Risk management is an essential component of modern investment theory and practice. Since the 1950s, with the advent of Markowitz’ portfolio theory, investors have weighed the risk-reward relationship and applied knowledge to portfolio optimization, diversification, and downside protection strategies. In the years following the global financial crisis of 2007-2008, the field of risk management has received significant attention and opportunities for financial professionals have expanded. For those seeking a stable role in an important area of finance, risk management may be the right path for you.
What is Risk Management?
In the context of finance and investing, risk management is focused on assessing, monitoring, and mitigating operational risk, credit risk, and market risk throughout the day-to-day activities of the firm. Risk will be analyzed in terms of the firm's balance sheet, trading book, and fluctuations in the value of the firm’s portfolio.
Across all types of investing, fund managers and traders take risk into account as they seek to employ successful investing and hedging strategies. Outside of the investment world, non-financial firms also pay attention to risk – mainly addressing business risks that affect cash flows and profitability. Although this article is targeted toward financial professionals, there are also career opportunities in risk management throughout many other industries around the world.
The methodologies of risk management encompass several approaches and specialized training is required. One of the most common techniques is the assessment of Value-at-Risk (VaR), which makes use of historical information and probability theory to analyze the likelihood and magnitude of losses that could occur during credit events or market turmoil. Variants include conditional Value-at-Risk (CVaR) and extreme value theory (EVT), as part of a risk manager’s toolkit. The analytical work entails backtesting portfolio strategies and stress testing actual portfolios to see what may happen under a range of adverse conditions. Additional practices in risk management include expected shortfall calculations, in-depth analysis of trading positions, and extensive work on compliance with regulations and regulatory capital requirements.
What is a Risk Manager?
Risk managers analyze and oversee a company’s investment and risk management program. They are responsible for identifying and evaluating risks that could affect investment portfolios adversely, or that could impact operations and harm the reputation or financial success of the organization.
Specific duties of risk managers include the following elements, which can be found in typical risk manager job descriptions posted by financial firms. The risk manager will:
- Conduct risk assessments, collect, and evaluate financial and investment documentation, as well as referring to market information, including reports and statistics relevant to the line of business and form of investment.
- Review and assess risk management policies and protocols, providing recommendations and implementing adjustments and improvements, as needed.
- Analyze key financial metrics and trading data such as cash flow, profit and loss statements, and paper trails of employee activity that might reveal fraudulent behavior.
- Create and present risk reports and compliance documentation to executive leadership and regulators.
Risk managers often work closely with many groups across the organization, extending from the front office trading and portfolio management teams to the back office, where accounting and clearing take place. For this reason, good organizational and communication skills are helpful.
Other roles in Risk Management
In the world of quant finance, there are other roles in risk management that each require excellent analytical and quantitative skills.
- Risk Analysts - Risk analysts evaluate individual assets, portfolios, and external industry and economic conditions to help firms make risk-aware investment decisions.
- Model Validation Quants - Model validation quants work with models and methods developed by front office quants to assess their validity and mitigate the existence of model risk. Responsibilities also include writing technical reports, providing quantitative analysis and model documentation, and maintaining programming libraries and test environments that support the validation process.
Quantitative Finance and Risk Management
Clearly from the descriptions above, there are close connections between quantitative finance and risk management. Risk managers and quants have strong quantitative and financial modeling skills, as they employ various techniques that draw on statistics and probability, calculus, linear algebra, discrete mathematics, and econometrics in their work. They often use Monte Carlo simulation and machine learning techniques and are likely to be proficient with programming in Python or R, for example. They also have knowledge of VaR and its variants and at least some familiarity with financial markets, including recent regulatory developments.
Risk Management Courses and the CQF
The domain knowledge for risk management is complex and those who are considering a career in the field will benefit greatly from completing a quantitative finance course, such as the Certificate in Quantitative Finance (CQF).
In addition to providing a solid grounding in all major asset classes and quantitative techniques for pricing, trading, and hedging, the CQF offers an entire module on Risk Management. In this module, CQF delegates will learn about the classical portfolio theory of Markowitz and the capital asset pricing model. They will study econometric models including the ARCH framework and risk management metrics such as VaR. They will also gain exposure to risk regulation and the Basel III framework, which is so prominent in the risk landscape today.
For further information on risk management careers in quantitative finance, download the CQF Careers Guide.