Module A: Introduction

Definition of financial risk management

Objectives of financial risk management
Demand for financial risk management
Risk management as a corporate decision making
process
Measuring the trade off between risk and return

Introduction
The financial crisis (2008) and our topic of financial risk
management
Could we have avoided the financial crisis if we had more
properly undergone the process of FRM ?

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Risk has two components:

uncertainty,

and

exposure.

[If either is not present, there is no risk]

Risk is a personal experience, not only because it is
subjective, but because it is individuals who suffer the
consequences of risk. Although we may speak of
companies taking risk, in actuality, companies are merely
conduits for risk. Ultimately, all risks which flow through
an organization accrue to individualsstockholders,
creditors, employees, customers, board members, etc.

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Risk provides the basis for opportunity

risk and exposure have subtle differences in their meaning. Risk

refers to the probability of loss, while exposure is the possibility of
loss, although they are often used interchangeably. Risk arises as a
result of exposure.

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There are three main sources of financial risk:

Financial risks arising from an organizations exposure to

changes in market prices, such as interest rates,
exchange rates, and commodity prices

Financial risks arising from the actions of, and

transactions with, other organizations such as vendors,
customers, and counterparties in derivatives transactions

Financial risks resulting from internal actions or failures

of the organization, particularly people, processes, and
systems

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Financial

risk management is a process to

deal with the uncertainties resulting from
financial markets.

It

involves assessing the financial risks facing an

organization and developing management
strategies consistent with internal priorities and
policies. Financial risks management shall provide
the firm with competitive advantage.
Strategies may involve the use of Derivatives
(example of long and short strategy)
Concept of hedging

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The

process of financial risk management

comprises of the following steps.
Identify

and prioritize key financial risks.

Determine an appropriate level of risk
tolerance.
Implement risk management strategy in
accordance with policy.
Measure, report, monitor, and refine as needed.

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Objectives of financial risk management

Objective of risk management is to reduce different
risks related to a pre selected domain to the level
accepted by society. It may refer to numerous types of
threats caused by environment, technology, humans,
organizations and politics. On the other hand it involves
all means available for humans, or in particular, for a risk
management entity (person, staff, and organization).

Realistic descriptions of the corporate environment give

justifications for the firms should devote careful attention
to the risks they face.

Risk management can increase the value of the firm by

reducing the probability of default.

Risk management can help to reduce taxes by reducing

the volatility of earnings.

The higher debt-equity leads to a higher risk for the firm.

Risk management can therefore be seen as allowing
the firm to have a higher debt-equity, which is beneficial
if debt financing is inexpensive.

Proper risk management helps reduce the cost of

retaining and recruiting key personnel.

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Does

Risk Management improve Firm

Performance?
Yes. Empirical results support the proposition. A
study found that risk management led to reduced
exposure to interest rate and exchange rate
movements. Risk management leads to lower
variability. And managing variability better
improves corporate performance. Less volatile
cash flows result in lower costs of capital and
more investments.

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How people perceive Risk {remember that risk is basically a

personal experience}?
Experience
Knowledge
Culture
Position
Financial status
Ability to influence outcome
Asymmetry
Complacency
Inadequate time horizons
Rose tinted glasses
Single-mindedness

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Understanding what risks we face

Measuring those risks

Deciding on what to do (managing risk)

To take the risk as it is (accept it)
Take action to minimize either the probability of the risk event
occurring or the impact should happen (mitigate it);
Do not accept the risk (avoid it).

Making sure decisions remain valid (monitoring risk)

[In cases where the risk is accepted or mitigated it will be
necessary to]
continually reappraise the risk to ensure it has not changed.
make sure that an adequate reward is being earned.
put in place contingency plans should an adverse event occur.
ensure that there are adequate reserves to protect against losses
arising from an adverse event.

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There are three broad alternatives for managing risk:

Do nothing and actively, or passively by default, accept
all risks.
Hedge a portion of exposures by determining which
exposures can and should be hedged.
Hedge all exposures possible.

Measurement and reporting of risks provides

decision makers with information to execute
decisions and monitor outcomes, both before
and after strategies are taken to mitigate
them.

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Measuring the trade off between risk and return

For the investor:
Utility (satisfaction level) = E(Rp) Risk penalty

Risk penalty (of the portfolio) depends upon the risk

tolerance level of the investor.

Risk penalty = 2m / tk
(m is the mix)
Thus, Umk = E(Rm) - 2m / tk (where tk = risk tolerance
level of investor K)
Quantum of risk undertaken for the reward (return)
generated in a portfolio is measured by the following
ways

Sharpe ratio
Tryenor ratio
Jensens
Famas decomposition

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When considering risk it is important to remember that it is only one

side of the equation. Risk must be balanced against reward. A good
definition of risk management which is:
the taking of deliberate actions to shift the odds in our favour.
To increase the odds of good outcomes and to decrease the odds of
bad outcomes.

The positive aspects are (risk reward trade off)

higher sales or profits
increased share price
increased market share
industry awards and recognition
high public esteem/customer satisfaction
good reputation.