UNIT II RISK MANAGMENT

RISK MANAGMENT
RISK
Variety of meanings for risk in business and our day today life. Risk is used to describe any situation where there is uncertainty about what outcome will occur

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RISK
In probability, statistics, Financial management and Investment management, risk is often used in a more specific sense to indicate possible variability in outcomes around some expected value Risk may also refer to the expected losses associated with a situation

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Risk
Eg. High risk policy-holder
Expected value of losses to be paid by the insurer is high

Eg. Japan is a high risk zone for earthquake

Expected losses from earthquake in Japan is higher than other countries

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RISK
Used in specific sense to describe variability around the expected value And also to describe the expected loss

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EXPECTED LOSS one situation is riskier than Another if it has greater

UNCERTAINITY (Variability Around expected loss )

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RISK IS COSTLY
Greater risks implies greater cost

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POTENTIAL LOSSES
DIRECT LOSS
If fire destroys a house, direct loss would be the price of the house

INDIRECT LOSS
Indirect losses arise as a consequence of direct loss If a house is destroyed, the owner would have additional expenses such as hotel and restaurant bills When a persons car is damaged, the time spent in getting the car repaired is an indirect loss

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For businesses, Indirect losses are extremely important The possibility of indirect losses is one main reason that businesses try to reduce risk For eg, A fire accident in factory will result in huge losses due to loss of sales

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TYPES OF INDIRECT LOSSES
Loss of normal profit ( Net cash flow) Extra operating expenses Higher cost of funds and foregone investments Bankruptcy costs ( Legal fees )

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TYPES OF RISK FACING BUSINESSES
Price risk Credit risk Pure risk

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PRICE RISK
Refers to uncertainty over the magnitude of cash flows due to possible change in output and input prices The three specific types of price risks are
Commodity price risk Exchange rate risk Interest rate risk

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Commodity price risk
Due to fluctuations in price of commodities such as minerals, oil, gas, metals . These may be the input or output for a company

Exchange rate risk

In this globalised business context, the input and output prices are affected by fluctuations in foreign exchange rates

Interest rate risk

Changes in interest rate affects a firms cost of borrowing funds

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CREDIT RISK
The risk that a firms customers and the parties to which it has lent money will delay or fail to make the promised payment Firms face credit risks for account receivables Firms will have to pay more to borrow money as credit risk increases E.g. Top credit risk is mainly for large financial institutions such as Banks when encounter large amount of loss.

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PURE RISK
Risk of reduction in value of business assets due to physical damage, theft and expropriation
What is expropriation?

Risk of legal liability for damages to customers, suppliers, shareholders and other parties Risk associated with paying benefits to injured workers Risk of death, illness and disability to employees

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TYPES OF RISK FOR INDIVIDUALS
Earnings Medical expenses Liability Physical Assets Financial Assets

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Risks associated with Earnings
Due to death Due to disability Due to aging Due to unemployment

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Risks associated with Medial expenses

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Risks associated with Liability
Related to automobiles Liable for death caused by accident In India, Government has made it mandatory for all individuals involved in driving of vehicles to take insurance for covering against this liability

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Risks associated with Physical Assets
Damages to Automobiles Damages to Home Damages to properties

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Risks associated with Financial Assets
Losses due to investments in shares Losses due to investments in Bonds