Risk Management

Course Information Course

Title: Risk Management
Course Code FIN-436
Credit Hours 3
rd
Course Level BBA 7Th, MBA 3

Course Evaluation Criteria

Assignments, Project & presentation 10%
Quizzes 05%
Mid-term 20%
Final 60%
Total 100
Lecture 1
Definitions of Risk
The term Risk is used in many ways and is given different definitions depending on the field and
context. Common to most definitions of risk is uncertainty and undesirable outcomes.
What Is Risk?
Risk is defined in financial terms as the chance that an outcome or investment's actual gains will
differ from an expected outcome or return. Risk includes the possibility of losing some or all of
an original investment.
Quantifiably, risk is usually assessed by considering historical behaviors and outcomes. In
finance, standard deviation is a common metric associated with risk. Standard deviation provides
a measure of the volatility of asset prices in comparison to their historical averages in a given
time frame.
Overall, it is possible and prudent to manage investing risks by understanding the basics of risk
and how it is measured. Learning the risks that can apply to different scenarios and some of the
ways to manage them holistically will help all types of investors and business managers to avoid
unnecessary and costly losses.
The Basics of Risk
Everyone is exposed to some type of risk every day – whether it’s from driving, walking down
the street, investing, capital planning, or something else. An investor’s personality, lifestyle, and
age are some of the top factors to consider for individual investment management and risk
purposes. Each investor has a unique risk profile that determines their willingness and ability to
withstand risk. In general, as investment risks rise, investors expect higher returns to compensate
for taking those risks.
Risk and its treatment
According to its definition, Risk Treatment is the process of selecting and implementing of
measures to modify risk. Risk treatment measures can include avoiding, optimizing, transferring
or retaining risk. The measures (i.e. security measurements) can be selected out of sets of
security measurements that are used within the Information Security Management System
(ISMS) of the organization.
Identification of Options
Having identified and evaluated the risks, the next step involves the identification of alternative
appropriate actions for managing these risks, the evaluation and assessment of their results or
impact and the specification and implementation of treatment plans.
Development of Action Plan
Treatment plans are necessary in order to describe how the chosen options will be implemented.
The treatment plans should be comprehensive and should provide all necessary information
about:
• proposed actions, priorities or time plans,
• resource requirements,
• roles and responsibilities of all parties involved in the proposed actions,
• performance measures,
 • reporting and monitoring requirements.
• Approval of Action Plan
As with all relevant management processes, initial approval is not sufficient to ensure the
effective implementation of the process. Top management support is critical throughout the
entire life-cycle of the process. For this reason, it is the responsibility of the Risk Management
Process Owner to keep the organization’s executive management continuously and properly
informed and updated, through comprehensive and regular reporting
Implementation of Action Plan
The Risk Management plan should define how Risk Management is to be conducted throughout
the organization. It must be developed in a way that will ensure that Risk Management is
embedded in all the organization’s important practices and business processes so that it will
become relevant, effective and efficient.
Identification of Residual Risks
Residual risk is a risk that remains after Risk Management options have been identified and
action plans have been implemented. It also includes all initially unidentified risks as well as all
risks previously identified and evaluated but not designated for treatment at that time.
It is important for the organizations management and all other decision makers to be well
informed about the nature and extent of the residual risk. For this purpose, residual risks should
always be documented and subjected to regular monitor-and-review procedures.
Classification of risk
In finance, risk is the probability that actual results will differ from expected results. In
the Capital Asset Pricing Model (CAPM), risk is defined as the volatility of returns. The concept
of “risk and return” is that riskier assets should have higher expected returns to compensate
investors for the higher volatility and increased risk.
Types of Risk
Broadly speaking, there are two main categories of risk: systematic and unsystematic. Systematic
risk is the market uncertainty of an investment, meaning that it represents external factors that
impact all (or many) companies in an industry or group. Unsystematic risk represents the asset-
specific uncertainties that can affect the performance of an investment.
Below is a list of the most important types of risk for a financial analyst to consider when
evaluating investment opportunities:
Systematic Risk – The overall impact of the market
Unsystematic Risk – Asset-specific or company-specific uncertainty
Political/Regulatory Risk – The impact of political decisions and changes in regulation
Financial Risk – The capital structure of a company (degree of financial leverage or debt
burden)
Interest Rate Risk – The impact of changing interest rates
Country Risk – Uncertainties that are specific to a country
Social Risk – The impact of changes in social norms, movements, and unrest
Environmental Risk – Uncertainty about environmental liabilities or the impact of changes in
the environment
Operational Risk – Uncertainty about a company’s operations, including its supply chain and
the delivery of its products or services
Management Risk – The impact that the decisions of a management team have on a company
Legal Risk – Uncertainty related to lawsuits or the freedom to operate
Competition – The degree of competition in an industry and the impact choices of competitors
will have on a company
Techniques for managing risk
Every business endeavor comes with some element of risk. Your ability to manage risk will not
only affect your company's profitability, but it could also mean the difference between staying in
business or not.
1. Avoiding the Risk
Avoidance should be the first option to consider when it comes to risk control. For example, if
you are transferring sensitive data from one location to another, you can avoid the risk of having
it stolen if you don't leave it in your car overnight. Another, perhaps more obvious example, is
paying clients with checks rather than mailing cash.
2. Retaining the Risk
Sometimes it's preferable to keep your level of risk as it is because the cost of avoiding the risk is
more than the cost of damage or loss. Often, we retain risk without even thinking about it. For
example, if you have $100 in petty cash in a locked drawer in your office, there is always the
chance someone could steal it. However, the cost of a wall safe would greatly exceed the amount
of money you would be protecting.

