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P1.T1.20.3. Risk management building blocks

Nicole Seaman

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Learning objectives: 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.


20.3.1. One of the risk management building blocks is risk aggregation. GARP asks the question, "Given the many different types of risk and risk metrics, a key problem in risk management is the challenge of seeing the bigger picture. How can senior managers identify the riskiest businesses on their watch and tell when the firm’s aggregate risk is approaching intolerable levels?" In regard to risk aggregation, which of the following statements is TRUE?

a. The financial crisis validated value at risk (VaR) as the ideal aggregation metric
b. The Greeks (e.g., delta, vega) are well-suited for aggregation to the enterprise level
c. For the market risk of derivative portfolios, aggregate notional amount is the best indicator of portfolio risk
d. Scenario analysis and stress testing can overcome the problem of measuring the frequency or probability of a rare event

20.3.2. One of the risk management building blocks is the need to balance risk and reward. Specifically, GARP says, "Economic capital provides the firm with a conceptually satisfying way to balance risk and reward. For each activity, firms can compare the revenue and profit they are making from an activity to the amount of economic capital required to support that activity." Each of the following statements is true about RAROC EXCEPT which is inaccurate?

a. For an activity to increase shareholder value, its RAROC should be higher than the cost of equity capital
b. Four applications of RAROC include business comparison, investment analysis, pricing strategies, and risk management cost/benefit analysis
c. Advantages of RAROC include (i) it has one universal regulatory definition (without credible variants), such that benchmarking against peers is easy; and (ii) it is easy to implement in practice
d. If RAROC's denominator is economic capital, which is typical, then its numerator should be an after-tax risk-adjusted expected return where the risk-adjusted refers to an adjustment for expected losses

20.3.3. One of the risk management building blocks is enterprise risk management (ERM). Which of the following is TRUE as a feature or implication of ERM?

a. ERM encourages organizational silos to sharpen their self-identities
b. ERM supports a firm's 360-degree view of risk which requires multiple tools
c. ERM enables a complex firm to summarize its overall risk into a single number
d. ERM replaces instances of judgment with the application of statistical science

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