Risk and uncertainty are a part of business, whether in finance or any other organizational domain. When it comes to financial matters, however, the stakes are much higher, making financial risk management a crucial activity. This criticality gets magnified when organizations deal with clients' finances, like in the case of investment and portfolio management firms.
To successfully manage risk, one needs to be able first to measure risk, and this article will cover the different ways an organization can measure risk, specifically in finance. Risk management is identifying, analyzing, and mitigating uncertainty in financial decisions. It especially involves mitigating uncertainty that could lead to financial losses.
Risk measurement is an attempt to quantify the potential losses of an investment so that its impact can be measured, and the event can be avoided (or its impact can be subdued). Measuring risk helps financial institutions manage investments and set proactive portfolio risk measures. Risk measurement and management strategies have evolved over the years.
What started with assumptions and intuitive estimates has grown into a science, with statistics and projections helping analysts determine to a fairly certain extent how probable the occurrence of risk is and how much damage it can cause. Today, risk measurement (and consequently, management) is an activity that is executed during almost every financial step - when an institution is looking to approve a loan, when an investor is looking to invest in a venture when handling asset portfolio management, and so on.
How Important is Risk Management?
History is rife with stories of businesses and economies collapsing due to a lack of thorough risk measurement in finance. The subprime mortgage crisis that occurred in the United States in 2007 is probably one of the most potent examples of the consequences of poor risk assessment.
The subprime mortgage crisis was a financial crisis that occurred in the US between 2007 and 2010. It not only led to a recession in the United States but also played a major role in the 2007 - 2008 Global Financial Crisis (GFC).
The crisis began with financial lenders offering attractive loans with extremely low-interest rates to potential home buyers during the housing boom (a period when many people in the US began buying houses). Over time, the interest rate increased, and property value dropped as the housing bubble burst.
This resulted in a huge number of people being unable to pay their mortgages and a rise in mortgage delinquency. This ultimately led to a recession and a major deflation of the US economy. A failure to assess the risk in offering low-interest rate loans while builders were churning out properties led to over-selling until the housing bubble burst. This lesson elucidates the importance of measuring potential risks, especially in financial activities like asset portfolio management.
Of course, neglecting risk at an organizational level might not lead to a global economic shutdown. However, within the organization's boundaries, the impact is still significant enough to cause massive financial losses. Therefore risk measurement and management are extremely vital when dealing with any financial asset, whether it is stock market portfolio management or investments.
Types of Financial Risk
Before getting into the different ways of calculating financial risk, it's important to understand the general types of financial risks.
- Market risk: The risk that arises from the changing business landscape. For a stockbroker, economic changes, political issues that impact the stock market, and so on are considered market risks.
- Credit risk: This is the risk that arises when a company lends credit to a client. The longer the client takes to return the credit and the larger the amount, the larger the risk.
- Liquidity risk: This is the inability of an organization to liquidate its assets for cash when the need arises quickly.
- Operational risk: The risk arising from within the organization, like system breakdowns, bad operational processes, high attrition rate, and so on.
- Currency risk: This is the risk of a change in the exchange rate between the operating and transactional currency. This is more relevant to organizations dealing with international clients.
Measuring Financial Risk
Risk, in simple words, can be defined as the deviation from a desired and expected outcome, and deviation can be measured using mathematics.
Most risk measurement strategies involve measuring the probability and the impact of a deviation from a standard outcome. Here are a few commonly used risk measurement strategies, examples, and implications.
Standard Deviation is one of the most common ways of measuring risk in finance. It is a method where the deviation of data in comparison to the mean value of the entire dataset is measured.
The first step in calculating Standard Deviation is calculating the dataset's mean or average value. The dataset is then studied to measure how much the extremes vary from the mean or the expected average. The larger the deviation, the larger the risk involved and the higher the investment volatility.
For example, consider a stock with a mean value of $100, a Standard Deviation of $10, and a certainty value of 95 per cent. This data project has a 95 per cent chance of the stock's price varies between $90 and $110 at the next closing. There is, however, a 5 per cent chance of the stock's price falling below $90 or rising above $110.
