Year: 2020

Enterprise risk management (ERM) is a plan-based business strategy that aims to identify, assess, and prepare for any dangers, hazards, and other potentials for disaster both physical and figurative that may interfere with an organization’s operations and objectives.

Enterprise risk management (ERM) in business includes the methods and processes used by organizations to manage risks and seize opportunities related to the achievement of their objectives. ERM provides a framework for risk management, which typically involves identifying particular events or circumstances relevant to the organization’s objectives (threats and opportunities), assessing them in terms of likelihood and magnitude of impact, determining a response strategy, and monitoring process. By identifying and proactively addressing risks and opportunities, business enterprises protect and create value for their stakeholders, including owners, employees, customers, regulators, and society overall.

ERM can also be described as a risk-based approach to managing an enterprise, integrating concepts of internal control, the Sarbanes–Oxley Act, data protection and strategic planning. ERM is evolving to address the needs of various stakeholders, who want to understand the broad spectrum of risks facing complex organizations to ensure they are appropriately managed. Regulators and debt rating agencies have increased their scrutiny on the risk management processes of companies.

According to Thomas Stanton of Johns Hopkins University, the point of enterprise risk management is not to create more bureaucracy, but to facilitate discussion on what the really big risks are.

The discipline not only calls for corporations to identify all the risks they face and to decide which risks to manage actively, but it also involves making that plan of action available to all stakeholders, shareholders and potential investors, as part of their annual reports. Industries as varied as aviation, construction, public health, international development, energy, finance, and insurance all utilize ERM.

Companies have been managing risk for years. Historically, they’ve done this by buying insurance: property insurance for literal, detrimental losses due to fires, thefts, and natural disasters; and liability insurance and malpractice insurance to deal with lawsuits and claims of damage, loss, or injury. But another key element in ERM is a business risk that is, obstacles associated with technology (particularly technological failures), company supply chains, and expansion and the costs and financing of the same.

More recently, companies have managed such risks through the capital markets with derivative instruments that help them manage the ups and downs of moment-to-moment movements in currencies, interest rates, commodity prices, and equities. From a mathematical point of view, all of these risks or “exposures” have been reasonably easy to measure, with resulting profits and losses going straight to the bottom line.

Modern businesses, however, face a much more diverse collection of obstacles and potential dangers. How companies manage the risks that defy easy measurements or a framework for management also falls under the ERM umbrella. These potentials for exposure include crucial risks such as reputation, day-to-day operational procedures, legal and human resources management, financial, the risk of failure of internal controls systems related to the Sarbanes-Oxley Act of 2002 (SOX), and overall governance.

ERM frameworks defined

There are various important ERM frameworks, each of which describes an approach for identifying, analyzing, responding to, and monitoring risks and opportunities, within the internal and external environment facing the enterprise. Management selects a risk response strategy for specific risks identified and analyzed, which may include:

• Avoidance: exiting the activities giving rise to risk
• Reduction: taking action to reduce the likelihood or impact related to the risk
• Alternative Actions: deciding and considering other feasible steps to minimize risks
• Share or Insure: transferring or sharing a portion of the risk, to finance it
• Accept: no action is taken, due to a cost/benefit decision

Monitoring is typically performed by management as part of its internal control activities, such as review of analytical reports or management committee meetings with relevant experts, to understand how the risk response strategy is working and whether the objectives are being achieved.

In 2003, the Casualty Actuarial Society (CAS) defined ERM as the discipline by which an organization in any industry assesses, controls, exploits, finances, and monitors risks from all sources for the purpose of increasing the organization’s short- and long-term value to its stakeholders.” The CAS conceptualized ERM as proceeding across the two dimensions of risk type and risk management processes. The risk types and examples include:

Hazard risk

Liability torts, Property damage, Natural catastrophe

Financial risk

Pricing risk, Asset risk, Currency risk, Liquidity risk

Operational risk

Customer satisfaction, Product failure, Integrity, Reputational risk; Internal Poaching; Knowledge drain

Strategic risks

Competition, Social trend, Capital availability

The risk management process involves:

• Establishing Context: This includes an understanding of the current conditions in which the organization operates on an internal, external and risk management context.
• Identifying Risks: This includes the documentation of the material threats to the organization’s achievement of its objectives and the representation of areas that the organization may exploit for competitive advantage.
• Analyzing/Quantifying Risks: This includes the calibration and, if possible, creation of probability distributions of outcomes for each material risk.
• Integrating Risks: This includes the aggregation of all risk distributions, reflecting correlations and portfolio effects, and the formulation of the results in terms of impact on the organization’s key performance metrics.
• Assessing/Prioritizing Risks: This includes the determination of the contribution of each risk to the aggregate risk profile, and appropriate prioritization.
• Treating/Exploiting Risks: This includes the development of strategies for controlling and exploiting the various risks.
• Monitoring and Reviewing: This includes the continual measurement and monitoring of the risk environment and the performance of the risk management strategies.

