Risk Management and Compliance
The Risk Management and Compliance domain tests whether you can name the risk, measure it sensibly, and describe the controls that keep a firm inside its appetite. Questions mix calculation (VaR, limits, capital) with governance: who owns the risk, who monitors it, and what must be escalated.
Risk taxonomy
- Market risk (price, rate, FX, volatility), credit and counterparty risk, liquidity risk (funding and market), operational risk (people, process, systems, external events), legal, regulatory and reputational risk.
- A risk appetite statement sits above a limits hierarchy (firm, desk, trader). The risk function must be independent and report to the board, not to the front office.
Measurement
- VaR: at a stated confidence level and horizon, the loss not expected to be exceeded. A 1-day 95% VaR of 2,000,000 on a 50,000,000 portfolio is 4% of value. Scale for 10 days with √t: 2,000,000 × √10 ≈ 6,325,000, valid under stable, independent returns.
- VaR says nothing about the size of losses beyond the threshold; expected shortfall does. Backtesting and stress testing cover model and tail risk.
- Credit expected loss = PD × LGD × EAD. Liquidity is measured by coverage, concentration and days to liquidate.
Compliance
- Know-your-client and AML: identification, beneficial ownership, source of funds, ongoing monitoring, suspicious transaction reporting.
- Conflicts: information barriers between research and corporate finance, personal account dealing pre-clearance, gifts and entertainment registers.
- Surveillance for insider dealing, manipulation and false trading; record-keeping and best-execution evidence.
Worked example
A desk holds 50,000,000 with 1-day 95% VaR of 2,000,000 and a 10,000,000 single-name limit. A proposed trade adds 12,000,000 of an issuer already held at 3,000,000. There are two problems: exposure would reach 15,000,000 against a 10,000,000 limit, and portfolio VaR would rise unless hedged. The trade must be rejected, scaled or given pre-approved limit relief before execution, and the decision recorded - not executed first and approved afterwards.
Traps
- Presenting VaR as the maximum possible loss, or comparing VaRs with different horizons and confidence levels.
- Scaling VaR by t instead of √t.
- Treating limits as post-trade checks; they are pre-trade controls.
- Confusing liquidity risk with market risk - a correctly marked position can still be unsellable.