LOS E requires us to:
describe risk budgeting and its role in risk governance
a. Once the risk tolerance is identified and acceptable and non-acceptable risks are defined, it is time for risk budgeting.
b. Risk budgeting is the process of quantifying and allocating tolerable risk to various activities and investments.
c. Like capital budgeting, where the portfolio weights are based on the security return contribution, in risk budgeting, the portfolio weights are based on the security risk contribution.
d. There could be many measures for the risk.
The single-dimensional risk measures are the measures such as the standard deviation, beta, value at risk of the securities or the portfolio. The value at risk of security could be marginal, component-based, incremental, or relative.
The multi-dimensional risk approach, on the other hand, evaluates the risk based on the risk profiles of the underlying classes.