The COSO ERM Framework has eight Components and four objectives categories. It is an expansion of the COSO Internal Control-Integrated Framework published in 1992 and amended in 1994. The eight components – additional components highlighted – are:

• Authority and pledge to the ERM
• RISK Management policy
• Mixer of ERM in the institution
• Risk Assessment
• Risk Response
• communication and reporting
• Information and Communication
• Monitoring

The four objectives categories, additional components highlighted are:

• Strategy: high-level goals, aligned with and supporting the organization’s mission
• Operations: effective and efficient use of resources
• Financial Reporting: Reliability of operational and financial reporting
• Compliance: Compliance with applicable laws and regulations

Differences and Solutions

Enterprise risk management is an extension of traditional risk management, and differs in the following ways.

• Strategic application. An ERM approach is integrated into an organizations business decision. Because the effort is enterprise-wide, it supersedes any departmental or functional autonomy to encourage continuous review and support of the organizations most value-based objectives.
• Risks considered. ERM involves managing all of the risks affecting an organization’s ability to meet its goals, regardless of the types of risks being considered. This carefully reviewed and benchmarked approach allows organizations the ability to stay focused on key areas of prosperity and survival.
• Performance metrics. ERM emphasizes results-based performance measurement throughout the organization. Results indicate whether a risk management technique helped to achieve a business goal, such as return on investment or return on assets. All forms of risk management, including ERM, are intended to help minimize the adverse effects of missed opportunities and losses.The specific benefits of ERM include maximizing the possible opportunities for growth, minimizing the expected organizational losses and therefore increasing the expected income and asset value, and reducing the residual uncertainty in all areas of the enterprise.

The returns potential of an investment option is of prime importance for every investor. But, while every investor would want to generate the highest possible returns, the quantum of risks involved is often overlooked.

The inherent nature of financial markets, irrespective of the type of investment you select, is such that the returns potential of the investment is directly linked to its risk. This phenomenon is known as risk-return trade-off.

The risk-return tradeoff states that the potential return rises with an increase in risk. Using this principle, individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or risk with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if the investor will accept a higher possibility of losses.

Risk-Return Trade-Off Calculation

Generally, the risk and return trade-off are calculated with the help of a few metrics. For instance, in the case of mutual funds, investors determine the trade-off with the help of these metrics-

Alpha

Alpha measures the risk-adjusted returns of a mutual fund scheme against its underlying benchmark. For instance, if a particular mutual fund follows Nifty 50, the risk-adjusted returns of the fund above or below the performance of the benchmark are considered alpha.

For instance, a negative alpha of 1 means that the mutual fund underperformed in comparison to its benchmark by 1%. A positive alpha indicates that the fund outperformed its benchmark. Higher the alpha is, the higher is the returns potential of the mutual fund.

Beta

Beta measures the volatility of the fund in line with its underlying benchmark. Higher or positive beta means that the fund you have selected is more volatile as compared to its benchmark. Funds have lower or negative beta if their volatility is lower than the benchmark.

Funds with lower betas are highly recommended to new investors as they are less volatile. But less volatility often leads to lower returns as compared to a fund with higher beta. But higher beta does not guarantee higher returns.

Sharpe Ratio

Sharpe Ratio is used for analysing the risk-adjusted returns potential of a mutual fund scheme. In other words, it measures the potential returns of a scheme against each unit of risk the scheme has undertaken.

So, Sharpe Ratio of 1 means that the returns potential of a fund is higher than what is expected for an investment at a particular risk level. If the ratio is below 1, it signifies that the returns potential of the fund is lower than the quantum of risk carried by the fund.

Standard Deviation

Standard deviation measures the individual returns of an investment over time against its average return for the same period. So, a higher standard deviation of a mutual fund scheme means that the fund is volatile and carries a higher level of risk as compared to a fund with a lower standard deviation.

The standard deviation of a fund is compared against the standard deviation of funds from the same category to understand how volatile and risky a particular fund is.

The risk-return tradeoff is the trading principle that links high risk with high reward. The appropriate risk-return tradeoff depends on a variety of factors including an investor’s risk tolerance, the investor’s years to retirement and the potential to replace lost funds. Time also plays an essential role in determining a portfolio with the appropriate levels of risk and reward. For example, if an investor has the ability to invest in equities over the long term, that provides the investor with the potential to recover from the risks of bear markets and participate in bull markets, while if an investor can only invest in a short time frame, the same equities have a higher risk proposition.

