FINRA Series 16 – Quiz 16

risk management includes the sequence of activities aimed to reduce or eliminate an entity’s potential to incur expected losses.

In its basic format, the risk management process is as follows:

Step 1: Identify the risks.
Step 2: Quantify and estimate the risk exposures or determine appropriate methods to transfer the risks.
Step3: Determinethecollectiveeffectsoftheriskexposuresorperformacost-benefit analysis on risk transfer methods.
Step 4: Develop a risk mitigation strategy (i.e., avoid, transfer, mitigate, or assume risk).
Step 5: Assess performance and amend risk mitigation strategy as needed.

Risk taking refers specifically to the active assumption of incremental risk in order to generate incremental gains. In that regard, risk taking can be thought of in an opportunistic context.

In its basic format, the risk management process is as follows:

Step 1: Identify the risks.
Step 2: Quantify and estimate the risk exposures or determine appropriate methods to transfer the risks.
Step3: Determinethecollectiveeffectsoftheriskexposuresorperformacost-benefit analysis on risk transfer methods.
Step 4: Develop a risk mitigation strategy (i.e., avoid, transfer, mitigate, or assume risk).
Step 5: Assess performance and amend risk mitigation strategy as needed.

Risk management is more concerned with the variability of losses, especially ones that could rise to unexpectedly high levels or ones that suddenly occur that were not anticipated (unexpected losses).

Value at risk (VaR) states a certain loss amount and its probability of occurring.

Economic capital refers to holding sufficient liquid reserves to cover a potential loss. For example, if one-day VaR is $2.5 million and the entity holds $2.5 million in liquid reserves, then it is unlikely to go bankrupt that day.

Stress testing is a form of scenario analysis that examines a financial outcome based on a given “stress” on the entity.

Loan defaults are increasing simultaneously while recovery rates are decreasing is an example of correlation risk. Correlation risk could drive up the potential losses to unexpected levels.

Expected loss considers how much an entity expects to lose in the normal course of business. It can often be computed in advance (and provided for) with relative ease because of the certainty involved.

There are eight key classes of risk: (1) market risk, (2) credit risk, (3) liquidity risk,
(4) operational risk, (5) legal and regulatory risk, (6) business risk, (7) strategic risk, and (8) reputation risk.

Market risk considers how changes in market prices and rates will result in investment losses. There are four subtypes of market risk: (1) interest rate risk, (2) equity price risk, (3) foreign exchange risk, and (4) commodity price risk.

Commodity price risk refers to the price volatility of commodities (e.g., precious metals, base metals, agricultural products, energy) due to the concentration of specific commodities in the hands of relatively few market participants.

Weak internal controls and lack of segregation of duties would represent a non-financial risk and be best described as an operational risk.

Reputation risk could arise partly due to the existence of the internet. For example, social networking sites and blogs could allow for rumors— true or false— to be spread about an entity very quickly.

The complexity of derivatives pricing means the pricing may not always be as accurate as possible so it will not always reflect all of the relevant risk factors. As a result, in practice, hedging with derivatives may not be a zero-sum game of transferring risk between periods or between participants.

Hedging activities may be extensive enough that they cause management to lose focus on the core business activities of the firm, possibly resulting in lost profits. Hedging often requires very specific skills, knowledge, research, and time, which may not be available within the management team.

As a start, a firm must know its risk and return goals before embarking on a risk management plan.

Mapping risks requires clarification as to which risks are insurable, hedgeable, noninsurable, or nonhedgeable.

Mapping risks could be performed for market risk, credit risk, business risk, and operational risk.

management should be aware of its general exposure to fluctuations in interest rates, foreign exchange rates, equity prices, and commodity prices.

Debtholders would likely be more concerned about minimizing all risks because their upside potential is generally limited to the rate of interest charged. In contrast, shareholders may be willing for the firm to accept a large but unlikely risk in order to increase equity prices.

Foreign currency risk refers to the risk of economic loss due to unfavorable changes in the foreign currency exchange rate; to the extent that there is production and sales activity in the foreign currency pricing risk would exist simultaneously

factors such as time horizon, accounting, and taxation need to be considered within any hedging strategy.

Interest rate risk refers to the risk inherent in a firm’s net exposure to unfavorable interest rate fluctuations.

Many reasons exist for a firm to hedge its risk exposures. Key reasons include lowering the cost of capital, reducing volatility of reported earnings, operational improvements, and potential cost savings over traditional insurance products.

Hedging activities should cover both the firm’s assets and liabilities in order to fully account for the risks.

The use of a fixtures contract to hedge future sales receipts must take into account that sales revenue is recognized only upon completion of transaction, although the futures contract requires periodic marking to market. Therefore, if the futures contract is in a “gain” position at the end of the year, there may be taxes payable prior to the receipt of any sales receipts.

Operational risk could cover activities pertaining to Smith’s input products (i.e., cork) and products exported to foreign countries (i.e., bottles of wine). In addition, there would be pricing risk for both the inputs and outputs. For example, the cost of the cork may have a significant impact on Smith’s ability to conduct business in a competitive manner. Also consider that Smith has sales to customers in foreign countries (with payment in the foreign currency) where there is the risk of the devaluation of the foreign currency in the future. Financial position risk refers to the balance sheet of a firm. Neither the purchases nor the sales impact Smith’s balance sheet.

Exchange-traded instruments cover only certain underlying assets and are quite standardized in order to promote liquidity in the marketplace. As a result, there is less customization with exchange-traded instruments. OTC financial instruments, in exchange for greater customization, are less liquid and more difficult to price compared to exchange-traded instruments. In addition, there is credit risk by either of the counterparties that would generally not exist with exchange-traded instruments.