Transcript Click to add title

RISK MANAGEMENT
Introduction Objectives
Risk Strategies
P Raju Iyer, B.Com, FICWA, ACS, MIMA,
MPhil, MBA(UK)
1
INTRODUCTION
 Distinction between uncertainty
 Uncertainty: A totally indefinable and unexpected happening. Cannot be
predicted as the variables are many and their interaction can be
innumerable.

For example different people behave and react differently to the same
situation and uncertainty arises.
 Risk: Can be identified as an event which has different probabilities of
happening, but the time of the event as well the impact of such event is not
known.
 If expressed mathematically risk is the dispersion of a probability
distribution.
 Example Japan has been a country which has suffered many earthquakes
over centuries and risk of earthquake is known or it can be said that Japan
is earthquake risk prone.
2
INTRODUCTION (Contd..)
However, when an earthquake will take place
is not known and to what extent it is
uncertain.
While uncertainty cannot be quantified, a risk
can be quantified through mathematical
models, probability models, correlation, etc.
And also measured through quantitative
models and technological tools.
OBJECTIVES OF RISK MANAGEMENT
Pre-Loss objectives
 Understanding environment
 Fulfillment of external obligations – statuary
requirements
 Reduction in anxiety through preventive measures
 Social obligations to make people aware of the risks
Post-Loss objectives
 Survival of the organization
 Continuance of the organization’s operations
 Initiate and improve the income /earnings
 Obligation to society
RISK MANAGEMENT STRATEGY
FORMULATION AND IMPLEMENTATION
Seven fold of Strategies
Avoid risk
Reduce risk
Retain risk
Combine risks
Transfer risk
Share risk
Hedge risk
RISK MANAGEMENT STRATEGY
FORMULATION AND IMPLEMENTATION
 Avoid Risk
 Is the prevention method and proven method.
 Results in complete elimination of exposure to loss due
to a specific risk.
 Involve avoidance of an activity which is risky. This can
be approached in two ways
 Do not assume risk: this means that no risky projects
are undertaken. This is a proactive avoidance.
 Discontinuance of an activity to avoid risk:
abandoning a project to avoid risk midway
RISK MANAGEMENT STRATEGY
FORMULATION AND IMPLEMENTATION
Reducing risk
 Attempt to decrease the quantum of losses arising
out of a risky happening through
 Loss prevention and
 Loss control
• Loss prevention:
 The most insignificant strategy of dealing with the risk
through
 Using prevention systems (like fire sprinkler systems,
burglar alarms, etc., are typical prevention measures)
 By understanding of the risk as well as relationship of
risky activity and environment. This helps to prevent loss
by:
 Modifying the risk involved
activity itself through
improved design or technology;
 Isolating through a proper layout or notifying the place
where the risky activity is to take place
 Instituting suitable safe guards through training of people,
safety devices and providing knowledge and institute
mock exercises, etc.
RISK MANAGEMENT STRATEGY
FORMULATION AND IMPLEMENTATION

Loss control:
 Controlling the extent of loss/ due to the
risk during or after occurrence of risk
 ex: Dowsing the fire in the case of fire
accident, e.g. Using fire hydrants, fire
extinguishers.
 Through o line process control which
operates in the event of a risky
happening, e.g., gas leaks fires.
RISK MANAGEMENT STRATEGY
FORMULATION AND IMPLEMENTATION
(Contd..)
 Retain Risk

Risk retention is adopted when it cannot be avoided, reduced or transferred.

It can be a voluntary or involuntary action.


Voluntary: risk retained through implied agreements intentionally accepting
existence of risk.
Involuntary: the organization is unaware of the risk and faces it when it comes
up.
 Combine Risks




When the business faces two or three risks the over all risk is reduced by a
combination.
Prevalent mainly in the area of financial risk.
Different financial instruments being negative risk return of co relation like
bonds and shares are taken in a single port folio to reduce the risk.
A physical risk of non-availability of a particular material is often solved by
having more than one supplier
RISK MANAGEMENT STRATEGY
FORMULATION AND IMPLEMENTATION
Transfer risk
 Causing another party to accept the risk, typically
by contract or for a consideration
 Liability among construction or other contractors
is very often transferred this way.
 The other agency may have core competency to
handle such risk 6 sharing risk
 Unlike transfer the risk, the sharing is out of mutual
benefit


