Risk Management Task
Risk management involves assessing, communicating, monitoring, and managing risks.
A large loss does not necessarily mean that risk management has failed. Losses are the result of risk taking, which is required for value creation.
Incorrectly Measuring and Managing Risk
Risk management can fail if the firm does not do the following:
- measure risks correctly,
- recognize some risk,
- communicate risks to top management,
- monitor and manage risks, and
- use appropriate metrics.
Mismeasurement can occur when management does not understand the distribution of returns of a single position or the relationships of the distributions among positions and how the distributions and correlations can change over time. Mismeasurement can also occur when managers must use subjective probabilities for rare and extreme events. The subjective probabilities can be biased from firm politics.
Failing to take known and unknown risks into account (i.e., ignoring risks) can take three forms:
- Ignoring a risk that is known.
- Knowing about a risk, but failing to properly incorporate it into risk models.
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Failing to discover all risks.
Senior managers must understand the results of risk management in order for it to be meaningful. Unless senior managers have the correct information to make decisions, risk management is pointless.
Risk managers must recognize how risk characteristics change over time. Many securities have complex relationships with market variables. Having an adequate incentive structure and firm-wide culture can help with the risk monitoring and managing process.
The Role of Risk Metrics
Risk metrics such as VaR are usually too narrow in scope. For example, VaR usually assumes independent losses across periods of time. Risk metrics generally fail to capture the effect of a firm’s actions on the overall market and behavior patterns such as predatory trading.
