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FRM Part I · FRM Exam Part I · The Governance of Risk Management

Which of the following best distinguishes risk appetite from risk capacity in a firm's governance framework?

Risk appetite is the amount of risk the board chooses to accept to pursue its strategy, and it should be set within risk capacity, which is the maximum risk the firm can bear given capital, liquidity and regulatory constraints. The two are distinct, with appetite below capacity.

  1. ARisk appetite is the maximum risk the firm can bear before breaching constraints, while risk capacity is the level the board chooses to accept
  2. BRisk appetite is the level of risk the board chooses to accept in pursuit of strategy, and it should sit within risk capacity, the maximum the firm can bearCorrect
  3. CRisk appetite applies only to market risk, while risk capacity applies only to credit risk
  4. DRisk appetite and risk capacity are identical terms and should be set at the same level

Explanation

Risk capacity is the maximum risk the firm can absorb given capital, liquidity and regulatory constraints. Risk appetite is the amount the board chooses to take, and should be set below capacity to leave a buffer. The first option reverses the definitions.

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