Risk Management
Dr S.M.Tariq Zafar
M.Com, PGDMM, PhD (Social Sector Investment)
syed.zafar@omancollege.edu.om,
smtariqz2015@gmail.com
Introduction
Definition of Risk Management:
•
A risk is a potential problem – it might happen and it might not
•
Conceptual it can be defined as it concern future happenings and involves change in
mind, opinion, actions, places, etc. it also involves choice and the uncertainty that
choice entails.
•
Risk management is a process of identification, analysis and either acceptance or
mitigation of uncertainty in investment decision-making.
•
Essentially, risk management occurs anytime an investor or fund manager analyzes
and attempts to quantify the potential for losses in an investment and then takes the
appropriate action (or inaction) given their investment objectives and risk tolerance.
•
Inadequate risk management can result in severe consequences for companies as well
as individuals. For example, the recession that began in 2008 was largely caused by
the loose credit risk management of financial firms.
•
Introduction Continued:
Risk have two Broad Characteristics:
– Uncertainty – the risk may or may not happen, that is, there are no 100% risks
(those, instead, are called constraints)
– Loss – the risk becomes a reality and unwanted consequences or losses occur
•
Risk Management is a Two-Step Process:
•
Determining what risks exist in an investment and then handling those risks in a way bestsuited to your investment objectives. Risk management occurs everywhere in the financial
world. It occurs when an investor buys low-risk Government bonds over more risky
corporate debt, when a fund manager hedges their currency exposure with currency
derivatives and when a bank performs a credit check on an individual before issuing
them a personal line of credit.
Risk Assessment:
DEFINITION:
The process of determining the likelihood that a specified negative event will occur. Investors
and business managers use risk assessments to determine things like whether to undertake a
particular venture, what rate of return they require to make a particular investment and how
to mitigate an activity's potential losses.
Examples of formal risk assessment techniques and measurements include conditional value
at risk-cVaR (used by portfolio managers to reduce the likelihood of incurring large losses);
loan-to-values ratios (used by mortgage lenders to evaluate the risk of lending funds to
purchase a particular property); and credit analysis (used by lenders to analyze a potential
client's financial data to determine whether to lend money and if so, how much and at what
interest rate).
Risk Participation:
Risk participation agreements are often used in international trade, but these agreements are
risky because the participant has no contractual relationship with the borrower. On the
upside, these transactions can help banks generate revenue streams and diversify their
income sources.
Risk Categorization – Approach #1
Project Risks:
They threaten the project plan
If they become real, it is likely that the project schedule will slip and that costs will
increase
Technical Risks:
They threaten the quality and timeliness of the software to be produced
If they become real, implementation may become difficult or impossible
Business Risks:
They threaten the viability of the business to be built
If they become real, they jeopardize the project or the financial market
Sub-Categories of Business Risks:
Market risk – building an excellent product or system that no one really wants
Strategic risk – building a product that no longer fits into the overall business
strategy for the company
Sales risk – building a product that the sales force doesn't understand how to sell
Management risk – losing the support of senior management due to a change in
focus or a change in people
Budget Risk: losing budgetary or personnel commitment
Financial Risk: Shortage of fund will hamper the growth. Without fund nothing can
be achieved
Risk Categorization – Approach #2
Known Risks:
Those risks that can be uncovered after careful evaluation of the project plan, the
business and technical environment in which the project is being developed, and
other reliable information sources (e.g., unrealistic delivery date)
Predictable Risks:
Those risks that are extrapolated from past project experience (e.g., past turnover)
Unpredictable risks:
Those risks that can and do occur, but are extremely difficult to identify in advance
Reactive vs. Proactive Risk Strategies:
Reactive Risk Strategies:
"Don't worry, I'll think of something"
The majority of financial teams and managers rely on this approach
Nothing is done about risks until something goes wrong
The team then flies into action in an attempt to correct the problem rapidly (fire fighting)
Crisis management is the choice of management techniques
Proactive Risk Strategies:
Steps for risk management are followed
Primary objective is to avoid risk and to have a contingency plan in place to handle
unavoidable risks in a controlled and effective manner
Steps for Risk Management:
1)
2)
3)
4)
Identify possible risks; recognize what can go wrong
Analyze each risk to estimate the probability that it will occur and the impact (i.e.,
damage) that it will do if it does occur
Rank the risks by probability and impact
- Impact may be negligible, marginal, critical, and catastrophic
Develop a contingency plan to manage those risks having high probability and high
impact
Risk Identification:
Risk identification is a systematic attempt to specify threats to the project plan. By
identifying known and predictable risks, the project manager takes a first step
toward avoiding them when possible and controlling them when necessary.
