Inherent Risk

The term “inherent risk” represents the natural risk existing within an investment or a business organisation. This risk shows uncertainty and potential for loss solely due to its own characteristics and market conditions. As an investor, understanding the inherent risk of financial instruments like mutual funds is important. It helps determine how much you could potentially lose.

Also, it is necessary for businesses to manage their inherent risk by using techniques like identifying inherent risk scores and implementing effective controls. Let’s understand the inherent risk meaning in detail, explore the different inherent risks associated with mutual funds, and learn how to manage them. Furthermore, we will also check how organisations can assess and tackle inherent risks so that they can ensure adaptability in a changing market.

What is inherent risk?

When financial instruments are considered, “inherent risk” refers to the potential for loss without considering external factors or risk mitigation strategies. This risk originates from:

• The specific features of the financial instruments
  and
• The broader market environment in which they operate

Let’s understand in detail

Nature of the instrument:

• Different financial instruments have inherent risks based on their nature
• For example:
  • Equity investments (stocks) are inherently volatile
  • That’s because their value is tied to the company's performance and market perceptions
  • Debt instruments (bonds) carry risks such as:
    • Interest rate risk (where bond prices fall as interest rates rise)
      and
    • Credit risk (the possibility that the issuer might default)

Maturity

• For bonds, the length of time, until the principal is repaid (maturity), is an inherent risk.
• Longer-term bonds are generally more sensitive to interest rate changes.

Complexity

• Some financial instruments, like derivatives, are inherently complex.
• They have higher inherent risks due to their structure and leverage.

Interest rates

• Central bank policies and interest rate changes directly affect:
  • Bond prices
    and
  • Stock market valuations

Market sentiment

• Investor confidence and market sentiment also lead to price volatility.
• Notably, most market bubbles and crashes are driven by collective investor behaviour rather than fundamental values.

Example of inherent risk

Let’s study an example to understand the concept better:

• Say you are investing in corporate bonds issued by ABC Ltd.
• These bonds offer an attractive interest rate, say 7% per annum.
• Some common inherent risks associated with this investment are:
  • Credit risk
    • There is a possibility that ABC Ltd. will face financial difficulties
    • Consequently, it will default on its interest or principal payments
  • Interest rate risk
    • The Reserve Bank of India will likely raise interest rates
    • If this happens, the market value of these bonds will decline
    • This happens because newer bonds offer higher returns
  • Market sentiment
    • Assume that the economic conditions of India changed
    • These are unfavourable for ABC Ltd. and will impact its business performance
    • As a result, the market sentiment towards the company changes
    • This negatively impacts the bond price

Also read about: What is a risk profile

Components of inherent risk

In a general business context, inherent risk represents the “raw or untreated risk” inherent in a process before the implementation of controls. Mostly, auditors of a company identify potential risks and their possible impacts. Let us look at the various components of inherent risk:

Business type

• The nature of a company's daily operations significantly influences inherent risk.
• This risk increases when a company is unable to adapt to its:
  • External factors
    or
  • Immediate dynamic environment

Execution of data processing

• The effectiveness of a company's IT infrastructure in processing and analysing data affects inherent risk.
• Often, weak data processing capabilities increase inherent risk due to the potential for errors or vulnerabilities.

Complexity level

• Companies that handle intricate transactions and operations face higher inherent risk.
• Owing to such complexities, such organisations often have complex reporting structures that can lead to significant misstatements.

Poor management

• Lack of oversight from management increases inherent risk as errors in day-to-day operations may go unnoticed.
• Also, disengaged leadership fails to address issues promptly, which further amplifies inherent risk levels.

Inherent risk in risk management

In risk management, inherent risk shows the level of risk inherent in a particular activity before any controlling measures are applied. In other words, it is the natural risk associated with an asset or activity.

For example:

• Say ABC Ltd. is a major Indian IT company.
• The company handles vast amounts of sensitive data for clients worldwide.
• Before any controlling measures are applied, ABC Ltd. faces inherent risks related to cybersecurity threats.
• If materialised, these risks lead to:
  • Significant financial losses
  • Reputational damage
  • Legal consequences

Understanding inherent risk is important for risk managers as it forms the basis for:

• Assessing the overall risk exposure
  and
• Determining appropriate risk management strategies

By identifying and evaluating inherent risk, organisations can allocate resources effectively and implement strategies to reduce the negative impacts.

