INTRODUCTION TO Dr.

Mary Joy Catipay-Teodosio, LPT

RISK
 UNDERSTANDING RISK
• Risk is the possibility of losing something of value (physical
health, social status, emotional well-being, or financial wealth).
• Risk implies uncertainty about deviation from expected
outcome
• Risk is a term in accounting and finance used to describe the
uncertainty that a future event with a favorable outcome will
occur.
• Risk is the probability that an investment will not perform as
expected and the investor will lose the money invested in the
project.
WHAT DOES RISK MEAN?
Example:
A production manager has to decide whether it will be worth
investing company funds into a new machine that will increase
production and require less direct labor. There is a certain amount
of risk with this decision because there is no certainty that the
machine will operate the way it is supposed to. Future sales could
dry up and leave the machine idle because there is no demand for
the product. It could also put a strain on the cash flow of the
company. All of the these factors contribute to the risk of
purchasing this new asset. Managers have to use financial ratios to
help analyze the expected rate of return and see if it is worth
taking the risk on the new purchase.
 MEASURING RISK
• Standard deviation is the most common proxy for risk, thus
the easiest way to approach the problem of risk
measurement is to catalogue the various inadequacies of
standard deviation as a risk measure.
• Standard deviation helps determine market volatility or
the spread of asset prices from their average price. When
prices move wildly, standard deviation is high, meaning an
investment will be risky. (Investopedia, 2021)
VOLATILITY VS.
UNCERTAINTY
• Standard deviation can be either a measure of uncertainty or a
measure of volatility.
• Example: Suppose we are running a portfolio optimizer using a set
of inputs that includes the assumptions that US stocks will have a
return of 12% and a standard deviation of 15%. The 15% figure can
be interpreted as an estimate of the volatility of stocks over the
forecast period, or can be interpreted as a measure of how much
uncertainty attaches to the return estimate.
1. Explain volatility base on the given example.
2. Explain uncertainty base on the given example.
VOLATILITY VS.
UNCERTAINTY
• A volatile investment is likely to be an uncertain investment,
except for special cases where a volatile investment might
produce a certain return if held to the end of a definite period.
And even in those cases, volatility will create uncertainty for
any investor whose holding period is itself uncertain.

• Uncertainty need not involve volatility, as the venture capital

partnership requiring a 10-year lock-up of capital whereby it
has no price volatility because it is non-marketable, but the
investment still offers substantial uncertainty – risk.
 TYPES OF RISK
1. Systematic Risk
- uncontrollable by an organization and macro in nature.
- it is also known as market risk or economic risk on non-diversifiable risk and it impacts
full economy or share market.
- there is no way to reduce systematic risk other than investing your money in some other
country.

2. Unsystematic Risk
- controllable by an organization and micro in nature
- it affects a small part of economy or sometime even single company.
- Bad management or low demand in some particular sector will impact a single company
or single sector – such risks can be reduced by diversifying once investments.
- Diversifiable risk is simply risk that is specific to a particular security or sector so its
impact on a diversified portfolio is limited.
SYSTEMATIC RISK

Interest Rate Risk

Market Risk

Purchasing Power / Inflationary

Risk
 INTEREST RATE RISK
 Interest-rate risk arises due to variability in the interest rates from time to
time. It particularly affects debt securities as they carry the fixed rate of
interest.
Interest Rate
Risk

Reinvestment
Price Risk
Risk

 Price risk arises due to the possibility that the price of the shares,
commodity, investment, etc. may decline or fall in the future.
 Reinvestment rate risk results from fact that the interest or dividend earned
from an investment cannot be reinvested with the same rate of return as it
was acquiring earlier.
 MARKET RISK
• Market risk is associated with consistent fluctuations seen in the
trading price of any particular shares or securities. That is, it arises
due to rise or fall in the trading price of listed shares or securities in
the stock market.
Market Risk

