Risk Management and Financial Risk
What CB1 tests in risk management and financial risk
This domain tests risk identification, measurement, appetite and control. Expect market, credit, liquidity and operational risk, plus capital adequacy, hedging and the limitations of quantitative models.
Core rules and concepts
- Risk appetite states how much risk an organisation accepts; risk tolerance sets limits. ERM integrates risks rather than managing them in silos.
- Market risk comes from prices, rates, FX and volatility; credit risk from counterparty default; liquidity risk from funding and market liquidity; operational risk from people, processes, systems and external events.
- VaR estimates a loss threshold over a horizon at a confidence level. It says nothing about the size of losses beyond that threshold.
- Expected shortfall averages losses in the tail and is more coherent for extreme risk. Stress tests explore plausible severe scenarios.
- Hedging reduces risk but creates basis risk, counterparty risk and costs. Capital and liquidity buffers absorb unexpected losses.
Worked example
A £1m portfolio has daily volatility 1%. Assuming a zero mean and normal returns, 95% one-day VaR = 1.645 × 1% × £1m = £16,450. At 99%, VaR = 2.326 × 1% × £1m = £23,260. For a 10-day horizon under square-root-of-time scaling, multiply by √10; that scaling assumes independent returns and stable volatility.
Traps that cost marks
Do not describe VaR as the maximum loss. Do not add VaRs across desks without considering correlation. Do not assume normal distributions in fat-tailed markets. Remember that a hedge can fail through basis risk or counterparty default.