Editing Financial risk management

{{Short description|Practice of protecting economic value in a firm by managing exposure to financial risk}}
{{Use dmy dates|date=April 2025}}
{{Financial risk types}}
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'''Institutions'''
*[[American Risk and Insurance Association]]
*[[Association of Insurance and Risk Managers in Industry and Commerce]]
*[[Global Association of Risk Professionals]]
*[[Global Risk Institute]]
*[[Institute of Risk Management]]
*[[Professional Risk Managers' International Association]]
*[[Risk and Insurance Management Society]]
'''Certifications'''
*[[Certificate in Quantitative Finance]] (CQF)
*[[Certified Risk Analyst]] (CRA)
*[[Professional certification in financial services#Certified Risk Management Professional|Certified Risk Management Professional]] (RIMS-CRMP)
*[[Certified Risk Professional]] (MIRM designation)
*[[Chartered Enterprise Risk Analyst]] (CERA; [[Society of Actuaries]])
*[[Chartered Enterprise Risk Actuary]] (CERA; [[Institute and Faculty of Actuaries]]) 
*[[Financial Risk Manager]] (FRM)
*[[Professional Risk Manager]] (PRM)
|}
'''Financial risk management''' is the practice of protecting [[Value (economics)|economic value]] in a [[business|firm]] by managing exposure to [[financial risk]] - principally [[credit risk]] and [[market risk]], with more specific variants as listed aside - as well as some aspects of [[operational risk]]. As for [[risk management]] more generally, financial risk management requires identifying the sources of risk, measuring these, and crafting plans to [[mitigation|mitigate]] them.<ref name="Christoffersen2011">{{Cite book |last=Peter F. Christoffersen |url=https://books.google.com/books?id=YkcMBGYbRasC |title=Elements of Financial Risk Management |date=22 November 2011 |publisher=Academic Press |isbn=978-0-12-374448-7}}</ref><ref>[https://www.gartner.com/en/finance/glossary/financial-risk-management Financial Risk Management], Finance Glossary. [[Gartner|Gartnergartner.com]]</ref> See {{slink|Finance|Risk management}} for an overview.

Financial risk management as a "science" can be said to have been born<ref name=":0">W. Kenton (2021). [https://www.investopedia.com/terms/h/harrymarkowitz.asp "Harry Markowitz"], investopedia.com</ref> with [[modern portfolio theory]], particularly as initiated by Professor [[Harry Markowitz]] in 1952 with his article, "Portfolio Selection";<ref>{{cite journal|last=Markowitz|first=H.M.|date=March 1952|title=Portfolio Selection|journal=The Journal of Finance|volume=7|issue=1|pages=77–91|doi=10.2307/2975974|jstor=2975974}}</ref> see {{slink|Mathematical finance|Risk and portfolio management: the P world}}.

The discipline can be qualitative and quantitative; as a specialization of [[risk]] management, however, financial risk management focuses more on when and how to [[Hedge (finance)|hedge]],<ref Name="Welch"/> often using financial instruments to manage costly exposures to risk.<ref name="Malz2011">{{Cite book |last=Allan M. Malz |url=https://books.google.com/books?id=rFX2f6AxH1QC |title=Financial Risk Management: Models, History, and Institutions |date=13 September 2011 |publisher=John Wiley & Sons |isbn=978-1-118-02291-7}}</ref>
*In the banking sector worldwide, the [[Basel Accords]] are generally adopted by internationally active banks for tracking, reporting and exposing operational, credit and market risks.<ref name="Van Deventer Imai">Van Deventer, Nicole L, Donald R., and Kenji Imai. Credit risk models and the Basel Accords. Singapore: John Wiley & Sons (Asia), 2003.</ref><ref name="Drumond">Drumond, Ines. "Bank capital requirements, business cycle fluctuations and the Basel Accords: a synthesis." Journal of Economic Surveys 23.5 (2009): 798-830.</ref>
*Within non-financial corporates,<ref name= "Hampton">John Hampton (2011). ''The AMA Handbook of Financial Risk Management''. [[American Management Association]]. {{ISBN|978-0814417447}}</ref><ref name="chron.com"/> the scope is broadened to overlap [[enterprise risk management]], and financial risk management then addresses risks to the firm's overall [[strategic management|strategic objectives]].
*[[insurance|Insurers]] manage their own risks with a focus on solvency and the ability to pay claims.<ref name="Grondin"/> Life Insurers are concerned more with longevity and interest rate risk, while short-Term Insurers emphasize [[Act of God|catastrophe-risk]] and claims volatility.
*In [[investment management]]<ref name="Kenton"/> risk is managed through diversification and related optimization; while further specific techniques are then applied to the portfolio or to individual stocks as appropriate.

In all cases, the last "[[Three lines of defence|line of defence]]" against risk is [[Financial capital|capital]], "as it ensures that a firm can continue as a [[going concern]] even if substantial and unexpected losses are incurred".<ref name="PRMIA"/>

==Economic perspective==
[[Neoclassical economics|Neoclassical]] [[financial economics|finance theory]] prescribes that (1) a firm should take on a project only if it increases [[shareholder]] value.<ref>See for example, [http://pages.stern.nyu.edu/~adamodar/New_Home_Page/AppldCF/other/Image2.gif "Corporate Finance: First Principles"], in [[Aswath Damodaran]] (2014). ''Applied Corporate Finance''. Wiley. {{ISBN|978-1118808931}}</ref> Further, the theory suggests that (2) [[management|firm managers]] cannot create value for shareholders or [[investment|investors]] by taking on projects that shareholders could do for themselves at the same cost; see [[Theory of the firm]] and [[Fisher separation theorem]].

Given these, there is therefore a fundamental debate relating to "Risk Management" and [[shareholder value]].<ref Name="Welch">See § "Does Corporate Risk Management Create Value?" in [https://corpfin.ivo-welch.info/read/source5.mba/13-npvadvice.pdf Capital Budgeting Applications and Pitfalls]. Ch 13 of [[Ivo Welch]] (2022). ''Corporate Finance'', 5 Ed. IAW Publishers. {{ISBN|978-0984004904}}</ref><ref Name="Lewellen">Jonathan Lewellen (2003). [http://ocw.mit.edu/courses/sloan-school-of-management/15-414-financial-management-summer-2003/lecture-notes/lec19_options.pdf Financial Management - Risk Management]. [[MIT OpenCourseWare|MIT OCW]]</ref><ref>[https://saylordotorg.github.io/text_risk-management-for-enterprises-and-individuals/s07-07-why-corporations-hedge.html Why Corporations Hedge]; Ch 3.7 in Baranoff ''et. al.''</ref> The discussion essentially weighs the value of risk management in a market versus the cost of [[bankruptcy]] in that market: per the [[Modigliani–Miller theorem|Modigliani and Miller framework]], hedging is irrelevant since diversified shareholders are assumed to not care about firm-specific risks, whereas, on the other hand hedging is seen to create value in that it reduces the [[probability of default|probability of financial distress]]. <!-- A further question, is the shareholder's desire to optimize risk versus taking exposure to pure risk (a risk event that only has a negative side, such as loss of life or limb). -->

When applied to financial risk management, this implies that firm managers should not hedge risks that investors can hedge for themselves at the same cost.<ref Name="Welch"/> This notion is captured in the so-called "hedging irrelevance proposition":<ref name="CHANDRASEKHAR">{{Cite book |last1=KRISHNAMURTI CHANDRASEKHAR |url=https://books.google.com/books?id=BNFX-gh6LlAC&pg=PA178 |title=Advanced Corporate Finance |last2=Krishnamurti & Viswanath (eds.) " |last3=Vishwanath S. R. |date=2010-01-30 |publisher=PHI Learning Pvt. Ltd. |isbn=978-81-203-3611-7 |pages=178–}}</ref> "In a [[perfect market]], the firm cannot create value by hedging a risk when the price of bearing that [[risk]] within the firm is the same as the [[price]] of bearing it outside of the firm."

In practice, however, financial markets are not likely to be perfect markets.<ref name="Hampton1982">{{Cite book |last=John J. Hampton |url=https://books.google.com/books?id=3NsJAQAAMAAJ |title=Modern Financial Theory: Perfect and Imperfect Markets |publisher=Reston Publishing Company |year=1982 |isbn=978-0-8359-4553-0}}</ref><ref name="Hoque2005">{{Cite book |last=Zahirul Hoque |url=https://books.google.com/books?id=-Wh0PQv0iYUC&pg=PA201 |title=Handbook of Cost and Management Accounting |publisher=Spiramus Press Ltd |year=2005 |isbn=978-1-904905-01-1 |pages=201–}}</ref><ref name="Butler2012">{{Cite book |last=Kirt C. Butler |url=https://books.google.com/books?id=ymRYTqoOkrYC&pg=PT37 |title=Multinational Finance: Evaluating Opportunities, Costs, and Risks of Operations |date=28 August 2012 |publisher=John Wiley & Sons |isbn=978-1-118-28276-2 |pages=37–}}</ref><ref name="Franzen2012">{{Cite book |last=Dietmar Franzen |url=https://books.google.com/books?id=xHwQBwAAQBAJ&pg=PA7 |title=Design of Master Agreements for OTC Derivatives |date=6 December 2012 |publisher=Springer Science & Business Media |isbn=978-3-642-56932-6 |pages=7–}}</ref> This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management, wherein they are able to determine which risks are cheaper for the firm to manage than for shareholders. Here, [[market risk]]s that result in unique risks for the firm are commonly the best candidates for financial risk management.<ref name=":1">{{Cite book |url=https://books.google.com/books?id=8Q6kvC8YenwC&pg=PA32 |title=Corporate Finance: Part I |publisher=Bookboon |isbn=978-87-7681-568-4 |pages=32–}}</ref>

==Application==
As outlined, businesses are exposed, in the main, to market, credit and operational risk. A broad distinction<ref name="PRMIA"/> exists though, between [[financial institution]]s and non-financial firms - and correspondingly, the application of risk management will differ. Respectively:<ref name="PRMIA"/>
For Banks and Fund Managers, "credit and market risks are taken intentionally with the objective of earning returns, while operational risks are a [[byproduct]] to be controlled". 
For non-financial firms, the priorities are reversed, as "the focus is on the risks associated with the business" - ie the production and marketing of the services and products [[competitive advantage|in which expertise is held]] - and their impact on revenue, costs and cash flow, "while market and credit risks are usually of secondary importance as they are a byproduct of the main business agenda". 
(See related discussion re [[Valuation (finance)#Valuing financial services firms|valuing financial services firms]] as compared to other firms.)
In all cases, as above, risk capital is the last "[[Three lines of defence|line of defence]]".

===Banking===
{{further|Bank#Capital and risk|Shadow banking system#Risks or vulnerability}}
[[Banks]] and other [[Wholesale banking|wholesale institutions]] face various [[financial risk]]s in conducting their business, and how well these risks are managed and understood is a key driver<ref name="OCC">[[Office of the Comptroller of the Currency]] (2019). ''Comptroller's Handbook'': [https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/corporate-risk-governance/pub-ch-corporate-risk.pdf "Corporate and Risk Governance"]</ref>
behind profitability, as well as of the [[Capital requirement|quantum of capital]] they are required to hold.<ref name="Zaher">Fadi Zaher (2022). [https://www.investopedia.com/articles/economics/08/economic-capital.asp  Using Economic Capital to Determine Risk], [[investopedia]].</ref>
Financial risk management in banking has thus grown markedly in importance since the [[2008 financial crisis]].<ref name="CRO article">[https://www.institutionalinvestor.com/article/b1505qj433jnpj/the-rise-of-the-chief-risk-officer The Rise of the Chief Risk Officer], ''[[Institutional Investor (magazine)|Institutional Investor]]'' (March 2017).</ref>
(This has given rise<ref name="CRO article"/> to [[Master of Quantitative Finance|dedicated degrees]] and [[Professional certification in financial services#Risk management and quantitative finance|professional certifications]].)

The broad distinction between [[Investment bank|Investment Banks]], on the one hand, and [[Commercial bank|Commercial]] and [[retail bank|Retail Banks]] on the other, carries through to the management of risk at these institutions.
Investment Banks profit from  trading - [[proprietary trading|proprietary]] and [[Flow trading|flow]] -  and earn fees from [[Structured product|structuring]] and [[Investment banking#Front office|deal making]]; the latter [[Investment banking#Corporate finance|includes]] listing securities so as to raise funding in the [[capital market]]s (and [[bookmaking|supporting]] these thereafter), as well as directly providing debt-funding for [[Corporate finance#Investment banking|large corporate "projects"]].
The major focus for risk managers here is therefore on market and credit risk.
Commercial and Retail Banks, as [[financial institution|deposit taking institutions]], profit from the spread between [[Deposit (finance)|deposit]] and loan rates.
The focus of risk management is then on [[loan default]]s from individuals or businesses, and on having enough [[liquid assets]] to meet [[Deposit risk|withdrawal demands]]; market risk concerns, mainly, the impact of interest rate changes on [[net interest margin]]s.

