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FRM PART- 1 > FRM- 1 > Flashcards

FRM- 1 Flashcards

1
Q

Reason for Launching Risk Governance Program

A

Failure in Risk Handling and Risk Governance leading to 2008 Economic Crises

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2
Q

Relationship between Enterprise and Risk

A
  1. Risk is linked with Production Activities of Enterprise

2. Enterprise is characterized by Uncertainty in its Operations to meet Customers’ Need

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3
Q

Role of Directors in Enterprise Management

A

Effective Oversight of Risk- Taking

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4
Q

Aim of Risk Governance Program

A
  1. Help Directors in Improving their Risk Management Oversight
  2. Enhance Risk Oversight Structures, Processes and Competence
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5
Q

Impact of Poor Risk Handling and Governance

A

Loss in Job, Goods and Services

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6
Q

Base of Risk-Taking Issues

A

Impact on the Value of the Firm

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7
Q

Various Definitions Related to Risk

A
  1. Focus only on Negative Implications of Risk

2. No Clear Distinction between Risk and Uncertainity

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8
Q

Two symbols Describing Risk

A
  1. Danger

2. Opportunity

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9
Q

Two symbols Imply

A

Danger and Opportunity Comes Hand-in-Hand

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10
Q

Good Risk-Taking Organization

A
  1. Planning for Crisis in Good Times

2. Looking for Opportunities in Bad Times

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11
Q

Risk Profile

A

Various Risks Faced by an Organization

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12
Q

Need of Risk Profile

A
  1. Aware of Risks Faced by the organization

2. Effective Risk Management as well as Risk Governance

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13
Q

Risk Profile Same for Every Organization & Industry

A

No

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14
Q

Next Step after Risk Profile

A
  1. Classifying the various risks into 3 groups:
    a. Risks to be passed on to the owners
    b. Risks to be hedged
    c. Risks to be exploited
  2. Risk Treatment Process
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15
Q

Risk profile made by Different Persons

A
  1. Different Due To

2. Different Experience

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16
Q

In Organization

A
  1. Clear Understanding of Various Risks Faced

2. Spell Out the Potential Risks

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17
Q

Risk Management

A
  1. Minimizing Exposure to the Wrong Risks

2. Increasing Exposure to the Good Risks

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18
Q

Corporate Governance

A
  1. Structures and Processes Direction and Control of Companies
  2. Relationship between Management, Board of Directors, Controlling Shareholders, Minority Shareholders and Other Stakeholders
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19
Q

Perspectives on Corporate Governance

A
  1. Agent Theory: Aligning Shareholders and Internal Agent
  2. Transaction Cost Theory
  3. Stewardship Theory: Managed and Guided in an Opportune manner (Achievement, Meaningfulness, Altruism of Human Motives)
  4. Resource Dependence Theory
  5. Stakeholder Theory: Agreements with Multiple Stakeholders on Various Directions that Create Value or Result into Risks if Neglected
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20
Q

Risk Governance

A

Director’s way of Authorizing, Optimizing and Monitoring Risk-Taking

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21
Q

Risk Governance Includes

A
  1. Skills
  2. Infrastructure (Organization Structure, Control, Information Systems)
  3. Culture
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22
Q

Good Risk Governance Defines

A
  1. Accountability
  2. Authority
  3. Communication and Reporting Mechanisms
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23
Q

Responsibility of Risk Oversight

A
  1. Board
  2. Risk Committee
  3. Audit and Risk Committee
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24
Q

Purpose of Risk Management

A

Making Firm More Valuable

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25
Q

Most Common Method for Valuation of a firm

A

Discounting of Future Cash flows through Risk-Adjusted Cost of Capital (CAPM)

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26
Q

Benefits of CAPM

A
  1. No Firm Risks

2. Only Market Risks

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27
Q

Criteria for Selecting a Risk Management Strategy

A

Value-Maximizing Risk Management Strategy

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28
Q

ERM

A

Enterprise Risk Management

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29
Q

ERM Vs. Previous Approach of Risk Management

A
  1. Holistic Approach of Managing Risks
  2. Previous Approache Focused on Handling of Risks by their Respective Departments
  3. Focuses on Value-Creation while Focusing on Risk Managment
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30
Q

Handling all the Risks Together

A

Better understanding of where:

  1. Risks could Multiply
  2. Risks could Cancel each other
  3. Risks could be Exploited
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31
Q

ERM’s Coordinated Function

A
  1. Chief risk officer
  2. Risk Governance
  3. Board’s Oversight
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32
Q

Two ERM Approaches

A
  1. COSO II ERM

2. CAS ERM Framework

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33
Q

COSO II ERM framework

A
  1. Committee of Sponsoring Organizations of the Treadway Commission
  2. Strategic, Operational, Reporting and Compliance Objectives
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34
Q