3. Spreading the Risk

Spreading the risk is often an inexpensive way of reducing the chances of a calamity. To protect
digital information, for example, it's a common practice to back up computer storage. This
protects the data from a drive error, viruses and malware. Moving the back-up drive to a separate
building spreads the risk even more thinly, protecting the data from physical theft or a fire in one
building. Companies with extremely valuable data often spread the risk even further by putting a
copy of the data in a different city.
4. Preventing or Reducing Loss
When exposing yourself or your company to risk is unavoidable, you can often reduce or
eliminate losses by taking safeguards against it. For example, if you own a hardware store, it's
unlikely that you can eliminate the chance of theft when your store is closed for the night.
However, purchasing an alarm system may be enough to make potential thieves avoid breaking
in at night. If they do break a window, having an alarm sound and having the police dispatched to
your store would reduce the amount the thieves could steal before they would be forced to flee.
5. Transferring the Risk
Transferring risk should usually be the last risk management technique you should use. Two
common examples include transferring the risk to another party in a contract and the purchase of
insurance. For example, a delivery company may contractually transfer the risk of damage to
packages to either the shipper or the receiver. A second way this company could transfer the risk
is by purchasing insurance so that if a package is damaged, the insurance company absorbs the
loss.
Developing Risk Management Strategies
Every business has a unique set of risks, which can vary from year-to-year and even from one
project to another. One method of managing risk and determining which strategies you should
use is to list the potential risks, rate the probability of them occurring and then to decide which
strategy is best to deal with each one.
Lecture 2
Introduction to risk management
Every organization small or large, is susceptible to risk in many different areas: operational,
market, legal, environmental, reputational, brand, liability, financial, and property losses. Any of
these can impact (positively or negatively) every municipality. Most local government
organizations are, of course, concerned primarily with the type of risk that may affect them in a
negative way.
This blog will examine the basic elements of local government risk management, including the
benefits of risk management, risk assessment, prioritization, and the adoption of risk
management response strategies.
What is Risk Management?
“Risk management” helps an organization to identify, evaluate, analyze, monitor, and mitigate
the risks that threaten the achievement of the organization’s strategic objectives in a disciplined
and systematic way (note the words “disciplined” and “systematic”).
Risk management is intentionally proactive, not reactive. It can be as simple as one crew
member mentioning that a coworker needs to wear her safety glasses, or it may involve
something as complex as a full asset allocation modeling of all of your organization’s capital
assets. Risk management practices can even be applied to events as broad and far-reaching as the
loss of a major employer in the community.
Different situations and events can simultaneously result in both good and bad consequences.
Each consequence may require a different risk management strategy. As an example, let’s say
that a new 300-home subdivision is planned for your community. On the positive side, an event
like this will likely be welcomed as it will mean more tax revenues, increased population to
support local business, and vitality for the community. On the negative side, however, it may also
result in increased traffic and added demands on law enforcement and fire services, and it may
upset neighbors who are averse to change. Each issue will require a separate risk management
strategy.
The Benefits of Risk Management
There are four major benefits of adopting a risk management system for your municipality.
First, risk management enhances management, both in day-to-day and long-term situations.
Knowing what might go wrong and how to deal with a situation lets you control the outcome.
Second, risk management systems streamline day-to-day operations. Employees who know the
proper procedures and policies are better able to do their jobs safely.
Third, risk management improves financial management. Losses, lawsuits, and injuries all cost
money and risk management helps your agency avoid these costs.
Finally, risk management helps provide consistent and enhanced services. Every time a loss
