Strategic Management

N. Chandrasekaran, Vice
President Currently, Take Solutions Ltd

P.S. Ananthanarayanan, Visiting

faculty at Bharathidasan Institute of
Management (BIM), Trichy

Oxford University Press 2011

Chapter 12

Risk Management:
Perspectives and Issues

Oxford University Press 2011

Risk Management: Perspectives

and Issues
Behold the turtle, he makes progress only when
he sticks his neck out.
Bruce Levin

Oxford University Press 2011

Learning Objectives
To

define uncertainty and risk and delineate their

impact on strategy

To

identify the different types of risk and classify them

To

develop the concept of risk assessment and

various methods of measurement

To

discuss the various mathematical models of risk

management

To

identify various risk management techniques

Oxford University Press 2011

UNCERTAINTY AND RISK

Uncertainty

Whenever some of the parameters are not clearly defined or the

probabilities are not known and they are not measurable, the
event becomes an uncertainty

Risk

Risk can be defined as the function of three variables namely:

Probability of a threat

Probability of vulnerabilities and

Probability of a potential impact

Oxford University Press 2011

CLASSIFICATION OF RISK
PHYSICAL RISK

Accidents: The primary cause of mortality from accidents caused

by consumption of alcohol or drugs, tiredness, and disregard for
safety precautions such as usage of helmets, and seat belts

Health risks: These arise from biological factors such as exposure

to radiation, bacteria, viruses, fungi, and other micro-organisms

Chemical risks: Effluents from chemical industries, leather

tanneries, textile dyeing, and nuclear power plants

Bioterrorism: biological agents used by the terrorists have become

potential threats to human life and health

Food adulteration: Improper storage of food products leads to

their deterioration and use of pesticides and insecticides in farming
poses potential health risks
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COUNTRY RISK

Political risk: political changes in a country resulting in instability of

a government

Legislative risk: fall out of the political risk change in governments

Micro risk: political actions in a host country which can affect

selectively certain foreign operations

Economic risk: emanates from the Economic and Industrial Policy

pursued by the government of the country

Sovereign risk: sovereignty is measured by the credit rating of the

country

Counterparty risk or default risk: business transactions which a

foreign investor has to undertake with indigenous businessman

Currency risk: stability of the currency of a country and its parity

with the currencies of other countries
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BUSINESS RISK
Systematic risk:

This risk which is part of business, arises due to factors that

affect the entire market such as changes in investment policy,
taxation policy, socio-economic parameters, global security
threats, etc

Unsystematic risk

This risk is specific to an individual, firm or a company and as

such fuller comprehension can lead to substantial reduction of
this risk

Oxford University Press 2011

FINANCIAL RISK

Credit risk: This risk is defined as the likelihood that a borrower

will fail to meet his commitments in accordance with agreed terms

Liquidity risk: This risk can relate to asset liquidity as well as

funding liquidity

Market risk: This risk deals with the portfolio of a companys

investments. Four important market risk factors which affect
valuation are Stock prices, Interest rates, Foreign exchange rates
,Commodity prices

Operation risk: This risk is influenced by the availability of raw

materials, consistency of output, transport and movement issues,
and labour-related issues

Oxford University Press 2011

ASSESSING AND MEASURING RISK

Sensitivity Analysis

It is the one most adopted by analysts, both for short-term and

long-term purpose

In a budgetary exercise, which is essentially a short-term one,

capacity utilization, price demand, etc., are taken separately as
well as together to measure the impact of the variation in the
parameter on profits/performance

In the long-term, sensitivity analysis identifies/focuses on such

parameters that are sensitive to the passage of time, such as
assumptions relating to statutory decisions, technological
obsolescence, and product life cycles
Oxford University Press 2011

Scenario Analysis

Measure the impact of risks on strategic performance

More qualitative than quantitative

creating possible scenarios over the time span of strategy

formulation and implementation delineating the impact of the
specific parameters selected for analysis.

For instance, government decisions are known to impact

corporate strategic performance in the form of availability of tax
holidays, stimulus packages, duties and levies, etc. and these
are identified as risks.

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Decision Trees

This is yet another technique used for go or no go decisions

and when certain risks are encountered

A decision tree is essentially a support tool for making

decisions and utilizes a tree-like model

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Monte Carlo Simulation

This model provides a decision maker with a range of possible

results and probabilities that they will happen for any choice of
action

The essence of a Monte Carlo simulation is that values are

sampled at random from the input probability distributions

Certainty Equivalent

A risk-averse individual or company always wants to gauge the

degree of risk and compute a return correspondingly as a
compensation for the additional risk

Higher the risk, the certainty coefficient is lower.

For instance, certainty equivalent coefficient is higher for a

replacement investment as against a new product investment

Oxford University Press 2011

Risk Adjusted Discount Rate Method

rp = rf + n + dp
where
rp = Risk adjusted discount rate for project p
rf = Risk free rate of interest
n = Premium for normal risk
dp = Premium for additional risk
Risk Adjusted Return on Capital
RAROC = Expected return/Economic capital or
RAROC = Expected return/Value at risk

Oxford University Press 2011

Asset Liability Management Model

Matching of assets and liabilities to generate a cautious

investment portfolio.

The purpose of this model is to optimize risk-adjusted returns to

the shareholders over a long run.

Two approaches for matching assets and liabilities are as follows

Duration: This is defined as a measure of price sensitivity in

relation to interest rates. It refers to the weighted average
maturity where the weights are applied in terms of present value

Oxford University Press 2011

Contd..

