Risk budgeting is focused on implementing the risk tolerance decisions taken at a strategic or governance level with the day-to-day management decision making. The risk budget will quantify risk by specific metrics and allocate risk across the organization.
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
- Value at Risk (VAR)
- Scenario loss
A multi-dimensional approach consists of layers of 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 is, therefore, focused on adding value to the overall enterprise when taking decisions while simultaneously remaining within the desired risk tolerance level.
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
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
The correct answer is A.
The governing body sets the risk tolerance at the governance or strategic level, and this tolerance is implemented through the risk budgeting process which allows management to quantify and allocates risk within the overall risk tolerance.
Reading 55 LOS 55e:
Describe risk budgeting and its role in risk governance