CAS ERM Framework

A
  1. Casualty Actuarial Society

2. Hazard, Financial, Strategic and Operational Risks

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35
Q

Risk Policy

A

Types and Degrees of Risks In Pursuit of Goals

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36
Q

Benefits of Risk Policy

A
  1. Limits Risk Profile

2. Aggregate Risk- Aversion of Decision-Makers

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37
Q

Attitude of Decision-Makers

A

Important Towards Risk- Aversion

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38
Q

Risk- Appetite

A

Amount of Risk in Pursuit of Long- Term Objectives

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39
Q

Risk- Tolerance

A

Boundaries of Risk- Appetite

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40
Q

Risk- Universe

A

Full Range of Risks

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41
Q

Pursuing Value- Maximization Risk Strategy

A

Assess Risk- Taking within Context of Valuation Methodlogy

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42
Q

2 Approaches for Adjusting Value for Risk

A
  1. Risk- Adjusted Discount Rate

2. Certainty Equivalents Cash Flow

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43
Q

Risk- Adjusted Discount Rate

A
  1. Discount Rate reflects the Risk of the Cash Flows

2. CF are taken as E (CF)

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44
Q

Certainty Equivalents Cash Flow

A
  1. CE (CF) reflects the Risk of the Cash Flows

2. Discount- Rate is the Risk- Free Rate

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45
Q

Adjusting Value for Risk is also known as:

A

Risk- Adjusted Value (RaV)

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46
Q

3 Steps to obtain RaV

A
  1. Expected Cash Flows: Probability across different scenarios and Cash Flows for different scenarios
  2. Risk-Adjusted Discount Rate: Risk-Free Rate + Risk Premium
  3. Present Value of the Cash Flows
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47
Q

Inputs for Risk-Adjusted Discount Rate:

A
  1. Cost of Equity:
    a. Risk- Free Rate
    b. Beta
    c. Risk Premium
  2. Cost of Debt:
    a. Risk- Free Rate
    b. Default Spread
    c. Marginal Tax-Rate
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48
Q

Characteristics of Risk-Free Rate

A
  1. No Default Risk: There is no uncertainty about the return on the investment (Not all Government Securities are Risk- Free)
  2. No Reinvestment Risk: 6-month T-bills may have different risk-free rate than 10-years T-bills ( Time Horizon Matters)
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49
Q

Relationship between Risk- Free Rate and Currencies

A

Expected Inflation

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50
Q

Beta

A

Measure of Relative Risk

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51
Q

Measuring Beta

A

Slope of the Regression of Returns on the Stock against Market Index

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52
Q

Disadvantages of Regression Technique

A
  1. Historical Beta: Does not take into account current business mix and financial leverage
  2. Estimated with Error
  3. Depends on the Regression Structure as well as the Market Index taken
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53
Q

Beta should Reflect:

A
  1. Products and Services: Fad/ Necessities
  2. Fixed Cost Structure: High Fixed Cost implies High Beta
  3. Financial Leverage: Higher Debt means Higher Fixed Cost (Interest Expenses)
54
Q

Another Way of Calculating Beta:

A

Weighted Average of the Betas of the Businesses in which the Firm Operates, corrected for Financial Leverage

55
Q

Firms with Multiple Businesses

A

Hurdle Rate for each Businesses Separately

56
Q

Equity Risk Premium

A

Additional Premium for investing in a Risky Asset

57
Q

Calculating Risk Premium

A
  1. Historical based on comparing of Risk-Premium with investment in Stocks against T-Bills/ T- Bonds
  2. Forward- Looking Premium
58
Q

Disadvantage of Historical Risk Premium

A

Significant Amount of Error involved

59
Q

Forward-Looking Premium:

A

Based on current Stock Price and Future Cash Flows

60
Q

Adjustment for Country Risk

A
  1. Emerging Market: Political Instability and Nature of Economy
  2. Adjust using Default Spread
61
Q

Default Spread

A
  1. Based on Rating Agencies’s Default Spread Relative to Different Ratings
  2. Implied Interest Rate
  3. Synthetic Bond Rating based on Financial Ratios
62
Q

Default Spread Depends on:

A
  1. Economic Uncertainty

2. Investors’ Risk Aversion

63
Q

Two More Inputs necessary for Cost of Capital:

A
  1. Tax Rate
  2. Market-value Weights (Weights may sometimes depend on the Target Weights for the entire business instead of Actual Funding Mix)
64
Q

Methods for Adjusting Expected Cash Flows for Risk

A
  1. Utility Functions (Difficult)
  2. Subjective Decrease- Different Judgments of Value based on Different Risk Aversion
  3. Risk-adjusted Cash Flow
65
Q

