Definition of Investment Risk Management:
In today’s era of rapid globalization there’s no industry or sector that is unfamiliar with investment risks. Especially if discuss in the context of financial risks, every investment is prone to one or other risk. This is where company invest in people to perform Investment Risk Management plans and strategies to minimize the risk on investment. Often bond issuers find themselves in situations where a he is unable to make expected principal payments, interest rate payments, or both.
Another type of investment risk is Business Risk, also known as unsystematic risk. Normally this risk is linked with personal securities. For instance issuer of a bond, stock or any other short term asset might run out of cash and declare himself bankrupt. The fluctuation of interest rate is a common plight, sometimes when an investor invests his money in stocks, bonds or mutual funds proffering fixed rate of return, change in interest rate might occur, for example it might rise, and when this happens the value of that bond will diminish. Municipal bonds output are also exposed to a particular type of risk. A security issued with the status of ‘tax-exempted’ might lose its status before it expires. As a result the investor will get lesser returns in comparison what he or she planned owing to low interest rate of municipal bonds, this is called tax-ability risk.
These risks further create possibility of failure in accomplishing the desired financial objectives. Different types of investment risks that have the potential of affecting an economic activity. Investment risk is related to the probability of losses in ROI (Return on Investment). Due to all this reasons, it become important for everyone to undergo through investment risk management to take calculated financial risks.
Inter-dependency of Investment Risk:
Every economic activity is exposed to some or other risks. For example equity risks, interest rates, exchange rates, commodity prices risks, credit risks, customer risks, supplier risks, partner risks, financing risk, market liquidity risk, cash flows risk, credit risk, market risk, foreign exchange risk, Shape risk, Volatility risk, Sector risk, Liquidity risk, Inflation risk and many more.
The fact that these risks are inter-dependent of each other and are might not act as a separate entity, increases the company’s vulnerability. To make it simpler for you to understand, you’ll have to know that there’s a strong linked between exchange rates and interest rates. There is inverse relation between the demand of foreign exchange rates and interest rates. Such types of co-dependencies are to be considered while structuring the framework of Investment and Financial Risk Management.
Types of Investment Risks:
When we have to plan for investment risk management, firstly we should be aware of different types of investment risks which we are exposed into. Broadly investment risks are categories into nine types, they are as followed:
- Market Risk (Like: Equity Risk \ Interest Rate Risk \ Currency Risk).
- Credit Risk.
- Liquidity Risk.
- Reinvestment Risk.
- Concentration Risk.
- Inflation Risk.
- Longevity Risk.
- Horizon Risk.
- Foreign Investment Risk.
Investment Risk Management Analysis:
What if interest rates were to rise by 80 basis points? What if the stock market is down by 27 per cent? How will the investment affected if the exchange rate were to rise by 40 per cent? And will the consequences impact us decreasingly if an important client were to leave the firm? Let us see some of the risk measurement methods, risk management strategies and investment risk management analysis to get better answer for our questions:
1. Scenario Analysis – Scenario analysis is another useful approach in quantifying risks. It is also known by stress tests, sensitivity tests, or ‘what if?’ analyses. Financial managers create more than one scenario and ask ‘what if’ these situations were to occur? For example: now, the results of these hypothetical scenario analyses are converted into a risk measure by assuming the risk exposure based on the calculations and maximum loss predicted is assumed to be the worst case scenario.
2. Value at Risk (VaR) – Another well-liked method of checking and measuring the financial risk is VaR analysis. VaR is measured with respect to the amount of potential loss, the possibility of that amount of loss, and the time frame. For example, a financial firm is prone to 15 per cent one month value at risk of INR 150000. This implies that there is a 15 per cent chance that the firm has to bear a loss of INR 150000 in any given month.
Let’s understand this concept of investment risk management method with another example, some another firm that has a well-built investment portfolio, and they’ve determined the VaR to be INR 30000, at a 20 per cent confidence level over a holding period of 35 days. Now, if no investments are infused or sold over within the time period of 35 days then there is a 20 per cent chance that the firm might lose out INR 30000. VaR is estimate of the possible maximum loss. Actual losses may be above or below the estimated value.
3. Regression Analysis – Regression analysis is a prominent approach which is used to study the consequences on one variable when the other one changes. Let’s say for instance what changes will cash inflow encounter when rate of interest increases or decreases.
4. Security Analysis – Investment risk analysis of tradable financial instruments like debts (money borrowed from market), equities (owner’s fund), mixture of these two and warrants of company is known as security analysis. Sometimes futures contracts and tradable credit derivatives are also included. Security analysis is further sub-categorized into fundamental analysis, which works in accordance to different fundamental business factors such as financial statements, and technical analysis, which focuses upon price trends and momentum.
A firm needs to understand the intensity and types of potential financial risks it is prone to. Investment risks are supposed to be eliminated or managed after the managers thoroughly analyze the situation and they’ve to choose the most apt approach or method as a part of investment risk management technique to check that risk.
Investment risk management aims to protect the firm from these risks by using several financial instruments. It can be quantitative and qualitative both. Investment Risk Management subject involves managing the relationship between internal aspects of financial institutions and the external factors that influences the investment. Also, it deals in modern financial markets. Financial and Investment Risk Management proffers foundational understanding about underpin modern investment and risk management techniques.