The risk analysis team can now compare this with other stocks to find the least risky one to invest in. This helps manage investments and mitigate portfolio risks.
Range analysis is another simple way of measuring the risk involved in a financial endeavor.
This method considers the range of possible outcomes for a financial asset (or activity). The difference between the highest and lowest value in the range is considered the width of the range. The larger the width, the risker the investment, as there are many possible outcomes with a wide range.
For example, there could be a mutual fund that offers returns of 10 per cent to 20 per cent (range is 20 - 10 = 10) and a certificate that offers returns of 5 per cent to 50 per cent (range is 50 - 5 = 45). Although the certificate offers a chance at more returns, it also has a higher risk value (since the range is larger).
The risk analysis team can use this (along with other metrics) to assess better investment and use this data for financial investment and risk management.
Standard Deviation and Range Analysis are methods of risk management that depend on the extremes (the lowest and highest value); theoretically, this range can be as large as infinite. Also, most financial assets do not oscillate from the minimum to maximum value but rather shift between a narrower range.
While they are both quite useful methods, a more realistic one is measuring risk using the historical data of a financial asset. This is what the Expected Value method does. This method uses recent financial asset data to find the risk impact and probability. Each possible outcome (based on past data) is multiplied by its probability, and the results are all added to get the Expected Value.
For example, on studying past data, it is found that a stock has a 30 per cent chance of giving a 20 per cent return, a 50 per cent chance of giving a 10 per cent return, and a 70 per cent chance of giving a 5 per cent return. The Expected Value is:
0.3 x 20 + 0.5 x 10 + 0.7 x 5 = 14.5 per cent.
The Expected Value is then compared to the desired outcome to measure risk. If the desired return is 40 per cent and the Expected Value is just 14.5 per cent, the risk is high. This helps teams identify which investments are good when looking into diversification in portfolio management.
Sharpe Ratio is another popular (and a little complex) way of measuring risk, especially for analyzing risk-adjusted returns. The Sharpe Ratio gives a measure of risk and insights into the returns generated. In case of excess returns, the Sharpe ratio predicts if the returns generated were, in fact, due to diligent and smart investing or because of an assumption of excessive risk.
The former tells the team to continue investing, whereas the latter indicates volatility and that the returns could vary excessively in the future. In the Sharpe ratio, the numerator is the difference between realized (or expected) returns and a benchmark value, like a risk-free rate of return.
The denominator is the Standard Deviation of returns over the same period. An asset with a Sharpe Ratio greater than 1 is generally considered a good asset.
What Does Financial Risk Measurement & Management Entail?
Measuring risk and creating mitigation strategies fall within the purview of the risk management department. This could be an individual or a team. Risk management is a part of the project team but a separate and independent vertical (in most organizations).
Risk assessment is a 5-step process:
- Identify the risks: Identify potential risks that could arise with the financial asset or investment. This could be a market crash, devalued shares, and so on.
- Define the impact: The next step is determining the impact of the risk if it were to occur (and, in most cases, the probability as well). The impact must be measured on multiple levels - organizational, departmental, individual, and so on. This step usually leaves the team with risks categorized by impact. This allows the team to decide which ones to act on first.
- Develop a proactive plan: For each identified risk, control measures must be developed. These are ways to avoid the risk and steps to be taken if the risk does occur.
- Documentation: The identified risks, their impact and probability, and the control measures must be well documented. This document acts as a blueprint for risk management.
- Review and update: New risks arise every time a financial asset is added, and risks also change as the financial asset changes. The final step in the risk assessment process is periodically reviewing and updating the risk register.
Risk measurement is an important part of the financial planning process. When done proactively and documented diligently, it gives the organization all the ammunition needed to avoid and, in worst-case scenarios, subdue financial and portfolio risks. Risk measurement gives teams the information needed to know if investment diversification and portfolio risk management are needed or if they can continue to invest in existing assets.
Risk measurement and planning do not in any way guarantee risk-free financial activities. It does, however, give the organization and its client confidence that they are prepared.
Risk measurement and planning are based on data; luckily, data capturing, and analysis are easy in today's technology-oriented world. Most organizations have robust and sufficient financial data to create an accurate and impactful risk management strategy.