Generic risks:
Risks that are a potential threat to every company, project and to its Financial
structure
Financial Product-specific risks:
Risks that can be identified only by those who have clear understanding of
the financial instrument, financial environment that is specific to the financial
product.
This requires examination of the financial instrument and the statement of
scope
"What special characteristics of this financial instrument which may threaten
our capital structure plan?
Risk Item Checklist:
Used as one way to identify risks
Focuses on known and predictable risks in specific subcategories
Can be organized in several ways
A list of characteristics relevant to each risk subcategory
Questionnaire that leads to an estimate on the impact of each risk
A list containing a set of risk component and drivers and their probability of
occurrence
Known and Predictable Risk Categories:
Financial Instrument limit and size – risks associated with overall limit and size of the
financial instrument which is launched or is to be launched.
Business impact – risks associated with constraints imposed by management or the
marketplace
Investors characteristics – risks associated with sophistication of the investors and the
company ability to communicate with the investor in a timely manner
Process definition – risks associated with the degree to which the financial instrument
process has been defined and is followed
Financial environment – risks associated with availability of investor and quality financial
environment in which instrument is be issued
Capital Structure to be built – risks associated with complexity of capital structure and
investment environment and the “risk associated" with the financial instrument and impact
of weighted average cost of capital on the company.
Staff size and experience and expertise– risks associated with overall technical expertise
of the financial engineers who will manage and control the work
Risk Components and Drivers:
The finance manager identifies the risk drivers that affect the following risk
components
Performance risk - the degree of uncertainty that the financial product will meet its
requirements and be fit for its intended use
Cost risk - the degree of uncertainty that the over all cost of capital will be maintained
Support risk - the degree of uncertainty that the resultant of financial instrument and
over all cost of capital will be easy to correct, adapt, and enhance
Schedule risk - the degree of uncertainty that the financial schedule will be maintained
and that the financial product will be issued on time
The impact of each risk driver on the risk component is divided into one of
four impact levels
Negligible, Marginal, Critical, and Catastrophic
Risk drivers can be assessed as Impossible, Improbable, Probable, and
Frequent
Risk Projection (Estimation):
Risk projection (or estimation) attempts to rate each risk in two ways
The probability that the risk is real
The consequence of the problems associated with the risk, should it occur
The project planner, managers, and technical staff perform four risk projection steps
The intent of these steps is to consider risks in a manner that leads to prioritization
Be prioritizing risks, the software team can allocate limited resources where they will
have the most impact
Risk Projection/Estimation Steps:
1)
2)
3)
4)
Establish a scale that reflects the perceived likelihood of a risk
Delineate the consequences of the risk
Estimate the impact of over all cost of capital risk on company’s capital structure
Note the overall accuracy of the risk projection so that there will be no
misunderstandings
Contents of a Risk Table:
A risk table provides a project manager with a simple technique for risk projection
It consists of five columns
Risk Summary – short description of the risk
Risk Category – one of seven risk categories
Probability – estimation of risk occurrence based on group input
Impact – (1) Catastrophic (2) Critical (3) Marginal (4) Negligible
RMMM – Pointer to a paragraph in the Risk Mitigation, Monitoring, and
Management Plan
Developing a Risk Table:
List all risks in the first column (by way of the help of the risk item checklists)
Mark the category of each risk
Estimate the probability of each risk occurring
Assess the impact of each risk based on an averaging of the four risk components to
determine an overall impact value
Sort the rows by probability and impact in descending order
Draw a horizontal cutoff line in the table that indicates the risks that will be given further
attention
Assessing Risk Impact:
Three factors affect the consequences that are likely if a risk does occur
Its nature – This indicates the problems that are likely if the risk occurs
Its scope – This combines the severity of the risk (how serious was it) with its overall
distribution (how much was affected)
Its timing – This considers when and for how long the impact will be felt
The overall risk exposure formula is RE = P x C
P = the probability of occurrence for a risk
C = the cost to the project should the risk actually occur
Risk Mitigation, Monitoring, and Management:
An effective strategy for dealing with risk must consider three issues
(Note: these are not mutually exclusive)
Risk mitigation (i.e., avoidance)
Risk monitoring
Risk management and contingency planning
Risk mitigation (avoidance) is the primary strategy and is achieved through a plan
Example: Risk of high staff turnover (see next slide)
Strategy for Reducing Staff Turnover:
•Meet with current staff to determine causes for turnover (e.g., poor working conditions,
low pay, competitive job market)
•Mitigate those causes that are under our control before the project starts
•Once the project commences, assume turnover will occur and develop techniques to
ensure continuity when people leave
•Organize project teams so that information about each development activity is widely
dispersed
•Define documentation standards and establish mechanisms to ensure that documents
are developed in a timely manner
•Conduct peer reviews of all work (so that more than one person is "up to speed")
•Assign a backup staff member for every critical technologist
•During risk monitoring, the project manager monitors factors that may provide
an indication of whether a risk is becoming more or less likely
•Risk management and contingency planning assume that mitigation efforts
have failed and that the risk has become a reality
•RMMM steps incur additional project cost
•Large projects may have identified 30 – 40 risks
•Risk is not limited to the financial instrument or to capital structure itself
•Risks can occur after the instrument has been issued in the financial market
WHY SHOULD WE STUDY FINANCIAL RISK
MANAGEMENT?
