Risk Measurement and Portfolio Construction

FE-535 opens by separating the risk-management process from a single risk number: identify exposures, measure them, evaluate the result, and decide how the portfolio should be constructed. The notes distinguish market, credit, liquidity, operational, and model risk because each fails in a different way.

Portfolio construction starts with the joint behavior of returns. Expected return, variance, and covariance determine how a position contributes to the whole portfolio. Diversification reduces idiosyncratic risk only when the exposures are not perfectly aligned; it cannot remove a common market shock.

The class frames risk measurement as a decision tool. A statistic is useful only if its assumptions, horizon, liquidity, and tail behavior match the decision it is meant to support.