Financial organisations must manage at least five main types of risk: investment risk, liquidity risk, counterparty risk, operations risk and legal and compliance risk. A failure in any of the five can be the source of a sixth, which is reputational risk.
This is the risk of loss or shortfall associated with fluctuations in investment values.
Sources of investment risk
Organisations decompose investment risk according to how they select and manage their portfolios. For example, banks and investment banks distinguish between market risk (exposure to interest rate fluctuations), currency risk and credit risk (exposure to defaults or downgrades by borrowers or issuers of corporate bonds).
Investment managers think of investment risk as associated with either allocation to asset classes such as equities, bonds and property, or selection of individual securities within asset classes.
Measures of investment risk
Different sources of risk demand correspondingly different risk measures. For example, Value-at-Risk (VaR) and Conditional Value-at-Risk (CVaR), also known as Extreme Tail Loss (ETL), are designed to quantify short-term vulnerability to extreme events. Long-term investors are more interested in measures of sustained risk, such as portfolio volatility, tracking error and the portfolio's sensitivities, or betas, to factors such as the markets in which it invests.
Investment risk is measured either by parametric or analytic methods, such as ...