Insurance is a method of sharing risk for a
consideration, viz., premium insurance loss,
undertakes to share the risk with the companies
and share their own risk through re insurance with
other companies.
Big conglomerates share risk among their own
group of companies in proportion to their risk
bearing strengths by creating a corpus instead of
paying premium to insurance companies.
RISK MANAGEMENT STRATEGY
FORMULATION AND IMPLEMENTATION
Hedging risk
 Hedging is done by an agency taking over the risk
for a consideration for a period and select band of
fluctuation.
 This is also really risk transfer but specifically used
for financial risks.
 Exposures
of funds to fluctuations in foreign
exchange rates, interest rates, prices, etc. Bring
about financial risks resulting in losses or gains.
 The downside risk is often taken care of by
hedging.
Risk optimization
 As there is no single type out of the seven above
are suitable for entire organization, risk
optimization attempts to utilize information on risk
to compute precisely what types and combinations
of risk to take.
 It also develops the precise tradeoff between risk
and reward and the corresponding appropriate
product pricing to reflect the risk taken.
RISK MANAGEMENT
TOOLS FOR RISK MEASUREMENT &
EVALUATION
Date/ Time / version
15
DEVELOP TOOLS FOR MEASUREMENT AND
EVALUATION
Risk measurement
 Tools for measurement are based on
the type of risk.
 Potential risk management often refers
to reducing downside potential and
enhances the returns on topside.
16

Risks are of many types as follows:
 Physical risk:
 Like Natural |Calamities: Fire, Tsunami, Floods,
Earthquake, etc.
 Arising
out of Political, Economic, Social,
Technological and Legal environments often
identified through the performance of lead
indicators.
 Social arena - Lead indicators can be pestilence,
expediencies, social upheavals, etc.,
 Political area - the change in government policy
capitalistic, democratic or totalitarian
DEVELOP TOOLS FOR MEASUREMENT AND
EVALUATION
 Economic front - Foreign Exchange variation, Capital
Market fluctuations, Trade Cycles, etc.
 Legal area- Implication of various Statutes affecting
Business, anti Trust bills, Factories Acts, Industrial
Disputes Act, and FEMA.
 Business risk:
 Inherent to a business due to its nature and
susceptibility to environment, e.g., Change of
fashion, business cycles, conflicts like war,
insurgency, cross border terrorism, technological
obsolescence, etc.
 Financial risk:
 Arising out of the nature of financial transactions
and conduct of business and investment.
MEASUREMENT OF RISK
 Measurement of physical risks

Natural calamities: measured by the application of technological tools.
 Earthquakes -on the Richter scale.
 Floods - through level monitoring and marking danger levels.
 Fire- flash point, fire point, ignition temperatures and propulsion
temperatures, spontaneous ignition temperatures (e.g., Coal dumps, oil
installations, explosive go downs, etc)




Social factors: done on the basis of the impact on the society, i.e., Increase in
crimes, violence and accidents, etc.
Political factors: by the impact of such government policy on the economic
activity, e.g., Government industrial policy and labor policy.
Economic : lead indicators are like variation in GDF, IIP, balance of payments,
stock market indices, etc.
Legal : impact of changes in legislation
MEASUREMENT OF RISK
(Contd..)
 Measurement of Business Risk
 Refers to variations in earnings due to demand
variability, price variability, variability for input
prices, etc, that are essentially external and are market
driven.
 Measurement of Financial Risk
 Arises out of financial leverage.
 Companies with a high degree of financial leverage
will have greater proportion of debt, are exposed to the
financial risk which is normally measure as a
capability to repay loans and service the loans.
MEASUREMENT OF RISK
(Contd..)
 Risk evaluation


Helps in quantifying the possible consequences of risk in value terms
Risk evaluation is based on two steps:
 Bench marking in relation to the importance of the risk to the
company
 Apply this yard stick for evaluation of all risks
 How to compute the effect of consequences of a risk?