Investors use the risk-return tradeoff as one of the essential components of each investment decision, as well as to assess their portfolios as a whole. At the portfolio level, the risk-return tradeoff can include assessments of the concentration or the diversity of holdings and whether the mix presents too much risk or a lower-than-desired potential for returns.

Measuring Singular Risk in Context

When an investor considers high-risk-high-return investments, the investor can apply the risk-return tradeoff to the vehicle on a singular basis as well as within the context of the portfolio as a whole. Examples of high-risk-high return investments include options, penny stocks and leveraged exchange-traded funds (ETFs). Generally speaking, a diversified portfolio reduces the risks presented by individual investment positions. For example, a penny stock position may have a high risk on a singular basis, but if it is the only position of its kind in a larger portfolio, the risk incurred by holding the stock is minimal.

Risk-Return Tradeoff at the Portfolio Level

That said, the risk-return tradeoff also exists at the portfolio level. For example, a portfolio composed of all equities presents both higher risk and higher potential returns. Within an all-equity portfolio, risk and reward can be increased by concentrating investments in specific sectors or by taking on single positions that represent a large percentage of holdings. For investors, assessing the cumulative risk-return tradeoff of all positions can provide insight on whether a portfolio assumes enough risk to achieve long-term return objectives or if the risk levels are too high with the existing mix of holdings.

Risk-Return Trade-Off in Mutual Funds

Even if you want to invest in mutual funds, you will see that the returns vary considerably between small-cap funds, mid-cap funds, large-cap funds, hybrid funds, debt funds, and others. Just like the returns, the quantum of risk varies too.

Small-cap equity funds have the highest level of risk, while debt funds are known to be relatively safer. But, the higher level of risk in small-cap funds can also deliver higher returns as compared to low-risk debt funds.

However, it is worth noting that a higher level of risk in no way guarantees higher returns. While high-risk investment options do have higher returns potential, this potential should never be confused with any guarantee. High-risk investments could very well deliver significant losses too.

A tool commonly used in risk management and project management. A risk register, also called a register log is created on the early stages of a project. It is an important document in your risk management plan; it enables you to identify potential risks in a project or an organization and at the same time, it helps you record and track issues and address problems as they arise. Although it is sometimes created just to fulfill regulatory requirements, it is a necessary tool to keep on top of potential issues that can deter you from your intended outcomes.

A risk register includes all relevant information about every risk that has been identified, from the nature of that risk to the level of risk to who owns it and down to what mitigation measures that have been put in place to respond to it. Generally, a risk register is shared between project stakeholders. It allows all of those involved in the project to be kept aware of issues and as well as providing a means of tracking the response to those issues. It can also be used to flag new project issues and also to give suggestions on what course of action is suitable to solve them.

As you may know, corporate and organizational projects may face risk at a certain point in time, a risk register provides better way and means to respond or address certain issues should they arise. Overall, a risk register is a useful tool that can help in the whole decision-making process and enables managers and project stakeholders to address issues in the most appropriate and effective way. Since a risk register contains all information about identified project risks, analysis of the severity of such risks and evaluations of the possible effective solutions to apply, people involved in the project can have a guarantee that issues can be resolved as quickly as possible.

It is imminent to have some sort of risks arise during the implementation of a project, however, these risks need not be a threat to the success of the project. Risks are simply issues that can arise during a project, if properly determined in advance, solution can also be determined. Therefore, risks can be resolved more efficiently and effectively with the use of the proper tools such as a risk management plan and a risk register.

There are five main indicators of investment risk that apply to the analysis of stocks, bonds, and mutual fund portfolios. They are alpha, beta, r-squared, standard deviation and the Sharpe ratio. These statistical measures are historical predictors of investment risk/volatility and they are all major components of modern portfolio theory (MPT).

MPT is a standard financial and academic methodology used to assess the performance of equity, fixed-income, and mutual fund investments by comparing them to market benchmarks.

Alpha

Alpha is a measure of an investment’s performance on a risk-adjusted basis. It takes the volatility (price risk) of a security or fund portfolio and compares its risk-adjusted performance to a benchmark index. The excess return of the investment relative to the return of the benchmark index is its alpha.

Simply stated, alpha is often considered to represent the value that a portfolio manager adds or subtracts from a fund portfolio’s return. An alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, an alpha of -1.0 would indicate an underperformance of 1%. For investors, the higher the alpha the better.

