Foundations of Risk Management is one of the four broad topics GARP tests in its FRM Part 1 exam. This broad topic has 20% weight in the exam, which means out of a total of 100 questions asked, you may expect 20 questions from this section. This section focuses on foundational concepts of risk management and how risk management adds value to an organisation. There are eleven chapters or readings in this section. If you go through the GARP-specific learning objectives (LOs) for this section, you will find most of the LOs are non-computational. Thus, this might appear easy. However, be informed that GARP often asks tricky questions on non-computational LOs. Therefore, to score well, non-computational LOs are to be equally emphasised.
Let me now take you through the essence of each of the eleven chapters or readings and identify concepts that GARP might test on exam day.
Chapter 1: The Building Blocks of Risk Management:
Chapter 1 is an introductory reading and covers fundamental risk management concepts. From this reading, GARP often tests candidates on their understanding of the general risk management process and its potential shortcomings, the idea of unexpected loss, the relationship between risk and reward, and the difference between financial and non-financial risks.
Chapter 2: How Do Firms Manage Financial Risk?
As a firm contemplates its risk management process, it needs to specify the internal goal. Furthermore, it needs to understand how much risk it wishes to retain, avoid, mitigate, or transfer. Risk mapping can help a firm recognize and prioritize risks it faces internally. Post risk mapping, mitigation tools should be selected, deployed, and monitored. Risk management should be treated as an iterative process. Once risks are identified, mitigation methods are to be deliberated. Risk managers need to reassess whether the risky business is in alignment with the firm strategically. From this reading, GARP’s favourite testable concepts include:
- Managing risk exposures.
- Hedging risk exposures.
- Foreign currency risk.
- The potential impact of risk management tools.
Chapter 3: The Governance of Risk Management
This reading focuses on corporate governance and includes discussions on the roles of shareholders, senior managers, and the board of directors. From this reading, GARP likes to test candidates on different best practices in corporate governance and risk management and the interdependence of functional units within a firm’s risk management ecosystem. In addition, GARP might test your understanding of the purpose and function of the mainboard committees, such as risk management, compensation, and audit.
Chapter 4: Credit Risk Transfer Mechanisms
This reading covers different means through which banks mitigate and transfer credit risk. On exam day, you might be tested on how credit default swaps (CDSs) and collateralized debt obligations (CDOs) facilitate risk transfer and the role that credit derivatives played in the financial crisis of 2007–2009. Also, don’t get surprised if you find tricky questions on various mechanisms for risk transfer, including marking-to-market, exposure netting, and the collateral process. Be thorough with your understanding of the securitization process and the originate-to-distribute model.
Chapter 5: Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM)
This reading begins with modern portfolio theory, the efficient frontier, and the capital market line. It then discusses the security market line (SML), the calculation of beta, and the capital asset pricing model (CAPM). On exam day, invariably, you will see questions on CAPM calculation. The reading concludes with discussions on some popular risk-adjusted measures of return, such as the Sharpe measure, the Treynor measure, Jensen’s alpha, the information ratio, and the Sortino ratio. If you pay attention, you will find all of these performance measures assess excess return over some form of risk. Therefore, it pays off to get these measures of performance memorized as they are popular testable concepts.
Chapter 6: The Arbitrage Pricing Theory and Multifactor Models of Risk and Return
The relationship between risk and return is one of the most talked-about concepts in finance. The capital asset pricing model (CAPM) states that the expected return on any asset gets determined by its exposure to the market portfolio, and beta is the risk exposure in the CAPM. In contrast, arbitrage pricing theory (APT) states that exposures determine expected returns to multiple factors interconnected to the macroeconomy. Factors betas are the risk exposures in the APT. On exam day, you might be asked to calculate expected returns using single-factor and multifactor models. Also, be at home with the Fama and French three-factor version of a multifactor model. In addition, GARP might test you on how to use a multifactor approach for constructing a hedged portfolio.
Chapter 7: Principles for Effective Data Aggregation and Risk Reporting
This reading is qualitative and explores the Basel Committee’s principles for effective risk data aggregation and risk reporting. Risk data aggregation and reporting are costly, and thus, senior management and the board of directors should devote adequate time and effort to this end. To be effective, risk reporting has to be accurate, comprehensive, clear, and valuable. From this reading, GARP might test your understanding of how data aggregation principles interact with each other.
Chapter 8: Enterprise Risk Management and Future Trends
Enterprise risk management (ERM) is a relatively new concept developed as an alternative to the traditional approach to risk management under which each risk was assessed, managed, and mitigated in silos by a specific unit within the firm. In this reading, you will get familiar with the concept and definitions of ERM, its pros and cons, and the five essential facets of an ERM program. The need for strong risk culture and the factors that hamper a strong risk culture are deliberated in detail. The importance of scenario analysis as a primary risk identification/management technique is emphasized. Also, the role that scenario analysis and stress testing plays in capital planning is discussed. On exam day, you might be tested on your understanding of the transition from a silo-based approach to risk management to an enterprise-wide strategy and the advantages of a holistic, firm-wide approach. Also, GARP likes to test candidates on how ERM relates to scenario analysis/stress testing and ultimately to bank capital planning.
Chapter 9: Learning from Financial Disasters
This reading consists of case studies relating to financial crises. Specifically, these cases relate to past failures brought about by interest rate risk, liquidity risk, model risk, the risk of a rogue trader’s actions, reputation risk, cyber risk, and the risks that stem from financial engineering and corporate governance failures. On exam day, you might get tested on the differences between the risk mitigation options of a static hedge and a dynamic hedge. Also, there could be questions on the causes of the financial disasters discussed in the various cases and how they could have been avoided.
Chapter 10: Anatomy of the Great Financial Crisis of 2007-2009
The financial crisis of 2007 to 2009 was brought about by an intricate mix of poor lending practices, easy access to credit, extravagant housing prices, and an interconnected banking and global financial system. From this reading, GARP might test your understanding of the background leading up to the financial crisis and the main factors that caused it. Also, there could be questions on how short-term funding by financial institutions led to an increase in systemic risk and how the regulators responded to the crisis.
Chapter 11: GARP Code of Conduct
This reading covers the GARP Code of Conduct which talks about the principles relating to ethical behaviour within the risk management profession. FRM candidates are expected to know all member responsibilities and sanctions that could be imposed if the Code is violated. The material in this reading appears to be relatively easy to understand; however, tricky questions on ethical standards are often asked in the exam.