Foundations of Risk Management
Risk, return, and governance
Foundations questions test whether you can separate risk (measurable dispersion of outcomes) from uncertainty (unquantified). Enterprise risk management (ERM) aggregates market, credit, liquidity, operational, and strategic risk; the trap is treating ERM as simple risk avoidance rather than risk-adjusted value maximization. Know the GARP Code of Conduct: integrity, confidentiality, conflicts, and professional standards.
Portfolio theory: diversification eliminates unsystematic risk, not systematic risk. CAPM: E(Ri)=Rf+beta_i[E(Rm)-Rf]. Beta measures sensitivity to the market; standard deviation measures total risk. Performance measures are a classic trap: the Sharpe ratio uses total risk in the denominator, Treynor uses beta, Jensen's alpha is excess return over CAPM, and the information ratio uses tracking error versus a benchmark. Use Sharpe for a fully diversified portfolio, Treynor for a well-diversified subportfolio, and alpha to test manager skill.
Worked example: A portfolio has expected return 12%, beta 1.2, market return 10%, and Rf 3%. CAPM required return = 3% + 1.2(10-3) = 11.4%. Jensen's alpha = 12% - 11.4% = +0.6%, so the manager added value after adjusting for systematic risk. If the question gives volatility instead of beta, do not use CAPM; use Sharpe.
Traps: confusing ex-ante and ex-post alpha; forgetting that portfolio beta is the weighted average of betas; and assuming low volatility means low risk without considering leverage or tail risk.