Investment Strategies

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.

Key Risks: Interest, Market, Credit, Currency, Liquidity, Legal, Operational

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.

Managing Risk, Diversification

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 Analysis

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.

  1. 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.

  1. 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
  1. 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.

Definition, Risk Process

The risk of an investment refers to the variability of its rate of return from the expected rate of return. Statistically, it can be measured with variance, standard deviation, range, and beta.

Risk Management is a five-step process:

Step 1: Establish the context

Step 2: Identify the risks

Step 3: Analyse the risks

Step 4: Evaluate the risks

Step 5: Treat the risks

Throughout each step, it is essential that there is consultation and communication with everyone

in organisation about its functions, activities and events (refer to diagram).

Step 1: Establish the Context

Before risk can be clearly understood and dealt with, it is important to understand the context in

which it exists. You should define the relationship between your club and the environment that it

operates in, so that the boundaries for dealing with risks are clear.

Establish the content by considering:

  • The strategic context: The environment within which the organisation operates
  • The organisational context: The objectives, core activities and operation’s of the club.

Step 2: Identify the Risks

The purpose of this step is to identify what could go wrong (likelihood) and what is the consequence (loss or damage) of it occurring.

Risks can be physical, financial, ethical or legal.

Physical risks are those involving personal injuries, environmental and weather conditions and the physical assets of the organisation such as property, buildings, equipment, vehicles, stock and grounds.

Financial risks are those that involve the assets of the organisation and include theft, fraud, loans, license fees, attendances, membership fees, insurance costs, lease payments, pay-out of damages claims or penalties and fines by the government.

Ethical risks involve actual or potential harm to the reputation or beliefs of your club, while legal risks consist of responsibilities imposed on providers, participants and consumers arising from laws made by federal, state and local government authorities.

Step 3: Analyse the Risks (& Evaluate)

This involves analysing the likelihood and consequences of each identified risk and deciding which risk factors will potentially have the greatest effect and should, therefore, receive priority with regard to how they will be managed. The level of risk is analysed by combining estimates of likelihood (table 1) and consequences (table 2), to determine the priority level of the risk (table 3).

It is important to consider the consequences and the likelihood of risk in the context of the activity, the nature of your club and any other factors that may alter the consequences of likelihood of risk.

Risk evaluation involves comparing the level of risk found during the analysis process with previously established risk criteria, and deciding whether risks can be accepted. If the risk falls into the low or acceptable categories, they may be accepted with minimal further treatment. These risks should be monitored and periodically reviewed to ensure they remain acceptable. If risks do not fall into the low or acceptable category, they should be treated using one or more of the treatment options considered in step 4.

Step 4: Treat the Risks

Risk treatment involves identifying the range of options for treating the risk, evaluating those

options, preparing the risk treatment plans and implementing those plans. It is about considering the options for treatment and selecting the most appropriate method to achieve the desired outcome. Options for treatment need to be proportionate to the significance of the risk, and the cost of treatment commensurate with the potential benefits of treatment.

According to the standard, treatment options include:

  • Accepting the risk: For example, most people would consider minor injuries in participating in the sporting activity as being an inherent risk.
  • Avoiding the risk: Is about your club deciding either not to proceed with an activity, or choosing an alternate activity with acceptable risk, which meets the objects of your club. For example, a cricket club wishing to raise funds, may decide that a rock-climbing competition without a properly trained and accredited instructor, equipment, etc. may be risky and may decide on a safer way of raising funds.
  • Reducing the risk: Likelihood, or consequences, or both, is commonly practiced treatment of a risk within sport; for example, use of mouth guards for players in some sports (i.e. contact sports).
  • Transferring the risk: In full or in part, will generally occur through contracts or notices, for example your insurance contract is perhaps the most commonly used risk transfer form used. Other examples include lease agreements, waivers, disclaimers, tickets, and warning signs.
  • Retaining the risk: Is knowing that the risk treatment is not about risk elimination, rather it is about acknowledging, the risk is an important part of the sport activity, and some must be retained because of the inherent nature of the sport activity. It is important to consider the level of risk which is inherent and acceptable.
  • Financing the risk: Means the club funding the consequences of risk i.e. providing funds to cover the costs of implementing the risk treatment. Most community nonprofit sport clubs would not consider this option.

