What Is Risk Management?

Why Is Risk Management Important?

Risk management is the process whereby one identifies, assesses, and controls the financial, legal, strategic, and security-related risks concerned with capital and earnings. These risks may arise from varied sources, including financial uncertainty, legal liabilities, strategic management errors, accidents, and natural disasters. In a worst-case scenario, though, it could be catastrophic and have a serious impact, like a major financial burden or even the shutdown of the business. To minimize the risk, an organization needs to apply resources to minimize, monitor, and control the impact of negative events while maximizing positive events. A consistent, systemic, and integrated approach to risk management can help determine how to best identify, manage and mitigate significant risks. The probability of a loss can be measured with the help of statistical tools that are predictors of investment risk and volatility based on historic data. Commonly used tools include standard deviation, Sharpe ratio, and beta.

Statistics:

• The market for global risk management is expected to grow from $4.46 billion in 2021 to $4.82 billion in 2022 at a CAGR of 8.0% and $6.20 billion in 2026 at a CAGR of 6.5%.

• 6% of CEOs are not making changes at all in Risk Management in response to stakeholder expectations.

• 44% of CEOs are making minor changes in Risk Management in response to stakeholder expectations.

• While 49% of CEOs are making major changes in Risk Management in response to stakeholder expectations.

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Risk Management Example  

If we take into account 15 years from Aug. 1, 1992, to July 31, 2007, the annualized return of the S&P 500 was 10.7%. This statistical number revealed the whole period scenario, but it does not predict what happened along the way. The average standard deviation (SD) of the S&P 500 was 13.5%. This is the difference between the average return and the real return throughout the 15 years. If we apply a model known as the bell curve model, any given outcome will fall within one SD of the mean about 67% of the time and within two SD about 95% of the period. An S&P 500 investor will expect a return to be 10.7% keeping a small window of change with an SD of 13.5% about 67% of the time; he may also assume a 27% (two SD) increase or decrease of 95% of the time. If the investor can afford the loss, he invests.

The Risk Management Process

Risk management is a protocol consisting of an alignment with various parameters like people, processes, and technology that enables an organization to establish objectives in line with values and risks. A successful risk assessment should meet all the legal, social, internal, contractual, and ethical goals, as well as monitor tech regulations. By giving attention to risk and resources to control the risk the company can protect itself from any uncertainty, minimize costs and increase the probability of business continuity and success. The risk management process includes three steps consisting of risk identification, risk analysis and assessment, and risk mitigation and monitoring.

What Are The Most Common Responses To Risk?  

Risk avoidance  – Avoidance is a practice to mitigate risk by not participating in activities that might negatively affect the company. A few examples of this might include not making any investments.

Risk reduction  -This practice of risk management minimizes the loss, rather than completely eradicating it. While accepting the risk, it stays focused to keep the loss maintained and preventing it from increasing. Examples can include health insurance.

Risk sharing  – When risks are shared, the possibility of loss is transferred from the individual to the team. A corporation is a good example of risk sharing several investors pool their capital and each only bears a portion of the risk that the company might fail.

 Transferring risk  – Contractually shedding a risk to a third party, such as insurance to cover possible property damage or injury shifts the risks associated with the property from the owner to the insurance company.

Risk acceptance – After all risk sharing, risk transfer, and risk reduction measures have been practiced, few risks remain because it is nearly impossible to make it zero which is also called residual risk.

Limitations And Risk Management Standards

Risk management standards set out specified strategic processes that begin with the goals of the company and thereby intend to identify its risks and promote the mitigation of risks through its implementation. Standards are often designed by intermediaries who work together to promote certain goals which ensure high-quality risk management processes. Its example can include the ISO 31 000 standards on risk management is an international standard that provides guidelines for effective risk control and its management. While adopting a risk management standard has its advantages, it is not without challenges. The new standard may not be able to fit easily into what we are already doing, in that case, we can introduce new ways to work which may need to get customized to the industry.

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The Cost of Risk  

Alpha and beta are two versions of risk. The fund managers charge their commission based on the higher the alpha factor, the higher will be their commission. If we take an example of an index fund or an exchange-traded fund (ETF), one pays one to 10 basis points (bps) for the annual management fees, while a high-octane hedge fund which is complex in trading needing strategies will involve high capital commitments and transaction costs, in such a case an investor will pay 200 basis points, plus give back 20% of the profits to the fund manager.

The variance in the pricing structure between the passive strategies and the active strategies (beta risk and alpha risk) shall motivate many investors to differentiate among these risks (e.g. to pay lower fees for the beta risk assumed and concentrate their more expensive exposures to defined alpha opportunities). This is generally called portable alpha, the idea that the alpha component of a total return is separate from the beta component. Its example will include a fund manager claiming for an active sector rotation strategy to beat the S&P 500 and show a record to beat the index by 1.5% on an annualized basis. For an investor, the 1.5% of excess return is the manager’s value, the alpha, and in turn, the investor pays happily higher fees to obtain it. The remaining total return, what the S&P 500 itself earned, has nothing to do with the manager’s ability. Derivatives are used for the Portable alpha strategies to refine how they obtain and pay for the alpha and beta factors of their exposure.