Traditional Risk Management Topics
Traditional risk management covers market, credit, liquidity, and enterprise risk, plus the measurement tools that connect them. The PRM exam tests whether you can select the right measure, interpret it, and recognize its limitations.
Core rules
- Market risk: VaR estimates a loss threshold over a horizon and confidence level; expected shortfall measures average loss beyond VaR.
- Credit risk: expected loss = PD × LGD × EAD; unexpected loss drives capital.
- Liquidity risk: distinguish funding liquidity from market liquidity; a position may be hard to sell at VaR’s assumed horizon.
- Stress testing complements statistical models by imposing severe but plausible shocks and correlation breakdowns.
- Risk appetite, limits, three-lines-of-defense governance, and independent validation make measures usable.
Worked example
A bond portfolio has a modified duration of 5 and a market value of $100 million. A stress scenario shifts yields up 150 basis points. The estimated price change is −5 × 0.015 × $100m = −$7.5m. If the firm’s one-day 99% VaR is $3m, the stress loss is larger and should drive the limit discussion. The reasoning: VaR is not a worst-case measure and assumes normal market liquidity; duration is local and ignores convexity, credit spread, and basis risk.
Traps
- Treating VaR as the maximum loss.
- Using a 10-day VaR without a consistent liquidity horizon.
- Relying on historical correlation in a crisis.
- Confusing expected loss with regulatory capital.
- Ignoring model risk and independent validation.