1.1 Basics of Risk Management

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1.1 Basics of Risk Management

Question 1

Jennifer Durrant is evaluating the existing risk management system of Silverman Asset Management. She is asked to match the following events to the corresponding type of risk. Identify each numbered event as a market risk, credit risk, operational risk, or legal risk event.

Insufficient training leads to misuse of order management system.
Credit spreads widen following recent bankruptcies.
Option writer does not have the resources required to honor a contract.
Credit swaps with counterparty cannot be netted because they originated in multiple jurisdictions.

A. 1: legal risk. 2: credit risk. 3: operational risk. 4: credit risk
B. 1: operational risk. 2: credit risk. 3: operational risk. 4: legal risk
C. 1: operational risk. 2: market risk. 3: credit risk. 4: legal risk
D. 1: operational risk. 2: market risk. 3: operational risk. 4: legal risk

Answer: C
Market risk: market prices and rates continually change, driving the value of securities and other assets up and down.

General market risk: an asset class will fall in value, leading to a fall in the value of an individual asset or portfolio.
Specific market risk: an individual asset will fall in value more than the general asset class.
The key forms: equity risk, interest rate risk, currency risk, and commodity price risk, credit spread.
Market risk can be managed through diversification benefits.

Credit risk: it rises from the failure of one party to fulfill its financial obligations to another party.

Default risk (bankruptcy risk): a debtor fails to pay interest or principal on a loan.
Downgrade risk: an obligor or counterparty is downgraded, indicating an increase in risk that may lead to an immediate loss in value of a credit-linked security.
Counterparty risk: A counterparty to a market trade fails to perform, including settlement or Herstatt risk.

Operational risk: the risk of loss resulting from non-financial problems such as inadequate or failed internal processes, people, and systems or from external events.

e.g., anti-money laundering risk, cyber risk, terrorist attacks, rouge trading.
It includes legal risk, cyber risk, but excludes business, strategic, and reputational risk.
The Basel Committee encourage banks to understand their operational risk using a variety of tools, but capital allocation would be based on a simpler standardized approach using weighted band size with a multiplier based on a bank’s record larger operational risk losses.

Liquidity risk: it is used to describe two quite separate kinds of risks: funding liquidity risk and market liquidity risk.

Funding liquidity risk: an entity is unable to pay down or refinance its debts with enough liquid cash and assets in order to meet its obligation.
Market liquidity risk (trading liquidity risk): the risk of a loss in asset value when markets temporarily seize up. This may force a seller to accept an abnormally low price, or take away the seller’s ability to turn an asset into cash and funding at any price.

Question 2

The enterprise risk management process includes several stages. Which of the following procedures would take place during the risk assessment stage?

A. Developing the following year’s budget for the risk management function.
B. Using simulation analysis to estimate VaR.
C. Purchasing insurance to mitigate a specific risk factor.
D. Selecting a risk strategy compatible with the firm’s risk appetite.

Question 3

Danielle Marquis is a quantitative analyst who works for a company that experiences risks in a sequential manner in that information obtained in earlier steps helps to make better estimates of future outcomes. Which of the following risk management tools should Marquis consider in her analyss?

A. Decision trees
B. Scenario analysis
C. Sensitivity analysis
D. Simulation

Answer: A
Decision trees depend on a successful outcome in one step before moving on to the next step.
Sensitivity analysis involves changing one variable at a time.
Scenario analysis estimates outcomes and values under several possible fixture scenarios.
Simulation is a complex tool that looks at distributions of values.

Question 4

PE2022PSQ21
A junior analyst at a bank is asked to provide suggestions on potential metrics the bank can use in its capital management program. The analyst prepares a presentation discussing the advantages and disadvantages of the $\text{RAROC}$ metric. Which of the following statements is most appropriate for the analyst to include in the presentation?

A. $\text{RAROC}$ will make it easier to compare the profitability of business divisions that require different levels of capital.
B. $\text{RAROC}$ allows the firm to benchmark its performance against operating targets set by industry peers.
C. $\text{RAROC}$ is an effective forward-looking tool to model potential extreme losses during stress scenarios.
D. An activity is adding value to the bank’s shareholders if its cost of equity capital is higher than its $\text{RAROC}$ .