All banks will focus also on operational risk, impacting here (at least) through [[regulatory capital]];
(large) banks are also exposed to [[Macroeconomics|Macroeconomic]] [[systematic risk]] - risks related to the aggregate economy the bank is operating in<ref>{{cite journal |last1=Bolt |first1=Wilko |first2=Leo de |last2=Haan |first3=Marco |last3=Hoeberichts |first4=Maarten van |last4=Oordt |first5=Job |last5=Swank |title=Bank Profitability during Recessions |journal=[[Journal of Banking & Finance]] |date=September 2012 |volume=36 |issue=9 |pages=2552–64 |doi=10.1016/j.jbankfin.2012.05.011 |url=https://www.dnb.nl/binaries/Working%20paper%20251_tcm46-236504.pdf |access-date=2022-03-22 |archive-date=2020-10-03 |archive-url=https://web.archive.org/web/20201003081538/https://www.dnb.nl/binaries/Working%20paper%20251_tcm46-236504.pdf |url-status=dead }}</ref>
(see [[Too big to fail]]).

====Investment banking====
[[File:VaR diagram.JPG|thumb|300px|The 5% Value at Risk of a hypothetical profit-and-loss [[probability density function]]]]
{{Specific Banking Frameworks Sidebar}}
{{further|Investment banking#Risk management}}
{{see also|Derivative (finance)#Risks|Interest rate swap#Risks|Option (finance)#Risks|Value at risk#VaR risk management|Corporate bond#Risk analysis}}
For [[investment banks]] - as outlined - the major focus is on credit and market risk.
Credit risk is inherent in the business of banking, but additionally, these institutions are exposed to [[counterparty credit risk]]. Both are [[Credit risk#Mitigation|to some extent offset]] by [[Margin (finance)|margining]] and [[Collateral (finance)|collateral]]; and the management is of the [[Net (economics)|net-position]].

Risk management here<ref name ="Haugh">Martin Haugh (2016). [http://www.columbia.edu/~mh2078/QRM/BasicConceptsTechniques.pdf "Basic Concepts and Techniques of Risk Management"]. [[Columbia University]]</ref><ref name="DeMeo">Roy E. DeMeo (N.D.) [https://mathfinance.charlotte.edu/sites/mathfinance.charlotte.edu/files/media/An%20Introduction%20to%20Value%20At%20Risk%20New.pdf "Quantitative Risk Management: VaR and Others"]. [[University of North Carolina at Charlotte|UNC Charlotte]]</ref><ref name="Van Deventer Imai"/><ref name="Drumond"/>
is, as discussed, simultaneously concerned with
(i) managing, and as necessary [[hedge (finance)|hedging]], the various positions held by the institution - both [[trading book|trading positions]] and [[banking book|long term exposures]];
and 
(ii) calculating and monitoring the resultant [[economic capital]], as well as the [[regulatory capital]] under [[Basel III]] — which, importantly, covers also [[Leverage (finance)|leverage]] and [[Market liquidity|liquidity]] — with regulatory capital as a floor.

Correspondingly, and broadly, the analytics<ref name="DeMeo"/><ref name ="Haugh"/> are based as follows:
For (i) on [[Greeks (finance)|the "Greeks"]], the sensitivity of the price of a derivative to a change in its underlying factors; as well as on [[Greeks (finance)#Related measures|the various other measures of sensitivity]], such as [[DV01]] for the sensitivity of a [[bond (finance)|bond]] or [[swap (finance)|swap]] to interest rates, and [[CS01]] or [[Credit default swap#Risk|JTD]] for exposure to [[credit spread (bond)|credit spread]]. 
For (ii) on [[value at risk]], or "VaR", an estimate of how much the investment or area in question might lose as market and credit conditions deteriorate, with a given probability over a set time period, and with the bank then holding [[economic capital|"economic"-]] or "[[risk capital]]" correspondingly; [[Value at risk#Details|common parameters]] are 99% and 95% worst-case losses - i.e. 1% and 5% - and one day and two week ([[Day count convention|10 day]]) horizons.<ref name="Pearson">{{cite book|first=Neil|last=Pearson|title=Risk Budgeting: Portfolio Problem Solving with Value-at-Risk|publisher=John Wiley & Sons|year=2002|isbn=978-0-471-40556-6}}</ref>
These calculations are mathematically sophisticated, and within [[Quantitative analysis (finance)#Risk management|the domain of quantitative finance]].

The regulatory capital quantum is calculated via specified formulae: risk weighting the exposures per highly standardized asset-categorizations, applying the aside frameworks, and the resultant capital — at least 12.9%<ref>Steven Nickolas (2023). [https://www.investopedia.com/ask/answers/043015/what-difference-between-tier-1-capital-and-tier-2-capital.asp "Tier 1 Capital vs. Tier 2 Capital"], Investopedia</ref> of these [[Risk-weighted asset]]s (RWA) — must then be held [[Capital requirement#Regulatory capital|in specific "tiers"]] and is measured correspondingly via the [[Capital requirement#Common capital ratios|various capital ratios]].
In certain cases, banks are allowed to use their own estimated risk parameters here; these [[Internal ratings-based approach (credit risk)|"internal ratings-based models"]] typically result in less required capital, but at the same time   [[Basel III: Finalising post-crisis reforms#Requirements|are subject to]] strict minimum conditions and disclosure requirements.
As mentioned, additional to the capital covering RWA, the aggregate [[balance sheet]] will require capital for [[Leverage (finance)|leverage]] and [[Market liquidity|liquidity]]; this is monitored via<ref name="LR etc"/> the [[Leverage ratio|LR]], [[Liquidity Coverage Ratio|LCR]], and [[Net stable funding ratio|NSFR]] ratios.

The [[2008 financial crisis]] exposed holes in the mechanisms used for hedging
(see {{slink|Fundamental Review of the Trading Book#Background}}, {{slink|Tail risk|Role of the 2007–2008 financial crisis}}, {{slink|Value at risk|Criticism}}, and {{slink|Basel III#Criticism}}).
As such, the methodologies employed [[Financial economics#Departures from normality|have had to evolve]], both from a modelling point of view, and in parallel, from a regulatory point of view.

Regarding the modelling, changes corresponding to the above are:
(i) For the daily [[PnL Explained#Sensitivities method|direct analysis of the positions]] at the [[Trading desk|desk level]], as a standard, measurement of the Greeks [[Valuation of options#Post crisis|now inheres]] the [[volatility surface]] — through [[local volatility|local-]] or [[stochastic volatility]] models — while re interest rates, discounting [[fixed income analysis|and analytics]] are under a "[[multi-curve framework]]". Derivative pricing [[XVA#Context|now embeds]] considerations re [[counterparty risk]] and [[Margin (finance)#Types of margin requirements|funding risk]], amongst others,<ref name="iacpm"/> through the [[credit valuation adjustment|CVA]] and [[XVA]] "valuation adjustments"; these [[XVA#Accounting impact|also carry]] regulatory capital.
(ii) For Value at Risk, the traditional [[Value at risk#Computation methods|parametric]] and [[Historical simulation (finance)|"Historical"]] approaches, are now supplemented<ref>{{Cite book|url=https://books.google.com/books?id=Rr_6y9evvowC&q=financial+crisis+2008+credit+risk+management|title=Credit Risk Management In and Out of the Financial Crisis: New Approaches to Value at Risk and Other Paradigms|last1=Saunders|first1=Anthony|last2=Allen|first2=Linda|publisher=John Wiley & Sons|year=2010|isbn=978-0-470-62236-0|location=Hoboken, NJ|language=en}}</ref><ref name="DeMeo"/>  with the more sophisticated [[Conditional value at risk]] / [[expected shortfall]], [[Tail value at risk]], and [[Extreme value theory]]<!-- (and [[potential future exposure|PFE]] and [[Potential future exposure#Expected exposure|EE]] for regulatory) -->. For the underlying mathematics, these may utilize [[Mixture model#A financial model|mixture models]], [[Principal component analysis#Quantitative finance|PCA]], [[volatility clustering]], [[Copula (probability theory)#Quantitative finance|copulas]], and other techniques.<ref>See for example III.A.3, in Carol Alexander, ed. (January 2005). ''The Professional Risk Managers' Handbook''. PRMIA Publications. {{ISBN|978-0976609704}}</ref>
Extensions to VaR include [[Margin at risk|Margin-]], [[Liquidity at risk|Liquidity-]], [[Earnings at risk|Earnings-]] and  [[Cash flow at risk]], as well as [[Liquidity risk#Liquidity-adjusted value at risk|Liquidity-adjusted VaR]].
For both (i) and (ii), [[model risk]] is addressed<ref>[[Riccardo Rebonato]] (N.D.). [http://www.quarchome.org/ModelRisk.pdf ''Theory and Practice of Model Risk Management''].</ref> through regular [[Quantitative analysis (finance)#Model validation|validation of the models]] used by the bank's various divisions; for VaR models, [[Backtesting#Financial analysis|backtesting]] is especially employed.

Regulatory changes, are also twofold. 
The first change, entails an [[Basel III#Summary of originally-proposed changes (2010) in Basel Committee language|increased emphasis]]<ref name="Investopdia_bank_stress_test">Troy Segal (2021). [https://www.investopedia.com/terms/b/bank-stress-test.asp  "What Is a Bank Stress Test? How It Works, Benefits, and Criticism"], Investopedia</ref> on [[Stress test (financial)#Bank stress test|bank stress tests]].<ref>[[Basel Committee on Banking Supervision]] (2009). [https://www.bis.org/publ/bcbs155.pdf "Principles for sound stress testing practices and supervision"]</ref> 
These tests, essentially [[Computer simulation|a simulation]] of the [[balance sheet]] for a [[Scenario planning#Finance|given scenario]], are typically linked to the macroeconomics, and provide an indicator of how sensitive the bank is to changes in economic conditions, whether it is [[Comprehensive Capital Analysis and Review|sufficiently capitalized]], and of its ability to respond to market events.
The second set of changes, sometimes called "[[Basel IV]]", entails the modification of several regulatory capital standards ([[Capital Requirements Regulation 2013|CRR III]] is the EU implementation).  In particular [[FRTB]] addresses market risk, and [[SA-CCR]] addresses counterparty risk; 
other modifications [[Basel III: Finalising post-crisis reforms#Requirements|are being phased in]] from 2023.

