Banking and Finance

Measurement and Management of Risk

Inadequate protection of both Information assets and Information System assets
leaves any organization vulnerable to computer crimes and can have catastrophic
consequences, particularly when confidentiality is involved. This article discusses
various aspects of data security from the professional perspective and also some of
the measures that can reduce the risk of leakage of data.

R
isk Management covers different types of in the case of a human life, the Risk Assessment
risk in a corporate enterprise pertaining is focused on the probability of the event, event
to market, credit, liquidity, event or frequency and its circumstances. We will try to
operations. Five key forces are changing the define the term risk from the point of view of
way the senior managers in major companies engineers and financial managers.
round the world view their future—new Engineering definition of risk:
technologies, globalisation, non-bank
competition, deregulation and opening Probability of Accident Consequences in Lost Money
up of previously protected markets. Risk = ------------------------------ x ----------------------------------------
The true measure of a business’ success Events per Time Period Per Event
is the rate at which it can improve its
range of products/services and the way it Financial definition of risk:
produces and delivers them. Risk Measurement It is “the chance that an investment’s actual
and Management is also one of the important return will be different than expected. This
function of the finance manager. In the changing includes the possibility of losing some or all of
global environment his decisions are affected the original investment. It is usually measured
by risk in a perceptible way. by calculating the standard deviation of the
historical returns or average returns of a specific
Meaning of Risk investment”. Risk in finance, as defined by Ron
There are many definitions of risk depending Dembo, is a general method to assess risk as
on the specific application and situational an expected after-the-fact level of regret. Such
contexts. In general, every risk (indicator) is methods have been successful in limiting
proportional to the expected losses, which can interest rate risk in financial markets. Financial
be caused by a risky event, and to the probability markets are considered to be a proving ground
of this event. James C. Van Horne has defined risk for general methods of risk assessment. A
as “the variability in the expected earnings of a fundamental idea in finance is the relationship
company”. Therefore, the differentiation of risk between risk and return. The greater the
definitions depends on the losses context, their amount of risk that an investor is willing to take,
assessment and measurement, as well as when the greater the potential return. The reason for
the losses are clear and invariable, for example this is that investors need to be compensated
for taking an additional risk.
— Dr. V. Gangadhar* and
Dr. G. Naresh Reddy** Risk Measurement
(*The author is Professor of Commerce and Business
Management, Kakatiya University, Warangal.
In the words of William Shockley measure
**The author is Lecturer, Department of Commerce is a comparison to a standard. The process of
and Business Administration, University Arts & measurement involves estimating the ratio of
Science College Kakatiya University, Warangal. They
can be reached at [email protected] and the magnitude of a quantity to the magnitude of
[email protected]) a unit of the same type (length, time, mass, etc).