occurs or property is damaged, reports need to be written, depositions taken, and so on, activities
that take time away from an employee’s ability to provide services to the public.
Why should we bother with risk management?
There are a number of reasons why a community or non-profit group should put some time into
considering risk management and it does go beyond the recent issue.
1. For your own safety
You want an atmosphere where everyone in your group feels safe and secure and knows their
safety and security is one of the paramount considerations in every activity your group
undertakes. A group that does this is normally a group that boasts a happy, loyal and effective
membership or volunteer force.
2. For the safety of the people you are trying to help
The mission of most community groups is to help people, not harm them. If you are providing
services for outside clients/groups the aim is to enhance their lives not do something that causes
them pain, either physical or mental.
3. The threat of possible litigation
In the current circumstances this is a very real threat. Litigation is increasing according to the
Insurance Council of Australia as are the size of the payouts for people who successfully sue.
Not every group has faced legal action and not everyone who gets hurt then sues over it but by
setting up a risk management strategy you can reduce the chance of people taking costly legal
action against that will financially hurt your organisation.
Objectives of risk management
Risk can be defined as the chance of loss or an unfavorable outcome associated with an action.
Uncertainty does not know what will happen in the future, the greater the uncertainty, the greater
the risk. For an individual, risk management involves optimizing expected returns subject to the
risks involved and risk tolerance. Risk is what makes it possible to make a profit. If there was no
risk, there would be no return to the ability to successfully manage it. For each decision there is a
risk return tradeoff. Anytime there is a possibility of loss (risk), there should be an opportunity
for profit.
Definition of Risk Management:
1) Risk management is an integrated process of delineating (define) specific areas of risk,
developing a comprehensive plan, integrating the plan, and conducting the ongoing evaluation’ –
Dr. P.K. Gupta.
2) Risk Management is the process of measuring, or assessing risk and then developing strategies
to manage the risk’ – Wikipedia.
3) Managing the risk can involve taking out insurance against a loss, hedging a loan against
interest rate rises, and protecting an investment against a fall in interest rates’ – Oxford Business
Dictionary.
Objective of Risk Management
Identifies And Evaluates Risk
Risk management identifies and analysis various risk associated with business. It identifies risk
at early stages and takes all necessary steps to avoid their harmful effects. Information from past
is analysed to recognise all possible future unfortunate events. Risk management properly
evaluates risk originated in business and develops a proper understanding regarding its real
causes. This all help in taking all measures in mitigating the effects of these risks.
Reduce And Eliminate Harmful Threats
Harmful risks and threat are part of every business organisation. They have negative effect on
productivity and profitability of business. Risk management techniques helps in avoiding and
reducing the effect of these threats to business. Risk manager formulates strategic plans for each
department and monitors their performance from time to time.
These perform series of workshop in organisation to develop proper understanding regarding risk
causes and how to overcome them among all employees. Managers guide them in avoiding the
identified faults and reduces these harmful threats.
Supports Efficient Use Of Resources
Risk management aims at efficient utilisation of all resources. Fuller utilisation leads to better
productivity and increased profits. Risk management techniques support strategic planning for
better results. It sets plans for functioning of business and ensures that all activities are going on
their planned track. Certain targets are set for each division within organisations and perform
routine check-ups from time to time. If any deviations arise, it takes all possible steps.
Better Communication Of Risk Within Organisation
Risk management develops better communication network between directors, managers and
employees. It helps in spreading all information regarding risk easily around the organisation
timely. All people are able to interact with each other effectively and discuss about core solution
about these risk. This helps in better understanding of several threats and taking timely action
against them.