Step 5: Monitor and Review

As with communication and consultation, monitoring and review is an ongoing part of risk management that is integral to every step of the process. It is also the part of risk management that is most often given inadequate focus, and as a result, the risk management programs of many organisations become irrelevant and ineffective over time. Monitoring and review ensure that the important information generated by the risk management process is captured, used and maintained.

Few risks remain static. Factors that may affect the likelihood and consequences of an outcome may change, as may the factors that affect the suitability or cost of the various treatment options.

Review is an integral part of the risk management treatment plan. As discussed earlier, risk management is an integral part of all core business functions, and it should be seen and treated as such. Risk management should be fully incorporated into the operational and management processes at every level of the organisation and should be driven from the top down.

Risk Immunization

Immunization, also known as multi-period immunization, is a risk-mitigation strategy that matches the duration of assets and liabilities, minimizing the impact of interest rates on net worth over time. For example, large banks must protect their current net worth, whereas pension funds have the obligation of payments after a number of years. These institutions are both concerned about protecting the future value of their portfolios and must deal with uncertain future interest rates.

Immunization helps large firms and institutions protect their portfolios from exposure to interest rate fluctuations. Using a perfect immunization strategy, firms can nearly guarantee that movements in interest rates will have virtually no impact on the value of their portfolios.

Immunization is considered a “quasi-active” risk mitigation strategy since it has the characteristics of both active and passive strategies. By definition, pure immunization implies that a portfolio is invested for a defined return for a specific period of time regardless of any outside influences, such as changes in interest rates.

The opportunity cost of using the immunization strategy is potentially giving up the upside potential of an active strategy for the assurance that the portfolio will achieve the intended desired return. As in the buy-and-hold strategy, by design, the instruments best suited for this strategy are high-grade bonds with remote possibilities of default. In fact, the purest form of immunization would be to invest in a zero-coupon bond and match the maturity of the bond to the date on which the cash flow is expected to be needed. This eliminates any variability of return, positive or negative, associated with the reinvestment of cash flows.

In finance, interest rate immunisation, as developed by Frank Redington is a strategy that ensures that a change in interest rates will not affect the value of a portfolio. Similarly, immunisation can be used to ensure that the value of a pension fund’s or a firm’s assets will increase or decrease in exactly the opposite amount of their liabilities, thus leaving the value of the pension fund’s surplus or firm’s equity unchanged, regardless of changes in the interest rate.

Interest rate immunisation can be accomplished by several methods, including cash flow matching, duration matching, and volatility and convexity matching. It can also be accomplished by trading in bond forwards, futures, or options.

Other types of financial risks, such as foreign exchange risk or stock market risk, can be immunised using similar strategies. If the immunisation is incomplete, these strategies are usually called hedging. If the immunisation is complete, these strategies are usually called arbitrage.

Cash flow matching

Conceptually, the easiest form of immunisation is cash flow matching. For example, if a financial company is obliged to pay 100 dollars to someone in 10 years, it can protect itself by buying and holding a 10-year, zero-coupon bond that matures in 10 years and has a redemption value of $100. Thus, the firm’s expected cash inflows would exactly match its expected cash outflows, and a change in interest rates would not affect the firm’s ability to pay its obligations. Nevertheless, a firm with many expected cash flows can find that cash flow matching can be difficult or expensive to achieve in practice. That meant that only institutional investors could afford it. But the latest advances in technology have relieved much of this difficulty. Dedicated portfolio theory is based on cash flow matching and is being used by personal financial advisors to construct retirement portfolios for private individuals. Withdrawals from the portfolio to pay living expenses represent the stream of expected future cash flows to be matched. Individual bonds with staggered maturities are purchased whose coupon interest payments and redemptions supply the cash flows to meet the withdrawals of the retirees.

