HAF 422:Financial Risk Management

Topic:

Markets, Risks and Risk

Management in Context
 WHAT IS RISK?
• Risk is defined in financial terms as:
• The chance that an outcome or investment's
actual gains will differ from an expected
outcome or return.
• Risk includes the possibility of losing some or
all of an original investment.
 WHAT IS RISK?
• Quantifiably, risk is usually assessed by
considering historical behaviors and
outcomes.
• In finance, standard deviation is a common
metric associated with risk.
o Standard deviation provides a measure of the
volatility of asset prices in comparison to their
historical averages in a given time frame.
 WHAT IS RISK?
• Overall, it is possible and prudent to manage
investing risks by understanding the basics of
risk and how it is measured.
• Learning the risks that can apply to different
scenarios and some of the ways to manage
them holistically will help all types of investors
and business managers to avoid unnecessary
and costly losses.
 THE BASICS OF RISK
• Everyone is exposed to some type of risk every day –
whether it’s from driving, walking down the street,
investing, capital planning, or something else.
• An investor’s personality, lifestyle, and age are some
of the top factors to consider for individual
investment management and risk purposes.
• Each investor has a unique risk profile that determines
their willingness and ability to withstand risk. In
general, as investment risks rise, investors expect
higher returns to compensate for taking those risks.1
 THE BASICS OF RISK
• A fundamental idea in finance is the
relationship between risk and return.
o The greater the amount of risk an investor is
willing to take, the greater the potential return.
 THE BASICS OF RISK
• Risks can come in various ways and investors need
to be compensated for taking on additional risk.
o For example, a U.S. Treasury bond is considered
one of the safest investments and when compared
to a corporate bond, provides a lower rate of
return.
o A corporation is much more likely to go bankrupt
than the U.S. government. Because the default risk
of investing in a corporate bond is higher, investors
are offered a higher rate of return.2
 THE BASICS OF RISK
• Quantifiably, risk is usually assessed by
considering historical behaviors and
outcomes.
• In finance, standard deviation is a common
metric associated with risk. Standard deviation
provides a measure of the volatility of a value
in comparison to its historical average. A high
standard deviation indicates a lot of value
volatility and therefore a high degree of risk.
 THE BASICS OF RISK
• Individuals, financial advisors, and companies can all
develop risk management strategies to help manage risks
associated with their investments and business activities.
• Academically, there are several theories, metrics, and
strategies that have been identified to measure, analyze,
and manage risks.
o Some of these include: standard deviation, beta, Value
at Risk (VaR), and the Capital Asset Pricing Model
(CAPM).
• Measuring and quantifying risk often allows investors,
traders, and business managers to hedge some risks away
by using various strategies including diversification and
derivative positions.
 RISKLESS SECURITIES
• While it is true that no investment is fully free of all
possible risks, certain securities have so little practical
risk that they are considered risk-free or riskless.
• Riskless securities often form a baseline for analyzing
and measuring risk. These types of investments offer
an expected rate of return with very little or no risk.
• Oftentimes, all types of investors will look to these
securities for preserving emergency savings or for
holding assets that need to be immediately
accessible.
 RISKLESS SECURITIES
• Examples of riskless investments and
securities include certificates of deposits
(CDs), money market accounts, U.S.
Treasuries, and municipal securities.3
• U.S. Treasuries are backed by the full faith and
credit of the U.S. government.4 Investors can
place money in multiple U.S. Treasury
securities with different maturity options
across the Treasury yield curve.5
 RISK AND TIME HORIZONS

• Time horizon and liquidity of investments is

often a key factor influencing risk assessment
and risk management.
• If an investor needs funds to be immediately
accessible, they are less likely to invest in high
risk investments or investments that cannot
be immediately liquidated and more likely to
place their money in riskless securities.
 RISK AND TIME HORIZONS
• Time horizons will also be an important factor
for individual investment portfolios.
o Younger investors with longer time horizons to
retirement may be willing to invest in higher risk
investments with higher potential returns.
o Older investors would have a different risk
tolerance since they will need funds to be more
readily available.6
 MORNINGSTAR RISK RATINGS
• Morningstar is one of the premier objective
agencies that affixes risk ratings to mutual
funds and exchange-traded funds (ETF).7
• An investor can match a portfolio’s risk profile
with their own appetite for risk.
 TYPES OF FINANCIAL RISK
• Every saving and investment action involves
different risks and returns.
• In general, financial theory classifies
investment risks affecting asset values into
two categories:
• systematic risk and unsystematic risk.
• Broadly speaking, investors are exposed to
both systematic and unsystematic risks.
 TYPES OF FINANCIAL RISK
• Business risk
• Credit risk
• Country risk
• Foreign exchange risk
• Interest rate risk
• Political risk
• Liquidity Risk
 RISK VS. REWARD
• The risk-return tradeoff is the balance between the
desire for the lowest possible risk and the highest
possible returns.
• In general, low levels of risk are associated with low
potential returns and high levels of risk are associated
with high potential returns.
• Each investor must decide how much risk they’re
willing and able to accept for a desired return. This will
be based on factors such as age, income, investment
goals, liquidity needs, time horizon, and personality.
 RISK VS. REWARD
• It’s important to keep in mind that higher risk doesn’t
automatically equate to higher returns.
• The risk-return tradeoff only indicates that higher risk
investments have the possibility of higher returns—but
there are no guarantees.
• On the lower-risk side of the spectrum is the
risk-free rate of return—the theoretical rate of return of an
investment with zero risk. It represents the interest you
would expect from an absolutely risk-free investment over a
specific period of time.
• In theory, the risk-free rate of return is the minimum return
you would expect for any investment because you wouldn’t
accept additional risk unless the potential rate of return is
greater than the risk-free rate.
 RISK AND DIVERSIFICATION
• The most basic – and effective – strategy for minimizing
risk is diversification.
• Diversification is based heavily on the concepts of
correlation and risk. A well-diversified portfolio will
consist of different types of securities from diverse
industries that have varying degrees of risk and
correlation with each other’s returns.
• While most investment professionals agree that
diversification can’t guarantee against a loss, it is the
most important component to helping an investor reach
long-range financial goals, while minimizing risk.8
 RISK AND DIVERSIFICATION
• There are several ways to plan for and ensure
adequate diversification including:
• Spread your portfolio among many different
investment vehicles – including cash, stocks,
bonds, mutual funds, ETFs and other funds.
• Look for assets whose returns haven’t historically
moved in the same direction and to the same
degree. That way, if part of your portfolio is
declining, the rest may still be growing.
 RISK AND DIVERSIFICATION
• Stay diversified within each type of investment. Include
securities that vary by sector, industry, region, and
market capitalization.
• It’s also a good idea to mix styles too, such as growth,
income, and value.
• The same goes for bonds: consider varying maturities and
credit qualities.
• Include securities that vary in risk. You're not restricted to
picking only blue-chip stocks. In fact, the opposite is true.
Picking different investments with different rates of return
will ensure that large gains offset losses in other areas.6
THE END