Also read about: Risk in mutual funds

Inherent risk in accounting

When it comes to accounting, inherent risk represents the chances of susceptibility in the financial statements of a business organisation. It shows the likelihood of material misstatements before considering the impact of internal controls.

Inherent risk in accounting is influenced by several factors, such as:

• Industry dynamics
• Complexity of transactions
• Management integrity

It is important for the auditors of a company to understand inherent risk as it helps in determining the scope of audit. As a rule of thumb, high inherent risk areas require more rigorous testing and scrutiny. This ensures the accuracy and reliability of financial reporting.

Inherent risk vs. Residual risk

In risk management, “inherent risk” and “residual risk” represent different stages of risk assessment and mitigation. Let’s understand both these terms in detail:

• Inherent risk
  • As discussed earlier, inherent risk refers to the level of risk associated with a specific activity before any controls are applied.
  • It represents the “natural level of risk” inherent in the activity.
  • It is influenced by several inherent characteristics and external factors.
  • Investors must note that, in essence, inherent risk is raw or untreated.
• Residual Risk
  • On the other hand, residual risk is the level of risk that remains after controls or risk mitigation measures have been implemented to reduce the inherent risk.
  • In other words, it shows the remaining or leftover inherent risk that still prevails in the organisation even after applying controls.
  • Residual risk reflects the effectiveness of risk management efforts.
  • In most cases, it shows what the management or stakeholders are willing to accept as the ongoing risk exposure.

Thus, the major differences between them is:

• Inherent risk refers to the initial risk, which is reduced by applying controls.
• On the other hand, residual risk shows the accepted level of risk, which is left untreated.

Also read about: What is risk return trade off

Inherent risks of mutual funds with the solution

Numerous studies have shown that investing in mutual funds can offer the benefits of diversification and consistent returns. However, despite being managed professionally, mutual funds also come with their own set of inherent risks, such as:

• Credit risk
• Interest rate risk
• Price risk
• Economic risk

Investors must understand them to protect their investments. Let’s understand each of these risks in detail:

1. Credit risk

Mutual funds are exposed to credit risk. It arises from the possibility of issuers defaulting on their debt obligations. This risk is prevalent in bond mutual funds that invest in:

• Corporate bonds
  or
• Lower-rated securities

If issuers default, it can lead to a decrease in the value of the mutual fund's holdings. Consequently, the net asset value (NAV) of the fund also declines.

Solution:

Investors can mitigate credit risk by diversifying their mutual fund investments across various sectors and credit ratings. Furthermore, you can reduce exposure to likely defaults and credit downgrades by:

• Opting for funds with higher-quality bonds
  and
• Thoroughly researching the fund manager's credit risk management strategies
  

2. Interest rate risk

Mutual funds, especially bond funds, are exposed to interest rate risk. It represents the potential of a decline in the value of fixed-income securities when interest rates rise. As a general rule, when interest rates increase, the market value of existing bonds decreases.

This reduction leads to capital losses for bond fund investors. This risk is particularly significant for long-duration bond funds.

Solution:

One of the best ways is to invest in mutual fund schemes with shorter durations. This reduces sensitivity to interest rate changes. Additionally, actively managed bond funds usually adjust holdings in response to rate movements. By investing in them, you can eliminate likely losses.

3. Price risk

Price risk is also known as market risk. It originates from fluctuations in the prices of securities held within the fund's portfolio. Price risk affects the overall value of the mutual fund and impacts:

• Its net asset value (NAV)
  and
• The returns earned by investors

Several factors lead to price volatility in the securities market, such as changes in:

• Market sentiment
• Economic conditions, and
• Geopolitical events

These factors also affect the performance of mutual funds and their capacity to generate stable returns.

Solution:

Usually, short-term fluctuations impact the profitability of mutual fund investors. However, if you stay invested in equity mutual funds for the long term, you can:

• Average out the risk
  and
• Reduce the price-risk factor to a minimum

Additionally, keep reviewing and adjusting your investment allocations to manage price volatility.

