Not Knowing Risk Management Can Be Risky
Table of Contents
- 1 Not Knowing Risk Management Can Be Risky
- 1.1 Definition of Risk and how risk is measured
- 1.2 Measuring Risk
- 1.2.1 I. There are two measures of risk used in the investment analysis of stocks:
- 1.2.2 II. Investing in fixed-income instruments comes with its own set of risks.
- 1.2.3 III. Risk of investing in foreign exchange denominated instruments
- 1.2.4 IV. Companies suffer from operational risk and financial risk.
- 1.2.5 Risk Management
Investment decisions are like a two-sided coin. If one side of investment is in return, the other is a risk. Uncertainty or risk is present in all investment decisions. An investor takes all investment/portfolio decisions based on his risk-return profile. If you are a conservative investor, you will buy investment assets with low volatility or potential loss probability. If you are an aggressive investor, you will purchase investment assets that have the potential to earn higher returns but are also accompanied by a higher proportion of losses. If you wish to pursue a career in corporate banking or investment banking, taking risk management courses is essential.
Definition of Risk and how risk is measured
When you do risk analysis, you identify, analyze, and accept uncertainty to mitigate them. As mentioned before, risk includes both upside deviations and downside deviations.
Risk measurement varies according to the type of financial investment. Here, we analyze the risk associated with stocks, fixed income securities, investing in foreign exchange denominated instruments, and risk arising from companies' operations. The risk associated with each type of investment is analyzed in a separate sub-section.
I. There are two measures of risk used in the investment analysis of stocks:
Risk is normally measured by standard deviation. As you know, standard deviation measures variances on the upside and downside of the arithmetic mean. Standard deviation is a measure of dispersion or variation around the measures of central tendency. Standard deviation measures portfolio risk. Portfolio risk can be classified into systematic and unsystematic risk. Outliers and extreme values can impact standard deviation. It also rates positive variations or deviations from the arithmetic mean as risk and assumes that a normal distribution captures the entire distribution of returns.
It measures market risk or risk inherent in the entire market or the market segment. This risk cannot be diversified away through careful stock picking. This risk affects the market, not a particular stock or industry segment.
This is a risk inherent in a particular company or industry segment. This can be diversified through careful Financial Analysis to weed out non-performing stocks or industry sectors. Stock selection helps in this process if stocks are added to the portfolio after careful financial analysis. Concentration risk happens when you invest a disproportionate amount in single security leading to unsystematic risk.
This is the risk that security returns variations or fluctuations move in tandem with market volatility and fluctuations. Returns of Market indices like Sensex 30 and Nifty 50 measure market returns. Beta is measured by the covariance of security returns and market returns. Beta estimates systematic risk or market risk.
II. Investing in fixed-income instruments comes with its own set of risks.
Interest rate risk is the key risk when investing in bonds and other fixed-income investments and mutual funds. This is the risk that market interest rates change after investing in a particular fixed-income security. Interest rates and bond prices have an inverse relationship. Interest rate affects you when you undertake bond trading as you may have purchased a bond at a premium but are forced to sell it at a discount before maturity. Interest rate risk is measured by duration, which is the first derivative of the change in prices in response to changes in the market interest rates.
This is the risk that the company does not make payments of the interest and principal repayments due on the bond. The company may be facing adverse financial circumstances and may be forced to default. Credit rating agencies periodically analyze credit risk and future outlook for the company as it impacts interest and principal payments. They provide credit ratings for the long term and short term, which signal the outlook for the company's financial position.
III. Risk of investing in foreign exchange denominated instruments
1) Exchange Risk:
Suppose you have invested in foreign exchange denominated securities, whether equity or debt. Your investments will be subject to exchange risk when the investments are valued at the market currency exchange rates for the home currency. Exchange risk, determined by relative interest rate movements, can positively impact portfolio valuation.
IV. Companies suffer from operational risk and financial risk.
1) Operational risk
This arises from the operations of the company and is measured by the variability of the Earnings and profits of the company.
2) Financial Risk:
This is a risk that arises from the financial leverage that the company has undertaken. Simply put, this refers to the proportion of debt to equity and the impact of interest cash flows on the profitability of the company.
When you study risk management, you study the totality of risks that affect an organization or an enterprise. As an investment banker, you need to analyze the various types of risks affecting the investment portfolios of your clients and the ultimate portfolio impact. Doing risk management courses is a must if you wish to pursue an investment banking career. Whether it is corporate or investment banking, risk management in banking becomes of the utmost importance, and knowledge of risk management is crucial. Knowledge of portfolio diversification, asset allocation, and hedging techniques is important to diversify your client's risk.
Imarticus learning Pvt Ltd can be of great help to you in this regard. Contact us through chat support, or drive to our training centers in Mumbai, Thane, Pune, Chennai, Bengaluru, Delhi, and Gurgaon.