Risk Management Notes
Risk: The quantifiable likelihood of loss or less-than-expected returns. Examples: currency risk, inflation risk, principal risk, country risk, economic risk, mortgage risk, liquidity risk, market risk, Opportunity risk, income risk, interest rate risk, prepayment risk, credit risk, unsystematic risk, call risk, business, risk, counterparty risk, purchasing- power risk, event risk.
Internal risk: Internal Risks are those risks which arise from the events taking place within the business enterprise. Such risks arise during the ordinary course of a business. These risks, can be forecasted and the probability of their occurrence can be determined.
External risk: External risks are those risks which arise due to the events occurring outside the business organisation. Such events are generally beyond the control of an entrepreneur. Hence, the resulting risks cannot be forecasted and the probability of their occurrence cannot be determined with, accuracy.
Various sources of risk:
- Customer risk.
- Technical risk.
- Delivery risk.
Risk Management: Risk management can be defined as a process used to manage systematically pure risk exposures. It is a procedure to minimize, the adverse effect of a possible financial loss by –
- identifying potential sources of loss
- measuring the financial consequences of a loss occurring
- using controls to minimize actual losses or their financial consequences.
Risk analysis: Risk analysis is the process of defining and analyzing the dangers to individuals, businesses and government agencies posed by potential natural and human-caused adverse events.
Risk management planning: Risk management planning is the process of developing the risk management plan through the process of identifying risks, assessing risks and developing strategies to manage risks.
Risk control: Risk control is a method, by which firms evaluate potential losses and take action to reduce or eliminate such threats. Risk control is a technique that utilizes findings from risk assessments and implementing changes to reduce risk in these areas.
Transfer of risk: Risk transfer is a risk management and control strategy that involves the contractual shifting of a pure risk from one party to another. One example is the purchase of an insurance policy, by which a specified risk of loss is passed from the policyholder to the insurer.
Hedging: Hedging is an investment made in order to reduce the risk ‘ of adverse price movements in a security, by taking an offsetting position in a related security, such as an option or a short sale.
Hedging Instruments: A hedging instrument is a designated financial instrument whose fair value or related cash flows should offset changes in the fair value or cash flows of a designated hedged item.
Foreign exchange rates fluctuate: The foreign exchange rate fluctuates because of the changes in the demand and supply position of foreign currency in the world market.
Process of risk management:
- Identify risk
- Evaluating risks.
- Select risk management techniques
- Implement and review decisions.
Foreign exchange risk:
- Exchange rate movements
- Foreign – Economic condition
- Political risk.
Classification of risk:
(1) Systematic Risks.
(2) Unsystematic Risks:
Examples of Systematic Risks:
(i) Market Risk
(ii) Interest Rate Risk
(iii) Purchasing Power Risk.
(iv) Examples of Unsystematic Risks
- Business Risk.
- Financial Risk
- Default or Insolvency Risk
(v) Other types of Risks
- Industry risk
- Stock-specific risk
- Liquidity risk
- Principal risk
- Currency risk
- Inflation risk.
kinds of foreign exchange exposure:
- Economic exposure
- Transaction exposure
- Translation exposure.
Various methods of managing transaction exposures:
- Forward market hedge.
- Money market hedge.
- Options market hedge.
- Exposure netting.
Various tools and techniques of foreign exchange risk management:
- Managing transaction exposures
- Exchange exposures:
- Information asymmetry
- Transaction cost
- Default cost.
- Managing economic exposures.
- Marketing Initiatives:
- Marketing selection
- Pricing strategy
- Product strategy
- Promotional strategy
- Production Initiatives
- Product sourcing
- Plant location
- Input mix.
- Raising productivity.
Vindicators of political and economic factors are below:
- Political risk Indicators
- Stability of local political environment
- Consensus regarding priorities
- Attitude of host government
- War.
- Mechanisms for expression of discontent.
- Economic Risk Indicators
- Inflation rate
- Current and potential state of country’s economy
- Resource Base
- Adjustment of external shocks.