The discipline can be qualitative and quantitative; as a specialization ofrisk management, however, financial risk management focuses more on when and how tohedge,[5] often using financial instruments to manage costly exposures to risk.[6]
In the banking sector worldwide, theBasel Accords are generally adopted by internationally active banks for tracking, reporting and exposing operational, credit and market risks.[7][8]
Insurers manage their own risks with a focus on solvency and the ability to pay claims.[11] Life Insurers are concerned more with longevity and interest rate risk, while short-Term Insurers emphasizecatastrophe-risk and claims volatility.
Ininvestment management[12] risk is managed through diversification and related optimization; while further specific techniques are then applied to the portfolio or to individual stocks as appropriate.
In all cases, the last "line of defence" against risk iscapital, "as it ensures that a firm can continue as agoing concern even if substantial and unexpected losses are incurred".[13]
Given these, there is therefore a fundamental debate relating to "Risk Management" andshareholder value.[5][15][16] The discussion essentially weighs the value of risk management in a market versus the cost ofbankruptcy in that market: per theModigliani and Miller framework, hedging is irrelevant since diversified shareholders are assumed to not care about firm-specific risks, whereas, on the other hand hedging is seen to create value in that it reduces theprobability of financial distress.
When applied to financial risk management, this implies that firm managers should not hedge risks that investors can hedge for themselves at the same cost.[5] This notion is captured in the so-called "hedging irrelevance proposition":[17] "In aperfect market, the firm cannot create value by hedging a risk when the price of bearing thatrisk within the firm is the same as theprice of bearing it outside of the firm."
In practice, however, financial markets are not likely to be perfect markets.[18][19][20][21] This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management, wherein they are able to determine which risks are cheaper for the firm to manage than for shareholders. Here,market risks that result in unique risks for the firm are commonly the best candidates for financial risk management.[22]
As outlined, businesses are exposed, in the main, to market, credit and operational risk. A broad distinction[13] exists though, betweenfinancial institutions and non-financial firms - and correspondingly, the application of risk management will differ. Respectively:[13]For Banks and Fund Managers, "credit and market risks are taken intentionally with the objective of earning returns, while operational risks are abyproduct to be controlled". For non-financial firms, the priorities are reversed, as "the focus is on the risks associated with the business" - ie the production and marketing of the services and productsin which expertise is held - and their impact on revenue, costs and cash flow, "while market and credit risks are usually of secondary importance as they are a byproduct of the main business agenda". (See related discussion revaluing financial services firms as compared to other firms.)In all cases, as above, risk capital is the last "line of defence".
Correspondingly, and broadly, the analytics[28][27] are based as follows:For (i) onthe "Greeks", the sensitivity of the price of a derivative to a change in its underlying factors; as well as onthe various other measures of sensitivity, such asDV01 for the sensitivity of abond orswap to interest rates, andCS01 orJTD for exposure tocredit spread. For (ii) onvalue at risk, or "VaR", an estimate of how much the investment or area in question might lose as market and credit conditions deteriorate, with a given probability over a set time period, and with the bank then holding"economic"- or "risk capital" correspondingly;common parameters are 99% and 95% worst-case losses - i.e. 1% and 5% - and one day and two week (10 day) horizons.[29]These calculations are mathematically sophisticated, and withinthe domain of quantitative finance.
The regulatory capital quantum is calculated via specified formulae: risk weighting the exposures per highly standardized asset-categorizations, applying the aside frameworks, and the resultant capital — at least 12.9%[30] of theseRisk-weighted assets (RWA) — must then be heldin specific "tiers" and is measured correspondingly via thevarious capital ratios.In certain cases, banks are allowed to use their own estimated risk parameters here; these"internal ratings-based models" typically result in less required capital, but at the same timeare subject to strict minimum conditions and disclosure requirements.As mentioned, additional to the capital covering RWA, the aggregatebalance sheet will require capital forleverage andliquidity; this is monitored via[31] theLR,LCR, andNSFR ratios.
Regulatory changes, are also twofold. The first change, entails anincreased emphasis[39] onbank stress tests.[40] These tests, essentiallya simulation of thebalance sheet for agiven scenario, are typically linked to the macroeconomics, and provide an indicator of how sensitive the bank is to changes in economic conditions, whether it issufficiently capitalized, and of its ability to respond to market events.The second set of changes, sometimes called "Basel IV", entails the modification of several regulatory capital standards (CRR III is the EU implementation). In particularFRTB addresses market risk, andSA-CCR addresses counterparty risk; other modificationsare being phased in from 2023.
Desks, or areas, will similarly belimited as to their VaR quantum (total or incremental, and under various calculation regimes), corresponding to their allocated[47] economic capital; a loss which exceeds the VaR threshold is termed a "VaR breach". RWA - with other regulatory results - is correspondingly monitored from desk level[42] and upward.
