Understanding risk

Basic modules
 1 Introduction
2 Types of risk

Identification of major types of risk

Sections
3

4 Risk management process

5 Importance of risk management

6 Case study
 1 Introduction
2 Types of risk

Identification of major types of risk

Sections
3

4 Risk management process

5 Importance of risk management

6 Case study
Introduction

Risk is the probability associated with a negative outcome that is associated with an event.

Definition of risk by Oxford dictionary:

‘the probability of loss, injury, or other adverse or unwelcome circumstances; a chance or situation
involving such a possibility.’

Is Risk = Uncertainty?
Types of risk
Financial risk

Risk
Market risk:
Financial risk Non financial risk • Financial risks are often associated with the overall market risk in the
business environment. These are of 3 different types –
• Foreign exchange risk
• Interest rate risk
Market risk Business risk
• Commodity risk

Operational Credit risk:

Credit risk risk
• This is the risk of default or the risk of occurrence of loss because of
the unwillingness of the customer or counterparty to meet its
Liquidity risk Legal risk obligations. These are of 2 types:
• Counterparty risk
• Sectoral risk

Political risk
Liquidity risk:
• This is the risk associated with the unavailability of liquid assets to
Regulatory risk meet obligations.

Solvency risk
Types of risk
Non-financial risk

Risk
Business risk:
• This type of risk is willingly undertaken by a company to ensure business
Financial risk Non financial risk growth

Operational risk:
Market risk Business risk • This is the risk of failure of internal processes, people, systems, policies
etc

Operational Legal risk:

Credit risk risk • When a company is unable to follow legal restrictions, applicable rules or
laws, sanctions etc. it is exposed to a situation that may have legal
consequences
Liquidity risk Legal risk
Policital risk:
• It is the risk associated with change in the political scenario of the nation
Political risk that affects the business of a company.

Regulatory risk:
Regulatory risk • Regulatory risk is the risk of adverse effect on the firm because of
changes in regulatory policies.

Solvency risk Solvency risk:

• This is the risk associated with the inability of an organisation to meet its
debt obligations in full even after having liquidated all its assets.
 1 Introduction
2 Types of risk

Identification of major types of risk

Sections
3

4 Risk management process

5 Importance of risk management

6 Case study
Identification and management of major types of risk

Market risk Credit risk Liquidity risk

• Currency/ interest rate • inability of a party bound by a contractual • inability of a company to liquidate its
fluctuations/ commodity prices agreement to pay its obligations. asset at the market price and its
subsequent inability to meet financial
obligations.

✓ Managed using different ✓ Assessment of credit rating of instrument ✓ Diversified investing in different sectors,
financial instruments and / company products, asset types etc.
strategies.
✓ Past loan history of a customer/corporate
✓ Maintain liquidity buffer (contingency
should be properly checked, i.e., the credit
funding plan) in the form of liquid assets,
record should be properly evaluated
such as cash and liquid funds can be
✓ Credit limits system retained to use in case of any short-term
liquidity requirements.
✓ Diversify potential loan customers
✓ Monitoring ICRA, CARE Moody’s etc.
 1 Introduction
2 Types of risk

Identification of major types of risk

Sections
3

4 Risk management process

5 Importance of risk management

6 Case study
Risk management process

The design and implementation of processes to identify, measure and manage varied risks is
termed as risk management.

•Source: Bharti Airtel Ltd. financial year 2017-18 annual report

Risk management process

Identification of Assessing and

Controlling the Monitoring of
the type of the measuring the
risk the risk
risk risk
Risk management process

Identification of the possible risk types that their company is exposed to helps them identify steps to be taken to mitigate them.

An Indian auto ancillary company imports in USD, EUR, JPY and HKD.
Percentage Share of Currencies in Total Imports

Amount in Currency of Percentage

Particular
millions (INR) transaction share (%)
Identification of
Imports (FY 3521.6 USD 82
the type of the
2018–19) risk
Euro 9
JPY 7
HKD 2
Hedging policy? 75% of USD exposure
Risk management process

Measures the amount of risk or maximum loss that it can incur in adverse situations

► Variance / Standard deviation

• to measure the amount of

variability/dispersion
σ 𝑿𝒊 − 𝑿 ഥ 2
𝑺2 =
𝒏−1
Assessing and
measuring the
► Scenario analysis risk
Scenario Analysis for Fluctuations in Price of Silver
Scenario Amount Price Price to be Scenario
• To analyse possible future events by change paid (1000 kg)
considering alternative possible Current
scenario - 42,000 4,20,00,000 -
outcomes
Increase by 5% 2100 44,100 4,41,00,000 21,00,000
Increase by 10% 4200 46,200 4,62,00,000 42,00,000
Increase by 15% 6300 48,300 4,83,00,000 63,00,000
Increase by 20% 8400 50,400 5,04,00,000 84,00,000
Risk management process

Measures the amount of risk or maximum loss that it can incur in adverse situations

► VaR

• To measure the maximum possible loss that can occur over a period within a
specified confidence interval.

