Economic capital refers to holding sufficient liquid

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Economic capital refers to holding sufficient liquid reserves to cover a potential loss. Scenario analysis takes into account potential risk factors with uncertainties that are often non-quantifiable. Stress testing is a form of scenario analysis that examines a financial outcome based on a given “stress” on the entity. Enterprise risk management takes an integrative approach to risk management within an entire entity, dispensing of the traditional approach of independently managing risk within each department or division of an entity. LO 1.4 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. Unexpected loss considers how much an entity could lose usually outside of the normal course of business. Compared to expected loss, it is generally more difficult to predict, compute, and provide for in advance because of the uncertainty involved.
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Page 12 ©2015 Kaplan, Inc. Topic 1 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 1 LO 1.5 There is a trade-off between risk and reward. In very general and simplified terms, the greater the risk taken, the greater the potential reward. However, one must consider the variability of the potential reward. The portion of the variability that is measurable as a probability function could be thought of as risk whereas the portion that is not measurable could be thought of as uncertainty. LO 1.6 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. Credit risk refers to a loss suffered by a party whereby the counterparty fails to meet its financial obligations to the party under the contract. Credit risk may also arise if there is an increasing risk of default by the counterparty throughout the duration of the contract. There are four subtypes of credit risk: (1) default risk, (2) bankruptcy risk, (3) downgrade risk, and (4) settlement risk. Liquidity risk is subdivided into two parts: (1) funding liquidity risk and (2) trading liquidity risk. Funding liquidity risk occurs when an entity is unable to pay down or refinance its debt, satisfy any cash obligations to counterparties, or fund any capital withdrawals. Trading liquidity risk occurs when an entity is unable to buy or sell a security at the market price due to a temporary inability to find a counterparty to transact on the other side of the trade. Operational risk considers a wide range of non-financial problems such as inadequate computer systems, insufficient internal controls, incompetent management, fraud, human error, and natural disasters.
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