Journal of Management (JOM)

Volume 6, Issue 5, September – October 2019, pp. 37–43, Article ID: JOM_06_05_007
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RISK MANAGEMENT IN FINANCE

N. R Nithya
Assistant Professor, Department of Commerce, Rathinam College of Arts and Science,
Coimbatore, Tamilnadu. India.

S. Shobana
Assistant Professor, Department of Commerce, Rathinam College of Arts and Science,
Tamilnadu. India.

ABSTRACT
A common definition of risk is an uncertain event that if it occurs, can have a
positive or negative effect on a project’s goals. The potential for a risk to have a
positive or negative effect is an important concept. Because, it is natural to fall into
the trap of thinking that risks have inherently negative effects. If investor is also open
to those risks that create positive opportunities, investor can make investment project
smarter, streamlined and more profitable. Think of the adage. “Accept the inevitable
and turn it to your advantage.” That is what investor do when investor mine project
risks to create opportunities.
Keywords: Risk, Investor, Risk Management and Finance
Cite this Article: N. R Nithya, S. Shobana, Risk Management in Finance, Journal of
Management (JOM), 6 (5), 2019, pp. 37–43.
http://www.iaeme.com/JOM/issues.asp?JType=JOM&VType=6&IType=5

1. INTRODUCTION
In the financial world, risk management is the process of identification, analysis and
acceptance or mitigation of uncertainty in investment decisions. Essentially, risk management
occurs when an investor or fund manager analyzes and attempts to quantify the potential for
losses in an investment, such as a moral hazard, and then takes the appropriate action (or
inaction) given his investment objectives and risk tolerance

2. RISK MANAGEMENT
Risk management occurs everywhere in the realm of finance. It occurs when an investor buys
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

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 N. R Nithya S. Shobana

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.

3. HOW DOES THE RISK MANAGEMENT WORKS?

However, in the investment world, the risk is necessary and inseparable from the
performance.
A common definition of investment risk is a deviation from an expected outcome. It can
express this deviation in absolute terms or relative to something else, like a market
benchmark. That deviation can be positive or negative, and it relates to the idea of "no pain,
no gain": to achieve higher returns, in the long run, investor have to accept the more short-
term risk, in the shape of volatility.
How much volatility depends on investor risk tolerance, which is an expression of the
capacity to assume volatility based on specific financial circumstances and the propensity to
do so, taking into account investor psychological comfort with uncertainty and the possibility
of incurring large short-term losses.

4. HOW INVESTORS MEASURE RISK?

Investors use a variety of tactics to ascertain risk. One of the most commonly used absolute
risk metrics is standard deviation, a statistical measure of dispersion around a central
tendency. The investor look at the average return of an investment and then find its average
standard deviation over the same time period. Normal distributions (the familiar bell-shaped
curve) dictate that the expected return of the investment is likely to be one standard deviation
from the average 67% of the time and two standard deviations from the average deviation
95% of the time. This helps investors evaluate risk numerically. If they believe that they can
tolerate the risk, financially and emotionally, they invest.
When applying the bell curve model, any given outcome should fall within one standard
deviation of the mean about 67% of the time and within two standard deviations about 95% of
the time. Thus, an S&P 500 investor could expect the return, at any given point during this
period, to be 10.7% plus or minus the standard deviation of 13.5% about 67% of the time; he
may also assume a 27% (two standard deviations) increase or decrease 95% of the time. If he
can afford the loss, he invests.

5. RISK MANAGEMENT AND PSYCHOLOGY

While that information may be helpful, it does not fully address an investor's risk concerns.
The field of behavioral finance has contributed an important element to the risk equation,
demonstrating asymmetry between how people view gains and losses. In the language of

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prospect theory, an area of behavioral 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.
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.

6. BETA AND PASSIVE RISK MANAGEMENT

Another risk measure oriented to behavioural tendencies is a draw down, which refers to any
period during which an asset's return is negative relative to a previous high mark. In
measuring drawdown, we attempt to address three things:
• the magnitude of each negative period (how bad)
• the duration of each (how long)
• the frequency (how often)

7. ALPHA AND ACTIVE RISK MANAGEMENT

If the level of market or systematic risk were the only influencing factor, then a portfolio's
return would always be equal to the beta-adjusted market return. Of course, this is not the
case: Returns vary because of a number of factors unrelated to market risk. Investment
managers who follow an active strategy take on other risks to achieve excess returns over the
market's performance. Active strategies include stock, sector or country selection,
fundamental analysis, and charting.
Active managers are on the hunt for an alpha, the measure of excess return. In our
diagram example above, alpha is the amount of portfolio return not explained by beta,
represented as the distance between the intersection of the x and y-axes and the y-axis
intercept, which can be positive or negative. In their quest for excess returns, active managers
expose investors to alpha risk, the risk that the result of their bets will prove negative rather
than positive. For example, a fund manager may think that the energy sector will outperform
the S&P 500 and increase her portfolio's weighting in this sector. If unexpected economic
developments cause energy stocks to sharply decline, the manager will likely underperform
the benchmark, an example of alpha risk.