To [[Risk manager|operationalize]] the above, [[Investment bank]]s, particularly, employ dedicated [[Investment bank#Risk management|"Risk Groups"]], i.e. [[Middle office|Middle Office]] teams monitoring the firm's risk-exposure to, and the profitability and structure of, its various [[business unit]]s, [[Bank#Products|products]], [[asset class]]es, desks, and / [[Political risk#Geopolitical risk|or geographies]].<ref name="iacpm 2"/>
By increasing order of aggregation:
# Financial institutions will set<ref name="MAR12">Bank for International Settlements (2019). [https://www.bis.org/basel_framework/chapter/MAR/12.htm MAR12 - Definition of trading desk]</ref><ref name ="Haugh"/><ref>Open Risk Manual (2021). [https://www.openriskmanual.org/wiki/Risk_Limit "Risk Limit"]</ref> [[Black–Scholes model#The Options Greeks|limit values for each of the Greeks]], or other sensitivities, that their [[Trader (finance)|traders]] must not exceed,  and traders [[Option (finance)#Risks|will then hedge]], offset, or reduce periodically if not daily; see the techniques [[#Investment management|listed below]]. These limits are set given a range<ref>Bank for International Settlements (2001). [https://www.bis.org/publ/bcbsca09.pdf Principles for the Management and Supervision of Interest Rate Risk]</ref> of plausible changes in prices and rates, coupled with the board-specified [[risk appetite]]<ref>Open Risk Manual (2021). [https://www.openriskmanual.org/wiki/Limit_framework "Limit framework"]</ref> re overnight-losses.<ref>Staff (2023). [https://fastercapital.com/content/Risk-Management--Mitigating-Overnight-Position-Volatility.html#Understanding-Overnight-Position-Volatility "Mitigating Overnight Position Volatility"]. fastercapital.com</ref>
# Desks, or areas, will similarly be [[Value at risk#VaR risk management|limited as to their VaR quantum]] (total or incremental, and under various calculation regimes), corresponding to their allocated<ref name="Guo"/> economic capital; a loss which exceeds the VaR threshold is termed a "VaR breach". RWA - with other regulatory results - is correspondingly monitored from desk level<ref name="MAR12"/> and upward. 
# Each area's (or desk's) [[Concentration risk#Monitoring and management|concentration risk will be checked]]<ref>[[Basel Committee on Banking Supervision]] (1999). [https://www.bis.org/publ/bcbs63.pdf "Risk Concentrations Principles"]</ref><ref name="iacpm 2">International Association of Credit Portfolio Managers (2022). [http://iacpm.org/wp-content/uploads/2022/02/IACPM-Risk-Mitigation-Techniques-White-Paper.pdf "Risk mitigation techniques in credit portfolio management"]</ref><ref>{{cite web|url=https://www.mfsa.com.mt%2Fpages%2Freadfile.aspx%3Ff%3D%2Ffiles%2FLegislationRegulation%2Fregulation%2Fbanking%2FcreditInstitutions%2Frules%2FBR_12_14%2FAnnex%25202G%2520-%2520Principles%2520for%2520the%2520Management%2520of%2520Concentration%2520Risk.pdf|title=Principles for the Management of Concentration Risk|publisher=Malta Financial Services Authority|year=2010}}</ref> against thresholds set for various types of risk, and / or re a single counterparty, [[Economic sector|sector]] or geography.
# [[Leverage (finance)#Risk|Leverage will be monitored]], at very least [[Leverage (finance)#Banking|re regulatory requirements]] via LR, the [[Leverage ratio|Leverage Ratio]], as leveraged positions [[Derivative (finance)#Leverage|could lose large amounts]] for a relatively small move in the price of the underlying. 
# Relatedly,<ref name="LR etc">[[PwC]] (2016). [https://www.icmagroup.org/assets/documents/Events/test/20%20-%20ICMA%20Presentation%20-%20Liquidity%20&%20Leverage_v1.pdf An overview of the LCR, NSFR and LR]</ref> [[Liquidity risk#Management|liquidity risk is monitored]]: LCR, the [[Liquidity Coverage Ratio]], measures the ability of the bank to survive a short-term stress, covering its total net cash outflows over the next 30 days with "[[high quality liquid assets]]"; NSFR, the [[Net stable funding ratio|Net Stable Funding Ratio]], assesses its ability to finance assets and commitments within a year (addressing also, [[maturity transformation]] risk). Any [[Duration gap|"gaps"]], also, [[Duration gap#Management|must be managed]].<ref name="IRRBB">Bank for International Settlements (2016).  [https://www.bis.org/bcbs/publ/d368.pdf Interest rate risk in the banking book]</ref>
#[[List of systemically important banks|Systemically Important Banks]] hold additional capital such that  their [[Total Loss Absorbency Capacity|total loss absorbency capacity]], TLAC, is sufficient<ref>Bank for International Settlements (2017). [https://www.bis.org/fsi/fsisummaries/tlac.pdf TLAC – Executive Summary]</ref> given both RWA and leverage. (See also "MREL"<ref>"Minimum Requirement for own funds and Eligible Liabilities"; see [https://wiki.treasurers.org/wiki/MREL MREL], treasurers.org</ref> for EU institutions.)

Periodically,<ref>[[Basel Committee on Banking Supervision]]  (2009). [https://www.bis.org/publ/bcbs152.pdf "Range of practices and issues in economic capital frameworks"]</ref> 
these all are estimated under a given stress scenario — [[List of bank stress tests|regulatory]] and,<ref>[[KPMG]] (2016).[https://assets.kpmg.com/content/dam/kpmg/xx/pdf/2016/11/stress-testing-a-benchmarking-analysis-of-systemically-important-financial-institutions.pdf "Stress testing - A benchmark analysis of systemically important financial institutions"]</ref> 
often, [[Scenario planning#Finance|internal]] — 
and risk capital,<ref name="OCC"/> [[Risk appetite#Levels|together with these limits]] if indicated,<ref name="OCC"/><ref name="RAF">[[Financial Stability Board]] (2013). [https://www.fsb.org/wp-content/uploads/r_131118.pdf "Principles for An Effective Risk Appetite Framework"]</ref> is correspondingly revisited (or optimized<ref>[[KPMG]] (2017). [https://assets.kpmg.com/content/dam/kpmg/uk/pdf/2017/07/balance_sheet_optimisation.pdf "Balance sheet optimisation:the returns dilemma for banks"]</ref>). 
The approaches taken center either on a hypothetical or [[List of stock market crashes and bear markets|historical scenario]],<ref name="Investopdia_bank_stress_test"/><ref name="DeMeo"/>
and may apply increasingly sophisticated mathematics<ref name="IMF Stress Testing">Li Ong (2014). [https://www.elibrary.imf.org/display/book/9781484368589/9781484368589.xml "A Guide to IMF Stress Testing Methods and Models"], [[International Monetary Fund]]</ref><ref name="DeMeo"/> to the analysis.
More generally, these tests [[Value at risk#VaR risk management|provide estimates]] for scenarios  beyond the VaR thresholds, thus “preparing for anything that might happen, rather than worrying about precise likelihoods".<ref name="Aldous">[[David Aldous]] (2016). [https://www.stat.berkeley.edu/~aldous/Blog/Aldous-2016-Wilmott.pdf Review of Financial Risk Management... for Dummies]</ref>
A reverse stress test, in fact, starts from the point at which "the institution can be considered as failing or likely to fail... and then explores scenarios and circumstances that might cause this to occur".<ref>[https://wiki.treasurers.org/wiki/Reverse_stress_test Reverse stress test], [[Association of Corporate Treasurers]]</ref>

A key practice,<ref name="Crouhy">Michel Crouhy (2006). [https://web.archive.org/web/20100331084924/https://www.nccr-finrisk.uzh.ch/media/pdf/conferences/presentation_Crouhy.pdf "Risk Management, Capital Attribution and Performance Measurement"]</ref> incorporating and assimilating the above, is to assess the [[Risk-adjusted return on capital]], RAROC, of each area (or product). Here,<ref name="Skoglund">J Skoglund (2010). [https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2070688 "Funds Transfer Pricing and Risk Adjusted Performance Measurement"]. [[SAS Institute]].</ref>  [[Economic value added|"economic profit"]] is divided by allocated-capital; and this result is then compared<ref name="Skoglund"/><ref name="Zaher"/> to the target-return for the area — usually, at least the [[cost of equity|equity holders' expected returns]] on the bank stock<ref name="Skoglund"/> — and identified under-performance can then be addressed. (See similar [[#Corporate_finance|below]] re. DuPont analysis.)
The numerator, risk-adjusted return, is realized trading-return less a [[Funds transfer pricing#Banking and finance|term and risk appropriate funding cost]] as charged [[Treasury management#Banks|by Treasury]] to the business-unit under the bank's [[funds transfer pricing]] (FTP) framework;<ref>[[Wolters Kluwer]] (2021).
[https://www.wolterskluwer.com/en/expert-insights/enhancing-fund-transfer-pricing-systems-at-a-time-when-they-are-needed-most "Enhancing fund transfer pricing systems"]</ref>
[[direct costs]] are (sometimes) also subtracted.<ref name="Crouhy"/>
The denominator is the area's allocated capital, as above, increasing as a function of position risk;<ref>Karen Moss (2018). [https://www.moodysanalytics.com/articles/2018/funds-transfer-pricing-in-banks "Funds-transfer-pricing in Banks: what are the main drivers?"]. [[Moodys Analytics]]</ref><ref>James Chen (2021). [https://www.investopedia.com/terms/r/raroc.asp "Risk-Adjusted Return on Capital (RAROC) Explained & Formula"], [[Investopedia]]</ref><ref name="Crouhy"/> several allocation techniques exist.<ref name="Guo">Guo, Qiheng, Daniel Bauer, and George H. Zanjani. 2021. [https://variancejournal.org/article/29684-capital-allocation-techniques-review-and-comparison "Capital Allocation Techniques: Review and Comparison."]  ''Variance'' 14 (2).</ref>
RAROC is calculated both ''[[ex post]]'' as discussed, used for performance evaluation (and related [[Performance-related pay#Financial sector|bonus calculations]]),
and  ''[[ex ante]]'' - i.e. [[expected return]] less [[expected loss]] - to decide whether a particular business unit should be expanded or contracted.<ref>See "Economic Capital and RAROC", Chapter 28 in Hull, John (2023).</ref>

Other teams, overlapping the above Groups, are then also involved in risk management.
[[Treasury management#Banks|Corporate Treasury]] is responsible for monitoring overall funding and capital structure; it shares responsibility for monitoring liquidity risk, and for maintaining the FTP framework.
Middle Office [[Financial analyst#Middle office|maintains the following functions]] also:
[[product control|Product Control]] is primarily responsible for insuring traders [[Mark-to-market accounting|mark their books to fair value]] — a key protection against [[rogue trader]]s — and for [[P&L Explained|"explaining" the daily P&L]]; with the [[PnL explained#PnL unexplained|"unexplained" component]], of particular interest to risk managers.
Credit Risk [[Financial analyst#Credit analysts|monitors the bank's debt-clients]] on an ongoing basis, re both exposure [[Debt service coverage ratio|and performance]].
In the [[Front office|Front Office]] - since counterparty and funding-risks span assets, products, and desks - specialized [[Credit valuation adjustment#Function of the CVA desk|XVA-desks]] are tasked with centrally [[XVA#Accounting impact|monitoring and managing]] overall CVA and XVA exposure and capital, typically with oversight from the appropriate Group.<ref name="iacpm">International Association of Credit Portfolio Managers (2018). [http://iacpm.org/wp-content/uploads/2018/06/IACPM-Fintegral-Making-the-Most-of-XVA-2018-White-Paper.pdf "The Evolution of XVA Desk Management"]</ref>
"Stress Testing" may similarly be centralized.

Performing the above tasks — while simultaneously ensuring that computations are consistent<ref>Michael Gibson (1997). [https://www.bis.org/publ/ecsc07f.pdf "Information systems for risk management"]. [[Federal Reserve Board]]</ref> [[OLAP cube#Operations|over the various]] areas, products,  teams, [[Coherent risk measure|and measures]] — requires that banks maintain a significant investment<ref>See e.g. [https://www.value-at-risk.net/build-vs-buy/ "Build vs Buy"] in Holton, G. (2013). ''Value-at-Risk: Theory and Practice'', Second Edition</ref>  in [[Investment banking#Technology|sophisticated infrastructure]], [[:Category:Financial software companies|finance / risk software]], and [[Quantitative analysis (finance)#Quantitative developer|dedicated staff]]. Risk software often deployed is from [[FIS (company)|FIS]], [[Kamakura Corporation|Kamakura]]<!-- / [[SAS (software)|SAS]] -->, [[Murex (financial software)|Murex]], [[Numerix]] (FINCAD) and [[Refinitiv]].
Large institutions may prefer systems developed entirely [[In-house software|"in house"]]
- notably<ref>Sarah Butcher (2017). [https://www.efinancialcareers.com/news/2017/03/secdb-quartz-athena-analytics "The $bn struggle to replicate Goldman Sachs' special powers"], efinancialcareers.com</ref> [[Goldman Sachs]] ("[[SecDB]]"), [[JP Morgan]] ("Athena"), [[Jane Street Capital|Jane Street]], [[Barclays]] ("BARX"), [[BofA Securities|BofA]] ("Quartz") - 
while, more commonly, the [[Derivative (finance)#Valuation|pricing]] [[Library (computing)|library]] will be [[Quantitative analysis (finance)#Library quantitative analysis|developed internally]], especially as this allows for currency re new products or market features.

