Step 4 develop a risk mitigation strategy ie avoid

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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. In practice, this process is not likely to operate perfectly in the above sequence. Two key problems with the process include identifying the correct risk(s) and finding an efficient method of transferring the risk. One of the challenges in ensuring that risk management will be beneficial to the economy is that risk must be sufficiently dispersed among willing and able participants in the economy. Unfortunately, a notable failure of risk management occurred during the financial crisis between 2007 and 2009 when it was subsequently discovered that risk was too concentrated among too few participants. Another challenge of the risk management process is that it has failed to consistently assist in preventing market disruptions or preventing financial accounting fraud (due to corporate governance failures). For example, the existence of derivative financial instruments greatly facilitates the ability to assume high levels of risk and the tendency of risk managers to follow each other’s actions (e.g., selling risky assets during a market crisis, which disrupts the market by increasing its volatility). In addition, the use of derivatives as complex trading strategies assisted in overstating the financial position (i.e., net assets on balance sheet) of many entities and understating the level of risk assumed by many entities. Even with the best risk management policies in place, using such inaccurate information would not allow the policies to be effective. Finally, risk management may not be effective on an overall economic basis because it only involves risk transferring by one party and risk assumption by another party. It does not result in overall risk elimination. In other words, risk management can be thought of as a zero-sum game in that some “winning” parties will gain at the expense of some “losing” parties. However, if enough parties suffer devastating losses due to an excessive assumption of risk, it could lead to a widespread economic crisis.
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©2015 Kaplan, Inc. Page 3 Topic 1 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 1 Measuring and Managing Risk LO 1.3: Evaluate and apply tools and procedures used to measure and manage risk, including quantitative measures, qualitative assessment, and enterprise risk management. Quantitative Measures Value at risk (VaR) states a certain loss amount and its probability of occurring. For example, a financial institution may have a one-day VaR of $2.5 million at the 95% confidence level. That would be interpreted as having a 5% chance that there will be a loss greater than $2.5 million on any given day. VaR is a useful measure for liquid positions operating under normal market circumstances over a short period of time. It is less useful and potentially dangerous when attempting to measure risk in non-normal circumstances, in illiquid positions, and over a long period of time.
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