Two of the most interesting topics in finance are measuring risk and then controlling or managing that risk. Risk is inherent in all businesses. However, it is a particularly complex phenomenon in the financial sector. Controlling those risks can be even more difficult. The near collapse of General Motors in 2007 is a relatively recent example.
Measuring risk in finance involves some of the most sophisticated probability-based mathematical and statistical models found in any discipline. One common risk metric in finance is known as company beta. It applies to publicly listed companies and measures their stock market risk. Beta is measured by the variation or volatility exhibited by the stock price of the firm.
Risk management is concerned with measuring and controlling risks impinging on a firm. This discipline can be complicated by financial products that transfer risk from one party to another. For example, wheat derivatives allow a farmer to transfer to another party the risk of receiving a low price for his wheat crop next year. Financial products allow firms to reshape the risk profile inherent in their underlying business.
Financial Institutions Price Risk
Financial institutions put a price on risk. That task forms a large part of their prime business. They are particularly vulnerable to risk and at the cutting edge of risk-management practices. Most modern risk-management texts devote at least one-third or more of their pages to the subject of credit risk. Assessing the risk of banks and insurance companies is particularly difficult.
Banks and Insurance Companies
Banks are in the business of making loans and issuing guarantees for the financial performance of their customers. They enter as principals into bilateral contractual agreements such as swaps, forward contracts and options, exposing them to the risk that counterparties will not fulfill their obligations. Insurance companies are similarly complex organizations. They put a price on a whole range of physical events such as the risk of a house fire, flooding or piracy at sea.
Derivatives and Risk
Derivative instruments are a particularly difficult case for risk managers because their potential exposure can be many times their face value. This is often referred to as their leverage. The value of outstanding or active derivatives is enormous, totaling trillions of dollars. Their value has been driven much higher over the last decade by the relatively new class of credit derivatives, the fastest-growing financial product in the years leading up to the 2007 global financial crisis.