1462 The Chartered Accountant March 2007

 Banking and Finance

A measurement is the result of such a process, the least amount of resources in the process
expressed as the product of a real number and a while reducing the negative effects of risks
unit, where the real number is the estimated ratio. as much as possible.
It is true that only quantifiable and identifiable
risks are managed in terms of providing hedge Objectives
cover or insurance. It is pertinent that enterprises The main objectives of the study are:
identify its key risks and the volume of exposure,
before it could decide on the type of hedging and a. To explain the concept of Risk, Risk
its timings, to optimize risk-return payoff. Range, Measurement and Risk Management.
Standard Deviation, Coefficient of Variation b. To discuss the different types of risk
and other Econometric tools are used for the
c. To analyse the techniques of risk
measurement of risk.
measurement
Risk Management d. To suggest the steps involved in the Risk
It is the process of identifying, analyzing Management process.
and evaluating the risk and selecting the best e. To present the summary of the study
possible methods for handling it. There is no
standard approach for Risk Management. Types of Risk
However, there are some common elements of A number of factors influence the risk.
successful risk management efforts: Depending upon the cause, the risk can be
(i) Recognition of the risk is the responsibility broadly classified into the following three major
of a programme management. categories:
(ii) The Risk Management process includes 1. Strategic Risks
planning for risk management, continu- 2. Operational Risks
ously identifying and analyzing programme
events, assessing the likelihood of their oc- 3. Investment Risks
currence and consequences, incorporat- Strategic Risks: These risks are the issues,
ing handling actions to control risk events which require companies to think on a large
and monitoring a programme’s progress scale. These risks have a major impact on the
towards meeting programme goals. In an company’s costs, prices, products and sales.
ideal Risk Management, a prioritisation pro- Some of the solutions, which companies bring
cess is followed whereby the risks with the to bear such risks, are shown in Table A.
greatest loss and the greatest probability of
occurring are handled first, and risks with Operational Risks: These risks can be
lower probability of occurrence and lower categorized according to their occurrence.
loss are handled later. In practice, the pro- Some occur at suppliers, others at the point of
cess can be very difficult, and balancing be- production, in the distribution chain or when
tween risks with a high probability of occur- the product is consumed. Operation risk stems
rence but lower loss vs. a risk with high loss from a variety of sources. Broadly speaking, these
but lower probability of occurrence can of- are process risk, people risk, technology risk
ten be mishandled. Risk management faces and disasters. Each of these categories must be
a difficulty in allocating resources properly. investigated to identify the risk elements, assign
This is the idea of opportunity cost. Re- a probability of occurrence, consequences if the
sources spent on Risk Management could event did happen and thus arrive at the weightage
be instead spent on more profitable activi- assigned to that risk operation hazards classified
ties. Again, ideal Risk Management spends by time are presented in Table B.

March 2007 The Chartered Accountant 1463

 Banking and Finance

TABLE - A
Strategic Risks
Strategic Risks Have an Impact Upon Solutions can be found in
the Company’s
Government and Economic Costs Strategic Planning of Markets
Factors and Products Empowerment
Customers Prices Quality Management
Competitors Products Customer Care
New Technology Sales Investment Innovation Cost
Reduction

TABLE-B
Operational Risks
Suppliers Process and Distribution Customers Competitors
Internal Risks
Interruption of Fire Counterfeiting Payment Competitor
Supplies Problems Activity
Poor Quality Pollution, Fraud, Tampering Changing Needs,
Supplies Computers Product Liability
Accidents
Labour Disputes
Terrorism, Kidnap
and Ransom

Some Important Operational Risks are: Likewise, formal process documentation,

(a) Process Risks: These stem from the design recruitment, induction, ongoing training
of the process and the extent of manual or and motivation policies are very important
human element in the steps of the process. A to mitigate those HR risks.
common risk is incorrect data capture. Since (c) Technology Risks: The financial industry is
data capture is often the very first step in a the leading user of technology worldwide.
process, an error there has consequences Even in India, banks, brokerages, exchanges
in all the succeeding steps and rectifying and mutual funds are aggressive users of the
the error in turn involves many stages latest technology. As technology becomes
of rollback. Data capture can easily be a key part of the process, its maintenance
classified as a risk with a high probability of and performance becomes a key risk factor.
occurrence and with costly consequences, The risks associated with the hardware
thus making it a high weightage risk. side of technology are somewhat easier
(b) People Risk: This risk is rarely considered a to contain, because they involve simple
formal risk. At the back of his mind, a manager monetary costs in redundancies. Hardware
is probably aware that there is excessive and networking skills are somewhat at a
dependence on one person, but this also premium, but these are generic skills and
means that he is too busy to train someone can be had at a cost. The risk associated with
else. A formal identification of key persons the application side is far more insidious and
and a strategy to contain that risk is essential. difficult to manage. Application technology