It is computed in terms of variable as well as fixed costs.
 For example, wherever an exposure to risk involves a loss as in the
case of a break down in a factory, the direct cost as a result of the
breakdown will have to be calculated.
 At the same time, if the factory comes back to production only after a
period, the standing charges during the period of shutdown will be the
fixed cost not recovered.
MEASUREMENT OF RISK



(Contd..)
Mathematical models as well as statistical analysis have been
helpful in risk assessment. While applying statistical analysis, two
concepts are applied for assessment of risk:
Measures of central tendency
 To arrive at one single value that will denote the characteristics
of the total data collected. Such a value is known as the central
value or average and can be expressed as mean, median and
mode according as the nature of risk being measured.
Measures of variation
 To study the dispersion or scatteredness.
 The statistical analysis is based on following methods (a) range
(b) mean deviation (c) standard deviation (d) variance (e) co
efficient of variation.
RISK MANAGEMENT
IMPLEMENTATION OF RISK
STRATEGIES
Date/ Time / version
© South Indian Regional Council for ICWAI
IMPLEMENT STRATEGY USING TOOLS
 Quantification of risk is done in the following manner:
 Using probability distributions (loss distributions)
 Normal distributions
 Monte carol simulation of distributions
 Correlation analysis
 Discounted cash flow analysis
 Often analysts focus on characteristics of loss distributions,
such as
 Expected loss
 Standard deviation of loss
 Maximum probable loss
 Sometimes information about the entire probability
distribution is available and useful.
IMPLEMENT STRATEGY USING TOOLS
(Contd..)
 Quantifying loss under normal distribution
 Though most loss distributions are not normal; still from
the central limit theorem using the normal distribution will
nevertheless be appropriate when
 Number of exposures is large
 Losses across exposures are independent
 For example,
 Where a firm has large number of employees and
workers suffer injury losses and
 Firms with firms having large fleets of cars suffering
automobile accident losses.
RISK POOLING AND DIVERSIFICATION



The concept of poling risk is the process of
identification of separate risks and put them all
together in a single basket, so that the monitoring,
combining, integrating or diversifying risk can be
implemented.
When all the risks have been identified, combined and
monitored according to the system drawn up to
quantify the total risk with a control figure ,
monitoring becomes easy.
If there are variations from the control figure,
deviation can be corrected by combining risks or
integrating risks or diversifying risks.

Risk pooling & monitoring
 There are various risk covering insurances in a business say executing a project
 Marine insurance - taken for shipping the various plant and machinery
from the manufacturers to the port near the project site,
 Transit insurance – during transshipment of goods from port to the project
site (the carrier takes care of this insurance on company’s behalf)
 Storage insurance – for the material at site until erection
 Erection insurance - during erection of different plant and machinery,
mechanical, electrical,
 Risks for commercial run: during testing and trial runs of the erected plant
and machinery for performance guarantee
 All these risks put together is pooling
 Each separate policy has a risk value and premium & the insurer and
insured have to carry out the obligations as per the insurance contract..
 Process of monitoring is to ensure about the execution of the obligations
RISK POOLING AND DIVERSIFICATION
(Contd..)



Risk Combining
 To reduce risk after pooling it can be combining through
a comprehensive policy from the plant and machinery
FOB to the completion of final commercial guarantee
run.
Risk integration
 Integrating risks will be to take care of similar risks in
the entire organization (all the foreign shipments
together, inland transit risks together)
Risk diversification
 This involves identifying that fraction, which is
systematic and the remaining unsystematic.
RISK POOLING AND DIVERSIFICATION


