Risk Management: An Introduction

PROF. VIVEK BHATIA

MFC, FCMA, CMA(AUST.), LIFA(UK), CFA(ICFAI),CFA(US)

Prof. Vivek Bhatia

Brief Outline of this Workshop
Learning Goals:

The Concept of Risk

 Sources of Risk

Types of Risks

Concept of Risk Management

Risk Management Techniques

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The Concept of Risk
Introduction:
Since time immemorial, human beings have tried to manage risks faced in
their day to day life
Examples: Keeping inflammable material away from fire, saving for possible
future needs, creation of a legal will

Risk is the possibility of the actual outcome being

different from the expected outcome

#Downside and the upside potential

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The Concept of Risk
Certainty, Risk & Uncertainty
Although the terms risk and uncertainty are often used interchangeably, they
are in fact not synonymous. There is a clear distinction between certainty,
uncertainty and risk

Certainty is the situation where it is known what will happen and the
happening or non happening of an event carries a 100% probability

Risk is the situation when there are a number of specific, probable outcomes,
but it is not certain as to which one of them will actually happen

Uncertainty is where even the probable outcomes are unknown. It reflects a

total lack of knowledge of what may happen

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The Concept of Risk
Risk
Risk is not an abstract concept. It is a variable which can be calibrated,
measured and compared
The degree of risk attached to
the likelihood of the occurrence of that event
its potential intensity, if it occurs

Hence, risk is generally measured

using the concept of

#STANDARD DEVIATION

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The Concept of Risk
Risk Vs. ‘Peril' and' Hazard'
While risk is the possibility of a loss, peril is a cause of a loss
Hazard, on the other hand, is a factor that may create or increase the
possibility of a loss in face of an undesired event, or may increase the
possibility of the happening of the undesired event
Example:
Fire is a peril that may cause loss
Inappropriate structure of a building is a hazard that increases the possibility
of a loss in case of a fire. Inappropriate wiring is a hazard that increases the
probability of a fire
Risk is the possibility of a loss due to these factors

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The Concept of Risk
Risk , Information & Perception
The degree of risk present in a particular situation is not an
absolute, independent amount. It is dependent on
the level of information available with the entity facing
the risk
the entity's perception of the expected value and the
probability distribution, which in turn determines the
degree of risk

Two different entities may interpret the same information

differently, or may have different expectations for the
future, which would lead to two different sets of
probability distributions
 Hence, the same set of circumstances may translate into
different levels of risk for different people

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The Concept of Risk
Risk & Corporate Value
Possibility of the actual market value of its shares being different from the
expected market value

 Possibility of a company's actual profits after tax (PAT) being different from
the expected PAT

 Possibility of either costs being higher than expected, or revenues being

rower than expected

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Sources of Risk

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Sources of Risk
Interest Rate Risk
The risk of an adverse effect of interest rate movements on a firm's profits or
balance sheet
Interest rates affect a firm in two ways - by affecting the profits and by
affecting the value of its assets or liabilities

Default Risk
The risk of non-recovery of sums due from outsiders, which may arise either
due to their inability to pay or unwillingness to do so
This risk has to be considered when credit is extended to any party

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Sources of Risk
Liquidity Risk
The risk of a possible bankruptcy arising due to the inability of the firm to
meet its financial obligations
There is a misconception that a profitable firm will have little or no liquidity
risk. It is possible that a firm may be very profitable but may have a severe
liquidity crunch because it has blocked its money in illiquid assets
Liquidity risk also refers to the possibility of having excess funds, i.e. the
risk of having more funds than it can profitably deploy

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Sources of Risk
Business Risk
The risk faced by a business from its external and internal environment
The risk may come from internal factors like labor strike, death of key
personnel, machinery breakdown, or external factors like government
policy, changes in customer preferences, etc.

Financial Risk
The risk of bankruptcy arising from the possibility of a firm not being able to
repay its debts on time
Higher the debt-equity ratio of a firm, higher the financial risk faced by it.
Liquidity risk and wrong capital structure are the prime reasons

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Sources of Risk
Market Risk
The risk of the value of a firm's investments going down as a result of market
movements. It is also referred to as price risk
Market risk cannot be distinctly separated from other risks defined above,
as it results from interplay of these risks. Interest rate risk and exchange
risk contribute most to the presence of market risk

Marketability Risk
The risk of the assets of a firm not being readily marketable
The situation of having non-marketable assets may or may not be linked to a
need for funds. When such assets are required to be sold due to a need for
funds, the non-marketability may lead to liquidity risk