1464 The Chartered Accountant March 2007

 Banking and Finance

is invariably customized to that particular (c) Bull-Bear Market Risk: It arises from the
business need. variability in market returns resulting from
the operators of bull and bear market
Investment Risks: Every investment involves
forces. When a security index rises fairly
uncertainties that make future investment
consistently from a low point, called a peak,
returns risky. Some of the sources of
for a period of time, this upward trend is
uncertainty that contribute to investment risks
called a bull market. The bull market ends
are aggregated into (a) Interest Rate Risk (b)
when the market index reaches a peak and
Purchasing Power Risk (c) Bull-Bear Market Risk starts a downward trend. The period during
(d) Default Risk (e) Liquidity Risk (f ) Callability which the market declines sharply is called
Risk (g) Convertibility Risk (h) Political Risk (i) a bear market.
Industry Risk (j) Currency Risks (k) Portfolio Risk
and (l) Country Risk. (d) Default Risk: It is that portion of an
investment’s total risk that results from
(a) Interest Rate Risk: It is defined as the changes in the financial integrity of the
potential variability of return caused by investment. It is a failure of the borrower
changes in the market interest rates. The to pay the interest and principal amount
degree of Interest Rate Risk is related to the within the stipulated period of time. The
length of time to maturity of the security. default risk has the capital risk and income
If the maturity period is long, the market risk as its components; it means not only
value of the security may fluctuate widely. failure to pay but also delay in payment.
Further, the market activity and investor
(e) Liquidity Risk: It is that portion of an
perceptions change with the change in the
asset’s total variability of return which
interest rates and interest rates also depend
results from price discounts given or sales
upon the nature of instruments such as
commissions paid in order to sell the asset
bonds, debentures, loans and maturity
without delay. It is a situation wherein it
period, credit worthiness of the security
may not be possible to sell the asset. Assets
issues, etc.
are disposed of at great inconvenience
(b) Purchasing Power Risk: This is the and cost in terms of money and time. Any
variability of return an investor suffers asset that can be bought and sold quickly
because of inflation. It is closely related is said to be liquid. Failure to realise with
to interest rate risk, since interest rates minimum discount to its value of an asset
generally rise when inflation occurs. is called liquidity risk.
Purchasing Power Risk is more relevant (f ) Callability Risk: It is that portion of a secu-
in case of fixed income securities; shares rity’s total variability of returns that derives
are regarded as hedge against inflation. from the possibility that the issue may be
It is the risk that the real rate of return called as the Callability Risk. Callability Risk
on security may be less than the nominal commands a risk premium that comes in the
return. There is always a chance that the form of a slightly higher average rate of re-
purchasing power of invested money will turn. This additional return should increase
decline or that the real return will decline as the risk that the issue will call increases.
due to inflation. The return expected by
(g) Convertibility Risk: It is that portion of the
investor will change due to change in real
total variability of return from a convertible
value returns. Cost-push inflation is caused
bond or a convertible preferred stock that
by rise in the costs due to inadequate
reflects the possibility that the investment
supplies and rising demand.
may be converted into the issuer’s common

March 2007 The Chartered Accountant 1465

 Banking and Finance

stock at a time or under terms harmful to Risk Measurement

the investor’s best interests.
Risk refers to variability. A variety of measures
(h) Political Risk: It arises from the exploitation have been used to capture different facets of
of a politically weak group for the benefit risk. The more important ones among them
of a politically strong group. An effort of are: Range, Standard Deviation, Coefficient of
various groups to improve their relative Variation and Semi-variance. Apart from this,
position increases the variability of return we also use – Sensitivity Analysis, Breakeven
from the affected assets. Regardless of Analysis, Simulation Analysis, Decision Tree
whether the changes that cause political Analysis, Value at Risk Analysis and Cash Flow at
risk are sought by political or by economic Risk Analysis.
interests, the resulting variability of returns Sensitivity Analysis: With the help of Sensitiv-
is called political risk if it is accomplished ity Analysis it is possible to show that the prof-
through legislative, judicial or administrative itability of a project alters with different values
branches of the government. assigned to the variables needed for the com-
(i) Industry Risk: It is that portion of putation (unit sales prices, unit costs, and sales
investment’s total variability of return volume). This analysis is frequently used if the
caused by events that affect the products simple and discounted methods of evaluation do
and the firms that make-up the industry. It not show a satisfactory profitability.
involves international tariffs and/or quotas
on the product produced by an industry.
There is always a chance that the
(j) Currency Risk: These are associated purchasing power of invested
with international investments not money will decline or that the
denominated in the home currency of the real return will decline due to in-
portfolio manager’s beneficiaries. These flation. The return expected by in-
risks involved the international payment of vestor will change due to change
cash. Currency risks on a global basis may in real value returns. Cost-push
be close to unsystematic meaning that they inflation is caused by rise in the
are uncorrelated across economies and are costs due to inadequate supplies
not prices. and rising demand.