To better understand the nature and volatility of financial markets
To understand the development of new financial products -- e.g., derivatives and hybrid
securities
To understand how these products can be used to change a firm’s risk profile and protect its
financial condition
UNPREDICTABILITY:
Interest rates
Inflation, cash flows (investing / lending), asset and liability values
Late 1970s -- Volcker / FED policy change
Commodity prices
Costs, substitute products
Price shocks -- OPEC, Kuwait
FX rates
International cash flows, relative competitiveness
Early 1970s -- Breakdown of Bretton Woods
FINANCIAL RISKS – EXAMPLES
Interest Rates
Savings & Loans
Inversion of yield curve around 1980
Commodity Prices
Continental Airlines
Price of fuel after Iraq invaded Kuwait
Foreign Exchange
Laker Airlines
Strengthening of US$ relative to pound in 1981
FINANCIAL RISK MANAGEMENT: A BROAD FRAMEWORK
FRM can take several (familiar and unfamiliar) forms
Asset hedges
Liability hedges
Asset-liability management
Contingent financing
Post-loss financing and recapitalization
WHY DO CORPORATIONS USE FINANCIAL DERIVATIVES?
Transaction hedges
FX; debt
Currency and interest rate risk
Strategic (economic) hedges
Protect cash flows or company value from movements in financial prices
Reduce funding costs
FX; synthetic debt
Trading derivatives for profit
WHY DON’T CORPORATIONS USE MORE DERIVATIVES?
Credit risk
No suitable instrument
Lack of knowledge
Accounting / legal issues
Transaction costs
Resistance by Board / upper management
.
VOCABULARY:
Financial derivative: a financial instrument whose value is a function of another
(“underlying”) financial instrument
Financial engineering: the creation and use of financial derivatives to aid in the
management of risk
Risk profile: describes the effect of changes in a financial price on the value of a firm
Risk and Diversification:
Every investment is characterised by Return and Risk. Concept of risk is intuitively
understood by investors. People chose investment option depending upon their risk and
return taking ability which varies from person to person. Every investment is done for
future expected return which is uncertain and unpredictable. The actual return realised
from the investment may not correspond to the expected return. This possibilities of
variation of the actual return from the expected return is termed as a risk. Thus risk can
be defined as a variability of returns. Investment with stable returns are low risky and
investment with fluctative returns are high risk investment. In general risk is referred as a
possibility of incurring a loss in a financial transaction.
ELEMENTS OF RISK:
The essence of risk in a investment is the variation in its returns. This variation is result
of number of factors. All factors which produce variation in returns from an investment
constitute the elements of risk. The elements of risk may be broadly classified into two
groups.
The first group comprises factors that are external to a company and effect a large
number of securities simultaneously. These are mostly uncountable in nature and are
known as systematic risk. Natural calamities, war, flood, political uncertainty etc.
The second group include those factors which are internal to companies and affect only
those particular companies. These are controllable to a great extent and are known as a
unsystematic risk. Risk like sales decline, production decline, quality control, labour
unrest etc. Managerial inefficeancy
The total variability in returns of a security represents the total risk of that security.
