Investment Risk Management

A. Introduction

Some dangers defy measurement and cannot be fully characterized by mathematical distributions. In his dissertation titled ‘Risk, Uncertainty, and Profit,' Frank Knight notably distinguished between measurable and unmeasurable hazards, highlighting the need for a clearer differentiation between the two. Oversimplifying risk to support a position is dangerous, given the range and breadth of risks in the financial markets. Measuring can be dangerous. When it comes to managing investment portfolios, not only do the managers have to think about what they're doing, but they also must consider not just the expected hazards, but also the hidden risks that can have a substantial influence about returns. As a result, risk management is no longer merely a component of an investment strategy, but rather the basic core of a well-run investment process.

A higher emphasis on expected returns and less on risk during the development of an investment plan may result in a mismatch between the investment objective and risk appetite. The goal of investment risk management is to assure clients that their assets are being managed according to the stated investment strategy, consistent with portfolio objectives (as defined by investment mandates), and according to professional standards of monitoring, control, and accountability.

Differential techniques that establish an appropriate control of investment functions are determined by each firm's risk management culture, size, scope, and geography. However, as regulators continue to scrutinize risk management controls, and as demands from institutional investors, investment consultants, and distributors expand, there is a growing need for minimum risk management best practices at investment management organizations.

B. Principles of Effective Investment Risk Management:

The global financial crisis brought risk management to the fore, highlighting how asset managers may suffer if they do not have a comprehensive risk framework in place. The market's response to the crisis demonstrated that established risk management procedures failed when they were most needed, particularly as the risk spread across previously uncorrelated asset classes. Although such Black Swan occurrences are impossible to forecast ex ante, asset managers can use a complete investment risk framework to manage risk in normal times while also being aware of and attempting to be prepared for such extreme events. So, what exactly does good risk management imply for asset managers?

The concepts of an effective investment risk management framework are based on investment objectives and risk expectations, risk quantification, risk management procedure, and overall control of the process.

1. Link between investment objectives & risk management - While all market participants are subject to some common risk variables, how they approach risk differs. Asset managers, for example, who invest their customers' money according to a defined investment object and rules, will think about risk differently from proprietary traders who invest their own money.

Investment risk management, in general, begins with the determination of the return objective and investment strategy, regardless of how risks are perceived. Every portfolio should have a clearly defined and documented mandate that outlines the investment goal and how important risks in asset deployment will be controlled.

2. Quantification of risks - Asset managers can better understand and manage risk in their portfolios by using quantitative methods to assess investment risks. Portfolio exposures, sources of return, and risk should be assessed on a regular basis to verify that they are in line with the mandate and to offer input on the strategy. The performance impact of these exposures, as well as the predicted risk, should be evaluated and validated against expectations and investing convictions.

3. Systematic and impartial process - Because of the scale and complexity of organizations, risk management processes must be integrated into their infrastructure. The integration of risk processes in this way removes reliance on individuals, hence bolstering senior management's claim of properly executing their fiduciary oversight obligation.

Furthermore, an independent staff should oversee and provide analytics and reporting to guarantee that all portfolios are subjected to the same level of investment risk management rigor. Exceptions in the process should be reported to management and reviewed.

4. Oversight and Accountability - A strong risk management approach is one that provides a clear line of sight of the risks that are being taken so that management is aware of them and can demonstrate active monitoring and management of them. To have open and honest talks about the risks, a periodic review mechanism should be implemented. These assessments can be administered by an independent investment risk team, which can provide unbiased oversight and support while also documenting activities to ensure that the procedure is being followed.

C. Investment Risk Management Framework:

Risk management has always been thought of as a tool for calculating, monitoring, and preventing losses, but it serves a broader, more practical purpose. Risks linked with investment management can be divided into two categories: those that contain an alpha component and those that are solely characterized by loss. Market risk offers upside potential as well as downside risks in the event of a market downturn, whereas counterparty and operational risks offer no alpha and must be avoided in a cost-effective manner.

Although the terminology may differ, the formulation of a robust investment management framework should go through the following steps:

1. Defining the major risks to which an organization may be exposed at various levels of the investment structure As investment objectives are converted into strategies and actual investments, a clear link between the points where funds flow in and the points where they are invested in the market allows for consistent monitoring and appraisal at various levels.

The firm may be exposed to varied risks depending on its investments and regulatory environment. When defining these risks, consider portfolio exposures, sources of return and risk, as well as client objectives and limits outlined in the mandates. The following hazards are the most common types of investment risk:

Market risk: Market risk refers to the dangers of market price changes that are either too high or too low. It encompasses changes in:

  • Interest rates

  • Stock prices

  • Currency

Credit risk: The risk of financial loss connected with default or a change in the credit quality of assets is referred to as credit risk. It could be because of:

  • Default by the counterparty or debtor

  • Downgrade of issue’s rating

  • Widening in spread

Liquidity risk: Liquidity risk refers to the possibility of a significant price fall in a securities transaction if the market is not deep enough to accommodate the intended transaction size efficiently.

2. Controlling By allocating resources and establishing criteria and tolerances for the stated risks, the risks can be mitigated. Allocating risk budgets and determining risk tolerances are part of a proactive risk management strategy. As part of their investing plan, portfolio managers should exercise discretion within well stated limitations.

These constraints should not limit the discretion of the portfolio manager; rather, they should connect the approach and focus with the investment objective and strategy. Unless the client or regulatory authority expressly states otherwise, these standards should be treated as guidelines rather than rigid limits.

3. Monitoring an independent risk team monitors the risks, escalates exceptions, and generates reports on a regular basis in a methodical and objective manner. Once the risks have been established and controls put in place, a systematic procedure of regular monitoring and reporting of these risks by an independent team guarantees that the methodology is validated and consistent. The independent team should produce analytics and reporting to guarantee that all portfolios are subjected to the same level of investment risk management rigor. The goal should be to achieve exception reporting, in which the most significant exposures, risk contributors, and risk factors are highlighted based on the data.

4. Assuring establishing oversight over the entire process, dividing roles and duties, and having regular evaluation and input would ensure consistency and comprehensiveness in the process. Clear demonstration, evaluation, and feedback in the risk management process go a long way toward reassuring customers and investors that a solid investment risk management approach is in place. Portfolios can have deviations from expected targets, ranges, or strategy, but only if the correct protocol of monitoring, escalation, challenging, and management is followed.


Risk management is an ever-evolving field, and any collection of best practices will inevitably change over time. Managers may ensure that the investment management process is aligned with risk expectations and risk tolerance by using the correct risk framework. This document serves as a foundation for investment managers to develop their own risk management framework. Investment managers should eventually be able to turn to this document as a guide during what will be a difficult but fruitful journey to developing the correct framework.

By Growthway's Intern

Kailash Mulchandani

IIM, Kashipur

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