CHAPTER 2: RISK MANAGEMENT

1. IDENTIFICATION OF TYPES OF RISK FACED BY AN ORGANIZATION

A business organization faces many types of risks. Important among them are discussed as below:

1.1 Strategic Risk

A successful business always needs a comprehensive and detailed business plan. Everyone knows that
a successful business needs a comprehensive, well-thought-out business plan but it’s also a fact of life
that, if things change, even the best-laid plans can become outdated if it cannot keep pace with the
latest trends. This is what is called as strategic risk.

So, strategic risk is a risk in which a company’s strategy becomes less effective and it struggles to
achieve its goal. It could be due to technological changes, a new competitor entering the market, shifts
in customer demand, increase in the costs of raw materials, or any number of other large-scale changes.

Examples:

• Kodak developed a digital camera by 1975 but considered this innovation as a threat to its core
business model and failed to develop it. When digital cameras were developed by others, Kodak
failed to capitalize and was left behind.

• Nokia failed to upgrade to touchscreen mobile phones, enabling Samsung to become the market
leader in that segment.

• Xerox, inventor of the photocopy machine, quickly adopted laser printing technology and changed
its business model to survive and scale profits further.

1.2 Compliance Risk

Every business needs to comply with rules and regulations. For example, with the advent of Companies
Act, 2013, and continuous updating of SEBI guidelines, each business organization has to comply with a
plethora of rules, regulations, and guidelines. Non-compliance leads to penalties such as fines and
imprisonment.

The real problem arises when a company ventures into a new business line or geographical area with
different applicable laws. For example, a cement company entering sugar business in a different state
may face different laws applicable to sugar mills in that state. Failure to comply with such laws poses a
serious threat to the company’s survival.

1.3 Operational Risk

This type of risk relates to internal risk and failure to cope with day-to-day operational problems.
Operational risk relates to both people and process.

Example:
An employee mistakenly pays ₹1,00,000 from the company account instead of ₹10,000. This is a people
and process risk. The organization can manage this by employing a second person to check the work or
installing an electronic system to flag unusual transactions.
1.4 Financial Risk

Financial Risk refers to unexpected changes in financial conditions such as prices, exchange rates, credit
ratings, interest rates, etc. Political risk, though not a direct financial risk, can lead to financial loss
through country risk caused by unexpected political changes in foreign countries.

Broad categories of Financial Risk include:

1.4.1 Counter Party Risk

Occurs due to non-honoring of obligations by the counter party, such as failure to deliver goods after
payment, failure to repay borrowings and interest, etc. This covers credit risk or default risk.

1.4.2 Political Risk

Mainly faced by overseas investors, this arises due to adverse government actions in the host country
such as:

• Confiscation or destruction of overseas properties

• Rationing of remittance to home country

• Restrictions on currency conversion

• Restrictions on borrowings

• Invalidation of patents

• Price control of products

1.4.3 Interest Rate Risk

Occurs due to changes in interest rates impacting assets and liabilities. This is particularly important for
banking companies whose earnings are spread between borrowing and lending rates. Interest rates may
be fixed or floating, and risk exists in both:

• If borrowed at floating rate, an increase causes higher liabilities.

• If borrowed at fixed rate, a decrease in floating rates makes the fixed interest cost comparatively
higher.

1.4.4 Currency Risk

Affects organizations dealing with foreign exchange as cash flows change with currency rate movements.
This can affect cash flows adversely or favorably. Example:

• Rupee depreciation benefits exporters like Infosys (increasing value of receivables).

• Rupee depreciation adversely affects importers like Indian Oil Corporation Ltd. (increasing liability
to pay in foreign currency).

1.4.5 Liquidity Risk

Defined as the inability of an organization to meet its liabilities as they become due. This arises when an
organization fails to generate adequate cash or faces timing mismatches in cash flows. More prevalent in
banking where maturities of assets and liabilities may mismatch.
2. EVALUATION OF FINANCIAL RISK

Financial risk can be evaluated from different perspectives:

(a) From Stakeholders’ Point of View:

• Equity shareholders view financial gearing (debt ratio) as a risk since in winding up, their claims
are least prioritized.

• Lenders see high gearing as a risk due to higher default probability on interest and principal
payments.

