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Risk Management

Risk ManagementThe world of finance is always subject to risks and thus losses. Risk management strategies are aimed at the prevention and mitigation of such risks.

What Is Risk Management?

It is the process of making decisions aimed at reducing the likelihood of a negative outcome and

minimizing potential losses. In the modern economy, the purpose of risk management is to increase the competitiveness of economic entities by protecting against the net risks.

The History of Risk Management Theory

The RM theory is based on three basic concepts: utility, regression, and diversification.

In 1738, the Swiss mathematician Daniel Bernoulli supplemented the probability theory with the

method of utility or attractiveness of one or another outcome of events. Bernoulli's idea was that during the decision-making process, people pay more attention to the size of the consequences of different outcomes rather than their probabilities.

At the end of the 19th century, the British researcher F. Galton proposed to consider regression or return to the mean value a universal statistical regularity. He interpreted the essence of the regression as the return of phenomena to the norm over time. Subsequently, it was proved that the regression rule operates in a variety of situations, starting with gambling and calculating the probability of accidents, and ending with the prediction of fluctuations in business cycles.

In 1952, Harry Markowitz, a graduate student at the University of Chicago, mathematically substantiated the strategy of investment portfolio diversification in his article "Portfolio Selection". Specifically, he showed how to minimize the deviations of return from an expected figure by means of a thoughtful distribution of investments. In 1990, Harry Markowitz was awarded the Nobel Prize for the development of the theory and practice of the stock assets portfolio optimization.

According to alternative views on the history of the emergence and development of RM, the term itself first appeared about 50 years ago to describe the efficiency of insurance acquisition.

Risk Management Stages

There are several key stages in RM:

  1. Identifying the risk and estimating its likelihood as well as the scale of the consequences. Determining the maximum possible loss.

  2. Selection of methods and tools for managing the identified risks. This is the most important stage.

  3. Development of a risk strategy to reduce the likelihood of a risk occurring and minimizing possible negative consequences.

  4. Implementation of the risk strategy.

  5. Evaluation of the achieved results and adjustment of the risk strategy.

Risk Management Methods and Tools

The basic RM methods are rejection, reduction, transfer, and acceptance. The RM tools are much wider. They include political, organizational, legal, economic, and social tools. As a system, RM allows the combination of several methods and tools. The most commonly used RM tool is insurance. It involves the transfer of responsibility to compensate for the alleged damage to a third party (insurance company).

Examples of other tools include:

  • refraining from excessively risky activities (rejection);

  • prevention or diversification (reduction);

  • outsourcing the costly risk functions (transfer);

  • formation of reserves (acceptance).

Risk Management in Finance

Financial risks are an integral part of all business activities in the market. The most common types of FR are:

  • Credit. This type of FR relates to a loss as a result of the borrower's failure to repay a loan or meet contractual obligations. Because of that, an investor may not receive the owed principal and interest (reward for assuming the credit risk), which leads to the growth of collection costs and the interruption of cash flows. Credit RM can reduce these losses.

  • Foreign exchange. As long as a business is dealing with a foreign company, it is always exposed to foreign exchange (FX) risk because one currency can be stronger than the other. Commodity prices, inflation, interest rates, and exchange rates can cause FX risk. It is impossible to completely avoid it but at least hedging can help minimize it.

  • Interest rate. This type of risk results from the change in market rates. It can affect the financial position of a bank and create disadvantageous financial results.

  • Liquidity. It is an impossibility to trade a given asset quickly enough to make the required profit or prevent a loss.

How Investors Measure Risk

Investors use a variety of risk measurement methods.

Standard Deviation

The most common risk measure for investors is the standard deviation, a statistical measure of

dispersion around a central tendency. It involves finding the average standard deviation of the average return of investment during the same time period. According to normal distributions (the bell-shaped curve), the expected ROI is likely to be:

  • one standard deviation from the average 67% of the time,

  • two standard deviations from the average 95% of the time.

Investors use this method to decide if they can afford the assumed loss.

For example, during the 15 years from August 1, 1992, to July 31, 2007, the average total return of the S&P 500 was 10.7%. The average standard deviation of the S&P 500 for the same period was 13.5%. This is the difference between the average return and the actual return over 15 years.

According to the bell-shaped curve model, any given outcome should be within one standard deviation of the average about 67% of the time and within two standard deviations about 95% of the time. Thus, an S&P 500 investor can expect the return at any given point during this period to be 10.7% plus or minus the standard deviation of 13.5% about 67% of the time. They may also assume a 27% (two standard deviations) increase or decrease 95% of the time. If they can afford this loss, they make an investment.

Value at Risk

Investors often want to know not just the degree of an asset's deviation from its expected outcome, but also how bad a loss on investment could be with a given level of confidence over a specific period. Value at risk (VAR) can answer this question. The following statement can be an example of VAR: "With about a 95% level of confidence, the maximum loss on this $2,000 investment over 2 years is $500".

Drawdown

This RM method refers to any period during which an asset's return is negative as compared with a previous high mark. When measuring the drawdown, the following criteria are considered:

  • the degree of each negative period (how bad),

  • the duration (how long),

  • the frequency (how often).

Strategies for Traders

Traders typically use the following RM strategies:

  • The 1% rule. According to this rule, a trader should never put more than one percent of their capital or trading account into a single trade. So, if the trader has $15,000 in their trading account, they should put no more than $150.

  • Stop-loss. This is the price at which a trader will sell a stock and take a loss on the trade. It often happens when a trade does not meet the trader's expectations.

  • Take-profit. This is the price at which a trader will sell a stock and take a profit on the trade.

  • Expected return calculation. The stop-loss and take-profit points can be used to calculate the expected return according to this formula:

[(Probability of Profit) x (Take Profit % Profit)] + [(Probability of Loss) x (Stop-Loss % Loss)]

  • Diversification. This refers to including different kinds of assets in the investment portfolio. As a result, the positive performance of one type of assets can mitigate the negative performance of other assets.

  • Hedging. It is an investment made to reduce the chance of risky price movements in an asset, which typically involves taking an offsetting position in relevant security. Hedging can be compared with an insurance policy for assets.

Summary

Risk management is a set of measures aimed at the evaluation and mitigation of possible negative outcomes (risks). In finance, investors typically measure risk with the help of standard deviation, value at risk, and drawdown. Traders also use the following RM strategies: the one percent rule, stop-loss/take-profit, expected return calculation, diversification, and hedging.