𝐕𝐚𝐑 = 𝑴 ∗ 𝒁𝛂 ∗ 𝛔
Assessing and
measuring the
risk
VaR is a useful metric as:
 It is a standard metric for risk across multiple markets such as
investment and forex.
 It has high usability and is commonly applied by companies.
 It is also mandated by regulators to measure risks.
Risk management process

Measures the amount of risk or maximum loss that it can incur in adverse situations

► VaR

Let us consider an investor who has ₹50 million portfolio consisting of long position in
bonds. With the standard deviation being 4.67%, the investor is interested in knowing the
VaR of one-day horizon and VaR for a one-month horizon at a confidence interval of 95%.
Assessing and
To calculate the VaR of one-day horizon, we will be using the following values:
measuring the
1. Z-score at 95% confidence interval = 1.645 risk
2. Daily standard deviation = 4.67%
3. Market value of the portfolio = ₹50 million
 Risk management process

Prioritising the risks that need to be controlled and applying the most appropriate measures to mitigate risks and avoid intrinsic losses
to the business.

 In a Proactive context, a business entity has already successfully integrated a risk management system

 In a Reactive context, a business entity looks retrospectively at the risk creating business decisions
and activities to remedy any risk treatments deemed necessary

Controlling the
The different levels of risk faced by a company can be classified as follows:
risk
A Low-level risk: It includes risks on which any control is not necessary as they are very basic in nature and
pose a low threat to the business activities of the company.

B Significant-level risk: It includes risks that should be controlled as and when they arise.

C High-level risk: These are the risks that require specific control plans as they pose high potential threat to the
business activities of the company.
Risk management process

Prioritising the risks that need to be controlled and applying the most appropriate measures to mitigate risks and avoid intrinsic losses
to the business.

Different strategies

Avoidance Minimization
strategies strategies

Transfer Corrective measure

Controlling the
risk
Reduction Contingency plan

Elusion

Diversification
Risk management process

Measures the amount of risk or maximum loss that it can incur in adverse situations

✓ Reassessing the existing risks, verifying that the assumptions are still valid and modifying
them as and when necessary
✓ Determining if the risk exposures have changed, evolved or declined because of emerging
business trends
✓ Determining if the risk responses are enough or should be updated
✓ Confirming if the policies and procedures formulated are effective in mitigating risks
✓ Monitoring the emergence of new risks Monitoring of
the risk
✓ Identifying the risk triggers, i.e., events that cause a risk to occur and the risk plan put in
place to address adverse consequences
✓ Tracking residual risks
✓ Checking if the contingency reserves are adequate
✓ Taking corrective measures to address risks occurred
✓ Retiring risks whose potential to affect company’s business activities has reduced or whose
risk level is considerably low
 1 Introduction
2 Types of risk

Components of risk management

Sections
3

4 Risk management process

5 Importance of risk management

6 Case study
Importance of risk management

✓ become aware of the potential risks it may be ✓ identify and assess the various sources of risk,
exposed to and provides them the solutions to and outline its future business plan and strategy
1

2
actively manage them. to eliminate these risks.

✓ Monitor and review the performance of business ✓ Compare the estimated levels of risk against the
operations and the various significant risks pre-established criteria, which allows risks to be
3

4
involved. ranked on the basis of their likelihood and their
financial consequences.
 1 Introduction
2 Types of risk

Components of risk management

Sections
3

4 Risk management process

5 Importance of risk management

6 Case study
Case Study

• Walda is a tire manufacturing firm that imports its raw material from Europe.

• It must make Euro payments at the end of 3 months of a production cycle.

• It is a cash rich company with surplus cash of ₹1000 crore.

• According to their investment policy, they invest 50% of their investible surplus in different securities such as bonds of
different companies and fixed deposits.

• The fixed deposits that they invest in are generally for a shorter period (15–20 days). The company can only invest in
AAA rated bonds.

• It runs a large surplus as it has few debt obligations and is expected to pay its suppliers after long periods.

• Though it has few debt obligations, it has borrowed ₹10 crores at a floating rate from the market for a new business
objective.
Case Study

• Walda is a tire manufacturing firm that imports its raw material from Europe.
Currency
• It must make Euro payments at the end of 3 months of a production cycle.

• It is a cash rich company with surplus cash of ₹1000 crore.

Reinvestment
• According to their investment policy, they invest 50% of their investible surplus in different securities such as bonds of
different companies and fixed deposits. Liquidity

• The fixed deposits that they invest in are generally for a shorter period (15–20 days). The company can only invest in
Credit
AAA rated bonds.

• It runs a large surplus as it has few debt obligations and is expected to pay its suppliers after long periods.

• Though it has few debt obligations, it has borrowed ₹10 crores at a floating rate from the market for a new business Interest rate
objective.
Ernst & Young LLP
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