8. THE COST OF RISK

In general, the more active the investment strategy (the more alpha a fund manager seeks to
generate), the more an investor will need to pay for exposure to that strategy. For a purely

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 N. R Nithya S. Shobana

passive vehicle like an index fund or an exchange-traded fund (ETF), investor might pay 15 to
20 basis points in annual management fees, while for a high-octane hedge fund employing
complex trading strategies involving high capital commitments and transaction costs, an
investor would need to pay 200 basis points in annual fees, plus give back 20% of the profits
to the manager.
The difference in pricing between passive and active strategies (or beta risk and alpha risk
respectively) encourages many investors to try and separate these risks (e.g., to pay lower fees
for the beta risk assumed and concentrate their more expensive exposures to specifically
defined alpha opportunities). This is popularly known as portable alpha, the idea that the
alpha component of a total return is separate from the beta component.
For example, a fund manager may claim to have an active sector rotation strategy for
beating the S&P 500 and show, as evidence, a track record of beating the index by 1.5% on an
average annualized basis. To the investor, that 1.5% of excess return is the manager's value,
the alpha, and the investor is willing to pay higher fees to obtain it. The rest of the total return,
what the S&P 500 itself earned, arguably has nothing to do with the manager's unique ability.
Portable alpha strategies use derivatives and other tools to refine how they obtain and pay for
the alpha and beta components of their exposure.

9. THE BOTTOM LINE

Risk is inseparable from return. Every investment involves some degree of risk, which can be
very close to zero in the case of a U.S. T-bill or very high for something such as concentrated
exposure to Sri Lankan equities or real estate in Argentina. Risk is quantifiable both in
absolute and in relative terms. A solid understanding of risk in its different forms can help
investors to better understand the opportunities, trade-offs, and costs involved with different
investment approaches.

10. TYPES OF RISK MANAGEMENT

10.1. Longevity Risk
One of the greatest concern’s investors have is that they will outlive their money. This is
longevity risk in a nutshell. Peoples are living longer and living healthier. That’s the good
news. The bad news is that the investor should plan on funding a potentially longer
retirement. Longevity risk is a good place to start our conversation about risk for two reasons.
• First, it clearly demonstrates that a discussion of investment risk is ultimately
about people, not abstract returns. The desire to meet a personal goal.
• Second, longevity risk is interesting because it clearly demonstrates how different
parties view the same risk. Insurance companies, for examples, view increased
longevity from the standpoint of being on the hook for paying benefits on certain
types of contract of those products to consumers, making it even more important
for them to attempt to ensure additional savings in retirement.

10.2. Inflation risk

Inflation is the increase in the cost of goods and services in an economy relative to the
currency. When we experience inflation in the India, the same number of rupees will buy less
in the market, that it did in the past.
The investor has more concerned with inflation later in life because they had an
opportunity to build savings that can be affected negatively by inflation. When the investor is
younger and have yet to build substantial savings, it may be indifferent to inflation.

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As an investor will need to be keenly aware of inflation risk and select asset classes and
investment strategies with the potential to provide a “real rate of return” which is return above
the rate of inflation.

11. REAL RATE OF RETURN = RETURN ABOVE THE RATE OF

INFLATION
11.1. Sequence of Returns Risk
Often investors focus on average returns. This can be the average of a portfolio allocation or
their own experiences in the past. The challenges with a plan based on an average return is
that even if it is achieved, there can be wide variation from year to year and the order in which
returns occur can affect the investor investment experience.
The investor can lessen their sequence of return risk by choosing a conservative
withdrawal amount, also known as a sustainable distribution rate, for many retiring at a
normal ae, this is 4%. It will generally be well below their expected return for the portfolio.
This will not only provide a cushion but also assist in combating the previously mentioned
risk of inflation. In addition to selecting a conservative withdrawal rate. The investor can
make sure to rebalance their portfolio periodically to make sure the investor are not exceeding
the level of risk necessary to reach their goals. This is important since their most aggressive
asset classes can potentially through appreciation represent a larger portion of their overall
balance than they did in their initial allocation.

11.2. Interest Rate Risk

Changes in interest rates can affect their portfolio in many ways. When interst rates go up, for
example, fixed income items such as bonds may no longer be as competitive and may
decrease in value. Even equities may experience the effect of the changing interest rates on
the overall economy or a specific business. Think of credit as the fuel that drives economic
activity. Interest is the cost of credit. What happens to their driving habits when fuel costs go
up?
The investor can protect their self from interest rate risk by owning many different asset
classes and choosing their fixed income investments so that the investor have a variety of
maturity dates among short, intermediate and long-term since longer maturities usually carry
the greatest interest rate risk. This strategy also comes with a bonus in that it also helps with
our next risk, liquidity risk.

