Summary

• What is risk management?

• How does risk management work?

  • Define aims

  • Identify risks

  • Risk Assessment

  • Define interventions

  • Surveillance

• Financial risk management

• Conclusion

What is risk management?

We constantly manage risks throughout our lives, whether during simple tasks (such as driving a car) or when signing up for new insurance or medical plans. Risk management is essentially about assessing and responding to these risks.

Most of us manage these unconsciously during daily activities. But when it comes to financial markets and business administration, risk assessment is a crucial practice that requires mindfulness.

In economics, we can describe risk management as the framework that defines how a company or investor manages financial risks, which are inherent in all kinds of businesses.

For traders and investors, the framework can include managing multiple asset classes, such as cryptocurrencies, Forex, commodities, stocks, indices, and real estate.

There are many types of financial risks, which can be classified in different ways. This article provides an overview of the risk management process. It also presents some strategies that can help traders and investors mitigate financial risks.

How does risk management work?

Usually, the risk management process involves five stages: setting objectives, risk identification, risk assessment, risk management and monitoring. However, depending on the context, these steps can change significantly.

Define aims

The first step is to define what the main objectives are, often linked to the risk tolerance of the company or the individual. In other words, how much risk are they willing to take to get closer to their goals.

Identify risks

The second step is to detect and define what the potential risks are. The goal is to reveal all kinds of events likely to cause negative effects. In the business environment, this step can also provide insightful information that is not directly related to financial risks.

Risk Assessment

After identifying risks, the next step is to assess their expected frequency and severity. Risks are then ranked in order of importance, making it easier to create or adopt an appropriate response.

Taken into account

The fourth step is to define the responses for each type of risk based on its level of importance. It establishes what measures to take in the event of an unfavorable event.

Surveillance

The final step in a risk management strategy is to monitor its effectiveness in response to events. This often requires ongoing data collection and analysis.

Financial risk management

There are many reasons why a strategy or trading plan may fail. For example, a trader may lose money because the market moves against their position in a futures contract or because they allow themselves to be guided by their emotions and end up selling in a panic.

Emotional reactions often cause traders to ignore or abandon their initial strategy. This is especially noticeable during bear markets (Bear) and periods of capitulation.

In the financial markets, most people agree that a good risk management strategy contributes significantly to their success. In practice, this can be as simple as setting stop-loss or profit-taking orders.

A robust trading strategy should provide a clear set of possible actions, which means traders can be more prepared to deal with all kinds of situations. However, as has been said, there are many ways to manage risk and, ideally, strategies should be continually reviewed and adapted.

Here are some examples of financial risks, along with a brief description of how they can be mitigated.

• Market Risks: These can be mitigated by using a Stop-Loss order on each position allowing them to be closed before incurring greater losses.

• Liquidity Risks: These can be mitigated by trading in high volume markets. Usually, assets with a high capitalization value in the market tend to be more liquid.

• Credit Risks: These can be reduced by using a trusted exchange platform so that the lender and borrower (or seller and buyer) do not question the trust they place in each other.

• Operational Risks: Investors can reduce operational risks by diversifying their portfolio, thus preventing the risks induced by exposure to a single project or a single company. They can also conduct research to find companies less likely to experience operational dysfunction.

• Systemic risks: They can also be reduced by diversifying the portfolio, but in this case, it is a question of favoring projects from companies from different types of industry. Preferably those with the least correlations.

To conclude

Before opening a trading position or allocating capital to a portfolio, traders and investors should consider a risk management strategy. However, it is important to keep in mind that financial risks can never be completely avoided.

Overall, risk management defines strategies for addressing risks, but in essence this is not risk mitigation. It also takes into account strategic thinking so that unavoidable risks can be included in the most effective way possible.

In other words, it is also about identifying, assessing and controlling risks, depending on the context and the strategy. The risk management process aims to evaluate the risk/reward ratio in order to prioritize the most favorable positions.