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Sources of Risk
Exchange Risk (Foreign Exchange Exposure)
It is defined as the change in the domestic currency value of assets and
liabilities to the changes in the exchange rates
This change may be positive or negative. Positive exposure gives rise to a gain
and negative exposure gives rise to a loss
Types of Exchange Risk
1. Accounting or translation exposure
2. Transaction exposure
3. Economic or operating exposure

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Risk Management
Introduction:
Corporate risk management refers to the process of a company attempting to
managing its risks at an acceptable level
It is a scientific approach to deal with various kinds of risks faced by a
corporate
According to Mark Dorfman, risk management is "the logical development and
execution of a plan to deal with potential losses“

 The aim of risk management is to maintain overall and specific risks at the
desired levels, at the minimum possible cost

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Risk Management
Introduction (continued):
Though it is a fact that risk includes both the upside and the downside
potential, generally the upside is acceptable, and even desired
Hence, corporate risk management generally attempts to manage the
possibility of profits being lower than expected

Risk management only aims at bringing the risk to a level that is in line with
the returns expected to be generated by the investment

As the factors affecting risk change continuously, the risk faced by a firm also
changes. Therefore, a company needs to continuously evaluate its risk level
and make an attempt to bring it at the targeted level. This may even include
efforts at increasing risk when it is below the targeted level

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Risk Management
Introduction (continued):
For the purpose of risk management, risks need to be classified as primary
risks and secondary risks
Primary risks are an essential part of the business undertaken
Secondary risks arise out of the business activities, but are not integrally
related to them
Example: risks arising out of the industry structure are primary in nature,
foreign currency exposure arising due to exports are secondary in nature
To a large extent, primary risks have to be borne in order to generate cash
flows. They can be covered only partly. Unlike primary risks, secondary risks
can be covered to a large extent, and only a part of them are unavoidable
Further, it is generally observed that when a firm faces a high degree of
primary risk, it can bear less of secondary risk. A firm having a low degree of
primary risk may be able to bear higher secondary risk, depending on the
management's risk bearing capacity

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Risk Management Techniques
Approaches to Managing Risks:
Risk Avoidance
Loss Control
Combination
Separation
Risk Transfer
Risk Retention
Risk Sharing

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Risk Management Techniques
Risk Management Process:
Risk management needs to be looked at as an organizational approach, as
management of risks independently cannot have the desired effect over the
long-term. This is especially necessary as risks result from various activities in
the firm, and the personnel responsible for the activities do not always
understand the risk attached to them
The risk management function involves a logical sequence of steps. These
steps are:
A.Determining Objectives
B.Identifying Risks
C.Risk Evaluation
D.Development of Policy
E.Development of Strategy
F.Implementation
G.Review

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Risk Management Techniques
Guidelines for Risk Management:
There are a number of instruments and tools available for management of risk
While going through the risk management process in general, and deciding
the instrument to be used for hedging a particular risk, the following
guidelines need to be kept in mind
 Common goal of risk management and financial management Flexibility
 Proper mix of risk management techniques
 Bringing risk to the optimal level
 Proactive risk management

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The Nature of Derivatives

 A derivative is an instrument whose value depends on the values of other more

basic underlying variables. Or A derivative is an instrument whose value is a
function the values of other more basic underlying variables.

 The Securities Contracts (Regulation) Act 1956 defines derivatives

as under :

Derivative includes
 Security derived from a debt instrument, share, loan whether secured or
unsecured, risk instrument or contract for differences or any other form
of security.
 A contract which derives its value from the prices, or index of prices of
underlying securities

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Features of Financial Derivatives

A derivative instrument relates to the future contract between two parties

Value derived from the values of the other underlying assets.

Counter parties have specific obligation under the derivative contract.

Derivative contract can either be direct or thru exchange like options & futures.

Usually settled by offsetting rather than delivery of the asset.

Known as deferred delivery or deferred payment instrument, easier to take long

& short positions.

Mostly secondary market instruments except warrants & convertibles.

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Derivatives Markets

Exchange traded
Traditionally exchanges have used the open-outcry system, but increasingly they
have switched to electronic trading
Contracts are standard there is virtually no credit risk
Example of default: HKFE in October, 1987

Over-the-counter (OTC)
A computer- and telephone-linked network of dealers at financial institutions,
corporations, and fund managers
Contracts can be non-standard and there is some small amount of credit risk
Defaults much bigger than exchanged based

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Examples of Derivatives

Forwards

Swaps Derivatives Futures

Options

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Ways Derivatives are Used

To hedge risks

To speculate (take a view on the

future direction of the market)

To lock in an arbitrage profit

To change the nature of a liability

Interest rate swap to reduce mortgage

risk in banks

To change the nature of an investment

without incurring the costs of selling
one portfolio and buying another

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Prof. Vivek Bhatia