MODULE – 2 : FINANCIAL RISK

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Contents

• Explaining the nature and origins of risk in an international

setting
• Analysing meaning of risk exposure and method of risk
measurement
• Critically evaluating currency exposure
• Expounding exchange rates
• Structural models of exchange rate determination

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Definitions of Risk
• Risk is the possibility of loss or injury, the degree of probability of such loss
occurring. In risk, the probable outcomes of all the possible events are
listed. Often risk is used interchangeably with uncertainty. But uncertainty
means that you have no estimate of probable occurance and the chances are
unknown. Hence risk and uncertainty are different from each other. Risk is
attached with every return.
• In finance terms, risk consists of two parts, systematic risk and unsystematic
risk. Systematic risk is caused by factors external to the particular company
and is uncontrollable by the company. This risk is universal to the market,
therefore all participants are affected by this risk. Unsystematic risk,
however, is when the risk factors are firm specific, unique and related to the
particular industry or company.
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In order to discuss the relative as well as the absolute degree of the risk of various

financial instruments, quantitative measures of risk are needed. Consistent with the

definition of risk, such measures should provide a summary of the degree to which

realized return is different from expected return. That is to say, such measures give

an indication of the dispersion of the possible returns.

If the distribution of returns is symmetrical, two meaningful measures of dispersion

are available: the variance and the standard deviation.

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 Financial risks

Market risk Credit risk Liquidity risk Operational risk

Asset liquidity
Directional Sovereign risk Fraud risk
risk

Non-directional Funding liquidity

Settlement risk Model risk
risk risk

People risk

Legal risk.

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• Directional risks are those risks where the loss arises from an exposure to
the particular assets of a market
• Non-Directional risk arises where the method of trading is not consistently
followed by the trader
• Absolute risk is without any content. For e.g., if a coin is tossed, there is
fifty percentage chance of getting a head and vice-versa
• Relative risk is the assessment or evaluation of risk at different levels of
business functions
• Basis risk is due to the possibility of loss arising from imperfectly matched
risks
• Volatility risk is of a change in the price of securities as a result of changes
in the volatility of a risk-factor 6
• 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.
• Settlement risk exists when counterparty does not deliver a security or its value in
cash as per the agreement of trade or business.
• 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
• 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.
• Recovery rate risk is an often neglected aspect of a credit-risk analysis. The
recovery rate is normally needed to be evaluated
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Financial risk

• Operational risk – The risk of loss due to failed internal processes, systems or external
events (Technical failures, human errors or frauds)
• Reputational risk – The risk of damage to a firms reputation which cna result in lost
business, legal action or decreased market value.
• Legal and regulatory risk – The risk of financial loss due to non compliance with laws
or changes in regulations that affect financial operations or products.
• Political Risk – The risk of financial loss due to changes in political conditions, such as
government policy changes, instability, war or law.
• Country risk – The risk associated with investing or conducting business in a specific
country including political instability, economic conditions or legal constraints
• Strategic risk – The risk that poor business decisions or failure to respond to market
changes may negatively impact a company’s finances.

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• Finance risks refer to potential losses or adverse impacts on financial
performance. Each type of financial risk requires its own risk
managements strategies such as hedging, diversification, or
adherence to regulatory frameworks. The main types of financial risk
are Systematic risk and Unystematic risk.

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Systematic Risks
• Systematic risk - This risk affects the entire market. Economic conditions, political
transactions and sociological changes affect the security market. The markets are
often seen to be in the bull or bear phase the push upward or downward caused
by all of the above factors. These factors are beyond the control of any corporate
or investor. They affect all investors and therefore systematic risk is unavoidable.
• Market risk- The risk of losses due to change in market prices, such as interest rates,
exchange rates, commodity prices or stock prices.
• Interest rate risk is caused when changes in interest rates affect borrowing costs and
investment returns.
• Currency risk is also called exchange rate risk, occurs when fluctuations in foreign exchange
rates affect transactions or asset values.
• Equity risk is the risk of changes in stock prices impacting investments in equity markets.\
• Commodity risk is when fluctuations in commodity prices, such as oil or gold can affect
businesses reliant on those commodities.