Answer: A
Learning Objective:

Interpret the relationship between risk and reward and explain how conflicts of interest can impact risk management
Evaluate, compare, and apply tools and procedures used to measure and manage risk,including quantitative measures, qualitative risk assessment techniques, and enterprise risk management.

A is correct. $\text{RAROC}$ allows firms to compare the profitability of business lines that require different amounts of economic capital.

B is incorrect. $\text{RAROC}$ does not provide a benchmark against a peer group; rather it assesses if internal projects or business units are providing value to the firm (i.e. providing risk-adjusted returns higher than the firm’s cost of equity capital).

C is incorrect. $\text{RAROC}$ uses an expected return but does not quantify losses during stress scenarios; other metrics such as expected loss or methods such as scenario analysis are more useful in assessing potential extreme losses during stress situation.

D is incorrect. The activity is adding value if its $\text{RAROC}$ is higher than the cost of equity capital.

Economic or risk capital: the firm required based on its understanding of its economic risk.
Regulatory capital: calculated based on regulatory rules and methodologies.

The bank can apply a classic formula for risk-adjusted return on capital( $\text{RAROC}$ ). $\text{RAROC}=\text{Reward}/\text{Risk}$

Reward can be described in terms of After-Tax Risk-Adjusted Expected Return.
Risk can be described in term of economic capital.

There are many practical difficulties in applying $\text{RAROC}$ , including

Its dependence on the underlying risk calculations.
Business lines often dispute the validity of $\text{RAROC}$ numbers for self-interested reasons.
Risk reports are full of numbers that look objective and empirical.
Decision-makers should always understand what the number means and what is driving it.
A drop in one risk component may not mean risk is declining.
Decision-makers should watch risk itself rather than a risk proxy of uncertain utility.

Question 5

Krista Skujins, FRM, is the CFO of a manufacturing firm. She is currently in the process of diversifying the firm’s investment portfolio by varying the correlations and asset classes among securities. Diversification is best characterized as which of the following risk treatments?

A. Risk avoidance
B. Risk transfer
C. Risk retention
D. Risk reduction

Answer: D
Retain: Firms will want to accept some risks in their entirety, or to accept part of a loss distribution.
Avoid: Firms may want to avoid the types of risk that they regard as “unnatural” to their business.
Mitigate: Other risks can be mitigated in various ways.
Transfer: Firms can transfer some portion of their risks to third parities using insurance, derivative, and securitization.

Question 6

PE2022PSQ25
The CFO of a publicly traded computer manufacturing company is assessing the concerns and motivations of different stakeholder groups with respect to the firm’s hedging strategies. Which of the following statements is correct?

A. If the firm’s equity investors hold a well-diversified portfolio of investments, they would typically prefer that the firm hedge risks specific to the computer industry.
B. Debt investors would typically prefer that the company use hedging strategies to increase the stability of its revenue stream.
C. The firm should typically not hedge the foreign exchange risk of long-term contracts to international customers.
D. Equity investors would typically not reward the firm for using hedging to reduce its tax exposure over a multi-year period:

Answer: B
Learning Obiective: Evaluate some advantages and disadvantages of hedging risk exposures and explain challenges that can arise when implementing a hedging strategy.

B is correct. Debt investors generally have little or no upside from a firm’s revenue volatility, so they would prefer that the firm use hedging strategies to make its revenue stream more stable.

A is incorrect. If the equity investors are already diversified, they would generally prefer that the firm not hedge its firm-specific risks, since most of the risks specific to the firm are already diversified away in the investors’ portfolios.

C is incorrect. Foreign exchange exposure is typically not a core competency of a computer manufacturer, so it would make sense in many instances for the firm to hedge this exposure. Also, since the firm is exposed for a longer period of time, this provides an additional argument
in favor of hedging.

D is incorrect. Hedging tax exposure in this manner increases after-tax earnings, so equity investors would prefer that the firm uses hedges in this case.

