Risk Budgeting

Risk budgeting focuses on the implementation of the risk tolerance decisions approved by the management at the strategic or governance level. The risk budget will quantify risk by specific metrics and allocate risk across the organization.

Risk Dimensions

A risk budget may be complex and multi-dimensional or make use of simple risk measures. The single-dimensional risk measures most commonly used in portfolio management are:

• standard deviation;
• beta;
• value at risk (VAR); and
• scenario loss.

A multi-dimensional approach consists of layers of the risk budget. For example, factor analysis may be performed to determine the risk premiums to various factors. The factor exposure may then have a strategic overlay, ensuring the overall equity risk, as measured by beta, is within a particular tolerance level.

Benefits of Risk Budgeting

By implementing a risk budget, a risk culture is created in which all decisions are evaluated with a risk-return tradeoff in mind. Management, therefore, focuses on adding value to the overall enterprise when making decisions and simultaneously remaining within the desired risk tolerance level.

Question

Which statement best describes the role of risk budgeting?

A. The risk budget quantifies risks and allocates risk across the organization based on the risk tolerance level

B. Management should try and “beat” their risk budget to ensure maximum value creation

C. The risk budget allows the governing body to determine the level of risk tolerance

Solution

The correct answer is A.

The governing body sets the risk tolerance at the governance or strategic level. This tolerance is implemented through the risk budgeting process which allows management to quantify and allocate risk within the overall risk tolerance.