Enterprise Risk: Theoretical Foundations

Description

Description: This course has been designed to introduce external and internal drivers that can result in a range of operational, financial, and strategic risks manifesting in organisations. This course examines the role of corporate governance and compliance, introducing relevant standards, and suggests methods of developing and implementing appropriate risk management strategies.

This course features dynamic and engaging video with audio narration, infographics and short quizzes to test your knowledge.

Background: If you ask investors what risk they assume when buying stocks, they likely will respond, “Losing Money”. Modern portfolio theorists do not, however, define risk as a likelihood of loss, but as volatility, which is determined using statistical measures of variance such as standard deviation and beta. While standard deviation is a measure of absolute volatility that shows how much an investment’s return varies from its average return over time, beta is a measure of relative volatility that indicates the price variance of an investment compared to the market as a whole. The higher the standard deviation or beta, the higher the risk, according to the theory. In a rising market, however, high volatility can boost the return potential of an investment. Volatility, in other words, is essentially a double-edged sword, and does not measure what an investor intuitively perceives as risk.

Suppose the price of a stock goes up 10 percent in one month, 5 percent the next, and 15 percent in the third month. The standard deviation would be five with a return of 32.8 percent. Compare this to a stock that declines 15 percent three months in a row. The standard deviation would be zero with a loss of 38.6 percent. An investor holding the falling stock might find solace knowing that the loss was incurred completely “risk-free.”

Typically the square root of the variance, called the standard deviation, is volatility. The modern portfolio theorists immediately recognized that the volatilities were changing over time. They found different answers for different time periods. A simple approach, sometimes called historical volatility, was and remains widely used. In this method, the volatility is estimated by the sample standard deviation of returns over a short period. But, what is the right period to use? If it is too long, then it will not be so relevant for today and if it is too short, it will be very noisy. Furthermore, it is really the volatility over a future period that should be considered the risk; hence a forecast of volatility is needed as well as a measure for today. This raises the possibility that the forecast of the average volatility over the next week might be different from the forecast over a year or a decade.
Risk – exposure to the chance of injury or loss; a hazard or dangerous chance. The degree of probability of such loss.

Volatility – Tending to fluctuate sharply and regularly.
The volatility of a stock or bond does not necessarily have to equate with its risk.
Consider this “volatile” stock chart compared to a less volatile one:
More Volatile – multiple 20-30% swings over this period.
Less Volatile – much less dramatic price action, slightly more than a 10% swing.
The more volatile stock goes up and down much more violently. But it makes billions of dollars every year, and has billions of dollars of cash on hand to weather hard economic times.