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Finance Risks

• Unsystematic risk refers to risk that is unique and peculiar to a company,

industry or asset and does not affect the entire market or economy, and is
limited to the individual entity or sector. This risk may stem from
managerial inefficiency, technological change in the production process,
availability of raw material, changes in consumer preference and labour
problems. Consumer preferences, technological upgradations alter the
demand for products and companies must stay abreast to upgrade their
products accordingly. The financial leverage components may also cause
high risk, causing risk of repayment, which also poses a credit risk/interest
rate risk.
• Mitigation of unsystemic risk can be done through diversification or through
change in company policies or approaches.
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Finance risks

• Credit risk – The risk that borrowers or counterparties will fail to meet the
obligations leadin to default.
• Default risk – A borrower fails to make payments on loans or bonds as stipulated.
• Counterparty Risk – A party in a financial transaction fails to fulfil its contractual
obligations.
• Liquidity risk – The risk of being able to buy or sell assets without affecting
the market price, or being unable to meet short term obligations due to
lack of cash.
• Funding liquidity risk – making up for insufficient cash flow to meet financial
obligations
• Market liquidity risk – Difficulty in selling an asset without significantly lowering its
price.

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Finance risk

• Systemic risk – The risk that the failure of a significant entity such as a
major financial institution, can trigger a collapse or severe disruption
in the entire financial system that are large or interconnected. It
affects the broader financial system, economy or market as a whole.
When systemic risk materialises, it can lead to widespread economic
downturns or financial crisis. Eg: Collapse of Lehman brothers 2008,
Bank runs, Sovereign debt crisis causing ripple effects on global
economy.
• Mitigation is possible through Government intervention and
regulation or policy change at global, national or industry specific
level.
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Financial Risk

• Financial risk in a company is associated with the capital structure of the

company. Capital structure consists of equity funds and borrowed funds.
The presence of debt and preference capital results in a commitment of
paying interest or pre fixed rate of dividend. The interest payment affects
the payments that are due to the equity investors. The use of debt with the
owned funds to increase the return to the shareholders is known as
financial leverage.
• Debt financing enables the corporate to have funds at a low cost and
financial leverage to the shareholders. When earnings of the company are
higher than the cost of borrowed funds, interest, it leads to increase in
shareholder earnings. When the earnings are low, it may lead to no or low
earnings to equity shareholders.
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 COMPANY ABC COMPANY XYZ
2020 2021 2022 2020 2021 2022
Equity capital 20,00,000 20,00,000 20,00,000 Equity capital 10,00,000 10,00,000 10,00,000
Debt 10,00,000 10,00,000 10,00,000 Debt 20,00,000 20,00,000 20,00,000
Operating income 3,00,000 4,00,000 2,00,000 Operating income 3,00,000 4,00,000 2,00,000
Earnings per share 1 1.50 0.50 Earnings per share 1 2.00 NIL
In the year 2020 both companies earned the same and the EPS were also same. However, next year, in 2021, the operating
income has increased by 2021 by 33.33%. In company ABC 33% rise in operating income has resulted in a 50% increase in
EPS, while in company XYZ, the effect of the increase in operating profit has resulted in 100% increase in EPS. This occurs
because bond holders receive only the fixed interest whether the company fares well or not. The increase in EPS would cause
a change in the capital appreciation in the shares of XYZ company during a good year.
In 2022, maybe due to changes in economic climate, there is a fall in operating profit by 33.33% for both the companies. This
has caused 50% fall in EPS for company ABC compared to 2020 and 67% fall compared to 2021, but XYZ’s EPS has fallen to
zero and shareholders are affected adversely. If we assume another situation of negative earnings it would badly affect XYZ,
as it can erode shareholder equity. Fixed return on borrowed capital either enhances or reduces the return to shareholders.

