Financial Risk Assessment Flashcards

A risk architect is comparing two portfolios with the same VaR but different Expected Shortfall (ES). Which portfolio represents higher tail risk?

Answer: The portfolio with the higher ES

ES measures the average loss beyond the VaR threshold; a higher ES means worse expected outcomes in the tail, indicating greater tail risk even when VaR is equal.

In financial risk assessment, what is the purpose of a 'risk-adjusted return on capital' (RAROC) calculation?

Answer: To compare business unit profitability after accounting for the economic capital consumed by their risk-taking

RAROC normalizes returns by the economic capital at risk, enabling fair comparisons of profitability across business units with different risk profiles.

Which qualitative factor is MOST critical when assessing the financial risk of a private company that lacks public market data?

Answer: Management quality and governance practices

For private companies without market-observable data, management quality and governance are critical qualitative factors that proxy for operational and strategic risk.

A risk model produces a VaR estimate of $10M at 99% confidence. Over 250 trading days, how many exceedances would indicate the model is poorly calibrated under Basel backtesting standards?

Answer: More than 4 exceedances (yellow zone threshold)

At 99% confidence over 250 days, the expected exceedances are 2.5; Basel III's traffic-light framework flags models entering the yellow zone at 5+ exceedances, with 4 being the upper green zone boundary.

What is the primary financial risk implication of a company having a high proportion of fixed costs relative to variable costs?

Answer: Higher operating leverage, amplifying earnings volatility during revenue fluctuations

High fixed costs increase operating leverage, causing small revenue changes to produce magnified swings in operating profit, increasing earnings volatility and financial risk.

Which of the following best describes 'concentration risk' in a financial institution's lending portfolio?

Answer: Excessive exposure to a single borrower, sector, or geography that amplifies correlated loss potential

Concentration risk arises when a portfolio has excessive exposure to correlated obligors or segments, so a single adverse event can cause large, simultaneous losses.

A financial institution uses a copula model in credit risk assessment. What is the primary advantage of this approach over simpler correlation assumptions?

Answer: It captures non-linear and tail dependence between credit assets that linear correlation misses

Copula models separate marginal default distributions from their joint dependence structure, capturing tail dependence where correlated defaults cluster during stress — something linear correlation cannot model.