Beta

Beta, also known as the beta coefficient, is a measure of the volatility, or systematic risk, of a security or a portfolio, compared to the market as a whole. Beta is calculated using regression analysis and it represents the tendency of an investment’s return to respond to movements in the market. By definition, the market has a beta of 1.0. Individual security and portfolio values are measured according to how they deviate from the market.

A beta of 1.0 indicates that the investment’s price will move in lock-step with the market. A beta of less than 1.0 indicates that the investment will be less volatile than the market. Correspondingly, a beta of more than 1.0 indicates that the investment’s price will be more volatile than the market. For example, if a fund portfolio’s beta is 1.2, it is theoretically 20% more volatile than the market.

Conservative investors who wish to preserve capital should focus on securities and fund portfolios with low betas while investors willing to take on more risk in search of higher returns should look for high beta investments.

R-squared

R-squared is a statistical measure that represents the percentage of a fund portfolio or a security’s movements that can be explained by movements in a benchmark index. For fixed-income securities and bond funds, the benchmark is the U.S. Treasury Bill. The S&P 500 Index is the benchmark for equities and equity funds.

R-squared values range from 0 to 100. According to Morningstar, a mutual fund with an R-squared value between 85 and 100 has a performance record that is closely correlated to the index. A fund rated 70 or less typically does not perform like the index.

Mutual fund investors should avoid actively managed funds with high R-squared ratios, which are generally criticized by analysts as being “closet” index funds. In such cases, it makes little sense to pay higher fees for professional management when you can get the same or better results from an index fund.

Standard Deviation

Standard deviation measures the dispersion of data from its mean. Basically, the more spread out the data, the greater the difference is from the norm. In finance, standard deviation is applied to the annual rate of return of an investment to measure its volatility (risk). A volatile stock would have a high standard deviation. With mutual funds, the standard deviation tells us how much the return on a fund is deviating from the expected returns based on its historical performance.

Sharpe Ratio

Developed by Nobel laureate economist William Sharpe, the Sharpe ratio measures risk-adjusted performance. It is calculated by subtracting the risk-free rate of return (U.S. Treasury Bond) from the rate of return for an investment and dividing the result by the investment’s standard deviation of its return.

The Sharpe ratio tells investors whether an investment’s returns are due to wise investment decisions or the result of excess risk. This measurement is useful because while one portfolio or security may generate higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater an investment’s Sharpe ratio, the better its risk-adjusted performance.

Quantitative Risk Assessment (QRA) is finding, assessing and analyzing the risks. With this useful technique you are able to predict precisely in a quantifiable way how the risk will affect your work’s progress. The results generated from this method are made after keeping a variety of assumptions and constraints in mind thus ensuring the validity of the results made. It helps to make cost effective decisions and manages the risks for the project. This helps identify preventive measures thereby reducing the likelihood of affecting the company and its team members.

Quantitative risk assessment (QRA) software and methodologies give quantitative estimates of risks, given the parameters defining them. They are used in the financial sector, the chemical process industry, and other areas.

In financial terms, quantitative risk assessments include a calculation of the single loss expectancy of monetary value of an asset.

In the chemical process and petrochemical industries a QRA is primarily concerned with determining the potential loss of life (PLL) caused by undesired events. Specialist software can be used to model the effects of such an event, and to help calculate the potential loss of life. Some organisations use the risk outputs to assess the implied cost to avert a fatality (ICAF) which can be used to set quantified criteria for what is an unacceptable risk and what is tolerable.

For the explosives industry, QRA can be used for many explosive risk applications. It is especially useful for site risk analysis when reliance on quantity distance (QD) tables is not feasible.

Quantitative Risk Assessment Done

The risks are identified and recorded into a list. From this list, risks need to be prioritized and then fed into a Risk Register. These risks are then ranked according to their level of severity and impact by using probability distributions to calculate the risk’s impact and probability. It also utilizes constraints like schedule, cost estimates and other resources.

Limitations

Some of the QRA software models described above must be used in isolation: for example the results from a consequence model cannot be used directly in a risk model. Other QRA software programs link different calculation modules together automatically to facilitate the process. Some of the software is proprietary and can only be used within certain organisations.

Due to the large amount of data processing required by QRA calculations, the usual approach has been to use two-dimensional ellipses to represent hazard zones such as the area around an explosion which poses a 10% chance of fatality. Similarly, a pragmatic approach is used in the simplification of dispersion results. Typically a flat terrain, unobstructed world is used to determine the behaviour of a dispersing cloud and/or a vaporizing pool. This presents problems when the effects of non-flat terrain or the complex geometry of process plants would no doubt affect the behaviour of a dispersing cloud. Though they have limitations, the 2D hazard zone and simplified approach to 3D dispersion modelling allow the handling of large volumes of risk results with known assumptions to assist in decision-making. The trade-off shifts as computer processing power increases.

