The Purpose of Risk Management
The purpose of risk management is twofold. First, it is used as a tool to manage losses of financial capital and other business risks in connection with the trading of financial instruments. Second, it provides for a means for trading activities to be conducted within a prescribed set of parameters and rules.
In the trading of financial instruments such as stocks, bonds, futures, options and currencies, investors are exposed to risks of loss resulting from adverse movements in the underlying asset price. Therefore, risk management should focus on the identification, measurement and control of price risk. An effective risk management system should also include the assessment of credit, counterparty and liquidity risk.
Measuring Risk
The first step of risk management is to accurately measure the risk of a financial instrument. This is done by quantifying the potential losses associated with the instrument. To calculate the risk, one must consider the expected return on the instrument, the volatility of the underlying asset, the liquidity of the instrument, the leverage associated with the instrument, the margin requirements and liquidity of the market, and the cost of borrowing money to purchase the instrument. Once the risk is accurately quantified, one can then determine the level of risk tolerance – the amount of risk one is willing to assume in order to obtain a desired level of return.
Managing Risk
Once the level of risk is established, it is necessary to implement the appropriate measures to manage the risk. This typically involves the use of diversification, hedging, and position sizing. Diversification is the practice of spreading investments across different types of assets in order to limit the potential for large losses due to a single security or market. Hedging is using derivatives or other instruments to reduce the potential for large losses due to adverse movements in the underlying asset. Position sizing is adjusting the size of one’s trades in order to maintain the desired level of risk.
Finally, it is essential to have a system in place to monitor the trading activity and to ensure that it remains within the established parameters. This includes monitoring the performance of the portfolio, both in terms of the return and risk. It also involves establishing stop-loss orders, which help limit the amount of loss that can occur due to a single adverse event.
Conclusion
Risk management is an essential tool for any investor. It is important to accurately measure the risk of a financial instrument, and then properly manage the exposure to risk using diversification, hedging and position sizing. Finally, it is essential to have a system in place to monitor the performance and ensure that it remains within the established parameters. By following these principles of risk management, investors can protect themselves from significant losses while still achieving their desired level of return.
