The term “finance” is used to describe topics related to the administration, production, and analysis of monetary and financial resources. Credit, debt, securities, and investment are all part of this method of financing, which relies on expected future profits to fund ongoing expenditures. Because of this temporal component, the study of finance is inextricably linked to the study of interest rates and the time value of money.
There are three major areas in finance:
- Public finance
- Corporate finance
- Personal Finance
Understanding Risk Management
In the world of finance, risk management is an ever-present reality. It happens when an investor prefers U.S. Treasury bonds to corporate bonds, when a fund manager uses currency derivatives to limit his exposure to foreign exchange fluctuations, and when a bank runs a customer’s credit report before extending a personal loan. To reduce or control exposure to risk, brokers use derivatives such as options and futures, while money managers employ various risk management strategies.
A lack of proper risk management can have devastating effects on businesses, people, and the economy as a whole. For instance, lenders who extended mortgages to people with poor credit; investment firms that bought, packaged, and resold these mortgages; and funds that invested excessively in the repackaged, but still risky, mortgage-backed securities all contributed to the subprime mortgage meltdown in 2007 and the subsequent Great Recession (MBSs).
Good, Bad, and Necessary Risk.
When most of us hear the word “risk,” we immediately think of something bad happening. However, risk is inherent in the investment world and cannot be eliminated if positive results are to be achieved.
The possibility of an unfavourable result is a common definition of investment risk. The dissimilarity can be stated either absolutely or in relation to another variable, such as a market standard.
While that deviation may be positive or negative, investment professionals generally accept the idea that such deviation implies some degree of the intended outcome for your investments. Therefore, one anticipates accepting the higher risk in order to achieve the higher returns. It’s also commonly believed that greater volatility corresponds to greater risk. While investment professionals constantly seek—and occasionally find—ways to reduce such volatility, there is no clear agreement among them on how it’s best done.
A person’s risk appetite, or in the case of an investment professional, the scope of their clients’ risk tolerance, is the sole determinant of how much volatility they should be willing to tolerate. Standard deviation, a statistical measure of dispersion around a central tendency, is one of the most popular absolute risk metrics. The standard deviation of an investment’s returns over a given time period can be calculated by first determining the average return over that time frame. According to normal distributions (the well-known bell-shaped curve), an investment’s return should be within one standard deviation of the average 67% of the time, and within two standard deviations of the average 95% of the time. This enables quantitative assessments of risk for investors. If they believe that they can tolerate the risk, financially and emotionally, they invest.
A Case Study in Risk Management
For instance, the total annualized return of the S&P 500 was 10.7% over the 15-year period from August 1, 1992, through July 31, 2007. This figure reveals the overall course of events, but it provides no context for those events. Comparatively, the S&P 500’s average standard deviation over the same time frame was 13.5%. That’s the gap between the average return and the real return during that entire 15-year time frame.
The bell curve hypothesis states that any observed value is likely to be within one standard deviation of the mean roughly 67% of the time and within two standard deviations roughly 95% of the time. Thus, during this time period, an S&P 500 investor could expect a return of 10.7% plus or minus the standard deviation of 13.5% about 67% of the time; he could also assume a 27% increase or decrease (95% of the time) by rounding up or down. He invests if he thinks he can withstand a loss.