The modeling of the consequences of hazardous events in a true 3D manner may require a different approach, for example using a computational fluid dynamics method to study cloud dispersion over hilly terrain. The creation of CFD models requires significantly more investment of time on the part of the modeling analyst (because of the increased complexity of the modeling), which may not be justified in all cases.

One major limitation of QRA in the safety field is that it is focussed primarily on the loss of containment of hazardous fluids and what happens when they are released. This renders QRA somewhat unworkable in hazardous industries that do not focus on fluid containment yet are still subject to catastrophic events (e.g. aviation, pharmaceuticals, mining, water treatment, etc.) This has led to the development of a risk process that draws on the experience of organisations and their employees to produce risk assessments that produce potential loss of life (PLL) outputs without fault and event tree modelling. This process is probably most commonly known by the name SQRA which was the first methodology to enter the marketplace in the late 1990s but is perhaps more accurately described by the term Experience-based Quantification (EBQ). Today there is a choice of software with which to undertake this methodology and it has been used extensively in the mining industry on a global basis.

In an effort to be fairer and to avoid adding to already high imprisonment rates in the US, courts across America have started using quantitative risk assessment software when trying to make decisions about releasing people on bail and sentencing, which are based on their history and other attributes. It analyzed recidivism risk scores calculated by one of the most commonly used tools, the Northpointe COMPAS system, and looked at outcomes over two years, and found that only 61% of those deemed high risk actually committed additional crimes during that period and that African-American defendants were far more likely to be given high scores that white defendants. These results are part of larger questions being raised in the field of machine ethics with regard to the risks of perpetuating patterns of discrimination via the use of big data and machine learning across many fields.

Advantages of Quantitative Risk Assessment

Below you will find a comprehensive list of benefits that you get with QRA.

It helps identifying potential:

• Hazards that you may face in every phase of your project’s creation
• Economic losses
• Accidental scenarios and their consequences
• Damage to the basic functionality of the system
• Effects of uncertainties and assumptions
• Control strategies
• Measures that need to be adopted to reduce risk levels
• So that it can reduce their negative impacts and thus increase outcome.
• Estimates of the likelihood of meeting targets.
• Contingency which needs to be communicated to achieve the desired level of comfort.

An investment strategy is what guides an investor’s decisions based on goals, risk tolerance, and future needs for capital. Some investment strategies seek rapid growth where an investor focuses on capital appreciation, or they can follow a low-risk strategy where the focus is on wealth protection.

In finance, an investment strategy is a set of rules, behaviors or procedures, designed to guide an investor’s selection of an investment portfolio. Individuals have different profit objectives, and their individual skills make different tactics and strategies appropriate. Some choices involve a tradeoff between risk and return. Most investors fall somewhere in between, accepting some risk for the expectation of higher returns.

Many investors buy low-cost, diversified index funds, use dollar-cost averaging, and reinvest dividends. Dollar-cost averaging is an investment strategy where a fixed dollar amount of stocks or a particular investment are acquired on a regular schedule regardless of the cost or share price. The investor purchases more shares when prices are low and fewer shares when prices are high. Over time, some investments will do better than others, and the return averages out over time.

Some experienced investors select individual stocks and build a portfolio based on individual firm analysis with predictions on share price movements.