Total Risk = Systematic risk + Unsystematic risk
Dyercification:
Diversification is a technique various financial that reduces risk by allocating
investment among various financial instruments, industries and other categories. It can
be done through hedging, mixes wide Varity of investments within portfolio.
Diversification aims to maximise return by investing in different components with
different risk and return factors. Diversification can minimise the risk but can not
guarantee against loss.
Different Types of Risk:
1.
Systematic Risk
The risk inherent to the entire market or an entire market segment is called Systematic
risk. It is also known as “undiversifiable risk,” “volatility” or “market risk,” affects the
overall market, not just a particular stock or industry. This type of risk is both
unpredictable and impossible to completely avoid. It cannot be mitigated through
diversification, only through hedging or by using the right asset allocation strategy.
Continued:
Interest rate changes, inflation, recessions, natural calamities, economic and political instability
and wars all represent sources of systematic risk because they affect the entire market. Systematic
risk underlies all other investment risks.
The Great Recession provides a prime example of systematic risk. It affected all asset class in
multiple ways, however, so investors with broader asset allocations were impacted less than those
who held nothing but stocks.
Systematic risk is further subdivided into interest rate risk, market risk and purchasing power
risk.
Interest Rate Risk -interest rate risk is the risk that an investment's value will change as a result
of a change in interest rates. This risk affects the value of bonds more directly than stocks.
Market Risk - This is the most familiar of all risks. Also referred to as volatility, market risk is
the the day-to-day fluctuations in a stock's price. Market risk applies mainly to stocks and
options. As a whole, stocks tend to perform well during a bull market and poorly during a bear
market - volatility is not so much a cause but an effect of certain market forces. Volatility is a
measure of risk because it refers to the behavior, or "temperament", of your investment rather
than the reason for this behavior. Because market movement is the reason why people can make
money from stocks, volatility is essential for returns, and the more unstable the investment the
more chance there is that it will experience a dramatic change in either direction.
Purchasing Power Risk:
Purchasing power risk refers to the variation in investor returns caused by inflation. Movement
in inflation impact the purchasing power of money. If inflation is upward then it will reduce the
purchasing power and if it is downward then it will increase the purchasing power.
The two important sources of inflation are rising costs of production and excess demand for
goods and services in relation to their supply. These kind of inflation are known as cost push and
demand pull inflation.
When demand is increasing and supply is constant in comparison, then price of goods will
increase thereby forcing out some of the excess demand and bringing the demand and supply into
equilibrium. This phenomenon is known as demand pull inflation.
Cost Push inflation occurs when the cost of production increases and this increase in cost is
passed on to the consumers by the producer through higher prices of goods.
Unsystematic Risk'
When return from security vary because of certain factors affecting only the company issuing
such security. Example such as, raw material scarcity, labour strike and management inefficiency
etc. Unsystematic risks are company- or industry-specific hazard that is inherent in each
investment. Unsystematic risk, also known as “non-systematic risk,” "specific risk,"
"diversifiable risk" or "residual risk," can be reduced through diversification. They are also
known as business risk and financial risk
This risk is unique to a company and to industry and affects it in addition to the systematic risk
affecting all securities. Unsystematic risk are unique risk affecting specific sector or company and
its securities and arise from two sources
(a) The operating environment of the company
(b) The financing pattern adopted by the company
Company Risk:
Company risk is also called "specific risk," " unsystematic risk or "diversifiable risk."
The financial uncertainty faced by an investor who holds securities in a specific firm. Company
risk can be mitigated through diversification; by purchasing securities in additional companies
and uncorrelated assets, investors can limit a portfolio's exposure to the ups and downs of a single
company's performance.
'Macro Risk'
A type of political risk in which political actions in a host country can adversely affect all foreign
operations. Macro risk can come about from events that may or may not be in the reigning
government's control.
For example, any company that is engaging in foreign direct investment in a country that is on
the verge of switching to an anti-foreigner slanted government would be facing tremendous
macro risk, because the government is likely to expropriate any and all foreign operations,
regardless of industry.
Country Risk
A collection of risks associated with investing in a foreign country. These risks include political
risk exchange rate risk, economic risk, sovereign risk and transfer risk, which is the risk of capital
being locked up or frozen by government action. Country risk varies from one country to the
next. Some countries have high enough risk to discourage much foreign investment.
Country risk can reduce the expected return on an investment and must be taken into
consideration whenever investing abroad. Some country risk does not have an effective hedge.
Other risk, such as exchange rate risk, can be protected against with a marginal loss of profit
potential.