11.3. Liquidity Risk

The investor may check the value of their home online recently and been excited to see the
value, only to have their thoughts turn to the process of selling. How long will it take? How
much will the commission be? What if it sits for too long after the investor have purchased
the next property? This is a perfect example of liquidity risk, but it’s not confined to real
estate only.
Many investors have lock-up periods or charges for early sale, often called “surrender
charges” in annuity contracts. The non-monetary costs such as hassle and uncertainty can
often be a large factor in considering some investments without a liquid market.

11.4. Market Risk

Market risk is what most investors imagine when they think of risk in general. It’s the
possibility that the value of their investment can decrease. Fortunately, there are ways to limit
their market risk. Avoid investing a sizable portion of their portfolio in a single asset.

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Investors often get ‘one ties’ and are so convinced in the merits of a single investment that
they lose sight of the additional risk they take by owning too much of any single investment.

11.5. Opportunity Risk

Opportunity risk is interesting because it is a type of risk people often assume unknowingly
when the are attempting to avoid risk in general. Sitting on the side lines or placing their
money under the mattress can seem safe. The investor will after all, preserve their principal
balance, which can be detrimental to their investment goals over extended periods of time.
Opportunity risk is also frequently coupled with inflation risk. It’s not just that their
preserving balance only while missing out on an additional return. The balance preserve is
worth less over time due to inflation. Standing still is going backward when the investor
considers what can purchase with their money?

11.6. Tax Risk

Tax risk is a very important consideration for investors. The investor may have an excellent
return on their investments, but it’s the amount ofable to keep after tax that will most directly
affect their lifestyle. There are several ways to contains tax risk and ensure the investor can
keep the most amount of their money possible.
Invest in all available “pools” of money. Often investors have most of their savings in tax-
deferred accounts such as their employer sponsored retirement accounts. Tax-deferred
accounts are only one of the three “pools” available to investors in the India.

12. STEPS IN A SOUND RISK MANAGEMENT PROCESS

As a project manager or team member, investor manage risk on a daily basis; it’s one of the
most important things investor do. If investor learn how to apply a systematic risk
management process, and put into action the core 5 risk management process steps, then
investor projects will run more smoothly and be a positive experience for everyone involved.
Uncertainty is at the heart of risk. Investor may be unsure if an event is likely to occur or
not. Also, investor may be uncertain what its consequences would be if it did occur.
Likelihood – the probability of an event occurring, and consequence – the impact or outcome
of an event, are the two components that characterize the magnitude of the risk.
All risk management processes follow the same basic steps, although sometimes different
jargon is used to describe these steps. Together these 5 risk management process steps
combine to deliver a simple and effective risk management process.

12.1. Step 1: Identify the Risk

Investor and investor team uncover, recognize and describe risks that might affect investor
project or its outcomes. There are a number of techniques investor can use to find project
risks. During this step investor start to prepare investor Project Risk Register.

12.2. Step 2: Analyze the risk

Once risks are identified investor determine the likelihood and consequence of each risk.
Investor develop an understanding of the nature of the risk and its potential to affect project
goals and objectives. This information is also input to investor Project Risk Register.

12.3. Step 3: Evaluate or Rank the Risk

Investor evaluate or rank the risk by determining the risk magnitude, which is the
combination of likelihood and consequence. Investor make decisions about whether the risk is

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acceptable or whether it is serious enough to warrant treatment. These risk rankings are also
added to investor Project Risk Register.

12.4. Step 4: Treat the Risk

This is also referred to as Risk Response Planning. During this step investor assess investorr
highest ranked risks and set out a plan to treat or modify these risks to achieve acceptable risk
levels. How can investor minimize the probability of the negative risks as well as enhancing
the opportunities? Investor create risk mitigation strategies, preventive plans and contingency
plans in this step. And investor add the risk treatment measures for the highest ranking or
most serious risks to investor Project Risk Register.

12.5. Step 5: Monitor and Review the risk

This is the step where investor take investor Project Risk Register and use it to monitor, track
and review risks.

13. CONCLUSION
Risk is about uncertainty. If investor put a framework around that uncertainty, then investor
effectively de-risk investor project. And that means investor can move much more confidently
to achieve investor project goals. By identifying and managing a comprehensive list of project
risks, unpleasant surprises and barriers can be reduced and golden opportunities discovered.
The risk management process also helps to resolve problems when they occur, because
those problems have been envisaged, and plans to treat them have already been developed and
agreed. Investor avoid impulsive reactions and going into “fire-fighting” mode to rectify
problems that could have been anticipated. This makes for happier, less stressed project teams
and stakeholders. The end result is that investor minimize the impacts of project threats and
capture the opportunities that occur.

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