Isbm - 1- Introduction to Risk Management
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Transcript of Isbm - 1- Introduction to Risk Management
822019 Isbm - 1- Introduction to Risk Management
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A man walks across the street and faces it A car could spin outof control and accidentally run into him
A woman sits down in first-class sleeper seat 1A to cross theocean on Airline Fly By Night and confronts it A flight delay could
cause her to be late to the crucial meeting that prompted her tospend $10000 on her ticket or the plane could end up in the oceanand she could miss the meeting in a more permanent sense
On a lighter note you try to bunk a class and in the processbump into your director
One is enjoying a stroll in the confines of your spacious gardenand a coconut lands on your nut
You are having a dinner date with a girl and half way throughyour girlfriend walks in
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It of course is risk Risk is everywhere
RISK IS THE POSSIBILITY OF THE ACTUALOUTCOME BEING DIFFERENT FROM THEEXPECTED OUTCOME
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INFORMATION SYSTEMS
Three principle factors significantly influence risk
Rapid growth in centralization of data and the informationextraction processes Increasing dependence on employees with skills talents
disciplines and sometimes motivations quite different from thosewith which management has been familiar in the past
Increased proliferation of mini micro and portable processingdevices with an associated distribution of key data to remotenodes for data extraction data update and data addition
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Assessment Scope
Can be a serious point of contentionSome individuals want to limit consideration to catastrophic events suchas fire flood earthquakesand volcanoesOthers want to focus only on intentional misconduct such asfraud and embezzlement
The correct position is that consideration must be extended to the effectsof all of the undesirable things that might happen to data or to the means
of accessing and processing data
Care must be taken to insist that concern is limited to the effects of undesirablethings and not extended to a virtually endless list of bad things ndash the threat list
It is not until the cost of the undesired event and its estimated frequency haveboth been examined that a potential source of damage can be
justifiably excluded from further consideration
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What is Banking
bull Section 5(b) defines banking lsquoAccepting for the
purpose of lending or investment of deposits
or money repayable on demand or otherwiseand withdrawable by cheque draft order or
otherwisersquo
Risk taking is an inherent functionof banking - Allan Greenspan
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Banks get affected by
bull Actions of Central Banks
bull Actions of the Government
bull
Domestic and International Disturbancesbull Inflation
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Deregulation
bull Banks are now operating in a fairly
deregulated environment and are required to
determine on their own interest rates on
deposits and advances
bull Intense competition for business involving
both the assets and liabilities together with
increasing volatility in the interest rates hasbrought pressure on the management of
banks to maintain a good balance among
spreads
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Risks Faced by Banks
bull Credit Risk
bull Market Risk
ndash Liquidity Risk
ndash Interest Rate Risk
bull Operational Risk
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Effects of Risk Factors
bull Loss of Market Value
bull Loss of Reserves
bull
Loss of stakeholders confidence
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WHAT IS RISK
bull Risk is defined asuncertainty concerning theoccurrence of a loss
bull Any event or possibility of
an event which can impaircorporate earnings or cashflow over short medium long term horizon
bull Risk can be defined as the
likelihood of occurrence of an undesirable eventcombined to themagnitude of its impact
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CERTAINITY ~ RISK~ UNCERTAINITY
bull Certainty is the situation where it is known what will
happen and the happening or non happening of an
event carries a 100 probability
bull Risk is the situation where there are a number of specific probable outcomes but it is not certain as
to which one of them will actually happen
bull Uncertainty is where even the probable outcomes
are unknown It reflects a total lack of knowledge of
what may happen
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Types of Risk according to Uncertainty perspective
bull Objective risk (Degree of Risk)
ndash The relative variation of actual loss from expectedloss
ndash Eg Loss of property in afire accident
bull Subjective risk
ndash It is defined as uncertaintybased on a personrsquos mental condition or stateor mind
ndash The impact of subjectiverisk varies depending onthe individual ie differentperception of risk
ndash Eg The driver may beuncertain whether he willarrive home safely withoutbeing arrested by thepolice for drunk driving
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NATURE OF RISK
bull If we recognize that risky changes cannot be beneficialand choose to sit idle but the risky world evolvesaround us will not allow us
bull How can we begin to develop a framework for
managing risk responsiblybull The answer to that question in very broad terms is
that a healthy and responsible risk managementframework that neither lends itself to over-cautionnor to carelessness is a framework that avoids three
basic fallaciesbull If risk management can be implemented without
falling into these three traps the groundwork for ahealthy risk management program has been laid
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CURRICULUM
bull Concept of risk - General
bull Types of risk ndash Case Studies
bull Quantifying risk - Numericals
bull Regulatory and Political risk ndash Global Business set up
bull Production and Operational risk ndash Basics and Case Study
bull IT and Risk Management ndash Role of IT amp MIS
bull Tools for Risk Management ndash Decision Trees Hazop Models QualityTools
bull Risk Governance Structures
bull
Organisational Strategy and Visionbull Internal Control
bull Implementing a risk mgt process
bull Assignment Project
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SOURCES OF RISK
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SOURCES OF RISK
TECHNOLOGY
COMPETITION PRODUCTIVITY
MARKETSHARE
PRICES
SOURCESOF
RISK
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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2
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A man walks across the street and faces it A car could spin outof control and accidentally run into him
A woman sits down in first-class sleeper seat 1A to cross theocean on Airline Fly By Night and confronts it A flight delay could
cause her to be late to the crucial meeting that prompted her tospend $10000 on her ticket or the plane could end up in the oceanand she could miss the meeting in a more permanent sense
On a lighter note you try to bunk a class and in the processbump into your director
One is enjoying a stroll in the confines of your spacious gardenand a coconut lands on your nut
You are having a dinner date with a girl and half way throughyour girlfriend walks in
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It of course is risk Risk is everywhere
RISK IS THE POSSIBILITY OF THE ACTUALOUTCOME BEING DIFFERENT FROM THEEXPECTED OUTCOME
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INFORMATION SYSTEMS
Three principle factors significantly influence risk
Rapid growth in centralization of data and the informationextraction processes Increasing dependence on employees with skills talents
disciplines and sometimes motivations quite different from thosewith which management has been familiar in the past
Increased proliferation of mini micro and portable processingdevices with an associated distribution of key data to remotenodes for data extraction data update and data addition
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Assessment Scope
Can be a serious point of contentionSome individuals want to limit consideration to catastrophic events suchas fire flood earthquakesand volcanoesOthers want to focus only on intentional misconduct such asfraud and embezzlement
The correct position is that consideration must be extended to the effectsof all of the undesirable things that might happen to data or to the means
of accessing and processing data
Care must be taken to insist that concern is limited to the effects of undesirablethings and not extended to a virtually endless list of bad things ndash the threat list
It is not until the cost of the undesired event and its estimated frequency haveboth been examined that a potential source of damage can be
justifiably excluded from further consideration
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3202012
What is Banking
bull Section 5(b) defines banking lsquoAccepting for the
purpose of lending or investment of deposits
or money repayable on demand or otherwiseand withdrawable by cheque draft order or
otherwisersquo
Risk taking is an inherent functionof banking - Allan Greenspan
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Banks get affected by
bull Actions of Central Banks
bull Actions of the Government
bull
Domestic and International Disturbancesbull Inflation
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Deregulation
bull Banks are now operating in a fairly
deregulated environment and are required to
determine on their own interest rates on
deposits and advances
bull Intense competition for business involving
both the assets and liabilities together with
increasing volatility in the interest rates hasbrought pressure on the management of
banks to maintain a good balance among
spreads
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3202012
Risks Faced by Banks
bull Credit Risk
bull Market Risk
ndash Liquidity Risk
ndash Interest Rate Risk
bull Operational Risk
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3202012
Effects of Risk Factors
bull Loss of Market Value
bull Loss of Reserves
bull
Loss of stakeholders confidence
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WHAT IS RISK
bull Risk is defined asuncertainty concerning theoccurrence of a loss
bull Any event or possibility of
an event which can impaircorporate earnings or cashflow over short medium long term horizon
bull Risk can be defined as the
likelihood of occurrence of an undesirable eventcombined to themagnitude of its impact
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CERTAINITY ~ RISK~ UNCERTAINITY
bull Certainty is the situation where it is known what will
happen and the happening or non happening of an
event carries a 100 probability
bull Risk is the situation where there are a number of specific probable outcomes but it is not certain as
to which one of them will actually happen
bull Uncertainty is where even the probable outcomes
are unknown It reflects a total lack of knowledge of
what may happen
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Types of Risk according to Uncertainty perspective
bull Objective risk (Degree of Risk)
ndash The relative variation of actual loss from expectedloss
ndash Eg Loss of property in afire accident
bull Subjective risk
ndash It is defined as uncertaintybased on a personrsquos mental condition or stateor mind
ndash The impact of subjectiverisk varies depending onthe individual ie differentperception of risk
ndash Eg The driver may beuncertain whether he willarrive home safely withoutbeing arrested by thepolice for drunk driving
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NATURE OF RISK
bull If we recognize that risky changes cannot be beneficialand choose to sit idle but the risky world evolvesaround us will not allow us
bull How can we begin to develop a framework for
managing risk responsiblybull The answer to that question in very broad terms is
that a healthy and responsible risk managementframework that neither lends itself to over-cautionnor to carelessness is a framework that avoids three
basic fallaciesbull If risk management can be implemented without
falling into these three traps the groundwork for ahealthy risk management program has been laid
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CURRICULUM
bull Concept of risk - General
bull Types of risk ndash Case Studies
bull Quantifying risk - Numericals
bull Regulatory and Political risk ndash Global Business set up
bull Production and Operational risk ndash Basics and Case Study
bull IT and Risk Management ndash Role of IT amp MIS
bull Tools for Risk Management ndash Decision Trees Hazop Models QualityTools
bull Risk Governance Structures
bull
Organisational Strategy and Visionbull Internal Control
bull Implementing a risk mgt process
bull Assignment Project
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17
SOURCES OF RISK
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SOURCES OF RISK
TECHNOLOGY
COMPETITION PRODUCTIVITY
MARKETSHARE
PRICES
SOURCESOF
RISK
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24
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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A man walks across the street and faces it A car could spin outof control and accidentally run into him
A woman sits down in first-class sleeper seat 1A to cross theocean on Airline Fly By Night and confronts it A flight delay could
cause her to be late to the crucial meeting that prompted her tospend $10000 on her ticket or the plane could end up in the oceanand she could miss the meeting in a more permanent sense
On a lighter note you try to bunk a class and in the processbump into your director
One is enjoying a stroll in the confines of your spacious gardenand a coconut lands on your nut
You are having a dinner date with a girl and half way throughyour girlfriend walks in
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It of course is risk Risk is everywhere
RISK IS THE POSSIBILITY OF THE ACTUALOUTCOME BEING DIFFERENT FROM THEEXPECTED OUTCOME
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INFORMATION SYSTEMS
Three principle factors significantly influence risk