Liquidity Risk
The risk stemming from the lack of marketability of an investment that cannot be
bought or sold quickly enough to prevent or minimize a loss. Liquidity risk is
typically reflected in unusually wide bid – ask spreads or large price movements
(especially to the downside). The rule of thumb is that the smaller the size of the
security or its issuer, the larger the liquidity risk.
Although liquidity risk is largely associated with micro-cap and small-cap stocks or
securities, it can occasionally affect even the biggest stocks during times of crisis.
The aftermath of the 9/11 attacks and the 2007-2008 global credit crises are two
relatively recent examples of times when liquidity risk rose to abnormally high
levels. Rising liquidity risk often becomes a self-fulfilling prophecy, since panicky
investors try to sell their holdings at any price, causing widening bid-ask spreads
and large price declines, which further contribute to market illiquidity and so on.
'Liquid Asset'
An asset that can be converted into cash quickly and with minimal impact to the price received.
Liquid assets are generally regarded in the same light as cash because their prices are relatively
stable when they are sold on the open market.
For an asset to be liquid it needs an established market with enough participants to absorb the
selling without materially impacting the price of the asset. There also needs to be a relative ease
in the transfer of ownership and the movement of the asset. Liquid assets include most stocks,
money market instruments and government bonds. The foreign exchange market is deemed to be
the most liquid market in the world because trillions of dollars exchange hands each day, making
it impossible for any one individual to influence the exchange rate.
'Market Exposure'
The dollar amount of funds or percentage of a portfolio invested in a particular type of security,
market sector or industry, which is usually expressed as a percentage of total portfolio holdings.
Market exposure, also known as “exposure,” represents the amount an investor can lose from the
risks unique to a particular investment.
The greater the market exposure, the greater the market risk. For example, in a portfolio
consisting of 20% bonds and 80% stocks, the investor’s market exposure to stocks is 80%. This
investor stands to lose or gain more depending on how stocks perform than from how bonds
perform.
'Idiosyncratic Risk'
Since idiosyncratic risk is by definition generally unpredictable, investors should seek
to minimize its negative impact on a portfolio by diversification or hedging.
For example, the risk of a pipeline company incurring massive damages because of an
oil spill can be mitigated by investing in a broad cross-section of stocks within the
portfolio.
As another example, consider a mining exploration company that is operating in a
nation where the risk of nationalization is fairly high. This risk can be diversified
either by investing in other mining companies that do not operate in the same nation,
or can be hedged through the use of options or other hedging instruments.
'Micro Risk'
A type of political that refers to political actions in a host country that can
adversely affect selected foreign operations. Micro risk can come about from
events that may or may not be in the reigning government's control.
For example, diplomatic tension with Country A has caused the citizens of
Country B to vandalize all Country A based companies situated in Country B. In
this example, only operations from Country A were faced with adverse
situations. Operations from other countries were not affected.
Political Risk:
Political risk represents the financial risk that a country's government will
suddenly change its policies. This is a major reason why developing countries
lack foreign investment.
'Active Risk‘
A type of risk that a fund or managed portfolio creates as it attempts to beat the returns of the
benchmark against which it is compared. In theory, to generate a higher return than the
benchmark, the manager is required to take on more risk. This risk is referred to as active
risk.
The more an active portfolio manager diverges from a stated benchmark, the higher the
chances become that the returns of the fund could diverge from that benchmark as well.
Passive managers who look to replicate an index as closely as possible usually provide the
lowest levels of active risk, but this also limits the potential for market-beating returns.
'Specific Risk'
Risk that affects a very small number of assets. Specific risk, as its name would imply, relates
to risks that are very specific to a company or small group of companies. This type of risk
would be the opposite of an overall market risk, or systematic risk.
Sometimes referred to as "unsystematic or diversifiable risk."
Foreign-Exchange Risk 1 . The risk of an investment's value changing due to changes in currency
exchange rates.
2. The risk that an investor will have to close out a long or short position in a foreign
currency at a loss due to an adverse movement in exchange rates. Also known as
"currency risk" or "exchange-rate risk".
When investing in foreign countries you must consider the fact that currency exchange
rates can change the price of the asset as well. Foreign exchange risk applies to all
financial instruments that are in a currency other than your domestic currency.
This risk usually affects businesses that export and/or import, but it can also affect
investors making international investments. For example, if money must be converted
to another currency to make a certain investment, then any changes in the currency
exchange rate will cause that investment's value to either decrease or increase when the
investment is sold and converted back into the original currency.