====Commercial and retail banking====
[[File:Risk in Banking.jpg|thumb| [[taxonomy|Risk taxonomy]] for retail and commercial banks]]
{{see also|Bank failure}}
{{further|Financial institution#Regulation|Volcker Rule}}

[[Commercial bank|Commercial]] and [[retail bank]]s<ref>Dr Andros Gregoriou (N.D.) [https://www.economicsnetwork.ac.uk/sites/default/files/Kent%20Matthews/lecture%2011%20Commercial%20Bank%20Risk%20Management.pdf Commercial Bank Risk Management]</ref><ref>Amalendu Ghosh (2012). "Managing Risks in Commercial and Retail Banking". Wiley. {{ISBN|9781118103531}}</ref><ref name="FC">Faster Capital (2024). [https://fastercapital.com/content/Risk-Management--Risk-Management-Rundown--Retail-vs--Commercial-Banking-Risk-Profiles.html Retail vs: Commercial Banking Risk Profiles]</ref><ref name="HKIB">Hong Kong Institute of Bankers (2023).
[https://bankinggps.hkib.org/major-roles-in-banking/risk-management/ Risk Management]</ref>
are, by nature, more conservative than Investment banks, earning steady income from lending and deposits;  their focus is more on the "[[banking book]]" than the "[[trading book]]".
The biggest concern here - as mentioned - is the credit risk due to [[loan default]]s from individuals or businesses. Liquidity risk, in this context not having enough liquid assets to meet [[Deposit risk|withdrawal demands]], is also a major focus; while interest rate risk concerns the impact of interest rate changes on [[net interest margin]]s (the spread between deposit and loan rates).

For these banks, regulatory oversight is often tighter due to their direct impact on the financial system. Thus they are also [[Banking regulation and supervision|highly regulated]] under Basel III and [[List of financial regulatory authorities by jurisdiction|national banking laws]], and will also be subject to regular stress testing by central banks; and all regulations above then apply (with local exceptions; e.g. an LCR "threshold" in the US<ref>{{Cite web|title=Changes to Applicability Thresholds for Regulatory Capital and Liquidity Requirements|url=https://www.occ.treas.gov/news-issuances/federal-register/2019/84fr59230.pdf|access-date=2025-03-13|website=occ.treas.gov}}</ref>). Additional to these, however, they must maintain high capital and liquidity ratios to [[deposit protection|protect depositors]]; see [[CAMELS rating system]].

Given their business model and risk appetite,<ref name="FC"/> as outlined, various differences result vs risk management at investment banks. 
* Banks here maintain specific (and often additional) [[Capital adequacy ratio|capital buffer]]s to cover potential loan losses; reflected also in the fact that retail and commercial loans usually attract [[Standardized approach (credit risk)#The summary of risk weights in standardized approach|higher RWA results]]<ref>Alicia Tuovila (2023).   [https://www.investopedia.com/terms/r/riskweightedassets.asp Understanding Risk-Weighted Assets], Investopedia</ref> than for assets typical in investment banking. See, e.g., the [[Allowance for Loan and Lease Losses|ALLL]] and [[Non-performing loan|NPL]] ratios.
*At the same time, credit exposure for these banks is to significantly more clients than at investment banks. For retail banks, "[[consumer credit risk]]" is often diversified across a vast number of borrowers, and these employ statistical models for (ongoing [[Consumer credit risk#Scorecards|"behavioral"]])  [[credit scoring]] and [[probability of default]]. Commercial banks deal with mid-sized [[Business loan#Bank loan|corporate loans]] and [[Corporate bond|bonds]], and apply [[accounting analyst|accounting-]] and [[financial analysis]] to determine creditworthiness; the approach differs re investment banking in that the broad client base allows for (necessitates) automation, with [[Financial analyst#Credit analysts|close monitoring]] on [[Management by exception|an exception basis]].  [[Artificial intelligence|AI]] / [[Machine learning|ML]] is increasingly employed at all stages.<ref name="Vyas">Anshul Vyas (2025). ''Revolutionizing Risk: The Role of Artificial Intelligence in Financial Risk Management, Forecasting, and Global Implementation''. {{SSRN|5224657}}</ref><ref name="Boukherouaa">E. Boukherouaa ''et al'' (2021). [https://www.elibrary.imf.org/view/journals/087/2021/024/087.2021.issue-024-en.xml ''Powering the Digital Economy: Opportunities and Risks of Artificial Intelligence in Finance'']. [[International Monetary Fund]] Departmental Papers</ref><ref name="Nassr">Iota Kaousar Nassr (2021). [https://www.oecd.org/en/publications/artificial-intelligence-machine-learning-and-big-data-in-finance_98e761e7-en.html Artificial Intelligence, Machine Learning and Big Data in Finance]. [[OECD]]</ref>
*Concentration risk, relatedly, differs in its [[Concentration risk#Monitoring and management|management]]: the concern is sector concentration as opposed to "name concentration".  Here, in calculating VaR for a credit portfolio,<ref>''World Finance'' (N.D.). [https://www.worldfinance.com/home/risk-encyclopaedia/credit-value-at-risk Credit value at risk]</ref> banks will incorporate a [[Joint probability distribution|joint]] default probability for the various sectors and / or industries. 
* Both retail and commercial banks employ strict [[liquidity risk#Management|liquidity management]] to ensure enough cash for [[Bank run|customer withdrawals]]: at a minimum meeting the above NSFR and LCR requirements; but also complying with their regulator's [[reserve requirement]]. See also [[liquidity at risk]].
* Both use [[Interest rate risk#At banks|interest rate hedging]] (e.g., swaps) but here, in the main, to protect their profit margin against rate fluctuations, and the resultant "margin compression";<ref>Angela Hinton and Chester Polson (2021). [https://www.fdic.gov/analysis/quarterly-banking-profile/fdic-quarterly/2021-vol15-2/article1.pdf "The Historic Relationship Between Bank Net Interest Margins and Short-Term Interest Rates"]. [[FDIC]] Quarterly. 15:2</ref> i.e., as opposed to addressing market risk ''per se''. Re the latter, they will often employ the abovementioned [[cash flow at risk]] and [[earnings at risk]] models. They also hold specific capital for [[interest rate risk in the banking book]],<ref name="IRRBB"/><ref>[https://wiki.treasurers.org/wiki/Interest_Rate_Risk_in_the_Banking_Book Interest Rate Risk in the Banking Book], treasurers.org</ref> "IRRBB", which deals with the risks associated with a change in interest rates, including [[duration gap|interest rate gaps]], [[basis risk]], yield curve risk, and [[Pin risk|option risk]].

The Risk Management function typically exists [[three lines of defence|independent of operations]] - although may sit in Treasury - and reports directly to the board.<ref name="HKIB"/> Its scope often extends to non-financial [[operational risk|operational]] and [[reputational risk]] (monitoring for any consequent [[run on the bank]]).
Specialised software is employed here, [[Banking software#Retail banks|both operationally]] and for [[Treasury management system|risk management and modelling]].

===Corporate finance===
[[File:CVP-FC-Contrib-PL.svg|thumb|[[Break-even (economics)|Contribution analytics]]: Profit and Loss for units sold at current fixed costs.]]
[[File:breakeven small.png|thumb|The same, [[Break-even (economics)#Break-even analysis|for varying]] (scenario-based) Revenue levels, at current Fixed and Total costs.]]
{{further|Asset and liability management|Treasury management|Strategic financial management|Managerial risk accounting}}
{{see also|Corporate finance#Financial risk management}}
In  [[corporate finance]], and [[financial management]] more generally,<ref name="Dahlquist">[https://openstax.org/books/principles-finance/pages/20-why-it-matters Risk Management and the Financial Manager]. Ch. 20 in {{cite book  | title=Principles of Finance| year=2022| isbn=9781951693541 | author = Julie Dahlquist, Rainford Knight, Alan S. Adams | publisher=OpenStax, Rice University|url = https://open.umn.edu/opentextbooks/textbooks/principles-of-finance}}</ref><ref name="chron.com"/>
financial risk management, as above, is concerned with [[business risk]] -  risks to the [[valuation (finance)|business’ value]], within the context of its [[business strategy]] and [[capital structure]].<ref name="Business Risk_Investopedia">Will Kenton (2022). [https://www.investopedia.com/terms/b/businessrisk.asp "Business Risk"], [[Investopedia]]</ref>
The scope here - ie in non-financial firms<ref name="PRMIA"/> - is thus broadened<ref name="Hampton"/><ref>Stanley Myint (2022). [https://prmia.org/Shared_Content/Events/PRMIA_Event_Display.aspx?EventKey=8702&WebsiteKey=e0a57874-c04b-476a-827d-2bbc348e6b08 ''Introduction to Corporate Financial Risk Management'']. [[PRMIA]] Thought Leadership [[Webinar]]</ref><ref name="Saylor">[https://biz.libretexts.org/Bookshelves/Finance/Book%3A_Risk_Management_for_Enterprises_and_Individuals/05%3A_The_Evolution_of_Risk_Management_-_Enterprise_Risk_Management/5.03%3A_Risk_Management_and_the_Firm%E2%80%99s_Financial_Statement%E2%80%94Opportunities_within_the_ERM "Risk Management and the Firm’s Financial Statement — Opportunities within the ERM"] in  Esther Baranoff, Patrick Brockett, Yehuda Kahane (2012). ''Risk Management for Enterprises and Individuals''. [[Saylor Academy]]</ref>
(re banking) to overlap [[enterprise risk management]], and financial risk management then addresses risks to the firm's overall [[strategic management|strategic objectives]], incorporating various (all) financial aspects<ref name="CIMA">Margaret Woods and Kevin Dowd (2008). [https://www.cimaglobal.com/Documents/ImportedDocuments/cid_mag_financial_risk_jan09.pdf ''Financial Risk Management for Management Accountants''], [[Chartered Institute of Management Accountants]]</ref> of the exposures and opportunities arising from business decisions, and their link to the firm’s [[risk appetite|appetite for risk]], as well as their impact on [[share price]].
In many organizations, risk executives [[Enterprise risk management#Implementing an ERM program|are therefore involved]] in strategy formulation: "the choice of which risks to undertake through the allocation of its scarce resources is the key tool available to management."<ref name = "Chance_Edleson">Don Chance and Michael Edleson (2021). ''Introduction to Risk Management''. Ch 10 in "Derivatives". [[CFA Institute]] Investment Series. {{ISBN|978-1119850571}}</ref>

Re the standard framework,<ref name="CIMA"/> then, the discipline largely focuses on operations, i.e. business risk, as outlined. 
Here, the management is ongoing<ref name="chron.com">Jayne Thompson (2019). [https://smallbusiness.chron.com/financial-risk-management-43326.html What Is Financial Risk Management?], [[chron.com]]</ref>  — see following description  — and is coupled with [[Business interruption insurance|the use of insurance]],<ref name="Vernimmen">[http://www.vernimmen.com/Vernimmen/Summaries_of_chapters/Part_5_FINANCIAL_MANAGEMENT/Chapter_51_Managing_financial_risks.html?iframe Managing financial risks]; summary of Ch. 51 in: Pascal Quiry; Yann Le Fur; Antonio Salvi; Maurizio Dallochio; [[Pierre Vernimmen]] (2011). Corporate Finance: Theory and Practice (3rd ed.). Wiley. {{ISBN|978-1119975588}}</ref>
managing the net-exposure as above: 
[[credit risk]] is usually addressed via [[Bad debt#Doubtful debt reserve|provisioning]] and [[Trade credit insurance|credit insurance]]; 
likewise, [[Risk management#Potential risk treatments|where this treatment is deemed appropriate]], [[Risk management#Assessment|specifically identified]] operational risks are also insured.<ref name="Saylor"/> 
[[Market risk]], in this context,<ref name="PRMIA">See "Market Risk Management in Non-financial Firms", in  Carol Alexander, Elizabeth Sheedy eds. (2015). ''The Professional Risk Managers’ Handbook 2015 Edition''. [[PRMIA]]. {{ISBN|978-0976609704}}</ref> is concerned mainly with changes in [[Commodity market#Traded commodity classes|commodity prices]], [[interest rate]]s, and [[exchange rate|foreign exchange rates]], and any adverse impact due to these on [[cash flow]] and [[profitability]], and hence share price.