Rapid growth in centralization of data and the informationextraction processes Increasing dependence on employees with skills talents
disciplines and sometimes motivations quite different from thosewith which management has been familiar in the past
Increased proliferation of mini micro and portable processingdevices with an associated distribution of key data to remotenodes for data extraction data update and data addition
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Assessment Scope
Can be a serious point of contentionSome individuals want to limit consideration to catastrophic events suchas fire flood earthquakesand volcanoesOthers want to focus only on intentional misconduct such asfraud and embezzlement
The correct position is that consideration must be extended to the effectsof all of the undesirable things that might happen to data or to the means
of accessing and processing data
Care must be taken to insist that concern is limited to the effects of undesirablethings and not extended to a virtually endless list of bad things ndash the threat list
It is not until the cost of the undesired event and its estimated frequency haveboth been examined that a potential source of damage can be
justifiably excluded from further consideration
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3202012
What is Banking
bull Section 5(b) defines banking lsquoAccepting for the
purpose of lending or investment of deposits
or money repayable on demand or otherwiseand withdrawable by cheque draft order or
otherwisersquo
Risk taking is an inherent functionof banking - Allan Greenspan
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Banks get affected by
bull Actions of Central Banks
bull Actions of the Government
bull
Domestic and International Disturbancesbull Inflation
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Deregulation
bull Banks are now operating in a fairly
deregulated environment and are required to
determine on their own interest rates on
deposits and advances
bull Intense competition for business involving
both the assets and liabilities together with
increasing volatility in the interest rates hasbrought pressure on the management of
banks to maintain a good balance among
spreads
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Risks Faced by Banks
bull Credit Risk
bull Market Risk
ndash Liquidity Risk
ndash Interest Rate Risk
bull Operational Risk
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Effects of Risk Factors
bull Loss of Market Value
bull Loss of Reserves
bull
Loss of stakeholders confidence
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WHAT IS RISK
bull Risk is defined asuncertainty concerning theoccurrence of a loss
bull Any event or possibility of
an event which can impaircorporate earnings or cashflow over short medium long term horizon
bull Risk can be defined as the
likelihood of occurrence of an undesirable eventcombined to themagnitude of its impact
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CERTAINITY ~ RISK~ UNCERTAINITY
bull Certainty is the situation where it is known what will
happen and the happening or non happening of an
event carries a 100 probability
bull Risk is the situation where there are a number of specific probable outcomes but it is not certain as
to which one of them will actually happen
bull Uncertainty is where even the probable outcomes
are unknown It reflects a total lack of knowledge of
what may happen
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Types of Risk according to Uncertainty perspective
bull Objective risk (Degree of Risk)
ndash The relative variation of actual loss from expectedloss
ndash Eg Loss of property in afire accident
bull Subjective risk
ndash It is defined as uncertaintybased on a personrsquos mental condition or stateor mind
ndash The impact of subjectiverisk varies depending onthe individual ie differentperception of risk
ndash Eg The driver may beuncertain whether he willarrive home safely withoutbeing arrested by thepolice for drunk driving
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NATURE OF RISK
bull If we recognize that risky changes cannot be beneficialand choose to sit idle but the risky world evolvesaround us will not allow us
bull How can we begin to develop a framework for
managing risk responsiblybull The answer to that question in very broad terms is
that a healthy and responsible risk managementframework that neither lends itself to over-cautionnor to carelessness is a framework that avoids three
basic fallaciesbull If risk management can be implemented without
falling into these three traps the groundwork for ahealthy risk management program has been laid
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CURRICULUM
bull Concept of risk - General
bull Types of risk ndash Case Studies
bull Quantifying risk - Numericals
bull Regulatory and Political risk ndash Global Business set up
bull Production and Operational risk ndash Basics and Case Study
bull IT and Risk Management ndash Role of IT amp MIS
bull Tools for Risk Management ndash Decision Trees Hazop Models QualityTools
bull Risk Governance Structures
bull
Organisational Strategy and Visionbull Internal Control
bull Implementing a risk mgt process
bull Assignment Project
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17
SOURCES OF RISK
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SOURCES OF RISK
TECHNOLOGY
COMPETITION PRODUCTIVITY
MARKETSHARE
PRICES
SOURCESOF
RISK
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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It of course is risk Risk is everywhere
RISK IS THE POSSIBILITY OF THE ACTUALOUTCOME BEING DIFFERENT FROM THEEXPECTED OUTCOME
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INFORMATION SYSTEMS
Three principle factors significantly influence risk
Rapid growth in centralization of data and the informationextraction processes Increasing dependence on employees with skills talents
disciplines and sometimes motivations quite different from thosewith which management has been familiar in the past
Increased proliferation of mini micro and portable processingdevices with an associated distribution of key data to remotenodes for data extraction data update and data addition
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Assessment Scope
Can be a serious point of contentionSome individuals want to limit consideration to catastrophic events suchas fire flood earthquakesand volcanoesOthers want to focus only on intentional misconduct such asfraud and embezzlement
The correct position is that consideration must be extended to the effectsof all of the undesirable things that might happen to data or to the means
of accessing and processing data
Care must be taken to insist that concern is limited to the effects of undesirablethings and not extended to a virtually endless list of bad things ndash the threat list
It is not until the cost of the undesired event and its estimated frequency haveboth been examined that a potential source of damage can be
justifiably excluded from further consideration
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What is Banking
bull Section 5(b) defines banking lsquoAccepting for the
purpose of lending or investment of deposits
or money repayable on demand or otherwiseand withdrawable by cheque draft order or
otherwisersquo
Risk taking is an inherent functionof banking - Allan Greenspan
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Banks get affected by
bull Actions of Central Banks
bull Actions of the Government
bull
Domestic and International Disturbancesbull Inflation
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Deregulation
bull Banks are now operating in a fairly
deregulated environment and are required to
determine on their own interest rates on
deposits and advances
bull Intense competition for business involving
both the assets and liabilities together with
increasing volatility in the interest rates hasbrought pressure on the management of
banks to maintain a good balance among
spreads
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Risks Faced by Banks
bull Credit Risk
bull Market Risk
ndash Liquidity Risk
ndash Interest Rate Risk
bull Operational Risk
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Effects of Risk Factors
bull Loss of Market Value
bull Loss of Reserves
bull
Loss of stakeholders confidence
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WHAT IS RISK
bull Risk is defined asuncertainty concerning theoccurrence of a loss
bull Any event or possibility of
an event which can impaircorporate earnings or cashflow over short medium long term horizon
bull Risk can be defined as the
likelihood of occurrence of an undesirable eventcombined to themagnitude of its impact
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CERTAINITY ~ RISK~ UNCERTAINITY
bull Certainty is the situation where it is known what will
happen and the happening or non happening of an
event carries a 100 probability
bull Risk is the situation where there are a number of specific probable outcomes but it is not certain as
to which one of them will actually happen
bull Uncertainty is where even the probable outcomes
are unknown It reflects a total lack of knowledge of
what may happen
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Types of Risk according to Uncertainty perspective
bull Objective risk (Degree of Risk)
ndash The relative variation of actual loss from expectedloss
ndash Eg Loss of property in afire accident
bull Subjective risk
ndash It is defined as uncertaintybased on a personrsquos mental condition or stateor mind
ndash The impact of subjectiverisk varies depending onthe individual ie differentperception of risk
ndash Eg The driver may beuncertain whether he willarrive home safely withoutbeing arrested by thepolice for drunk driving
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NATURE OF RISK
bull If we recognize that risky changes cannot be beneficialand choose to sit idle but the risky world evolvesaround us will not allow us
bull How can we begin to develop a framework for
managing risk responsiblybull The answer to that question in very broad terms is
that a healthy and responsible risk managementframework that neither lends itself to over-cautionnor to carelessness is a framework that avoids three
basic fallaciesbull If risk management can be implemented without
falling into these three traps the groundwork for ahealthy risk management program has been laid
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CURRICULUM
bull Concept of risk - General
bull Types of risk ndash Case Studies
bull Quantifying risk - Numericals
bull Regulatory and Political risk ndash Global Business set up
bull Production and Operational risk ndash Basics and Case Study
bull IT and Risk Management ndash Role of IT amp MIS
bull Tools for Risk Management ndash Decision Trees Hazop Models QualityTools
bull Risk Governance Structures
bull
Organisational Strategy and Visionbull Internal Control
bull Implementing a risk mgt process
bull Assignment Project
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17
SOURCES OF RISK
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SOURCES OF RISK
TECHNOLOGY
COMPETITION PRODUCTIVITY
MARKETSHARE
PRICES
SOURCESOF
RISK
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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INFORMATION SYSTEMS
Three principle factors significantly influence risk
Rapid growth in centralization of data and the informationextraction processes Increasing dependence on employees with skills talents
disciplines and sometimes motivations quite different from thosewith which management has been familiar in the past
Increased proliferation of mini micro and portable processingdevices with an associated distribution of key data to remotenodes for data extraction data update and data addition
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Assessment Scope
Can be a serious point of contentionSome individuals want to limit consideration to catastrophic events suchas fire flood earthquakesand volcanoesOthers want to focus only on intentional misconduct such asfraud and embezzlement
The correct position is that consideration must be extended to the effectsof all of the undesirable things that might happen to data or to the means
of accessing and processing data
Care must be taken to insist that concern is limited to the effects of undesirablethings and not extended to a virtually endless list of bad things ndash the threat list
It is not until the cost of the undesired event and its estimated frequency haveboth been examined that a potential source of damage can be
justifiably excluded from further consideration
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3202012
What is Banking
bull Section 5(b) defines banking lsquoAccepting for the
purpose of lending or investment of deposits
or money repayable on demand or otherwiseand withdrawable by cheque draft order or
otherwisersquo
Risk taking is an inherent functionof banking - Allan Greenspan
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Banks get affected by
bull Actions of Central Banks
bull Actions of the Government
bull
Domestic and International Disturbancesbull Inflation
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Deregulation
bull Banks are now operating in a fairly
deregulated environment and are required to
determine on their own interest rates on
deposits and advances
bull Intense competition for business involving
both the assets and liabilities together with
increasing volatility in the interest rates hasbrought pressure on the management of
banks to maintain a good balance among
spreads
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3202012
Risks Faced by Banks
bull Credit Risk
bull Market Risk
ndash Liquidity Risk
ndash Interest Rate Risk
bull Operational Risk
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Effects of Risk Factors
bull Loss of Market Value
bull Loss of Reserves
bull
Loss of stakeholders confidence
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WHAT IS RISK
bull Risk is defined asuncertainty concerning theoccurrence of a loss
bull Any event or possibility of
an event which can impaircorporate earnings or cashflow over short medium long term horizon
bull Risk can be defined as the
likelihood of occurrence of an undesirable eventcombined to themagnitude of its impact
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CERTAINITY ~ RISK~ UNCERTAINITY
bull Certainty is the situation where it is known what will
happen and the happening or non happening of an
