INTRODUCTION TO RISK &

RISK MANAGEMENT
Damodaran/ch.1,2,3

Contents
1.
2.
3.
4.
5.
6.
7.

Some examples
What is risk?
Continuous risks vs. Event risks
Reclassifying continuous risks
Further classification of risks
Consequences of risk & implications
Further reclassification of risk
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Contents
8. Why should we manage risk?
9. Management of risk
10.Valuing assets under influence of
risk
11.Risk adjustment in valuation
models

1. Some Examples
Business risks investments / operations
Financial risks borrowing & lending
Financial investment risks capital
losses / gains
Gambling & lotteries losses / gains
Professional hazards
Untimely death of persons
Sickness / Disease / Injury
Natural calamities
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The Foregoing Implies

We cannot do business without
risk
Risk is both bad & good for
business
We cannot live without risk
Risk is big business

The Goal of Risk

Management
The goal is NOT to eliminate risk.
Why?
The goal is to maintain risk at a
predetermined level of acceptability
and maximise the returns

2. What is Risk?
It is present in situation(s) that have
multiple outcomes and some or all of
the outcomes may be adverse
Such situations are referred to as
experiments
The various possible outcomes may
be known but cannot be predicted
with certainty
e.g. Death or sickness of an
individual, losses due to natural
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Some Essential Elements of Risk

1. Multiple outcomes
2. Some (or all) of the outcomes may
be adverse
3. Occurrence of any of the possible
outcomes cannot be predicted with
certainty
4. Or the order in which the outcomes
will occur cannot be predicted with
certainty
5. A chance factor is associated with

2. What is Risk
So Defining risk has two
aspects:
Probabilities of certain
events occurring
Consequences of the events

Threats & Risks

Earthquake, flood, draught,
terrorism are threats and not
risks
Why ?

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2A: Why is Risk Important?

Risk causes different extent of aversion in
different individuals leading to different
economic choices
It is the natural reaction to the presence
of risk in the decision making scenario
It affects economic choices of individuals
& institutions
The higher the risk the higher is the riskaversion and the higher is the impact on
economic choices
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2A: Why is Risk Important?

Risk has important
consequences for:
Investment choices
Corporate Finance
Valuation

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2A: Why is Risk Important

Investment choices:
3 aspects of investment decision
making
Asset allocation:
Cash/Bonds/Stocks
Asset selection
Performance evaluation: a. How
do we measure risk? b. How
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2A: Why is Risk Important

Corporate Finance:
3 major decisions in
corporate finance
Investment (capital
expenditures)
Financing (debt vs. equity)
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2A: Why is Risk Important

Valuation of assets
Risk affects Asset Pricing
As it is in the real world, it may
be / not be done rationally
Rational valuation is likely to
lead to gains
Irrational valuation is likely to
lead to losses
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3. Continuous Risk vs. Event

Risk
What is continuous risk?
What is event risk?

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3. Continuous Risk vs. Event

Risk
Continuous risks are those which tend to
occur & affect at all times
There is complete certainty (100%
probability) that such risks will have an
observable / perceptible impact at any
period of time
The impact can be adverse / favourable
Eg. Exchange rate volatility, Interest rate
volatility, Inflation, Stock market volatility,
Commodity price volatility
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3. Continuous Risk vs. Event

Risk
Event risks (aka Discrete risks) would not
manifest themselves for long time periods - they
will suddenly occur in some time period
The probability of occurrence in any period is low
The economic consequences of such risks are
generally serious, adverse, devastating, leading
to widespread damages / losses
Eg. Natural calamities (acts of god - cyclone,
earthquakes, floods, fires); Political events (war,
change of power, riots, nationalisation);
Terrorism; Accident
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3. Continuous Risk vs. Event

Risk
Continuous risk
Effective
continuously over
time
Occurrence in any
time period is certain
100% probability

May lead to both

losses & gains
Source: Market /
Economy

Event risk
Effective after long
gaps of time
Occurrence in any
time period is highly
uncertain Less than
100% probability;
very small
Will always lead to
heavy losses
Sources:
Heterogeneous

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4. Reclassifying Continuous
Risks
Continuous risks can be reclassified
from an investment perspective into:
1. Risks in fixed income assets
2. Risks in variable income assets
Risks of both types of assets arise
from market
But they are affected by different
market factors
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4. Reclassifying Continuous
Risks
Fixed income assets are affected by
interest rate volatility
Variable income assets are affected
by volatility of required returns of
investors
Both types of factors cause capital
gains & losses in the value of the
assets held
Result: Favourable / Adverse impact
on investors wealth

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5. Further Classification of
Risks
Risks for variable income assets can
be further classified into:
1. Systematic risks / market risks /
Non-diversifiable risks
2. Unsystematic risks / Firm-specific
risks / Diversifiable risks

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5. Further Classification of
Risks
Systematic risks arise out of market factors
Important market risk factors: Purchasing
power risk, Interest rate risk, Exchange rate
risk, Economic growth rate
The impact of systematic risk factors cannot
be eliminated by holding a diversified
portfolio of assets
The riskiness of assets as part of a
diversified portfolio of assets is determined
by their sensitivity to systematic risk
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5. Further Classification of
Risks
Unsystematic risks do not arise out of
market factors; they arise out of assetspecific or firm specific factors
Important firm specific factors: Operating
risk, Financial risk, other firm-specific
factors
Impact of unsystematic risk factors can be
eliminated by holding a diversified
portfolio of assets unsystematic risks of
various assets counteract each other
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6. Consequences of Risk &