(k) Portfolio Risk: Portfolio managers attempt Breakeven Analysis: The financial manager
to maximize returns given an acceptable is interested to know how much should be
level of risk. Industry practitioners describe produced and sold at a minimum to ensure cost
the five different Portfolio Management recovery and this is called breakeven analysis.
Risks as: interest rate risk, liquidity risk, The minimum quantity at which loss is avoided
credit risk, operating risk and currency risk. is called the breakeven point.
(l) Country Risk: It involves the possibility of Simulation Analysis: The decision maker in
losses due to country specific economic, an organisation may like to know the likelihood
political or social events or because of of risks. The information can be generated by
company specific characteristics, therefore all Simulation Analysis, which may be used for
political risks are country risks but all country developing the probability profile of a criterion of
risks are not political risks. A sovereign risk merit by randomly combining values of variables,
involves the possibility of losses on private which have a bearing on the chosen criterion.
claims as well as on direct investment.
Sovereign risk is important to banks whereas Decision Tree Analysis: It is a useful tool
Country Risk is important for MNCs. where sequential decision making in the face

1466 The Chartered Accountant March 2007

 Banking and Finance

of risk is involved. This analysis involves four classes, such as critical and essential.
important steps— (i) identifying the problem Step 3: Identifying the Threats: Threats can
and alternatives (ii) delineating the decision be defined as anything that contributes to
tree (iii) specifying probabilities and monetary the interruption or destruction of any service/
outcomes and (iv) evaluation of various decision product. Various threats can be grouped into
alternatives. environmental, internal and external threats.
Value at Risk Analysis (VAR): It is one of the Step 4: Risk Assessment: The process of Risk
proven and the most used measures of risks by Assessment includes not only assessment as
financial institutions. VAR measures the likely to the provability of occurrence but also the
change in marked to market value of a portfolio, at assessment as to the potential severity of loss,
specified time periods with certain confidence. if risk materialises. This will assist in determining
Cash Flow at Risk Analysis (C-far): It has the appropriate risk mitigation strategy, the
been specifically developed for non-financial residual risk and investment required to mitigate
organisations with cash flow as variable. the risk.
The following two features of non-financial Step 5: Developing Strategies for Risk
organisation had resulted in the development Management: Once risks have been identified
of the C-far model. Firstly, certain assets of non- and assessed, the strategies to manage the risk
financial organisations could be accurately fall into one or more of these four categories:
valued at market prices. Secondly, the risk free
and continuous future cash flows represent the (i) Risk Avoidance: Not doing an activity
value of any a non-financial organisation. Hence, that involves risk and losing out on the
cash flows are taken as proxy for measuring risks. potential gain that accepting the risk
Cash Flow at risk measures the deviation of cash might have provided.
flows from the expected volume. In other words, (ii) Risk Mitigation: Implementing controls
it gives an idea as to how much of cash flow the to protect infrastructure and to reduce
portfolio might lose in a given time with given the severity of the loss.
probability.
(iii) Risk Reduction/Acceptance: Formally
Risk Management acknowledge that the risk exists and
monitoring it. In some cases it may not
Risk Management is the process of identify- be possible to take immediate action to
ing assets at risk, assigning appropriate values, avoid/mitigate the risk. All risks that are
identifying threats to those assets, measuring not avoided or transferred are retained
or assessing risk and then developing strategies by default.
to manage the risk. In the risk management the
following steps are to be taken to minimize the (iv) Risk Transfer: Causing another party
risk. to accept the risk i.e. sharing risk with
partners or insurance coverage.
Step 1: Identification of Assets at Risk: The
first step in the Risk Management process is to Conclusion
identify the assets in support of critical business
Risk Measurement and Management is
operations. The assets could fall under different
one of the important functions of the finance
groups, which are physically tangible and
manager. The changing global environment
conceptual assets.
constantly affects his decisions. But effective Risk
Step 2: Valuation of Assets: The assets so Measurement and Management is a must for all
identified and grouped in the previous step business organisations to survive profitably in
are to be valued and categorised into different the long run. r

March 2007 The Chartered Accountant 1467