event carries a 100 probability
bull Risk is the situation where there are a number of specific probable outcomes but it is not certain as
to which one of them will actually happen
bull Uncertainty is where even the probable outcomes
are unknown It reflects a total lack of knowledge of
what may happen
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Types of Risk according to Uncertainty perspective
bull Objective risk (Degree of Risk)
ndash The relative variation of actual loss from expectedloss
ndash Eg Loss of property in afire accident
bull Subjective risk
ndash It is defined as uncertaintybased on a personrsquos mental condition or stateor mind
ndash The impact of subjectiverisk varies depending onthe individual ie differentperception of risk
ndash Eg The driver may beuncertain whether he willarrive home safely withoutbeing arrested by thepolice for drunk driving
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NATURE OF RISK
bull If we recognize that risky changes cannot be beneficialand choose to sit idle but the risky world evolvesaround us will not allow us
bull How can we begin to develop a framework for
managing risk responsiblybull The answer to that question in very broad terms is
that a healthy and responsible risk managementframework that neither lends itself to over-cautionnor to carelessness is a framework that avoids three
basic fallaciesbull If risk management can be implemented without
falling into these three traps the groundwork for ahealthy risk management program has been laid
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CURRICULUM
bull Concept of risk - General
bull Types of risk ndash Case Studies
bull Quantifying risk - Numericals
bull Regulatory and Political risk ndash Global Business set up
bull Production and Operational risk ndash Basics and Case Study
bull IT and Risk Management ndash Role of IT amp MIS
bull Tools for Risk Management ndash Decision Trees Hazop Models QualityTools
bull Risk Governance Structures
bull
Organisational Strategy and Visionbull Internal Control
bull Implementing a risk mgt process
bull Assignment Project
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17
SOURCES OF RISK
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SOURCES OF RISK
TECHNOLOGY
COMPETITION PRODUCTIVITY
MARKETSHARE
PRICES
SOURCESOF
RISK
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24
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Assessment Scope
Can be a serious point of contentionSome individuals want to limit consideration to catastrophic events suchas fire flood earthquakesand volcanoesOthers want to focus only on intentional misconduct such asfraud and embezzlement
The correct position is that consideration must be extended to the effectsof all of the undesirable things that might happen to data or to the means
of accessing and processing data
Care must be taken to insist that concern is limited to the effects of undesirablethings and not extended to a virtually endless list of bad things ndash the threat list
It is not until the cost of the undesired event and its estimated frequency haveboth been examined that a potential source of damage can be
justifiably excluded from further consideration
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3202012
What is Banking
bull Section 5(b) defines banking lsquoAccepting for the
purpose of lending or investment of deposits
or money repayable on demand or otherwiseand withdrawable by cheque draft order or
otherwisersquo
Risk taking is an inherent functionof banking - Allan Greenspan
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Banks get affected by
bull Actions of Central Banks
bull Actions of the Government
bull
Domestic and International Disturbancesbull Inflation
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Deregulation
bull Banks are now operating in a fairly
deregulated environment and are required to
determine on their own interest rates on
deposits and advances
bull Intense competition for business involving
both the assets and liabilities together with
increasing volatility in the interest rates hasbrought pressure on the management of
banks to maintain a good balance among
spreads
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Risks Faced by Banks
bull Credit Risk
bull Market Risk
ndash Liquidity Risk
ndash Interest Rate Risk
bull Operational Risk
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Effects of Risk Factors
bull Loss of Market Value
bull Loss of Reserves
bull
Loss of stakeholders confidence
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WHAT IS RISK
bull Risk is defined asuncertainty concerning theoccurrence of a loss
bull Any event or possibility of
an event which can impaircorporate earnings or cashflow over short medium long term horizon
bull Risk can be defined as the
likelihood of occurrence of an undesirable eventcombined to themagnitude of its impact
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CERTAINITY ~ RISK~ UNCERTAINITY
bull Certainty is the situation where it is known what will
happen and the happening or non happening of an
event carries a 100 probability
bull Risk is the situation where there are a number of specific probable outcomes but it is not certain as
to which one of them will actually happen
bull Uncertainty is where even the probable outcomes
are unknown It reflects a total lack of knowledge of
what may happen
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Types of Risk according to Uncertainty perspective
bull Objective risk (Degree of Risk)
ndash The relative variation of actual loss from expectedloss
ndash Eg Loss of property in afire accident
bull Subjective risk
ndash It is defined as uncertaintybased on a personrsquos mental condition or stateor mind
ndash The impact of subjectiverisk varies depending onthe individual ie differentperception of risk
ndash Eg The driver may beuncertain whether he willarrive home safely withoutbeing arrested by thepolice for drunk driving
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NATURE OF RISK
bull If we recognize that risky changes cannot be beneficialand choose to sit idle but the risky world evolvesaround us will not allow us
bull How can we begin to develop a framework for
managing risk responsiblybull The answer to that question in very broad terms is
that a healthy and responsible risk managementframework that neither lends itself to over-cautionnor to carelessness is a framework that avoids three
basic fallaciesbull If risk management can be implemented without
falling into these three traps the groundwork for ahealthy risk management program has been laid
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CURRICULUM
bull Concept of risk - General
bull Types of risk ndash Case Studies
bull Quantifying risk - Numericals
bull Regulatory and Political risk ndash Global Business set up
bull Production and Operational risk ndash Basics and Case Study
bull IT and Risk Management ndash Role of IT amp MIS
bull Tools for Risk Management ndash Decision Trees Hazop Models QualityTools
bull Risk Governance Structures
bull
Organisational Strategy and Visionbull Internal Control
bull Implementing a risk mgt process
bull Assignment Project
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17
SOURCES OF RISK
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SOURCES OF RISK
TECHNOLOGY
COMPETITION PRODUCTIVITY
MARKETSHARE
PRICES
SOURCESOF
RISK
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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What is Banking
bull Section 5(b) defines banking lsquoAccepting for the
purpose of lending or investment of deposits
or money repayable on demand or otherwiseand withdrawable by cheque draft order or
otherwisersquo
Risk taking is an inherent functionof banking - Allan Greenspan
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Banks get affected by
bull Actions of Central Banks
bull Actions of the Government
bull
Domestic and International Disturbancesbull Inflation
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Deregulation
bull Banks are now operating in a fairly
deregulated environment and are required to
determine on their own interest rates on
deposits and advances
bull Intense competition for business involving
both the assets and liabilities together with
increasing volatility in the interest rates hasbrought pressure on the management of
banks to maintain a good balance among
spreads
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Risks Faced by Banks
bull Credit Risk
bull Market Risk
ndash Liquidity Risk
ndash Interest Rate Risk
bull Operational Risk
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Effects of Risk Factors
bull Loss of Market Value
bull Loss of Reserves
bull
Loss of stakeholders confidence
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WHAT IS RISK
bull Risk is defined asuncertainty concerning theoccurrence of a loss
bull Any event or possibility of
an event which can impaircorporate earnings or cashflow over short medium long term horizon
bull Risk can be defined as the
likelihood of occurrence of an undesirable eventcombined to themagnitude of its impact
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CERTAINITY ~ RISK~ UNCERTAINITY
bull Certainty is the situation where it is known what will
happen and the happening or non happening of an
event carries a 100 probability
bull Risk is the situation where there are a number of specific probable outcomes but it is not certain as
to which one of them will actually happen
bull Uncertainty is where even the probable outcomes
are unknown It reflects a total lack of knowledge of
what may happen
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Types of Risk according to Uncertainty perspective
bull Objective risk (Degree of Risk)
ndash The relative variation of actual loss from expectedloss
ndash Eg Loss of property in afire accident
bull Subjective risk
ndash It is defined as uncertaintybased on a personrsquos mental condition or stateor mind
ndash The impact of subjectiverisk varies depending onthe individual ie differentperception of risk
ndash Eg The driver may beuncertain whether he willarrive home safely withoutbeing arrested by thepolice for drunk driving
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NATURE OF RISK
bull If we recognize that risky changes cannot be beneficialand choose to sit idle but the risky world evolvesaround us will not allow us
bull How can we begin to develop a framework for
managing risk responsiblybull The answer to that question in very broad terms is
that a healthy and responsible risk managementframework that neither lends itself to over-cautionnor to carelessness is a framework that avoids three
basic fallaciesbull If risk management can be implemented without
falling into these three traps the groundwork for ahealthy risk management program has been laid
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CURRICULUM
bull Concept of risk - General
bull Types of risk ndash Case Studies
bull Quantifying risk - Numericals
bull Regulatory and Political risk ndash Global Business set up
bull Production and Operational risk ndash Basics and Case Study
bull IT and Risk Management ndash Role of IT amp MIS
bull Tools for Risk Management ndash Decision Trees Hazop Models QualityTools
bull Risk Governance Structures
bull
Organisational Strategy and Visionbull Internal Control
bull Implementing a risk mgt process
bull Assignment Project
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17
SOURCES OF RISK
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SOURCES OF RISK
TECHNOLOGY
COMPETITION PRODUCTIVITY
MARKETSHARE
PRICES
SOURCESOF
RISK
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Banks get affected by
bull Actions of Central Banks
bull Actions of the Government
bull
Domestic and International Disturbancesbull Inflation
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Deregulation
bull Banks are now operating in a fairly
deregulated environment and are required to
determine on their own interest rates on
deposits and advances
bull Intense competition for business involving
both the assets and liabilities together with
increasing volatility in the interest rates hasbrought pressure on the management of
banks to maintain a good balance among
spreads
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Risks Faced by Banks
bull Credit Risk
bull Market Risk
ndash Liquidity Risk
ndash Interest Rate Risk
bull Operational Risk
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Effects of Risk Factors
bull Loss of Market Value
bull Loss of Reserves
bull
Loss of stakeholders confidence
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WHAT IS RISK
bull Risk is defined asuncertainty concerning theoccurrence of a loss
bull Any event or possibility of
an event which can impaircorporate earnings or cashflow over short medium long term horizon
bull Risk can be defined as the
likelihood of occurrence of an undesirable eventcombined to themagnitude of its impact
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CERTAINITY ~ RISK~ UNCERTAINITY
bull Certainty is the situation where it is known what will
happen and the happening or non happening of an
event carries a 100 probability
bull Risk is the situation where there are a number of specific probable outcomes but it is not certain as
to which one of them will actually happen
bull Uncertainty is where even the probable outcomes
are unknown It reflects a total lack of knowledge of
what may happen
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Types of Risk according to Uncertainty perspective
bull Objective risk (Degree of Risk)
ndash The relative variation of actual loss from expectedloss
ndash Eg Loss of property in afire accident
bull Subjective risk
ndash It is defined as uncertaintybased on a personrsquos mental condition or stateor mind
ndash The impact of subjectiverisk varies depending onthe individual ie differentperception of risk
ndash Eg The driver may beuncertain whether he willarrive home safely withoutbeing arrested by thepolice for drunk driving
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NATURE OF RISK
bull If we recognize that risky changes cannot be beneficialand choose to sit idle but the risky world evolvesaround us will not allow us
bull How can we begin to develop a framework for
managing risk responsiblybull The answer to that question in very broad terms is
that a healthy and responsible risk managementframework that neither lends itself to over-cautionnor to carelessness is a framework that avoids three
