CHAPTER 10 CORPORATE RISK MANAGEMENT

1. Introduction y Risk is the possibility of the actual outcome being different from the expected outcome. It includes both the downside and the upside. Downside is the possibility of the actual results being adverse compared to the expected results while upside in the possibility of the actual results being better than the expected results. Risk & uncertainty are not the same. Risk is a situation where there are a number of specific, probable outcomes but it is not certain as to which one of them will actually happen. Uncertainty is a situation where even the probable outcomes are unknown. It reflects a total lack of knowledge of what may happen. Risk is generally measured using the statistical concept of standard deviation. The objective of a firm is to create wealth for its shareholders. The wealth is reflected in the market value of its shares. The risk faced by a firm is the possibility that the actual market value of its shares may be different from the expected market value. The downside risk stems from the possibility of either the costs being higher than expected or revenues being lower than expected or both with the result that actual PAT may be lower than expected PAT. The upside risk may result from either the possibility of costs being lower than expected or revenues being higher than expected or both.

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2. Classification of Risks y The wide array of risks that a business firm is exposed to may be classified into 5 categories as under: i. ii. iii. iv. v. y Technological Risks Economic Risks Financial Risks Performance Risks and Legal/Regulatory Risks

Technological Risks arise mostly in the R&D and operation stages of the value chain. High R&D risks particularly in high-tech sectors can significantly impact their profitability. Operating risk arises when new technologies lead to problems in production or in delivery of services or when a production breakdown occurs or defective products lead to product liability suits.

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Economic Risks arise from fluctuations in revenues (output price and demand) and production costs (raw material costs, energy cost & labour cost). General macro economic conditions and the competitive environment in which the firm operates determine the nature of economic risks. Financial Risks arise from the volatility of interest rates, currency rates, commodity prices and stock prices. Financial risks can be further subdivided into the following i. ii. iii. Interest rate risk Exchange risk Market risk

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Performance Risks arise when the contract counterparties do not fulfill their obligations. Normally a firm enters into a contracts with buyers, suppliers, sub contractors and others Legal & regulatory Risks arise from changes in laws & regulations

3. Risk Management y y y y y y Corporate risk management refers to the process of a firm attempting to manage its risk at an acceptable level. It is a dynamic process which changes according to the evolving scenario. The aim of risk management is to maintain overall and specific risks at the desired levels, at the minimum possible costs The goal of risk management is not the complete elimination of risk Modern finance theory regards risk management activities at reducing total corporate risks as irrelevant. Total risk consists of systematic risk & unsystematic risk. Traditional financial theory states that the market rewards only systematic risk faced by a firm. As the unsystematic risk can be diversified away, the market does not compensate the investors for bearing it. So the presence of unsystematic risk does not increase the cost of capital of a firm. Thus, a firm is not required to manage its unsystematic risks, as the costs involved reduce the return on investment without reducing the cost of capital. This argument, however, does not take into account the indirect effect of unsystematic risk on the cash flows of a firm. A firm having a high degree of unsystematic risk faces reduced confidence of the various stakeholders (suppliers, customers, employees). All these factors results in the firm s cash flows falling down. Hence it can be said that managing unsystematic risks is essential for a firm to stabilize its earnings and to add value to its investors wealth.

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4. Approaches to Risk Management y The different approaches to risk management are i. ii. iii. iv. v. vi. vii. y Risk Avoidance Loss Control Combination Separation Risk Transfer Risk Retention Risk Sharing

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Risk Avoidance: This is an extreme approach of risk management. Risk is avoided by not undertaking the activity that entails risk. This approach may be relevant in certain circumstances but it is not possible nor is it prudent to use it for managing all kinds of risks. Loss Control: This refers to the attempt to reduce either the possibility of loss or quantum of loss. Combination: This refers to the technique of combining more than one business activity in order to reduce the overall risk of the firm. It is known as aggregation or diversification. While combining business activities it must be ensured that they are not positively correlated in which case the risk will be even more. Separation: This is the technique of reducing risk through separating parts of businesses or assets or liabilities. Risk Transfer: This involves transferring risk to another party who is willing to bear risk. This may be done in 3 ways: i. ii. iii. By transfer of the assets itself-for example spinning off a part of business By transferring the risk without transferring the title of the asset/liability. This may be done by hedging through various derivative instruments By arranging a third party to pay for losses if they occur, without transferring the risk itself. This is referred to as risk financing. This is done by buying insurance.

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Risk Retention: This means risk is retained without doing anything to avoid or reduce or transfer risk. Risk may be retained consciously as techniques of managing risks may be costly or unavailable or risk may even be retained unconsciously. Risk Sharing: This technique is a combination of risk retention & risk transfer. Under this technique, a particular risk is managed by retaining a part of it and transferring the rest to a party willing to bear the risk.

5. Risk Management Process y y Risk management needs to be looked at as an organized approach. Risks cannot be managed independently by different departments as then the effect will be less than optimal. Risk management involves the following steps i. ii. iii. iv. v. vi. vii. y Determination of Objectives Identification of Risks Risk Evaluation Development of Policy Development of Strategy Implementation Review

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Determination of Objectives: This is the first and most important step. At the corporate level, the firm has to decide the objectives of risk management which differ from firm to firm and over a period of time. Identification of Risks: every firm is unique & faces unique set of risks based on its business, the economic, social & political factors, the industry in which it operates, factors internal to the firm and various other factors. It is therefore necessary for the firm to identify the possible sources of risks and the kinds of risks it may face. Risk Evaluation: Once the risks are identified, they need to be evaluated for ascertaining their significance. The significance of a risk depends not only in the size of the loss that it may result in but also on the probability of occurrence of such loss. On the basis of these factors, risks needs to be classified as i. Critical risks ii. Important risks iii. Others Critical risks are those that may result in bankruptcy of the firm. Important risks are those that may cause severe financial distress; others include those that may result in losses which the firm may easily bear in the normal course of business. Development of Policy: A risk management policy has to be developed keeping in mind the following i. ii. iii. iv. Risk tolerance level of the firm Risks to be managed Risks that need not be managed Costs of management of risk

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Development of Strategy: Based on the policy, the firm has to develop the strategy to be followed for managing the risk. Strategy is nothing but an action plan for proper implementation of the policy. It will mean identifying the responsibilities of those entrusted with the task of managing different kinds of risks. It will also mean framing detailed guidelines for management of risk for use by the operating levels of management. Implementation: This is the operational part of risk management Review: The implementation needs to be reviewed periodically. The objective is two fold i. ii. To ensure that the policy is being followed as per the action plan. To study the deviation, if any, and to initiate suitable corrective actions wherever required.

6. Risk Management Techniques y There are 2 kinds of techniques that can be used for management of various categories of risks. i. ii. y y y Internal Techniques External Techniques

Internal techniques are those that are part of the day to day operations of the firm. External techniques are those that require the firm to enter into some kind of financial contract with another entity Examples of internal techniques i. ii. Asset-liability management to manage both interest rate risk and currency risk Exposure netting, leading & lagging and choosing the currency of invoice to manage exchange rate risks.

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Examples of external techniques i. Forward cover ii. Futures iii. Options iv. Swaps

7. Guidelines to Risk Management i. ii. iii. iv. v. The goals of risk management & financial management are the same. Paper mix of risk management techniques Pro active risk management Flexibility in approach Risk bearing to be kept at the optimal level.

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