Correspondingly, the practice here covers two perspectives; these are shared with corporate finance more generally:
# Both risk management and corporate finance share the goal of enhancing, or at least preserving, firm [[Value (economics)|value]].<ref name="Dahlquist"/> Here,<ref name= "Hampton"/><ref name="CIMA"/> businesses [[Financial analysis#Firm-level analysis|devote much time and effort]] to (short term) [[liquidity risk|liquidity-]], [[Cash flow forecasting#Function|cash flow-]] and [[Managerial finance#Managerial accounting techniques|performance monitoring]], and Risk Management then also overlaps [[cash management|cash-]] and [[Treasury management#Corporates|treasury management]], especially as impacted by capital and funding as above. More specifically re business-operations, management emphasizes their [[Break-even (economics)#Margin of safety|break even dynamics]], [[contribution margin]] and [[operating leverage]], and the [[Revenue management#Dynamic re-evaluation|corresponding monitoring]] and [[Revenue management#Levers|management of revenue]], [[Cost analyst|of costs]], and [[Variance (accounting)#Variance analysis|of other budget elements]].  The [[DuPont analysis]] entails a "decomposition" of the firm's [[return on equity]], ROE, allowing management [[Return on equity#The DuPont formula|to identify and address]] specific areas of concern,<ref name="Hargrave">Marshall Hargrave (2022). [https://www.investopedia.com/terms/d/dupontanalysis.asp Dupont Analysis], [[Investopedia]].</ref> preempting any underperformance vs  [[Capital asset pricing model#Asset-specific required return|shareholders' required return]].<ref>See discussion under § [https://www.oreilly.com/library/view/financial-accounting-in/9780470635292/ch05sec12.html Shareholder Value, ROE, and Cash Flow Analyses] in: Jamie Pratt and Michael Peters (2016). ''Financial Accounting in an Economic Context'' (10th Edition). Wiley Finance. {{ISBN|978-1-119-30616-0 }}</ref> In larger firms, specialist [[Risk Analyst]]s complement this work with [[Financial modeling#Accounting|model-based analytics]] more broadly;<ref name="SiegelShim1997_2">See §39 "Corporate Planning Models", and §294 "Simulation Model" in  {{cite book|author1=Joel G. Siegel|author2=Jae K. Shim|author3=Stephen Hartman|title=Schaum's quick guide to business formulas: 201 decision-making tools for business, finance, and accounting students|url=https://books.google.com/books?id=4JpojQPk8YsC|access-date=12 November 2011|date=1 November 1997|publisher=McGraw-Hill Professional|isbn=978-0-07-058031-2}}</ref><ref name="Shimko">David Shimko (2009). [https://web.archive.org/web/20100717072252/http://www.qfinance.com/financial-risk-management-best-practice/quantifying-corporate-financial-risk?full Quantifying Corporate Financial Risk]. archived 2010-07-17.</ref>   in some cases, employing [[Financial modeling#Quantitative finance|sophisticated stochastic models]],<ref name="Shimko"/><ref>See for example [https://brainly.in/question/7072253 this problem] (from [[John C. Hull (economist)|John Hull's]] ''Options, Futures, and Other Derivatives''), discussing cash position modeled stochastically.</ref>  in, for example, [[Asset and liability management#Managing gaps|financing activity prediction]] problems, and for [[Corporate finance#Quantifying uncertainty|risk analysis ahead of a major investment]].
# Firm exposure to long term market (and business) risk is a direct result of previous [[Capital budgeting|capital investment decisions]]. Where applicable here<ref name="PRMIA"/><ref name="CIMA"/><ref name="Dahlquist"/> —  usually in large corporates and [[Investment banking#Sales and trading|under guidance from]]<ref>David Shimko (2009). [https://web.archive.org/web/20101224200933/https://www.qfinance.com/contentFiles/QF02/g1xtn5q6/12/0/dangers-of-corporate-derivative-transactions.pdf Dangers of Corporate Derivative Transactions]</ref> their investment bankers — risk analysts will manage and hedge<ref name="Vernimmen"/> their exposures using traded [[financial instruments]] to create [[Hedge (finance)#Categories of hedgeable risk|commodity-]],<ref>[[Deloitte]] / MCX (2018). [https://www2.deloitte.com/in/en/pages/risk/articles/commodity-price-risk-management.html Commodity price risk management]</ref><ref>[[CPA Australia]] (2012). [https://www.cpaaustralia.com.au/-/media/project/cpa/corporate/documents/tools-and-resources/business-management/managing-commodity-risk.pdf?rev=749d5fc8486241f48b1c652abe154d73 A guide to managing commodity risk]</ref> [[hedge (finance)#Categories of hedgeable risk|interest rate-]]<ref>[[Association of Chartered Certified Accountants]] (N.D.). [https://www.accaglobal.com/gb/en/student/exam-support-resources/professional-exams-study-resources/p4/technical-articles/interestrate-riskmanagement.html Interest rate risk management]</ref><ref>[[CPA Australia]] (2008). [https://www.cpaaustralia.com.au/-/media/project/cpa/corporate/documents/tools-and-resources/business-management/understanding-and-managing-interest-rate-risk-guide.pdf?rev=efd9cfc245884551bcd1c107e3252ae6 Understanding and Managing Interest Rate Risk]</ref> and [[foreign exchange hedge]]s<ref name="Garrett">[[Association of Chartered Certified Accountants]] (N.D.). [https://www.accaglobal.com/gb/en/student/exam-support-resources/fundamentals-exams-study-resources/f9/technical-articles/forex.html Foreign currency risk and its management]</ref><ref>[[CPA Australia]] (2009). [https://www.cpaaustralia.com.au/-/media/project/cpa/corporate/documents/tools-and-resources/business-management/managing-foreign-exchange-risk.pdf?rev=9a26cc216d6040709c1a2b2432537be5 A guide to managing foreign exchange risk]</ref> (see further below).  Because company specific, "[[Over-the-counter (finance)|over-the-counter]]" (OTC) [[contract]]s  tend to be costly to create and monitor —  i.e. using [[financial engineering]] and / or  [[structured product]]s — [[Derivative (finance)|"standard" derivatives]] that trade on well-established [[Exchange (organized market)|exchanges]] are often preferred.<ref Name="Lewellen"/><ref name="CIMA"/> These comprise  [[option (finance)|options]], [[futures contract|futures]], [[forward contract|forwards]], and [[swap (finance)|swaps]]; the "second generation" [[exotic derivatives]] usually trade OTC.  Complementary to this hedging, periodically, Treasury may also [[Corporate finance#Capitalization structure|adjust the capital structure]], reducing [[Leverage (finance)#Corporate finance|financial leverage]] - i.e. repaying debt-funding  - so as to accommodate increased business risk; they may also suspend [[dividend]]s.<ref>Claire Boyte-White  (2023). [https://www.investopedia.com/articles/investing/101215/4-reasons-company-might-suspend-its-dividend.asp 4 Reasons a Company Might Suspend Its Dividend], [[Investopedia]]</ref>

[[Multinational corporation]]s are faced with additional challenges, particularly as relates to [[foreign exchange risk]], and the scope of financial risk management modifies significantly in the international realm.<ref name="Garrett"/>
Here, dependent on [[time horizon]] and risk sub-type —
[[Foreign exchange risk#Transaction risk|transactions exposure]]<ref>"Contrary to [[conventional wisdom]] it may be rational to hedge translation exposure.":  Raj Aggarwal (1991). [https://www.emerald.com/insight/content/doi/10.1108/eb013676/full/html "Management of Accounting Exposure to Currency Changes: Role and Evidence of Agency Costs"]. ''Managerial Finance'', Vol. 17 No. 4, pp. 10-22.</ref> (essentially that discussed above),
[[Foreign exchange risk#Translation risk|accounting exposure]],<ref>Aggarwal, Raj, "The Translation Problem in International Accounting: Insights for Financial Management." Management International Review 15 (Nos. 2-3, 1975): 67-79. (Proposed accounting framework for evaluating and developing translation procedures for multinational corporations).</ref> 
and [[Foreign exchange risk#Economic risk|economic exposure]]<ref>{{Cite journal|url=http://www.iijournals.com/doi/abs/10.3905/jpm.1997.409611|title=Cross-Hedging Currency Risks in Asian Emerging Markets Using Derivatives in Major Currencies|first1=Raj|last1=Aggarwal|first2=Andrea L.|last2=DeMaskey|date=April 30, 1997|journal=The Journal of Portfolio Management|volume=23|issue=3|pages=88–95|doi=10.3905/jpm.1997.409611|s2cid=153476555 |url-access=subscription}}</ref>
— so the corporate [[Currency analytics|will manage its risk]] differently.
The forex risk-management discussed here and above, is additional to the per transaction [[Forward exchange market|"forward cover"]] that [[importer]]s and [[exporter]]s purchase from their bank (alongside other [[trade finance]] mechanisms).

Hedging-related transactions will attract their own [[accounting]] treatment, and corporates (and banks) may then require changes to systems, processes and documentation;<ref>[[Price Waterhouse Coopers]] (2017). [https://www.pwc.com/gx/en/audit-services/ifrs/publications/ifrs-9/achieving-hedge-accounting-in-practice-under-ifrs-9.pdf Achieving hedge accounting in practice under IFRS 9]</ref><ref>Conti, Cesare & Mauri, Arnaldo (2008). "Corporate Financial Risk Management: Governance and Disclosure post IFRS 7", ''Icfai Journal of Financial Risk Management'', {{ISSN|0972-916X}}, Vol. V, n. 2, pp.&nbsp;20–27.</ref>
see [[Hedge accounting]], [[Mark-to-market accounting]], [[Hedge relationship]], [[Cash flow hedge]], [[IFRS 7]], [[IFRS 9]], [[IFRS 13]], [[FASB 133]], [[IAS 39]], [[Accumulated other comprehensive income|FAS 130]].

It is common for large corporations to have dedicated risk management teams — typically within [[FP&A]] or [[corporate treasury]] — reporting to the [[Chief Risk Officer|CRO]]; often these overlap the [[internal audit]] function (see [[Three lines of defence]]).
For small firms, it is impractical to have a formal risk management function, but these typically apply the above practices, at least the first set, informally, as part of the [[financial management]] function; see [[Financial analyst#Financial planning and analysis|discussion]] under [[Financial analyst]].

The discipline relies on a [[Financial management#Financial management systems|range of software]],<ref>See: {{Cite web|title=Financial Management System (FMS) - Gartner Finance Glossary|url=https://www.gartner.com/en/finance/glossary/financial-management-system-fms-|access-date=2022-01-06|website=Gartner|language=en}}</ref> correspondingly, from [[spreadsheet]]s (invariably as a starting point, and frequently in total<ref>Jeremy Fabbri (2020). [https://web.archive.org/web/20201126214125/https://riskwatch.com/2020/11/05/should-you-use-spreadsheets-for-risk-management/ Should You Use Spreadsheets for Risk Management?]</ref>) through commercial [[Enterprise performance management|EPM]] and [[Business intelligence|BI]] tools, often [[BusinessObjects]] ([[SAP]]), [[Oracle Business Intelligence Suite Enterprise Edition|OBI EE]] ([[Oracle Corporation|Oracle]]), [[Cognos]] ([[IBM]]), and [[Power BI]] ([[Microsoft]]).<ref>N. Shmeleva (2024). [https://cfoclub.co.za/using-predictive-analytics-in-risk-management/ "Using Predictive Analytics in Risk Management"]</ref>

===Insurance===
{{further|Insurance#Insurers' business model}}
{{see also|IFRS 17}}
[[File:Kaskaskia Island 1993 flooding.jpg|thumb|Actuaries use [[extreme value theory|Extreme Value Theory]] to model rare events such as "[[100-year flood]]s". Pictured is [[Kaskaskia, Illinois]], entirely submerged during the [[Great Flood of 1993]].]]
[[insurer|Insurance companies]] make [[Loss ratio#Insurance loss ratio|profit]]<ref name="Goldfarb"/><ref name="Nissim">Doron  Nissim (2010). [http://www.columbia.edu/~dn75/Analysis%20and%20Valuation%20of%20Insurance%20Companies%20-%20Final.pdf ''Analysis and Valuation of Insurance Companies''] {{Webarchive|url=https://web.archive.org/web/20191020201443/http://www.columbia.edu/~dn75/Analysis%20and%20Valuation%20of%20Insurance%20Companies%20-%20Final.pdf |date=2019-10-20 }}, [[Columbia Business School]]</ref> through [[Underwriting#Insurance underwriting|underwriting]] — selecting which risks to insure, charging a risk-appropriate [[insurance premium|premium]], and then [[Insurance#Claims|paying claims]] as they occur — [[Insurance#Insurers' business model|and by investing]] the premiums they collect from insured parties.
They will, in turn, manage their own risks<ref name="Grondin">Thomas M. Grondin (2001). [https://www.soa.org/globalassets/assets/library/proceedings/record-of-the-society-of-actuaries/2000-09/2001/january/RSA01V27N218PD.PDF "Risk Management Practices in the Insurance Industry"]. [[Society of Actuaries]]</ref><ref>Michel-Kerjan  and Lorenzo Serino (2024). [https://www.mckinsey.com/capabilities/risk-and-resilience/our-insights/navigating-shifting-risks-in-the-insurance-industry "Navigating shifting risks in the insurance industry"]. mckinsey.com</ref><ref>David Ingram (2005). [https://www.soa.org/library/newsletters/the-actuary-magazine/2005/april/adv2005april/ "Advancing Risk Management"]. [[Society of Actuaries]]</ref><ref name="Nissim"/>
with a focus on solvency and the ability to pay claims: 
[[Life insurer|Life Insurers]]<ref name="Farr">Ian Farr, Adam Koursaris and Mark Mennemeyer (2016). [https://www.soa.org/globalassets/assets/Files/Research/Projects/research-2016-economic-capital-life-insurance-report.pdf "Economic Capital for Life Insurance Companies"]. [[Society of Actuaries]]</ref>
are concerned more with longevity risk and interest rate risk; 
Short-Term Insurers ([[property insurance|Property]], [[health insurance|Health]], [[casualty insurance|Casualty]])<ref name="Goldfarb">Richard Goldfarb (2010). [https://www.casact.org/sites/default/files/old/studynotes_goldfarb2010.pdf "P&C Insurance Company Valuation"]. [[Casualty Actuarial Society]]</ref>
emphasize [[Act of God|catastrophe-]] and claims volatility risks.

