outline the challenges that are faced in the selection of an optium solution in finalizing an risk management strategy
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Failure to use appropriate risk metrics
VaR is a popular risk metric, but it can only tell us the largest loss the firm expects to incur at a given confidence level. VaR tells us nothing about the distribution of the losses that exceed VaR. This would suggest the application of VaR doesn’t guarantee the success of risk management. In addition, the effectiveness of implementing VaR also depends on the liquidity of the financial market. If the market is illiquid, then daily VaR measures lose their meaning. This is because if a firm sits on a portfolio that cannot be traded, a daily VaR measure is not a measure of the risk of the portfolio because the firm is stuck with the portfolio for a much longer period of time.
Mismeasurement of known risks
Risk managers sometimes make mistakes in assessing the probability or the size of losses. Similarly they could use the wrong distribution. For a financial institution with many positions, although they may properly estimate the distribution associated with each position, the correlation between the different positions may be mismeasured. Mismeasurement of known risk is a common problem in risk management practice.
Failure to take known risks into account
According to Stulz, it is very difficult to consider all the risks in a risk measurement system, or it is costly to do so. This is because nobody can forecast future events perfectly.
Failure in communicating risks to top management
Risk managers communicate information about the risk position of the firm to top management and the board. The management and board use this information to determine the firm’s risk strategy. If a risk manager is unable to communicate this information effectively, top management may make decisions that are badly informed, or they may develop an overoptimistic perception of the risk position of the firm.
Failure in monitoring and managing risks
Finally, it is challenging for risk managers to capture all the changes in the risk characteristics of securities and to adjust their hedges accordingly. As a result, risk managers may fail to adequately monitor or hedge risks simply because the risk characteristics of securities may change too quickly to allow them to assess them and put on effective hedges.
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