Risk
Definition of Risk differs from one discipline to another.
Economists, Statisticians, Decision theorists and Insurance
theorists disagree on a common definition.
Risk has been variously defined as
•The possibility of loss
•Uncertainty concerning a possible loss
•Possibility of an unfortunate occurrence
•The dispersion of actual from expected results
•The probability of an unfortunate occurrence
•The dispersion of actual from expected results
•The probability of any outcome different from the one
expected Potential
Damage
Insurance industry often refers risk as exposure to loss
Risk
Degree of risk is a measure of the accuracy with which the outcome of
an event based on chance can be predicted
Peril refers to the cause of loss. Ex: Fire, theft, windstorms
Hazard is a condition that may create or increase the chance of loss
occurring from a given peril
Moral Hazard == Dishonesty
Morale Hazard == Careless Attitude
Sources of Risk
Internal
• Procurement
• Availability of Expertise
• Technological factor
• Project feasibility
External
• Competitive disadvantage
• Market fluctuations
• Government Policy
• Economic factors
Measure of Risk
Frequency And Severity
• High Frequency and High Severity
• High Frequency and Low Severity
• High Severity and Low Frequency
• High Severity and High Frequency
Classification of Risk
Fundamental and
Particular
Financial and
Non Financial
Risk Types
Pure and
Speculative
Static and Dynamic
Static and Dynamic Risk
Static risks are those which occur even if there is no change in the
economy
-- due to peril of the nature
-- dishonesty of other individuals
No gain to society; Predictable to great extent; Occur with
regularity; results in destruction of asset (s)
Dynamic risks are those which occur because of changes in the
economy.
-- benefit society in long run as they are adjustments to the
economy
-- affect large number of people
-- cannot be predictable accurately
Fundamental and Particular Risk
•Fundamental risk affects a number of people
•Particular are restricted to individuals or some people
Pure and Speculative Risk
Pure risk result in only loss no gains
Personal risk – death, old age, disability
Property risk – loss of property, additional expense by
property
Liability risk – unintentional injury to other persons or
damage to their property through negligence
or carelessness
Speculative risks may result in GAINS also
Inflation Risk: When inflation increases, the return on the
investment decreases after adjusting for the
decline in purchasing power due to inflation.
Business Cycle Risk: The return on an investment fluctuates
according to the overall business or economy
cycle.
Interest Rate Risk: The risk on account of changes in interest
rates. Bond prices decline when the interest
rates rise and vice versa.
Currency Risk: The risk on account of changes in foreign
exchange rates, which may adversely impact returns or
profitability. For example if the domestic currency (INR)
appreciates the returns from an investment in foreign currency
asset decreases and vice versa. For companies entering into foreign
currency transactions, the fluctuation in forex rates may impact
revenues and profits denominated in foreign currency.
Commodity Price Risk: The risk on account of rise in commodity
prices, which form an important input item for a company, or the
risk for a commodity producer on account of fall in commodity
prices is commodity price risk.
Defining Risk Management
Risk Management is “identification,analysis and
economic control of those risks which can
threaten the assets or earning capacity of the
enterprise”
“Risk Management is a scientific approach to
dealing with pure risks by anticipating possible
accidental losses and designing and
implementing procedures that minimize the
occurrence of loss or the financial impact of
the losses that do occur.”
Risk Management Process
Identify
Report Analyze
Treat Assess
Methods of Handling Risk s
1. Risk Avoidance
2. Risk Reduction
3. Risk Retention
4. Risk Transfer
5. Risk Sharing
Methods of Handling Risk s
Risk Avoidance --- refuse to accept the risk willingly; not engage into action
that gives rise to risk
Risk Reduction ---can be done in through prevention and control techniques
Ex: medical care, security guards, sprinklers etc.
Risk Retention --- You are forced to retain risk as no alternatives are
available
Risk Transfer– from one individual to another who is willing to bear the
risk. Hedging is a method of risk transfer
Risk Sharing– is a special case of both risk transfer and retention. When risk
is shared it is transferred from individual to group. Sharing is
also a form of retention where risks transferred to the group
are retained along with the risks of other members of the
group
An effective Enterprise Wide Risk Management
An effective Enterprise Wide Risk Management
Framework requires four distinct components
Framework requires four distinct components
• Defining processes
Operations Strategy • Identifying and
and controls for /Systems evaluating all the
managing risk risks inherent in a
• Specifying firm activities
management • Establishing a
information firm-wide risk
requirements tolerance and
Risk appetite level
• Procuring
appropriate Management • Developing
systems Framework guidelines for
managing risk
• Establishing and • Establishing clear
develop accountabilities
appropriate risk for risk
measurement management
methodologies • Developing
• Understanding competencies and
assumptions and Organization expertise to
limitations
Measurement
manage risk
successfully
Determine
Capital
Available
Review Set Target
Performanc Returns
e
Allocate
Capital To
Business
Units
Standard Deviation
l In investments risk is measured in terms of standard deviation
l Most important measure of variation
l Shows variation about the mean
l Has the same units as the original data
å( Xi - µ )
2
l Standard Deviation:
s = i =1
N
σ2= Variance is a measure of dispersion of a set of data points around its
mean
Xi=Observation
µ= Mean
N = Total No. of observation
Total Risk = Systematic Risk and Unsystematic Risk
Systematic Risk : affect all sectors / companies / securities in varying
degrees Has an impact on entire market. This is undiversifiable.
Systematic risk of a security can be measured by relating that securities
variability with the variability in the stock market index..
The statistical measure is called b.
Higher variability = Higher Systematic Risk
Unsystematic Risk: This is associated with security of a particular
company and can be reduced by combining it with
another security .
Use the concept of DIVERSIFICATION
Example Board
CEO
Line
Credit Finance Treasury
Management
Credit Risk Balance Sheet Market Risk Business Risk
Management Management Management Management
! Credit ! Asset/Liability ! Pricing ! Relationship
management management VAR methodologies
Methodologies/
! profitability
! Bankruptcy ! MIS systems ! Implied volatility ! Product pricing
prediction Financing
Models
! ! Equity basis risk ! Business planning
! Credit exposure requirements ! Yield curve risk ! Reputation risk
! Settlement risk ! Management ! Profit translation risk ! Competitive
! Credit spread information ! Commodity spread outsourcing
risk risk
! FX volatility
! Forward price risk