4. Economic risk

The economic risk refers to the likely impact of macroeconomic factors on mutual fund investments. This risk arises from changes in economic indicators such as:

• GDP growth
• Inflation rates
• Unemployment levels
• Monetary policies

Economic fluctuations affect the performance of various asset classes held within mutual fund portfolios and lead to changes in investment returns.

Solution:

Investors can mitigate economic risk in mutual funds by selecting schemes with consistent performance records. By investing in funds that have shown resilience across various economic conditions, you can safeguard capital from the effects of economic downturns. Therefore, always exercise caution and perform a thorough historical assessment when choosing funds.

Read also about: What is a value at risk

What factors determine inherent risk?

To better evaluate the risk associated with investment choices, investors must understand the determinants of inherent risk. It helps improve overall portfolio returns and implement appropriate risk management strategies. Let’s look at the various factors that influence inherent risk:

1. Type of business

Different industries have varying levels of inherent risk due to factors such as:

• Regulatory environment
• Competition
• Market dynamics

For example, industries with high regulatory scrutiny and complex operations have higher inherent risk levels.

2. Technology usage and data processing

The extent of technology adoption and the efficiency of data processing systems influence inherent risk. Organisations heavily reliant on outdated or inadequate technology face higher inherent risk due to increased susceptibility to:

• Cyber threats
• Data breaches
• Operational disruptions

On the other hand, organisations with robust technology infrastructure and effective data processing capabilities experience lower inherent risk levels.

3. Complexity level

The complexity of an organisation's operations and financial reporting significantly impacts inherent risk. It is pertinent to note that complex business processes increase the likelihood of:

• Errors
• Misstatements
• Regulatory compliance issues

Usually, high complexity levels necessitate more extensive controls and monitoring efforts to mitigate inherent risk effectively.

4. Ineffective, inefficient, or unethical management

It is commonly believed that ineffective or inefficient management leads to:

• Poor decision-making
• Inadequate oversight
• Lack of adherence to policies and procedures

Additionally, unethical behaviour or misconduct within management ranks increases the likelihood of:

• Fraud
• Financial misstatements
• Compliance violations

Thus, trustworthy and competent leadership is important for reducing inherent risk and creating a culture of transparency and accountability.

Also read about: What is market risk definition

How to measure inherent risk?

Measuring inherent risk involves evaluating two key criteria:

• Impact
  and
• Likelihood

Let’s understand both these terms individually:

Impact

• It refers to the potential effect of an event on an organisation.
• This effect ranges from negligible to extreme.
• For example:
  • Say you are assessing the inherent risk of a cybersecurity breach
  • To do so, you would consider its likely impact on:
    • Financial position
    • Regulatory compliance
    • Reputation of the organisation

Likelihood

• This indicates the probability of the risk occurring in the absence of controls.
• These criteria are multiplied to generate an “inherent risk score”.
• For example:
  • Assume that the likelihood of a breach is high and its potential impact is severe
  • In this case, a high inherent risk score would reflect this heightened risk level.

Investors must note that inherent risk scores are valuable for calculating residual risk. They help in:

• Guiding audit and compliance efforts
• Deciding an ideal allocation of risk management resources
• Providing a quantitative measure of “risk exposure”
  

Inherent risk scoring

Inherent risk scoring involves assessing the potential impact and likelihood of risk events before implementing controls. It provides a baseline for evaluating risk exposure. This score is calculated by multiplying:

• The expected impact
  by
• The likelihood of occurrence

Once inherent risks are identified, controls are implemented to mitigate them. These controls reduce the probability of risk events and lead to residual risk (residual risk is the remaining risk exposure after the implementation of controls).

It is worth noting that both inherent and residual risk assessments:

• Analyse risks in business processes
  and
• Evaluate control effectiveness

Such assessments are essential for audits and compliance with standards like ISO 27001. They also facilitate efficient capital allocation and help organisations manage risks effectively across all domains.

Also read about: What is default risk

How to manage inherent risk?