Reassures Stakeholders
Stakeholders are an important part of every business organisation. Business must aim at serving
the interest of its stakeholders for their support. Risk management helps in increasing the
confidence of stakeholders in business and assures them of non-occurrence of any unfortunate
incident.
They feel safe by the implementation of risk management techniques that will timely control and
avoid all harmful risk. This leads to better trust among business and its stakeholders.
Support Continuity Of Organisation
Risk management has an efficient role in long term growth and survival of the business. Every
business faces several risk and unfortunate events during its life cycle. These unfortunates, if not
treated timely, will affect the organisation capital and profit or even leads to its termination.
It avoids all these risks by monitoring continuously the operations throughout the life of the
project. It reduces anxiety by overcoming all fear of uncertainty and develops a safe working
environment within the organisation. This increases the productivity and overall stability of
business organisations.

Steps in the risk management process

The following steps are involved in the process of risk management

1. Establish the Context:

The purpose of this stage of planning enables to understand the environment in which the
respective organization operates, that means the thoroughly understand the external environment
and the internal culture of the organization. You cannot resolve a risk if you do not know that it
is. At the initial stage it is necessary to establish the context of risk. To establish the context there
is a need to collect relevant data. There is a need to map the scope of the risks and objectives of
the organization.
2. Identification:
After establishing the context, the next step in the process of managing risk is to identify
potential risks. Risks are about events that, when triggered, will cause problems. Hence, risk
identification can start with the source of problems, or with the problem itself. Risk identification
requires knowledge of the organization, the market in which it operates, the legal, social,
economic, political, and climatic environment in which it does its business, its financial strengths
and weaknesses, its helplessness to unplanned losses, the manufacturing processes, and the
management systems and business mechanism by which it operates. Any failure at this stage to
identify risk may cause a major loss for the organization. Risk identification provides the
foundation of risk management. The identification methods are formed by templates or the
development of templates for identifying source, problem or event. The various methods of risk
identification are – Brainstorming, interview, checklists, structured ‘What-if’ technique
(SWIFT), scenario analysis, Fault Tree Analysis (FTA), Bow Tie Analysis, Direct observations,
incident analysis, surveys, etc.
3. Assessment:
Once risks have been identified, they must then be assessed as to their potential severity of loss
and to the probability of occurrence. These quantities can be either simple to measure, in the case
of the value of a lost building, or impossible to know for sure in the case of the probability of an
unlikely event occurring. Therefore, in the assessment process it is critical to make the best
educated guesses possible in order to properly prioritize the implementation of the risk
management plan.
4. Potential Risk Treatments:
Once risks have been identified and assessed, all techniques to manage the risk fall into one or
more of these four major categories.
• Risk Transfer
• Risk Avoidance
• Risk Retention
• Risk Control
5. Review and evaluation of the plan:
Initial risk management plans will never be perfect. Practice, experience and actual loss results,
will necessitate changes in the plan and contribute information to allow possible different
decisions to be made in dealing with the risk being faced. Risk analysis results and management
plans should be updated periodically. There are two primary reasons for this
–a) To evaluate whether the previously selected security controls are still applicable and
effective.
b) To evaluate the possible risk level changes in the business movement.
There are risks that do no change and are static in nature. However, other dynamic risks of not
continually monitored and reviewed may grow like a bubble and their financial, legal and ethical
impacts soon get out of control.
Lecture 3
Types of risk incurred by financial institutions
Risk can be referred to like the chances of having an unexpected or negative outcome. Any
action or activity that leads to loss of any type can be termed as risk. There are different types of
risks that a firm might face and needs to overcome. Widely, risks can be classified into three
types: Business Risk, Non-Business Risk, and Financial Risk.
Business Risk: These types of risks are taken by business enterprises themselves in order to
maximize shareholder value and profits. As for example, Companies undertake high-cost risks in
marketing to launch a new product in order to gain higher sales.
Non- Business Risk: These types of risks are not under the control of firms. Risks that arise out
of political and economic imbalances can be termed as non-business risk.
Financial Risk: Financial Risk as the term suggests is the risk that involves financial loss to
firms. Financial risk generally arises due to instability and losses in the financial market caused
by movements in stock prices, currencies, interest rates and more.
Risks Faced by Financial Institutions
Credit Risk : the risk that promised cash flows from loans and securities held by FIs may not be
paid in Full.
Liquidity Risk : the risk that a sudden and unexpected increase in liability withdrawals may
require an FI to liquidate assets in a very short period of time and at low prices.
Interest Rate Risk : the risk incurred by an FI when the maturities of its assets and liabilities are
mismatched and interest rates are volatile.
Market Risk : the risk incurred in trading assets and liabilities due to changes in interest rates,
exchange rates, and other asset prices.
Off-Balance -Sheet Risk : the risk incurred by FI as the result of its activities related to
contingent assets and liabilities.
Foreign Exchange Risk : the risk that exchange rate changes can affect the value of an FI’s
assets and liabilities denominated in foreign currencies.
Country or Sovereign Risk : the risk that repayments by foreign borrowers may be interrupted
because of interference from foreign governments or other political entities.
Technology Risk : the risk incurred by an FI when its technological investments do not produce
anticipated cost savings.
Operational Risk : the risk that existing technology or support systems may malfunction, that
fraud may occur that impacts the FI”s activities , and/or external shocks such as hurricanes and
floods occur.
Insolvency Risk : The risk that an FI may not have enough capital to offset a sudden decline in
the value of its assets relative to its liabilities.
Types of financial risk
The types of financial risk are written as under
Financial risk is one of the high-priority risk types for every business. Financial risk is caused
due to market movements and market movements can include a host of factors. Based on this,
financial risk can be classified into various types such as Market Risk, Credit Risk, Liquidity
Risk, Operational Risk, and Legal Risk.

