FRM Part 1

Book 1 – Foundations of Risk Management

THE BUILDING BLOCKS OF RISK MANAGEMENT

 Learning Objectives
After completing this reading you should be able to:
 Explain the concept of risk and compare risk management with risk taking.
 Describe elements, or building blocks, of the risk management process and
identify problems and challenges that can arise in the risk management
process.
 Evaluate and apply tools and procedures used to measure and manage risk,
including quantitative measures, qualitative assessment, and enterprise risk
management.
 Distinguish between expected loss and unexpected loss, and provide
examples of each.
 Interpret the relationship between risk and reward and explain how conflicts of
interest can impact risk management.
 Describe and differentiate between the key classes of risks, explain how each
type of risk can arise, and assess the potential impact of each type of risk on
an organization.
 Explain how risk factors can interact with each other and describe challenges
in aggregating risk exposures.
 Risk and its Management
What is risk?
 Potential variability of returns around an expected return.
 Financial risk can be managed and mitigated.
 There is no return without risk.
 Risk managers pride themselves in their ability to price risks and provide
adequate compensation for the risk taken in business activities.
o Example: To generate a return for shareholders, lenders such as
JPMorgan Chase are faced with constant credit risk –
borrowers/mortgagors may default on agreed upon payments.
 Risk and its Management
Risk Management Identify risk
exposures
 Risk management includes the selection
of the type and level of risk that is
appropriate for the firm to assume. Measure and Find instruments
estimate and facilities to
 Instruments that allow a company to risk exposures shift or trade risks

transfer risk also allow other firms to

assume that risk as a counterparty. Assess effects Assess costs and
of exposures benefits of instructs
 Since 2007-2009 financial crisis an
overdependence on historical-statistical
treatment of risk has been abandoned
From
From a arisk
risk
mitigation
o There has been more emphasis on mitigation
strategy: strategy:
• Avoid
Avoid
scenario analysis and stress • Transfer
Transfer
testing, which examine the impact of • Mitigate
Mitigate
• Keep
Keep
adverse scenarios or stress.

Evaluate
performance
TABLE 1 The risk management process
 Risk and its Management
Risk Management as a process
✓ Understanding, costing, and efficiently managing
unexpected levels of variability in the financial
outcomes for a business
✗ Not the process of controlling and reducing expected
losses, which is a budgeting, pricing, and business
efficiency concern
 Risk and its Management
Risk Management as a process
 Even a conservative business can take on a significant amount of risk
quite rationally, in light of:
o Its confidence in the way it assesses and measures the unexpected
loss levels.
o The accumulation of sufficient capital or the deployment of other risk
management techniques to protect against potential unexpected loss
levels.
o Appropriate returns from the risky activities, once costs of risk capital &
risk management are taken into account.
o Clear communication with stakeholders about the company’s target
risk.
RISK - The variability that can be quantified in terms of probabilities
UNCERTAINTY - The variability that cannot be quantified at all
 Risk and its Management
Challenges in risk management
 During stressful conditions it is very difficult to predict the behavior of
risk factors (correlations between various risks are known to increase).
 Risk management is often subject to monetary constraints (model
development, monitoring and remuneration costs).
 As an entity grows, so does its risk profile (more capital projects,
more employees, more social costs).
 Fast-changing technology comes with risks, e.g., cyber risk, money
laundering.
 The agency problem: on one hand, managers must keep risk in check;
on the other, they have to generate a good return for shareholders.
 Risk and Reward
Expected loss versus unexpected loss
 The expected loss, EL, is the average credit loss that we would
expect from an exposure or a portfolio over a given period. It’s the
anticipated deterioration in the value of a risky asset.
 Unexpected loss, UL, is the average total loss over and above
the expected loss. It’s the variation in the expected loss. It is
calculated as the standard deviation from the mean at a certain
confidence level (more of these in subsequent chapters).

Expected loss Unexpected loss

Portfolio loss
 Risk and Reward
 Higher systematic risk is associated with higher returns from a portfolio.

High risk
Low risk High return
Low return

 The demanded returns from risky assets may not be clear unless the
market of the asset is efficient and transparent.

