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P1.T1.605 Other risks (Topic review)

Nicole Seaman

Director of FRM Operations
Staff member

605.1. Risk measurement tends to employ so-called downside risk metrics such as value at risk and expected shortfall (ES). With respect to these measures, each of the requirements below is important; each is either somewhat important or very important. HOWEVER, among the following which is the LEAST important requirement for an effective risk measurement approach?

a. Minimal model error: Minimization of model error and incorrect model implementation
b. Loss tail accuracy: accurate specification of the distributional tail
c. Precise output metrics: A high degree of precision in calculated downside risk measures
d. Future-oriented distribution: Characterization of a future (as opposed to current or historical) distribution

605.2. A classic concept in risk management is that a firm cannot and should not attempt to eliminate risk. If an enterprise were somehow theoretically risk-free, then it would not be able to create value. This is an important premise in establishing the principle that risk management is more than a compliance and risk-avoidance function. Rather, risk management aspires to be an ally in value creation.

More specifically, and with respect to financial risks, there is a classic trade-off in finance between expected return and risk: higher expected returns are compensation for assuming greater risk. However, which of the following risks is the most notable general EXCEPTION to this rule?

a. Operational risk
b. Funding liquidity risk
c. Trading liquidity risk
d. Concentration risk (in credit risk at the portfolio level)

605.3. In Appendix 1.1., Crouhy's high-level typology of risk exposures includes the following list of risks (Michel Crouhy, Dan Galai, and Robert Mark, The Essentials of Risk Management, 2nd Edition (New York: McGraw-Hill, 2014)):
  • Market risk: the risk that changes in financial market prices and rates will reduce the value of a security or a portfolio,
  • Credit risk: the risk of an economic loss from the failure of a counterparty to fulfill its contractual obligations, or from the increased risk of default during the term of the transaction,
  • Liquidity risk: this is most often but not always classified as a sub-type of market risk,
  • Operational risk: the risk of loss resulting from inadequate or failed processes, people and systems or from external events,
  • Legal and regulatory risk: these are always classified as operational risks in the FRM,
  • Business risk: the inherent risks which the firm willingly assumes to create competitive advantage and add shareholder value,
  • Strategic risk: traditionally in the FRM, this is a firmwide business risk, but NOT an operational risk which is a non-business financial risk!
  • Reputation risk: traditionally in the FRM, this is a firmwide non-business, non-financial risk (also NOT an operational risk) however there is some debate and evolution.
Each of the following is a true statement EXCEPT which is false?

a. While all four are sub-types of market risks, commodity price risk is uniquely different from equity price risk, interest rate risk and foreign exchange risk
b. Value at risk (VaR) is optimal for market risk but is poorly designed for credit and operational risk; and VaR cannot realistically play a role in enterprise risk and economic capital metrics, where elliptical properties are desirable
c. Systemic risk was a focus of the Dodd-Frank Act and refers to the potential for the failure of one institution to create a chain reaction or domino effect on other institutions and consequently threaten the stability of financial markets
d. Liquidity has two versions: (i) funding liquidity risk which increases with balance sheet leverage and can be exploited by variation margin; and (ii) trading liquidity risk (aka, asset liquidity risk) which is measured by tightness (e.g., bid-ask spread), market depth/breadth, and/or resiliency/immediacy.

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