Risk Management

What is risk ?
Risk is uncertainty about the outcome… in a
general sense
Possible variability in outcomes around some
expected values….Specific meaning used for events.
Risk can be defined as degree of variation in the
possible outcome from an uncertain event or as the
variable in the possible outcome.-According to
Federation of insurance institute.
Ex: Virat Kohli’s batting average is 72
based on past data. So the expected score
he is likely to hit is 72.
However, there is a degree variability
around this value. He might duck out or
hit a century.
Risk v/s Uncertainty
Risk Uncertainty
Probability of the possible Probability of the possible
outcomes of the event is known outcomes is not known
Ex: The houses located near NH Ex: But the proportion of
are in risk of demolishing at the demolishing the houses is
time of road extension. unknown.
Sources of risk

Sources of risk

External source Internal source

1. Economic factors 1. Operational factors.
2. Natural factors. 2. Human factors.
3. Political factors. 3. Technological factors
4. Physical factors.
Unsystematic Risk

► Unsystematic risk is that portion of risk which can be

minimize through diversification of the investment by
forming portfolio. If we form a portfolio using the
negatively correlated investment securities then it would
be possible to minimize the risk at lower level. This types
of risk is known as diversiable risk Theoretically it is
possible to eliminate the portion of unsystematic risk but
in real sense it is not possible to eliminate the risk
through diversification.
Systematic Risk
► Systematic risk is that portion of
risk which cannot minimize through
diversification of the investments. 

► Systematic risk is mainly arisen

from the macro economic variables
which are beyond our control. Beta
is the measure of the systematic
risk. Sometimes this risk is also
known as systematic market risk.
Sources of systematic risk are
given below with short explanation.
Business Risk
►Business risk is the risk which
mainly arise when a firm or
business organization unable to
generate sufficient revenue to
maintain its operating expenditure
through providing service or selling
products, that is risk is directly
related with the operation of the
firm.
Financial Risk
►When a firm is unable to pay off its
fixed financial obligation then this
type of risk may arise. This type of
risk is involved with the levered firm
which uses debt capital for
business. In some cases this risk
can lead a lead a company to
bankruptcy.
Liquidity Risk
►This risk is involved with the
marketability of a security or
investment that is the capacity to
generate asset into cash as much
quicker as possible. If an investment
is takes less time to convert into cash
then it is liquid asset or investment.
Country Risk

►Unstable political condition of a

country is responsible for this type
of risk. If this risk is more than an
economy definitely fall, so does
business.
Exchange Rate Risk

►Exchange of currency is required

when a country is involved with
import and export. For importing
product or services foreign currency
basically dollar is used. So if there
is more fluctuation of the exchange
rate frequently then a business may
incur loss. This probable loss is the
risk for the business.
Types of risk:
►Interest rate risk
►Exchange risk
►Liquidity risk
►Default risk
►Internal and external business risk
►Financial risk
►Events of god
►Market risk
►Credit risk
►Personnel risk
►Production risk
Methods of handling risk
Risk Avoidance
• Loss prevention
Loss Control • Loss reduction
Risk retention
Non-insurance
transfer
Insurance
Risk management
► Risk management is the identification,
assessment and prioritization of risks followed
by coordinated and economical application of
resources to minimize, monitor and control the
probability and/or impact of unfortunate events.
► Jorin defined risk management as the process
by which various risk exposures are identified.,
measured and controlled.
► Risk management refers to the systematic
application of principles, approach and
processes to the tasks of identifying and
assessing risks and then planning and
implementing risk responses.
Risk management process
Objectives of risk management
► To be consistent with corporate objectives of returns
and safety
► To provide good service to customers
► Initiate action to reduce or prevent risk and its
effects
► Minimise human costs of risk
► To meet statutory and legal obligations
► Minimise financial losses and claims
► Minimise the risks associated with new developments
and activities.
► To be able to make informed decisions and make
choices on possible outcomes.
 Definition and meaning:

►Risk is the possibility of something

unpleasant happening or the chance of
encountering loss or harm.
►Risk, in the present context, means the
uncertainty of future cash flows. The
objective of the companies is believed to be
maximization of shareholders wealth.
►Hence, the possibility of the growth rate of the
shareholders wealth falling short of the set
targets can be considered as the risk a
corporate faces.
 Risk identification:
The job of a risk manager involves identification of:
►The nature of risk
►The remedial measures available for managing the
risk
►The cost of managing the risk.
►Hence, the risk manager job involves in ensuring
that the risk is maintained at the desired level. It
must be clearly understood that risk management
does not always mean risk reduction. In all such
cases where risk is imperative, increasing the
predictive ability also forms part of risk
management.
Types of risk:
►Interest rate risk
►Exchange risk
►Liquidity risk
►Default risk
►Internal and external business risk
►Financial risk
►Events of god
►Market risk
►Credit risk
►Personnel risk
►Production risk
Managing the risk:

Once the different types of risks are identified,

the next step involves identifying the alternate
tools available for managing the risk. The tools
may be described as under:

►Avoidance
►Loss control
►Separation
►Combination
►Transfer.
Introduction to risk and
insurance:
►Insurance is an important risk management
tool. In a typical insurance arrangement, the
insurer promises, in return for a premium, to
fulfill its contractual obligations upon the
occurrence of some event, often a qualified
loss.
►Insurance can be viewed as a risk financing
arrangement, because the promise that the
insurer gives is contingent capital that the
insured secures for future use, subject to the
terms and conditions of the contract.
Classification of insurance:

