Risk Management: Types of Risks in Finance PDF

RISK MANAGEMENT TYPES OF RISKS IN FINANCE Prepared by: Dwight D. Dacquel, MBA LEARNING OBJECTIVES: At the end of this lesson, you are expected to: Understand and differentiate Types of Financial Risks: Distinguish between systematic and unsystematic risk Identify and recogniz...

RISK MANAGEMENT TYPES OF RISKS IN FINANCE Prepared by: Dwight D. Dacquel, MBA LEARNING OBJECTIVES: At the end of this lesson, you are expected to: Understand and differentiate Types of Financial Risks: Distinguish between systematic and unsystematic risk Identify and recognize components of systematic & unsystematic risk Analyze risk management strategies and their impact on financial decision-making. DEFINITION: Risk in Finance: the possibility of a negative financial outcome  QUESTION: Remember the 2008 financial crisis? Aka as GLOBAL FINANCIAL CRISIS (GFC)  QUESTION:  https://www.thebalancemoney.com/2008-financial- crisis-3305679  QUESTION:  https://www.thebalancemoney.com/what-caused-2008-global-financial-crisis- 3306176  DEFINITION: Systematic Risk - Risks that are inherent to the entire market or economy, uncontrollable by individual organizations. -Macro-level, uncontrollable, affects the entire market.  SYSTEMATIC RISK 1. INTEREST RATE RISK - is the possibility that a change in interest rates will reduce the value of a fixed-rate investment or debt security.  Price Risk: Changes in bond prices due to fluctuating interest rates.  Reinvestment Rate Risk: Uncertainty about reinvestment returns when interest rates change.  https://corporatefinanceinstitute.com/resources/career-map/sell-side/risk-management/interest-rate-risk/  INTEREST RATE RISK  HOW TO MITIGATE INTEREST RATE RISK?  1. Diversification  If a bondholder is afraid of interest rate risk that can negatively affect the value of his portfolio, he can diversify his existing portfolio by adding securities whose value is less prone to interest rate fluctuations (e.g., equity). If the investor has a “bonds only” portfolio, he can diversify the portfolio by including a mix of short- term and long-term bonds.  2. Hedging  The interest rate risk can also be mitigated through various hedging strategies. These strategies generally include the purchase of different types of derivatives. The most common examples include interest rate swaps, options, futures, and forward rate agreements (FRAs).  https://corporatefinanceinstitute.com/resources/career-map/sell-side/risk-management/interest-rate-risk/  SYSTEMATIC RISK 2. MARKET RISK - is the possibility of an investor experiencing losses due to factors that affect the overall performance of the financial markets.  Absolute Risk: The overall risk of an investment.  Relative Risk: The risk of an investment relative to a benchmark.  Directional Risk: The risk associated with a specific market trend (e.g., rising or falling stock prices).  Non-Directional Risk: The risk associated with market volatility, regardless of direction.  Basis Risk: The risk that the difference between two correlated assets (e.g., a futures contract and the underlying asset) will change unexpectedly.  Volatility Risk: The risk that the price of an asset will fluctuate significantly.  https://www.investopedia.com/terms/m/market  HOW TO MITIGATE MARKET RISK?  1. Diversification  Spread investments across various asset classes (stocks, bonds, real estate, commodities) to reduce exposure to any single market's volatility.  Include geographic diversification to mitigate region-specific risks.  2. Hedging  Use financial instruments such as derivatives (options, futures, swaps) to protect against adverse price movements.  Example: Currency futures to lock in exchange rates, or options to cap losses in stock prices.  3. Asset Allocation  Maintain a balanced portfolio tailored to risk tolerance and market conditions.  Adjust allocations periodically based on market analysis and personal/organizational goals.  HOW TO MITIGATE MARKET RISK?  4. Stop-Loss Orders  Set automatic orders to sell an asset if its price falls below a predetermined level to limit potential losses.  5. Risk Management Policies  Establish internal guidelines and limits for risk exposure, ensuring adherence to sound financial practices.  Use Value at Risk (VaR) models to quantify potential losses and guide decisions.  6. Stress Testing and Scenario Analysis  Conduct simulations of extreme market conditions to evaluate portfolio vulnerabilities and develop contingency plans.  HOW TO MITIGATE MARKET RISK?  7. Monitoring and Analysis  Regularly monitor market trends, news, and economic indicators.  Employ technical and fundamental analysis to anticipate market movements.  8. Liquidity Management  Maintain sufficient liquid assets to meet obligations without selling investments at a loss during volatile periods.  