Market Risk:
This type of risk arises due to the movement in prices of financial instrument. Market risk can be
classified as Directional Risk and Non-Directional Risk. Directional risk is caused due to
movement in stock price, interest rates and more. Non-Directional risk, on the other hand, can be
volatility risks.
Credit Risk:
This type of risk arises when one fails to fulfill their obligations towards their counterparties.
Credit risk can be classified into Sovereign Risk and Settlement Risk. Sovereign risk usually
arises due to difficult foreign exchange policies. Settlement risk, on the other hand, arises when
one party makes the payment while the other party fails to fulfill the obligations.
Why financial institution needs to manage risk
Importance of Risk Management
Risk management is an important process because it empowers a business with the necessary
tools so that it can adequately identify and deal with potential risks. Once a risk has been
identified, it is then easy to mitigate it. In addition, risk management provides a business with a
basis upon which it can undertake sound decision-making.
For a business, assessment and management of risks is the best way to prepare for eventualities
that may come in the way of progress and growth. When a business evaluates its plan for
handling potential threats and then develops structures to address them, it improves its odds of
becoming a successful entity.
In addition, progressive risk management ensures risks of a high priority are dealt with as
aggressively as possible. Moreover, the management will have the necessary information that
they can use to make informed decisions and ensure that the business remains profitable.
Lecture 4
Managing credit risk
Know Your Customer
Knowing your customer is essential because it is the foundation for all succeeding steps in the
credit process. To be successful, you must operate on pertinent, accurate, and timely information.
The information you gather and the relationships you establish are critical to positioning yourself
as a valued financial consultant and provider of financial products and services. Establishing a
good relationship can bring a long stream of equity to your institution.
Analyze Nonfinancial Risks
Understand your customer’s business by analyzing nonfinancial risks. Information gathered in
this step is critical to positioning yourself as a financial consultant to your customer and a valued
member of your financial institution’s lending team. The concept of risk management can apply
to a single loan or customer relationship (micro) or to an entire loan portfolio (macro).
There is risk to every line item on the balance sheet and income statement and you must learn
how to evaluate those risks, which fall into the broad categories of: • Industry • Business •
Management.
Understand the Numbers
There are many benefits and risks associated with establishing a banking relationship with any
entity or individual. As a lender, you should know:
• How the requested funds are going to be used and how they are anticipated to be repaid.
• How to identify, categorize, and prioritize all of the risks inherent with the customer that are
known at the time of the analysis as well as those that are anticipated to be in existence over the
period of the relationship.
Structure the Deal
The first step is to understand the business. Before completing a financial analysis on the
organization, you identify the characteristics that influence a company’s success by studying:
1. The nature of the business.
2. The nature of the industry.
3. The impact of economic conditions.
4. Its business strategy.
5. The competencies or deficiencies of management.
Price the Deal
Determining the appropriate pricing is a critical. It ensures that your financial institution will be
adequately compensated for the risk of the deal.
Present the Deal
Communicating your findings in a cogent and professional manner is a critical step in getting
