Risk Management (including derivatives, hedging and exposure management)
What the exam tests
Risk management covers identification, measurement and mitigation of market, credit, liquidity and operational risk. Expect VaR, duration gaps, credit metrics, hedging rationale and whether a hedge reduces economic exposure rather than only accounting volatility.
Core rules
- ERM aligns risk appetite with strategy; hedging is justified by reducing expected distress costs, tax convexity, underinvestment and managerial risk aversion-not by forecasting skill.
- VaR at confidence c: portfolio value × z × volatility for the horizon; scale by √t under i.i.d. returns. VaR is a quantile, not the maximum loss.
- Credit risk: expected loss = PD × LGD × EAD; unexpected loss drives capital.
- Natural hedges, netting, matching and leading/lagging may be cheaper than derivatives.
- Stress testing and scenario analysis complement VaR because correlations and liquidity break down in crises.
Worked example
A ₹10 crore portfolio has daily volatility 1.2%. One-day 95% VaR = 10 crore × 1.645 × 0.012 = ₹19.74 lakh. Ten-day 95% VaR, assuming independence, = 19.74 × √10 = ₹62.4 lakh. If the portfolio is expected to earn 0.05% daily, some conventions reduce VaR by the expected return, giving about ₹19.24 lakh for one day; state the convention.
Traps
VaR ignores tail losses beyond the quantile; using 99% z=2.33 with a 95% label; scaling VaR by 10 instead of √10; treating hedging as speculation; ignoring basis risk and credit risk of the derivative counterparty.