Risk Measurement - An Overview

What Are Risk Measures?

The statistical measures that are used to make historical predictions of the investment risk and volatility are known as risk measures. The risk measures are also the main components in the modern portfolio theory. The modern experts portfolio theory is a financial and academic method that is used to assess the performance of any stock in comparison to the benchmark index.

There are 5 principal risk measures, and all these 5 principles provides a special method to measure the risk that is included in the investments that are considered for evaluating the risk of any stock. These 5 principles of risk measurement are alpha, beta, standard deviation, r square and Sharpe ratio. The risk measures can be utilised individually or jointly to perform the assessment of risk. At the time of making a comparison of two investment opportunities it is essential to measure the risk by using any one of the principles of risk measurement.

What Are The Five 5 Elements Of Risk Management?

The five components of risk management are stated below:

1. Risk Identification

Identification of risk is very important for risk management as if the risk is not identified properly then it will not be able to take preventive measures that are to be taken to mitigate the risk. risk is identified by documenting potential risk and then categorise the actual risk that is faced by the business. It is essential to identify almost all the risks associated with the business as this will assist the management to reduce the probability of reducing the occurrence of risk in the operational activities of the business.

2. Risk Analysis

After identifying the risk it is essential to analyse the risk to detect the impact of the risk on the business activities. From the analysis of the risk, it can be possible to identify the level of exposure the business to a specific risk. if the risk in reality occurs then the potential cost that the company have to incur. Risk can be segregated again in to different categories like high risk, moderate risk or minor risk, this also depends on the potential for disruption. The correct categorisation may not be that important in comparison to the detection of the risk that will have more pressing threat than the other type of risk.

3. Response Planning

Response planning is the element of risk management which will give the direction to the management about the actions that they should take after identifying and analysing the risk. This means it helps to select the correct risk prevention method that should be imposed to prevent that risk. for example, if the company feels that the risk of phishing occurs in the organisation due to use of unauthorised emails the response planning will be security awareness training.

4. Risk Mitigation

The implementation of the response plan is the process of risk mitigation. It is the method that is adopted to mitigate the risk so that the adverse effect of the risk can be reduced to the level of acceptance and the business activities can be operated with more efficiency. The organisation should impose such control measures and go with right financing that will reduce the level of risk. the management should test the risk mitigation techniques to check whether such risk mitigation process is working properly or not.

5. Risk Monitoring

After the risk mitigation process, it is essential to monitor the risk as risk are not static so it essential to monitor the risk every time. The probable impact and the occurrence of change is very high as a risk that is considered as a minor risk can be changed to a major risk and cause major problem for the business. The process of risk monitoring is to observe all the activities from which a probable risk may generate and take initiatives to mitigate the risk.

What Is The Most Common Measure Of Risk In Finance?

The most common measure of risk is standard deviation, it is most absolute type of risk measurement technique as it is not measured in relation to the different class of assets. Standard deviation is used to measure the spread of return around the average return. For instance, the S&P can provide average return was 11.5% and the standard deviation of the same was 17.60 during the period of 1970-2012. If it is assumed that the distribution of the return is normal that means that 95% of the annual returns were within two standard deviations of the annual return on an average that range between 23.7% and 46.7%. a high standard deviation gives the indication that the investors that are holding such assets with high standard deviation will face higher uncertainties in the returns. As the standard deviation is very effective and also provide more accurate results it is considered as the most common method of risk measurement. In financial risk management the operational risks may be acceptable up to a certain level of risk tolerance.

Why Are Risk Measures Important? 

Risk measurement is important to identify the risk and make comparison between the asset that are highly risk or less risky. From the view point of the investors the it is essential to measure the risk that is involved in an investment as it will help the investor to take the decision whether to make investment in the assets or not. The measurement of risk will help to select such assets that are less risky and will provide higher return. In finance measurement of risk will assist the fund managers to consider the asses that are less volatile and provide steady return to the investors. Thus, risk measurement is important to identify the risk and take actions so that the risk can be mitigated. Since the financial landscape has shifted into an online and constantly evolving market place, it becomes more important to protect the organization from financial risks and losses. 

How Is Acceptable Risk Measured?

A management of the company will consider a risk as acceptable when the risk falls below an arbitrary defined probability that is the level of risk is below the level that has been tolerated before by the same organisation. The trial-and-error method are often used to measure the acceptable risk as it can be possible through the application of the trial-and-error method to find the optimal and balanced results from which it can be possible to determine the level up to which a company can tolerate risk and accept that risk.