Risk Management
What you must know
Expect questions on the risk universe and how firms respond to it. Classify risks as strategic, operational, financial, and compliance/reporting. Understand enterprise risk management (ERM) as a portfolio view linking risk appetite to strategy-COSO's framework emphasizes governance and culture, strategy and objective-setting, performance, review and revision, and information/communication/reporting. Risk responses are accept, avoid, reduce (mitigate), share (transfer), and pursue/exploit for upside risk. Financial risk tools: forwards and futures (obligation, fixed price, futures are standardized and marked to market), options (right, not obligation; buyer pays a premium), and swaps (exchange cash flows, commonly fixed for floating to convert variable-rate debt to fixed). Also know diversification, value at risk, internal controls, segregation of duties, and the fraud triangle.
Traps that show up
- Saying an option holder is obligated to exercise. Only the writer is obligated if the holder exercises.
- Confusing hedging with speculation: a hedge offsets an existing exposure.
- Missing the direction of an interest rate swap: a borrower paying floating who fears rising rates pays fixed and receives floating.
- Forgetting that futures require margin and daily settlement while forwards are customized and carry counterparty risk.
- Treating risk avoidance as always superior-avoidance may sacrifice the return the entity exists to earn.
Worked example
A firm owes $10 million at floating SOFR + 1%. Fearing rate increases, it enters a swap paying 4% fixed and receiving floating. If SOFR rises to 4.5%, the loan costs 5.5% but the swap nets +0.5%, so the effective cost is fixed at 5.0%. If rates fall, the firm pays more on the swap but less on the loan-cost stays 5.0%.
Rule of thumb
Identify the exposure first, then the instrument that offsets it. If the position loses when rates rise, the hedge must gain when rates rise.