Country Economic Risk
The risk that arises from investment in foreign countries. Factors such as economic
development and currency exchange rate influence the amount of risk associated with the
investment. Countries with stable economic growth have less risk as compared to those
countries
whose
economic
growth
fluctuates
rapidly
through
time
Credit or Default Risk
Credit risk is the risk that a company or individual will be unable to pay the contractual
interest or principal on its debt obligations. This type of risk is of particular concern to
investors who hold bonds in their portfolios. Government Bonds, especially those issued by
the federal government, have the least amount of default risk and the lowest returns, while
Corporate Bonds tend to have the highest amount of default risk but also higher interest
rates. Bonds with a lower chance of default are considered to be investment grade, while
bonds with higher chances are considered to be junk bonds. Bond rating services, such as
Moody's, allows investors to determine which bonds are investment-grade, and which bonds
are junk
.
FINANCIAL RISK
Financial risk is a function of financial leverage which is the use of debt in the capital
structure. The present of debt in the capital structure creates fixed payments in the form of
interest which is a company payment is to be made whether company make profit or loss.
These fixed financial charges creates more variability in the earning per share (EPS).
Occurrence of variability in EPS due to presence of debt content in the capital structure of
the company is referred as a financial charges. This is specific to each company and forms
part of its unsystematic risk.
FINANCIAL RISK MANAGEMENT:
Financial risk management is a systematic practice of creating economic value in a firm by
implementing financial instruments to control exposure to risk especially credit risk and
market risk. Other types of risks like foreign exchange, sharp volatility, sector, liquidity,
inflation risk etc. It can be quantitative and qualitative and requires identifying its sources,
measuring it and plans to address them. Financial risk is considered as a additional risk
which a shareholder bears when a company use debt in addition to equity funds.
Calculating Risk and Reward:
An intelligent investor would attempt to anticipate the kind of risk that is likely to face. He
would also attempt to estimate the extent of risk associated with different investment
proposals.
Quantification of risk is necessary for investment analysis thus prudent investor will try to
measure or quantify the risk of each investment that he considers before making the final
selection.
Risk in investment is associated with return. It cannot be measured without reference to
return. The return, in turn depends on the cash inflows to be received from the investment.
Continued:
There are many reasons for this, but one of those comes from the inability of individual
investors to manage risk. Risk / reward is a common term in financial vernacular, but
what does it mean? Simply put, investing money into the investment markets has a high
degree of risk, and if you're going to take the risk, the amount of money you stand to gain
needs to be big. If somebody you marginally trust asks for a $50 loan and offers to pay
you $60 in two weeks, it might not be worth the risk, but what if they offered to pay you
$100? The risk of losing $50 for the chance to make $100 might be appealing.
That's a 2:1 risk/reward, which is a ratio where a lot professional investors start to get
interested. A 2:1 ratio allows the investor to double their money. If that person offered you
$150, then the ratio goes to 3:1.
Suppose:
Now let's look at this in terms of the stock market. Assume that you did your research and
found a stock you like. You notice that XYZ stock is trading at $25, down from a recent
high of $29. You believe that if you buy now, in the not-so-distant future, XYZ will go
back up to $29 and you can cash in. You have $500 to put towards this investment, so you
buy 20 shares. You did all of your research but do you know your risk / reward ratio? If
you're like most individual investors, you probably don't.
Continued:
Before we learn if our XYZ trade is a good idea from a risk perspective, what else should we
know about this risk/reward ratio? First, although a little bit of gut feeling finds its way in to
most investment decisions, risk/reward is completely an objective. It's a calculation, and the
numbers don't lie. Second, each individual has their own tolerance for risk. You may love
bungee jumping, but somebody else might have a panic attack just thinking about it.
Next, risk/reward gives you no indication of probability. What if you took your $500
and played the lottery? Risking $500 to gain millions is a much better investment than
investing in the stock market, from a risk/reward perspective, but a much worse choice in
terms of probability.
The Calculation
The calculation of risk/reward is very easy. You simply divide your net profit (the reward) by
the price of your maximum risk. Using the XYZ example above, if your stock went up to $29
per share, you would make $4 for each of your 20 shares for a total of $80. You paid $500 for
it, so you would divide 80 by 500 which gives you 0.16. That means that your risk/reward,
for this idea, is 0.16:1. Most professional investors won't give the idea a second look at such
a
low
risk/reward
ratio, so
this is a terrible idea. Or
is it?