Periodically,[53] these all are estimated under a given stress scenario —regulatory and,[54] often,internal — and risk capital,[23]together with these limits if indicated,[23][55] is correspondingly revisited (or optimized[56]). The approaches taken center either on a hypothetical orhistorical scenario,[39][28]and may apply increasingly sophisticated mathematics[57][28] to the analysis.More generally, these testsprovide estimates for scenarios beyond the VaR thresholds, thus “preparing for anything that might happen, rather than worrying about precise likelihoods".[58]A reverse stress test, in fact, starts from the point at which "the institution can be considered as failing or likely to fail... and then explores scenarios and circumstances that might cause this to occur".[59]
A key practice,[60] incorporating and assimilating the above, is to assess theRisk-adjusted return on capital, RAROC, of each area (or product). Here,[61]"economic profit" is divided by allocated-capital; and this result is then compared[61][24] to the target-return for the area — usually, at least theequity holders' expected returns on the bank stock[61] — and identified under-performance can then be addressed. (See similarbelow re. DuPont analysis.)The numerator, risk-adjusted return, is realized trading-return less aterm and risk appropriate funding cost as chargedby Treasury to the business-unit under the bank'sfunds transfer pricing (FTP) framework;[62]direct costs are (sometimes) also subtracted.[60]The denominator is the area's allocated capital, as above, increasing as a function of position risk;[63][64][60] several allocation techniques exist.[47]RAROC is calculated bothex post as discussed, used for performance evaluation (and relatedbonus calculations),andex ante - i.e.expected return lessexpected loss - to decide whether a particular business unit should be expanded or contracted.[65]
Commercial andretail banks[69][70][71][72]are, by nature, more conservative than Investment banks, earning steady income from lending and deposits; their focus is more on the "banking book" than the "trading book".The biggest concern here - as mentioned - is the credit risk due toloan defaults from individuals or businesses. Liquidity risk, in this context not having enough liquid assets to meetwithdrawal demands, is also a major focus; while interest rate risk concerns the impact of interest rate changes onnet interest margins (the spread between deposit and loan rates).
For these banks, regulatory oversight is often tighter due to their direct impact on the financial system. Thus they are alsohighly regulated under Basel III andnational banking laws, and will also be subject to regular stress testing by central banks; and all regulations above then apply (with local exceptions; e.g. an LCR "threshold" in the US[73]). Additional to these, however, they must maintain high capital and liquidity ratios toprotect depositors; seeCAMELS rating system.
Given their business model and risk appetite,[71] as outlined, various differences result vs risk management at investment banks.
Banks here maintain specific (and often additional)capital buffers to cover potential loan losses; reflected also in the fact that retail and commercial loans usually attracthigher RWA results[74] than for assets typical in investment banking. See, e.g., theALLL andNPL ratios.
Concentration risk, relatedly, differs in itsmanagement: the concern is sector concentration as opposed to "name concentration". Here, in calculating VaR for a credit portfolio,[78] banks will incorporate ajoint default probability for the various sectors and / or industries.
Contribution analytics: Profit and Loss for units sold at current fixed costs.The same,for varying (scenario-based) Revenue levels, at current Fixed and Total costs.
It is common for large corporations to have dedicated risk management teams — typically withinFP&A orcorporate treasury — reporting to theCRO; often these overlap theinternal audit function (seeThree lines of defence).For small firms, it is impractical to have a formal risk management function, but these typically apply the above practices, at least the first set, informally, as part of thefinancial management function; seediscussion underFinancial analyst.
Fundamental here, therefore, are risk selection andpricing discipline, which as outlined, prevent insurers from taking on unprofitable business. Forexpected claims — i.e. those covered, on average, by thepricing model’s assumptions refrequency and severity —reserves are set aside (actuarial, withstatutory reserves as a floor). These will cover both known claims, reported but unpaid, as well as those which areincurred but not reported (IBNR). To absorbunexpected losses, insurance companies maintain a minimum level of capital plus an additionalsolvency margin. Capital requirements are based onthe risks an insurer faces, such as underwriting risk, market risk, credit risk, and operational risk, andare governed by frameworks such asSolvency II (Europe) and Risk-Based Capital[114] (U.S.).To further mitigate large-scale risks — i.e. to reduce exposure to catastrophic losses — insurers transfer portions of their risk toReinsurers. Here, analogous to VaR for banks, to estimate potential losses at various thresholdsinsurers use simulations, while stress tests assess how extreme events might impact capital and reserves under various[115] scenarios. In parallel with all these, as above, premiums collectedare invested to generate returns which will supplementunderwriting profits, and the fund is then risk-managed as follows:[116] ALM must ensure that investmentsalign with the timing and amount of expected claim payouts; while returns ("float") are defended using the techniques[117]discussed in the next section.As for banks, all models areregularly reviewed,[118] comparing,[119]i.a., "Actual versus Expected".
