Introduction to Financial Risk Management-

Concepts
Session (1-2)
Financial Derivative and Risk Management

Lecture by: Dr. Khalid Ul Islam

Assistant Professor
(IBSB, IFHE Bengaluru Campus)
[Link]@[Link]

Ph.D. (Financial Economics, DSE, DU)

MFC (Finance & Control)
[Link]. (Accounting & Finance)
PGDIBO (International Business)
UGC-JRF/SRF, NET/SLET
Consultation Hours: Wednesday 3:00 to 4:15 pm AMFI (Mutual Fund Investing) Advisor
 Risk

Icy Road

Bad Weather
What is Risk?

• A chance or possibility of danger, loss, injury or other adverse consequences- Oxford

English Dictionary

• However, taking a risk can also result in a positive outcome.

• Risk is related to uncertainty of outcome.

• Example; Owning a motor car

Risks associated with owning a car
Where does Risk come from?

• Human created- Wars, Changes in policies, Business Cycles, Inflation,

etc.

• Natural Disasters- Weather changes, floods, earthquakes.

• Technological Innovations
Introducing the Concepts; Certainty, Risk and
Uncertainty

• Certainty: State of being free from doubt.

• Uncertainty: is doubt about our ability to predict the future outcome

of current events.

• Risk: is potential variation in outcomes.

So how is Risk different from uncertainty?

The term risk is used in situations where the probabilities of possible

outcomes are known or can be estimated with some degree of
accuracy, whereas uncertainty is used in situations where such
probabilities cannot be estimated.

- American Academy of Actuaries

Risk is a psychological concept…
• Objective Risk: (Based on Objective Probability)

As an objective concept, risk is measurable. Also called degree of risk, is defined as the relative variation of
actual loss from expected loss.

 An example of house insurance

• Subjective Risk: (Based on Subjective Probability)

Also called as perceived risk. Defined as uncertainty based on a person’s mental condition or state of mind.

 An example of a drunk driver.

Consider the following example
• Two bets:

1. $1
2. $100

• Both the bets have a 50% probability of loss

• And, Expected value of $0

• Which one is more risky?

Psychological aspect of Risk

• $100 bet may seem to be attractive to a Risk Seeker

• And a Risk Averse would be fearful to take the bet.

Concept of Risk Premium

• A risk averse individual may find the $100 bet unattractive and may be
willing to take the risk if provided with a compensation. E.g. $10 as a
payment to take the bet/risk.

• This level of compensation is called as the “risk premium”.

What’s then Risk Premium?

It is the minimum amount over and above the expected value that is
required to induce a person to participate in a bet.

(Based on the principle of risk and return in finance theory).

Irrationalities also occur…. Example of fixing a ceiling fan.

Levels of Uncertainty
• Information plays an important role in perceiving risk. (Has economic
value)
• Communication reduces the level of uncertainty. (Has to be credible)
Level Characteristics Examples

None (Certainty) Outcomes can be predicted with Physical laws, Natural Sciences
precision
Level 1 (Objective Uncertainty) Outcomes are identified and Games of chance- coin toss,
probabilities are know cards, dice
Level 2 (Subjective Uncertainty) Outcomes are identified but Business ventures, Investment
probabilities are unknown projects
Level 3 Outcomes are not fully identified Space exploration, Genetic
and probabilities are unknown research
Types of Risk
Pure risk vs Speculative risk

Pure Risk also called as the hazard risk exists when there is a chance of
loss but no chance of gain. (operational or insurable risks)

Speculative risk also called as the opportunity risk, business risk or

commercial risk exists when there is a chance of gain as well as a
chance of loss. (investments)
Identify which type of risk is it
These two risks are associated with dwelling:

• Market value risk

• Fire risk
Types of Risks
• Diversifiable Risk: Also called as idiosyncratic risk, unsystematic risk or
unique risk.
• A risk is diversifiable if there is a possibility to reduce risk through
pooling or risk sharing agreements.

• Non-diversifiable Risk: Also called as systematic risk.

• A risk is non-diversifiable if pooling arrangements are ineffective in
reducing risk.

• Example of risk of floods for dwellings.

Risk Matrix
Types of Risks
• Financial Risk: Potential for losses or adverse consequences arising
from financial transactions, investments, or financial activities.
• It is primarily associated with the uncertainty and volatility of financial
markets and instruments.

• Non-financial Risk: Encompasses a broader range of risks that are not

directly tied to financial transactions or markets.
• These risks are typically associated with a company's operations,
reputation, compliance, or external factors.
Business Risks….

• Business decisions;

• Business environment.
 A Comparative View:
Business Decisions: Business Environment:

 Investment decision;  Competition;

 Product-development choices;  Exposure to macro-economic risks.
 Marketing strategies;
 Organisational structure.
Financial risks:
• Interest rate shocks;

• Adverse price movements of financial securities;

• Defaults.
Types of Risk
• Policy risk: refers to the potential impact that changes in government
policies or regulations can have on businesses, investments, or the
overall economic environment.

• It is a type of non-financial risk that can significantly affect various

sectors and industries.