Strategies

• No strategy: Investors who don’t have a strategy have been called Sheep. Arbitrary choices modeled on throwing darts at a page (referencing earlier decades when stock prices were listed daily in the newspapers) have been called Blind Folded Monkeys Throwing Darts [no source]. This famous test had debatable outcomes.
• Active vs Passive: Passive strategies like buy and hold and passive indexing are often used to minimize transaction costs. Passive investors don’t believe it is possible to time the market. Active strategies such as momentum trading are an attempt to outperform benchmark indexes. Active investors believe they have the better than average skills.
• Momentum Trading: One strategy is to select investments based on their recent past performance. Stocks that had higher returns for the recent 3 to 12 months tend to continue to perform better for the next few months compared to the stocks that had lower returns for the recent 3 to 12 months. There is evidence both for and against this strategy.
• Buy and Hold: This strategy involves buying company shares or funds and holding them for a long period. It is a long term investment strategy, based on the concept that in the long run equity markets give a good rate of return despite periods of volatility or decline. This viewpoint also holds that market timing, that one can enter the market on the lows and sell on the highs, does not work for small investors, so it is better to simply buy and hold.
• Long Short Strategy: A long short strategy consists of selecting a universe of equities and ranking them according to a combined alpha factor. Given the rankings we long the top percentile and short the bottom percentile of securities once every re-balancing period.
• Indexing: Indexing is where an investor buys a small proportion of all the shares in a market index such as the S&P 500, or more likely, an index mutual fund or an exchange-traded fund (ETF). This can be either a passive strategy if held for long periods, or an active strategy if the index is used to enter and exit the market quickly.
• Pairs Trading: Pairs trade is a trading strategy that consists of identifying similar pairs of stocks and taking a linear combination of their price so that the result is a stationary time-series. We can then compute Altman_Z-score for the stationary signal and trade on the spread assuming mean reversion: short the top asset and long the bottom asset.
• Value vs Growth: Value investing strategy looks at the intrinsic value of a company and value investors seek stocks of companies that they believed are undervalued. Growth investment strategy looks at the growth potential of a company and when a company that has expected earnings growth that is higher than companies in the same industry or the market as a whole, it will attract the growth investors who are seeking to maximize their capital gain.
• Dividend growth investing: This strategy involves investing in company shares according to the future dividends forecast to be paid. Companies that pay consistent and predictable dividends tend to have less volatile share prices. Well-established dividend-paying companies will aim to increase their dividend payment each year, and those who make an increase for 25 consecutive years are referred to as a dividend aristocrat. Investors who reinvest the dividends are able to benefit from compounding of their investment over the longer term, whether directly invested or through a Dividend Reinvestment Plan (DRIP).
• Dollar cost averaging: The dollar cost averaging strategy is aimed at reducing the risk of incurring substantial losses resulted when the entire principal sum is invested just before the market falls.
• Contrarian investment: A contrarian investment strategy consists of selecting good companies in time of down market and buying a lot of shares of that company in order to make a long-term profit. In time of economic decline, there are many opportunities to buy good shares at reasonable prices. But what makes a company good for shareholders? A good company is one that focuses on the long-term value, the quality of what it offers or the share price. This company must have a durable competitive advantage, which means that it has a market position or branding which either prevents easy access by competitors or controls a scarce raw material source. Some examples of companies that response to these criteria are in the field of insurance, soft drinks, shoes, chocolates, home building, furniture and many more. We can see that there is nothing “fancy” or special about these fields of investment: they are commonly used by each and every one of us. Many variables must be taken into consideration when making the final decision for the choice of the company. Some of them are:
  • The company must be in a growing industry.
  • The company cannot be vulnerable to competition.
  • The company must have its earnings on an upward trend.
  • The company must have a consistent return on invested capital.
  • The company must be flexible to adjust prices for inflation.
• Smaller companies: Historically medium-sized companies have outperformed large cap companies on the Stock market. Smaller companies again have had even higher returns. The very best returns by market cap size historically are from micro-cap companies. Investors using this strategy buy companies based on their small market cap size on the stock exchange. One of the greatest investors, Warren Buffett, made money in small companies early in his career combining it with value investing. He bought small companies with low P/E ratios and high assets to market cap.

Market Risk

The risk of investments declining in value because of economic developments or other events that affect the entire market. The main types of market risk are equity risk, interest rate risk and

Currency risk

• Equity risk: Applies to an investment in shares. The market price of shares varies all the time depending on demand and supply. Equity risk is the risk of loss because of a drop in the market price of shares.
• Interest rate risk: Applies to debt investments such as bonds. It is the risk of losing money because of a change in the interest rate. For example, if the interest rate goes up, the market value of bonds will drop.
• Currency risk: Applies when you own foreign investments. It is the risk of losing money because of a movement in the exchange rate. For example, if the U.S. dollar becomes less valuable relative to the Canadian dollar, your U.S. stocks will be worth less in Canadian dollars.

Liquidity Risk

The risk of being unable to sell your investment at a fair price and get your money out when you want to. To sell the investment, you may need to accept a lower price. In some cases, such as exempt market investments, it may not be possible to sell the investment at all.

Concentration Risk

The risk of loss because your money is concentrated in 1 investment or type of investment. When you diversify your investments, you spread the risk over different types of investments, industries and geographic locations.

Credit Risk

The risk that the government entity or company that issued the bond will run into financial difficulties and won’t be able to pay the interest or repay the principal at maturity. Credit risk applies to debt investments such as bonds. You can evaluate credit risk by looking at the credit rating of the bond. For example, long-term Canadian government bonds have a credit rating of AAA, which indicates the lowest possible credit risk.