Non-
Directional
Absolute Risk Relative Risk directional Basis Risk Volatility Risk
Risk
Risk
 MARKET RISK
1. Absolute risk is without any content. For example: if a coin is
tossed, there is fifty percentage chance of getting a head and vice-
versa.
2. Relative risk is the assessment or evaluation of risk at different
levels of business functions. For example: a relative-risk from a
foreign exchange fluctuation may be higher if the maximum sales
accounted by an organization are of export sales.
3. Directional risks are those risks where the loss arises from an
exposure to the particular assets of a market. For example: an
investor holding some shares experience a loss when the market
price of those shares falls down.
 MARKET RISK
4. Non-directional risk arises where the method of trading is not
consistently followed by the trader. For example: the dealer will buy
and sell the share simultaneously to mitigate the risk.
5. Basis risk is due to the possibility of loss arising from
imperfectly matched risks. For example: the risks which are in
offsetting positions in two related but non-identical markets.
6. Volatility risk is of a change in the price of securities as a result
of changes in the volatility of a risk-factor. For example: it applies to
the portfolios of derivative instruments; where the volatility of its
underlying is a major influence of prices.
 PURCHASING POWER OR
INFLATIONARY RISK
• Purchasing power risk is also known as inflation risk. It is so, since it
emanates from the fact that it affects a purchasing power adversely. It is
not desirable to invest in securities during an inflationary period.
Purchasing Power/ Inflationary Risk

Demand Inflation Risk Cost Inflation Risk

•Demand inflation risk arises due to increase in price, which result from an
excess of demand over supply.
•Cost inflation risk arises due to sustained increase in the prices of goods
and services.
UNSYSTEMATIC RISK

Unsystematic
Business Risk/
Liquidity Risk

Risk
Financial Risk/
Credit Risk

Operational Risk
 BUSINESS RISK/ LIQUIDITY
RISK
• Business risk is also known as liquidity risk. It is so, since it emanates
from the sales and purchase of securities affected by business cycles,
technological changes, etc.
Business
Risk

Asset Funding
Liquidity Liquidity
Risk Risk

• Asset liquidity risk is due to losses arising from an inability to sell or

pledge assets at, or near, their carrying value when needed.
•Funding liquidity risk exists for not having an access to the sufficient-
funds to make a payment on time.
 FINANCIAL RISK/ CREDIT
RISK
• Financial risk also known as credit risk. It arises due to change in
the capital structure of the organization. The capital structure
mainly comprises of three ways by which funds are sourced for the
projects.
 owned funds
 borrowed funds
 retained earnings Financial Risk

Non-
Exchange Recovery Credit Event Sovereign Settlement
directional
Rate Risk Rate Risk Risk Risk Risk
Risk
 FINANCIAL RISK/ CREDIT
RISK
1. Exchange rate risk is also called as exposure rate risk. It is a
form of financial risk that arises from a potential change seen in the
exchange rate of one country’s currency in relation to another
country’s currency and vice-versa.
2. Recovery rate risk is an often neglected aspect of a credit-risk
analysis. The recovery rate is normally needed to be evaluated. For
example: the expected recovery rate of the funds tendered as a loan
to the customers by banks, non-banking financial companies, etc.

 Recovery rate, commonly used in credit risk management, refers to the

amount recovered when a loan defaults. In other words, the recovery rate is
the amount, expressed as a percentage, recovered from a loan when the
borrower is unable to settle the full outstanding amount
 FINANCIAL RISK/ CREDIT
RISK
3. Sovereign risk is associated with the government. Here, a
government is unable to meet its loan obligations, reneging (to
break a promise) on loans it guarantees, etc.
4. Settlement risk exists when counterparty does not deliver a
security or its value in cash as per the agreement of trade or
business.
 OPERATIONAL RISK
• Operational risks are the business process risks failing due to
human errors. It occurs due to breakdowns in the internal
procedures, people, policies and systems.
• Operational risk is the prospect of loss resulting from inadequate
or failed procedures, systems or policies.

Operation Model Risk

al Risk
People Risk

Legal Risk

Political Risk
 OPERATIONAL RISK
1. Model risk is involved in using various models to value financial
securities. It is due to probability of loss resulting from the weaknesses in
the financial-model used in assessing and managing a risk.
2. People risk arises when people do not follow the organization’s
procedure, practices and/or rules. That is, they deviate from their
expected behavior.
3. Legal risk arises when parties are not lawfully competent to enter an
agreement among themselves. Furthermore, this relates to the regulatory-
risk, where a transaction could conflict with a government policy or
particular legislation (law) might be amended in the future with
retrospective effect.
4. Political risk occurs due to changes in government policies. Such
changes may have an unfavorable impact on an investor.
 THE KNOWN-UNKNOWN CLASSIFICATION OF RISK

