With the economy performing the worst it has since the great depression, and the US Government having to spend trillions of tax payer dollars to bail out investment banks and insurance companies, it is clear that far more effective risk management practices must be put into place. It is absolutely sickening that hard working US taxes payers are stuck flipping the bill to save greedy investment banks and insurance companies that invested foolishly with money they were entrusted to protect.
Public companies must adhere to strict financial risk management practices so they are not allowed to make high risk investment decisions that can lead to huge losses. We cannot repeat the financial meltdown we are experiencing now in 2008, especially since it was caused by greed.
What is even more disappointing about the financial crisis we are in is it could have been avoided. There are many outstanding financial risk management software applications available that can protect against making bad investment decisions that can lead to great losses.
So, the question is, what is financial risk and how is it measured?
Financial risk is the probability that an investment’s actual return will be different than expected. This includes the possibility of losing some or all of the financial value of a particular investment.
Now here is where investing gets tricky. It is known that the more risk you take, the more potential there is for a large gain. However, the more risk you take, the more potential there is for a huge loss. This is where greed can become very dangerous. One of the main reasons we are experiencing the financial disaster we are in right now is from investment banks and insurance companies investing in high risk consumer mortgages. They took the risk that they would earn a large return from offering high interest mortgages to people with poor credit. They also took a huge risk by allowing consumers to take out zero money down mortgages and interest-only mortgages.
Where the problem occurred is that a greater than expected percentage of consumers who received these mortgages could not pay them. And if people are not paying their mortgages, the investment loses value and causes financial losses. With advanced risk management software, investors would have been alerted that the potential for loss with these high risk mortgages was great and that the investor should be very aware that making these investments could lead to a huge loss.
The purpose of financial risk management software is to protect against making bad investment decisions that may lead to a large financial loss. It does this by estimating the how much risk is being taken for a particular investment choice and how much money could be lost if the investment loses value.
Here are a few advanced methods financial risk management software uses to calculate risk:
1. Measure value at risk (VaR). VAR is a technique that uses the statistical analysis of historical market trends and volatilities to estimate the likelihood that a given portfolio’s losses will exceed a certain amount. It can be thought of as the worst loss that might be expected from holding a particular investment over a specific period of time.
2. Monte Carlo. This is a problem solving technique used to approximate the probability of certain outcomes by running multiple trial runs, called stimulations, by using random variables.