Formula for Risk-Adjusted Cash Flow

A

Multiply each Cash Flow with Risk-Free Rate and divide by Risk-Adjusted Discount Rate with both Rates raise to Appropriate Power according to Time-Period

66
Q

Different Investments Have

A

Different Hurdle Rates due to Different Risk Exposures

67
Q

ERM

A
  1. Creates Business Value through Integrated Process of Identification, Estimation, Assessment, Handling, and Controlling of Risk
  2. Recognizes Imperfection of Market, Imperfection of Diversification and Bankruptcy Costs
68
Q

CAPM Deals with Risk Management

A

No

69
Q

Define ERM

A
  1. Manage Market Risk, Credit Risk, Operational Risk and Economic Capital and Risk Transfer to Maximize a Firm’s Value
  2. Managing Uncertainty
  3. Identification, Assessment and Handling of Risks through Corporate Actions to Monitor, Control and Minimize their Adverse Effects or Maximize the Realization of Opportunities
  4. Methodically addressing Risks associated to various activities with the goal of Achieving Sustained Benefit within Each Activity and across Portfolio of all Activities
70
Q

Corporate Finance and ERM

A

Both focuses on Maximizing Firms Value or Shareholder’s Value

71
Q

AIRMIC

A

Association of Insurance and Risk Managers

72
Q

Risk Management Process

A
  1. Risk Policy
  2. Risk Profile
  3. Likelihood and Consequences
  4. Value-based Model for Estimating Impact on Firm Value
  5. Risk Treatment
73
Q

AIRMIC Framework

A
  1. Risks and Enterprise’s Objectives
  2. Risk Assessment
  3. Risk Treatment
  4. Risk Monitoring
74
Q

Risks and Enterprise’s Objectives

A
  1. Resources for Risk Management and Risk Treatment
  2. Degree of Risk Aversion and Risk Policy
  3. Strategic Objectives and Operational goals compatible with Above
75
Q

Risk Assessment

A
  1. Risk Analysis

2. Risk Evaluation

76
Q

Risk Analysis

A
  1. Risk Identification

2. Risk Estimation

77
Q

Risk Identification

A
  1. Exposure to Uncertainty

2. Downside and Upside Risks

78
Q

Tools for Risk Identification

A
  1. Brainstorming
  2. Questionnaires
  3. Risk Assessment Workshops
  4. Incident Investigation
  5. Industry Benchmarks
  6. Business Studies on Business Processes both Internal as well as External
  7. Scenario Analysis
  8. Auditing and Inspection
79
Q

Risk Maps

A
  1. Name
  2. Qualitative Description
  3. Up/ Downside Scenarios
  4. Probability of Occurrence
  5. Person handling Risk
  6. Techniques to Monitor
  7. Preliminary Evaluation of the Economic Impact of the Scenarios
80
Q

Risk Estimation

A
  1. Probability of Event

2. Impact on Cash Flows

81
Q

3 Methods for Risk Estimation

A
  1. Purely Qualitative
  2. Semi Quantitative
  3. Purely Quantitative
82
Q

Purely Qualitative

A
  1. Qualitative Scaling

2. Probability- Impact Matrix

83
Q

P-I Matrix

A
  1. Qualitative Scale for Probability of Occurrence
  2. Qualitative Scale for Impact
  3. Qualitative Scale for Risk-Rating
84
Q

Disadvantage of Purely Qualitative Estimate

A
  1. Highly Subjective

2. Only for Pure Downside Risks

85
Q

Semi Quantitative

A
  1. Quantifying the Qualitative Scaling

2. Risk Rating by Multiplying Probability Score with Impact Score: Severity Risk Index or Risk Score

86
Q

Pure Quantitative

A
  1. Focus on the Distribution of Probability of Risky Events

2. 4 Steps

87
Q

4 Steps in Pure Quantitative Estimation

A
  1. Causal Model
  2. Probability Distribution of Inputs
  3. Probability Distribution of Outputs
  4. Validate the Model
88
Q

Risk Evaluation

A
  1. Enterprise Value

2. Significance of Risk to the Organization based on the Risk Policy

89
Q

Risk Treatment

A
  1. Risk Avoidance
  2. Risk Transfer
  3. Risk Reduction
  4. Risk Retention
90
Q

Risk Transfer

A
  1. Risk Hedging
  2. Insurance Policies/ Derivatives
  3. Smoothness of Cash Flows or Lowering of Cost of Capital
  4. Various Tools available for Risk Transfer
91
Q

Reason for Risk Transfer

A

Cost of RT < Enterprise Value Generated

92
Q

Risk Retention

A
  1. Risk Neglected

2. Firm’s Risk Strategy

93
Q

Risk Reduction

A

Portfolio Diversification

94
Q

Risk Monitoring

A
  1. Risks Retained
  2. Business Variables as Sources of Risks Assumed
  3. Obsolescence of Risk Analysis
  4. Quality and Effectiveness of Risk Process
95
Q

Benefits of Probabilistic Approaches

A
  1. More Data-Intensive View of Uncertainty

2. Focus not Only on Uncertainty in Expected Cash Flows

96
Q

3 Probabilistic Approaches

A
  1. Sensitivity Analysis
  2. Scenario Analysis
  3. Simulations
97
Q

Sensitivity Analysis

A
  1. Assess Sensitivity of Decision Outcomes to Changes in Key Assumptions
  2. Analysis Focus on 2 or 3 Most Important Variables
98
Q

Use of Scenario Analysis

A
  1. Macroeconomic Environment Dependent

2. Competitive Response

99
Q

Scenario Analysis

A
  1. Possible Scenarios- Values and
  2. Their Probabilities
  3. Calculate the Expected Value
100
Q

Use of Decision Trees

A

Sequential Risks

101
Q

Simulations

A
  1. Distribution of Values

2. Distribution of Inputs

102
Q

Value at Risk (VaR)

A
  1. Confidence Interval
  2. Specified Level of Loss
  3. Fixed Time-Period over which Risk is Assessed
103
Q

VaR Requires

A
  1. Bank’s Capital
  2. Regulatory Limit
  3. VaR Limit Based on Above
104
Q

Disadvantages of VaR

A
  1. Large Standard Error

2. Black Swan

105
Q

Black Swan

A

Break from Normal Distributions and Historical Data Patterns

106
Q

VaR Limit

A

Trading Positions Closed or Modified

107
Q

Doubts

A
  1. Decision Outcomes

2. Regulatory Limits

108
Q

RM Affects Value By

A
  1. Increasing Return and

2. Reducing Variance in Return

109
Q

4 Key Inputs of Firm Value

A
  1. Cash Flow Generation from Assets and Investments
  2. Expected Growth Rate in Cash Flows
  3. Time Period: Length of Competitive Advantage Period
  4. Discount Rate : Reflecting Riskiness of the Firm and Funding Mix
110
Q

Reducing Downside Risks Refers To

A

Risk-Hedging

111
Q

Increasing Exposure to Upside Risks Refers To

A

Risk-Taking

112
Q

Cost of Hedging Depends On

A
  1. Type of Risk Hedged

2. Product Used to Hedge

113
Q

Cost of Hedging

A
  1. Explicit Costs

2. Implicit Costs

114
Q

Explicit Costs

A
  1. Reflected in Financial Statements

2. E.g. Insurance/ Put Options

115
Q

Implicit Costs

A
  1. Affects Earnings But Not Reflected in Financial Statements
  2. E.g. Futures/ Forwards
116
Q

Framework for Risk Hedging

A
  1. Benefits > Cost
  2. Less Costly for Firm or Investors
  3. Investors Capable of Hedging the Risk
117
Q

Approaches to Hedging

A
  1. Investment Choices
  2. Financing Choices
  3. Insurance
  4. Derivatives
118
Q

Choice of Hedging

A
  1. Type of Risk

2. Firm’s Aim from Hedging

119
Q

Hedging Decision Not Based On

A
  1. Inertia

2. Fear

120
Q

Risk Management Must

A

Create Value for the Firm

121
Q

Doubts

A
  1. Expected Growth Rate in Cash Flows
  2. Time Period
  3. Financing Choices
122
Q

Strategic Risk- Taking Affects

A

4 Key Inputs to Firm Value:

  1. Efficient Operations
  2. More Reinvestment and Higher Returns
  3. Competitive Risk- Taking
  4. Exploit Upside- Risk and Reduce Downside- Risk
123
Q

Taking Advantage of Taking Risks

A
  1. Information Advantage
  2. Speed Advantage
  3. Experience/ Knowledge Advantage
  4. Flexibility
  5. Resource Advantage
124
Q

Information Advantage

A

Better Information and Early

125
Q

Speed Advantage

A

Act Quickly and Appropriately

126
Q

Flexibility

A

Capacity to Change Course Quickly

127
Q

Resource Advantage

A
  1. Capital Access

2. Debt Capacity

128
Q

Organizing for

A

Risk- Taking

129
Q

Most- Important Ingredient in RM

A

Luck

130
Q

3 Propositions

A
  1. Today’s Hero will be Tomorrow’s Goat
  2. Luck is not a Skill
  3. Life is not Fair

FRM PART- 1 (6 decks)

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