Set out ways to change a portfolio's exposure to risk
The idea
Four responses are available once a risk is identified. It can be avoided, by not undertaking the activity — appropriate where the exposure is uncompensated or outside competence. It can be accepted and retained, with capital held against it, which is right for risks the organisation is paid to bear. It can be transferred, through insurance or by passing it to a third party. Or it can be shifted, using derivatives to change the shape of the payoff distribution. Choosing between them turns on cost and on whether the organisation has comparative advantage in bearing the risk.
A practice question
Which response to risk involves not undertaking the activity at all?
- Risk transferWhy not: The activity proceeds and its risk is passed to another party, typically an insurer.
- Risk avoidance — correct
- Risk retentionWhy not: The activity proceeds and the risk is kept, with capital held against it.
Avoidance removes the exposure by declining the activity, which is the right answer where the risk is uncompensated or falls outside the firm's competence.
A harder one
A firm buys an option rather than an insurance policy. Which response has it chosen?
- Transfer, since a counterparty now bears the riskWhy not: A counterparty is involved in both, but transfer denotes an insurance-type arrangement; an option reshapes the payoff distribution.
- Avoidance, since the exposure is removedWhy not: The underlying exposure remains; only its distribution of outcomes has changed.
- Shifting, which reshapes the payoff — correct
An option reshapes the distribution rather than passing the risk to a third party. One response moves the exposure elsewhere; the other reshapes it while keeping it.
The hardest tier
Which risks should an organisation retain rather than hedge?
- All risks, since hedging always costs more than it savesWhy not: Too sweeping. Hedging an exposure the firm has no advantage in bearing is often worth its cost.
- Only risks that are too small to measureWhy not: Size is not the criterion; a large risk the firm is paid to bear is exactly the kind to retain.
- Risks it is paid to bear and understands — correct
Hedging a risk the firm has comparative advantage in managing removes the source of return. A bank that hedges away all credit risk has no business; the framework exists to distinguish the risks that constitute the business from the incidental ones that should be laid off.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →