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INVESTMENT MARKET | MANAGING INVESTMENT MARKET RISK

Updated on January 9, 2011

Investment can be risky when not properly managed. Investment market is a volatile one in the sense that many derivatives have been created through a process known as financial engineering thereby making the presence of market risk more pronounced.

Market risk is the probability that a firm’s value or cash flow will move in an unfavourable way – this is usually caused by movements in underlying sources of risk. For instance, a company might be concerned about movements in interest rates, foreign exchange rates, stock prices, or commodity prices.

WHAT IS RISK MANAGEMENT?

Risk management is the practice of defining the risk level a firm desires, identifying the risk level is currently operating at, and using derivatives or other financial instruments to adjust the actual risk level to the desired risk level.

Risk management has so grown that large companies are now set up specifically to manage risk. They assume opposite direction against the end users with the hope of making profit from the spread between the buying and selling prices and subsequently hedge the underlying risks of their portfolios of derivatives.

BENEFITS OF INVESTMENT MARKET RISK MANAGEMENT

  • Risk management reduces the probability of an individual or company going bankrupt- bankruptcy is a costly process in which the legal system becomes partial claimant on a firm or an individual’s value / investment.
  • Risk management is important as it encourages a win-win situation. Managers manage companies so that their perks will be increased and at the same time making the owners of the business happy and wealthier.
  • Risk management helps prevent a situation of overtrading or understanding
  • Risk management helps ensure that firms generate the required cash flow to execute investment projects- i.e. ensuring that the working capital of a company is met.
  • Risk management saves taxes.
  • Risks are managed by some people / company in order to reap the benefits of arbitrage opportunities whenever possible.

TOOLS USED BY INVESTMENT RISK MANAGERS TO CONTROL RISK

  • Gamma
  • Delta
  • Vega

The tools listed above are specialised investment risk management that sophisticated modern investors use to monitor and manage risk. You as an ordinary or passive investor do not need this.

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