hard · FRM Part 1 Foundations of Risk Management
A bank's risk appetite framework distinguishes between risks it should bear (to earn a return) and risks it should hedge or transfer. Management classifies its core lending franchise as a risk to bear, but treats the resulting interest-rate gap in the banking book as a risk to hedge. A board member objects that this is inconsistent.
Which response best reconciles the policy using the concept of comparative advantage in risk-bearing?
- The objection is valid: any risk arising from a core activity is by definition a risk the bank has a comparative advantage in, so the interest-rate gap should also be borne, not hedged.
- Credit risk on the loans reflects the bank's informational comparative advantage and is compensated, whereas the interest-rate gap is an incidental exposure where the bank has no edge, so hedging it isolates the rewarded risk.
- The policy is backwards: interest-rate risk is more liquid and observable, so the bank has a comparative advantage there, and the illiquid credit risk is what should be transferred.
- Both risks should be hedged, because a risk appetite framework exists to minimize total risk, and bearing any avoidable exposure violates the prudent-banker principle.
Sign up free to see the explanation and track your rank →
More FRM Part 1 Foundations of Risk Management practice
- According to the CAPM, which type of risk are investors compensated for bearing?
- What specific variety of liquidity risk is being described?
- How is 'Risk Capacity' distinguished from 'Risk Appetite' in a standard risk governance fr
- If two portfolios have the same Sharpe ratio but one has positive skewness and the other h
- In a 'Liquidity Spiral', what is the primary channel by which market liquidity risk and fu
- In the context of the CAPM, what is the definition of 'Alpha' (α)?
- In the risk decomposition formula σ^2_i = β^2_i σ^2_M + σ^2_ε, what does σ^2_ε represent?
- The BCBS 239 principle of 'Timeliness' suggests that risk reporting should be more frequen