MBA III

FINANCIAL RISK
MANAGEMENT
INTRODUCTION:
 Financial risk management is the practice of economic
value in a firm by using financial instruments to manage
exposure to risk.
 financial risk management requires identifying its sources,
measuring it, and plans to address them.
 Financial risk management can be qualitative and
quantitative. As a specialization of risk management,
financial risk management focuses on when and how to
hedge using financial instruments to manage costly
exposures to risk.
1.FINANCIAL
RISK
MEANING:
 Financial risk is the possibility that the shareholders
or the other financial stakeholders will lose their
money.
 Such risk mainly arises in those companies which
issues debt securities and they have inadequate cash
to repay them.
 When a company uses debt financing ,then it has to
pay to the debt holders first then to the shareholders.
 Financial risk refers to the possibility of a company
whether govt. or private in default to pay on the
purchased securities by the holders.
CONTD.:
 Financial risk is a type of “specific risk”that
passes to many types of risk related to company’s
capital structure,financing and finance industry.
RISK:
 The chance that the actual outcome from an investment
will differ from the expected outcome.
 Risk & return go hand in hand. One cannot think about
any return without risk.
 Higher the risk,higher the return. This means that,the
more variable the possible outcomes that can occur,the
greater is the risk.
CATEGORIES OF RISK:
 Diversifiable/specific
Company/unsystematic risk Non-
-company strikes diversifiable/market/countr
-lockouts y/systematic risk
-bankruptcy -changes in tax rates
-death of key officer etc. -War & other calamities
-change in economic policy
-increase or decrease in
inflation rates
-recession etc.
RISK EXPLANATION
CONTINUED:
 Risk is measured with the help of Beta().
 Beta is a measuring factor which helps to know about
the volatility of the market.
 It also helps to check the sensetivity of the market
returns.
 Further, beta can be categorised in three types:

->1(if beta is greater than 1 for any security X,it is an

aggressive security.)
-=1 1(if beta is equal to 1 for any security X,it is a
moderate security.)
-<1 1(if beta is less than 1 for any security X,it is a
conservative security.)
FEATURES OF RISK:
 Uncertain in nature.
 Can bring good as well as bad results.
 Inseparable part of investments.
 Bearing risk is a never ending process.
 Can be measured in terms of investments.
 Can be or cannot be avoided.
 Can be short term or long term.
RISK PROCESS:
Identify the risk
Whenever any company starts any new project,the
first thing that one should understand is to identify
the type and amount of risk involved in that work.
For this, the risk department has to uncover and
recognise the risk and maintain the project risk
register.
ANALYSE THE RISK
 Once risks are identified,next step is to determine
the likelihood and the consequence of each risk.
The nature of the risk and its potential to affect the
goals and objectives should be noted in the project
risk register.
 The company has to identify the type of risk,
whether it is avoidable or it is to be borne by the
company.
EVALUATE OR RANK THE RISK
 At this stage,risk is evaluated whether the
company can tolerate it or not. If yes then what
could be the possible measures that a
TREAT THE RISK:
 This is also referred as “risk response planning”.
At this level,ranks are provided to the risks
available in the projects and the highest ranked
risk is to be treated first,so that it reaches to the
acceptable risk levels.
MONITOR THE RISK:
 This is the last step of this process. The working of
the project is monitored continuously and reviews
are done if the results are not normative.
RISK ORGANIZATION:
 Every company has to bear the risk.
 The biggest risk with any organization is that the
organization has no appreciation of risk.
 Risk management is important to any firm. When
dveloping a strategy to manage risk,following are
the types:
-Risk avoidance
-risk reduction
-risk transfer
-risk retention
RISK AVOIDANCE
 It a risk is present which is unacceptable to the
company,then the company has the option to
refrain from the activities.
 If the company can avoid the risk and it doesn’t
has to bear the loss while avoidingthe company
can then opt for risk avoidance.
RISK REDUCTION:
 Second method to reduce the amount of risk
instead to avoid it
 It can be done by finding different methods to
reduce risk.
 Methods such as installation of security systems to
prevent from theft,fire etc.
RISK TRANSFER:
 Risks can be transferred through contracts,as for
example,in construction projects where the builder
assumes aany risks associated with faulty
construction
RISK RETENTION:
 Organizations has to bear some risk and losses that
might subsequently arise.
 For e.g.,risks due to war,flood etc.
RISK VS TIME:
 Time has a very impressive impact over risk.
 While stocks and bonds can be risky in short run,but the
longer you hold your investments, lower is the risk in
that investments.
 And greater the odds of earning a return close to the
long term average.
 Savings could result to less returns or even loss in short
term.
 Long term investors are in a position to allocate a larger
portion of their portfolio to higher risk investments as
long time horizon is associated with lower volatility.
 Long term invts. Could lead to higher returns.
RISK VS RETURN:
 Higher the risk,higher the return.
 Low levels of uncertainty or risk are associated
with low potential returns,where as high levels of
risk or uncertainy are associated with higher
potential returns.
 Acc. To risk-return trade off,invested money can
render higher profits only if the investor is willing
to accept the possibility of losses.
 Appropriate trade off depends on various factors
like-risk tolerance,potential to replace lost
funds,time etc.
KEY RISKS:
 Interest rate risk:
Interest rate risk refers to the risk which occurs due
to change in interest rates. Other things being equal
security prices moves inversely to interest rates.
o The chance that an unexpected change in interest