Disadvantages Of Hedging Risk Exposures

Hedging can only stabilize earnings within a relatively short time horizon of a few years.
Hedging also has costs that are both transparent (e.g., an option premium) and opaque (e.g., he dangers arising from tactical errors and rogue trading).
Investors who own firms might feel that risk is diversified away in the context of their investment portfolios.

Advantages Of Hedging Risk Exposures

There are many market imperfections.
Improving revenue stability also sends an important message to debt investors.
Hedging can be used as a tool to increase the firm’s cash flows.
Hedging has the effect of increasing after-tax revenues.
Managers may use hedging to ensure their firm meets key short-terms target’s that affect their prestige and compensation.

Question 7

Which of the following statements regarding exchange-traded and over-the-counter (OTC) financial instruments is correct?

A. There is greater liquidity with exchange-traded financial instruments.
B. There is greater customization with exchange-traded financial instruments.
C. There is greater price transparency with OTC financial instruments.
D. There is credit risk by either of the counterparties inherent in exchange-traded instruments.

Question 8

Which of the following statements regarding corporate risk governance is correct?

A. Management of the organization is ultimately responsible for risk oversight.
B. A risk committee is useful for enforcing the firm’s risk governance principles.
C. Effective risk governance requires multiple levels of accountability and authority.
D. The point of risk governance is to minimize the amount of risk taken by the organization.

Answer: B
The Board of Directors is ultimately responsible for risk oversight.

Effective risk governance simply requires clear accountability, authority, and methods of communication; it is not necessary to have multiple levels.

The point of risk governance is to consider the methods in which risk-taking is permitted, optimized, and monitored; it is not necessarily to minimize the amount of risk taken.

The real point of risk governance is to increase the value of the organization from the perspective of the shareholders and/or stakeholders.

Question 9

The chief risk officer of an international bank is instructing his direct reports on best practices for conducting country risk analysis and presenting the findings to senior executives. Which of the following recommendations would be considered the most questionable?

A. Risk analysis should be consistent, using rigorous frameworks that allow for valid cross-county comparison.
B. Risk reports should be concise, with easy to understand conclusion that have sufficient detail to make them meaningful.
C. Risk reports should be informative, providing the end user the rationable behind any assessment without any “black boxes” that are difficult to understand.
D. Risk analysis should be open-ended, presenting several scenarios and taking no particular position on any issue that could bias decision-makers.

Question 10

At large financial institutions, the board of directors plays a key role in the process of creating a culture of risk management. As part of this role, one function that should be fulfilled by the board of directors is to:

A. Establish a policy to address individual risk factors by reducing, hedging, or avoiding exposure to each risk.
B. Develop risk reports and communicate them to organizational division leaders to conform with best practices
C. Address issues that could potentially represent a conflict of interest by creating committees cornposed exclusively of executive board members
D. Monitor the effectiveness of the company’s governance practices and make any necessary changes to ensure proper compliance

Question 11

A strong risk governance structure can help a financial institution more effectively manage its risks. Several corporate governance theories have been developed to explain how institutions can address issues which could prevent risk factors from being effectively managed and controlled to maximize firm value. Within the context of the governance theory known as “agency theory”, what is one of the key objectives of corporate governance?

A. Ensuring continued access to essential resources
B. Ensuring that the company’s executives represent the company fairly and ethically in dealings with business partners.
C. Reducing transactional hazard costs through internal corporate governance practices.
D. Aligning the interests of corporate managers with the interests of shareholders.

Question 12

Which of the following statements regarding the responsibilities of the chief risk officer (CRO) is least accurate?

A. The CRO should provide the vision for the organization’s risk management.
B. In addition to providing overall leadership for risk, the CRO should communicate the organization’s risk profile to stakeholders.
C. Although the CRO is responsible for top-level risk management, he is not responsible for the analytical or systems capabilities for risk management.
D. The CRO may have a solid line reporting to the CEO or a dotted line reporting to the CEO and the board.

Question 13

PE2018Q18 / PE2019Q18
The board of directors of a diversified industrial firm has asked the risk management group to prepare a risk appetite for the organization. Which of the following activities should take place as part of the process of developing the company’s risk appetite?

