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P1.T1.20.2. Primitive risk factors and tail risk

Nicole Seaman

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Learning objectives: 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.

Questions:

20.2.1. According to GARP, one of the building blocks in risk management is a proper understanding of the difference between expected loss, unexpected loss, and extreme risk; aka, tail risk. In regard to this building block, which of the following statements is TRUE?

a. Effective risk management should reduce a credit portfolio's expected loss (EL) to approximately zero
b. Expected loss is a product of (i) the probability of the risk event occurring; (ii) the severity of the loss if the risk event occurs, and (iii) the expected recovery rate
c. While expected loss (EL) is a function of default correlation, unexpected loss (UL) is NOT influenced by portfolio granularity
d. Although banks theoretically do not need to set aside provisions when loan products are accurately priced, in realistic practice, banks should provision for expected losses


20.2.2. A big part of a risk manager's job is to identify her firm's risk factors. Each of the following statements about risk factors is true EXCEPT which is false?

a. Two examples of primary (aka, primitive) risk factors include the return on a broad stock market index and the risk-free spot (aka, zero) interest rate
b. For any risk factors that are represented by categorical or discrete variables, the risk manager should seek to replace them with either interval, ratio, or continuous risk factor variables
c. One of the risk manager's key activities is to deconstruct primitive risk factors into the important loss drivers, the relationship of the loss drivers with each other, and the wider business environment
d. Machine learning, as a subset of artificial intelligence, holds the potential to help risk managers identify the "unknown unknowns" (aka, unk-unks)


20.2.3. About tail risk, GARP observes, "Some risk events have a diabolical side that seems designed to outwit the human mind. This may be because such events are very rare and extreme or they arise from unobserved structural changes in a market." Which of the following statements about tail risk is TRUE?

a. Extremely rare events can happen even if the system is structurally stable
b. The problem with tail risk is that we lack statistical techniques to help us make the tails visible
c. Structural change by definition impacts neither expected loss nor unexpected loss nor tail risk
d. The risk manager can approach tail risk in financial markets in the same way that she would approach a natural or mechanical system

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