Fundamental here, therefore, are risk selection and [[insurance premium|pricing discipline]], which as outlined, prevent insurers from taking on unprofitable business.  
For ''expected'' claims — i.e. those theoretically inhering in the [[Actuarial science|pricing model’s]] assumptions re [[Hazard rate|frequency]] and severity — [[reserve (accounting)|reserves]] are set aside ([[actuarial reserve|actuarial]], with [[statutory reserve]]s as a floor). These will cover both known claims, reported but unpaid, as well as those which are [[incurred but not reported]] (IBNR). 
To absorb ''unexpected'' losses, insurance companies maintain a minimum level of capital plus an additional [[Solvency ratio|solvency margin]]. Capital requirements are based on [[Own risk and solvency assessment|the risks an insurer faces]], such as underwriting risk, market risk, credit risk, and operational risk, and [[:Category:Insurance regulation|are governed]] by frameworks such as [[Solvency II]] (Europe) and Risk-Based Capital<ref>[https://content.naic.org/sites/default/files/inline-files/MDL-312.pdf Risk-Based Capital (RBC) For Insurers Model Act] 2012. [[National Association of Insurance Commissioners]]</ref> (U.S.).
To further mitigate large-scale risks — i.e. to reduce exposure to catastrophic losses — insurers transfer portions of their risk to [[reinsurance|Reinsurers]].  Here, analogous to VaR for banks, to estimate potential losses at various thresholds [[Stochastic modelling (insurance)|insurers use simulations]], while stress tests assess how extreme events might impact capital and reserves under various scenarios.  
In parallel with all these, as above, premiums collected [[Investment fund|are invested]] to generate returns which will supplement [[Insurance#Underwriting and investing|underwriting profits]], and the fund is then risk-managed as follows:  ALM must ensure that investments [[Liability-driven investment strategy|align with the timing and amount]] of expected claim payouts; while returns ("float") are defended using the techniques [[#Investment management|discussed in the next section]].

Specific treatments will, as outlined, differ by insurer-profile:
*Life Insurers<ref name="Farr"/> deal with long-term risks tied to [[Mortality rate|mortality]], [[longevity]], and interest rates. Policies (e.g., [[whole life insurance|whole life]], [[life annuity|annuities]]) can span decades, making them sensitive to long-term economic and [[demographic shift]]s. Reserves are large and complex due to the long duration of liabilities, with capital models emphasizing [[longevity risk]], [[interest rate risk]], and [[Cancellation (insurance)|lapse risk]]. Stress tests, correspondingly, focus on long-term scenarios (e.g. sustained low interest rates, or a [[pandemic]] related spike in mortality). [[Wilkie investment model|ALM here]] is critical, and investments will be in long-term, stable assets ([[Stock fund#Balanced fund|bonds as well as equities]]) to match these [[duration (finance)|long-duration]] liabilities. Reinsurance is often used for [[excess deaths|excess death]] claims.
*Short-Term Insurers<ref name="Goldfarb"/> [[Insurance cycle|face more volatility]] relative to Life companies, while claims are typically resolved within a year or two (although [[tail event]]s  - e.g. [[asbestos litigation]] - can linger). Thus, reserves are shorter-term but must account for high uncertainty in claim frequency and severity; IBNR may be significant, especially after large events. Capital requirements focus on underwriting risk (e.g., mispricing policies) and catastrophe risk (e.g., [[hurricane]]s, [[earthquake]]s).  Stress tests therefore emphasize short-term catastrophic scenarios, and specialized [[Catastrophe modeling|catastrophe models]] are widely used. Rapid claims settlement reduces reserving duration compared to life insurance, and portfolios lean toward liquid, shorter-term assets (e.g., cash, short-term bonds).  Reinsurance is widely utilized to cap exposure to catastrophes; as are [[Reinsurance sidecar#Precedents|quota-share]] or [[Reinsurance#Non-proportional|excess-of-loss treaties]] re single events.

In a typical insurance company, Risk Management and the [[Actuary#Traditional employment|Actuarial Function]] are separate but closely related departments, each with distinct responsibilities. In smaller companies, the lines might blur, with actuaries taking on some risk management tasks, or vice versa.  Regardless, the Head Actuary (or Chief Actuary or Appointed Actuary) has specific responsibilities, typically requiring formal "sign-off": Reserve Adequacy and Solvency and Capital Assessment, as well as Reinsurance Arrangements. The relevant calculations are usually performed with specialized software — provided e.g. by [[Willis Towers Watson|WTW]] and [[Milliman]] — and often using [[R (programming language)|R]] or [[SAS (software)|SAS]].

===Investment management===
{{further|Portfolio optimization|Active management|Passive management}}
{{see also|Post-modern portfolio theory|Financial economics#Portfolio theory}}
[[File:Asset Allocation.pdf|thumb|right|250px|[[Modern portfolio theory]] suggests a diversified portfolio of [[shares]] and other [[asset classes]] (such as debt in [[corporate bonds]], [[treasury bond]]s, or [[money market funds]]) will realise more predictable returns if there is prudent market regulation.]]
[[File:markowitz frontier.jpg|thumb|250px|right|Efficient Frontier. The [[hyperbola]] is sometimes referred to as the "Markowitz bullet", and its upward sloped portion is the efficient frontier if no risk-free asset is available. With a risk-free asset, the straight [[capital allocation line]]  is the efficient frontier.]]
[[Image:Pareto Efficient Frontier for the Markowitz Portfolio selection problem..png|thumb|right|250px|Here maximizing return and minimizing risk such that the portfolio is [[Pareto efficiency|Pareto efficient]] (Pareto-optimal points in red).]]
[[Fund manager]]s, classically,<ref name="Drake_Fabozzi"/> define the risk of a [[portfolio (finance)|portfolio]] as its [[variance]]<ref name="Kenton">Will Kenton (2023). [https://www.investopedia.com/terms/r/riskmanagement.asp What Is Risk Management in Finance, and Why Is It Important?], [[investopedia.com]]</ref> (or [[standard deviation]]), and through [[diversification (finance)|diversification]] the [[portfolio optimization|portfolio is optimized]] so as to achieve the lowest risk for a given targeted return, or equivalently the highest return for a given level of risk;
these risk-efficient portfolios form the "[[efficient frontier]]" (see [[Markowitz model]]).
The logic here is that returns from different assets are highly unlikely to be perfectly [[correlation|correlated]], and in fact the correlation may sometimes be negative. 
In this way, market risk particularly, and other financial risks such as [[inflation risk]] (see below) can at least partially be moderated by forms of diversification.

A key issue, however, is that the (assumed) relationships are (implicitly) forward looking.
As observed in the [[late-2000s recession]], historic relationships can break down, resulting in losses to market participants believing that diversification would provide sufficient protection (in that market, including funds that had been explicitly set up to avoid being affected in this way<ref>{{cite journal | url=http://web.mit.edu/Alo/www/Papers/august07.pdf | title=What Happened To The Quants In August 2007? | first1=Amir E.| last1=Khandani|first2=Andrew W. |last2=Lo | year=2007|journal = Journal of Financial Markets|
volume =14| issue = 1|pages = 1–46| doi=10.1016/j.finmar.2010.07.005 | hdl=1721.1/108275 }}</ref>).
A related issue is that [[Markowitz model#Demerits of the HM model|diversification has costs]]: as correlations are not constant it may be necessary to regularly [[Active management|rebalance the portfolio]], incurring [[transaction costs]], negatively impacting [[investment performance]];<ref>[[William F. Sharpe]] (1991). [http://www.stanford.edu/~wfsharpe/art/active/active.htm "The Arithmetic of Active Management"] {{Webarchive|url=https://web.archive.org/web/20131113071513/http://www.stanford.edu/~wfsharpe/art/active/active.htm |date=2013-11-13 }}. ''Financial Analysts Journal'' Vol. 47, No. 1, January/February</ref>
and as the fund manager diversifies, so this problem compounds (and a large fund may also exert [[market impact]]).
See {{slink|Modern portfolio theory|Criticisms}}.

Addressing these issues, more sophisticated approaches [[Financial economics#Portfolio theory|have been developed]], both to [[risk measure|defining risk]], and to the [[Portfolio optimization#Improving portfolio optimization|optimization itself]]. (Respective examples: [[Tail risk parity|(tail)]] [[risk parity]], focuses on allocation of risk, rather than allocation of capital; the [[Black–Litterman model]] modifies the "Markowitz optimization", to incorporate the  views of the portfolio manager.<ref>Guangliang He and Robert Litterman (1999). [https://people.duke.edu/~charvey/Teaching/BA453_2004/GS_The_intuition_behind.pdf "The Intuition Behind Black-Litterman Model Portfolios"]. [[Goldman Sachs]] Quantitative Resources Group</ref>)
Relatedly, modern [[financial risk modeling]] employs a variety of techniques — including [[value at risk]],<ref>Ballotta, L., & Fusai, G. (2018). [https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2816355 "A gentle introduction to value at risk"]. {{ssrn|2942138}} .</ref> [[Historical simulation (finance)|historical simulation]], [[Stress test (financial)|stress tests]], and [[extreme value theory]] — to analyze the portfolio and to forecast the likely losses incurred for a variety of risks and scenarios.

Importantly, when applying these approaches the Manager must ensure that the portfolio's risk level matches [[Investor profile|the investor's objectives]] and comfort zone, i.e. must ensure [[risk tolerance]] alignment; see [[Fiduciary duty]].  Relatedly, and in parallel, the fund's ([[Prospectus (finance)|advertised]]) [[investment style]] will, almost necessarily, define its own risk tolerance and [[risk appetite|appetite]], and hence selection and application of risk management techniques.  For both individuals and Funds, generally, longer time horizons allow for greater tolerance of short-term volatility, while shorter horizons require more conservative strategies. More specifically, a [[value investing|value fund]], for example, will be concerned more with [[fundamental analysis|firm fundamentals]] and less with market returns, while a [[growth investing|growth fund]] is exposed to market risk ([[beta (finance)|beta]]) and sector-specific risks.

