Introduction to Financial Risk Management

Learning Objectives
• Understand the meaning of risk and risk management.

• Understand the importance, benefits and the practice of risk

management

• Understand different types of risks faced by business firms.

• Understand the importance of Integrated Risk Management at the

enterprise level (Enterprise Risk Management)

• Understand the steps involved in the process of risk management

 Risk
• Risk represents a condition in which there is a
possibility that the actual outcome deviates
adversely from the expected outcome.

• Risk is present when actual loss is likely to be more

than the expected loss or when the actual returns
from an investment are likely to be less than the
expected returns.
 Risk Management
• Risk management is the practice of defining the risk level a firm desires,
identifying the risk level it currently has, and using derivatives or other
financial instruments to adjust the actual risk level to the desired risk
level.

• Risk management has become more important in recent times because:

• Interest rates, exchange rates and stock prices are more volatile today
than in the past.

• Significant losses incurred by firms that did not practice risk management

• Improvements in information technology

• Favorable regulatory environment

 Benefits of Risk Management
• Risk management reduces bankruptcy costs
• It reduces the cost of capital
• It leads to lower employee compensation
• It enables investment in profitable projects
• It enables companies to focus on main
business
• It may lead to tax advantages
 Risk Management Practice
• Survey Results (1998: Wharton School: 400 Respondents)

• About half of the respondents reported that they use derivatives as

a risk-management tool.

• One-third of derivative users actively take positions reflecting their

market views

• Some used good old-fashioned techniques such as the physical

storage of goods (i.e., inventory holdings), cash buffers, and
business diversification.
 Risk Management Practice
• Not everyone chooses to manage risk, and risk management
approaches differ from one firm to the next

• Some firms use cash-flow volatility, while others use the

variation in the value of the firm as the risk management
object of interest

• Large firms tend to manage risk more actively than do small

firms
 Risk Management and Firm
Performance
• Researchers have found that less volatile cash flows result in lower
costs of capital and more investment.

• It has also been found that a portfolio of firms using risk

management would outperform a portfolio of firms that did not,
when other aspects of the portfolio were controlled for.

• Similarly, a study found that firms using foreign exchange

derivatives had higher market value than those who did not.

• Analysis of the risk management practices in the gold mining

industry found that share prices were less sensitive to gold price
movements after risk management. Similarly, in the natural gas
industry, better risk management has been found to result in less
variable stock prices.
 Types of Risk
• Business Risk

• Non-Business Risks
 Business Risks
• Business risks are those that a firm willingly assumes as a part
of its business activities.

• These risks relate to the product market in which the firm

operates and arise due to technological, competitive and
consumer related factors.

• Business risks also include risks arising out of operating

leverage (the degree of fixed costs versus variable costs) and
macroeconomic factors such as economic cycles, changes in
incomes etc.
 Non-Business Risks
• These include strategic risks and financial risks.

• Strategic risks result from fundamental shifts in the economy or

political environment. Expropriation and nationalization are
examples of such risks.

• Financial risks arise from an organization’s exposure to financial

markets (market risk), its transactions with others (credit risk), and
its reliance on processes, systems, and people (operational risk)

• There is also the Liquidity risk which is often clubbed under market
risk.
 Financial Risks
• Market risk arises due to movement in financial
variables such as security prices, interest rates, foreign
exchange rates etc. The risk is that of fluctuations in
portfolio value due to changes in these financial
variables.

• Credit risk is also known as Default risk and is the risk

that the other party may be unwilling or unable to
fulfill its contractual obligation. Losses due to credit
risk can occur before the actual default due to changes
in the credit rating of the counterparties.
 Financial Risks
• Operational risk is the risk arising out of failed or
inadequate internal processes, people and systems or from
external events.

• Liquidity risk is of two types.

• Funding liquidity risk is the inability to raise funds at

normal cost.

• Trading related liquidity risk is the risk that an institution

will not be able to execute a transaction at the prevailing
market prices
 Integrated Risk Management
• Integrated risk management also popularly called Enterprise
wide Risk Management (ERM), looks at various kinds of risk -
market risk, credit risk, liquidity risk, operational risk and
business risk in a holistic fashion.

• An integrated view generates a better picture of the risk

climate of the organization and also helps in making the risk
management process more efficient and effective.
 Integrated Risk Management
• Considerable cost savings can be achieved by aggregating and
netting out positions.

• A firm wide approach can reveal natural hedges and guide the
firm‘s strategy towards activities that are less risky when
considered as a whole.