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Financial risk

• Financial risk considers the difference between EBIT and EBT

• EBIT is earnings before interest and tax, while EBT is earnings before tax.
• Business risk causes variations between revenue and EBIT.
• The payment of interest affects the eventual earnings of the company stock.
• Volatility in the rates of return on the stock is magnified by the borrowed
money.
• The variation in income caused by borrowed funds in highly levered firms are
greater compared to the company with low leverage.
• The financial leverage or financial risk is an avoidable risk because it is the
management who has to decide how much to be funded with equity capital and
borrowed capital.
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Topics

1. Primary market
2. Secondary market
3. SEBI – Formation, objective, functions, organisation of SEBI
4. SEBI - Role in the primary market.
5. Book Building – Process
6. SEBI and secondary market
7. Mutual funds and SEBI
8. SEBI and FIIs
9. Stock market Indices- Usefulness and computation
10. BSE
11. NSE
12. NSDL
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Minimising risk exposure
• Market risk protection
• By understanding the market price movements through patterns
• Stocks come with values of beta ß and variance δ which gauge the risk
• Holding period as required, buy low sell high
• Protection against interest rate risk
• Hold to maturity, else can lead to loss of interest
• Can invest in short term securities like bonds and treasury bills.
• Invest in bonds with differing maturity dates.
• Protection against inflation
• Investing in bonds with fixed low return may not hedge against inflation
• Invest in short term securities and avoid long term investment.
• Investment diversification, in avenues like real esate, precious metals, antique, art, bonds, shares, mutual funds,
Post office schemes etc
• Protection against business and financial risk
• Guard against the business risk by doing a SWOT on industry and company.
• Analysing the profitability trend of the company
• Analysing the capital structure of the company, Debt equity mix.
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Financial risk faced by Government

• Financial risk for a government arises in the following situations:

• government losing control of its monetary policy
• its inability or unwillingness to control inflation
• government defaulting on its bonds
• other debt issues
• A government issues debt in the following form:
• Bonds
• Funding wars
• Building bridges
• Building infrastructure
• Paying for general day-to-day operations
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Measurement of risk

• Expressing the risk in terms of quantitative measure is essential for an

investor or analyst to understand the risk involved.
• Expressing the risk of a stock in quantitative terms makes it comparable with
other stocks.
• Though risk can be measured, it may not exactly represent the quantum of
risk, it is a sum total of social, political, economic and management factors.
Measurement provides an approximate quantification of risk.
• The statistical tool often used to measure and used as a proxy for risk is Beta,
variance and standard deviation.
• Beta is a measure of the systematic risk involved.
• Standard deviation or variance is a measure of the unsystematic risk
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Standard deviation

• It is a measure of the dispersion of the values of variables around its mean or it is

the square root of the sum of the squared deviations from the mean divided by
the number of observances, which is the variance. The arithmetic mean of the
returns may be the same for two companies but the returns may vary widely.
Step 1: Calculate mean of observation using the formula
(Mean = Sum of Observations/Number of Observations)
Step 2: Calculate squared differences of data values from the mean.
(Data Value – Mean)2
Step 3: Calculate average of squared differences.
(Variance = Sum of Squared Differences / Number of Observations)
Step 4: Calculate square root of variance this gives the Standard Deviation.
(Standard Deviation = √Variance)

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Standard deviation of the sample
where,

s is Population Standard Deviation

xi is ith observation
x̄ is Sample Mean
N is Number of Observations

Standard deviation of the population

where,

σ is Population Standard Deviation

xi is ith Observation
μ is Population Mean
N is Number of Observations

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 Company A Company B
r p r.p r p r.p
6 0.10 0.60 4 0.10 0.40
7 0.25 1.75 6 0.20 1.20
8 0.30 2.40 8 0.40 3.20
9 0.25 2.25 10 0.20 2.00
10 0.10 1.00 12 0.10 1.20
ƩE(r) 8.00 ƩE(r) 8.00

In the above example, though both the companies expected return is same, the variability of returns varies from
6% to 10% in company A while it varies from 4% to 12% in company B. In order to find out the variation, the
standard deviation technique is applied.