(b) From Company’s Point of View:

• Excessive borrowing or lending to defaulters may force liquidation.

(c) From Government’s Point of View:

• Failure or downgrade of financial institutions can cause societal distrust (e.g., Lehman Brothers
collapse).

• Includes risk from willful defaulters and sovereign debt crises.

3. VALUE-AT-RISK (VAR)

As per Wikipedia, Value at Risk (VAR) is a measure of risk of investment. Given normal market
conditions over a set period (say one day), it estimates how much an investment might lose. This
investment may be a portfolio, capital investment, or foreign exchange.

VAR answers two basic questions:

(i) What is the worst-case scenario?
(ii) What will be the loss?

History:

• First applied in 1922 at New York Stock Exchange.

• Became widely used in the financial world in the 1990s.

3.1 Features of VAR

(i) Components of Calculation:

• Time Period

• Confidence Level (commonly 95% or 99%)

• Loss expressed as percentage or amount

(ii) Statistical Method:

VAR is a statistical tool based on Standard Deviation.

(iii) Time Horizon:

Can be applied over different time horizons: 1 day, 1 week, 1 month, etc.
(iv) Probability:
Assuming normal distribution, probability of maximum loss can be predicted.

(v) Risk Control:

Risk can be controlled by setting limits on maximum permissible loss.

(vi) Z Score:
Z Score indicates how many standard deviations a value is from the mean. When multiplied by standard
deviation, it provides VAR.

3.2 Application of VAR

VAR can be applied:

(a) To measure maximum possible loss on any portfolio or trading position.
(b) As a benchmark for performance measurement of trading operations.
(c) To fix limits for individuals dealing in the front office of treasury departments.
(d) To enable management decision-making on trading strategies.
(e) As a tool for Asset and Liability Management, especially in banks.

3.3 Example of VAR Calculation

Suppose you hold shares worth ₹2 crore of X Ltd. whose market price standard deviation is 2% per day.
Assuming 252 trading days a year, determine the maximum loss over 1 trading day and 10 trading days
with 99% confidence level.

• Z Score for 99% confidence = 2.33

• Volatility in rupees = 2% of ₹2 crore = ₹4 lakh

• Maximum loss for 1 day = ₹4 lakh × 2.33 = ₹9.32 lakh

• Maximum loss for 10 days = √10 × ₹9.32 lakh = ₹29.47 lakh

4. APPROPRIATE METHODS FOR IDENTIFICATION AND MANAGEMENT OF FINANCIAL RISK

Financial risk categories are addressed individually for identification and management.

4.1 Counter Party Risk

Identification hints:

• Failure to obtain necessary resources for projects or transactions.

• Regulatory restrictions by Government.

• Hostile actions by foreign governments.

• Let down by third parties.

• Insolvency of counter parties.

Management techniques:
(1) Due diligence before dealing with third parties.
(2) Avoid over-commitment to a single entity or connected entities.
(3) Know exposure limits.
(4) Regularly review credit approval limits and procedures.
(5) Rapid action on any likelihood of default.
(6) Use performance guarantees, insurance, or other instruments.

4.2 Political Risk

Identification from government actions:

• Insistence on resident investors or labor.

• Restriction on currency conversion.

• Expropriation of foreign assets.

• Price fixation of products.

Assessment methods:
(1) Refer political rankings published by business magazines.
(2) Evaluate country’s macro-economic conditions.
(3) Analyze popularity and stability of the current government.
(4) Take advice from home country embassies in host countries.

Risk mitigation techniques:

(i) Local sourcing of raw materials and labor.
(ii) Entering joint ventures.
(iii) Local financing.
(iv) Prior negotiations.

4.3 Interest Rate Risk

Identification factors:

1. Government monetary policy.

2. Government actions such as demonetization.

3. Economic growth rates.

4. Industrial data releases.

5. Foreign investment flows.

6. Stock market changes.

Note: Management of interest rate risk is discussed in detail in a separate chapter.

4.4 Currency Risk

Identification parameters:
(1) Government actions impacting currency (e.g., Brexit causing pound depreciation).
(2) Nominal interest rates (Interest Rate Parity theory).
(3) Inflation rate (Purchasing Power Parity theory).
(4) Natural calamities.
(5) War, coup, rebellion, etc.
(6) Change of government and its foreign investment policies.