Implications
Consequences of Risk: Risks faced by an
entity would affect one or more of the
following:
Assets
Liabilities
Revenues
Expenses
How?
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6. Consequences of Risk &

Implications
If the entity is impacted by event risks
then each of the above items would be
adversely affected
If the entity is impacted by continuous
risks then each of the above items would
be either adversely or favourably affected
An entity faces both types of risks and
must adopt strategies to manage both
the same strategy wont work for both
types
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6. Consequences of Risk &

Implications
Adverse impact on assets would decrease their
value
Adverse impact on liabilities would increase
their value
Adverse impact on revenues would decrease
them
Adverse impact on expenses would increase
them
Favourable impact would have opposite effects
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6. Consequences of Risk &

Implications
Net effect of all adverse & favourable
impacts on all assets, liabilities, revenues &
expenses would be on shareholder wealth
Risk management strategy of a firm should
be able to counteract all effects adverse &
favourable, such that there is no impact on
shareholder wealth
Various risk management tools are available
for managing various types of risks
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7. Further Reclassification of
Risk
Risks in the context of business
entities can be further classified into:
A. Credit risk
B. Market risk
C. Operational risk

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7A: Credit Risk

It applies to all business entities to
the extent they do business on credit
Hence this risk will necessarily affect
banks, FIs & NBFCs
It is also applicable to cos. in other
industries as well that do business on
credit
To the extent cos. face this risk there
is potential loss of capital
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7A: Credit Risk

Assessment of profit: As a conservative
approach to assessment of profits cos.
should provide for such losses due to
default before arriving at a value of profit
Pricing of credit: Further assessment of
credit risk is important from a business
perspective for BFS cos. because the
credit-based products of such cos. can be
appropriately priced after incorporating
adequate risk premium in the interest rate
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7B: Market Risk

Market risk refers to the impact of
factors related to market and
economy
Eg. Inflation, interest rates, exchange
rates, prices of listed stocks,
commodity prices, energy prices
Such factors would affect: revenues,
expenses, profits & market value of
the firm
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7B: Market Risk

To the extent the co. holds securities or
derivative products as investments it is
exposed to the risk of capital losses on such
investments
This in turn would mean erosion of capital and
has to be provided for
Though the market risk factors are
heterogeneous in nature they all originate
either in the market or the economy at large &
affect all firms no firm can escape the impact
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7C: Operational Risk

A very heterogeneous category
All risks which cannot be classified under
the previous two categories, fall in this
Risk factors include: processes, human
errors, frauds, sabotage, reputational risk
Some of the factors are internal & some
external
The factors do not have a common origin
Most challenging to deal with
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8. Why Should We Manage

Risk?
Risk has to be managed in order to protect
the existence of the entity under various
circumstances
The entity must exist under the impact of all
risk factors and must be able to grow in
terms of value
Risks can again be divided into two groups:
(a) Those which have very low likelihood of
occurrence but very high impact; (b) Those
which have high likelihood but low impact
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8. Why Should We Manage

Risk?
Risks in group (a) are event risks and
have to be protected against
If not done their occurrence may bring
about the extinction of the organisation
Risks in group (b) are typically
continuous risks
Not managing such risks would not
result in the extinction of the
organisation
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8. Why Should We Manage

Risk?
But not managing risks in (b) would result
in volatility of revenues, expenses & profits
resulting in volatility of shareholders
wealth & returns & higher cost of capital
Managing such risks would result in
stability of shareholder wealth & lower cost
of capital
This has implications for further financing
of the firm
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8. Why Should We Manage

Risk?
Lower volatility of profits result in
lower cost of equity capital
This also results in lower cost of debt
capital because volatility of profits
indicate operating risk of the co.
Lower cost of equity & debt capital
enables the co. to increase its equity
& debt capital at lower cost
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9. Management of Risk
Management of risk involves the
following basic steps:
A. Risk identification
B. Risk measurement
C. Risk hedging / mitigation

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9A: Risk Identification

Before risk can be managed it has to
be identified identifying the cause
Different types of risk have different
characteristics hence they have to
be dealt with in different ways
Identifying the risk helps in
identifying the best possible
technique to manage it
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9B: Risk Measurement

Measuring the risk involves:
(a) Measuring the likelihood of the risk
(b) Measuring the impact of the risk
Can be done both quantitatively &
qualitatively
Helps in:
(a) Prioritising the risks
(b) Taking adequate measures to manage
risks
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9C: Risk Hedging /

Mitigation
These are tools & techniques that can be
adopted to counteract the impact of risk
Generally the tools involve a cost
The firms have to identify the tool & the
extent of protection given its cost
Some tools & techniques protect the firm from
the downside impact of risk but prevents it to
exploit the beneficial impact too
Some tools can offer protection from the
downside impact as well as enable the firm to
exploit upside potential
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10. Valuing Assets Under Influence of

Risk
The term asset is a generic term
Asset can be financial or non-financial
asset
It might also represent an entity such
as a co.
An entity such as a co. is like a
collection of assets & liabilities it can
be treated as net asset (or a net
liability)
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10. Valuing Assets

Why to Value Assets?
Assets have to be acquired / disposed
While acquiring assets the issue is: What
is the fair price to pay for the asset?
While disposing assets the issue is: What
is the fair price to receive for the asset?
Assessing the fair price for an asset is
both a quantitative and subjective issue

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10. Valuing Assets

Why to Value Assets?...
The quantitative aspect generally
relates to the valuation framework
The subjective aspect relates to the
estimation of inputs to the framework
data estimation
Valuation becomes important for
investment decisions & corporate
restructuring decisions (M&A)
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10. