Reading 55: Introduction to Risk Management

Question 1

List the benefits of an effective risk culture.

Answer 1

Lower probability of management being surprised by an event.

More discipline, leading to better consideration of trade-offs and risk-return relationships.

Prompter response to unfavorable events and more effective mitigation of losses.

Fewer operational errors from deficiencies in policies and procedures, transparency, and risk awareness.

Stronger level of trust between the governing body and management.

A better company image or reputation because it is perceived as prudent and value-focused.

Question 2

Identify the desirable properties of good risk governance.

Answer 2

Provide a sense of the worst loss that the organization can manage in various scenarios.

Provide clear guidance, but leave enough flexibility to execute strategy.

Focus on enterprise risk management. The entire economic balance sheet of the business should be considered.

Provide a regular forum where the risk framework and key risk issues are discussed at management level.

Provide for the appointment of a chief risk officer (CRO) responsible for building and implementing and managing the risk framework.

Question 3

What is risk management not about?

Answer 3

Risk management is not about minimizing risk. It is about actively understanding and embracing those risks that offer the best chance of achieving an organization’s goals with an acceptable chance of failure.

Risk management is not even about predicting risks. It is about being prepared for (positive or negative) unpredictable events such that their impact would have already been quantified and considered in advance.

Question 4

What does standard deviation measure?

Answer 4

The range over which a certain percentage of the outcomes would be expected to occur.

Question 5

Distinguish between self-insurance and diversification as they relate to risk acceptance.

Answer 5

Self-insurance refers to retaining exposure to a risk that is considered undesirable but is too costly to eliminate by external means.

When it comes to portfolio risk management, diversification is the key to eliminating non-systematic risk, but other forms of risk management may be needed to mitigate other risks.

Question 6

Define risk management.

Answer 6

It is the process by which an organization or individual defines the level of risk that should be taken, measures the level of risk actually being taken, and then continually ensures that the latter is consistent with the former, with the aim of maximizing the company’s or portfolio’s value. Stated differently, risk management refers to all the decisions and actions that must be taken in order to achieve return/performance objectives while taking on an acceptable level of risk.

Question 7

Differentiate between market risk, credit risk, and liquidity risk.

Answer 7

Market risk arises from changes in interest rates, stock prices, exchange rates, and commodity prices.

Credit risk is the risk of loss if one party fails to pay an amount owed on an obligation.

Liquidity risk is the risk of a substantial downward valuation adjustment when trying to sell an asset.

Question 8

List the 3 primary types of financial risks.

Answer 8

1. Market risk
2. Credit risk
3. Liquidity risk

Question 9

Give the factors that affect a company’s risk tolerance.

Answer 9

The more dynamic a company is in its ability to respond to adverse events, the higher its risk tolerance.

The greater the loss a company can bear without impairing its status as a going concern, the higher its risk tolerance.

The stronger the company’s competitive position, the higher its risk tolerance.

The overall competitive landscape in the industry, and the regulatory landscape also influence a company’s risk tolerance.

Question 10

What does compliance risk encompass?

Answer 10

Regulatory risk, accounting risk, and tax risk. It refers to the risk of the organization’s incurring significant unexpected costs, back taxes owed, financial restatements, and penalties.

Question 11

Identify ways in which insurers manage their risk exposure.

Answer 11

Transfer some of the risk to another insurer, known as reinsurance.

Write provisions into contracts to exclude coverage of special cases.

Contain provisions to guard against moral hazards, such as suicide or destroying one’s own property.

Issue bonds that permit them to legally avoid paying principal and/or interest if insurance claims exceed a certain amount.

It is common for policies to contain a deductible.

Question 12

Identify the framework risk management should address.

Answer 12

Risk governance

Risk identification and measurement

Risk infrastructure

Defined policies and processes

Risk monitoring, mitigation, and management

Communications

Strategic analysis or integration

Question 13

What is operational risk used to describe?

Answer 13

All internal risks that arise from the people and processes that work together in an organization to produce its output.

Question 14

Distinguish between single-dimensional and multi-dimensional risk budgeting.

Answer 14

Single-dimensional risk measures include standard deviation, beta, value at risk (VaR), and scenario loss.

Multi-dimensional risk approaches include one where portfolio risk is evaluated based on the risk profiles of underlying asset classes, and another risk-factor approach where exposure to various risk factors is used to capture associated risk premiums.

Question 15

Describe model risk.

Answer 15

Model risk is the risk of a valuation error resulting from using an incorrectly specified model or improperly using a valid model.

Question 16

Describe risk shifting.

Answer 16

Risk shifting refers to actions that change the distribution of risk outcomes. While risk transfer is typically associated with insurance, risk shifting is associated with derivative contracts and risk modification vehicles. Risk shifting mechanisms are used when the organization wants to modify the probability distribution of returns or adjust the payoff diagram of its risk exposures.

Question 17

Describe the “Greeks”: delta, gamma, vega, and rho.

Answer 17

Delta: measures the sensitivity of the value of a derivative to a small change in the underlying asset.

Gamma: captures the impact of relatively large changes in the underlying asset on the value of the derivative.

Vega: captures the impact of changes in the volatility of the underlying asset on the value of an option contract.

Rho: measures the sensitivity of the value of a derivative contract to changes in interest rates.

Question 18

Identify the roles within the risk management framework performed by the governing body or board.

Answer 18

It determines the organization’s goals and priorities, which form the basis of enterprise risk management.

It determines the organization’s risk appetite and tolerance; that is, it defines which risks are acceptable, which risks must be mitigated and to what extent, and which risks are unacceptable.

It is responsible for overseeing risk management to continually ensure that it is functioning properly and is consistent with the goal of maximizing value.

Question 19

Explain the benefit of risk budgeting.

Answer 19

It forces the organization into thinking about risk trade-offs and fosters a culture where risk is an important consideration in all key decisions. Every step or decision the organization takes is based on the philosophy of maximizing value added while remaining within the confines of its risk tolerance.

Question 20

Explain non-financial risks.

Answer 20

Non-financial risks arise from outside the financial markets. They emanate from a variety of sources, such as the relationship between the organization and its peers, regulators, governments, the environment, suppliers, employees, and customers.