Systematic risk
 Inherent and peculiar to the type of business or the
organization
 Can be reduced or diversified by acting with in the
organization, which is through functional level
strategy.
Unsystematic risk
 Also known as market risk is external to an
organization and is also termed as market risk.
 The identification of characteristics of market risk
through statistical correlation “beta”, which can be
manipulated through portfolio management.
IMPACT OF MACRO ECONOMIC FACTORS
AND RISK
 General principle is that higher the risk the return needs to be higher
 However, risk perceptions of investors tend to be different with the onset of
business cycles.
 In recession investors tend to be conservative as their appetite for risk is reduced
and they go after growth sectors which have lower risk.
 In a security market, low risk growth sector has always been the biggest gainer in
terms of returns.
 Thus onset of recession upsets the risk return balance.
 Macro economic factors like change in interest rates, inflation, money supply and
index of industrial production have a big impact on the investors risk perception.
 Analysis has shown that in a regime of high interest rates and high inflation low
risk sectors perform better than high risk stocks.
 As the interest rates and inflation decline the high risk sectors tend to do better.
INSURANCE, INSURABILITY OF RISK AND
INSURANCE CONTRACTS
 Transferring or lifting of risk from one individual to a group and sharing of losses on
an equitable basis by all members of the group.
 In legal terms insurance is a contract (policy) in which one party (insurer) agrees to
compensate another party (insured) of its losses for a consideration (premium).
 Insurance is a means whereby a large number of people agree to share the loss which
a few of them are likely to incur in the future.
 Insurance is also a means for handling risk.
 The business of insurance is related to the protection of the economic value of any
asset. So, every asset that has a value needs to be insured.
 Both tangible goods and intangibles can be insured.
(Contd..)
RISK MANAGEMENT
CORPORATE RISK MANAGEMENT
Date/ Time / version
32
INTRODUCTION
 An individual is risk averse and prefers to keep his money safely at a place where it
is risk free, say a scheduled bank for which he gets an interest rate called “risk free
rate”.
 The incentive to invest this money in an activity involving risk could be to get a
higher return for the increased risk. This is known as “risk premium”.
 Risk in a traditional sense
 The risk is understood as the sacrifice made by an individual by deferring the use of
money to a future day by investing that money in a venture promising a higher
return which has uncertainty.
 The forces that contribute to the variations in return can both be external or internal
to a company in which an individual has invested.
 These forces can partly be controllable and the remaining uncontrollable.
 The uncontrollable portion, which is essentially external, is known as systematic
risk and the controllable internal risk is known as unsystematic risk.
33
SYSTEMATIC RISK
 Market Risk: Variability in ROI in the market is referred to as market risk.

This is caused by investor reaction to the tangible as well as intangible events.

Tangible events like economic, political, social events

And intangible events arising out of a market psychology or the other factors
like interest rates and inflation also form part of the forces behind market risk.
 Interest Rate Risk:



This risk refers to the uncertainty of market volumes in the future and the
quantum of future income caused by the variations in the interest rates.
These interest rates are normally controlled by the RBI in our country and the
exigencies for changing the interest rates arise out of many economic factors
which are monitored by the |Central Bank.
Normally, when the interest rates increase the companies with higher quantum
of borrowed money will have to pay out higher quantum of interest reducing
their earnings and vice versa.
SYSTEMATIC RISK
(Contd..)
 Purchasing power risk:
 Is the uncertainty of the purchasing power of the monies to be
received, in the future. In short purchasing power risks
refers to the impact of inflation or deflation on an
investment. Prudent investors normally include a premium
for purchasing power risk in their estimate of expected return.
 Exchange risk:

With the globalization of market cross border transactions are
on the increase. Balance of payments comprising the net
effect of exports and imports are subject to fluctuation in the
various currencies. The need to recognize this exchange risk
is obvious as the international trade operations may be
profitable or loss-making unless this risk is taken care of.
UNSYSTEMATIC RISK
 That fraction of total Risk which is unique to a Company or an
Industry due to
 Inherent internal factors like managerial capabilities, consumer
responsiveness, lab our unrest, etc. The operating environment
of the business R( Business Risk) and
 The financing modalities (Financial Risk)
 Business risks



Can be again divided into internal and external business risks.
Internal business risk is mainly due to the variations in the
operational efficiency of the company.
External business risks arise out of circumstances imposed on
the company by external forces like business cycle, certain
statutory restrictions or sops
UNSYSTEMATIC RISK
(Contd..)
 Financial risk




