Risk Management Flashcards
Types of risk
Strategic risk
Compliance risk
Operational risk
Financial risk
Strategic risk
A risk in which a company’s strategy becomes less effective and it struggles to achieves its goal.
It could be due to
- technological changes,
- a new competitor entering the market
- shifts in customer demand,
- increase in the costs of raw materials
Compliance risk
Every business needs to comply with rules and regulations.
This risk happens when company fail to comply with rules and regulations
Noncompliance leads to penalties in the form of fine and imprisonment
Operational risk
This type of risk relates to Internal risk.
It also relates to failure on the part of the company to cope with day to day operational problems.
Operational risk relates to ‘people’ as well as ‘process’.
Financial risk
Financial Risk is referred as the unexpected changes in financial conditions such as prices, exchange rate, Credit rating, and interest rate etc.
Also people who borrowed money and who are unable to pay for the money they borrowed is a type of Financial Risk.
Financial risk can be classified into
1: counter party risk
2: political risk
3: interest rate risk
4: curreny risk
5: liquidity risk
What is counter party risk,
How to identify it.
How to mitigate the risk
This risk occurs due to non- honoring of obligations by the counter party, which can be the failure to deliver the goods for the payment already made or repayment of borrowing
How to Identify Counterparty Risk?
Failure to obtain necessary resources.
Regulatory restrictions from Government.
Hostile action of foreign government.
Let down by third party.
Become insolvent.
How to mitigate/manage/reduce this risk?
Carrying out Due Diligence before dealing with third party.
Do not over commit to single entity.
Know your exposure limits.
Review credit limits regularly.
Rapid action in case of defaults.
Use guarantee
What is poltical risk
How to identify
How to overcome or reduce
This type of risk is faced by an overseas investors, as the adverse action by the government of host country may lead to huge losses.
This risk can be identified from the following actions by host country Government:
Insistence on resident investors.
Restriction on currency conversion.
Repatriation of foreign assets.
Price fixation.
Since this risk mainly relates to investments in foreign country, company should assess country risk as follows:
By referring political ranking.
By evaluating macro-economic conditions.
By analyzing popularity of current government.
By taking advises from embassies.
Techniques to mitigate this risk are as follows:
Local sourcing of raw materials and labour
Entering in joint ventures
Local financing
Prior negotiations
What is interest rate risk
How to identify
How to mitigate it
This risk occurs due to change in interest rate resulting in change in asset and liabilities.
This risk is more important for banking companies
How to Identify Interest Rate Risk?
- Monetary Policy of the Government
- Any action by Government such as
demonetization etc. - Economic Growth
- Release of Industrial Data
- Investment by foreign investors 6. Stock market changes
How to mitigate/manage/reduce this risk?
- Using Forward Rate Agreement
- Using Swaps
- Using Interest Rate Futures
- Using Caps, Collars, & Floors
Curreny risk
This risk mainly affects the
organization dealing with foreign exchange as their cash flows changes with the movement in the currency exchange rates
How to Identify Currency Risk?
- Government Action
- Nominal Interest Rate
- Inflation Rate: Purchasing power parity theory discussed in later chapters impact the value of
currency - War, natural calamities
How to mitigate/manage/reduce this risk?
- Using Home Currency Invoicing
- Using Forward Contracts
- Using Futures Contracts
- Using Options Contract
- Using Swaps
- Leading or Lagging the foreign currency receivables or payables
Liquidity risk
- Broadly liquidity risk can be defined as inability of organization to meet it liabilities whenever they become due.
- This risk mainly arises when organization is unable to generate adequate cash or there may be some mismatch in period of cash flow generation.
- This type of risk is more prevalent in banking business where there may be mismatch in maturities and receiving fresh deposits pattern.
Evaluation of financial risk
Stakeholder Angel:
1. Major stakeholders of a business are equity shareholders and they view financial gearing i.e. ratio of debt in capital structure of company as risk since in event of winding up of a company they will be least prioritized.
- Even for a lender,
existing gearing is also a risk since company having high gearing faces more risk in default of payment of interest and principal repayment.
Company Angle:
From company’s point of view if a company borrows excessively or lend to someone who defaults, then it can be forced to go into liquidation
Government angle:
From Government’s point of view, the financial risk can be viewed as failure of any bank or (like Lehman Brothers) down grading of any financial institution leading to spread of distrust among society at large. Even this risk also includes willful defaulters. This can also be extended to sovereign debt crisis.
Var
- VAR is a measure of risk of investment given the normal market condition in a set of period, say, one day it estimates how much an investment might lose
- VAR answers two basic questions 1. What is worst case scenario? 2. What will be loss?
- VAR answers the question, “What is my worst-case scenario?” or “How much could I lose in a really bad month?”
Components of Calculations of var
Components of Calculations:
- Time Period
- Confidence Level - Generally 95% and 99%
- Loss in percentage or in amount
Application of VaR
1: To measure the maximum possible loss on any portfolio or a trading position.
2:As a benchmark for performance measurement of any operation or trading.
3: To fix limits for individuals dealing in front office of a treasury department
4: As a tool for Asset and Liability Management especially in banks.
5:To enable the management to decide the trading strategies
