Risk Management and Risk Measurement
Core Concepts
Risk management involves identifying, measuring, and mitigating risks: market risk (equity, interest rate, currency, commodity), credit risk, liquidity risk, operational risk, and systemic risk. Candidates must understand risk measurement tools: Value at Risk (VaR), stress testing, scenario analysis, and Greek letters for options (delta, gamma, vega, theta, rho). Key concepts: diversification, hedging, and the risk management process (identify, assess, control, monitor). Traps often involve misinterpreting VaR (it does not measure worst-case loss, only loss at a confidence level over a horizon), confusing delta (price sensitivity) with gamma (delta sensitivity), and misunderstanding the limitations of historical simulation. Also, the distinction between systematic and unsystematic risk, and the role of capital adequacy (Basel III, CRD IV). Candidates should know the three lines of defence model and the importance of risk culture. Another trap: the treatment of liquidity risk in stressed conditions and the difference between funding liquidity and market liquidity.
Worked Example / Rule of Thumb
A portfolio has a 1-day 95% VaR of EUR 1 million. This means there is a 5% chance of losing more than EUR 1 million in one day, not that the maximum loss is EUR 1 million. Rule of thumb: VaR is a threshold, not a worst-case scenario; always complement with stress testing.
Key Points
- Risk types: market, credit, liquidity, operational, systemic.
- VaR: loss threshold at a confidence level over a horizon; not worst-case.
- Greeks measure option sensitivities: delta, gamma, vega, theta, rho.
- Stress testing and scenario analysis complement VaR.
- Three lines of defence: business, risk management, internal audit.
- Basel III and CRD IV set capital and liquidity requirements.