Key objective
 Make transparent all the potential risks for the firm and identify activities
that may be detrimental for the firm in the long term.
Classification of Risk and its Impact
• Market risk arising from changes in interest rates, foreign exchange
rates, or equity and commodity price factors. (FRM part 2 book 1)

Three
• Credit risk: risk arising from a potential change in credit quality of an
major
asset. These include adverse effects arising from credit downgrading,
categories default, and the dynamics of recovery rates. (FRM part 2 book 2)

• Operational risk: risk arising from operational breakdowns resulting

from inadequate or failed internal processes, people, and systems.
(FRM part 2 book 3)

Classification can lead to unaddressed risks

& gaps in responsibilities
 Classification of risks is arbitrary and based on judgment calls.
 Creation of silos of expertise which are separated in terminology, risk measures,
reporting lines and personnel is a major source of gaps.
Classification of Risk and its Impact
Risk measurement tool
 VaR – the maximum amount of loss that could possibly be incurred at a given
level of confidence.
 Worst-case scenario analysis assumes that the worst loss will occur at the same
time across all sources of risk (business lines).
 Enterprise-wide risk management: Rather than manage risks in silos, a holistic
enterprise-wide approach is adopted.
 ERM tools include conceptual tools that facilitate enterprise-wide risk
measurement, monitoring tools that facilitate enterprise-wide risk identification, and
organizational tools such as senior risk committees with a mandate to look at all
enterprise-wide risks.
 A firm limits its exposure to a risk level agreed upon by the board and provides
its management and board of directors with reasonable assurances regarding the
achievement of the organization’s objectives.
 Quantification of Risk and its
Impact
 Once classification of risk is done, it can be quantified.
 Ranking of risks can help make rational in-class comparative
decisions.
 Assigning numbers to some risk factor can help weigh one decision
against another with some precision.
 If an absolute cost or price is put on a risk then rational economic
decisions about assuming, managing, and transferring risks can be
made.
 At this point, risk management decisions become fungible with many
other kinds of management decision in the running of an enterprise.
Quantification of Risk and its
Impact
The VaR measure
 Works under normal conditions of the market and only over a short
period.
o However, it is a poor and misleading measure of risk in abnormal
markets, over longer time periods, or for illiquid portfolios.
 Depends upon the control environment.
 Trading controls can be circumvented.

The Risk Manager

 Identifies the potential sources of risk and make them visible to key
decision makers and stakeholders in terms of probability
 Typology of Risk
Market Risk

Credit Risk

Liquidity Risk

Operational Risk
RISKS Legal And Regulatory Risk

Business Risk

Strategic Risk

Reputation Risk
TABLE 2 Typology of risks
 Market Risk
 Potential reduction in value of a portfolio or a security due to changes in
financial market prices and rates.

PRICE RISK

General market risk component Specific market risk component

The risk that the market as a Idiosyncratic component

whole will fall in value

 In trading activities, a risk arises both from open (unhedged) positions

and from imperfect correlations between market positions that are
intended to offset one another.
 Market Risk
Classification
 Interest rate risk
o Fluctuations in the market interest rates which may cause a decline in
the value of interest rate sensitive portfolios.
o Example: when interest rate rise, bond values fall; a portfolio with
bonds may witness a loss in value

 Equity price risk

o Has much to do with the volatility in the stock prices.
o Can be specific or systematic
 Systematic risk can’t be done away with by diversification.
 Idiosyncratic or specific risk is the component of volatility
determined by firm specific characteristics like its management,
production line etc. This can be done away with by diversification.
 Market Risk
Classification
 Foreign Exchange Risk
o Manifests in operations that involve foreign currencies; imperfectly hedged
positions in certain currencies may arise, causing exposure to exchange rates.
o Driven by imperfect correlations in currency prices and fluctuating international
interest rates.

 Commodity price risk

o It is the volatility associated with the prices of commodities.
o Since the concentration of supply of commodities is consolidated in a few hands,
the commodity price volatility can be magnified.
o Due to the presence of a limited number of players in most of the commodities,
liquidity becomes a factor that affects volatility.
o Commodities are divided into perishable like agricultural products, energy
commodities etc, and nonperishable commodities like precious metals etc.
 Equity price risk General
market risk
Trading
risk
Interest rate risk Specific
risk
Market risk Gap risk
Foreign exchange
Financial risk
risk
Commodity price
risk
Credit risk
Issue risk

Transaction risk Issuer risk

Counterparty
Portfolio concentration
credit risk

TABLE 3 Schematic presentation, by categories, of financial risks

 Credit Risk
 Counterparty not fulfilling its contractual obligations is the credit risk.
Classification

Default risk- Refusal or incapacity of the borrower to

meet the obligations of debt contract by more than the
relief period.

