[ 2009 FRM Sample Exam ] Operational and Integrated risk management Q3 department, management, regarding, following, procedures

Abey

 

3. Which of the following is an appropriate practice of risk management and control for a financial institution?

A. Senior management participates in active discussions with traders regarding procedures for measuring and managing risk.

B. The year-end bonus of the staff of the risk management department is potentially a large part of the risk manager's annual compensation.

C. The risk management department conducts stress testing on a daily basis and compiles a daily risk report for the assessment of senior management. Moreover, it informs the senior management whenever a limit is exceeded and seeks instructions from senior management when a limit is exceeded.

D. The risk report produced by the risk management department is written in a manner appropriate to the risk manager's academic training.

Abey

 

Correct answer is Afficeffice" />

A is an appropriate practice. Senior management should regularly evaluate the procedures in place to manage risk to ensure that those procedures are appropriate and sound. One of the major sources of information is from the traders because they are the "end-user" of the risk management mechanisms.

B is not an appropriate practice. As a matter of general policy, compensation policies - especially in the risk management, control and senior management functions - should be structured in a way that is sufficiently independent of the performance of trading activities, thereby avoiding the potential incentives for excessive risk-taking that can occur if, for example, salaries are tied too closely to the profitability of derivatives.

C is not an appropriate practice. Stress tests should not be limited to quantitative exercises that compute potential losses or gains. They should also include more qualitative analyses of the actions management might take under particular scenarios. Contingency plans outlining operating procedures and lines of communication, both formal and informal, are important products of such qualitative analyses. This kind of procedures should be drafted during the process of new product/business approval.

D is not an appropriate practice. Management information systems should translate the measured risk for derivatives activities from a technical and quantitative format to one that can be easily read and understood by senior managers and directors, who may not have specialised and technical knowledge of derivatives products. Risk exposures arising from various derivatives products should be reported to senior managers and directors using a common conceptual framework for measuring and limiting risks.