Risk Management

Risk management generally follows a cycle. First, risks are identified: what could go wrong? Then they are assessed: how likely is each risk, and how severe would its impact be? Next, a response is chosen, and finally risks are monitored and reviewed over time.

There are four broad ways to respond to a risk. It can be avoided, by not undertaking the risky activity. It can be reduced, through controls, diversification or safety measures. It can be transferred, for example by buying insurance or using derivatives to hedge. Or it can be accepted, when the cost of addressing it outweighs the potential loss.

For example, an airline faces the risk of rising fuel prices. It might reduce this risk by buying more fuel-efficient aircraft and transfer part of it by using futures contracts to fix the price of some of its future fuel purchases.

In financial institutions, risk management covers credit risk, market risk, liquidity risk and operational risk, among others, and is often overseen by a chief risk officer. For individuals, risk management includes building emergency savings, buying insurance and diversifying investments.