Difficulties

Immunisation, if possible and complete, can protect against term mismatch but not against other kinds of financial risk such as default by the borrower (i.e., the issuer of a bond). It might also be difficult to find assets with suitable cashflow structures that are necessary to ensure a particular level of overall volatility of assets to have a proper match with that of liabilities.

Once there is a change in interest rate, the entire portfolio has to be restructured to immunise it again. Such a process of continuous restructuring of portfolios makes immunisation a costly and tedious task.

Users of this technique include banks, insurance companies, pension funds and bond brokers; individual investors infrequently have the resources to properly immunise their portfolios.

The disadvantage associated with duration matching is that it assumes the durations of assets and liabilities remain unchanged, which is rarely the case.

Risk Management V/s Risk Measurement

Risk Management

According to the Marquette University Risk Unit, risk management is the continuing process to identify, analyze, evaluate, and treat loss exposures and monitor risk control and financial resources to mitigate the adverse effects of loss. We typically simplify this a bit and describe it as the Identification, Analysis (or Measurement), Treatment and Monitoring of risk. 

Risk Management is the art, science, process and all the ongoing activities involved in identifying, understanding, assessing, monitoring and then effectively reducing one’s exposure to risks, and the likelihood, impact and undesirable results should any of those risks materialize.

Although risks can be managed, it’s important to appreciate that risks are always evolving (Old risks can metamorphose and change, while new, unfamiliar risks are always emerging) and can never be truly eliminated.

Risk Measurement is the effort to “quantify” the likelihood and potential impact of a given risk or set of risks occurring. It’s just one of the many possible elements of risk assessment.

Measuring risk is generally conducted by using probability and statistical analysis of historic data that conforms to a classic “normal” bell curve distribution. As a result “Standard deviation” is the most common unit now used for risk measurement.

This approach was first articulated by Prof. Frank Knight, in his 1921 book “Risk, Uncertainty, and Profit.” In that book Dr. Knight was the first person to observe that the principal difference between Risk and Uncertainty is that “Risk” can be measured (using statistical methods) and “Uncertainty” cannot be measured. That’s so because the variability of the range of outcomes of uncertain phenomena do not conform to the bell curve distribution model, and by definition cannot measured.

As a result its extremely important to recognize the risk measurement is only reliable when its used in analyzing phenomenon where bell curve distribution patterns are the norm, (outcomes are unknown, but probabilities are known) such as casino gambling, slot machines, lottery, height, weight, and life expectancy.

Attempting to measure risk in areas where uncertainty reigns, (Outcomes are unknown and probabilities are unknown) such as romance, war, earthquakes, business, and investing is flawed & problematic from the very start.

Risk Organization

Risk Organization is the process of identifying, quantifying, and managing the risks that an organisation faces. As the outcomes of business activities are uncertain, they are said to have some element of risk. These risks include strategic failures, operational failures, financial failures, market disruptions, environmental disasters, and regulatory violations. Risk is a statistical concept that is measured using statistical concepts that are related to the unknown future. Almost all investments are exposed to it.

Risk Organization involves identifying the types of risk exposure within the company, measuring those potential risks, proposing means to hedge, insure or mitigate some of the risks and estimating the impact of various risks on the future earnings of the company.

While it is impossible that companies remove all risk from the organisation, it is important that they properly understand and manage the risks that they are willing to accept in the context of the overall corporate strategy. The Organization of the company is primarily responsible for risk Organization, but the board of directors, internal auditor, external auditor, and general counsel also play critical roles.

Risk can be managed in a number of ways: by the buying of insurance, by using derivative instruments as hedges, by sharing risks with others, or by avoiding risky positions altogether.

Duration Analysis of Risk

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. A bond’s duration is easily confused with its term or time to maturity because they are both measured in years. However, a bond’s term is a linear measure of the years until repayment of principal is due; it does not change with the interest rate environment. Duration, on the other hand is non-linear and accelerates as time to maturity lessens.

Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. At the same time, duration is a measure of sensitivity of a bond’s or fixed income portfolio’s price to changes in interest rates. In general, the higher the duration, the more a bond’s price will drop as interest rates rise (and the greater the interest rate risk). As a general rule, for every 1% change in interest rates (increase or decrease), a bond’s price will change approximately 1% in the opposite direction, for every year of duration. If a bond has a duration of five years and interest rates increase 1%, the bond’s price will drop by approximately 5% (1% X 5 years). Likewise, if interest rates fall by 1%, the same bond’s price will increase by about 5% (1% X 5 years).

Certain factors can affect a bond’s duration, including:

  • Time to maturity. The longer the maturity, the higher the duration, and the greater the interest rate risk. Consider two bonds that each yield 5% and cost $1,000, but have different maturities. A bond that matures faster say, in one year would repay its true cost faster than a bond that matures in 10 years. Consequently, the shorter-maturity bond would have a lower duration and less risk.
  • Coupon rate. A bond’s coupon rate is a key factor in calculation duration. If we have two bonds that are identical with the exception on their coupon rates, the bond with the higher coupon rate will pay back its original costs faster than the bond with a lower yield. The higher the coupon rate, the lower the duration, and the lower the interest rate risk.

The duration of a bond in practice can refer to two different things. The Macaulay duration is the weighted average time until all the bond’s cash flows are paid. By accounting for the present value of future bond payments, the Macaulay duration helps an investor evaluate and compare bonds independent of their term or time to maturity.

The second type of duration is called “modified duration” and, unlike Macaulay duration, is not measured in years. Modified duration measures the expected change in a bond’s price to a 1% change in interest rates. In order to understand modified duration, keep in mind that bond prices are said to have an inverse relationship with interest rates. Therefore, rising interest rates indicate that bond prices are likely to fall, while declining interest rates indicate that bond prices are likely to rise.

Macaulay Duration

Macaulay duration finds the present value of a bond’s future coupon payments and maturity value. Fortunately for investors, this measure is a standard data point in most bond searching and analysis software tools. Because Macaulay duration is a partial function of the time to maturity, the greater the duration, the greater the interest-rate risk or reward for bond prices.

Macaulay duration can be calculated manually as follows:

Ethical issues in CRM

Customer Relationship Management (CRM) can be beneficial to both supplier and customer. The supplier reduces costs by offering only products that are wanted, when they are wanted, and he passes the cost savings on to the customer who signed up for the company’s CRM. To implement such a system, extensive information about the customer must be collected and stored. The two concerns with regard to this system are customer privacy and the accuracy of the information collected.

Collecting Customer Data

Ethical issues originating with the collection of customer data for CRM are related to secure collection methods and to the verification of the information. Ethical companies ensure that sensitive information such as credit credit card numbers or medical histories are collected in a secure environment and transmitted back to the databases securely. During data collection, it is also critical to verify the identity of the customer and the accuracy of the information being submitted. High security for these functions is costly but ethically necessary.

Storing CRM Data

Once customer data is safely in a company database, ethical companies adhere to four principles regarding storage. Data is only stored with the agreement of the customer. Customers must be able to view their data and either change their data or ask for it to be changed. Customers can withdraw from the program, and such a withdrawal causes their data to be erased. The ethics behind these principles are that the data belongs to the customer and the customer must be able to control his data.

Using CRM Data

Given that much of the customer data for CRM is sensitive, ethical companies ensure the data is kept private to the maximum extent possible. To achieve this, the company must store the data in a form or in a location not generally accessible. The data must only be consulted when necessary for the fulfillment of a CRM task, and only those employees who handle the data to complete the task are able to access the data. When sub-suppliers need to use the data, they must first commit to restrictions similar to what the CRM company has in place.

Disposing of CRM Data

Since customers must be able to withdraw from the CRM program and since their data is then erased, the company needs a procedure in place for safely destroying customer data when it is no longer needed. While deletion from the database is initially sufficient as long as the database remains secure, data on obsolete equipment and equipment that changes status to non-secure is at risk. An ethical company has detailed policies and procedures for tracking and destroying data and keep accurate records of such activities.

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