Risk Management
Core concepts
Risk management identifies, measures, and controls exposures. Know the main risk types: market risk (systematic), credit risk, liquidity risk, operational risk, interest-rate risk, and concentration risk. Understand measurement tools: standard deviation, beta, value at risk (VaR), and stress testing. Grasp diversification (reduces unsystematic risk but not systematic risk) and hedging (offsetting exposures with derivatives). Be able to discuss risk tolerance, risk budgeting, and the difference between hedging and speculation.
Traps in questions
Examiners test systematic versus unsystematic risk - diversification cannot eliminate market-wide risk. Watch for VaR misinterpretation: a 1-day 95% VaR of $1 million means a 5% chance of losing more than $1 million in a day, not a maximum loss. Distinguish hedging (reducing risk) from speculation (taking risk for return). Also watch for confusing liquidity risk (can't sell without a price concession) with solvency risk (can't meet obligations).
Worked rule of thumb
Use the risk-reduction check: does the action lower the portfolio's exposure to a risk factor, or merely shift it? Buying a put option on an index to protect a portfolio is a hedge; buying a call option to bet on a rally is speculation. For VaR, always restate the confidence level, horizon, and that it is a threshold, not a ceiling.
Exam strategy
Name the specific risk type in the scenario before choosing an answer; many distractors address the wrong risk.