Economic Risk Services Flashcards

Question 1

What is the difference between risk and uncertainty in economic analysis?

Accepted Answer

Risk describes situations where the possible outcomes are known and each has an estimable probability. Uncertainty describes situations where outcomes or their probabilities cannot be reliably measured. This distinction explains why some exposures can be priced or insured, while others require judgment, scenario planning, and flexible decisions.

Question 2

What is economic risk exposure, and how does it differ from the risk event itself?

Accepted Answer

Economic risk exposure is the degree to which a person, firm, or institution could lose value from an economic change. The risk event is the change itself, such as a price drop. Exposure measures what is at stake, so the same event can cause very different losses for different parties.

Question 3

Why do economists distinguish systematic risk from idiosyncratic risk?

Accepted Answer

Systematic risk affects many assets or markets at once, such as recessions or broad interest rate shifts, and cannot be fully removed by diversification. Idiosyncratic risk is specific to one firm or asset, such as a product recall or a management failure. Diversifying across many holdings can substantially reduce idiosyncratic risk.

Question 4

Why does the time horizon matter when measuring economic risk?

Accepted Answer

The time horizon is the period over which a risk is assessed, such as one day, one quarter, or several years. Longer horizons allow more opportunity for prices, rates, and borrower conditions to move, so the same exposure can look riskier over time. Analysts must match the horizon to the decisions being made.

Question 5

What is expected loss, and how is it typically calculated?

Accepted Answer

Expected loss is the average loss an institution anticipates over a given period, based on probabilities of outcomes. A common formulation multiplies probability of default, exposure at default, and loss given default. Expected loss is a planning figure, distinct from unexpected loss, which captures variability around that average.

Question 6

How does risk tolerance differ from risk capacity?

Accepted Answer

Risk tolerance is the willingness of a person or organization to accept variability. Risk capacity is the objective ability to absorb losses without jeopardizing essential obligations, such as liquidity needs or solvency requirements. A sound plan respects the lower of the two, since willingness cannot support losses the balance sheet cannot bear.

Question 7

What is a risk appetite statement, and who typically approves it?

Accepted Answer

A risk appetite statement is a formal description of the amount and types of risk an organization is willing to pursue to achieve its objectives. It usually sets quantitative limits and qualitative boundaries that guide daily decisions. Boards of directors typically approve it, and management is responsible for operating within it.

Question 8

What is a risk factor, and why is identifying it a first step?

Accepted Answer

A risk factor is an underlying variable that drives changes in the value of exposures, such as interest rates, commodity prices, exchange rates, or unemployment. Identifying factors comes first because it reveals which external forces matter for modeling. Without that mapping, measurement tools produce numbers with little meaning.

Question 9

What is market risk, and which types of prices does it usually cover?

Accepted Answer

Market risk is the possibility of losses from movements in market prices. It usually covers interest rates, exchange rates, equity prices, and commodity prices, along with the volatility and correlations that link them. Market risk affects traded positions and can change in value quickly, even when a borrower is still paying.

Question 10

What is interest rate risk, and how can rising rates affect a bond's price?

Accepted Answer

Interest rate risk is the exposure to losses in value caused by changes in market interest rates. When rates rise, the present value of fixed payments falls, so existing bond prices typically decline. Longer maturities and lower coupons generally make bond prices more sensitive to rate changes.

Question 11

How does foreign exchange risk arise for a company that sells goods abroad?

Accepted Answer

Foreign exchange risk arises when a company receives payments or incurs costs in a currency other than its reporting currency. If the foreign currency weakens before payment is converted, the amount received in home currency falls. Exporters often use forward contracts to lock in rates and stabilize expected cash flows.

Question 12

What is commodity price risk, and which industries commonly face it?

Accepted Answer

Commodity price risk is the exposure to losses or cost increases caused by changes in prices of raw materials or energy products. Airlines face fuel price risk, food manufacturers face grain and dairy price risk, and mining firms face metal price risk. Producers and buyers may use futures or swaps to reduce uncertainty.

Question 13

What is basis risk in hedging, and why can it persist after a hedge is placed?

Accepted Answer

Basis risk is the danger that the price of a hedging instrument does not move in step with the price of the exposure being hedged. It arises when the hedge and the underlying asset differ in location, grade, delivery date, or product specification. This mismatch means hedges rarely offset risk perfectly.

Question 14

How does a forward contract differ from an option in managing price risk?

Accepted Answer

A forward contract obligates both parties to trade an asset at an agreed price on a future date, locking in that price. An option gives the holder the right, but not the obligation, to trade at a set price, which limits downside while preserving upside. Options require an upfront premium, while forwards do not.