your proposal approved. Credit decisions should not be made on financial statement analysis
alone. A credit review would not be complete without an equally significant emphasis on the
qualitative issues such as the ability of management, the competitive business environment, and
the economic issues relating to the business.
Close the Deal
Closing the Deal takes place after the analysis, structuring, and pricing have been completed.
Monitor the Relationship
In today’s competitive environment, you cannot afford to wait for your loans to be repaid and
expect your clients to call you for other products and services. To have a competitive advantage
in today’s market, you must continue to monitor the risk profile of your client and, at the same
time, pursue opportunities to develop and expand the relationship.
Credit analysis
Credit analysis is the process of determining the ability of a company or person to repay their
debt obligations. In other words, it is a process that determines a potential borrower’s credit
risk or default risk. It incorporates both qualitative and quantitative factors. Credit analysis is
used for companies that issue bonds and stocks, as well as for individuals who take out loans. To
learn more, check out CFI’s Credit Analyst Certification program.
Uses for Credit Analysis
Credit analysis is important for banks, investors, and investment funds. As a corporation tries to
expand, they look for ways to raise capital. This is achieved by issuing bonds, stocks, or taking
out loans. When investing or lending money, deciding whether the investment will pay off often
depends on the credit of the company. For example, in the case of bankruptcy, lenders need to
assess whether they will be paid back.
Similarly, bondholders who lend a company money are also assessing the chances they will get
their loan back. Lastly, stockholders who have the lowest claim priority access the capital
structure of a company to determine their chance of being paid. Of course, credit analysis is also
used on individuals looking to take out a loan or mortgage.
Credit analysis is used by:
Creditors to determine a corporation’s ability to pay back loans
Creditors to determine an individual’s ability to pay back a loan or mortgage
Investors to determine a corporation’s financial stability
A Commercial Banking & Credit Analyst (CBCA)
Credit Analysis for Loans
When a corporation is in need of capital, it can ask banks for a loan. Banks, or creditors, can be
secured or unsecured. As briefly mentioned before, there is an order of priority for claims during
bankruptcy. Secured lenders have the first claim on assets used as collateral. They are followed
by unsecured creditors.
Of course, creditors would like to avoid a bankruptcy scenario, which is why they utilize a credit
analysis process to determine a corporation’s ability to pay back the loan. Loans can also be
given to individuals and individuals also go through a credit check.
For corporate loans, the 5 C’s of Credit are often used to determine credit quality:
• Character
• Capacity
• Capital
• Conditions
• Collateral
For individual loans, credit scores are used, which include:
• Payment history
• Amounts owed
• Length of credit history
• Credit mix
• New credit
Bonds
Bondholders look at a corporation’s bond rating to determine the default risk. Popular rating
systems that perform credit analysis include Moody’s and S&P. Bonds that are ranked high are
investment grade and have low default risk. Those that are non-investment grade are called high
yield or junk bonds. They are dependent on favorable business, financial, and economic
conditions to meet financial commitments.
A company that already has high levels of debt will have a lower bond rating, as they are
considered to have a higher level of risk. Bondholders are usually behind creditors for claim
priorities. So, in the case of bankruptcy, they have less claim on a company’s assets. That’s
another reason why high levels of existing debt are a risk.

