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CFA Level I · CFA Level I Exam · Introduction to Risk Management

A firm's risk management committee reviews a proposed trading strategy. The strategy has an expected return above the hurdle, but its estimated worst-case loss would exceed the board's stated risk budget for the desk. The most appropriate action under a sound risk governance framework is to:

The committee should reduce the position size or modify the strategy so the potential loss fits within the desk's risk budget. Risk budgets reflect the board's risk tolerance and should constrain strategies. Approving on expected return alone, or raising the budget to fit the strategy, would undermine risk governance.

  1. Aapprove the strategy because the expected return exceeds the hurdle
  2. Breduce the position size or modify the strategy so the potential loss fits within the risk budgetCorrect
  3. Craise the risk budget to match the strategy's worst-case loss

Explanation

A risk budget allocates the risk the organization is willing to take, derived from its risk tolerance. A strategy should be adjusted to fit the budget rather than the budget being changed to fit the strategy. Approving on return alone ignores risk limits, and raising the budget undermines governance.

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