Question 15

What is a hedge ratio, and why might a firm choose a ratio below one?

Accepted Answer

A hedge ratio is the size of a hedge relative to the exposure it protects. A ratio of one fully matches the exposure, while a smaller ratio leaves part of the risk unhedged. A firm might choose a lower ratio to reduce hedging costs or retain some benefit from favorable moves.

Question 16

Why do traders monitor the Greeks, such as delta, when managing option portfolios?

Accepted Answer

Greeks are sensitivity measures that show how an option's value responds to changes in underlying factors. Delta measures sensitivity to the price of the underlying asset, while other measures address volatility, time decay, and interest rates. Monitoring them helps traders understand and adjust exposures across a portfolio of options.

Question 17

What is credit risk, and what does default mean in that context?

Accepted Answer

Credit risk is the possibility that a borrower or counterparty fails to meet contractual obligations, causing the lender or creditor to lose money. Default generally means failing to make a required payment of interest or principal on the agreed schedule. Downgrades can also cause losses before any default occurs.

Question 18

What is counterparty risk, and how does it differ from general credit risk?

Accepted Answer

Counterparty risk is the danger that the other party to a financial contract fails to perform before settlement. It often arises in derivatives, repurchase agreements, and trade transactions, where exposure may change as market prices move. General credit risk often refers to loans with a fixed exposure, while counterparty exposure can grow or shrink.

Question 19

What role does collateral play in reducing credit exposure?

Accepted Answer

Collateral is an asset pledged to secure an obligation, giving the lender a claim on it if the borrower defaults. By reducing the amount that would be lost after recovery, collateral lowers loss given default. Common examples include real estate, securities, and cash, with haircuts applied to reflect possible price declines.

Question 20

What is a credit rating, and what does a downgrade signal to investors?

Accepted Answer

A credit rating is an opinion, issued by a rating agency, about the creditworthiness of a borrower or debt instrument. Ratings are expressed as letter grades that rank the relative likelihood of default. A downgrade signals that the agency sees higher credit risk, which can raise borrowing costs and prompt investors to sell.

Question 21

What is a credit spread, and what might a widening spread indicate?

Accepted Answer

A credit spread is the difference in yield between a corporate or other risky bond and a comparable government bond. The spread compensates investors for default risk, liquidity risk, and other factors. A widening spread often indicates that investors demand more compensation for credit risk, which may reflect deteriorating economic conditions.

Question 22

How do banks use loan covenants to manage credit risk over the life of a loan?

Accepted Answer

Loan covenants are conditions written into loan agreements that require the borrower to maintain certain financial ratios, reporting standards, or actions. Covenants give lenders early warning when a borrower's condition weakens, allowing renegotiation before losses grow. Breaching a covenant can trigger default provisions, higher pricing, or additional collateral requirements.

Question 23

What is loss given default, and why does it vary across loans?

Accepted Answer

Loss given default is the share of an exposure that a lender expects to lose if a borrower defaults, after recoveries. It varies because recovery depends on seniority, collateral quality, legal jurisdiction, and the value of the assets available when the borrower fails. Two loans with identical default probabilities can carry different expected losses.

Question 24

How does a bank use a credit scoring model when deciding on a loan application?

Accepted Answer

A credit scoring model converts applicant information, such as payment history, debt levels, income, and length of credit history, into a score. The score estimates the likelihood that the applicant will default within a given period. Lenders compare the score against their underwriting criteria to decide whether to approve, decline, or price the loan.

Question 25

What does Value at Risk measure, and what inputs does it require?

Accepted Answer

Value at Risk estimates a loss threshold that a portfolio should exceed only with a small, stated probability over a specified horizon. Its main inputs are the portfolio composition, the distribution or volatility assumptions for risk factors, the correlations among them, and the chosen confidence level and time horizon.

Question 26

What is standard deviation, and why is it used as a basic risk measure?

Accepted Answer

Standard deviation measures how widely a set of returns or outcomes spreads around their average. A higher value indicates greater variability and therefore greater uncertainty about future results. It is popular because it is easy to compute and expressed in the same units as the data.

Question 27

What is volatility, and how is it commonly annualized?

Accepted Answer

Volatility is the standard deviation of returns, usually measured for an asset or portfolio over a given interval. Analysts commonly annualize daily volatility by multiplying by the square root of the number of trading days in a year. This scaling assumes returns are independent over time, an assumption that does not always hold.

Question 28

What is correlation, and why does it matter for portfolio risk?