The entire subject of risk management is based on the ability of the manager to
identify, value, and then mitigate the correct risks. Classification of risks is a vital step
in this process. It is important to realize that there is no standard framework for
classifying risks.
 Different people use different frameworks. One such framework was made popular by
Donald Rumsfeld, who was Secretary of Defense for the United States during the
subprime mortgage crisis. This framework classifies risks based on knowns and
unknowns. It is important to realize that this framework was not created by Donald
Rumsfeld.
It already existed in a lesser-known psychological construct called the Johari Window.
Donald Rumsfeld just popularized the adoption of the concept to characterize and
classify financial risks. In this article, we will understand how risks are classified in the
known-unknown framework.
The known unknown framework is a matrix that helps classify risks based on the
knowledge that we have about them. This framework is unique in the sense that it
acknowledges that there are some risks that we cannot find out about no matter how
diligent we are. After the 2008 crisis, this matrix has been routinely used to classify
risks into four different categories.
 THE KNOWN-UNKNOWN
CLASSIFICATION OF RISK

1. Known Known Risks

Known knowns are the easiest type of risks when it comes to risk management.
One known stands for the fact that the organization is aware that such a risk
exists. The other known is for the fact that the risk can be measured and its
effects can be quantified. An example of such a risk would be the possibility that
a firm would lose some of its customers to its competitors. Almost every firm is
aware that such a risk exists. Also, they can reasonably quantify the probability of
customers leaving them and the impact that such a loss would have on their
financial statements.
These types of risks are easiest to manage because the probability of them
occurring as well as their impact is known. Mathematical models can be
developed that help make decisions that minimize the occurrence as well as the
impact of such risks. Technology such as business process workflows can bring
about a certain level of automation which helps better mitigate and even avoid
these risks to some extent.
2. Known Unknown Risks
Known unknown risks are the second category of risks that
companies generally face. These risks are called known
unknowns because the organization is aware of the existence of
such a risk. However, at the same time, the organization is not
aware of the probability that this risk will affect them. At the
same time, they are not able to quantify the impact that these
risks will have on their business if they materialize.
Risks related to lawsuits can be put in this category. This is
because companies are aware that they are liable for all the
actions of their employees and even their subcontractors.
Hence, there is always a possibility that they might become
targets of a lawsuit due to the willful or negligent misconduct of
one of their associates. However, it is difficult to gauge the
probability of such an event taking place as well as the financial
impact it may have. Lawsuits can cost the company anywhere
between a few thousand dollars to billions of dollars!
3. Unknown Unknown Risks
These are the most dangerous type of risks which an
organization faces. One unknown stand for the fact that the
company is not even aware of the existence of such a risk. The
other unknown goes without saying. This is because the
company is not even aware of the existence of such a risk.
Hence, the question of measuring and quantifying risk does not
really arise. These risks typically tend to have a very high
impact and endanger the very existence of the organization.
Examples of such risks include extreme weather events. The
coronavirus global pandemic is another classic example of this
risk. No matter how hard the risk managers would have tried,
they would have found it difficult to predict the existence and
impact of this type of risk with any degree of accuracy. This is
where all the mathematical models of risk management begin to
fail. These events have been labeled as "black swan events"
based on the
Companies, however, do not completely give up on these risks.
4. Unknown Known Risks
These are risks that are created due to the negligence of the
company. For instance, companies should ideally be aware
that they face some amount of market risk or counterparty
risk. Hence, believing that an adverse event will never occur
is negligent on the part of the company. These risks are
seldom mentioned in the company's risk management
framework. This is because, in a properly managed risk
department, such risks should not exist at all. However, many
times these risks are present in even the best organizations in
the world. The subprime mortgage crisis and the subsequent
financial crisis that it brought is testimony to this fact.
The fact of the matter is that every industry, as well as every
business, faces risks that are unique and different from the
other. The known unknown framework is an effective way to
classify these risks.
 THREE LEVELS OF RISK
Level 1: Known Risk
 These are risks that an organization are aware of, and can
identify and plan for.
Level 2: Developing Risk
 These are risks that an organization are aware of, but the full
extent and implications are not completely clear.
Level 3: Black Swan Risk
 These are risks that are unforeseen and hard to predict or
avoid. Described as events with low likelihood, but high impact.
SOURCES:
• https://
[Link]/drumacasieb/risk-presentation-73195384
• 3 G Handy Guide: Risk Management