The Building Blocks of Risk Management -Foundations - Chapter 1 Flashcards
1.1 Describe and provide examples of fundamental risk fac-tors and their sub-risk factors that drive the probability of a firm’s default
1.1 PD of a firm is driven by a firm’s strength or weakness in terms of key variables such as financial ratios, industry sector, country, quality of data, and management quality. Each fundamental set of risk factors is driven by sub-factors. For example, management years of experience is a sub-factor of the management quality variable.
1.2 What are the four components of a risk management process?
1.2 The risk manager first attempts to identify the risk then next analyzes the risk. Subsequently the risk manager assesses the impact of any risk event and ultimately man-ages the risk. In summary, the four components are 1. Identify the risk, 2. Analyze the risk, 3. Assess Impact of risk, and 4. Manage the risk.
1.3 Provide an example of what is meant by basis risk
1.3 A form of market risk known as basis risk occurs if a posi-tion intended to hedge another position might do so imperfectly.
1.4 What are two types of liquidity risk?
1.4 The two types are funding liquidity risk and trading liquidity risk Funding liquidity risk refers to the case where a firm can-not access enough liquid cash and assets to meet its obli-gations. For example, banks take in short-term deposits and lend the money out for the longer term at a higher rate of interest. Trading liquidity risk refers to a case where markets temporarily seize up. For example, if market participants cannot, or will not, take part in the market, this may force a seller to accept an abnormally low price, or take away their ability to turn an asset into cash and funding at any price.
1.5 What drives market risk across all markets?
1.5 Market risk is driven by (1) general market risk and (2) specific market risk. General market risk is the risk that an asset class will fall in value, leading to a fall in the value of an individual asset or portfolio. Specific market risk is the risk that an individual asset will fall in value more than the general asset class.
1.6 What is meant by strategic risk?
1.6 Strategic risks involve making large investments, in long-term decisions about the firm’s direction, that can affect its future direction and strategy.
1.7 Describe how risk managers become involved in business risk.
1.7 Risk managers have specific skills they can bring to bear in terms of quantifying aspects of business risk. For example, credit risk experts often become involved in managing supply chain risk. Risk managers should be involved at the start of business planning. For example, it may be impossible to fund the construction of a power station without some form of energy price risk manage-ment strategy in place.
1.8 What Is reputation risk? Provide examples in your answer.
1.8 Reputation risk is the danger that a firm will suffer a sud-den fall in its market standing or brand with economic consequences. Rumors can be fatal in themselves. For example, a large failure in credit risk management can lead to rumors about a bank’s financial soundness. Inves-tors and depositors may begin to withdraw support in the expectation that others will also withdraw support. Unethical behavior of managers in the firm can hurt its reputation.
1.9 What is meant by economic capital? Contrast it with regulatory capital.
1.9 Economic (risk) capital is the amount of capital the firm requires based on its understanding of its economic risks. Regulatory capital is calculated based on regulatory rules and methodologies.
1.10 What is the basic idea of RAROC? Provide the RAROC equation in your answer.
1.10 RAROC = Reward>Risk. Reward can be described in terms of After-Tax Risk-Adjusted Expected Return. Risk can be described in terms of economic capital. RAROC should be higher than the cost of equity capi-tal. RAROC = After@Tax Net Risk-Adjusted Expected Return*/economic capital *After-Tax Expected Return is adjusted for EL
1.11 What are a few applications of RAROC? Provide exam-ples in your answer
1.11 RAROC can be used in business comparison, investment analysis, pricing strategy, and cost-benefit analysis. * Business comparison: For example, compare the performance of business lines that require different amounts of economic capital. * Investment analysis: For example, assess likely returns from future investments (e.g., the decision to offer a new type of credit product). * Pricing strategies: For example, examine pricing strategy for different customer segments and prod-ucts (e.g., it may have set prices too low to make a risk-adjusted profit). * Risk management cost/benefit analysis: For example, compare the dollar cost of risk manage-ment (e.g., risk transfer via insurance, to the dollar benefits).
1.12 What is counterparty risk and give an example?
1.12 Counterparty risk is the risk that the counterparty to a trade will fail to perform. Counterparty risk includes settlement or Herstatt risk.
1.13 If a bank’s management is told that under normal market conditions, the daily VaR at the 97.5% confidence level for its trading portfolio is USD 14 million. What does that mean?
1.13 This VaR means that with respect to its trading port-folio, under normal market conditions, there is a 2.5% probability that the loss can be more than $14 million in one day.
1.14 Provide a list of examples of risk management that can be seen in early history.
1.14 See Figure 1.2 in Chapter 1
1.15 Provide a list of the key risk management building blocks.
1.15 1. The risk management process 2. Identifying known and unknown risks 3. EL, unexpected loss, and tail loss 4. Risk factor breakdown 5. Structural change from tail risk to systemic crisis 6. Human agency and conflicts of interest 7. Typology of risks and risk interactions 8. Risk aggregation 9. Balancing risk and reward 10. Enterprise risk management (ERM)