basic fallaciesbull If risk management can be implemented without
falling into these three traps the groundwork for ahealthy risk management program has been laid
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CURRICULUM
bull Concept of risk - General
bull Types of risk ndash Case Studies
bull Quantifying risk - Numericals
bull Regulatory and Political risk ndash Global Business set up
bull Production and Operational risk ndash Basics and Case Study
bull IT and Risk Management ndash Role of IT amp MIS
bull Tools for Risk Management ndash Decision Trees Hazop Models QualityTools
bull Risk Governance Structures
bull
Organisational Strategy and Visionbull Internal Control
bull Implementing a risk mgt process
bull Assignment Project
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17
SOURCES OF RISK
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SOURCES OF RISK
TECHNOLOGY
COMPETITION PRODUCTIVITY
MARKETSHARE
PRICES
SOURCESOF
RISK
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Deregulation
bull Banks are now operating in a fairly
deregulated environment and are required to
determine on their own interest rates on
deposits and advances
bull Intense competition for business involving
both the assets and liabilities together with
increasing volatility in the interest rates hasbrought pressure on the management of
banks to maintain a good balance among
spreads
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Risks Faced by Banks
bull Credit Risk
bull Market Risk
ndash Liquidity Risk
ndash Interest Rate Risk
bull Operational Risk
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Effects of Risk Factors
bull Loss of Market Value
bull Loss of Reserves
bull
Loss of stakeholders confidence
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WHAT IS RISK
bull Risk is defined asuncertainty concerning theoccurrence of a loss
bull Any event or possibility of
an event which can impaircorporate earnings or cashflow over short medium long term horizon
bull Risk can be defined as the
likelihood of occurrence of an undesirable eventcombined to themagnitude of its impact
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CERTAINITY ~ RISK~ UNCERTAINITY
bull Certainty is the situation where it is known what will
happen and the happening or non happening of an
event carries a 100 probability
bull Risk is the situation where there are a number of specific probable outcomes but it is not certain as
to which one of them will actually happen
bull Uncertainty is where even the probable outcomes
are unknown It reflects a total lack of knowledge of
what may happen
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Types of Risk according to Uncertainty perspective
bull Objective risk (Degree of Risk)
ndash The relative variation of actual loss from expectedloss
ndash Eg Loss of property in afire accident
bull Subjective risk
ndash It is defined as uncertaintybased on a personrsquos mental condition or stateor mind
ndash The impact of subjectiverisk varies depending onthe individual ie differentperception of risk
ndash Eg The driver may beuncertain whether he willarrive home safely withoutbeing arrested by thepolice for drunk driving
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NATURE OF RISK
bull If we recognize that risky changes cannot be beneficialand choose to sit idle but the risky world evolvesaround us will not allow us
bull How can we begin to develop a framework for
managing risk responsiblybull The answer to that question in very broad terms is
that a healthy and responsible risk managementframework that neither lends itself to over-cautionnor to carelessness is a framework that avoids three
basic fallaciesbull If risk management can be implemented without
falling into these three traps the groundwork for ahealthy risk management program has been laid
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CURRICULUM
bull Concept of risk - General
bull Types of risk ndash Case Studies
bull Quantifying risk - Numericals
bull Regulatory and Political risk ndash Global Business set up
bull Production and Operational risk ndash Basics and Case Study
bull IT and Risk Management ndash Role of IT amp MIS
bull Tools for Risk Management ndash Decision Trees Hazop Models QualityTools
bull Risk Governance Structures
bull
Organisational Strategy and Visionbull Internal Control
bull Implementing a risk mgt process
bull Assignment Project
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17
SOURCES OF RISK
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SOURCES OF RISK
TECHNOLOGY
COMPETITION PRODUCTIVITY
MARKETSHARE
PRICES
SOURCESOF
RISK
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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3202012
Risks Faced by Banks
bull Credit Risk
bull Market Risk
ndash Liquidity Risk
ndash Interest Rate Risk
bull Operational Risk
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3202012
Effects of Risk Factors
bull Loss of Market Value
bull Loss of Reserves
bull
Loss of stakeholders confidence
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WHAT IS RISK
bull Risk is defined asuncertainty concerning theoccurrence of a loss
bull Any event or possibility of
an event which can impaircorporate earnings or cashflow over short medium long term horizon
bull Risk can be defined as the
likelihood of occurrence of an undesirable eventcombined to themagnitude of its impact
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CERTAINITY ~ RISK~ UNCERTAINITY
bull Certainty is the situation where it is known what will
happen and the happening or non happening of an
event carries a 100 probability
bull Risk is the situation where there are a number of specific probable outcomes but it is not certain as
to which one of them will actually happen
bull Uncertainty is where even the probable outcomes
are unknown It reflects a total lack of knowledge of
what may happen
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Types of Risk according to Uncertainty perspective
bull Objective risk (Degree of Risk)
ndash The relative variation of actual loss from expectedloss
ndash Eg Loss of property in afire accident
bull Subjective risk
ndash It is defined as uncertaintybased on a personrsquos mental condition or stateor mind
ndash The impact of subjectiverisk varies depending onthe individual ie differentperception of risk
ndash Eg The driver may beuncertain whether he willarrive home safely withoutbeing arrested by thepolice for drunk driving
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NATURE OF RISK
bull If we recognize that risky changes cannot be beneficialand choose to sit idle but the risky world evolvesaround us will not allow us
bull How can we begin to develop a framework for
managing risk responsiblybull The answer to that question in very broad terms is
that a healthy and responsible risk managementframework that neither lends itself to over-cautionnor to carelessness is a framework that avoids three
basic fallaciesbull If risk management can be implemented without
falling into these three traps the groundwork for ahealthy risk management program has been laid
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CURRICULUM
bull Concept of risk - General
bull Types of risk ndash Case Studies
bull Quantifying risk - Numericals
bull Regulatory and Political risk ndash Global Business set up
bull Production and Operational risk ndash Basics and Case Study
bull IT and Risk Management ndash Role of IT amp MIS
bull Tools for Risk Management ndash Decision Trees Hazop Models QualityTools
bull Risk Governance Structures
bull
Organisational Strategy and Visionbull Internal Control
bull Implementing a risk mgt process
bull Assignment Project
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17
SOURCES OF RISK
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SOURCES OF RISK
TECHNOLOGY
COMPETITION PRODUCTIVITY
MARKETSHARE
PRICES
SOURCESOF
RISK
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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3202012
Effects of Risk Factors
bull Loss of Market Value
bull Loss of Reserves
bull
Loss of stakeholders confidence
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WHAT IS RISK
bull Risk is defined asuncertainty concerning theoccurrence of a loss
bull Any event or possibility of
an event which can impaircorporate earnings or cashflow over short medium long term horizon
bull Risk can be defined as the
likelihood of occurrence of an undesirable eventcombined to themagnitude of its impact
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CERTAINITY ~ RISK~ UNCERTAINITY
bull Certainty is the situation where it is known what will
happen and the happening or non happening of an
event carries a 100 probability
bull Risk is the situation where there are a number of specific probable outcomes but it is not certain as
to which one of them will actually happen
bull Uncertainty is where even the probable outcomes
are unknown It reflects a total lack of knowledge of
what may happen
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Types of Risk according to Uncertainty perspective
bull Objective risk (Degree of Risk)
ndash The relative variation of actual loss from expectedloss
ndash Eg Loss of property in afire accident
bull Subjective risk
ndash It is defined as uncertaintybased on a personrsquos mental condition or stateor mind
ndash The impact of subjectiverisk varies depending onthe individual ie differentperception of risk
ndash Eg The driver may beuncertain whether he willarrive home safely withoutbeing arrested by thepolice for drunk driving
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NATURE OF RISK
bull If we recognize that risky changes cannot be beneficialand choose to sit idle but the risky world evolvesaround us will not allow us
bull How can we begin to develop a framework for
managing risk responsiblybull The answer to that question in very broad terms is
that a healthy and responsible risk managementframework that neither lends itself to over-cautionnor to carelessness is a framework that avoids three
basic fallaciesbull If risk management can be implemented without
falling into these three traps the groundwork for ahealthy risk management program has been laid
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CURRICULUM
bull Concept of risk - General
bull Types of risk ndash Case Studies
bull Quantifying risk - Numericals
bull Regulatory and Political risk ndash Global Business set up
bull Production and Operational risk ndash Basics and Case Study
bull IT and Risk Management ndash Role of IT amp MIS
bull Tools for Risk Management ndash Decision Trees Hazop Models QualityTools
bull Risk Governance Structures
bull
Organisational Strategy and Visionbull Internal Control
bull Implementing a risk mgt process
bull Assignment Project
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17
SOURCES OF RISK
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SOURCES OF RISK
TECHNOLOGY
COMPETITION PRODUCTIVITY
MARKETSHARE
PRICES
SOURCESOF
RISK
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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WHAT IS RISK
bull Risk is defined asuncertainty concerning theoccurrence of a loss
bull Any event or possibility of
an event which can impaircorporate earnings or cashflow over short medium long term horizon
bull Risk can be defined as the
likelihood of occurrence of an undesirable eventcombined to themagnitude of its impact
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CERTAINITY ~ RISK~ UNCERTAINITY
bull Certainty is the situation where it is known what will
happen and the happening or non happening of an
event carries a 100 probability
bull Risk is the situation where there are a number of specific probable outcomes but it is not certain as
to which one of them will actually happen
bull Uncertainty is where even the probable outcomes
are unknown It reflects a total lack of knowledge of
what may happen
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Types of Risk according to Uncertainty perspective
bull Objective risk (Degree of Risk)
ndash The relative variation of actual loss from expectedloss
ndash Eg Loss of property in afire accident
bull Subjective risk
ndash It is defined as uncertaintybased on a personrsquos mental condition or stateor mind
ndash The impact of subjectiverisk varies depending onthe individual ie differentperception of risk
ndash Eg The driver may beuncertain whether he willarrive home safely withoutbeing arrested by thepolice for drunk driving
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NATURE OF RISK
bull If we recognize that risky changes cannot be beneficialand choose to sit idle but the risky world evolvesaround us will not allow us
bull How can we begin to develop a framework for
managing risk responsiblybull The answer to that question in very broad terms is
that a healthy and responsible risk managementframework that neither lends itself to over-cautionnor to carelessness is a framework that avoids three
basic fallaciesbull If risk management can be implemented without
falling into these three traps the groundwork for ahealthy risk management program has been laid
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CURRICULUM
bull Concept of risk - General
bull Types of risk ndash Case Studies
bull Quantifying risk - Numericals
bull Regulatory and Political risk ndash Global Business set up
bull Production and Operational risk ndash Basics and Case Study
bull IT and Risk Management ndash Role of IT amp MIS
bull Tools for Risk Management ndash Decision Trees Hazop Models QualityTools
bull Risk Governance Structures
bull
Organisational Strategy and Visionbull Internal Control
bull Implementing a risk mgt process
bull Assignment Project
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17
SOURCES OF RISK
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SOURCES OF RISK
TECHNOLOGY
COMPETITION PRODUCTIVITY
MARKETSHARE
PRICES
SOURCESOF
RISK
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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CERTAINITY ~ RISK~ UNCERTAINITY
bull Certainty is the situation where it is known what will
happen and the happening or non happening of an
event carries a 100 probability
bull Risk is the situation where there are a number of specific probable outcomes but it is not certain as
to which one of them will actually happen
bull Uncertainty is where even the probable outcomes
