LO 69.3: Describe risk budgeting and the role of quantitative methods in risk budgeting.
The risk budget quantifies the risk plan. There needs to be a structured budgeting process to allocate risk capital to meet the entitys objectives and minimize deviations from the plan. Each specific allocation from the risk budget comes with a reasonable return expectation. The return expectation comes with an estimate of variability around that expectation.
With risk budgets, an amount of VaR could be calculated for each item on the income statement. This allows RORC to be calculated individually and in aggregate.
Quantitative methods (i.e., mathematical modeling) may be used in risk budgeting as follows: 1. Set the minimum acceptable levels of RORC and ROE over various time periods. This is to determine if there is sufficient compensation for the risks taken (i.e., risk-adjusted profitability).
2 . Apply mean-variance optimization (or other quantitative methods) to determine the
weights for each asset class.
3. Simulate the portfolio performance based on the weights and for several time periods.
Apply sensitivity analysis to the performance by considering changes in estimates of returns and covariances.
Ris k M o n it o r in g