• By providing an aggregate measure of risk, ERM helps

companies to decide what the optimal level of capital they
must hold is.
 Integrated Risk Management

Firm Wide Risk

Business Risk Non-Business Risk

Financial Risk Other Risks

Business (Market, Credit, (Reputational,
Business Decisions
Environment Operational, Regulatory,
Liquidity) Po;litical)
Steps in Risk Management Process
 Identifying Potential Losses
• Sources of information
• Risk-Questionnaires
• Exposure Checklists
• Insurance Policy Checklists
• Expert Advice
• Physical Inspection
• Financial Statements
• Historical Data
• Analysis of Contracts
 Evaluating Potential Losses
• Estimation of potential frequency and severity of loss.

• Frequency of loss is the probable number of losses that is

likely to occur in a given time period ( nil, slight, moderate and
high)

• Severity of loss is the probable amount of loss (critical,

important and unimportant)

• Severity of loss may also be expressed in terms of maximum

possible loss and maximum probable loss.
Selecting the Appropriate Techniques
for Treating Loss Exposure
• Risk Control Techniques (to reduce frequency and severity
of losses)
a. Avoidance
b. Loss Control
(i) Loss prevention
(ii) Loss reduction

• Risk Financing Techniques

a. Retention (firm retains a part or all the losses)
b. Non-insurance transfer (through contracts, derivatives
and hold harmless agreements)
c. Insurance
 Avoidance
• Avoidance implies avoiding the risk altogether.

• For example, a firm can avoid the risk of loss arising out of accidents
by its fleet of vehicles by not maintaining its own fleet and using
only hired vehicles.

• It is not practically possible to avoid all risks. One has to decide as to

what risks are reasonable to assume.

• Avoidance is recommended when both loss frequency and loss

severity is high. For example when there is frequent conviction of
company drivers on account of accidents committed by them.
 Loss Control
• Loss control involves activities designed to reduce the frequency and severity
of losses.

• Two major components of loss control are loss prevention and loss reduction.

• Loss prevention aims at reducing the frequency of losses.

• For example, loss by theft may be prevented by having adequate security

arrangements and bad debt losses may be prevented using strict credit
appraisal.

• The purpose of loss reduction is to reduce the severity of loss after it occurs.

• For example loss from bad debts can be reduced by not allowing further credit
to delinquent accounts and losses from decline in prices of securities can be
reduced by putting stop loss limits.
 Retention
• The firm retains all or part of a given risk.

• It creates a cash cushion financed out of notional insurance

premium i.e. Instead of paying insurance premium to an insurance
company, the company invests the premium itself.

• Retention is Effective when

• No other method of treatment is available
• The worst possible loss is not serious
• losses are highly predictable

• For example, a firm may decide not to take an insurance policy for
losses arising out of petty thefts by employees and shop-lifting by
customers.
 Retention
• Advantages
Saving of money on insurance premium
Greater incentive for loss prevention

• Disadvantages
Possible higher losses exceeding money saved on insurance
premium
Possible higher expenses on loss control
 Non-Insurance Transfers
• Risks are transferred to a party other than an insurance
company using

• Contractual clauses (e.g. entering into a fixed price contract

with a building contractor to transfer the cost escalation risk,
paying in domestic currency for imported materials), and

• Hedging transactions (e.g. using derivative securities to offset

risks arising out of fluctuations in the prices of underlying
securities.)
 Non-Insurance Transfers
• Advantages
Possibility of transferring uninsurable exposures
May cost less than insurance
Potential losses may be shifted to someone in a better
position to exercise loss control.

• Disadvantages
Transfer of potential loss may fail due to language
ambiguity
Firm may still be liable if the transferee fails to pay
Insurer may not give sufficient premium credit for the
transfer
 Insurance
• Insurance is the most practical method of
handling risks in most of the cases.
• When a firm uses insurance, it has to decide
on the insurance coverage and has to select
the insurer
• Insurance is advisable for risks such as fire,
explosions where the frequency risks is low
but the severity of loss is high
 Insurance
• Advantages
Indemnification after a loss occurs
Reduction in uncertainty
Availability of valuable risk management services
Income tax deductibility of premiums

• Disadvantages
Insurance has a cost
Considerable time and effort involved in negotiation
Lax attitude towards loss control
 The Method to be Used

Type of Loss Loss Frequency Loss Severity Appropriate Risk

Management Technique

1. Low Low Retention

2. High (shoplifting) Low Loss control and

Retention

3. Low (fires, High Insurance

explosion)

4. High (frequent High Avoidance

conviction)