• Policy risk arises when there is uncertainty or instability in the

regulatory framework or when there are sudden policy shifts that can
disrupt business operations or alter the economic landscape.
Regulatory Risk
• Regulatory risk refers to the potential impact of changes or
uncertainties in regulations, laws, or government policies on
businesses, industries, or investments.

• It encompasses the risks associated with compliance requirements,

regulatory enforcement actions, and the evolving regulatory landscape.

• Regulatory risk can affect organizations in various ways, including their

operations, financial performance, reputation, and ability to achieve
strategic objectives.
Political Risk
• Political risk refers to the potential negative impact that political factors and
government actions can have on businesses, investments, or economic
activities in a particular country or region.

• It encompasses uncertainties and challenges arising from political

instability, changes in government policies, geopolitical tensions, social
unrest, or other political events.

• Political risk can significantly affect various aspects of business operations,

including profitability, market access, regulatory environments, and overall
business sustainability.
Operational Risk
• Operational risk refers to the potential loss or negative impact resulting
from inadequate or failed internal processes, systems, human errors, or
external events.

• It encompasses risks arising from day-to-day operations and activities

within an organization.
Concentration Risk
• Concentration risk refers to the potential loss or negative impact that can
arise from having a significant exposure or dependency on a single or
limited number of assets, sectors, customers, suppliers, geographic
regions, or other sources of risk.

• It stems from a lack of diversification and can leave an organization

vulnerable to adverse events or fluctuations in those concentrated areas.

• For example; asset concentration risk, sector concentration risk, customer,

supplier concentration risk, geographic concentration risk, credit
concentration risk.
Inflation Risk
• Inflation risk refers to the potential negative impact that rising or
unexpected inflation can have on the purchasing power of money and the
value of investments.

• It arises when the rate of inflation exceeds the rate of return on

investments or when inflation erodes the real value of income and assets
over time.
Interest Rate Risk
• Interest rate risk refers to the potential negative impact on the value of
investments or the profitability of financial instruments caused by changes
in interest rates.

• It arises from the fact that changes in interest rates can affect the present
value of future cash flows, bond prices, borrowing costs, and the overall
cost of capital.

• For example; Bond Prices, yield cure fluctuations, borrowing costs, cash
flow and investment decisions.
Foreign Exchange Risk
• Also known as currency risk or exchange rate risk, refers to the potential
negative impact on financial results or the value of investments caused by
fluctuations in foreign exchange rates.

• It arises from the fact that exchange rates between different currencies are
subject to change due to various economic, political, and market factors.

• Transaction Exposure, Translation Exposure and Economic Exposure.

Market Risk
• Also called as price risk.

• Market risk refers to the potential for losses or adverse effects on

investments or portfolios due to fluctuations in the overall market
conditions.

• It arises from the uncertainty and volatility in financial markets, driven by

factors such as economic conditions, geopolitical events, interest rates, and
investor sentiment.
Liquidity Risk
• Liquidity risk refers to the potential difficulty or inability to buy or sell an
asset quickly and at a fair price without causing significant impact on its
market price.

• It arises from the possibility of insufficient market depth, low trading

volumes, or the absence of interested buyers or sellers.

• Another aspect is that liquidity risk arises when a firm is unable to fulfil its
financial obligations.
Reinvestment Risk
• Reinvestment risk refers to the risk that future cash flows, such as coupon
payments or investment returns, cannot be reinvested at the same rate of
return as the original investment.

• It arises from the uncertainty of future interest rates or investment

opportunities.

• Reinvestment risk is particularly relevant for fixed-income investments,

such as bonds or certificates of deposit, where periodic interest or coupon
payments are received.
Credit Risk

• Credit risk refers to the potential of loss arising from a borrower or

counterparty's inability or unwillingness to fulfill their financial obligations,
resulting in default or delayed payment.

• It is the risk that the borrower or counterparty may fail to repay the
principal or interest amount as agreed upon in a loan or credit agreement .
Default Risk

• Default risk refers to the likelihood that a borrower or issuer will fail to
meet its financial obligations and repay its debt as per the agreed terms.

• It is the risk of non-payment or delayed payment of interest and principal

on loans, bonds, or other forms of credit.
Downgrade Risk
• Downgrade risk refers to the potential for a downgrade in the credit rating
of a borrower, issuer, or security.

• It is the risk that a credit rating agency lowers its assessment of the
creditworthiness of an entity, indicating increased credit risk.

• Downgrades typically occur due to factors such as deteriorating financial

conditions, increased debt levels, negative industry or economic trends, or
adverse events affecting the borrower.
Risk Management Process
Risk Management Techniques
• Risk Avoidance: Avoiding the risk all together. Not engaging in the activity that entails risk.

• Risk Retention: Identify acceptable risk and retain it, if cost of managing is more.

• Loss Control: Attempt to reduce either the possibility of loss or quantum of loss.

• Risk Diversification: Combining more than one business activities to reduce the overall risk of the firm.

• Risk Separation: Technique of reducing risk through separating parts business, assets or liabilities.

• Risk Transfer: Entity originally exposed to risk transfers it to another party which is willing to bear the
risk.
• Insurance
• Hedging
Thank You!