Management of inherent risk involves a structured approach. We can broadly classify it into:

• Identification
• Assessment
• Mitigation

Let’s understand how you can manage inherent risks through simple steps:

1. Identify your inherent risks

Start by mapping out the organisation's entire risk framework. A comprehensive assessment ensures all risks are recognised, from severe to less critical ones. Furthermore, it is important to use the right technology that will:

• Collect all of this information
  and
• Store it in an ideal location
  

2. Assess and prioritise your inherent risk

Next, quantify each inherent risk in terms of:

• Impact
  and
• Likelihood

You can prioritise mitigation efforts by ranking risks by severity. This kind of ranking guides in:

• What should be the scope of your resource allocation?
  and
• What are the best risk management strategies that can be implemented?
  

3. Mitigate inherent risk

Once you have identified and assessed the inherent risk, now is the time to handle it by applying various controls:

• Acceptance
  • If the risk aligns with your accepted risk tolerance, simply accept it as “viable”.
• Avoidance
  • Sometimes, you can avoid a particular set of risks by simply avoiding the activities causing them.
  • Based on a thorough assessment, you can decide not to engage in risky activities.
  • However, by doing so, you will also lose on the benefits that those ignored activities could have generated.
• Reduction
  • In this technique, you implement controls to reduce the impact or likelihood of risks while still indulging in risky activities.
• Transfer
  • Alternatively, you can choose to transfer the risk to a third party, mostly insurance companies.
  • This way, your organisation can still perform risky activities without assuming risk.
    

4. Communicate the results

To effectively utilise the results of inherent risk assessment findings, communicate them at all levels, from frontline staff to executives and boards. This enhances the effectiveness of overall risk management efforts.

Also read about: What is liquidity risk

5. Understand your risk profile

You will need collaborations across the enterprise to:

• Understand your risk profile
  and
• Identify prevailing inherent risks

This collective effort requires creating a culture of:

• Trust
• Honesty
• Transparency within the organisation

By openly sharing the magnitude of inherent risks, all stakeholders can collectively work towards protecting the firm. Always remember that an enterprise-wide effort ensures that different departments and teams can provide unique perspectives on risks specific to their areas of operation. This kind of sharing allows for a more holistic understanding of the organisation's risk profile.

6. Build a collective understanding

Building a collective understanding of a firm's risks involves aligning with the impact of these risks across departments. While each department may prioritise different risks, a common firm-wide perspective ensures consistency in assessing the impact of inherent risk.

For example,

• Assume that in an organisation:
  • HR prioritises compliance with labour laws
  • IT department focuses on cybersecurity breaches
• A collective understanding means everyone agrees on how serious these risks are.
• So, even if HR thinks labour laws are important and IT thinks hacking is the biggest risk, they work together to decide which is more urgent for the whole company.
• This way, they can work in cohesion and enhance the overall risk management efforts.
  

7. Iterate the process

Regularly reviewing and updating risk assessments is crucial as a company grows. It is always considered a good practice to regularly check your assumptions about risks. This helps in improving the processes related to:

• How do you manage the risk assumptions?
  and
• How do you run your business?

Using tools that can be easily used by everyone involved makes this process quicker and more effective. By doing this, you can save time and get a better understanding of the risks, which helps you make better decisions.

Conclusion

Inherent risk represents the natural or untreated risk present in a business organisation before applying any internal controls. Investors who understand inherent risks related to their investments are better positioned to avoid capital losses and enhance their trading outcomes.

For business organisations, one effective way to measure inherent risk is by calculating the inherent risk score. Once identified, businesses can implement controls to eliminate it. What gets left is the residual risk, which represents the risk tolerance limit of management.

Furthermore, as a practice, businesses must eliminate risk management through collaborations across departments. This way, they can enhance their resilience and readiness to address emerging threats.

When it comes to mutual funds, they carry several inherent risks like credit risk, interest rate risk, price risk, and economic risk. To manage them, investors can diversify their investments, prefer funds with strong past performance, and remain invested for the long term via Systematic Investment Plans (SIPs).

Wondering how much you can accumulate by making SIPs? Use the free mutual fund calculator today and determine your maturity amount.

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