are unknown It reflects a total lack of knowledge of
what may happen
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Types of Risk according to Uncertainty perspective
bull Objective risk (Degree of Risk)
ndash The relative variation of actual loss from expectedloss
ndash Eg Loss of property in afire accident
bull Subjective risk
ndash It is defined as uncertaintybased on a personrsquos mental condition or stateor mind
ndash The impact of subjectiverisk varies depending onthe individual ie differentperception of risk
ndash Eg The driver may beuncertain whether he willarrive home safely withoutbeing arrested by thepolice for drunk driving
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NATURE OF RISK
bull If we recognize that risky changes cannot be beneficialand choose to sit idle but the risky world evolvesaround us will not allow us
bull How can we begin to develop a framework for
managing risk responsiblybull The answer to that question in very broad terms is
that a healthy and responsible risk managementframework that neither lends itself to over-cautionnor to carelessness is a framework that avoids three
basic fallaciesbull If risk management can be implemented without
falling into these three traps the groundwork for ahealthy risk management program has been laid
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CURRICULUM
bull Concept of risk - General
bull Types of risk ndash Case Studies
bull Quantifying risk - Numericals
bull Regulatory and Political risk ndash Global Business set up
bull Production and Operational risk ndash Basics and Case Study
bull IT and Risk Management ndash Role of IT amp MIS
bull Tools for Risk Management ndash Decision Trees Hazop Models QualityTools
bull Risk Governance Structures
bull
Organisational Strategy and Visionbull Internal Control
bull Implementing a risk mgt process
bull Assignment Project
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17
SOURCES OF RISK
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SOURCES OF RISK
TECHNOLOGY
COMPETITION PRODUCTIVITY
MARKETSHARE
PRICES
SOURCESOF
RISK
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Types of Risk according to Uncertainty perspective
bull Objective risk (Degree of Risk)
ndash The relative variation of actual loss from expectedloss
ndash Eg Loss of property in afire accident
bull Subjective risk
ndash It is defined as uncertaintybased on a personrsquos mental condition or stateor mind
ndash The impact of subjectiverisk varies depending onthe individual ie differentperception of risk
ndash Eg The driver may beuncertain whether he willarrive home safely withoutbeing arrested by thepolice for drunk driving
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NATURE OF RISK
bull If we recognize that risky changes cannot be beneficialand choose to sit idle but the risky world evolvesaround us will not allow us
bull How can we begin to develop a framework for
managing risk responsiblybull The answer to that question in very broad terms is
that a healthy and responsible risk managementframework that neither lends itself to over-cautionnor to carelessness is a framework that avoids three
basic fallaciesbull If risk management can be implemented without
falling into these three traps the groundwork for ahealthy risk management program has been laid
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CURRICULUM
bull Concept of risk - General
bull Types of risk ndash Case Studies
bull Quantifying risk - Numericals
bull Regulatory and Political risk ndash Global Business set up
bull Production and Operational risk ndash Basics and Case Study
bull IT and Risk Management ndash Role of IT amp MIS
bull Tools for Risk Management ndash Decision Trees Hazop Models QualityTools
bull Risk Governance Structures
bull
Organisational Strategy and Visionbull Internal Control
bull Implementing a risk mgt process
bull Assignment Project
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17
SOURCES OF RISK
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SOURCES OF RISK
TECHNOLOGY
COMPETITION PRODUCTIVITY
MARKETSHARE
PRICES
SOURCESOF
RISK
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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NATURE OF RISK
bull If we recognize that risky changes cannot be beneficialand choose to sit idle but the risky world evolvesaround us will not allow us
bull How can we begin to develop a framework for
managing risk responsiblybull The answer to that question in very broad terms is
that a healthy and responsible risk managementframework that neither lends itself to over-cautionnor to carelessness is a framework that avoids three
basic fallaciesbull If risk management can be implemented without
falling into these three traps the groundwork for ahealthy risk management program has been laid
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CURRICULUM
bull Concept of risk - General
bull Types of risk ndash Case Studies
bull Quantifying risk - Numericals
bull Regulatory and Political risk ndash Global Business set up
bull Production and Operational risk ndash Basics and Case Study
bull IT and Risk Management ndash Role of IT amp MIS
bull Tools for Risk Management ndash Decision Trees Hazop Models QualityTools
bull Risk Governance Structures
bull
Organisational Strategy and Visionbull Internal Control
bull Implementing a risk mgt process
bull Assignment Project
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17
SOURCES OF RISK
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SOURCES OF RISK
TECHNOLOGY
COMPETITION PRODUCTIVITY
MARKETSHARE
PRICES
SOURCESOF
RISK
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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CURRICULUM
bull Concept of risk - General
bull Types of risk ndash Case Studies
bull Quantifying risk - Numericals
bull Regulatory and Political risk ndash Global Business set up
bull Production and Operational risk ndash Basics and Case Study
bull IT and Risk Management ndash Role of IT amp MIS
bull Tools for Risk Management ndash Decision Trees Hazop Models QualityTools
bull Risk Governance Structures
bull
Organisational Strategy and Visionbull Internal Control
bull Implementing a risk mgt process
bull Assignment Project
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17
SOURCES OF RISK
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SOURCES OF RISK
TECHNOLOGY
COMPETITION PRODUCTIVITY
MARKETSHARE
PRICES
SOURCESOF
RISK
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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17
SOURCES OF RISK
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SOURCES OF RISK
TECHNOLOGY
COMPETITION PRODUCTIVITY
MARKETSHARE
PRICES
SOURCESOF
RISK
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22
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23
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24
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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SOURCES OF RISK
TECHNOLOGY
COMPETITION PRODUCTIVITY
MARKETSHARE
PRICES
SOURCESOF
RISK
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22
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23
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24
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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20
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22
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23
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24
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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21
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22
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23
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24
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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22
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23
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24
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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23
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24
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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24
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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TYPES OF RISK
bull From functional perspective
ndash Credit risk
ndash Market risk
ndashOperational risk
ndash Other risks
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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bull It is risk to each partyof a contract that theother will not live upto its contractualobligations In most of financial contracts thisrisk is known asDefault Risk
bull Credit risk is of twotypes ndash Pre settlement risk
ndashSettlement risk
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Pre settlement and Settlement Risk
bull Pre-settlement risk is the bankruptcy of
the counterparty prior to settlement
bull Settlement risk arises with respect to the
settlement of a transaction The risk issuch a situation is that one party may
perform its obligations while the other
does not ndash CASE STUDY
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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KALYANI
bull It was the afternoon of 26 June 1974 and the Bank had received allits foreign currency receipts in Europe but had not made any of itsUS Dollar Payments
bull
This position continued till the end of the business day whenGerman banking regulators closed the bank due to insolvency
bull As a result the counterparties were left holding unsecured claimsagainst the bankrupt bankrsquos assets
bull BASEL COMMITTEE states that this risk arises when a counter partypays the currency it sold but does not receive the currency it bought
bull According to the consultative paper issued by the BASEL Committeeon Banking Supervision 1999 foreign exchange settlement failurescan arise from Counterparty Default operational problems andmarket liquidity constraints among other factors
bull Foreign exchange settlement risk clearly has a credit risk dimension
If a bank cannot make the payment of the currency it soldconditional upon its final receipt of the currency it bought it facesthe possibility of losing the entire principal value of the transaction
CASE STUDY GERMAN HERSTATT BANK
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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bull It is the risk of fluctuations in portfolio value becauseof movements in suchvariables
bull
It is the risk of losses dueto movements in financialmarket variables ieInterest rates foreignexchange rates security
prices etc
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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CASE STUDY BARINGS BANKbullIt is a British merchant bank
bullThe bank was expecting that the Japanese stock market index
Nikkei would rise if they take position in buying futures
bullThe bank took position of around $8 billion
bullHowever because of a number of reasons and earthquake at
Kobe Nikkei crashed resulting in a $12 billion losses to bank in a
monthrsquos time which exceeded bankrsquos own net worth
bullThe movement of prices or market index is sometimes driven by
some events and this is called Event Risk
20032012 30
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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TYPES OF MARKET RISK
bull Price risk
bull Forex risk
bull
Country riskbull Liquidity risk
bull Interest rate risk
bullTechnology risk
P i Ri k
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Price Riskbull The possibility of not realizing the expected price
may be called the Price Risk
ndash Eg The problem most of the farmers are facingbull Types of price risk
ndash Symmetrical Vs Unsymmetrical
ndash Absolute Vs relative
ndash Asset liquidity
ndash Discontinuity and event
ndash Concentration
ndash Credit spread
ndash Volatility risk
ndash Systemic risk ndash Systematic risk Vs unsystematic risk
S t i l V U t i l
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Symmetrical Vs Unsymmetrical
bull Symmetrical implies that the movement of an
asset price in either direction leads to acorresponding impact on the position value
bull In Unsymmetrical risk the impact is unequal
ndash Eg Consider an institution holding an equitysecurity in its portfolio An increase or decrease
in the price of an equal dimension would result
in corresponding change in the value of the
position held by the institution multiplied by the
number of securities held
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Absolute Risk Vs Relative Risk
bull Absolute risk is measured with reference to
the initial investmentbull Relative risk is measured relative to the
benchmark index
ndash Eg an investment of Rs100000 may decline in
value to Rs95000 as a result of fall in prices
ndash There is an absolute negative return of 5
ndash If the index during this period has dropped by
10 the relative return on the instrument isbetter compared to the return on the index
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Discontinuity and Event Riskbull Discontinuity implies a large movement that occurs
over a small time interval and potentially create alarge loss
bull It is very difficult to establish the probability of discontinuity
bullThis may be a result of an observable political orgovernment policy wars devaluation etc
ndash Eg after 11 September 2001 the stock markets allaround the world witnessed a fall
ndash
On 17 May 2002 there was a significant fall in the IndianStock Markets in anticipation of a change in theGovernment
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Asset liquidity Risk
bull In case of assets which are not very liquid it
may not be possible to execute a large
transaction at the market price
bull Trying to do so can result in a high cost ie a
sharp and unfavorable movement in shareprice
ndash Eg A large sale order could quickly dampen the
price which is not in the sellerrsquos interest
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Concentration Risk
bull Lack of diversification leads to concentration
risk
bull This risk arises out of a very large exposure to
a particular company industry geographic
region or market
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Credit Spread Risk
bull Credit Spread is the difference between the
yield on corporate bonds and treasury bonds
bull Credit spread risk is the risk that yields on
