Financial Risk Management (FRM): An Introduction
Human impulse tends to focus on what we get in return for our actions. In other words, we often evaluate whether a project is good or bad based on its expected outcome. But risks should be an integral part of decision-making, as they can easily sway seemingly excellent endeavors into catastrophic ones. This is truer than ever when we talk about the world of Financial Risk Management (FRM). So, why do risks impact financial decisions? What challenges do FRM specialists face? And what skills do you need to possess to join their exclusive ranks?
At its core, risk management is about controlling the risks an entity brings upon itself. As such, FRM is focused on financial risks of various kinds: market risks, credit risks, liquidity risks, and operational risks.
In the realm of Finance, “risk” is the possibility that an outcome turns out to be different than what was expected. However, there are debates on the proper depiction of risk.
Some say that, by definition, risks are immeasurable, so any metric is futile. Others highlight how risk is the tendency for, say, an investment to be different from a benchmark. So, R-Squared is their preferred measure. In contrast, for capital budgeting decisions, practitioners prefer a measure of the dispersion of potential outcomes. Hence, standard deviation is the favored metric there.
Risk managers not only understand the mathematics behind these measures, but they also know how to pick the most appropriate one.
Known and Unknown Expectations
Risk management is also about controlling exposure to “unknown unknowns.” To illustrate, we can classify future outcomes into the following four categories.
- Known Knowns
- Unknown Knowns
- Known Unknowns
- Unknown Unknowns
The best kind of FRM will consider the fourth classification, unknown unknowns, or the events you haven’t even imagined yet.
Arguably, the COVID-19 pandemic was an unanticipated unknown for most businesses. That is, we might have expected — and made allowances for — economic downturns despite not knowing where interest rates will be or how economies would grow or contract (i.e., known unknowns). But no one really could predict the lockdowns or the supply-chain crisis.
To reiterate: excellent financial risk management enforces measures that control both known and unknown unknowns.
Financial planning risk management helps the firm avoid extreme decisions that could lead to the collapse of the business. Recall that managers, particularly myopic executives with compensations tied to short-term accomplishments, are incentivized to take on more risks.
In terms of financial investments, financial risk management will have controls that try to dodge portfolio-destroying choices. The news is fraught with success stories of investors making huge bets and winning big. But these stories rarely account for the extreme risks taken to achieve those gains.
Decisions that lead to maximum returns are not always optimal. Therefore, as financial analysts and risk managers, you have an obligation to assess decisions holistically and account for risks together with returns. For example, consider an investment with higher expected return that upon closer examination turns out to be suboptimal.
|Expected Return||Standard Deviation|
At first glance, Investment A seems to be the superior choice, with an expected return of 12.0% compared to Investment B’s 9.0%. But taking risks into account tells a different story. Let us consider the Sharpe ratios, a return-per-risk measure, of both investments. You can download our free Sharpe ratio – Excel Template to get you started.
|Investment A||(12.0% – 3.0%) / 7.5%||1.20|
|Investment B||(9.0% – 3.0%) / 4.5%||1.33|
According to the Sharpe ratio measure, when we account for risks, Investment B is the better choice. While we expect higher returns with Investment A, we are also taking on more unjustified risks following.
Of course, other reward-to-risk measures like the Information ratio may still point to Investment A as the better alternative, and these conflicting results further emphasize the complexity of financial risk management.
Managing risks follows a five-step process that includes identifying, analyzing, evaluating, deciding, and monitoring. Let’s briefly go over each of these steps.
Different circumstances (e.g., companies, investments, environments, and so on) imply diverse risk types. So, knowing what you’re up against is the first step.
Considering the characteristics of risks is crucial because it determines the appropriate risk metrics to operate. For instance, if a hedge fund actively seeks risks to earn excess returns over a benchmark, the Information ratio may be the relevant criterion and not the Sharpe.
Next, we assess the risk based on its characteristics. For financial risk management, this step typically involves two statistical techniques — descriptive and inferential statistics.
Now that you have your results, it is time to make an informed decision as a financial analyst. Do you hedge your bets and control risks? Is elimination appropriate, or should the firm proceed as usual?
The astute risk manager doesn’t stop at deciding on actions to take. Instead, they continuously monitor these risks, anticipating the inevitable change in unknown factors.
In conclusion, real-world complexities and unknowns make risk management a challenging field. However, practitioners are also well-compensated, according to Glassdoor’s risk management salary figures.
For instance, many start off as risk analysts earning anywhere from $54K to $113K. Their responsibilities include disseminating risk information to various stakeholders and providing assistance in testing business controls. Consequently, professionals with years of relevant experience can become head underwriters with salaries reaching $180K+.
Many of the challenges of FRM are greatly eased by an understanding of statistical probabilities. Hence, a solid grasp of this science will make getting a foot in the door that much easier. Sign onto our Statistics for Data Science and Business Analysis course and start developing the computational rigor necessary for financial risk management. This course is a fantastic complement to obtaining a financial risk management certificate.
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