Specific treatments will, as outlined, differ by insurer-profile:
Life Insurers[113] deal with long-term risks tied tomortality,longevity, and interest rates. Policies (e.g.,whole life,annuities) can span decades, making them sensitive to long-term economic anddemographic shifts. Reserves are large and complex due to the long duration of liabilities, with capital models emphasizinglongevity risk,interest rate risk, andlapse risk. Stress tests, correspondingly, focus on long-term scenarios (e.g. sustained low interest rates, or apandemic related spike in mortality). Reinsurance is often used forexcess death claims.ALM here is critical, and investments will be in long-term, stable assets (bonds as well as equities) to match theselong-duration liabilities.
Short-Term Insurers[109]face more volatility relative to Life companies, while claims are typically resolved within a year or two (althoughtail events - e.g.asbestos litigation - can linger). Thus, reserves are shorter-term but must account for high uncertainty in claim frequency and severity; IBNR may be significant, especially after large events. Capital requirements focus on underwriting risk (e.g., mispricing policies) and catastrophe risk (e.g.,hurricanes,earthquakes). Stress tests therefore emphasize short-term catastrophic scenarios, and specializedcatastrophe models are often used. Reinsurance is widely utilized to cap exposure to catastrophes; as arequota-share orexcess-of-loss treaties re single events. Rapid claims settlement reduces reserving duration compared to life insurance, and portfolios lean toward liquid, shorter-term assets (e.g.,cash,short-term bonds).
In a typical insurance company, Risk Management and theActuarial Function are separate but closely related departments, each with distinct responsibilities. In smaller companies, the lines might blur, with actuaries taking on some risk management tasks, or vice versa. Regardless, the Head Actuary (or Chief Actuary or Appointed Actuary) has specific responsibilities, typically requiring formal "sign-off": Reserve Adequacy and Solvency and Capital Assessment, as well as Reinsurance Arrangements. The relevant calculations are usually performed with specialized software — provided e.g. byWTW andMilliman — and often usingR orSAS.
Modern portfolio theory suggests a diversified portfolio ofshares and otherasset classes (such as debt incorporate bonds,treasury bonds, ormoney market funds) will realise more predictable returns. Illustrated is a typicaldiversified fund, whereasset allocation is between asset classes; within each, managers may further select specific securities.Efficient Frontier. Thehyperbola is sometimes referred to as the "Markowitz bullet", and its upward sloped portion is the efficient frontier if no risk-free asset is available. With a risk-free asset, the straightcapital allocation line is the efficient frontier.Here maximizing return and minimizing risk such that the portfolio isPareto efficient (Pareto-optimal points in red).
A key issue, however, is that the (assumed) relationships are (implicitly) forward looking.As observed in thelate-2000s recession, historic relationships can break down, resulting in losses to market participants believing that diversification would provide sufficient protection (in that market, including funds that had been explicitly set up to avoid being affected in this way[121]).A related issue is thatdiversification has costs: as correlations are not constant it may be necessary toregularlyrebalance the portfolio, incurringtransaction costs, negatively impactinginvestment performance;[122]and as the fund manager diversifies, so this problem compounds (and a large fund may also exertmarket impact).SeeModern portfolio theory § Criticisms.
An important requirement, regardless of approach, is that the Manager must ensure[120][134] that the portfolio's risk level matchesthe investor's objectives and comfort zone, i.e. must ensurerisk tolerance alignment. Correspondingly, the fund's (advertised)investment strategy will, almost necessarily, define its own risk tolerance andappetite, and hence selection and application of optimization-criteria and risk management techniques. SeeFiduciary duty,Fund governance andInvestment policy statement.Here, for both individuals and Funds, generally, longer time horizons allow for greater tolerance of short-term volatility, while shorter horizons require more conservative strategies. A further generalization: portfolios constructed using mathematical-approaches are more exposed to market risk and thestock market cycle; while those constructed bystock picking are exposed, more, tofirm and sector specific risks.
Guided by the analytics, and / or the above considerations, fund managers (andtraders) will implement specificrisk hedging techniques andstrategies.[120][12]As appropriate, these are applied to the portfolio as a whole ("top-down") or to individual holdings ("bottom-up"):
To protect the overall portfolio, fund managers[136]may sell thestock market index future orbuy puts on thestock market index option;[137][138] the respective sensitivities,portfolio beta andoption delta, determine the number of hedge-contracts required.[136] For both, the logic is that the (diversified) portfolio is likely highly correlated with thestock index it is part of: thus if the portfolio-value declines, the index will have declined likewise with the derivative holder profiting correspondingly.[136] Fund managers may (instead) engage in "portfolio insurance", a dynamic hedging process that involves selling index futures during periods of decline and using the proceeds to offset portfolio losses.
