Risk Management
Domain 5: Risk Management
This domain tests identification, measurement, and control of risks in client portfolios and advisory firms. Expect questions on market, credit, liquidity, operational, and regulatory risk, plus the limits that contain them.
Risk categories and tools
- Market risk: beta, duration, volatility, VaR, stress tests. VaR is a loss threshold over a horizon and confidence level, not a worst-case loss.
- Credit risk: issuer default, counterparty exposure, settlement risk. Liquidity risk: inability to sell at a fair price; funding risk.
- Operational risk: process, people, systems, fraud, cyber. Legal/regulatory and Shariah non-compliance risk can trigger losses and sanctions.
- Controls: segregation of duties, pre-trade limits, exposure caps, stop-losses, collateral and margin, diversification, business continuity, and independent compliance monitoring.
Worked example
A portfolio of PKR 10 million has a one-day 95% VaR of 2%, or PKR 200,000. Reasoning: on 95% of days, losses are expected to be below PKR 200,000; on about 5% of days, they may exceed it. VaR says nothing about the size of the tail loss beyond the threshold, so a stress test assuming a 10% market fall (PKR 1 million) is added. If the client's maximum tolerable one-day loss is PKR 150,000, the portfolio breaches policy and exposure should be reduced or hedged.
Traps
VaR is not a maximum loss. Diversification reduces unsystematic risk, not systematic risk. A stop-loss can fail in a gap or illiquid market. Margin reduces counterparty risk but creates liquidity demands.