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.
Operational risk is 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. The reduction of operational risk requires companies to manage people to reduce human failures ranging from unintentional errors to fraudulent activities; manage systems, particularly IT and communication systems, and ensure compliance with internal policies and procedures; and manage political, legal, and settlement risks.
One example of operational risk that has a human component and that is more frequent in the financial services industry than in any other industry is rogue trading. Rogue trading refers to situations wherein traders bypass management controls and place unauthorised trades, at times causing large losses for the companies they work for. Rogue trading may involve fraudulent trading that is done for personal enrichment or to make up losses. Exhibit 1 lists a number of rogue trading incidents that occurred in the past.
Compliance risk is the risk that a company fails to comply with all applicable rules, laws, and regulations. The company may face sanctions and damage to its reputation as a result of non-compliance. Examples of key compliance risks that have the potential to inflict serious damage on investment firms and their employees include corruption, inadequate tax reporting, insider trading, and money laundering.
Investment risks take different forms depending on the company’s investments and operations. Investment firms typically experience: market risk, caused by changes in market conditions affecting prices; credit risk, caused by borrowers’ inability and/or unwillingness to make timely payments of interest and principal; and liquidity risk, caused by difficulties in buying or selling assets or securities quickly without a significant concession in price.
Value at risk, which provides an estimate of the minimum loss of value that can be expected for a given period of time with a given probability, is a widely-used metric to measure risk. By relying on historical data and making assumptions about the distribution of returns, VaR suffers from weaknesses that are typical of all measures that rely on models.
Although most companies in the investment industry have dedicated risk management functions, it is important to remember that risk is not just the responsibility of the risk management team—everyone is a risk manager. So, even if you are not a risk management specialist, you should still seek to understand risk management process, systems, and tools and participate in risk management activities in your organisation.