contributing factors to the subprime crisis?

A

The subprime crisis was caused by neglecting risk management activities during the boom years, particularly ignoring risks associated with structured financial products, leading to failed institutions and a global financial crisis.

55
Q

What are some key issues discussed post-crisis in corporate governance, especially in the banking industry?

A

Key issues include board composition, risk appetite, compensation, and stakeholder priority, focusing on improving governance structures and risk management practices.

56
Q

How have regulators influenced risk management practices in banks?

A

Regulators have mandated banks to develop formal and board-approved risk appetites reflecting the firm’s tolerance for risk, emphasizing the importance of setting enterprise risk limits and engaging the board in risk oversight.

57
Q

How has board composition been addressed post-financial crisis?

A

Post-crisis discussions emphasized the importance of board independence, engagement, and financial industry skills, although statistical analysis hasn’t shown a clear correlation between board composition and bank performance.

58
Q

What are the main causes of Lehman Brothers’ collapse?

A

Lehman Brothers’ collapse resulted from failures in risk management, including the overuse of leveraged financial products and inadequate board oversight, highlighting the consequences of neglecting risk management.

59
Q

What role does compensation play in controlling risk behavior?

A

Boards control compensation schemes to assess and mitigate risk-taking behavior, often by limiting bonus structures, introducing delayed payments, and implementing clawback provisions to align incentives with long-term risks.

60
Q

What is the infrastructure of risk governance, and what are the choices in risk management?

A

The infrastructure involves understanding business strategies, setting risk appetites, overseeing operations, and involving risk management in business planning. Choices in risk management include scrapping activities, risk reduction through hedging or insurance, risk mitigation through control measures, or accepting risks to generate shareholder value.

61
Q

What should risk management strategies prioritize?

A

Risk management strategies should prioritize impacting economic performance over accounting performance, focusing on long-term sustainability and value creation for shareholders.

62
Q

How can the seriousness of a firm about its risk management process be assessed?

A

The seriousness of a firm’s risk management process can be gauged by assessing the career path in the risk management division, incentives awarded to risk managers, the presence of ethics within the firm, and the authority to whom risk managers report.

63
Q

What is the primary responsibility of the board of directors concerning corporate governance?

A

The primary responsibility of the board of directors is to steer the firm in alignment with the interests of shareholders while considering the interests of other stakeholders like debt holders. It involves weighing the assumption of risks against projected returns and avoiding agency risks between management and stakeholders.

64
Q

How does the board ensure alignment between risk management operations and shareholder value creation?

A

The board ensures alignment by rewarding staff based on risk-adjusted performance to prevent financial manipulation and stock price boosting. It checks the quality and reliability of risk information, educates itself on risk management, sets risk appetite, and assesses risk metrics over time.

65
Q

What is the role of the chief risk officer (CRO) in integrating corporate governance and risk management?

A

Chief risk officers are tasked with integrating corporate governance and risk management activities, ensuring alignment between strategic objectives, risk management practices, and value creation for shareholders.

66
Q

How should the board handle technical aspects of risk management?

A

The board should have technical sophistication to develop clear strategies and directives concerning crucial risk disciplines. A qualified risk committee, separate from the audit committee, should handle these technicalities, given their differences in skills and responsibilities.

67
Q

What role does the board play in assessing and interpreting risk data?

A

The board is responsible for checking the quality and reliability of risk information, as well as interpreting data to ensure that risk management operations are aligned with value creation for shareholders.

68
Q

Why is it important for the board and the CEO to act independently of each other?

A

Independence between the board and the CEO ensures that corporate governance roles remain separate from executive roles, reducing conflicts of interest and enhancing accountability and transparency within the firm.

69
Q

How does the board ensure alignment between risk management and value creation?

A

By setting risk appetite, assessing risk metrics, and educating itself on risk management, the board ensures that risk management operations are directed towards creating value for shareholders while minimizing agency risks and maximizing long-term sustainability.

70
Q

What weakness did the 2007-2009 financial crisis highlight in financial institutions?

A

The crisis reflected weaknesses in risk management and oversight within financial institutions, prompting post-crisis regulatory emphasis on risk governance to address both financial risks.

71
Q

What is risk governance, and what does it entail?