Associated with the modalities adopted by a company to finance its
activities.
Financial Leverage like the Debt/ Equity Ratio,
Managing financial risk by Asset Liability Management
A composite risk picture to be drawn by an approach known as
“Building Block”, accumulation is done at 3 successive levels.
 Level 1: Standalone Risks within a single risk factor (ex, credit
risk)
 Level 2: Risks of different risk factors with in a single business
area
 Level 3: Risks across all the business lines in a Corporate
Helps to isolating the incremental effects due to diversification.
(Normally, effects of diversification are the highest in level 1, lower
in level 2 and lowest in level 3.)
RISK MANAGEMENT TOOLS
Type of risk
Market
Narration
Tools
Risk arising due to change in
Value at risk (var),
market factors like asset prices,
scenario analysis
exchange rates, interest rates, etc
Credit
Business
Risk arising out of the failure to
Expected loss,
honor obligations for payments
unexpected loss
Due to change in conditions in
Historical earnings
revenue recognition and exposure
volatility, analogues
such as fluctuation in demand,
competition etc.
RISK MANAGEMENT MODELING PROCESS
 Relates to the methodology adopted for measuring risk and
performance.
 The two general classes of stochastic risk models are either
Statistical Analytic models & Structural Simulation models.
 Analytic methods


Often require a restrictive set of assumptions and certain assumed
probability distribution.
Easy and speedy.
 Simulation methods (Monte Carlo):


Require a large number of computer generated trials to estimate a
solution.
Robust and flexible and can deal with complex problems but data
requirement is a challenge.
PROJECT RISK MANAGEMENT
 Need :
 Project is one time process unique in nature, has a long
gestation period and based on many assumptions to be
realized at a future point as also regarding environment
and statutory policies.
 With a gestation period running into a few years any
change or revision in assumptions can transform itself
into a big risk.
 Management of such risks can be difficult and would
require special tools and models.
 Normally, projects are considered as dynamic, iterative
and often chaotic systems.
PROJECT RISK MANAGEMENT (Contd..)
Market Related Risks
Completion Risks
Institutional Risk
Turbulence
PROJECT RISK MANAGEMENT (Contd..)
 Types of project risks, measurement and models

The project risks can be classified under three different head:

Standalone risks:
 This is quantification of risk of a project when it is viewed in isolation.

Corporate risks:
 When the project is taken as part of a corporate entity its contribution
towards the total risk of the company

Systematic risks:
 This represents the market risk of the project
 These risks can be measured statistically by applying:

Range

Mean absolute deviation

Standard deviation

Coefficient of variance

Semi-variance
(Contd..)
PROJECT RISK ASSESSMENT IN PRACTICE
 In reality, the risk assessment is done through considering the various
components of the financial estimates and developing certain judgmental
approaches:



Estimation of revenues: revenues projected for a project need to be
justified on the basis of real data available and then the projections are
made conservatively. This avoids optimistic projections of income
Cost estimates: always include a margin of safety to take care of impact
of inflation over the time horizon for which the projections are being
made. Here again the margin of safety is computed on the basis of trend
analysis of inflation over the recent past and the lead indicators that are
available from fundamental analysis
Acceptable return on investment: this is the prime measure and as such it
should be arrived at on the basis of certain consensus. It will depend on
the payback period to be assumed, the industry experience and the
company’s norm for return on any new project on the basis of the current
experience
PROJECT RISK ASSESSMENT IN PRACTICE
(Contd..)

Overall certainty index: the critical risks of the project are
identified and the certainty index of each of these risks is
quantified. Then the overall certainty index is developed as an
average of the critical indices already computed. For instance, raw
material availability, power availability, intensity of competition is
a few of the risks, which are quantified in terms of certainty
indices. The cumulative average is the overall certainty index
 Judgmental perceptions:


Three different estimates of return on the investment are developed –
pessimistic, most likely and optimistic on the basis of the stage at
which the particular industry is in its life cycle.
On the basis of the three estimates and comparing them with the earlier
methods available on certainty equivalent coefficient, a judgmental
decision can be taken
PROJECT RISK ASSESSMENT IN PRACTICE
(Contd..)
 Approaches to project risk management
 Are six fold as follows:
 Decisioneering to assess and mitigate risk
 Build robust strategic systems
 Instilling govern ability
 Shaping institutions
 Hedging and diversifying risks through portfolios
 Embracing risks