Risk management in finance detail with explanation.

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 given the fund's investment objectives and risk tolerance. Risk is inseparable from return. However, in the investment world, risk is necessary and inseparable from desirable performance.

Types of Risk Management? 

The risk is divided into 2 categories that is systematic risk and unsystematic risk. 

Systematic risk is also known as market risk as it affect a large number of total market .  .Other common types of systematic risk can include interest rate risk, inflation risk, currency risk, liquidity risk, country risk, and sociopolitical risk. On other hand, unsystematic risk is 'specific risk ' or stock specific risk . This risk is associated with the particular industry or stock and does not affect whole market .

Types of risks associated with investment

Business risk :- Business risk, also known as "stock specific risk", pertains to the risks of a particular company or a stock. However, this risk may be specific to a sector as often companies pertaining to a specific sector have identical risks. For example, all sugar manufacturing companies will suffer if the sugarcane output is low in a particular year due to poor rainfall. The risk is the possibility that the company may go bankrupt, leading to crashing of the stock price or an issuer of a bond not being able to pay the promised interest or principal amount. The reasons for this can be many from poor management to fraud to running out of capital. The easiest solution to avoid business risk is to diversify.

Currency risk :- Currency risk is the risk that arises with the change in the value of one currency against other currencies. Let's say you invest in US dollars, where 1 USD = Rs 70. Now if the USD falls due to some reason, then the value of your investment will also fall. Currency risk persists for all investments done in any other currency than your home currency and is especially prominent in the case of short-term investments.

Inflationary risk :- This refers to the risk that your investments and cash flow will considerably reduce in purchasing power due to inflation. The best way to avoid inflationary risk is to invest in equities that give higher returns than inflation over the long-term

Interest rate risk :- Interest rate risk is the risk that the value of the fixed-rate debt instrument will decline due to the rise in interest rates. The fixed rate will become less attractive if the base rate increases.

Market risk :- This is simply the risk you take when you invest in the stock market. It is taken as a form of systematic risk as it follows its own broad trends and cycles and cannot be avoided by diversification unlike business or stock specific risk. One way to ride through the market risk is to stay invested for a long-term period.

Management risk :- Management risk usually comes  when investing in a mutual fund or portfolio management services. The risk is that the fund manager may under perform with respect to the given benchmark. 

Liquidity risk :- This refers to the possibility that you may not be able to sell and raise money from your investments when needed. Liquidity refers to the readiness to sell an asset. For example, stocks are very liquid, whereas your house is highly illiquid. The risk with illiquid assets like real estate or fixed term deposits is that they are not very easy to sell at the desired moment of time, if needed, due to lack of opportunities or lock in period.

Regulatory /legislative risk :- This is when the lawmakers or regulators of a country pass new laws or announce regulations that may hurt your investments or the sector that you have invested in. For example, if the government takes out a law to limit the production and usage of non-renewable energy like thermal energy, it would adversely affect your investments in the stocks of all coal and thermal power companies.

Political/country risk :- This usually refers to the risk that a country carries due to its unfavourable policies or social situation that may lead to increased loss of investment. For example, a company making profit but having operations out of politically sensitive areas like Africa or Middle-East may have lower valuation, therefore lower stock price, due to its country risk. When you invest, you are exposed to a mix of these risks depending upon the type of your investment. Being aware of the risks associated with an investment and weighing the potential returns against the potential risk is important for making an investment decision. This is essentially the approach of risk-aware investing. The key is to analyse the potential risks to understand if they justify the potential returns.

Process of risk management

Risk management is an important process and almost everyone manages risk on a daily basis. The risk management process is a framework for the actions that need to be taken. There are five basic steps that are taken to manage risk; these steps are referred to as the risk management process. It begins with identifying risks, goes on to analyze risks, then the risk is prioritized, a solution is implemented, and finally, the risk is monitored. In manual systems, each step involves a lot of documentation and administration.  The process for risk management is given below :-

Step 1: Identify the Risk 

The first step is to identify the risks that the business is exposed to in its operating environment. There are many different types of risks – legal risks, environmental risks, market risks, regulatory risks, and much more. It is important to identify as many of these risk factors as possible. In a manual environment, these risks are noted down manually. If the organization has a risk management solution employed all this information is inserted directly into the system. The advantage of this approach is that these risks are now visible to every stakeholder in the organization with access to the system. Instead of this vital information being locked away in a report which has to be requested via email, anyone who wants to see which risks have been identified can access the information in the risk management system. 