Reinvestment Risk

The risk of loss from reinvesting principal or income at a lower interest rate. Suppose you buy a bond paying 5%. Reinvestment risk will affect you if interest rates drop and you have to reinvest the regular interest payments at 4%. Reinvestment risk will also apply if the bond matures and you have to reinvest the principal at less than 5%. Reinvestment risk will not apply if you intend to spend the regular interest payments or the principal at maturity.

Inflation Risk

The risk of a loss in your purchasing power because the value of your investments does not keep up with inflation. Inflation erodes the purchasing power of money over time – the same amount of money will buy fewer goods and services. Inflation risk is particularly relevant if you own cash or debt investments like bonds. Shares offer some protection against inflation because most companies can increase the prices they charge to their customers. Share prices should therefore rise in line with inflation. Real estate also offers some protection because landlords can increase rents over time.

Horizon Risk

The risk that your investment horizon may be shortened because of an unforeseen event, for example, the loss of your job. This may force you to sell investments that you were expecting to hold for the long term. If you must sell at a time when the markets are down, you may lose money.

Longevity Risk

The risk of outliving your savings. This risk is particularly relevant for people who are retired, or are nearing retirement.

Foreign Investment risk

The risk of loss when investing in foreign countries. When you buy foreign investments, for example, the shares of companies in emerging markets, you face risks that do not exist in India, in your home country, for example, the risk of nationalization. (Bank Nationalization in India)

Manager Risk

The chance that a pooled fund will underperform due to poor investment decisions of the fund manager.

Business Risk

This refers to the risk of a particular business failing and thereby loosing its investment. Poor business performance may be caused by a variety of factors like heightened competition, emergence of new technologies, etc.

Financial Risk

The financial risk is a result of over dependence on borrowed funds. If a company uses a large amount of debt, then it has to pay a relatively large amount of fixed interest. During recession due to lower revenue, risk of non-payment of fixed interest increases and exposes the company to financial risk.

Systematic and Unsystematic Risk

The risk of any individual stock can be separated into two components: non-diversifiable and diversifiable risk. Non-diversifiable risk is that part of the total risk that is in relation to the general economy or the stock market as a whole and hence, cannot be eliminated by diversification.

Non-diversifiable risk is also referred to as market or systematic risk.

• Diversifiable risk, on the other hand, is margin of the company or industry and hence can be eliminated by diversification. Diversifiable risk is also called as unsystematic risk or specific risk.
• Example of non-diversifiable or market risk factors: Major change in tax rates, war and other calamities, an increase or decrease in inflation rates, a change in economic/ environmental policy, industrial recession, an increase in international oil prices, etc.
• Example of diversifiable or specific risk factor: Strike in company, bankruptcy of a major supplier, death/resignation of key company officer, unexpected entry of new competitor into the market, etc.

Legal Risk

Legal risk is the risk arising from failure to comply with statutory or regulatory obligations. Generally, all laws in the host country will apply to an entrepreneur’s local business operations. Examples include filing procedures, employment law, environmental law, tax law, and ownership requirements.

A strategy used by investors to manage risk. By spreading your money across different assets and sectors, the thinking is that if one area experiences turbulence, the others should balance it out. It’s the opposite of placing all your eggs in one basket.

Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event.

Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Here, we look at why this is true and how to accomplish diversification in your portfolio.

Different Types of Risk

Investors confront two main types of risk when investing. The first is undiversifiable, which is also known as systematic or market risk. This type of risk is associated with every company. Common causes include inflation rates, exchange

rates, political instability, war, and interest rates. This type of risk is not specific to a particular company or industry, and it cannot be eliminated or reduced through diversification it is just a risk investor must accept.

Systematic risk affects the market in its entirety, not just one particular investment vehicle or industry.

The second type of risk is diversifiable. This risk is also known as unsystematic risk and is specific to a company, industry, market, economy, or country. It can be reduced through diversification. The most common sources of unsystematic risk are a business risk and financial risk. Thus, the aim is to invest in various assets so they will not all be affected the same way by market events.

Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk. The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.

Diversification strives to smooth out unsystematic risk events in a portfolio, so the positive performance of some investments neutralizes the negative performance of others. The benefits of diversification hold only if the securities in the portfolio are not perfectly correlated that is, they respond differently, often in opposing ways, to market influences.

• Diversification reduces risk by investing in investments that span different financial instruments, industries, and other categories.
• Risk can be both undiversifiable or systemic, and diversifiable or unsystemic.
• Investors may find balancing a diversified portfolio complicated and expensive, and it may come with lower rewards because the risk is mitigated.

