Introduction to Risk Management
One thing that is guaranteed when it comes to financial markets is the uncertainty that comes with the territory. Desirable returns come with a degree of risk which needs to be managed. This article will explore what risk management is, as well as what approaches are taken to mitigate or hedge risk, before looking at what the future holds for this integral part of finance.
What is Risk Management?
Before looking at what risk management is, it is integral to understand what risk itself is. When making an investment decision, the weigh-up between the expected returns of the investment and the actual returns deviating from what was expected is what ultimately leads to whether an investment is made. The deviation from what was expected is what risk is. As (in most cases) financial professionals look to achieve the maximum return on investments possible, any downward deviations from what was expected would ideally be mitigated. This is where risk management comes in.
Risk management is all about protecting the value of your assets from adverse conditions, situations, and circumstances. Whilst the financial markets can be extremely unpredictable, there are a variety of risks that are viewed as some of the most important to mitigate against. What is done to reduce these risks will be spoken about later, but here is an explanation of some of the most common types of risk.
Interest Rate Risk – This is the risk that changes in the interest rate will lead to changes in the value of assets. For example, given the inverse relationship between bonds and interest rates, increases in the interest rates generally lead to a fall in the price of bonds.
Foreign Exchange Risk – This is risk that arises from changes in exchange rates. Not only is this crucial in Foreign Exchange trading, but also investments made in securities across international boundaries. Changes in the exchange rate can alter the value of investments and thus can impact the actual returns of these investments.
Credit Risk – This is the risk that creditors will fail to meet contractual obligations. Usually, this type of risk is in reference to loans and so is very prevalent in the bond market. An example of this would be an investment into low-grade or ‘junk’ bonds which does not recuperate the full return of the bond contract due to the company folding.
Market Risk – This is a general risk term used to emphasise the uncertainty associated with an investment decision. Consequently, this type of risk includes the risks mentioned previously as well as the risks associated with the condition of the market.
It is important to note here that the risk appetite of individuals is pivotal in understanding risk management and the methods used. Having a low tolerance to losses is likely to mean that managing risk is of paramount importance. Meanwhile, so-called risk-lovers would spend less time focussing on how to mitigate or hedge risk and spend more time finding prospective investments. What this highlights is the subjective nature of risk management, which contributes directly to the approaches made.
What Approaches are Used?
There are a huge variety of approaches, both quantitative and qualitative, used to manage risk. As mentioned previously, the subjectivity involved in the risk management space is likely to influence the techniques used.
On a more quantitative basis, there are many techniques used by investors to both mitigate and hedge their investment decisions. Firstly, statistical models (such as the Value-at-Risk statistic) can be used to estimate the extent of losses on portfolios or investments. The Value-at-Risk financial model estimates the possibility of experiencing losses in a given time period and loss amount (usually given as a percentage).
Statistical models are not the only tool in a risk manager’s toolbox though. The use of financial derivatives to hedge an investment is another popular method. Derivatives (such as options, forward contracts, futures etc.) are financial instruments that have their values derived from underlying financial assets, indicators, or commodities. Through using derivatives, investors can hedge their investment risk by entering into derivative contracts which limit the extent for losses. Let’s say an investor holds 1,000 shares of Company A and does not want to lose the return that they have already accumulated. However, the investor is worried that the shares in Company A will fall in price. The investor therefore decides to purchase put options (derivative contracts giving the investor the option to sell a given security at a given price and time period) to ensure that if the shares do decrease in price as expected, the gains made previously can still be realised.
On a more qualitative basis, an important component of managing risk is the quality and capabilities of the managers making the decisions. The costs of a lack of proficient management when it comes to monitoring risk can be evidenced in the recent losses experienced by Credit Suisse as a result of the collapse of Greensill Capital. Credit Suisse continued to offer Greensill financing despite warnings of the difficulties that the firm was facing. The failure to act prior to Greensill Capital’s collapse is set to cost Credit Suisse shareholders up to $3billion. These issues highlight the need for management who truly understand risk and do not overlook the dire consequences for not acting in the best interests of the company as a whole.
The Future of Risk Management
The abnormality of the past 18 months due to the COVID-19 pandemic has thrusted risk management into the spotlight. There is certainly a spectrum for change, especially with the advancements of technology expected in the space. This change is certainly underway with 22% of banks investing more than 25% of their annual risk budget to digitize risk management. Artificial Intelligence is also a component that is being increasingly incorporated into the risk management space within the financial services industry.
Whilst technology will certainly have a role to play in the upcoming years, the importance of exceptional risk managers cannot be undermined. The risk management failures of Credit Suisse in the past year highlight this need for adept individuals who can recognise and stay clear of reputation-damaging risks.
In conclusion, the importance of risk management within the financial world cannot be undermined. Failure to manage the huge number of risks when making an investment decision puts all stakeholders in a firm in potential jeopardy. With the COVID-19 pandemic as well as recent events highlighting the ever-present need for managing risk, it will be interesting to see how technological change leads to adaptations in the risk management space.