Accepted Answer

Correlation measures the tendency of two variables to move together, with values ranging from negative one to positive one. In a portfolio, lower correlations between holdings generally reduce total risk, because losses in one position may be offset by gains or smaller losses in another. Correlations often rise during market stress, weakening diversification.

Question 29

How does stress testing complement traditional statistical risk measures?

Accepted Answer

Stress testing evaluates how a portfolio or institution would perform under severe but plausible scenarios, such as a sharp recession. Unlike statistical measures that rely on recent or historical patterns, stress tests can capture events that have rarely or never been observed. Results help management judge whether capital and liquidity buffers are adequate.

Question 30

What is a backtest, and what does it reveal about a risk model?

Accepted Answer

A backtest compares a risk model's past predictions with the losses that actually occurred over a historical period. For example, if a model claims a one percent daily loss threshold, the number of days exceeding it should roughly match that frequency. Backtesting reveals whether a model is well calibrated, underestimating risk, or too conservative.

Question 31

Why is model risk considered a separate source of risk in financial institutions?

Accepted Answer

Model risk is the possibility that decisions based on a model are wrong because of errors in design, incorrect assumptions, flawed data, or misuse. Models simplify reality, so their outputs can look precise while missing important features. Because many decisions rely on models, model failures can cause losses even when market conditions are ordinary.

Question 32

How do analysts use scenario analysis when data for historical modeling is limited?

Accepted Answer

Scenario analysis builds a small set of coherent hypothetical situations, each with a narrative and linked assumptions about key variables. Analysts then estimate how exposures would change in each case. This approach is useful when past data is sparse, structural change is likely, or outcomes depend on rare events that statistical models cannot estimate.

Question 33

What are the main ways an organization can respond to an identified risk?

Accepted Answer

Organizations can avoid a risk by not undertaking the activity, reduce it through controls or diversification, transfer it through insurance or contracts, or accept it deliberately when the expected return justifies the exposure. Most plans combine several responses, matched to the size and likelihood of each risk.

Question 34

What is a risk register, and what information should it contain?

Accepted Answer

A risk register is a living record of identified risks within an organization or project. Each entry typically includes a description, the affected objectives, likelihood and impact ratings, current controls, an owner, and planned responses. Regular review keeps the register current as conditions and priorities change.

Question 35

How do hedging policies differ from speculative trading in a corporate treasury?

Accepted Answer

Hedging policies aim to reduce exposures that arise from ordinary business activities, such as currency receipts or fuel purchases. Speculative trading seeks profit from anticipated price moves and adds exposure rather than removing it. Sound treasury governance defines permitted instruments, limits, approval levels, and reporting so that hedging stays separate from speculation.

Question 36

What is an enterprise risk management framework, and what is its purpose?

Accepted Answer

An enterprise risk management framework is an integrated set of policies, processes, roles, and tools for identifying, assessing, and managing risks across an entire organization. Its purpose is to connect risk decisions with strategy and performance. Frameworks typically cover governance, identification, measurement, response, and monitoring.

Question 37

Why is risk governance important, and who has responsibility for it?

Accepted Answer

Risk governance sets clear accountability for how risks are taken, monitored, and escalated across an organization. Boards oversee risk appetite and major exposures, executive management implements policies and controls, and internal audit provides independent assurance. Clear roles prevent gaps in oversight and help decision makers act before problems grow.

Question 38

How can insurance serve as a risk transfer tool, and what are its limits?

Accepted Answer

Insurance transfers the financial consequences of specified losses to an insurer in exchange for premiums. It protects against events that are random, insurable, and not under the insured's direct control. Insurance has limits, including exclusions, deductibles, policy caps, and the risk that the insurer cannot pay, so it does not remove the underlying exposure.

Question 39

What is a key risk indicator, and how does it support early action?

Accepted Answer

A key risk indicator is a measurable metric that signals a rising likelihood or impact of a particular risk. Examples include the share of overdue receivables, rising credit spreads, or growing inventory levels. Tracking these indicators against thresholds lets managers act early, before a problem becomes a loss.

Question 40

Why should organizations test and review their risk responses over time?

Accepted Answer

Risk conditions change as markets, technology, regulations, and internal operations evolve, so a response that worked previously may become inadequate. Regular testing and review confirm that controls operate as designed and that residual risk remains within appetite. Lessons from incidents and near misses should feed back into the framework to strengthen future decisions.

Economic Risk Services Flashcards

1Foundations of Economic Risk

2Market and Price Risk

3Credit and Counterparty Risk

4Risk Measurement and Modeling

5Risk Management Strategies and Practice

Learning Resources