Equity
Equity investors buy stock in a company and benefit from a rise in stock price and
from dividends. The credit of a company affects investors in two ways: (1) the value of the stock;
(2) their claim on assets.
Firstly, the value of the stock depends on the growth and stability of a company. Balancing
growth and stability is important and debt plays a role. Debt can drive investment and growth but
too much debt will decrease the stability of a company. If a company has too much debt, then the
stock value will decrease due to lower perceived stability. Higher debt can signify that there is a
higher risk the company will not be able to satisfy its financial commitments and that its stock
price will drop.
On the other hand, if a company has no debt at all, then investors will wonder if the company has
the ability to expand and grow. If not, then stock prices will not appreciate. Credit analysis helps
determine both the growth potential and stability of a company.
The second concern for equity holders about credit quality is the claim on assets. Equity holders
have the least claim on assets of a company in the case of bankruptcy. If the company goes
bankrupt, shareholders will get their claim only if secured and unsecured creditors did not
already take all the remaining assets. This is why the level of existing debt is important for equity
holders as well.

Lecture 6 and 7
Country and Sovereign Risk
What is Country Risk?
Country risk refers to the uncertainty associated with investing in a particular country, and more
specifically the degree to which that uncertainty could lead to losses for investors. This
uncertainty can come from any number of factors including political, economic, exchange-rate,
or technological influences. In particular, country risk denotes the risk that a foreign government
will default on its bonds or other financial commitments increasing transfer risk. In a broader
sense, country risk is the degree to which political and economic unrest affect the securities of
issuers doing business in a particular country.
What Is Sovereign Risk?
Sovereign risk is the chance that a national government's treasury or central bank will default on
their sovereign debt, or else implement foreign exchange rules or restrictions that will
significantly reduce or negate the worth of its forex contracts.
What is the difference between country risk and sovereign risk?
Sovereign ratings capture the risk of a country defaulting on its commercial debt obligations •
Country risk covers the downside of a country's business environment including legal
environment, levels of corruption, and socioeconomic variables such as income disparity.

Difference between credit and sovereign risk

The main differences are written as under
Credit Risk Sovereign Risk
Credit risk is the possibility of losing a lender Sovereign risk is the potential that a nation's
takes on due to the possibility of a borrower not government will default on its sovereign debt
paying back a loan. by failing to meet its interest or principal
payments.
Consumer credit risk can be measured by the Sovereign risk is typically low, but can cause
five Cs: credit history, capacity to repay, capital, losses for investors in bonds whose issuers are
the loan's conditions, and associated collateral. experiencing economic woes leading to a
sovereign debt crisis.
Consumers posing higher credit risks usually Strong central banks can lower the perceived
end up paying higher interest rates on loans. and actual riskiness of government debt,
lowering the borrowing costs for those nations
in turn.

Country risk evaluation technique

International investing is a great way to diversify any stock portfolio, but investing in Italy or
Nigeria isn't the same as investing in the United States. Country risk refers to a country's
economic and political risks that may affect its businesses and result in investment losses. These
evolving risk factors are critical for international investors to monitor over time. Here's how to
quickly and easily measure and analyze country risk.
Measuring Risk
A country's risk can generally be divided into two groups: economic risks and political risks.
Economic risks are associated with a country's financial condition and ability to repay its debts.
For instance, a country with a high debt-to-GDP ratio may not be able to raise money as easy to
1
support itself, which puts its domestic economy at risk. Political risks are associated with a
country's politicians and the impact of their decisions on investments. For instance, desperate
politicians supporting nationalizations could pose a threat to investors in certain strategic
industries.
Analyzing Risk
There are many different ways to analyze a country's risk. From beta coefficients to sovereign
ratings, investors have several different tools at their disposal. International investors should use
a combination of these techniques to determine a country's risk, as well as the risk associated
with any individual international investment or security.
Checklist & Other Tips
International investors can determine country risk using this simple three-step process:
Check sovereign ratings: Look up the country's sovereign ratings issued by the S&P, Moody's,
and Fitch to get a baseline look at the country's level of risk and monitor for any negative watch
updates.
Read the latest: Search on Google News or other international news aggregators for any
economic news surrounding a country as a form of qualitative research, or check public data
sources like the International Monetary Funds or World Bank.
Check the asset's risk: Determine the specific investment's risk by looking at quantitative
factors, such as the beta coefficient; a higher beta coefficient equates to greater risk.
Lecture 8
Foreign Exchange Risk
What is Foreign Exchange Risk?
Foreign exchange risk, also known as exchange rate risk, is the risk of financial impact due to
exchange rate fluctuations. In simpler terms, foreign exchange risk is the risk that a business’
financial performance or financial position will be impacted by changes in the exchange rates
between currencies.
Types of Foreign Exchange Risk
The three types of foreign exchange risk include:
1. Transaction risk
Transaction risk is the risk faced by a company when making financial transactions between
jurisdictions. The risk is the change in the exchange rate before transaction settlement.
Essentially, the time delay between transaction and settlement is the source of transaction risk.
2. Economic risk
Economic risk, also known as forecast risk, is the risk that a company’s market value is impacted
by unavoidable exposure to exchange rate fluctuations. Such a type of risk is usually created by
macroeconomic conditions such as geopolitical instability and/or government regulations.

3. Translation risk
Translation risk, also known as translation exposure, refers to the risk faced by a company
headquartered domestically but conducting business in a foreign jurisdiction, and of which the
company’s financial performance is denoted in its domestic currency. Translation risk is higher
when a company holds a greater portion of its assets, liabilities, or equities in a foreign currency.

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