LECTURE 1 Introduction to Risk
Management
RISK
Risk is the variability between expected return and actual return
Risk is the chance or possibility of suffering loss due to future
uncertainty.
Risk is the probability that actual result will differ from expected
result. In the Capital Asset Pricing Model (CAPM) risk is defined as
volatility of return.
It refers to the degree or probability of loss in the future
RISK MANAGEMENT
•A risk is “an uncertain event or condition that, if it occurs has a
positive or negative effect on a project’s objectives.
•A risk management plan is a document that a project manager
prepare to foresee risks, estimate impacts, and define response to
risk.
•Risk management is a process that allows risk managers to balance
the operational and economic costs of reducing and managing risk.
•It is usually the responsibility of top management and it’s
performed by risk managers.
•Its process involves the study of impact and probability. Impact
means loss and probability means chance of occurring loss.
PROCESS OF RISK
MANAGEMENT
1. Identification: It means identify all the threats and losses that thinks of by
business. It simply states that identifies all the uncertainty that may happen in
near future.
2. Assessment: It means evaluation of risk by determining the likelihood of
happening of risk. In short assess the reasons of the risk that may happen in
future.
3. Mitigation: It refers to implement the process in response to risk that may
happen. In short a process will introduce to reduce the risk so that chances of
loss will decrease.
4. Monitoring: In this step the risk manager monitor the progress of plan that is
implemented to reduce the risk. It also should monitor that plan should be
implemented on continuous basis.
5. Reporting: In this step, response plan should communicate with all stakeholders
for effectiveness of plan and stakeholders also would engaged with it.
REACTIVE VS PROACTIVE
RISK MANAGEMENT
STRATEGIES
•Reactive risk management tries to reduce the damage of potential
threats and speed an organization recovery from them, but assume
that those threats will happen eventually.
•Proactive risk management identifies threats and aims to prevent
those events from ever happening in the first place.
CAUSES OF RISK
Wrong Decision or wrong timing
Term of Investment- Long term investment are more risky than
short term investment as future is uncertain
Level of Investment
Political and legal factors government policies
INVESTORS ATTITUDE
1. Risk Averse
2. Risk Neutral
3. Risk seeking
KINDS OF RISK
1. Systematic Risk: Cannot Reduce/ Eliminate/ Minimize
2. Unsystematic: Risk: Reduce/Eliminate/ Minimize
KINDS OF RISK
Systematic Risk Unsystematic Risk
Uncontrollable Controllable
Non Diversifiable Diversifiable
External Macro Economy Factor Internal Micro Factor
Beta, Standard Deviation, Total Risk- Systematic
Risk=Unsystematic Risk
Overall Economy Impact
Certain Organization
Inflation, Unemployment High operating cost, high turnover
Market Risk, Interest Risk Financial Risk, Business Risk
TYPES OF RISK
1. Default Risk
2. Business Risk
3. Financial Risk
4. Purchasing Power Risk/ Inflation Risk
5. Interest Risk
6. Market Risk
7. Liquidity Risk
8. Political Country Risk
9. Foreign Exchange Risk
SYSTEMATIC RISK
It refers to the risk caused by factors external to business which
affects the entire industry and not any specific business. They are
uncontrollable and unavoidable by a business and are associated
with economic, social, legal and political aspects of all shares in an
economy.
SYSTEMATIC RISK
Market Risk
Interest rate Risk
Purchasing Power Risk
MARKET RISK
• It is the risk caused by the alternating forces of demand and
supply i.e the value of investment increases or decreases due to
movement in the market factors.
•The possibility for an investors to experience losses due to factors
that affect the overall performance of financial market is called
market Risk
SOURCES OF MARKET RISK
• Unpredictable changes in commodity prices
• Unpredictable changes in security (Equity) prices.
•Unpredictable changes in Interest rate
•Unpredictable changes in Exchange rate
INTEREST RATE RISK
It is the risk that adversely affects the investment due to
unexpected changes in market interest rates. A change in
monetary policy by the central bank will directly affect the debt
instrument like bonds and debentures due to changes in interest
rates.
UNSYSTEMATIC RISK
• It refers to the risk caused by factors internal to business and
unlike systematic risk it is specific to a business and hence can be
controlled by the business. It arises due to lack of operating
efficiency in a business or due to its inability to grow or maintain
competitive edge or achieve stable profit.
•Business Risk
1. Internal Risk: it is associated with the operational efficiency of
the business.
2. External Risk: it is the associated with the economic social
political and legal factors external to the business which can
affect it adversely.
FINANCIAL RISK
• It is the risk related to the capital structure of a business. An
inefficient capital structure results in financial instability and leads
to unstable earnings. Hence there must be optimum mix of debt
and equity to ensure financial stability and reduce financial risk.
•Types of financial risk
1. Credit Risk
2. Currency Risk
3. Country Risk
4. Liquidity Risk
CREDIT RISK
• Credit risk is the risk of loss resulting from the borrower failing to
make full and timely payments of interest and/or principal. Credit
risk concept is widely used in debt capital market
TYPES OF CREDIT RISK
• Financial institution face different types of credit risks.
1. Default Risk
2. Concentration Risk
3. Country Risk
4. Institutional Risk
5. Market Liquidity risk
6. Downgrade risk
TYPES OF CREDIT RISK
• Default Risk: default risk also known or called as default
probability or probability of default, that borrowers face full and
timely payment of principles of interest in debt security.
•Concentration Risk : It is also known as industry, the level of risk in
a bank’s portfolio arising from concentration (Overexposure) to a
single counter-party sector or company.
•Country Risk: Country risk refers to the risk of investing or lending
in a country arising from possible changes in the business
environment that may adversely affect operating profits or the
value of assets in the country.
TYPES OF CREDIT RISK
• Institutional Risk: Institutional risk arises due to the breakdown in
the legal structure of the institution.
•Market Liquidity Risk: Refers to a widening of the bid ask spreads
on an issuer’s bonds. Lower quality bonds tends to have greater
market liquidity risk than higher quality bonds, and during times of
market or financial stress, market liquidity risk arises.
•Downgrade Risk: Refers to a decline in an issuer’s credit
UNSYSTEMATIC RISK
Business Risk
Internal Risk
External Risk
Financial Risk
Credit Risk
Currency Risk
Country risk
Liquidity Risk
TYPES OF RISK
• Business Risk: Building a product that no one wants or loosing
budgetary commitments.
•Technical Risk: Concerned with quality, design, implementation,
interface, maintenance problems.
•Project Risk: Concerned with schedule, cost, resources, customer
related issues.