Quora Answer: What is Inherent Risk in Investment?

The following is my answer to a Quora question: “What is inherent risk in investment?”

Inherent risk is one of the risks auditors looks for.  The other two are control risk, and detection risk.  Inherent risk would be the risk in a financial statement, which may be due to an error such as a misstatement or an omission of particulars or facts, which is distinct from control risk.  Control risk is when the misstatement is a failure of the controls.  This is the worst-case scenario risk because all controls have failed.

An auditor, or compliance manager, looks at the level of inherent risk, and sets the detection level, and report standards commensurate to that risk, based on his professional expertise.  Sometimes, as shown during the Sub-Prime Crisis, this is found to be inadequate.  They look for the beneficial ownership relationships, opportunities for fraudulent transactions, disclosure requirements which we call the KYC (Know Your Client), and exposure.

With regards to investments, we are looking at the actual risk, as opposed to the marketed one.  This becomes especially complicated when we consider large transactions, in tranches, of bundled products of varying grades, from investment to junk.

A common example of inherent risk is found in futures contracts and options, where revenue is estimated based on a demand that cannot be adequately quantified to be hedged against.  The company is then leveraged against expected revenue that may not arrive should the market turn inclement.  Collateralised debt obligations (CDOs) are another example, where the secondary market collapses, which lowers the price of the CDOs.  This was what happened in 2008.