In a previous article, we introduced the
CFA Institute Investment Foundation Program (Read
more here). It is a free program
designed for anyone who wants to enter or advance within the investment
management industry, including IT, operations, accounting, administration, and
marketing. Candidates who successfully
pass the online exam earn the CFA Institute Investment Foundations Certificate.
There are total of 20 Chapters in 7
modules, covering all the essential topics in finance, economics, ethics and
regulations. This series of articles
will highlight the core knowledge of each chapter.
Chapter 18 provides an overview of the risk
management. The learning outcome of chapter 18 is as follows:
·
Define
risk and identify types of risk;
·
Define
risk management;
·
Describe
a risk management process;
·
Describe
risk management functions;
·
Describe
benefits and costs of risk management;
·
Define
operational risk and explain how it is managed;
·
Define
compliance risk and explain how it is managed;
·
Define
investment risk and explain how it is managed;
·
Define
value at risk and describe its advantages and weaknesses.
This chapter puts the emphasis on the
types of risks that companies in the investment industry (investment firms) and
people working for these companies face. It is important for companies to
develop a structured process that helps them recognise and prepare for a wide
range of risks. Although risk management is sometimes viewed as a specialist
function, a good risk management process will encompass the entire company and
filter down from senior management to all employees, giving them guidance in
carrying out their roles.
Risk arises out of uncertainty. It can
be defined as the effect of uncertain future events on a company or on the
outcomes the company achieves. One of these outcomes is the company’s
profitability, which is why the effects of risk on profit and rates of return
are often assessed.
There are three risks to which companies
in the investment industry are typically exposed and that are discussed in this
chapter:
Operational risk, which refers to the risk of losses
from inadequate or failed people, systems, and internal policies and
procedures, as well as from external events that are beyond the control of the
company but that affect its operations. Examples of operational risk include
human errors, internal fraud, system malfunctions, technology failure, and
contractual disputes.
Compliance risk, which relates to the risk that a
company fails to follow all applicable rules, laws, and regulations and faces
sanctions as a result.
Investment risk, which is the risk associated with
investing that arises from the fluctuation in the value of investments.
Although it is an important risk for investment professionals, it is less
important for individuals involved in support activities, so it receives less
coverage than operational and compliance risks in this chapter.
A structured risk management process
generally includes five steps: setting objectives, detecting and identifying
events, assessing and prioritising risks, selecting a risk response, and
controlling and monitoring activities.
It is important for a company to build a
risk matrix and select key risk measures to prioritise risks and warn when risk
levels are rising. Depending on their
expected level of frequency and severity, risks will receive different levels
of attention:
Green. Risks in the green area should not receive much attention
because they have a low expected frequency and a low expected severity.
Yellow. Risks coded yellow are either more likely but of low
severity, or more severe but unlikely. They should receive a little more
attention than risks in the green area, but less attention than risks in the
orange area.
Orange. Risks in the orange area have a higher expected frequency
or higher expected severity than risks coded yellow, so they should be
monitored more actively.
Red. Risks coded red should receive special attention because
they have a relatively high expected frequency and their effect on the company
would be severe.
Black. Risks in the black area are highly unlikely but would
have a catastrophic effect. These risks are sometimes called “black swans”,
which is in reference to the presumption in Europe that black swans did not
exist and is a belief that persisted until they were discovered in Australia in
the 17th century. These risks are usually not identified until after they
occur.
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