A

Risk governance involves establishing an organizational structure to define, implement, and authorize risk management practices. It emphasizes transparency and communication channels among organizations, stakeholders, and regulators.

72
Q

What is the role of the board of directors in risk governance?

A

The board of directors holds responsibility and authority in risk management, analyzing major risks and rewards in the firm’s business strategy to ensure alignment with strategic objectives within risk appetite limits.

73
Q

What is the Risk Appetite Statement (RAS), and why is it important?

A

The RAS is a critical component of corporate governance, articulating the aggregated amount and types of risks a firm is willing to accommodate or avoid to achieve its business objectives. It helps maintain equilibrium between risks and returns, fostering a positive attitude towards various risks and achieving desired credit ratings.

74
Q

What should the Risk Appetite Statement (RAS) contain?

A

The RAS should contain the firm’s risk appetite and risk tolerance measures, defining the maximum amount of risks taken at both the business and enterprise levels. It should also establish the relationship between risk appetite, risk capacity, risk profile, and risk tolerance.

75
Q

What is the difference between risk tolerance and risk appetite?

A

Risk tolerance is the number of acceptable results relative to business objectives, serving as a tactical measure of risk. Risk appetite, on the other hand, is the aggregate measure of risk, reflecting the firm’s willingness to accommodate or avoid risks in pursuit of strategic objectives.

76
Q

How does risk appetite relate to risk capacity?

A

Risk appetite sets the overall level of risk a firm is willing to accept, while risk capacity represents the maximum amount of risk the firm can handle. Risk appetite should be below risk capacity to ensure the firm operates within its risk tolerance and achieves risk-adjusted return objectives.

77
Q

What is the significance of maintaining equilibrium between risks and returns in risk governance?

A

Maintaining equilibrium ensures that risks taken align with desired returns, preventing excessive risk-taking or risk aversion, and maximizing the firm’s ability to achieve its strategic objectives while minimizing adverse outcomes.

78
Q

How does the Risk Appetite Statement (RAS) contribute to risk management practices?

A

The RAS provides clear guidelines for risk management practices, enabling the firm to expand its strategic objectives within defined risk appetite limits and ensuring alignment between risk-taking activities and overall business goals.

79
Q

What is the responsibility of the board of directors in the banking industry concerning risk management?

A

The board charges committees like risk management committees with ratifying policies and directives related to risk management, framing policies for division-level risk metrics, and ensuring effective policy implementation.

80
Q

What is the role of the audit committee of the board in risk governance?

A

The audit committee verifies the accuracy of financial and regulatory reporting, ensures compliance with standards in regulatory and risk management activities, and maintains independence from executive influence to uphold transparency and communication.

81
Q

How is expertise ensured in the board of directors regarding risk management activities?

A

Nonexecutive board members may lack expertise in risk management, leading to potential domination by executives. Training programs, support systems, or the inclusion of a risk advisory director on the board can address this issue.

82
Q

What are the responsibilities of the risk management committee?

A

The risk management committee independently reviews various forms of risk, approves individual credits, monitors securities portfolios and market trends, and reports to the board about risk levels, credits, and interactions with auditors and management committees.

83
Q

Why was the compensation committee established, and what changes were made to executive compensation?

A

The compensation committee was established to prevent scenarios where CEOs influence board members to compensate themselves at the expense of shareholders. Compensation schemes were revised to focus on risk-adjusted performance and align business activities with long-term economic profitability.

84
Q

What is the role of the chief risk officer (CRO) in risk governance?

A

The CRO designs risk management programs, policies, and methodologies, monitors risk limits, and acts as an intermediary between the board and management, ensuring alignment with risk tolerance and management’s understanding of risk conditions.

85
Q

How do organizational units collaborate in risk governance?

A

Staff, executives, and business line managers collaborate to manage, monitor, and report various risks, ensuring effective risk management practices are implemented throughout the firm’s operations.

86
Q

What role does the audit function play in risk management?

A

The audit function independently assesses risk management frameworks and processes, ensuring compliance with regulatory standards and the reliability of risk metrics and measures. It reports to the board about business strategies’ alignment with risk management expectations.

87
Q

What is credit risk?

A

The possibility that funds disbursed may not be recovered following an event of default by the borrower.

88
Q

What are the ways banks deal with credit risk exposure?

A

Accept the risk, avoid the risk, reduce the risk, or transfer the risk to another entity or person.

