Risk Management L2

Section: Risk Management — Level 2 Estimated study time: 60 minutes Content: Risk management at CFA Level 2 extends beyond identifying risk types to measuring, monitoring, and managing them quantitatively. The primary risk metrics are Value at Risk (VaR), Expected Shortfall (CVaR), scenario analysis, and stress testing. Risk management frameworks distinguish between market risk (losses from changes in market prices), credit risk (losses from counterparty default), liquidity risk (inability to exit positions at fair value), operational risk (failures of people, processes, and systems), and model risk (reliance on models with incorrect assumptions). At Level 2, the focus is on how these risks interact, their measurement methodologies, and how derivatives and other instruments are used to modify the portfolio's risk profile. Value at Risk (VaR) is the most widely used market risk measure. VaR(X%, T) represents the maximum loss expected over holding period T at confidence level X%. For example, a 1-day 99% VaR of $1M means there is a 1% probability that the portfolio will lose more than $1M in a single day. Three estimation methods are used: (1) Historical simulation — using actual historical return data (past N days) to construct the empirical loss distribution; no distributional assumption required, captures fat tails and correlations implicitly, but limited by the historical sample. (2) Parametric (analytical) VaR — assumes returns are normally distributed: VaR = mu - z*sigma, where z is the appropriate z-score (2.326 for 99%, 1.645 for 95%); computationally efficient but understates tail risk. (3) Monte Carlo simulation — generates a large number of random scenarios based on modeled factor distributions and correlations; flexible but computationally intensive. Expected Shortfall (CVaR, Conditional Value at Risk) addresses VaR's principal limitation…