Introduction

to
Financial Risk Management
Lecture I

By:

Muhammad Afraz Abdur Rahman

 What is Risk ?
• Risk

Deviations from your expectations

• Risk Aversion

Tendency to avoid additional risk

• Risk-Return Relationship

Positive because of Risk Aversion

 What is Risk ?
• Risk can be defined as any source of randomness that may have an adverse impact
on a person or corporation.

• Accordingly, risk management is the reaction to risk by individuals or businesses

as they attempt to ensure that the risks to which they are exposed are the risks to
which they think they are exposed and want to be exposed.
 What is Risk ?
• The uncertainty must be quantifiable

• Statistics allows us to quantify this specific uncertainty by using measures of

dispersion.

• In a business context, risk is usually expressed only the negative deviations from
expected values
 Broad Categories of Risk
• Business Risk

• Related to Operations

• Financial Risk

• Market uncertainties
 Other Types of Risk
• Event Driven
• Market Risk
• Credit Risk
• Operational Risk
• Liquidity Risk
• Legal Risk

• Diversifiability
• Systematic
• Unsystematic
 Some Fallacies About Risk
• Risk is always bad

• Some risks are so bad that they must be eliminated at all costs

• Playing it safe is the safest thing to do

 Why Practice Risk Management ?
• Impetus for Risk Management

• Growth in risk management instruments, e.g. derivatives

• To handle unacceptable risks and focus on strategic risks

• From past lessons

• Efforts of financial institutions and information technology

• Regulatory environment
 Fallacies About Risk Management
• Risk management is done to avoid or eliminate risks.

• Risk management is done to increase the profits or reduce losses.

 What is Financial Risk Management ?

Risk management is the practice of defining the risk level a firm desires,
identifying the risk level a firm currently has, and using derivatives or
other financial instruments to adjust the actual level of risk to the
desired level of risk.
Chance & Brooks
 What is Financial Risk Management ?

Risk management is the practice of defining the risk level a firm

desires, identifying the risk level a firm currently has, and using
derivatives or other financial instruments to adjust the actual level of
risk to the desired level of risk.
Chance & Brooks
 What is Financial Risk Management ?
• Core Risks
• Non core Risks
 Can Risk Management Create Value ?
• Efficient vs. Inefficient markets.

• Risk management irrelevance proposition.

• Systematic and Unsystematic risks.

• Value of the Firm:

Cash. flows
Value of the firm =
(1  Discount.Rate)

• Discount Rate = Rf +B (Rm-Rf)

 Can Risk Management Create Value ?
• There is no rationale in hedging un-systematic risk if capital markets are efficient
as investors can eliminate it through portfolio diversification (homemade risk
management tactics).

• Eliminating unsystematic risk subjects the firm to additional costs of hedging,

with no additional gain
 Risk Managing Techniques

• Retaining the risk

• Neutralizing the risk

• Transferring the risk

 Benefits of Risk Management
• Value Creation in Imperfect Markets
• Avoid passing up profitable investment opportunities
• Stabilize volatile operating profits
• Avoid bankruptcy costs and financial distress costs
• Firms protect their wealth
• Corporate tax management
• Enjoy optimal capital structure
• Better incentives to managers
• Retain valuable large shareholders
• Attract stakeholders to make firm specific investments
 The Risk Framework
• Risk awareness

• Risk assessment & monitoring

• Risk management (i.e. strategies for dealing with risk)

 Risk Awareness
Risks may be:

• Strategic
• Tactical
• Operational
 Risk Awareness
• Strategic Risk are those affecting the overall direction and outcome of the
project, such as changes in macroeconomic factors or changes in corporate
policies.

• Tactical risks affect the way the various parts of the project are interlinked,
the way resources are acquired or the way in which the business functions
involved in the project run.

• Operational risks are those affecting the day to day running of the project.
 Risk Assessment & Monitoring
• A useful way to manage risk is to identify potential risks and then
categorize them according to the likelihood of occurrences and the
significance of their potential impact.

• Internal Audit
• Information systems
 Risk Management
• Risk can be either accepted or dealt with. Possible solutions for
dealing with risk include:

• Mitigating the risk – reducing it by setting in place control

procedures
• Hedging the risk – taking action to ensure a certain outcome
• Diversification – reducing the impact of one outcome by having a
portfolio of different ongoing projects.
 The 4T Approach to Risk Management
• Tolerate it
• Transfer it
• Terminate it
• Treat it
 The 4T
Approach to
Risk
Management
Illustration
of the 4T
Approach