Diversification by Asset Class

Fund managers and investors often diversify their investments across asset classes and determine what percentages of the portfolio to allocate to each. Classes can include:

• Stocks: Shares or equity in a publicly traded company
• Bonds: Government and corporate fixed-income debt instruments
• Real estate: Land, buildings, natural resources, agriculture, livestock, and water and mineral deposits
• Exchange-traded funds (ETFs): A marketable basket of securities that follow an index, commodity, or sector
• Commodities: Basic goods necessary for the production of other products or services
• Cash and short-term cash-equivalents (CCE): Treasury bills, certificate of deposit (CD), money market vehicles, and other short-term, low-risk investments

Risk exposure is the measure of potential future loss resulting from a specific activity or event. An analysis of the risk exposure for a business often ranks risks according to their probability of occurring multiplied by the potential loss if they do. By ranking the probability of potential losses, a business can determine which losses are minor and which are significant enough to warrant investment.

Risk exposure in any business or an investment is the measurement of potential future loss due to a specific event or business activity and is calculated as the probability of the even multiplied by the expected loss due to the risk impact.

There are two categories of risks: pure risks and speculative risks. Pure risks are unexpected risks that cannot be controlled, such as unexpected death and natural disasters. Speculative risks are voluntary risks that have an uncertain outcome, such as business investments or new product introductions. When things go wrong, speculative risks can result in losses such as brand damage, compliance failures, security breaches, and liability issues.

Risk exposure is a quantified loss potential of business. Risk exposure is usually calculated by multiplying the probability of an incident occurring by its potential losses.

When considering loss probability, businesses usually divide risk into two categories: pure risk and speculative risk. Pure risks are categories of risk that are beyond anyone’s control, such as natural disasters or untimely death. Speculative risks can be taken on voluntarily. Types of speculative risk include financial investments or any activities that will result in either a profit or a loss for the business. Speculative risks carry an uncertain outcome. Potential losses incurred by speculative risks could stem from business liability issues, property loss, property damage, strained customer relations and increased overhead expenses.

To calculate risk exposure, variables are determined to calculate the probability of the risk occurring. These are then multiplied by the total potential loss of the risk. To determine the variables, organizations must know the total loss in dollars that might occur, as well as a percentage depicting the probability of the risk occurring. The objective of the risk exposure calculation is to determine the overall level of risk that the organization can tolerate for the given situation, based on the benefits and costs involved. The level of risk an organization is prepared to accept is called its risk appetite.

Risk Exposure formula = Probability of Event * Loss Due to Risk (Impact)

Types of Risk exposure

1. Transaction Exposure

Transaction Exposure occurs due to changes in the exchange rate in foreign currency. Such exposure is faced by a business operating internationally or dependant on components, which needs to be imported from other countries, resulting in a transaction in foreign exchange. Buying and selling, lending, and borrowing, which involves foreign currency, have to face transaction exposure.

The following risk involved in Transaction exposure:

1. Exchange Rate: It occurs in case of the difference between the date of the transaction contract made and the transaction executed, for, E.g., Credit Purchase, Forward Contracts, etc.
2. Credit Risk: Default risk in case the buyer or borrower is unable to pay.
3. Liquidity Risk: In the case of contracts involving future date payments denominated in foreign currency, which might affect the credibility of the buyer or borrower.

Transaction Exposure is mostly managed using various derivatives contracts to hedge, so risk arises from these transactions will not affect income or expense.

2. Operating Exposure

Measurement of business operating cash flow is affected due to a change in the exchange rate, which results in a growth in profit. Competitive effect and conversion effect will take place in the case of multinationals compare to local businesses operating in their domestic country. Such risk is managed by adopting a proper pricing strategy and reducing costs through local operations, outsourcing, etc.

3. Translation Exposure

Translation Exposure arises due to changes in assets or liabilities of the balance sheet having a subsidiary in a foreign country while reporting its consolidated financial statements. It measures changes in the value of assets and liabilities of the company due to exchange rate fluctuation. Translation exposure does not affect the company’s operating cash flow or profit from overseas, but such risk only arises while reporting consolidated financial statements.

Translation Exposure in managed by the use of derivative strategies in foreign exchange to avoid ambiguity in the mind of investors of the company. The company accepts specific ways while maintains reporting financial statements.

Various Method

• Current/non-current method
• Monetary/Non-monetary method
• Temporal
• Current rate

4. Economic Exposure

Change in value of business due to a change in the exchange rate. The cost of the business is calculated by discounting future cash flows discounted at a specific rate. Economic exposure is a mixture of relevant items in firms’ operations related to transaction exposure and translation exposure. The company’s operating exposure and transaction exposure makes economic exposure to a business. Economic vulnerability always exists in business due to its continuous nature. Present value calculations applied in all future cash flows of business as per expected and real change in the exchange rate affect the value of the business.