duration matched credit sensitive bonds and
treasury bonds could move differently
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Volatility Risk
bull Volatility refers to the degree of
unpredictable change in a financial variable
over a period of time
bull It results not from changes in levels of prices
but their volatility
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Systemic Risk
bull It can arise in the context of a failure of a
major market system or institution
sometimes called the ldquoDomino Effectrdquo which
has an adverse impact on several otherinstitutions
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Systematic Risk Vs Unsystematic Risk
bull It is called an Undiversifiable risk since it is
inherent to any security in a particular market
ndash Economic Political and Social Risk
bull Unsystematic risk are diversifiable risk which
is unique to a firm
ndash Management problem labour problem etc
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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20032012 KALYANI 50
RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Forex Risk
bull The risk of an investments value changing
due to changes in currency exchange rates
bull It is also known as currency risk or
exchange-rate risk
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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20032012 60
STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Country risk
bull It is also known as sovereign risk
bull When a domestic banking institution may
transform itself into an international one
when it starts lending across its borders or
invests in instruments issued by foreign
organizations the first risk that it encounters
is country risk
CASE STUDY
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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CASE STUDYbullIn early 80s Brazilian and Mexican Governments announced debt
repayment moratorium(CEASE) which delayed debt repayment to
the lenders of USbullAt that period exposure of US banks to these countryrsquos FIs and
government was huge and they suffered heavy losses
bullThe Citigroup alone had to provide $3 billion to cover expected
losses
bullThe same situation was also encountered by US Japanese and
European banks in early 90 in their exposure to country like
Indonesia and Russia
bullIn the year 2001 Argentina also defaulted $130 billion ingovernment issued debt because of an overvalued peso
20032012 44
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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20032012 88
No
Risk hellip
No
Gain
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Liquidity Risk
LIQUDITY RISK
FUNDING RISKASSET LIQUIDITY
RISK
It is the inability to raise fundsat normal cost
It is the lack of trading depth in the marketfor a security or class of assets
822019 Isbm - 1- Introduction to Risk Management
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20032012 46
Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
822019 Isbm - 1- Introduction to Risk Management
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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20032012 48
Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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20032012 49
bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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20032012 KALYANI 50
RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Interest rate risk
bull Interest rate risk is the risk (variability in
value) borne by an interest-bearing asset
such as a loan or a bond due to variability of
interest rates
IMPACT OF INTEREST RATE INCREASE AND
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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20032012 55
WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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20032012 56
Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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20032012 60
STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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IMPACT OF INTEREST RATE INCREASE AND
DECLINE ON FIrsquoS PROFITABILITY
bullSuppose a Bank borrows Rs100 crores from the market for 2 years 10 pa and creates an asset of the same amount for 5 yearrsquos
period 12 pa
bullThis mismatch between the two is quite visible
bullProfitability of bank per year = 100 2 = 2 croresbullIn case there is an upward trend of interest rate after 2 years and
the cost of liability goes upto 13 the bank will post a loss of rs 1
crore
bullIf the movement in interest rate is downward and comes down to8 for liability bankrsquos profit wil increase from Rs2 crores to Rs 4
crores
20032012 47
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
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20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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Technology Risk
bull Technology needs a lot of money time and
effort in order to be implemented
bull If the system implementation is too slow or
the performance is ineffective the risk is that
the entire investment may not result in
adequate repayment
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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bull It could risk if procedures are not properlydocumented and examinedfor robustness
bull The controls built into
these procedures also haveto be properly examined toensure that errors are notinadvertently incorporatedin processing
bull
Operational risk isreasonably significant incommercial andinvestment banks wealthmanagement businesses
RISK FACTORS
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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20032012 56
Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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20032012 58
bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
822019 Isbm - 1- Introduction to Risk Management
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20032012 60
STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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20032012 63
3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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RISK FACTORS
bullAccounting errorbullCapacity riskbullContract risk
bullMisspelling suitabilitybullProduct complexitybull
Project riskbullReporting error
bullSettlement Payment errorbullTransaction errorbullValuation error
bullEmployee collusion and Fraud
bullEmployee errorbullEmployee misdeedbullEmployers liability
bullEmployment lawbullHealth and safetybullIndustrial actionbullLack of knowledge and skillsbullLoss of key personnel
bullData qualitybullProgramming errorsbullSecurity breach
bullStrategic risksbullSystem capacitybull
System compatibilitybullSystem delivery
bullSystem failurebullSystem suitability
INTERNAL RISK FACTORS
PEOPLE SYSTEMSPROCESSES
EXTERNAL RISK FACTORS
bullLegal
bullMoney launderingbullOutsourcingbullPoliticalbullRegulatory
bullSupplier riskbullTax
bullFirebullNatural disasterbullPhysical securitybullTerrorism
bullTheft
EXTERNAL PHYSICAL
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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20032012 67
RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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20032012 69
RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
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20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
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20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
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20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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bull Off balance sheet risk ndash In additional to assets and liabilities recognized on a firmrsquos
balance sheet there are transactions that do not give rise to anyasset or liability at present but could do so in the future Theseare off balance sheet items
ndash Eg a letter of credit issued on behalf of a customer sometimes banks alsooffer underwriting facilities for issue of stocks and bonds In such casesthere is no liability at that time for the bank
ndash In case of default by the customer or under subscription of stocks and bondsthe bank is required to pay up or subscribe to the undersubscribed portion
bull
Regulatory risk ndash Compliance with regulatory requirements is critical for the long
term survival
ndash Non compliance can expose an organization to reputation riskarising out of structures passed by the regulators or fines orpenalties levied by them or suspensions or cancellations of
licenses ordered by them in extreme cases
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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bull There is a major risk
that a financial services
product may become
absolute oruncompetitive
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
822019 Isbm - 1- Introduction to Risk Management
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20032012 60
STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
822019 Isbm - 1- Introduction to Risk Management
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20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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bull The capital market risk usually defines the risk involved in
the investmentsbull The stark potential of experiencing losses following a
fluctuation in security prices is the reason behind the capitalmarket risk
bull The capital market risk cannot be diversified
bull The capital market risk can also be referred to as the capitalmarket systematic risk
bull While an individual is investing on a security the risk andreturn cannot be separated
bull The risk is the integrated part of the investment
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
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4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
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RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
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s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
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RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
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bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
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RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
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Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
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Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
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Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
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An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
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y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
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20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
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3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
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4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
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6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
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Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
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Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
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Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
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No
Risk hellip
No
Gain
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WHAT IS RISK MANAGEMENT
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
822019 Isbm - 1- Introduction to Risk Management
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20032012 56
Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
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NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
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bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
822019 Isbm - 1- Introduction to Risk Management
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20032012 60
STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
822019 Isbm - 1- Introduction to Risk Management
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20032012 63
3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
822019 Isbm - 1- Introduction to Risk Management
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20032012 65
4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
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RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
822019 Isbm - 1- Introduction to Risk Management
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20032012 67
RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
822019 Isbm - 1- Introduction to Risk Management
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20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
822019 Isbm - 1- Introduction to Risk Management
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20032012 69
RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
822019 Isbm - 1- Introduction to Risk Management
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20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7189
20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
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20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
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20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
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20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
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20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
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20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
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20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