Variance δ2 = √Standard deviation δ

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 Company A
r P r - E(r) (r - E(r))2 P(r - E(r))2
6 0.10 -2.00 4 0.4
7 0.25 -1.00 1 0.25
8 0.30 0.00 0 0
δ = √1.3 = 1.14
9 0.25 1.00 1 0.25
10 0.10 2.00 4 0.4 The expected returns are same for A & B,
1.3 but variations in expected return are
different. Company A is more stable
compared to B’s expected return. The
Company B standard deviation helps to measure the
r P r - E(r) (r - E(r))2 P(r - E(r))2 variability of the return, which is a measure
4 0.10 -4.00 16 1.6 of teh systematic and unsystematic risk
6 0.20 -2.00 4 0.8
δ = √4.8 = 2.19
8 0.40 0.00 0 0
10 0.20 2.00 4 0.8
12 0.10 4.00 16 1.6
4.8

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 BoI Yes Bank
YEA R B Y Find the mean, standard deviation and
2017 5 161 variance.
2018 -16 50.3
Also ascertain the probability of
2019 7.8 -22 recession hitting by 20%, or expecting
2020 8.7 16.5 normalcy 60% or boom 20% hitting the
2021 66.8 3.8 market and ascertain returns accordingly.
2022 35.9 5
Also estimate which of the two are
2023 -8.1 76.2
advisable to be included in the portfolio?
2024 -33.1 107.9

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 BoI Yes Bank
YEA R B Y B- B' Y-Y' (B- B')2 (Y- Y')2
2017 5 161 -3.38 111.16 11.39 12357.10
2018 -16 50.3 -24.38 0.46 594.14 0.21
2019 7.8 -22 -0.58 -71.84 0.33 5160.63
2020 8.7 16.5 0.32 -33.34 0.11 1111.39
2021 66.8 3.8 58.43 -46.04 3413.48 2119.45
2022 35.9 5 27.53 -44.84 757.63 2010.40
2023 -8.1 76.2 -16.48 26.36 271.43 694.98
2024 -33.1 107.9 -41.48 58.06 1720.18 3371.25
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 BoI Yes Bank
YEA R B Y B- B' Y-Y' (B- B')2 (Y- Y')2
2017 5 161 -3.38 111.16 11.39 12357.10
2018 -16 50.3 -24.38 0.46 594.14 0.21
2019 7.8 -22 -0.58 -71.84 0.33 5160.63
2020 8.7 16.5 0.32 -33.34 0.11 1111.39
2021 66.8 3.8 58.43 -46.04 3413.48 2119.45
2022 35.9 5 27.53 -44.84 757.63 2010.40
2023 -8.1 76.2 -16.48 26.36 271.43 694.98
2024 -33.1 107.9 -41.48 58.06 1720.18 3371.25
Total 67.0 398.7 6768.68 26825.42
Mean 8.38 49.84
Variance 846.08 3353.18
Std Dev 29.0875 57.90663

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 Measurement of Risk-Probability
Distribution
The risk of an asset is assessed by the use of probability
distribution, Based on the probabilities assigned to the actual
returns, the expected values of return can be computed
Possible Outcome Probability Returns Expected return
BoI
Recession .20 14% 2.8 % [.20*.14]
Normal .60 16% 9.6 %
Boom .20 18% 3.6 %
YesBank Expected return of RIL 16 %
Recession .20 8% 1.6 % [.20*.08]
Normal .60 16% 9.6 %
Boom .20 24% 4.8 %
Expected return of WIPRO 16 %

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Covariance
Covariance is a concept used to determine different investments
returns over a period of time in relation to different variables.
Usually, the variables will be marketable securities in a portfolio.

A positive covariance means the asset returns move up or down

together. A negative covariance means that they move in opposite
directions. By using negative covariance, the manager can
determine if the portfolio is adequately diversified. It is good to
have securities that have negative covariance with one another.
This ensures that when one security return falls, another
security’s return will rise to offset the loss.

Covariance may be used even when units of measure are

different. Therefore covariance does not indicate the degree to
which the two items being measured more in relation to one
another. Risk and volatility can be reduced in a portfolio by Cov(x,y)= δ/Mean
pairing assets that have a negative covariance.

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Correlation

• Correlation, in the finance and investment industries, Correlation is a standardized measure of the strength and
is a statistic that measures the degree to which two direction of the linear relationship between two variables. It
securities move in relation to each other. Correlations is derived from covariance and ranges between -1 and 1.
are used in advanced portfolio management,
Unlike covariance, which only indicates the direction of the
computed as the correlation coefficient, which has a
value that must fall between -1.0 and +1.0. relationship, correlation provides a standardized measure.