A. Constructing a list of all risks to which the company could potentially be exposed to.
B. Deciding the total amount of risk the company is willing to accept across the organization.
C. Determining the maximum amount of exposure to each specific risk factor the company is willing to maintain.
D. Communicating a risk governance strategy across the organization

Answer: B
Learning Objective: Explain how a company can determine whether to hedge specific risk factors, including the role of the board of directors and the process of mapping risks.

B is correct. This is an example of risk appetite.
A is incorrect. This is an example of a risk profile as it’s a list of all risk factors to which the company can potentially be exposed to.
C is incorrect. This is an example of developing risk tolerance.
D is incorrect. This is an example of risk governance.

Risk appetite describes the amount and types of risk a firm is willing to accept.

A statement about the firm’s willingness to take risk in pursuit of its business goals.
The sum of the mechanisms linking this top-level statement to the firm’s day-to-day risk management operations.
The risk appetite statement should be approved by the broad.
It is set below the firm’s total risk bearing capacity, and above the amount of risk the firm is exposed to currently.

Question 14

Which of the following tasks regarding risk appetite would be reasonably performed by an organization’s Board of Directors?

I. Develop the organization’s risk appetite statement.
II. Determine if the risk appetite may cause risks in other areas of the organization.

A. I only
B. Il only
C. Both I and II
D. Neither I nor II

Answer: B
Developing the organization’s risk appetite statement is the responsibility of management. It is the Board’s role to review and provide appropriate feedback on management’s work with regard to the risk appetite statement.

Determining if the risk appetite may cause risks in other areas of the organization is consistent with the Board’s oversight role.

Question 15

Which of the following statements regarding risk appetite and risk tolerance is correct?

I. Risk appetite directly impacts the allocation of resources.
II. Risk tolerance is a measure of an organization’s ability to take risk.

A. I only
B. Il only
C. Both I and II
D. Neither I nor II

Answer: A
Risk tolerance refers to the range of acceptable outcomes related to achieving a business objectives.

Question 16

A growing regional bank has added a risk committee to its board. One of the first recommendations of the risk committee is that the bank should develop a risk appetite statement. What best represents a primary function of a risk appetite statement?

A. To quantify the level of variability for each risk metric that a firm is willing to accept.
B. To state specific new business opportunities that a firm is willing to pursue.
C. To assign risk management responsibilities to specific internal staff members.
D. To state a broad level of acceptable risk to guide the allocation of the firm’s resources.

Answer: D
A risk appetite statement states a broad level of risk across the organization the firm is willing to accept in order to pursue value creation. The statement is typically broadly articulated and can be communicated across the organization, and helps to allocate resources to specific objectives at the firm.

Question 17

Firms commonly incentivize their management to increase the firm’s value by granting managers securities tied to the firm’s stock. Some securities, however, can reduce managerial incentives to manage risk within the firm. Which is likely the best example of this type of security?

A. Deep in-the-money call option on the firm’s stock
B. At-the-money call option on the firm’s stock
C. Deep out-of-the-money call option on the firm’s stock
D. Long position in the firm’s stock

Answer: C
Deep out-of-the-money calls have no value unless the firm value increases substantially, so providing deep out-of-the-money calls as an incentive could cause managers to take substantially higher risks and perform, less hedging.

With an at-the-money call, managers could still be incentivized to take greater risks but they would not have to aim for as large of a stock price increase to recognize significant value from their options, so the danger of mismanaging risk is less.

A deep in-the-money call would have a similar investment profile as a long equity position and both of the latter choices would provide the least managerial incentive to reduce risk management.

Question 18

PE2021Q96 / PE2022Q96
A risk analyst at a growing bank is concerned about a loan exposure to a large manufacturing company which is losing significant market share in its industry. The analyst considers the use of different credit risk transfer mechanisms, including CDS, to manage this exposure. Which of the following statements correctly describes an appropriate benefit of using CDS in this situation?