►Social versus private

►Life versus non-life
►Personal versus commercial
►Direct versus reinsurance.
Risk management process:
►The risk management function involves a
logical sequence of steps:
►determining objectives: the objective may
be to protect profits, or to develop
competitive advantage.
►The objective of risk management needs to
be decided upon by the management, so that
the risk manager may fulfill his
responsibilities in accordance with the set of
objectives.
 Risk identification:
►Every organization faces different risks, based
on its business, the economic, social and
political factors, the features of the industry it
operates in – like the degree of competition, the
strengths and weakness of its competitors,
availability of raw material, factors internal to
the company like the competence and outlook
of the management, state of industry relations,
dependence on foreign markets for inputs, sale
or finances capabilities of its staff etc.
►Each corporate needs to identify the possible
sources of risks and the kinds of risks faced by
it.
Risk evaluation:
►Once the risks are identified, they need to
be evaluated for ascertaining their
significance.
►The significance of a particular risk depends
upon the size of the loss that it may result
in, and the probability of the occurrence of
such loss.
►On the basis of these factors, the various
risks faced by the corporate need to be
classified as critical risks, important risks
and not-so-important risks.
Risk assessment:
►It is the step in a risk management procedure.
►Risk assessment consists in an objective
evaluation of risk in which assumptions and
uncertainties are clearly considered and
presented.
►Part of the difficulty of risk management is
that measurement of both of the quantities in
which risk assessment is concerned -
potential loss and probability of occurrence -
can be very difficult to measure.
►The chance of error in the measurement of
these two concepts is large.
►A risk with a large potential loss and a low
probability of occurring is often treated
differently from one with a low potential
loss and a high likelihood of occurring.
►In theory, both are of nearly equal priority
in dealing with first, but in practice it can
be very difficult to manage when faced
with the scarcity of resources, especially
time, in which to conduct the risk
management process.
Risk exposure:
►The amount of risk an investor has taken on
in a particular investment or a portfolio. Or to
what extent a business could be affected by
certain factors that may have a negative
impact on earnings.
►Exposure of physical assets
►Exposure of financial assets
►Exposure of human assets
Exposure to legal liability:
►Our exposure to legal liability is significant,
and damages that we may be required to pay
and the reputational harm that could result
from legal action against us could materially
adversely affect our businesses.
►Around the world, liability to any business
due to litigation, damages, claims etc., has
become a major issue of concern. Millions
of dollars are lost by companies over legal
suits and settlements. Such risks are there to
an individual also.
Financial derivatives:

►A derivative is a financial instrument (or,

more simply, an agreement between two
parties) that has a value, based on the
expected future price movements of the asset
to which it is linked—called the underlying
asset—such as a share or a currency.
►There are many kinds of derivatives, with the
most common being swaps, futures, and
options. Derivatives are a form of alternative
investment.
Participants in derivative markets:
►Hedgers: a transaction in which an investor seeks
to protect a position or anticipated position in the
spot market by using an opposite position in
derivatives is known as a hedge. A person who
hedges is called hedger.
►Speculators: a person who buys and sells a
contract in the hope of profiting from subsequent
price movements is known as a speculator.
►Arbitrageurs: these are the third important
participants in the derivative market. Arbitrage
means obtaining risk-free profits by
simultaneously buying and selling identical or
similar instruments in different markets. The
person who dose this activity is called arbitrageur.
Risk management tools:

►Hedging: hedging means identifying two

exactly correlated assets as far as returns are
concerned. one can hedge the risk by buying
one assets while simultaneously selling the
others.
►Forwards: a forward is a contract to buy or
sell an assets at a predetermined future date
for a current price, i.e., paying today’s price
for the delivery of the asset at a future date.
►Futures: a future is a contract between two
parties to buy or sell an assets at a certain
price at a certain time in the future.
►Options: an options contract gives a buyer
the right but not the obligation to purchase
or sell an assets.

►Swaps: swaps are the risk management

tools which involve the exchange of one set
of financial obligation for the another,
aiming at reducing the financial obligation
rate of the parties involved into the deal.

►Hybrid debt securities: it is a debt

security combined with any other type of
derivative. ex: convertible bonds.
Risk management:
►Risk management is the identification,
assessment, and prioritization of risks
followed by coordinated and economical
application of resources to minimize,
monitor, and control the probability and/or
impact of unfortunate events or to maximize
the realization of opportunities.
►. It is a process by which various risk
exposure are identified. Measured &
controlled. Our understanding of risk has
been much improved by development of
derivatives market.- Jorion
 Pure risk & Speculative risk:

►Pure risk is defined as a situation in

which there are only the possibilities of
loss or no loss. The only possible
outcomes are adverse (loss) & neutral
(no loss).
►Examples: premature death, damage to
property from fire, lighting, flood,
earthquake.
 Pure & speculative risk

►Speculative risk is defined as a situation

in which either profit or loss is possible.
►For example: if you purchase 100 shares
of common stock, you would profit if the
price of the stock increases but would
lose if the price declines. Other examples
of speculative risks include betting on a
horse race, investing in real estate.