• Correlation is closely tied to diversification, the Positive Correlation (close to +1): As one variable increases,
concept that certain types of risk can be mitigated by the other variable also tends to increase.
investing in assets that are not correlated. Negative Correlation (close to -1): As one variable increases,
• Correlation measures association, but doesn't show if the other variable tends to decrease.
x causes y or vice versa—or if the association is caused Zero Correlation: There is no linear relationship between
by a third factor. the variables.
• Correlation may be easiest to identify using a
scatterplot, especially if the variables have a non-linear
yet still strong correlation.

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Correlation

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Covariance vs. Correlation

• Covariance is also distinct from correlation, another statistical metric often used
to measure the relationship between two variables. While covariance measures
the direction of a relationship between two variables, correlation measures the
strength of that relationship. This is usually expressed through a correlation
coefficient, which can range from -1 to +1.

• While the covariance does measure the directional relationship between two
assets, it does not show the strength of the relationship between the two assets;
the coefficient of correlation is a more appropriate indicator of this strength.
• A correlation is considered strong if the correlation coefficient has a value close to
+1 (positive correlation) or -1 (negative correlation). A coefficient that is close to
zero indicates that there is only a weak relationship between the two variables.
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Critically evaluating currency
exposure
• The global market presents the exchange risk also

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Expounding exchange rates

• A common definition of exchange rate risk relates to the effect of

unexpected exchange rate changes on the value of the firm (Madura,
1989). In particular, it is defined as the possible direct loss (as a result
of an unhedged exposure) or indirect loss in the firm’s cash flows,
assets and liabilities, net profit and, in turn, its stock market value
from an exchange rate move. To manage the exchange rate risk
inherent in multinational firms’ operations, a firm needs to determine
the specific type of current risk exposure, the hedging strategy and
the available instruments to deal with these currency risks.

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• Multinational firms are participants in currency markets by virtue of their international operations. To measure the impact
of exchange rate movements on a firm that is engaged in foreign-currency denominated transactions, i.e., the implied
value-at-risk (VaR) from exchange rate moves, we need to identify the type of risks that the firm is exposed to and the
amount of risk encountered (Hakala and Wystup, 2002). The three main types of exchange rate risk that we consider in
this paper are (Shapiro, 1996; Madura, 1989): 1. Transaction risk, which is basically cash flow risk and deals with the effect
of exchange rate moves on transactional account exposure related to receivables (export contracts), payables (import
contracts) or repatriation of dividends. An exchange rate change in the currency of denomination of any such contract will
result in a direct transaction exchange rate risk to the firm; 2. Translation risk, which is basically balance sheet exchange
rate risk and relates exchange rate moves to the valuation of a foreign subsidiary and, in turn, to the consolidation of a
foreign subsidiary to the parent company’s balance sheet. Translation risk for a foreign subsidiary is usually measured by
the exposure of net assets (assets less liabilities) to potential exchange rate moves. In consolidating financial statements,
the translation could be done either at the end-of-the-period exchange rate or at the average exchange rate of the period,
depending on the accounting regulations affecting the parent company. Thus, while income statements are usually
translated at the average exchange rate over the period, balance sheet exposures of foreign subsidiaries are often
translated at the prevailing current exchange rate at the time of consolidation; and 3. Economic risk, which reflects
basically the risk to the firm’s present value of future operating cash flows from exchange rate movements. In essence,
economic risk concerns the effect of exchange rate changes on revenues (domestic sales and exports) and operating
expenses (cost of domestic inputs and imports). Economic risk is usually applied to the present value of future cash flow
operations of a firm’s parent company and foreign subsidiaries. Identification of the various types of currency risk, along
with their measurement, is essential to develop a strategy for managing currency risk.

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Structural models of exchange rate
determination
• Balance of payments approach

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RISK AND RETURN
Two Sides of the Investment Coin

• The return of an investment consists of two components:

• Current return
• Capital return

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