Foundations of Risk Management
Foundations of Risk Management is the vocabulary-and-judgment domain of the exam. It tests whether you can separate risk (measurable dispersion of outcomes) from uncertainty, classify exposures into market, credit, liquidity, operational, and strategic categories, and explain how a board converts a risk appetite statement into limits, policies, and reporting lines. Expect questions on the three lines of defense, the CRO and board risk committee, and the classic failures - Barings' missing front/back-office segregation, LTCM's leverage and correlation assumptions, Metallgesellschaft's stack-and-roll basis risk.
Core rules
- ERM aggregates risk firm-wide; it is not the same as hedging every exposure. Diversification means firm-level risk is below the sum of silo risks - but correlations rise in stress.
- CAPM prices only systematic risk: E(R) = Rf + β(E(Rm) − Rf). Unsystematic risk is diversifiable and earns no premium.
- Sharpe ratio = (E(R) − Rf)/σ and uses total risk; Treynor uses β; Jensen's alpha is the intercept relative to CAPM.
- Modigliani-Miller: capital structure is irrelevant in frictionless markets; risk management adds value mainly through taxes, distress costs, and reduced underinvestment.
Worked example
A portfolio is expected to return 12% with volatility 18%. The risk-free rate is 3%, the market risk premium is 6%, and the portfolio beta is 1.3. Sharpe = (12 − 3)/18 = 0.50. CAPM required return = 3 + 1.3(6) = 10.8%. Alpha = 12 − 10.8 = +1.2%. Because beta exceeds 1, the portfolio must be judged against 10.8%, not 12%; a raw return above the market index says nothing about skill.
Traps
- Dividing excess return by beta when the question asks for Sharpe (and the reverse).
- Substituting σ where β belongs inside CAPM.
- Confusing risk appetite (willingness to bear risk) with risk capacity (ability to bear it).
- Assuming ERM diversification is a free lunch that survives a crisis.