89
Q

What are credit derivatives?

A

Financial instruments transferring credit risk of an underlying portfolio from one party to another without transferring the portfolio itself.

90
Q

What are the main types of credit derivatives?

A

Credit default swaps, collateralized debt obligations, collateralized loan obligations, total return swaps, and credit spread swap options.

91
Q

What is a Credit Default Swap (CDS)?

A

A contract where one party makes payments to another and receives compensation if a third party defaults.

92
Q

What are the advantages of Credit Default Swaps (CDSs)?

A

Acts as shock absorbers during corporate crises, increases liquidity, and provides evidence of the debtor’s financial health.

93
Q

What are the disadvantages of Credit Default Swaps (CDSs)?

A

Susceptible to speculation, lack of clear termination events, and potential for abuse and manipulation.

94
Q

What are Collateralized Debt Obligations (CDOs)?

A

Structured products created by banks to offload risk, often composed of diversified portfolios of mortgages and corporate bonds.

95
Q

What are the advantages of Collateralized Debt Obligations (CDOs)?

A

Can increase credit availability, accommodate different risk tolerances, and transform illiquid securities into liquid ones.

96
Q

What are the disadvantages of Collateralized Debt Obligations (CDOs)?

A

Can lead to relaxed lending standards, market fears may cause liquidity issues, and contributed to the 2007/2009 financial crisis.

97
Q

What are Collateralized Loan Obligations (CLOs)?

A

Similar to CDOs but with underlying debt being company loans instead of mortgages.

98
Q

What is a Total Return Swap (TRS)?

A

A credit derivative allowing two parties to exchange both credit and market risks.

99
Q

What are the advantages of Total Return Swaps (TRSs)?

A

Allows parties to gain economic exposure without holding assets and is preferred for financing by hedge funds.

100
Q

What are the disadvantages of Total Return Swaps (TRSs)?

A

Exposed to counterparty risk and interest rate risk.

101
Q

What is a Credit Default Swap Option (CDS option)?

A

An option on a credit default swap, giving the holder the right to buy or sell protection on a specified reference entity for a certain spread.

102
Q

What are some traditional approaches firms use to mitigate credit risk?

A

Insurance, netting, marking-to-market/margining, and termination clauses.

103
Q

What is securitization?

A

Repackaging loans and other assets into securities that can be sold in the securities markets to eliminate risk from the originating bank’s balance sheet.

104
Q

What are the benefits of the Securitization Process for banks?

A

Introduces specialization, reduces reliance on traditional capital sources, introduces flexibility in financial statements, and expands credit product range.

105
Q

What are the drawbacks of the Securitization Process for banks?

A

Can lead to relaxed lending standards, difficulty in renegotiating terms, and may contribute to riskier lending practices.

106
Q

What is a Mortgage Pass-Through?

A

The simplest structure of Mortgage-Backed Securities (MBSs), where cash flows directly from borrowers to investors with a short processing delay.

107
Q

What role does a mortgage servicer play in Mortgage-Backed Securities (MBSs)?

A

Manages the cash flow from borrowers to investors in exchange for a fee.

108
Q

What is Netting in credit risk management?

A

Offsetting the value of multiple positions or payments due to be exchanged between two or more parties to minimize net exposure.

109
Q

What is Marking-to-Market/Margining in credit risk management?

A

Settlement of gains and losses on a contract daily to avoid accumulation of large losses over time and minimize net exposure.

110
Q

What is Termination in credit risk management?

A

A situation where parties develop trigger clauses in a contract that give the counterparty the right to unwind the position using a predetermined methodology.

111
Q

What are the advantages of Termination in credit risk management?

A

Provides mechanisms to manage risk triggered by specific events such as rating downgrades or performance thresholds.

112
Q

What are the disadvantages of Termination in credit risk management?

A

Counterparties may exploit trigger clauses, and termination events may not always be easy to define or enforce.

113
Q

What is a Special Purpose Vehicle (SPV) in the securitization process?

A

A separate entity that purchases loan pools from originators and issues securities backed by those pools to investors.

114
Q

What are some key benefits of the Securitization Process for borrowers?

A

Expanded range of credit products and reduced borrowing costs.

FRM Part1: Foundation of Risk Management (2 decks)

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