Continued
Let's Get Real
Unless you're an inexperienced stock investor, you would never let that $500 go all the way
to zero. So, your actual risk isn't the entire $500. Every good investor has a stop-loss, or a
price on the downside that limits their risk. If you set a $29 sell limit price as the upside,
maybe you set $20 as the maximum downside. Once your stop-loss order reaches $20, you
sell it and look for the next opportunity. Because we limited our downside, we can now
change our numbers a bit. Your new profit stays the same at $80, but your risk is now only
$100 ($5 maximum loss multiplied by the 20 shares that you own) 80/100= 0.8:1. This is
still not ideal.
What if we raised our stop-loss price to $23, risking only $2 per share or $40 loss in total?
80/40 is 2:1, which is acceptable. Some investors won't commit their money to any
investment that isn't at least 4:1, but 2:1 is considered the minimum by most. Of course, you
have to decide for yourself what the acceptable ratio is for you.
Continued:
Notice that to achieve the risk/reward profile of 2:1, we didn't change the top number.
When you did your research and concluded that the maximum upside was $29, that was
based on technical analysis and fundamental research. If we were to change the top number,
in order to achieve an acceptable risk/reward, we're now relying on hope instead of good
research. Every good investor knows that relying on hope is a losing proposition. Being
more conservative with your risk is always better than being more aggressive with your
reward. Risk/reward is always calculated realistically, yet conservatively.
The Steps
To incorporate risk/reward calculations in to your research, follow these steps:
1. Pick a stock using exhaustive research.
2. Set the upside and downside targets based on the current price.
3. Calculate the risk/reward.
4. If it is below your threshold, raise your downside target to attempt to achieve an
acceptable ratio.
5. If you can't achieve an acceptable ratio, start over with a different investment idea.
Once you start incorporating risk/reward, you will quickly notice that it's difficult to find
good investment or trade ideas. The pros comb through, sometimes, hundreds of charts
each day looking for ideas that fit their risk/reward profile. Don't shy away from this. The
more meticulous you are, the better your chances of making money.
'Risk Control'
The method by which firms evaluate potential losses and take action to reduce or
eliminate such threats. Risk control is a technique that utilizes findings from risk
assessments (identifying potential risk factors in a firm's operations, such as technical
and non-technical aspects of the business, financial policies, and other policies that may
impact the well-being of the firm), and implementing changes to reduce risk in these
areas.
Risk control takes that information gained during risk assessments and develops and
applies changes to control the risks. Risk control can involve the implementation of
new polices and standards, physical changes and procedural changes that can reduce or
eliminate certain risks within the business. Risk control is an important action taken by
firms that is intended to proactively identify, manage and reduce or eliminate risks.
'Event Risk'
1. The possibility that an unforeseen event will negatively affect a company or industry.
Unforeseen corporate reorganizations or bond buyback may have positive or negative
impacts upon the market price of a stock.
2. The risk associated with a changing portfolio value due to large swings in market prices.
Also referred to as "jump risk" or "fat-tails." These are extreme portfolio risks due to
substantial changes in market price.
3. The possibility that a bond issuer will miss a coupon payment to bondholders because of a
dramatic and unexpected event. Credit rating agencies may downgrade the issuer’s credit
rating as a result, and the company will have to pay investors more for the higher risk of
holding its debt.
Companies can easily insure against some types of event risk, such as fire, but other events,
such as terrorist attacks, may be impossible to insure against because insurers don’t offer
policies that cover such unforeseeable and potentially devastating events. In some cases,
companies can protect themselves against risks through financial products such as act of
God bonds, swaps, options and collateralized debt obligations.
Continued:
Another type of event risk is the possibility of a corporate takeover or restructuring such
as a merger, acquisition or leveraged buyout. These events can require a firm to take on
new or additional debt, possibly at higher interest rates, which it may have trouble repaying.
Companies also face regulatory risk, in that a new law could require a company to make
substantial and costly changes in its business model. For example, if the president signed a
law making the sale of cigarettes illegal, a company whose business was the sale of
cigarettes would suddenly find itself out of business.
Companies also face event risk from the possibility that the CEO could die suddenly, a key
product could be recalled, the company could come under investigation for suspected
wrongdoing, and the price of a key input could suddenly increase substantially or countless
other sources.