Risk Management PDF

2 RISK MANAGEMENT A/ Financial Risk Management Ø Risks cannot be eliminated totally when engaged in a business, so as the financial risk. Ø How much financial risk can be born by the entity is dependent on factors such as: Company Objectives Ø If the objective of the entity is not profit maximizatio...

2 RISK MANAGEMENT A/ Financial Risk Management Ø Risks cannot be eliminated totally when engaged in a business, so as the financial risk. Ø How much financial risk can be born by the entity is dependent on factors such as: Company Objectives Ø If the objective of the entity is not profit maximization, it will not think of financial risk or analysis, although even for a non-profit organization it is useful. Risk Tolerance Ø If the entity can absorb large amount of losses from any shocks, it will think less about financial risk, although analyzing and managing financial risk has become a crucial function today of any organization irrespective of size. A/ Financial Risk Management Ø Financial Risk Management is a comprehensive process that consists of four steps: 1. Identifying Risks 2. Assessing Risks 3. Treating Risks 4. Reporting Risks A/ Financial Risk Management B/ Financial Risk Analysis Ø Financial risk analysis comprises of two main parts: Identifying the risk factors and controlling them to decide how to manage them effectively. Step 1 – Identifying Financial Risk Factors Ø Financial Risk Factors depend on the nature of business of the entity. Ø For a company engaged purely in local business, foreign currency exchange risk is not much of a concern and this will be the major concern for a multi-national company. Ø For a banking or lending institute, interest rate risk and credit risk would be the major concern. Secondly, risk tolerance that is the significance of the identified risk factors should be analyzed. B/ Financial Risk Analysis Step 2 – Assessing the Financial Risk Factors Assessing and analyzing is essential to understand the extent and significance of a particular risk factor for an organization. Different financial risk analysis tools could be used for this purpose. VaR, you said? Widely used across the industry, VaR is one of the most popular risk management method used by financial institutions Preferred market risk approach for capital requirement management within the 2006 Basel 2 framework What is it? VaR is a statistical technique designed to measure the maximum loss that a portfolio of assets “could” suffer over a given time horizon with a specified level of confidence Three key elements: a Period of time, a Probability level , a Loss amount On One day, there is a 95% Probability that we will not lose more than $1,000,000 Normal distribution The Normal distribution or Gaussian distribution is one of the most commonly used statistical tool to model random variables distribution Why is it so popular? Important because of the Central Limit Theorem which broadly states that for a big enough sample, the distribution a random variable average tend/converge to be normally distributed 1/ Type of VaR: Historical method Directly calculated from past returns Re-organizes actual historical returns in order from worst to best For example, suppose we want to calculate the 1-day 95% VaR for an equity using 100 days of data. VaR corresponds to the least worst of the worst 5% of returns. Simply put, because we are using 100 days of data, the VaR corresponds to the 5th worst day. Step 3 – Financial Risk Treatment Risk treatment is dependent on the significance of risk to the company and frequency of its occurrence. Below diagram explains the risk treatment methods available: Financial Risk Retention Ø If the value of risk is within the tolerable level of the entity, it would decide to do nothing about it. Ø Accepting certain amount of risk is necessary to be in the business and make profits Financial Risk Reduction Ø Although the significance is low, if the entity identifies the frequency of risk is high due to any reason controllable by the company or using any other techniques, it would decide to reduce the risk by controlling the frequency Financial Risk Transfer Ø If the frequency is low but if the magnitude is high, the entity would try to transfer the risk contractually to another party just like taking a fire insurance Financial Risk Avoidance Ø These are the risks, which should be effectively kept away from the entity as their significance and frequency are high. For example, if a financial institution is going to give a big amount of loan to a definite defaulter, he will not pay the interest or capital. Ø So the best option is not to extend credit and we call it risk avoidance Liquidity Risk Management Liquidity Diversification Ø Assets and liabilities mature at different durations and proper matching will ensure that the company has the required level of liquidity at the right time Scenario Analysis and Contingent Plans Ø Although the company assets and liabilities are matched, it is suggested to create possible scenarios where the company would face liquidity problems and should have contingency funding for urgent incidences accordingly Liquidity at Risk Ø Liquidity problems are forecasted for a foreseeable future with probability for occurrence and holding sufficient liquid funds to finance them Derivatives Ø Hedging liquidity risk using a technique such as options, forwards or swaps Credit Risk Management Credit Diversification Ø It is possible for the entity to reduce credit risk by diversifying the counterparties without concentrating on few and by reducing the exposure level to each borrower. Entity can also focus on lending to different industries Credit Scoring Models Ø Number of factors are identified, which can affect the credit worthiness of a borrower and scorings are assigned to assess each borrower individually. Ø This exercise can take place before extending the credit and then periodically Effective Credit Collection or Recovery Mechanisms Ø A dedicated department or team can be assigned to follow up the collections and work specifically to recover the outstanding credits Effective Credit Mechanisms Collection Credit Terms or Recovery Extending credit encourages customers to buy from us...... but it ties up resources in accounts receivable. Minimize Accounts Receivable Operational Risk Management Risk Identification Ø The identification process needs to involve staff from all levels of the business if possible, bringing a variety of experiences to make a cohesive result. Risks that can be identified by work floor staff will be very different and no less critical than those identified from the board. Risk Assessment Ø Need to be done from both a quantitative and qualitative perspective and factors like the frequency and severity of occurrence need to be taken into consideration. The assessment needs to prioritize the management of these risks in relation to those factors. Measurement and Mitigation Ø Mitigating these risks is the next stage, with controls put in place that should limit the company’s exposure to the risks and the potential damage caused by them Monitoring and Reporting Ø Plan must be in place for the ongoing, monitoring and reporting these risks and demonstrate how effective it has been. It should ensure that the solutions put in place are continuing to be effective and doing their job in managing the risks. Interest Rate Risk Management Matching Ø The entity can match its assets and liabilities to have a common interest rate, which means if the entity has taken a loan in floating interest rate, it can also hold an asset in floating interest rate. Smoothing Ø The entity can hold assets or liabilities in both fixed and floating interest rates in a balanced manner, so that floating rates function as natural hedge during the times of interest rate changes. Derivatives Ø Options, forwards, futures and swaps can be used to hedge risk. Foreign Currency Exchange Rate Risk Management Invoicing in Local Currency Ø An exporter or importer don’t need to worry about currency fluctuations if they can trade in home currency internationally. This is possible only for few countries with strong currencies. Matching Ø An entity can use a technique of hedging by timing the foreign currency receipts and payments in the same period. This functions as natural hedge for currency appreciation or depreciation. Leading and Lagging Ø If an exporting company is expecting to receive money for traded goods and expects the currency to depreciate in next two months, the company can make an effort to receive the payment early. Ø On the other hand, if an importing company has an obligation to pay for received goods and it expects the currency to depreciate in next two months, the company can delay the payment. Derivatives Ø Options, forwards, futures and swaps can be used to hedge risk.