KEY CONCEPTS OF FINANCE

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Understanding Risk
Risk is the probability that financial loss will occurred. Risk management is a three stage process:

1. Identify the Risk

A financial institution such as a bank, faces the following typical types of risks: Credit risk - This is the risk of default by a borrower. Regulatory risk - This refers to the risk of loss if a Financial Institution (FI) does not comply with the regulations needed by a countrys regulator. Liquidity risk - This is the risk of not having cash when it is needed. This risk is critical for a bank, as it needs to always have sufficient money on hand to repay withdrawals by depositors. Operational risk - This is the risk of loss occurring from inefficiency in a banks people, process and systems. This includes risk of theft, fraud, process inefficiency and so on. Legal risk - This is the risk of loss resulting from not being adequately protected by legal contract. Market risk - Any entity when trading in a market is exposed to the risk of loss, and a bank is no different, if it trades in financial markets. Depending on the specific market, the market risk can be further categorized into: Equity risk (risk of loss in the stock markets), Interest rate risk (risk of loss in bond markets), etc.

Credit risk, operational risk and market risk are regulated by a global standard called the Basel Norms. By global, we mean that, the norms are broadly similar across the world for all banks.

2. Measuring Risk
There are different methods of measuring the types of risk. All methods consider the following factors to arrive at a measure of riskProbability of an adverse event: The measurement of this probability uses various statistical techniques. Monetary impact of the adverse event: If the adverse or loss-causing event occurs, how much money would be lost?

3. Managing Risk
Once the risk is identified and measured, steps can be taken to lessen its impact.

Diversification- Diversification refers to spreading risk across different actions or options.

Hedging- This refers to protecting oneself against risk, using specific financial instruments. Insurance- Another way to manage risk is to transfer it to an insuring party, paying a fee (called the premium). Setting risk limits- A business can set risk limits to the amount of risk it is willing to face, and thus manage risk.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2010. Proprietary content. Please do not misuse!

KEY CONCEPTS OF FINANCE

A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM
Avoid the risk- If a business feels that a particular event will prove too risky, it need not expose itself to that risk at all.

The Risk-return Principle The higher the expected return, the higher is the attached risk and the lower the risk; the lower is the potential reward. That means, if you expect higher returns from any investment, there will be a higher risk associated with it, and vice versa. Risk Management Systems Technology plays an important role in risk management. Banks need risk management systems to manage the different types of risk they face. For example, a market risk management system tracks the investments of a bank at any point, their prices, and the notional profit/loss of the portfolio. It will also have alerts when a trader has exceeded limits such as maximum amount s/he can trade, maximum loss s/he can be exposed to, etc.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2010. Proprietary content. Please do not misuse!