Bankruptcy risk- The risk associated with a

borrower’s inability to clear his debt leading to a
takeover of his collateralized assets.

Downgrade risk- The risk that there might be a

decline in credit ratings of a borrower because of a
decline in his creditworthiness.

Settlement risk- The risk that a counterparty won’t

deliver as per the settlement agreements even though
the other party has delivered.
 Credit Risk
 Matter of concern only when the position is an asset and not a liability.
 If the position is an asset then a default by the counterparty may cause a
loss of total or a partial value of the position.
 The value that is likely to be recovered is called recovery value while the
amount that is expected to be lost is called loss given default.

Issues
 Creditworthiness of the obligor: Based on this, appropriate interest rate
or spread should be charged to compensate for the risk undertaken
 Concentration risk: The extent of diversification of the obligor should be
a concern.
 The state of the economy: When the economy is booming, the
frequency of defaults is comparatively lower than when there is a
recession.
 Liquidity Risk
 It comprises of funding liquidity risk and trading liquidity risk.

Funding liquidity risk

 Risk that a firm will not be able to settle its obligations immediately
when they are due
 It relates to raising funds to roll over debt and to meet margin calls and
collateral requirements
 Funding liquidity risk can be managed by holding highly liquid assets
like cash.

Trading liquidity risk

 Risk associated with the inability of a firm to execute transactions at
the prevailing market price.
 It may reduce institution’s ability to hedge market risk and also it’s
capacity to liquidate assets when necessary.
 Liquidity Risk

Market risk

Financial
risk

Credit risk

TABLE 4 The dimensions of liquidity risk

 Operational Risk
 Risk that arises due to operational weaknesses like management
failure, faulty controls, inadequate systems etc.
 Human factor risk is one of the important operational risks and it results
from human errors.
 Technology risk arises from computer system’s failure.

Legal and Regulatory Risk

 Risk arising from the fact that some counterparty might not have the
legal or regulatory authority to engage in a transaction.
 There may also be situations when the regulations are amended and a
firm is no longer authorized to engage in certain forms of transactions.
 This may seriously affect the cost structure and the way a firm works.
 Business Risk
 It arises from the uncertainties in demands, the cost of production and
the cost of delivery of products.
 Managed by framing appropriate marketing policy, inventory policies,
choices of products, their channels and suppliers etc.
 Business risk is affected by the quality of firm’s strategy and its
reputation.

Strategic Risk
 Risk associated with the risk of significant investments for which the
uncertainty of success and profitability is high.
 Related to the strategic change in the policies of a company to make it
more competitive in the marketplace.
 Reputation Risk
 Enterprise can settle its obligations to counterparties and creditors.
 It follows ethical practice.
 Trust and fair dealing are two very important things that drive
businesses.

Systemic Risk
 Risk associated with a potential failure of one institution creating a
chain effect causing the collapse of entire industries and threatening the
stability of the market.
 The perception that a leading institution would collapse.
 Book 1 – Foundations of Risk Management

THE BUILDING BLOCKS OF RISK MANAGEMENT

Learning Objectives Recap:

 Explain the concept of risk and compare risk management with risk taking.
 Describe elements, or building blocks, of the risk management process and identify
problems and challenges that can arise in the risk management process.
 Evaluate and apply tools and procedures used to measure and manage risk,
including quantitative measures, qualitative assessment, and enterprise risk
management.
 Distinguish between expected loss and unexpected loss, and provide examples of
each.
 Interpret the relationship between risk and reward and explain how conflicts of
interest can impact risk management.
 Describe and differentiate between the key classes of risks, explain how each type of
risk can arise, and assess the potential impact of each type of risk on an organization.
 Explain how risk factors can interact with each other and describe challenges in
aggregating risk exposures.