rates will negatively affect the value of an

investment.
MARKET/SYSTEMATIC RISK:
 It refers to the variability of returns due to
fluctuations in the securities market.
 All the securities are exposed to market risk but
equity shares get the most affected.
 This risk includes a wide range of factors like
recessions,wars etc.
CURRENCY RISK:
 Also known as exchange rate risk, is the possibility
that the currency depreciation will negatively
affect the value of the ones’ assets,investments and
other related interest and dividend payment
streams,especially those securities denominated in
foreign currency.
FACTORS AFFECTING
FOREIGN EXCHANGE RATES:
 Inflation rate
 Interest rate
 BOP
 Govt. debt
 Terms of trade
 Political stability and performance
 Recession
 Specuation
CREDIT RISK:
 A credit risk is the risk of default on a debt that
may arise from a borowwer falling to make
payments.
 The losses may be complete or partial.
 In efficient market,higher levels of credit risk will
be associated with higher borrowing cost.
 Losses can arise due to:

Consumer may fail to make payment due to

mortagage loan,credit card etc.
An insolvent co. does not pay a policy obligation.
CREDIT RISK:
 Insolvent bank won’t refunds to deposition.
 A govt. grants bankruptcy protection to an
insolvent consumer or b/s.
 A b/s doesn’t pay an employees’ earned wages
when due.
 To reduce such risk,a lendor must perform a credit
check on the prospective borrower may require the
borrower to take out appropriate insurance etc.
LIQUIDIY RISK:
 The risk is associated with the secondary market in
which the particular security is traded.
 It is the risk that a co. or bank may be unable to
meet short term financial demands.
 This usually occurs due to the unability to convert
a security or hard asset to cash without a loss of
capital.
INFLATION RISK:
 With rise in inflation,there is a reduction of
purchasing power.
 Hence it is also called purchasing power risk and
affects all securities.
 This risk also directly related to interest rate risk as
interest rates go up with inflation.
BUSINESS RISK:
 This refers to the risk of doing business in a
particular industry and it gets transferred to the
investors who invest in the company.
FINANCIAL RISK:
 It arises when companies resort to financial
leverage or the use of debt financing.
 The more the co. uses debt,the more is the
financial risk.
LEGAL RISK:
 It is the risk of financial or reputational loss that
can result from lack of awareness or
misunderstanding.
OPERATIONAL RISK:
 It is the risk remaining after determining financing
and systematic risk, and includes risks resulting
from breakdowns in internal procedures,people
and systems.
 It can also include other classes of risk, such as
frauds,security,privacy pritection,legal risk etc.
 It affects clients’ satisfaction,reputation and
shareholders’ value and b/s volatility.
2.RISK IN
INVESTMENT
DECISIONS
WHAT IS RISK ANALYSIS?
 Risk analysis is the process of assessing the
likelihood of an adverse event occurring within
the corporate, government, or environmental
sector.
 Risk analysis is the study of the underlying
uncertainty of a given course of action and
refers to the uncertainty of forecasted cash flow
streams, the variance of portfolio/stock returns,
the probability of a project's success or failure,
and possible future economic states.
 risk analyst starts by identifying what could go
wrong. The negative events that could occur are
then weighed against a probability metric to
measure the likelihood of the event occurring.
Finally, risk analysis attempts to estimate the
extent of the impact that will be made if the event
happens.