Risk Management Explained - Finally!

luv2wrt By luv2wrt, 15th Nov 2013 | Follow this author | RSS Feed | Short URL http://nut.bz/g4o73rpz/
Posted in Wikinut>Business>Investment

The primary purpose of risk measurement is to help identify the source of risk, quantify the risk, and then control the risk within a given portfolio.

Risk Management Explained - Finally!

The primary purpose of risk measurement is to help identify the source of risk, quantify the risk, and then control the risk within a given portfolio.

Modern portfolio theory teaches us that the risk in a portfolio is derived from the volatility in the price of the asset (i.e. how much the price jumps up and down from day to day). The best explanation is how Benjamin Graham described what causes market price movements:
"In the short run, the market is like a voting machine--tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine--assessing the substance of a company."

To help us uncover why our portfolio moves up and down in value, we need the help of a conceptual framework called the Risk Triangle. The Risk Triangle decomposes the major components of risk measurement into - Factor Analysis, Value at Risk (VAR) and Stress Testing. We will use this framework throughout the remaining of this post to hang together the notion of risk in a cohesive way.

Sourcing Risk:

Modern portfolio theory tells us that you are only compensated for the risks you take (i.e. there is no such thing as a free lunch). Because of that fact, the returns both positive and negative are derived from what is known as factors.

Factors can really be anything you want them to be, such as meaningful factors like oil, large cap growth or nonsensical factors like the number of times a cat crosses the road and the number of times a cricket chirps within a two minute span.

An example should help crystallize the concept. Take for example an oil company and its relationship to the price of oil. If the price of oil goes up, then the company makes more profit and is therefore worth more (and the inverse is true). The former relationship is obvious, but what about a not-so-obvious example with a diaper manufacturer and how it relates to the price of oil. Unless you know a lot about diaper manufacturing you probably wouldn’t know that petroleum is a major cost input into the process to manufacture diapers. So if the price of oil goes up, then the costs of diaper manufacturing go up, then profits fall and therefore the company is worth less (and the inverse is true).

Most relationships in economics are not straightforward and are very complex. Being able to tease apart those factors and relationships is difficult at best and impossible at worst. In any case, it isn’t something you can do in your mind once the number of factors exceeds one. This difficulty can be overcome with a little statistical gymnastics known as factor analysis.

There are two forms of factor analysis - multi-linear regression and principle component analysis (PCA). The best way to think of them is bottom up and top down. With multi-linear regression the user would identify the factors and put them into the risk measurement software. The system would tell you how good of a job you did describing the risk in the portfolio. The problem here is that if you put garbage in, then you get garbage out. Alternatively with PCA it is more of a top down approach. The risk measurement software will tell you how much of the risk can be explained. Only then do you enter the factors you are interested in and the system will tell you much each factor actually explains the risk (a.k.a. risk decomposition).

That all may seem overwhelming, but don’t worry about it. The main fact is that there is software that will take care of it for you and it implements both methodologies. This is a good thing because having both approaches helps you compare and contrast against each other. For instance, if the multi-linear regression approach says you didn’t do a good job explaining the risk then you may thing that there isn’t a way to explain the risk. Otherwise having the PCA approach along side the multi-linear regression approach we can determine that the overall risk can be explained very well. Thus we must not have done a very good job at picking our factors and must return to the drawing board.

It is also important to note at this time the type of risk we have been implicitly talking about is called market risk. There are actually four components to market risk - equity risk, interest rate risk, currency risk and commodity risk. Equity risk is due to the fluctuations of stock prices. Interest rate risk is due to changes in prices due to fluctuations in the interest rate (e.g. when interest rates rise, bond prices fall). Currency risk is due to the fluctuations in exchange rates that can cause a gain/loss in the asset. Commodity risk is due to the changes in commodity prices like the one mentioned above (e.g. oil, gold and copper).

We will review some examples of these risks a bit later in our next posting and also cover quantifying risk with VAR and Stress Tests.

Tags

Investment, Investment Manager, Investment Strategy, Risk Factors, Risk Management

Meet the author

author avatar luv2wrt
I enjoy technology and finance. I work for investment banks and hedge funds. My primary focus is on risk management and portfolio management as it relates to investing in the stock markets.

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Comments

author avatar Sivaramakrishnan A
20th Nov 2013 (#)

I feel there are too many variables for an ordinary person to make an informed judgement. His reaction will come last. Good analysis - siva

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author avatar Rose*
20th Nov 2013 (#)

Great article. It's a pity most small businesses ignore this process

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author avatar Retired
30th Nov 2013 (#)

Hello Dear, how are you doing today? am ( Miss rose) i visited your lovely profile today and am interested in knowing more about you. please kindly write me back directly to my private email address is(roseapia_2013@yahoo.in )for you to know more about me. I believe knowing each other will help us in future communications. please write me directly to my email address here (roseapia_2013@yahoo.in ) .

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author avatar Rose*
8th Mar 2014 (#)

Not many businesses pay attention to risk management - not even the big banks who failed to see the financial meltdown coming

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