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Risk Analysis and Risk Management

Economic risk is referred to as the risk exposure of an investment made in a foreign country
due to changes in the business conditions or adverse effect of macroeconomic factors like
government policies or collapse of the current government and significant swing in the
exchange rates.

Types of Economic Risk

 
#1 – Sovereign Risk

This type of economic risk is one of the most critical risks that can have a direct impact on the
investment since the repercussions arising out of these risks can trigger other troubles that are
related to the business. Sovereign Risk is the risk that a government cannot repay its debt and

default on its payments. When a government becomes bankrupt, it directly impacts the
businesses in the country. Sovereign Risk is not limited to a government defaulting but also
includes the political unrest and change in the policies made by the government. A change in
government policies can impact the exchange rate, which might affect the business
transactions, resulting in a loss where the business was supposed to make a profit.
#2 – Unexpected Swing in Exchange Rate

This type of sovereign risk is the risk if the market moves drastically to impact the exchange
rate. When the market moves considerably, it affects international trade. This can be due to
speculation or the news that can cause a fall in demand for a particular product or currency. Oil
prices can significantly impact the market movement of other traded products. As mentioned
above, government policies can also result in a dip or hike in the market movement. Change in
inflation, interest rates, import-export duties, and taxes also impact the exchange rate. Since
this directly impacts trade, exchange rates risk seeming to be a significant economic risk.
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#3 – Credit Risk

This type of sovereign risk is the risk that the counterparty will default in making the obligation
it owes. Credit risk is entirely out of control since it depends on another entity’s worthiness to
pay its debts. The counterparty’s business activities need to be monitored on a timely basis so
that the business transactions are closed at the right time without the risk of counterparty
default to make payments.

Business Risk
With a stock, you are purchasing a piece of ownership in a company.  With a bond, you are
loaning money to a company.  Returns from both of these investments require that that the
company stays in business. If a company goes bankrupt and its assets are liquidated, common
stockholders are the last in line to share in the proceeds.  If there are assets, the company’s
bondholders will be paid first, then holders of preferred stock.  If you are a common
stockholder, you get whatever is left, which may be nothing.

 Inflation Risk
 Inflation is a general upward movement of prices.  Inflation reduces purchasing power,
which is a risk for investors receiving a fixed rate of interest.  The principal concern for
individuals investing in cash equivalents is that inflation will erode returns.

Interest Rate Risk

Interest rate changes can affect a bond’s value.  If bonds are held to maturity the investor will
receive the face value, plus interest.  If sold before maturity, the bond may be worth more or
less than the face value.  Rising interest rates will make newly issued bonds more appealing to
investors because the newer bonds will have a higher rate of interest than older ones.  To sell
an older bond with a lower interest rate, you might have to sell it at a discount.

Liquidity Risk
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This refers to the risk that investors won’t find a market for their securities, potentially
preventing them from buying or selling when they want. This can be the case with the more
complicated investment products.  It may also be the case with products that charge a penalty
for early withdrawal or liquidation such as a certificate of deposit (CD).

Risk Analysis

Risk Analysis is a process that helps you to identify and manage potential problems that
could undermine key business initiatives or projects. 
To carry out a risk analysis, follow these steps:
1. Identify Threats
The first step in Risk Analysis is to identify the existing and possible threats that you might face.
These can come from many different sources. For instance, they could be:

 Human – Illness, death, injury, or other loss of a key individual.

 Operational – Disruption to supplies and operations, loss of access to essential assets, or

failures in distribution.

 Reputational – Loss of customer or employee confidence, or damage to market reputation.

 Procedural – Failures of accountability, internal systems, or controls, or from fraud.

 Project – Going over budget, taking too long on key tasks, or experiencing issues with
product or service quality.

 Financial – Business failure, stock market fluctuations, interest rate changes, or non-
availability of funding.

 Technical – Advances in technology, or from technical failure.

 Natural – Weather, natural disasters, or disease.

 Political – Changes in tax, public opinion, government policy, or foreign influence.

 Structural – Dangerous chemicals, poor lighting, falling boxes, or any situation where staff,
products, or technology can be harmed.

2. Estimate Risk
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Once you've identified the threats you're facing, you need to calculate both the likelihood of
these threats being realized, and their possible impact.
One way of doing this is to make your best estimate of the probability of the event occurring,
and then to multiply this by the amount it will cost you to set things right if it happens. This
gives you a value for the risk:
 Risk Value = Probability of Event x Cost of Event
Avoid the Risk
In some cases, you may want to avoid the risk altogether. This could mean not getting involved
in a business venture, passing on a project, or skipping a high-risk activity. This is a good option
when taking the risk involves no advantage to your organization, or when the cost of addressing
the effects is not worthwhile.

Share the Risk

You could also opt to share the risk – and the potential gain – with other people, teams,
organizations, or third parties.
For instance, you share risk when you insure your office building and your inventory with a
third-party insurance company, or when you partner with another organization in a joint
product development initiative.
Accept the Risk
Your last option is to accept the risk. This option is usually best when there's nothing you can do
to prevent or mitigate a risk, when the potential loss is less than the cost of insuring against the
risk, or when the potential gain is worth accepting the risk.
For example, you might accept the risk of a project launching late if the potential sales will still
cover your costs.
Before you decide to accept a risk, conduct an Impact Analysis  to see the full consequences of
the risk. You may not be able to do anything about the risk itself, but you can likely come up
with a contingency plan  to cope with its consequences.
Control the Risk
If you choose to accept the risk, there are a number of ways in which you can reduce its impact.
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Business Experiments  are an effective way to reduce risk. They involve rolling out the high-risk
activity but on a small scale, and in a controlled way. You can use experiments to observe
where problems occur, and to find ways to introduce preventative and detective actions before
you introduce the activity on a larger scale.
 Preventative action involves aiming to prevent a high-risk situation from happening. It
includes health and safety training, firewall protection on corporate servers, and cross-
training your team.
 Detective action involves identifying the points in a process where something could go
wrong, and then putting steps in place to fix the problems promptly if they occur. Detective
actions include double-checking finance reports, conducting safety testing before a product
is released, or installing sensors to detect product defects.
Plan-Do-Check-Act  is a similar method of controlling the impact of a risky situation. Like a
business experiment, it involves testing possible ways to reduce a risk. The tool's four phases
guide you through an analysis of the situation, creating and testing a solution, checking how
well this worked, and implementing the solution.