Introduction to Financial Risk and Financial Risk Management

Risk management occurs everywhere in the realm of finance. It occurs when an investor buys U.S. Treasury bonds over corporate bonds, when a fund manager hedges his currency exposure with currency derivatives, and when a bank performs a credit check on an individual before issuing a personal line of credit. Stockbrokers use financial instruments like options and futures, and money managers use strategies like portfolio and investment diversification to mitigate or effectively manage risk.

Inadequate risk management can result in severe consequences for companies, individuals, and the economy. For example, the subprime mortgage meltdown in 2007 that helped trigger the Great Recession stemmed from bad risk-management decisions, such as lenders who extended mortgages to individuals with poor credit; investment firms who bought, packaged, and resold these mortgages; and funds that invested excessively in the repackaged, but still risky, mortgage-backed securities (MBS).

• Risk management is the process of identification, analysis and acceptance or mitigation of uncertainty in investment decisions.
• Risk is inseparable from return in the investment world.
• A variety of tactics exist to ascertain risk; one of the most common is standard deviation, a statistical measure of dispersion around a central tendency.
• Beta, also known as market risk, is a measure of the volatility, or systematic risk, of an individual stock in comparison to the entire market.
• Alpha is a measure of excess return; money managers who employ active strategies to beat the market are subject to alpha risk.

Risk Management and Psychology

While that information may be helpful, it does not fully address an investor’s risk concerns. The field of behavioural finance has contributed an important element to the risk equation, demonstrating asymmetry between how people view gains and losses. In the language of prospect theory, an area of behavioural finance introduced by Amos Tversky and Daniel Kahneman in 1979, investors exhibit loss aversion: They put more weight on the pain associated with a loss than the good feeling associated with a profit.

Often, what investors really want to know is not just how much an asset deviates from its expected outcome, but how bad things look way down on the left-hand tail of the distribution curve. Value at risk (VAR) attempts to provide an answer to this question. The idea behind VAR is to quantify how large a loss on investment could be with a given level of confidence over a defined period. For example, the following statement would be an example of VAR: “With about a 95% level of confidence, the most you stand to lose on this $1,000 investment over a two-year time horizon is $200.” The confidence level is a probability statement based on the statistical characteristics of the investment and the shape of its distribution curve.

Of course, even a measure like VAR doesn’t guarantee that 5% of the time will be much worse. Spectacular debacles like the one that hit the hedge fund Long-Term Capital Management in 1998 remind us that so-called “outlier events” may occur. In the case of LTCM, the outlier event was the Russian government’s default on its outstanding sovereign debt obligations, an event that threatened to bankrupt the hedge fund, which had highly leveraged positions worth over $1 trillion; if it had gone under, it could have collapsed the global financial system. The U.S. government created a $3.65-billion loan fund to cover LTCM’s losses, which enabled the firm to survive the market volatility and liquidate in an orderly manner in early 2000.

Risk Management In The Cryptocurrency Space