A. They quantify the manufacturing company’s default risk and allow the bank to monitor changes in this risk on a real-time basis.
B. They provide an agreement to periodically revalue the loan and transfer any net value change.
C. They require the manufacturing company to pay back the loan in full at an earlier point in time.
D. They allow the bank to offset its exposure to the company with loan exposures to other manufacturing companies.

Answer: A
Leaning Objective: Compare different types of credit derivatives, explain their applications, and describe their advantages.

CDS (or credit default swaps) are credit derivatives that quantify a company’s default risk and allow the bank to monitor changes in the company’s default risk on a real-time basis. This is an improvement over credit ratings, which only update assessments of companies’ default risk on a periodic basis.

B is incorrect. This would be a feature of marking-to-market/margining.

C is incorrect. This would be an example of a termination/put option mechanism.

D is incorrect. CDS do not provide an offset using loan exposures to other counterparties.

A separate transfer mechanism, netting, can be used to offset negative and positive exposures to the same counterparty but this statement does not correctly describe netting either.

Question 19

A risk analyst is reconciling customer account data held in two separate databases and wants to ensure the account number for each customer is the same in each database. Which dimension of data quality would she be most concerned with in making this comparison?

A. Completeness
B. Accuracy
C. Consistency
D. Currency

Question 20

A risk manager is analyzing several portfolios, all with the same current market value. Which of the following portfolios would likely have the highest potential level of unexpected loss during a sharp broad-based downturn in financial markets?

A. A portfolio of US Treasury notes with 2 to 5 years to maturity.
B. A portfolio of long stock positions in an international large cap stock index combined with long put options on the same index.
C. A portfolio of mezzanine tranche MBS structured by a large regional bank.
D. A short position in futures for industrial commodities such as copper and steel.

Answer: C
Learning Objective: Distinguish between expected loss and unexpected loss, and provide examples of each.

The portfolio of mortgage backed securities would have the highest unexpected loss since the securities should have the highest correlation (covariance) and should have the most risk of moving downward simultaneously in a crisis situation.

Question 21

PE2018Q96 / PE2019Q96
Which of the following is not necessarily considered a failure of risk management?

A. Failure to use appropriate risk metrics
B. Failure to minimize losses on credit portfolios
C. Failure in communicating risk issues to top management
D. Incorrect measurement of known risks

Answer: B
Learning Objective: Analyze and identify instances of risk management failure.

A failure to minimize losses on credit portfolios is not necessarily a failure of risk management. The firm may have used prudent risk management and decided that the potential rewards from entering into the credit agreements adequately compensated the firm for the risks taken. It could also have ignored the advice of its risk managers to attempt to minimize its credit losses. Either way, this is not necessarily a failure of risk management.

Question 22

PE2020Q18 / PE2021Q18 / PE2022Q18
A treasury risk manager working for a large bank is responsible for liquidity risk management. The manager is particularly interested in processes for funding liquidity risk management. Which of the following is the most appropriate process used for funding liquidity risk management?

A. Building VaR models
B. Purchasing credit default swaps
C. Implementing asset-liability management
D. Calculating loss given default

Answer: C
Learning Objective: Evaluate, compare, and apply tools and procedures used to measure and manage risk, including quantitative measures, qualitative risk assessment techniques, and enterprise risk management.

C is correct. Asset/liability management is a process used in managing banks’ funding liquidity risk, with techniques including gap and duration analysis. This is important because maturity mismatches on banks’ balance sheets (for example, if a bank funds longer-term loans using short-term deposits) can create risk for a bank if short-term interest rates rise faster than longer term rates.

A is Incorrect. VaR models are used to manage market risk.

B is incorrect. Credit default swaps are used to hedge against counterparty risk, which is a form of credit risk.

D is incorrect. Calculating loss given default is used to quantify credit risk.

Question 23

PE2019Q22 / PE2020Q22 / PE2021Q22 / PE2022Q22
A risk manager is analyzing several portfolios, all with the same current market value. Which of the following portfolios would likely have the highest potential level of unexpected loss during a sharp broad-based downturn in financial markets?

Answer: C
Learning Objective: Distinguish between expected loss and unexpected loss, and provide examples of each.