The COSO Framework for Internal Control
February 12, 2025
Most of the literature in market risk management is dedicated to explaining the methods which are used in the management of regular market risk. This means that importance is rightly given to the management of the cases which are likely to occur 99% of the time. However, the recent past has shown us that there […]
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The discipline of risk management has been evolving through the years. As a result, the process of measuring risk and assigning numerical values to them has also been evolving over the years. The earlier measures of risk were simplistic and rudimentary in nature. With the passage of time, quants have started getting increasingly involved in the field of risk management. Hence, some of the newer measures are complex and mathematically advanced and hence provide better results.
In this article, we will have a closer look at some of the measures of risk which have been used throughout the years.
Investments with the least width i.e. the least deviation from expected value are considered to be least risky. For instance, the expected return from a certificate of deposit can vary between 3% and 4%. However, when it comes to equity, the range could be 0% to 100%. Hence, the certificate of deposit is considered less risky as compared to equity assets.
There are stocks of blue-chip companies which have been providing stable returns for many years. Hence, the data of the recent past should be taken into account while considering the riskiness of an asset. Thus, started the practice of using recent data as a benchmark to predict the possible future value. The method was quite simple, the probability of different values in the range was found out by analyzing the past data. The value and the probability were then multiplied together to find the expected value.
For instance, if there is a 60% chance that the stock will give a 10% return and there is a 40% chance that it will give a 20% return. The expected value is 0.6*10 + 0.4*20 = 6% +8% = 14%! In this case, the expected return is 14%. One of the ways to manage risk is to maximize the expected value based on past data.
This is the most widely used measure of risk in the world today. All major financial models use the concept of standard deviation. This is because this measure considered the probability of every possible outcome in the range along with the probability that has been assigned to it. The simple thumb rule is that a higher standard deviation denotes a higher dispersion from the mean. Hence, the riskiness is higher. Investors look for assets with a higher mean or average rate of return and lower dispersion.
The case with beta is slightly different. Beta compares the volatility of the asset as compared to the benchmark. For instance, if the value of the benchmark rose by 50% whereas that of the asset rose by 80%, it is said to have a higher beta.
The bottom line is that there are several different indicators of risk. Different indicators are used by different indicators during different times. As an organization, the decision regarding which indicators need to be used in which case needs to be mentioned in the risk policy.
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