Bond portfolios, when e.g. a component of anasset-allocation fund or otherdiversified portfolio, are typically managed similar to equity above: the fund manager will hedge her bond allocation withbond index futures or options; with the number of contracts, a function ofduration.[139][140][136] In other contexts, the concern may be thenet-obligation or net-cashflow, where the fund manager respectively employsinterest rate immunization orcashflow matching. Immunization is a strategy that ensures that a change in interest rates will not affect the value of a fixed-income portfolio (an increase in ratesresults in a decreased instrument value). It is often used to ensure that the value of apension fund's assets (or an asset manager's fund) increase or decrease in an exactly opposite fashion to their liabilities, thus leaving the value of the pension fund's surplus (or firm's equity) unchanged, regardless of changes in the interest rate. Cashflow matching is similarly a process of hedging in which a company or other entity matches its cash outflows - i.e., financial obligations - with its cash inflows over a given time horizon. See alsoladdering,[141]dedicated portfolio,liability-driven investment strategy.
Further, and more generally, various safety-criteria may also inform overall portfolio composition, both at initial construction and, in this context, as a risk overlay.TheKelly criterion[147]will suggest - i.e. limit - the size of a position that an investor should hold in her portfolio.Roy's safety-first criterion[148]minimizes the probability of the portfolio's return falling below a minimum desired threshold.Chance-constrained portfolio selection similarly seeks to ensure that the probability of final wealth falling below a given "safety level" is acceptable.
RegardingDiscretionary Funds: Managers here, as mentioned, rely largely[131][132]on insight, monitoringcompany-level risks,industry dynamics, andmacro-factors, and will reduce exposure, or hedge, based on any perceived risks.The weight attached to the various concerns will differ given the strategy employed:value funds, for example, focus on changes infirm fundamentals (but otherwise will "buy and hold"); whilegrowth funds are exposed to both market (beta)and sector returns.In parallel, Managers apply (practice derived) position-levelstop loss rules, as well as portfolio-level construction limits re max position size, sector exposure, country or currency exposure, and benchmark-relativetracking error.As asupplement, Managers (atlarger institutions) may use various of the above quantitative tools to monitor risk exposures and potential losses.
All managers - especially those with long horizons - must ensure a positivereal growth rate, i.e. that theirportfolio-returns at least matchinflation (and regardless of market returns). Since this phenomenon impacts all securities,[153]inflation risk will typically be managed[154][155] at the portfolio level. Here the manager will programmatically[156] (or heuristically) increase exposure[157] to inflation-sensitive stocks (e.g.consumer staples) and / or invest intangible assets andcommodities, as well asinflation swaps andinflation-linked bonds (ILBs). The latterinflation derivatives can, in fact, provide a directinflation hedge: to fully offset inflation,[158]the proportion of the portfolio in ILBs, for example, will correspond to its “inflation beta”[159][160][157](sensitivity of portfolio return to increases in inflation, measured using regression).
While portfolio risks are managed day-to-day by the fund manager, theChief Risk Officer - often[167]Chief Investment Officer - is responsible for overall risk.[168][169][170]The Risk Function ("Group" at an IB, as above) thus monitors aggregate firm-level risks (exposure across funds, as well as, e.g.,reputational risk) ensuring alignment with the firm'srisk appetite andregulatory obligations; it will, relatedly, be involved in scenario generation - economic and geopolitical - and stress testing.This team also provides independent challenge and escalation if a fund breaches its risk budget (e.g. VaR, stress losses and sector concentration). The CRO typically signs off on stress testing, liquidity risk reviews, andmodel validation.
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^abVan Deventer, Nicole L, Donald R., and Kenji Imai. Credit risk models and the Basel Accords. Singapore: John Wiley & Sons (Asia), 2003.
^abDrumond, Ines. "Bank capital requirements, business cycle fluctuations and the Basel Accords: a synthesis." Journal of Economic Surveys 23.5 (2009): 798-830.
^abcdefSee "Market Risk Management in Non-financial Firms", in Carol Alexander, Elizabeth Sheedy eds. (2015).The Professional Risk Managers’ Handbook 2015 Edition.PRMIA.ISBN978-0976609704
^Anshul Vyas (2025).Revolutionizing Risk: The Role of Artificial Intelligence in Financial Risk Management, Forecasting, and Global Implementation.SSRN5224657
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