Convexity
This is defined as the change in duration corresponding to
changes in yield as follows:

where
Di = Change in yield (in decimals), P0 = Initial price
P+ = Price if yields increase by Di, P- = Price if yields decline by Di

Combining convexity and duration is a good approach to examining

the influence on change in yield on the market values of assets
and liabilities
Oxford University Press 2011

Beta Analysis

Beta can be used to determine the actual riskiness of the stock

Beta = Co-variance(i, m)/Variance(m)

Where i = i th stock
m = market movements

Probability risk assessment (PRA):

In this method, risk is identified by two factors, namely, the severity
of adverse consequences that are possible and the probability of
such an occurrence of each consequence

Oxford University Press 2011

Value at Risk (VaR)

VaR is one of the popular methods of measuring financial risks.

There are different types of VaRlong-term VaR, marginal VaR,

factor VaR, and shock VaR

VaR is defined as the threshold value such that the probability of a

portfolio making a market to a market loss over a specific time

horizon exceeds this value

VaR essentially identifies the boundary between normal days and

extreme occurrences

VaR applications - financial risk management, risk measurement,

control and reporting, calculating regulatory capital.

Oxford University Press 2011

Black Scholes Model

This model is a mathematical representation of financial

markets and derivative investment instrument

This is based on partial differential equations, the solution of

which is applied in pricing options.

The assumptions include the price of the stock, risk free interest
rate, drift rate, volatility of the asset, time frame, value of the
portfolio, and accumulated profit or loss on the basis of a
particular hedging strategy.

Standard normal cumulative distribution function and a

standard normal probability density function are also included

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Hazard and Operability Study(HAZOP)

The HAZOP study is a systematic and structured application
to examine a projected or current process or operations in
order to identify and evaluate areas that may prove to be a
risk to employees or equipment

Worksheets on HAZOP include the following

Reference number , Guide word , Deviation, Possible causes,

Consequences, Safeguards, Recommendations regarding
action to be taken, Follow-up

Procedurally this study applies to

all sequences of operations, identification of human errors and

failures of technical systems, and establishing boundary
conditions
Oxford University Press 2011

The Principles of Risk Management

1. Create value
2. Be an integral part of organizational processes
3. Be part of decision-making
4. Explicitly address uncertainty
5. Be systematic and structured
6. Be based on the best available information
7. Be tailored to objectives/acceptable risk margins
8. Take into account human factors
9. Be transparent and inclusive
10. Be dynamic, iterative, and responsive to change
11. Be capable of continual improvement and enhancement
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Risk avoidance
This

principle is based on the possibility of totally

avoiding a risk that has been identified

This

can be done by not performing an activity that

potentially spells risk such as the purchase of a
property or business that is prone to litigations

If

a particular business activity in the company

involves high risk, this business activity can be closed
down or phased out

Oxford University Press 2011

Risk reduction

Risk reduction or optimization aims at reduction in the severity

of laws or the probability that laws may not be passed

Risk reduction can be termed as mitigation that would include all

measures taken to reduce the effect of the hazard

It includes steps to mitigate physical, economic, and social

vulnerability

Outsourcing can be considered an act of risk reduction if the

vendor has the expertise and a higher capability in mitigating risk.

For example, demolition of an old, risky, high-rise building could be

outsourced to an expert vendor who could implode the building
without causing any damage to the environment or people

Oxford University Press 2011

Risk retention

Risk retention as an exercise and a strategy is attempted

mainly in the case of operational risk in business

This denotes acceptance of the loss or benefit arising out of

a risk when it takes place

In short, it is also termed as self insurance

This method is useful

-When the probability of occurrence is very low
-a reserve built within the system over a period can take
care of such losses arising out of risk retention

Oxford University Press 2011

Combination of risks

Where an individual, a firm, an organization, or a company

faces more than one risk, it becomes necessary to
understand these different risks and their relationships

It becomes necessary to assess the overall risk caused by

such risks and the possibility of reduction, if combined

EX. Portfolio management

This is particularly important where the cost of mitigation or

transfer of individual risks put together is far greater than the
cost of transferring or mitigating

When risks in projects are considered for combination, three

types of risk scores are computed viz Hazard scores,
Exposure scores , Combined scores

Oxford University Press 2011

Sharing of risk

This term denotes sharing of risk with another party, and the
loss or benefit arising from a risk

For instance an insurance company or any third party, who is

an expert in handling risk, compensates the risk bearer for the
loss that arose from a risk that occurred.

sharing of risk is also termed as risk transfer

The risk bearer has to own an insurable interest that can be

transferred to an insurer for a consideration known as
premium

Compensation, too, is set at a particular value indicated in the

policy.
Oxford University Press 2011

Hedging risk

Risk arising from price fluctuations, fluctuation in foreign

exchange currency parities, etc. are covered by forward
contracts with special agencies such as financial institutions

an effort to offset the risk of price fluctuations in the opposite

direction in another market to reduce the unwanted risk

There are various special vehicles available in finance

Forward contracts, swaps, options, and many types of over-thecounter and derivative products, as well as of futures
contracts

Oxford University Press 2011

More Questions
1.

How does risk modeling help risk assessment? In addition,

identify a particular risk and apply any one of the techniques
for assessment

2.

Identify a conglomerate that has many diversified activities

out of which a few are risk-prone. How can the risks be
phased out? Prepare a report

3.

Visit a service company near your institute and identify

operational risks and the reason for retention of operational
risk

4.

Cite an example of a company and work out an assignment

by identifying various risks that can be transferred.

Oxford University Press 2011