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5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
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20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
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CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
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20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
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20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
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20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
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86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
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Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
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20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
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WHAT IS RISK MANAGEMENT
bull Risk Management is the ndash identification assessment and prioritization of risks ndash followed by coordinated and economical application of resources
ndash to minimize monitor and control the probability andor impact of unfortunate events
bull It can also be defined as a process that identifies loss
exposures faced by an organization and selects the mostappropriate technique for treating such exposures
bull Risk Management is the name given to a logical andsystematic method of identifying analyzing treating andmonitoring the risks involved in any activity or process
822019 Isbm - 1- Introduction to Risk Management
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Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
822019 Isbm - 1- Introduction to Risk Management
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20032012 57
NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
822019 Isbm - 1- Introduction to Risk Management
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20032012 58
bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
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OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
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STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
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1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
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2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
822019 Isbm - 1- Introduction to Risk Management
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3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
822019 Isbm - 1- Introduction to Risk Management
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It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
822019 Isbm - 1- Introduction to Risk Management
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20032012 65
4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
822019 Isbm - 1- Introduction to Risk Management
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20032012 66
RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
822019 Isbm - 1- Introduction to Risk Management
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20032012 67
RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
822019 Isbm - 1- Introduction to Risk Management
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20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6989
20032012 69
RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7089
20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7189
20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
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20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
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20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
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20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
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20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
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20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
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20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
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822019 Isbm - 1- Introduction to Risk Management
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20032012 56
Risk Managementpractices are widely usedin public and the private
sectors covering a widerange of activities oroperations
These include
Who uses Risk Management
bull Finance andInvestment
bull
Insurancebull Health Care
bull Public
Institutionsbull Governments
NEED FOR RISK MANAGEMENT
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 5789
20032012 57
NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
822019 Isbm - 1- Introduction to Risk Management
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20032012 58
bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
822019 Isbm - 1- Introduction to Risk Management
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20032012 59
OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6089
20032012 60
STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6189
20032012 61
1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6289
20032012 62
2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6389
20032012 63
3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6489
20032012 64
It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6589
20032012 65
4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
822019 Isbm - 1- Introduction to Risk Management
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20032012 66
RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6789
20032012 67
RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6889
20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6989
20032012 69
RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7089
20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7189
20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7389
20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
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20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
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20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
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20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
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20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
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822019 Isbm - 1- Introduction to Risk Management
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20032012 57
NEED FOR RISK MANAGEMENT
bull Globalization
bull Share holders wealth maximization
bull Risk have to be managed effectively and on the otheradequate returns have to be ensured
bull An impact on one institution can have a fallout for otherinstitutions in the market
bull Separation of ownership and management
bull Growing no of transactions and complexity of products
bull
Increased volatility around the world
SEBI AND RISK MANAGEMENT
822019 Isbm - 1- Introduction to Risk Management
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20032012 58
bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
822019 Isbm - 1- Introduction to Risk Management
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20032012 59
OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6089
20032012 60
STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6189
20032012 61
1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6289
20032012 62
2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6389
20032012 63
3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6489
20032012 64
It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6589
20032012 65
4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6689
20032012 66
RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6789
20032012 67
RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6889
20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6989
20032012 69
RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7089
20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7189
20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7389
20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
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822019 Isbm - 1- Introduction to Risk Management
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20032012 58
bull According to Clause 49-IV of the listing agreement of the SEBI
ndash The company shall lay down procedures to inform the Boardmembers about the risk assessment and minimizationprocedures These procedures shall be periodically reviewedto ensure that executive management controls risk throughmeans of a properly defined framework
ndash The CEO and CFO have to certify to the Board that they haveevaluated the effectiveness of internal controls and they havedisclosed to the auditors and audit committee deficiencies in
the design or operation of internal controls if any of whichthey are aware and the steps they have taken or propose totake to rectify these
ndash Among the information to be placed before the Board
bull Quarterly details of forex exposures and the steps taken bymanagement to limit the risks of adverse exchange rate
movement if material
OBJECTIVES OF RISK MANAGEMENT
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 5989
20032012 59
OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6089
20032012 60
STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6189
20032012 61
1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6289
20032012 62
2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6389
20032012 63
3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6489
20032012 64
It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6589
20032012 65
4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6689
20032012 66
RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6789
20032012 67
RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6889
20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6989
20032012 69
RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7089
20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7189
20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7389
20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 5989
20032012 59
OBJECTIVES OF RISK MANAGEMENT
bull Brings order and system to the process of riskquantification
bull Enables the assigning of value to estimated risk of loss
bull Flags extreme risky situations for necessary mitigateaction by management
bull Improves risk awareness when it is actively courtedby the company
bull Results in increased valuation and reduced cost of capital
bull
More objective performance appraisal based on riskadjusted capital employed
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6089
20032012 60
STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6189
20032012 61
1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6289
20032012 62
2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6389
20032012 63
3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6489
20032012 64
It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6589
20032012 65
4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6689
20032012 66
RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6789
20032012 67
RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6889
20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6989
20032012 69
RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7089
20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7189
20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7389
20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6089
20032012 60
STEPS IN RISK MANAGEMENT PROCESS
Identify loss exposures
Analyze the loss exposures
Implement and monitor the RiskManagement Program
Select the appropriate techniques for treating the loss exposures1 Risk control 2 Risk Financingbull Avoidance Retentionbull Loss prevention Non Insurance transfersbull Loss reduction Commercial Insurance
1 Id if L E
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6189
20032012 61
1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6289
20032012 62
2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6389
20032012 63
3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6489
20032012 64
It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6589
20032012 65
4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6689
20032012 66
RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6789
20032012 67
RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6889
20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6989
20032012 69
RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7089
20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7189
20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7389
20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6189
20032012 61
1 Identify Loss Exposures
bull Property loss exposures
bull Liability loss exposures
bull Business income loss exposures
bull Human resources loss exposures
bull Crime loss exposures
bull Employee benefit loss exposures
bullForeign loss exposures
bull Reputation and public image of the company
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6289
20032012 62
2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6389
20032012 63
3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6489
20032012 64
It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6589
20032012 65
4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6689
20032012 66
RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6789
20032012 67
RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6889
20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6989
20032012 69
RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7089
20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7189
20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7389
20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6289
20032012 62
2 Analyze the loss exposure
bull Estimation of frequency and severity of loss
ndash Loss frequency refers to the probable number of
losses that may occur during some given time
period ndash Severity refers to the probable size of the losses