Step 2: Analyze the Risk 

Once a risk has been identified it needs to be analyzed. The scope of the risk must be determined. It is also important to understand the link between the risk and different factors within the organization. To determine the severity and seriousness of the risk it is necessary to see how many business functions the risk affects. There are risks that can bring the whole business to a standstill if actualized, while there are risks that will only be minor inconveniences in the analysis. In a manual risk management environment, this analysis must be done manually. When a risk management solution is implemented one of the most important basic steps is to map risks to different documents, policies, procedures, and business processes. This means that the system will already have a mapped risk framework that will evaluate risks and let you know the far-reaching effects of each risk. 

Step 3: Evaluate the Risk 

Risks need to be ranked and prioritized. Most risk management solutions have different categories of risks, depending on the severity of the risk. A risk that may cause some inconvenience is rated lowly, risks that can result in catastrophic loss are rated the highest. It is important to rank risks because it allows the organization to gain a holistic view of the risk exposure of the whole organization. The business may be vulnerable to several low-level risks, but it may not require upper management intervention. On the other hand, just one of the highest-rated risks is enough to require immediate intervention. 

Go in more depth Bringing Quantitative Risk Analysis to Enterprise Risk Management 

Step 4: Treat the Risk 

Every risk needs to be eliminated or contained as much as possible. This is done by connecting with the experts of the field to which the risk belongs. In a manual environment, this entails contacting each and every stakeholder and then setting up meetings so everyone can talk and discuss the issues. The problem is that the discussion is broken into many different email threads, across different documents and spreadsheets, and many different phone calls.  In a risk management solution, all the relevant stakeholders can be sent notifications from within the system. The discussion regarding the risk and its possible solution can take place from within the system. Upper management can also keep a close eye on the solutions being suggested and the progress being made within the system. Instead of everyone contacting each other to get updates, everyone can get updates directly from within the risk management solution. 

Step 5: Monitor and Review the Risk 

Not all risks can be eliminated – some risks are always present. Market risks and environmental risks are just two examples of risks that always need to be monitored. Under manual systems monitoring happens through diligent employees. These professionals must make sure that they keep a close watch on all risk factors. Under a digital environment, the risk management system monitors the entire risk framework of the organization. 

Strategies of risk management

Portfolio Diversification

Having a diversified portfolio is also essential for managing risk. Investing in a single company or industry is risky. For example, you could potentially pick a poorly-run company or one that gets hit with an antitrust suit, even in an industry that’s outperforming others. Investing across the overall stock market reduces the risk. One way to diversify instantly is to invest in mutual funds or exchange-traded funds (ETFs). 

Buy-and-Hold 

Adopting a buy-and-hold strategy can also reduce risk over time. A Fidelity study of 1.5 million workplace savers found that people who kept their money invested after the stock market dropped by nearly 50% in late 2008 and early 2009 grew their account balances by 147% between June 2008 and the end of 2017. Those who cashed out of stocks in the fourth quarter of 2008 or the first quarter of 2009 earned average returns of just 74% through 2017.1 

Equity Glide Path 

An equity glide path is a common approach to risk management that focuses on age-based asset allocation. Younger investors can often afford more risk because their money has more time to recover from losses. Someone in their 20s and 30s might invest aggressively by putting most of their money in stocks. As the investor gets closer to retirement, they’d shift money out of stocks and into safer assets with lower returns, like bonds and CDs. For example, suppose you start at age 25 with 90% invested in stocks and 10% invested in bonds. But by age 50, you may have 70% in stocks and 30% in bonds. By age 60, your portfolio might be 50% stocks and 50% bonds and CDs, especially if you’re hoping to retire soon. 

Advantages and disadvantages of risk management

Advantages of risk management	Disadvantages of risk management
1.     It encourages the firm to think about its threats. In particular, risk management encourages it to analyse risks that might otherwise be overlooked.	1.Qualitative risk assessment is subjective and lacks consistency.
2.     In clarifying the risks, it encourages the firm to be better prepared. In other words, it helps the firm to manage itself better.	2.Unlikely events do occur but if the risk is unlikely enough to occur is maybe better to simply retain the risk and deal with the result if the loss does in fact occur.
3.     It lets the organization prioritize its investment and reduces internal disputes about how money should be spent.	3.Spending too much time assessing and managing unlikely risks can divert resources that could be used more profitably.
4.     It reduces duplication of systems. Integration of environmental and health and safety systems are one instance.