9. Utilizing Technology  Leverage risk management software and tools to track exposures, model risks, and optimize portfolio decisions.  SYSTEMATIC RISK 3. Purchasing Power/Inflationary Risk - refers to the risk that the value of money will decrease over time due to rising inflation. - Inflationary risk is the risk that the future real value (after inflation) of an investment, asset, or income stream will be reduced by unanticipated inflation.  Demand Inflation Risk: Rising prices due to increased demand.  Cost Inflation Risk: Rising prices due to increased costs of production.  https://www.investopedia.com/terms/i/inflation  HOW TO MITIGATE PURCHASING POWER RISK?  Incorporate Inflation Premiums:  Build an inflation premium into the interest rate or required rate of return (RoR).  Example: Add 3% to the interest rate if a 3% decline in money value is expected over a year.  Adjust for Unanticipated Inflation:  Simply adding an inflation premium cannot address unexpected inflation changes.  Use Inflation-Protected Securities:  Treasury Inflation-Protected Securities (TIPS):  Adjust coupon and principal payments based on the Consumer Price Index (CPI).  Provide a guaranteed real return aligned with actual inflation rates.  HOW TO MITIGATE PURCHASING POWER RISK?  Consider Variable-Rate Securities:  Provide protection as cash flows (interest, dividends) are linked to indices (e.g., prime rate) influenced by inflation.  Leverage Convertible Bonds:  Offer dual benefits by sometimes trading like bonds and other times like stocks.  Correlation with stock prices provides partial inflation protection.  DEFINITION: Unsystematic Risk - Risks specific to a company or industry that can be mitigated through strategies like diversification.. -Micro-level, controllable, specific to a company or industry.  UNSYSTEMATIC RISK 4. BUSINESS / LIQUIDITY RISK - refers to the potential inability of a company to meet its short-term financial obligations, such as paying debts or suppliers, due to a lack of liquid assets  Asset Liquidity Risk: Difficulty in selling an asset without significant price changes.  Funding Liquidity Risk: Inability to secure necessary funding.  HOW TO MITIGATE LIQUIDITY RISK?  Implement Cash Management Strategic  Regular Cash Flow Analysis – monitor cash inflows and outflows regularly  Cash Forecasting – forecast future cash needs based on operational and seasonal needs  Optimize Working Capital – negotiate better payment terms  HOW TO MITIGATE LIQUIDITY RISK? Maintain a Stable Cash Reserve  Emergency Fund Allocation - Set aside a portion of profits as a liquidity buffer to cover unexpected expenses or downturns.  Access to Credit Lines - Secure standby credit facilities or overdraft agreements to address short- term cash shortfalls.  HOW TO MITIGATE LIQUIDITY RISK? Diversify Revenue Streams  Expand Product/Service Offerings - Introduce new products or services that generate additional revenue streams.  Geographical Diversification - Target multiple markets to reduce dependency on a single region  Customer Base Diversification - Avoid overreliance on a single customer or segment for revenue.  LIQUIDITY RISK What are some possible consequences of Poor Liquidity Management?  UNSYSTEMATIC RISK 5. FINANCIAL / CREDIT RISK - refers to the possibility that a borrower or a company may default on their financial obligations, such as loans, credit card debt, or other financial commitments.  Exposure Rate Risk: Risk related to the level of exposure.  Recovery Rate Risk: Risk of recovering less than expected from defaults.  Credit Event Risk: Risk of unexpected credit-related events.  Sovereign Risk: Risk associated with government debt defaults.  Settlement Risk: Risk of transaction settlement failures.  HOW TO MITIGATE CREDIT RISK?  For Exposure Rate Risk  Diversify Credit Exposure  Set Exposure Limit  For Recovery Rate Risk  Secure Adequate Collateral  Strengthen Recovery Processes  For Credit Event Risk  Monitor Credit Ratings  Use Credit Derivatives  HOW TO MITIGATE CREDIT RISK?  For Sovereign Risk  Assess Country Risk  Diversify Geographic Exposure  For Settlement Risk  Use DVP Systems  Partner with Trusted Counterparties  UNSYSTEMATIC RISK 6. OPERATIONAL RISK - involves potential losses due to failures in internal processes, systems, or external events. -focuses on how things are accomplished within an organization, not necessarily what is produced or inherent within an industry.  Model Risk: Errors or inaccuracies in financial models can lead to flawed decisions and financial losses.  People Risk: Losses resulting from human error, negligence, or fraudulent activities.  Legal Risk: Costs or losses arising from legal actions, regulatory breaches, or non-compliance.  Political Risk: The risk of losses caused by political instability THANK YOU!