Guided by the analytics, and the above considerations, fund managers (and [[Trader (finance)|traders]]) will apply specific risk hedging techniques.<ref name="Drake_Fabozzi">Pamela Drake and [[Frank Fabozzi]] (2009). [https://media.wiley.com/product_data/excerpt/52/04704073/0470407352.pdf What Is Finance?]</ref><ref name="Kenton"/>
As appropriate, these may relate to the portfolio as a whole or to individual holdings:

*To protect the overall portfolio,<ref name="Clarke"/> fund managers [[Short (finance)#Futures and options contracts|may sell]] the [[stock market index future]] or [[Put option#Buying a put|buy puts]] on the [[stock market index option]];<ref>Staff (2020). [https://www.investopedia.com/ask/answers/040815/what-index-option-trading-and-how-does-it-work.asp What is index option trading and how does it work?], [[Investopedia]]</ref><ref>Daniel Laboe (2021). [https://www.nasdaq.com/articles/how-to-properly-hedge-your-portfolio-using-put-options-2021-08-19 How To Properly Hedge Your Portfolio Using Put Options], nasdaq.com</ref> the respective sensitivities, [[beta (finance)|portfolio beta]] and [[Greeks (finance)#Delta|option delta]], determine the number of hedge-contracts required.<ref name="Clarke"/> For both, the logic is that the (diversified) portfolio is likely highly correlated with the [[stock index]] it is part of: thus if the portfolio-value declines, the index will have declined likewise with the derivative holder profiting correspondingly.<ref name="Clarke">For discussion and examples re calculating the appropriate "optimal hedge ratio" - based on [[beta (finance)|beta]], [[Greeks (finance)#Delta|delta]], or [[Duration (finance)|duration]] - and then executing, see: Roger G . Clarke (1992). [https://www.cfainstitute.org/-/media/documents/book/rf-publication/1992/rf-v1992-n5-4438-pdf.pdf "Options and Futures: A Tutorial"]. [[CFA Institute]] Research Foundation</ref> Fund managers may (instead) engage in "[[portfolio insurance]]", a dynamic hedging process that involves selling index futures during periods of decline and using the proceeds to offset portfolio losses. (These techniques are more relevant when the portfolio is constructed "top-down"; i.e. by [[asset allocation]].)
*Fund managers, or traders, may also wish to [[Hedge (finance)#Hedging a stock price|hedge a specific stock's price]]. Here, they may likewise<ref name="Clarke"/> [[Options strategy#Bearish strategies|buy a single-stock put]], [[Hedge (finance)#Hedging equity and equity futures|or sell]] a [[Single-stock futures|single-stock future]]. Alternative strategies may rely on assumed relationships between related stocks, employing, for example, a [[Long/short equity|"long/short" strategy]]. (These techniques are more relevant when the portfolio is constructed "bottom-up"; i.e. by [[stock picking]].)
*[[Bond fund|Bond portfolios]], when e.g. a component of an [[Stock fund#Asset allocation fund|asset-allocation fund]] or other [[Mutual fund|diversified portfolio]], are typically managed similar to equity above: the fund manager will hedge her bond allocation with [[bond index]] futures or options; with the number of contracts, a function of [[Duration (finance)|duration]].<ref>Staff (2020). [https://www.bloomberg.com/professional/blog/how-to-hedge-your-bond-portfolio-against-falling-rates/ How to hedge your bond portfolio against falling rates],  [[bloomberg.com]]</ref><ref>Jeffrey L. Stouffer (2011). [https://www.fa-mag.com/news/protecting-a-bond-portfolio-with-futures-contracts-7127.html Protecting A Bond Portfolio With Futures Contracts], ''Financial Advisor Magazine''</ref><ref name="Clarke"/> In other contexts, the concern may be the [[Asset–liability mismatch|net-obligation]] or net-[[cashflow]]. Here the fund manager employs [[immunization (finance)|interest rate immunization]] or [[cashflow matching]]. Immunization is a strategy that ensures that a change in interest rates will not affect the value of a fixed-income portfolio (an increase in rates [[Bond valuation#Present value approach|results in]] a decreased instrument value). It is often used to ensure that the value of a [[pension fund]]'s assets (or an asset manager's fund) increase or decrease in an exactly [[Liability-driven investment strategy|opposite fashion to their liabilities]], thus leaving the value of the pension fund's surplus (or firm's equity) unchanged, regardless of changes in the interest rate. Cashflow matching is similarly a process of hedging in which a company or other entity matches its cash outflows - i.e., financial obligations - with its cash inflows over a given time horizon. See also [[laddering]],<ref>C. Kopp (2022). [https://www.investopedia.com/terms/b/bondladdering.asp "Bond Laddering: How it Works, Benefits, Variations"], [[investopedia.com]]</ref> [[Dedicated portfolio theory|dedicated portfolio]].
*For individual [[bond (finance)|bonds]] and other [[Fixed income|fixed income securities]],  specific [[Fixed income#Risks|credit and interest rate risks]] can be hedged<ref name="Clarke"/> using  [[interest rate derivative|interest rate-]] and [[credit derivative]]s (although with care, under multi-curves<ref name="CQF">[https://www.cqfinstitute.org/sites/default/files/2021-02-fitch-multicurve-V-1-1_0.pdf  "Multi-curve and collateral framework"], [[Professional certification in financial services#Certificate in Quantitative Finance|CQF Institute]].</ref> ). Sensitivities [[interest rate risk|re interest rates]] are measured using [[bond duration|duration]] and [[bond convexity|convexity]] for bonds, and [[DV01]] and [[key rate duration]]s generally, and an offsetting derivative-position is purchased. For [[credit risk]],<ref>See e.g. OpenGamma Quantitative Research (2013). [https://quant.opengamma.io/Pricing-and-Risk-Management-of-Credit-Default-Swaps-OpenGamma.pdf The Pricing and Risk Management of Credit Default Swaps]</ref> sensitivities are measured via [[CS01]], while analysts use models such as [[Jarrow–Turnbull model|Jarrow–Turnbull]] and [[KMV model|KMV]] to estimate the ([[Rational pricing#The risk neutrality assumption|risk neutral]]<ref>Jorge A. Chan-Lau (2006). [https://www.imf.org/external/pubs/ft/wp/2006/wp06104.pdf Market-Based Estimation of Default Probabilities and Its Application to Financial Market Surveillance] [[International Monetary Fund]]</ref>) [[probability of default]], hedging where appropriate, usually [[Credit default swap#Hedging|via credit default swaps]]. Probabilities ([[Mathematical finance#History: Q versus P|actuarial]]) may also be obtained from [[Bond credit rating]]s; then, often at a portfolio level — e.g. for credit-VaR — analysts will use a [[Stochastic matrix|transition matrix]] of these<ref>Paul Glasserman (2000). [https://www0.gsb.columbia.edu/faculty/pglasserman/B6014/Prob_Credit.pdf Probability Models of Credit Risk]</ref> to estimate the probability [[Bond valuation#Relative price approach|and impact]] of a "credit migration",<ref>Mukul Pareek (2021). [https://riskprep.com/tutorials/credit-migration-framework/ "Credit Migration Framework"]</ref><ref>Staff (2021). [https://www.investopedia.com/articles/investing/121515/how-credit-rating-risk-affects-corporate-bonds.asp  How Credit Rating Risk Affects Corporate Bonds], [[Investopedia]]</ref> aggregating the bond-by-bond result. Interest rate- and credit risk together, may be hedged via a [[Total return swap]]. See [[Fixed income analysis]]
*For [[option strategy|derivative portfolios]], and positions, [[Greeks (finance)#Use of the Greeks|the Greeks]] are a vital risk management tool: as above, these measure sensitivity to a small change in a given underlying price, rate, [[Volatility risk|or parameter]], and the portfolio [[Option (finance)#Risks|is then rebalanced accordingly]]<ref name="Clarke"/> by including additional derivatives with offsetting characteristics, or by purchasing or selling [[Delta neutral#Creating the position|specified units]] of  the [[underlying |underlying security]].

Further, and more generally, various safety-criteria may also guide overall portfolio construction.
The [[Kelly criterion]]<ref>Justin Kuepper (2023). [https://www.investopedia.com/articles/trading/04/091504.asp Using the Kelly Criterion for Asset Allocation and Money Management], [[Investopedia]]</ref> [[Kelly criterion#Application to the stock market|will suggest]] - i.e. limit - the size of a position that an investor should hold in her portfolio.
[[Roy's safety-first criterion]]<ref>Will Kenton (2020). [https://www.investopedia.com/terms/r/roys-safety-first-criterion.asp Roy's Safety-First Criterion (SFRatio) Definition and Calculation], [[Investopedia]]</ref> [[Roy's safety-first criterion#Example|minimizes the probability]] of the portfolio's return falling below a minimum desired threshold.
[[Chance-constrained portfolio selection]] similarly seeks to ensure that the probability of final wealth falling below a given "safety level" is acceptable.

Managers may also employ [[Multiple factor models|factor models]]<ref>[https://www.cfainstitute.org/-/media/documents/book/rf-publication/1994/rf-v1994-n4-4445-pdf.ashx "A Practitioner's Guide to Factor Models"]. [[CFA Institute]] Research Foundation</ref> (generically [[arbitrage pricing theory|APT]]) to measure exposure to macroeconomic and market [[Risk factor (finance)|risk factors]]<ref name="Sharpe">[[William F. Sharpe]] (1999). [https://web.stanford.edu/~wfsharpe/mia/fac/mia_fac3.htm#Factor-based%20Portfolio%20Expected%20Returns%20and%20Risks "Factor-based Expected Returns, Risks and Correlations"]</ref> using [[time series]] regression. Ahead of an anticipated movement in any of these factors, the Manager may then, [[Factor investing|as indicated]], reduce holdings, hedge, or purchase offsetting exposure. 
Inflation for example, although impacting all securities,<ref>Troy Segal (2022). [https://www.investopedia.com/ask/answers/what-is-inflation-and-how-should-it-affect-investing/ "What is inflation and how does inflation affect investments?"]. [[Investopedia]]</ref> can be managed<ref>James Chen (2022). [https://www.investopedia.com/terms/i/inflation-hedge.asp "Inflation Hedge"], Investopedia</ref><ref>{{Cite web |last=Staff |date=2022-01-31 |title=Managing Portfolio Risk in A High-Inflation Market |url=https://klofinancialservices.com/news/managing-portfolio-risk/ |access-date=2023-05-12 |website=KLO Financial Services |language=en-GB}}</ref> at the portfolio level by appropriately<ref>See. e.g., [[Morgan Stanley]] (2022). [https://www.morganstanley.com/im/en-gb/intermediary-investor/insights/articles/managing-inflation-risk-through-improved-portfolio-optimization.html "Managing Inflation Risk through Improved Portfolio Optimization"]</ref> increasing exposure to inflation-sensitive stocks (e.g. [[Global Industry Classification Standard|consumer staples]]), and / or by investing in [[Asset#Tangible assets|tangible assets]], [[commodity|commodities]] and [[inflation-linked bond]]s; the latter may also provide a direct hedge.<ref>Dmitry Pugachevsky (2023). [https://www.risk.net/risk-management/7956666/managing-inflation-risk-with-hedging-strategies Managing inflation risk with hedging strategies], risk.net</ref>

Newer and broader, and often qualitative <ref name="New York Life"/> risks, must be managed concurrently.
These include
ESG risks (financially material risks related to the broader [[environmental, social, and governance]] contexts in which the firm operates), 
<ref name="Morningstar">[https://www.morningstar.com/business/insights/blog/esg/limiting-climate-esg-risk “How Investors Can Limit Climate and ESG Risk”], [[Morningstar, Inc.|Morningstar]]</ref>
[[Cyber risk quantification|cybersecurity risks]] (a material drop in share prices caused, e.g., by a significant [[ransomware]] incident) <ref name="RLAM">[https://www.railpen.com/knowledge-hub/reports/cybersecurity-risk-and-resilience-guidance-for-investors "Cybersecurity Risk & Resilience"], [[Royal London Asset Management]]</ref> 
and [[geopolitical risk]]s.
<ref name="New York Life">[https://www.newyorklifeinvestments.com/global-markets/geopolitics "Geopolitical risk in a shifting world order"], [[New York Life Investments]]</ref>
These risks are often less tangible and less immediately visible than traditional financial risks,<ref name="Morningstar"/>
<ref>Lauren Goodwin (2019). [https://blogs.cfainstitute.org/investor/2019/04/02/geopolitical-risk-in-portfolio-management "Geopolitical Risk in Portfolio Management"], [[CFA Institute]]</ref>
and quantifying these can be challenging.<ref name="New York Life"/> 
Managers may then employ techniques such as scenario analyses, and, sometimes, [[Game theory#Political science|approaches from game theory]]. 
Based on this, in the case of geopolitical risks they will then diversify geographically and / or increase exposure (possibly factor-wise) to [[Safe-haven currency|macro-sensitive assets]] such as [[Gold as an investment#Investment strategies|gold]], [[Price of oil#Speculative trading and crude oil futures|oil]], and [[Bitcoin]].
ESG and cybersecurity risks are dealt with by diversification, and (for bottom-up portfolios) proactive screening,<ref name="Morningstar"/> with [[shareholder activism|direct management engagement]]<ref name="RLAM"/> as necessary.
The rise of [[alternative investments]] (e.g., [[cryptocurrencies]], [[private equity]]) introduces unique risks that must also be addressed.
<ref>Ebony Howard (2024). [https://www.investopedia.com/tech/why-crypto-asset-management-next-big-thing/ "Crypto Asset Management: Definition, How It Works, and Goals"], Investopedia</ref>
<ref>Kurt Winkelmann, Raghu Suryanarayanan, Ferenc Szalai (2019). [https://navegastrategies.com/research/managing-private-equity-risk/ "Managing Private Equity Risk"]</ref>

In parallel with all above,<ref>Carl Bacon (2019). [https://www.cfainstitute.org/-/media/documents/book/rf-lit-review/2019/rflr-performance-attribution.ashx "Performance Attribution History and Progress"], [[CFA Institute]] Research Foundation</ref><ref name="McMillan"/> managers — active and [[Passive management|passive]] — periodically monitor and manage [[tracking error]], i.e. [[Investment management#Risk-adjusted performance measurement|underperformance]] vs a [[Benchmark (finance)|"benchmark"]].
Here, they will use [[performance attribution|attribution analysis]] preemptively so as to diagnose the source early, and to take corrective action: realigning, often factor-wise, on the basis of this "feedback".<ref name="McMillan">Michael McMillan (2012). [https://blogs.cfainstitute.org/investor/2012/06/01/performance-measurement-and-attribution-the-what-why-and-how-of-the-investment-management-process/ "Performance Measurement: The What, Why, and How of the Investment Management Process"], [[CFA Institute]]</ref><ref>True Tamplin (2023). [https://www.financestrategists.com/wealth-management/investment-management/benchmarking-and-performance-attribution/ "Benchmarking and Performance Attribution"], ''Finance Strategists''</ref>
[[Style drift#Implications|As relevant]], they will similarly use [[Returns-based style analysis|style analysis]] to address [[style drift]].
See also [[Fixed-income attribution]].

