CPA Australia Financial Risk Management flashcards

33 cards. Read the term and the definition here. The deck at the top of this page is optional.

Three lines model

First line business units own and manage risk, second line risk and compliance set frameworks and monitor independently, third line internal audit gives independent assurance to the board.

Risk appetite statement

A board-approved articulation of how much risk the firm will accept to pursue its objectives, expressed through quantitative limits and qualitative boundaries that cascade to business units.

RAROC

Risk-adjusted return on capital equals risk-adjusted profit divided by economic capital allocated to the activity. It allows comparison of returns across businesses with different risk profiles.

Economic capital

The capital a firm holds to absorb unexpected losses at a target confidence level over a horizon. It is internally modelled, unlike regulatory capital, which follows prescribed rules.

Residual risk

The risk remaining after controls and mitigants are applied. It should be rated using evidence of control effectiveness testing, not merely the existence of documented controls.

Value at Risk

The loss threshold not expected to be exceeded with a stated probability over a stated horizon. It ignores the size of losses beyond that threshold, so tail measures supplement it.

Expected Shortfall

The average loss in the worst tail beyond the VaR quantile. It is sub-additive and coherent, and Basel's FRTB uses it at 97.5% instead of 99% VaR.

Parametric VaR formula

VaR equals the z-score for the chosen confidence level multiplied by portfolio volatility and position value. It assumes normally distributed returns and linear exposures.

Historical simulation

A VaR method that revalues the current portfolio using historical return scenarios from a chosen window and reads the loss at the required percentile. Accuracy depends on the window.

VaR backtesting

Comparing realised profit and loss against VaR forecasts. Under Basel's traffic-light approach, five or more exceptions in 250 days at 99% raises the capital multiplier.

Option delta and gamma

Delta is the change in option value per unit change in the underlying; gamma is the rate of change of delta. Delta hedging neutralises first-order risk but leaves gamma exposure.

Stress testing

Applying historical or hypothetical severe scenarios to the current portfolio without probability weighting, to reveal losses VaR may miss and to inform limits and capital planning.

Expected loss formula

Expected loss equals probability of default times loss given default times exposure at default. Pricing must recover expected loss plus funding and capital costs.

Loss given default

One minus the recovery rate on a defaulted exposure, expressed as a percentage of exposure at default. It reflects collateral, seniority, and workout costs.

Exposure at default

The amount owed at the time of default, including drawn balances plus a credit conversion factor applied to undrawn commitments that could be drawn before default.

Credit default swap

A contract where the protection buyer pays a periodic premium and receives compensation if a reference entity defaults. The spread approximates PD times LGD.

Wrong-way risk

A situation where exposure to a counterparty rises as that counterparty's credit quality falls, often because posted collateral or underlying trades are correlated with the counterparty.

Credit risk mitigation

Collateral, guarantees, or netting that reduces loss given default or exposure. Recognition requires legal enforceability, prompt realisability, and haircuts for price volatility.

Liquidity coverage ratio

High-quality liquid assets divided by net cash outflows over a 30-day stress period, required to be at least 100% so the firm can survive a short severe run.

Net stable funding ratio

Available stable funding divided by required stable funding over a one-year horizon, required to be at least 100% to limit reliance on short-term wholesale funding.

High-quality liquid assets

Assets that are unencumbered, readily convertible to cash, and eligible for central bank facilities. They are tiered Level 1, 2A, and 2B with increasing haircuts and caps.

Survival horizon

The number of days a firm can continue meeting obligations under a stress scenario using its counterbalancing capacity before corrective management action takes effect.

Contingency funding plan

A documented playbook with early warning indicators, escalation triggers, and pre-assessed funding actions such as asset sales, secured borrowing, and central bank facilities.

Funding concentration risk

Reliance on a small number of depositors or wholesale providers, or on short-term funding for long-dated assets, which can force rapid asset sales in a run.

Operational risk definition

The risk of loss from inadequate or failed internal processes, people, systems, or external events. Basel excludes strategic and reputational risk, though firms manage them at enterprise level.

Basel event taxonomy

Seven operational loss categories: internal fraud, external fraud, employment practices, clients and business practices, physical asset damage, business disruption, and execution or process failure.

Loss distribution approach

Operational risk capital from modelling annual loss frequency and severity distributions and taking a high quantile, typically 99.9%, of the aggregate annual loss distribution.

Key risk indicator

A forward-looking metric with defined thresholds that signals rising risk exposure, enabling pre-emptive action. It must be measurable, owned, and linked to a decision rule.

Model validation

Independent assessment of a model's conceptual soundness, data quality, implementation, and outcomes against actual results, performed by parties separate from model developers.

Put-call parity

For European options on a non-dividend stock, call minus put equals spot minus the present value of the strike. Violations create arbitrage opportunities.

Interest rate swap

An agreement to exchange fixed and floating interest payments on a notional principal. The fixed rate is set at inception so the swap's initial value is zero.

Basis risk

Residual exposure when a hedging instrument and the hedged item are imperfectly correlated, due to differing indices, tenors, or credit quality, so the hedge does not fully offset losses.

Hedge accounting

IFRS 9 rules allowing gains and losses on hedging instruments to be recognised with the hedged item, requiring documented objectives, prospective effectiveness assessment, and reclassification.