that may occur
3 Select appropriate techniques for
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6389
20032012 63
3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6489
20032012 64
It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6589
20032012 65
4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6689
20032012 66
RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6789
20032012 67
RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6889
20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6989
20032012 69
RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7089
20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7189
20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7389
20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6389
20032012 63
3 Select appropriate techniques for
treating the loss exposure
bull Risk control
ndash Risk control refers to
techniques that reduce
the frequency and
severity of lossesbull Avoidance
bull Loss prevention
bull Loss reduction
bull Risk Financing
ndash It refers to techniques
that provide for the
funding of losses
bull Retention
bull Non insurance transfers
bull Commercial insurance
bull AVOIDANCEndash It refers to not holding such an assetliability as a means of avoiding the risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6489
20032012 64
It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6589
20032012 65
4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6689
20032012 66
RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6789
20032012 67
RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6889
20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6989
20032012 69
RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7089
20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7189
20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7389
20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6489
20032012 64
It refers to not holding such an assetliability as a means of avoiding the risk
ndash Eg Exchange risk
bull LOSS CONTROL ndash They have been assumed either voluntarily or because they could not be avoided
ndash Objective of these measures is either to prevent a loss or to reduce the probability of loss
ndash Eg Insurance
ndash Raising funds through floating rate bearing instruments
bull SEPARATION ndash Avoiding loss by disbursement of assets in different locations
ndash Diversification
ndash Storage (hard and soft) etc
bull COMBINATION ndash Diversification
ndash Purchasing materials from multiple suppliersbull TRANSFER
ndash Risk can be transferred by transferring the assetliability itself bull Holding a Real Estate or Foreign exchange
ndash Transferring the risk without transferring the assetliabilitybull Leasing or currency swap
ndash Making a third party for the losses without actually transferring the riskbull Insurance policy
4 Implement and Monitor the Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6589
20032012 65
4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6689
20032012 66
RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6789
20032012 67
RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6889
20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6989
20032012 69
RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7089
20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7189
20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7389
20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6589
20032012 65
4 Implement and Monitor the Risk
Management Program
bull Risk management policy statement
bull Risk management manual
RISK MANAGEMENT MATRIX
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6689
20032012 66
RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6789
20032012 67
RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6889
20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6989
20032012 69
RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7089
20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7189
20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7389
20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6689
20032012 66
RISK MANAGEMENT MATRIX
TYPE OF LOSS LOSS
FREQUENCY
LOSS
SEVERITY
APPROPRIATE
RISK
MANAGEMENT
TECHNIQUE
1 LOW LOW RETENTION
2 HIGH LOW LOSS PREVENTION
AND RETENTION
3 LOW HIGH INSURANCE
4 HIGH HIGH AVOIDANCE
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6789
20032012 67
RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6889
20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6989
20032012 69
RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7089
20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7189
20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7389
20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6789
20032012 67
RISK MANAGEMENT APPROACHES
bull The goal of risk management is not to
eliminate risk but to ensure that risk remains
at a predetermined level of acceptability
bull Risk and reward often go together
Higher expectations
Of rewards
Higher level of risk Higher returns
Approac es to Ris Management
bull Risk avoidance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6889
20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6989
20032012 69
RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7089
20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7189
20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7389
20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6889
20032012 KALYANI 68
s a o da ce
bull Loss control
ndash It is an attempt to reduce either the possibility of a loss or the quantum of loss
ndash Lending floating rate ndash Investing floating rate
bull Combination ndash Combining more than one business activity in order to reduce the overall risk of the firm
ndash WIPRO
bull Separation
bull Risk transfer
bullRisk retention ndash Risk is retained when nothing is done to avoid reduce or transfer it
ndash It may be retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques
bull Risk sharing
ndash It is a combination of Risk Retention and Risk Transfer
ndash A particular risk is managed by retaining a part of it and transferring the rest to a party willing
to bear it
ndash Eg a firm and its supplier may enter into an agreement whereby if the market price of the
commodity exceeds a certain price in the future the seller foregoes a part of the benefit in
favor of the firm and if the future market price is lower than predetermined price the firm
passes on a part of the benefit to the seller
RISK MANAGEMENT TOOLS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6989
20032012 69
RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7089
20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7189
20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7389
20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 6989
20032012 69
RISK MANAGEMENT TOOLS
bull Risk management information systems (RIMS)
bull Risk management intranets and Websites
bull Risk maps
bull
Value at Risk (VaR) analysisbull Hedging
bull Derivatives
bull Hybrid debt securities ndash Convertible bonds
ndash Floating rate Notes
RMIS
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7089
20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7189
20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7389
20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7089
20032012 70
bull It is a computerized
database that permits the
risk manager to store andanalyze risk management
data and to use such data
to predict and attempt to
control future loss levels
bull It is useful for
ndash Decision making
ndash Property exposures
ndash
Listing of claims ndash Tracking employees
RISK MANAGEMENT INTRANETS AND WEB SITES
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7189
20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7389
20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7189
20032012 71
RISK MANAGEMENT INTRANETS AND WEB SITES
bull Departments can establish
websites which includes
FAQs and a wealth of other
information
bull An intranet is a website
with search capabilities
designed for a limitedinternal audience
bull Through intranet
employees can obtain a list
of procedures to follow
Risk Maps
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7389
20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7289
20032012 72
Risk Mapsbull Risk maps are grids
detailing the potentialfrequency and severity of risks faced by theorganization
bull It requires risk managers toanalyze each risk that theorganization faces before
plotting it on the mapbull Use of risk maps varies
from simply graphing theexposures to employingsimulation analysis to
estimate likely lossscenarios
Value at Risk Analysis (VaR)
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7389
20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7389
20032012 73
Value at Risk Analysis (VaR)
bull It is the worst probable
loss likely to occur in agiven time periodunder regular marketconditions at some
level of confidencebull Based on VaR estimate
the risk level could beincreased or
decreased dependingon risk tolerance
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7489
20032012 74
Hedging
bull It means identifying two exactly correlatedassets as far as returns are concerned
bull One can hedge the risk by buying one of the
assets while simultaneously selling the others
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7589
20032012 75
An Integrated Approach toCorporate Risk Management- Why Total Risk Matters
Why Total Risk Matters
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7689
20032012 76
y
1The adverse incentive problem
bull
Managers are more likely to choose high riskinvestments that benefit the share holders at the
expense of debenture holders
bull They have a tendency to exit promising lines of
business or liquidate the entire firm when they havewould otherwise continue to operate
bull They may have an incentive to produce goods of
inferior quality and provide a less safe work
environment for their employees
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7789
20032012 77
2 The Effect on Sales
bull The incentive of companies in financialdistress to produce lower quality products will
scare off potential customers
bull Risky firms become victims of lost consumerconfidence
bull Customers arenrsquot as willing to do business
with a firm that might be going out of business
ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7889
20032012 78
3The effect on operating costs
bull The value of investing in a long term relationshipwith a customer will depend on whether the
customer is expected to survive in the long run
bull
The lower the likelihood of future survival the moreof these relationship costs the customer will have to
bear up front in the form of higher prices or less
closely tailored services and products
bull Lower risk firms also have an easier time attractingand retaining good personnel
h ff f
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 7989
20032012 79
4The effect on financing cost
bull A company that expects to remain in businesswill generally be very protective of its creditreputation
bull
The value of a good credit reputationhowever is lower for firms that may notsurvive to reap the long run benefits
bull Such firms have an incentive to borrow money
under false pretenses and mistreat creditors inorder to dealy the onset of bankruptcy
h bl f k
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8089
20032012 80
5 The problem of risk aversion
bull
A temporary increase in risk can do permanentdamage to the firm if some stakeholders leave inresponse to their perception of added personal risk
bull In order to reconstitute the organization the firm
must bear a variety of fixed costs associated withreplacing those risk averse stakeholders
bull Eg Costs of hiring and training new managerssalespeople and other employees adding new
distributors and finding new suppliers reduce thevalue of the firm as an ongoing entity
6 ff
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8189
20032012 81
6 Tax Effects
bull As the variability of operating profitsincreases so does the probability that a firm
will be unable to make full use of its tax
credits and depreciation and interest expensetax deductions
bull An increase in total risk will lead to a
reduction in expected corporate cash flows
CHARACTERISTICS OF FIRMS WITH
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8289
20032012 82
CHARACTERISTICS OF FIRMS WITH
HIGH COSTS OF FINANCIAL RISK
bull Industry specific factors
bull Firm specific factors
I d S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8389
20032012 83
Industry Specific Factors
bull Products that require repairsbull Goods or services whose quality is an
important attribute but is difficult to
determine in advancebull Products for which there are switching costs
bull Products whose value to customers dependson the services amp complementary productssupplied by independent co`s
Fi S ifi F
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8489
20032012 84
Firm Specific Factors
bull High growth opportunities
bull Substantial organizational assets
bull Large excess tax deductions
Methods of Reducing Total Risk
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8589
20032012 85
Methods of Reducing Total Riskbull Restricting the Debt- Equity ratio
bull Futures amp Forwards contractsbull Insurance
bull Avoiding high risk projects
bull
Reducing degree of operating leveragebull Merger with a larger more financially stable firm
bull Product compatibility
bull
Off-the-shelf componentsbull Training programs
bull USING MANUFACTURERS REPRESENTATIVES
Characteristics of Firms with High Cost
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8689
86
g
of Financial Risk
bull INDUSTRY SPECIFIC
bull FIRM SPECIFIC
To Summarise hellip
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8789
20032012 87
Effective Management Risk benefits hellip
bull Efficient allocation of capital to exploit different risk
reward pattern across business
bull Better Product Pricing
bull Early warning signals on potential events impactingbusiness
bull Reduced earnings Volatility
bull
Increased Shareholder Value
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8889
20032012 88
No
Risk hellip
No
Gain
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
822019 Isbm - 1- Introduction to Risk Management
httpslidepdfcomreaderfullisbm-1-introduction-to-risk-management 8989