Given the complexity of these analyses and techniques, Fund Managers typically rely on [[Financial software#Fund management|sophisticated software]] (as do banks, above). 
Widely used platforms are provided by [[BlackRock]] ([[Aladdin (BlackRock)|Aladdin]]), [[Refinitiv]] ([[Eikon]]), [[Finastra]], [[Murex (financial software)|Murex]], [[Numerix]], [[Markov Processes International|MPI]] and [[Morningstar, Inc.#Morningstar Direct|Morningstar]].

== See also ==
;Articles:
*{{slink|Outline of finance#Risk management}}

;Discussion:
* [[Asset and liability management]]
* [[Basel III: Finalising post-crisis reforms]]
* [[Corporate governance]]
* [[Enterprise risk management]]
* {{slink|Finance|Risk management}}
* {{slink|Risk management|Finance}}

;Lists:
*[[List of economic crises|economic crises]]
*[[Economic bubble#Notable asset bubbles|asset bubbles]]
*[[List of stock market crashes and bear markets|stock market crashes and bear markets]]
*[[List of trading losses|trading losses]]
*[[List of corporate collapses and scandals|corporate collapses and scandals]]
*[[Accounting scandals#List of biggest accounting scandals|accounting scandals]]
*[[List of banking crises|banking crises]]
**[[List of bank runs|bank runs]]
**[[List of largest U.S. bank failures|largest U.S. bank failures]]
**[[List of bank failures in the United States (2008–present)|bank failures in the United States (2008–present)]]

==Bibliography==
{{refbegin|30em}}
'''Financial institutions'''
* {{Cite book |last=Allen, Steve L. |title=Financial Risk Management: A Practitioner's Guide to Managing Market and Credit Risk |publisher=John Wiley |year=2012 |edition =2|isbn= 978-1118175453}}
* {{Cite book |last=Coleman, Thomas |title=A Practical Guide to Risk Management |publisher=[[CFA Institute]]|url= https://www.cfainstitute.org/-/media/documents/book/rf-publication/2011/rf-v2011-n3-1-pdf.pdf |year=2011|isbn=978-1-934667-41-5}}
* {{Cite book |last=Crockford, Neil |title=An Introduction to Risk Management |edition = 2|publisher=Woodhead-Faulkner |year=1986 |isbn=0-85941-332-2}}
* {{Cite book |last1=Crouhy, Michel|last2 = Galai, Dan |last3= Mark, Robert |title=The Essentials of Risk Management |publisher=McGraw-Hill Professional |year=2013 |edition =2|isbn=9780071818513}}
*{{Cite book |last=Christoffersen, Peter |url=https://www.sciencedirect.com/book/9780121742324/elements-of-financial-risk-management#book-description |title=Elements of Financial Risk Management |date= 2011 |publisher=Academic Press |isbn=978-0-12-374448-7|edition =2}}
* {{Cite book |last=Farid, Jawwad Ahmed |title= Models at Work: A Practitioner's Guide to Risk Management |publisher=Palgrave Macmillan |year=2013 |isbn= 978-1137371638}}
* {{Cite book |last1=  Hull, John|title=Risk Management and Financial Institutions|edition = 6|publisher=John Wiley |year=2023|isbn=978-1-119-93248-2|url=https://www-2.rotman.utoronto.ca/~hull/riskman/index.html |author1-link=John C. Hull (economist) }}
* {{Citation |last1=McNeil |first1=Alexander J. |title=Quantitative Risk Management. Concepts, Techniques and Tools |url=https://press.princeton.edu/books/hardcover/9780691166278/quantitative-risk-management |year=2015 |series=Princeton Series in Finance |place=Princeton, NJ |publisher=Princeton University Press |isbn=9780691166278 |edition=revised|mr=2175089 |zbl=1089.91037 |last2=Frey |first2=Rüdiger |last3=Embrechts |first3=Paul}}
* {{Cite book |last1=Miller, Michael B. |title=Quantitative Financial Risk Management |publisher=John Wiley |isbn=9781119522201|year = 2019}}
* {{Cite book |last1=  Roncalli, Thierry|title=Handbook of Financial Risk Management
|publisher=Chapman & Hall |year=2020|isbn=9781138501874|url=https://www.routledge.com/Handbook-of-Financial-Risk-Management/Roncalli/p/book/9781138501874 }}
* {{Cite book |last=Tapiero, Charles |title=Risk and Financial Management: Mathematical and Computational Methods |publisher=John Wiley & Son |year=2004 |isbn=0-470-84908-8}}
* {{Cite book |last1=van Deventer |title=Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management |last2=Donald R. |last3=Kenji Imai |last4=Mark Mesler |publisher=John Wiley |year=2004 |isbn=978-0-470-82126-8}}
* {{Cite book |last=Wernz, Johannes |title=Bank Management and Control: Strategy, Pricing, Capital and Risk Management |publisher=Springer |year=2021 |edition =2|isbn= 978-3030428686}}
'''Corporations'''
* {{Cite book |last1= Baranoff, Etti|last2= Brockett, Patrick|last3= Kahane, Yehuda|title=Risk Management for Enterprises and Individuals|publisher=Saylor|year=2009|isbn=9780982361801|url=https://saylordotorg.github.io/text_risk-management-for-enterprises-and-individuals/}}
* {{Cite book |last1= Blunden, Tony|last2= Thirlwell, John|title=Mastering Risk Management|publisher=FT Publishing International|year=2021|isbn=978-1292331317}}
* {{Cite book |last=[[Aswath Damodaran|Damodaran, Aswath]] |title=Strategic Risk Taking: A Framework for Risk Management|url=https://pages.stern.nyu.edu/~adamodar/New_Home_Page/valrisk/book.htm  |publisher=FT Press |year=2007|isbn=978-0137043774}}
* {{Cite book |last=García, Francisco J. P. |title=Financial Risk Management: Identification, Measurement and Management |publisher=Palgrave Macmillan |year=2017 |isbn= 978-3-319-41365-5}}
* {{Cite book |last=Hampton, John |title=The AMA Handbook of Financial Risk Management | publisher=[[American Management Association]] |year=2011 |isbn=978-0814417447}}
* {{Cite book |last=Lam, James |title=Enterprise Risk Management: From Incentives to Controls |publisher=John Wiley |year=2003 |isbn=978-0-471-43000-1}}
* {{Cite book |last1= Myint, Stanley|last2= Famery, Fabrice|title=The Handbook of Corporate Financial Risk Management |publisher= Risk Books|year=2019|isbn= 978-1782723929}}
'''Portfolios'''
* {{Cite book |last1= Baker, H. Kent|last2= Filbeck, Greg |title=Investment Risk Management|publisher=Oxford Academic|year=2015|isbn= 978-0199331963}}
* {{Cite book |last1= Cowell, Frances|title=Risk-Based Investment Management in Practice|publisher=Palgrave Macmillan|year=2013|doi=10.1057/9781137346407 |isbn=978-1-137-34639-1|url=https://link.springer.com/book/10.1057/9781137346407}}
<!-- *{{cite book | last=Fabozzi | first=Frank J. |author2=Sergio M. Focardi |author3=Petter N. Kolm  | title=Financial Modeling of the Equity Market: From CAPM to Cointegration | publisher=[[John Wiley & Sons|Wiley]] | location=Hoboken, NJ | year=2004 | isbn=0-471-69900-4}}
 -->*[[Frank Fabozzi|Fabozzi, Frank J.]]; Petter N. Kolm; Dessislava Pachamanova; Sergio M. Focardi (2007). [https://www.wiley.com/en-us/Robust+Portfolio+Optimization+and+Management-p-9780471921226 ''Robust Portfolio Optimization and Management'']. Hoboken, New Jersey: John Wiley & Sons. {{ISBN|978-0-471-92122-6}}
* {{Cite book |last1= Grinold, Richard |last2=Kahn, Ronald   |title= Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Controlling Risk 
 |publisher=McGraw Hill |year=1999|isbn= 978-0070248823|edition =2nd}}
* {{Cite book |last1= Harvey, Campbell |last2=Rattray, Sandy |last3= Van Hemert, Otto |title= Strategic Risk Management: Designing Portfolios and Managing Risk |publisher=Wiley Finance |year=2021|isbn=  978-1119773917 |author1-link=Campbell Harvey }}
* {{Cite book |last1= Maginn, John L. |last2 =  Tuttle, Donald L.|last3=Pinto, Jerald E.|last4= McLeavey, Dennis W.   |title= Managing Investment Portfolios: A Dynamic Process |publisher=Springer |year=2007|isbn=  978-0470080146|edition=3rd}}
* {{Cite book |last1= Paleologo, Giuseppe A. |title= Advanced Portfolio Management: A Quant's Guide for Fundamental Investors |publisher=Wiley |year=2021|isbn=  978-1119789796|edition=1st}}
* {{Cite book |last=Rasmussen, M. |title=Quantitative Portfolio Optimisation, Asset Allocation and Risk Management |publisher=Palgrave Macmillan |year=2003|isbn= 978-1403904584}}
* {{Cite book |last1= Schulmerich, Marcus|last2=Leporcher, Yves-Michel|last3=Eu, Ching-Hwa |title=Applied Asset and Risk Management |publisher=Springer |year=2015|isbn=  978-3642554438}}
'''Insurers'''
* {{Cite book |last=Doff, René |title=Risk Management for Insurers |publisher=Risk Books |year=2015|edition =3|isbn= 978-1782722458}}
* {{Cite book |last=Elliott, Michael |title=Insurer Risk and Capital Management |publisher=American Institute For Chartered Property Casualty Underwriters|year=2015|isbn= 978-0894638176}}
* {{Cite book |last=Thoyts, Rob |title=Insurance Theory and Practice |publisher=Routledge |year=2010|isbn= 978-0415559058}}
{{refend}}

== References ==
{{Reflist|refs=http://www.iplaneducation.com/product/frm-online-classes/}}

== External links ==
* [https://www.risk.net/glossary Glossary of financial risk management terms], [[Risk (magazine)|Risk.net]]
* [https://globalriskinstitute.org/resources/ Risk management resources], [[Global Risk Institute]]
* [https://www.rims.org/resources/risk-knowledge Risk knowledge library], [[Risk and Insurance Management Society]] 
* [https://fincyclopedia.net/risk-management Risk management entries], Fincyclopedia
* [http://www.risk.net/journal Risk Journals], [[Risk (magazine)|Risk.net]]
* [http://www.garp.com Global Association of Risk Professionals], [[Global Association of Risk Professionals|GARP]]
* [https://prmia.org/ Professional Risk Managers' International Association], [[Professional Risk Managers' International Association|PRMIA]]
* [http://www.ceranalyst.org/ Chartered Enterprise Risk Analyst], [[Society of Actuaries]]
<!-- too niche * [http://www.sigmadewe.com/portfoliomanagement.html?&L=1 Managing a portfolio of stock and risk-free investments: a tutorial for risk-sensitive investors] -->

{{Financial risk}}
{{Risk management}}
{{Authority control}}

{{DEFAULTSORT:Financial Risk Management}}
[[Category:Financial risk management| ]]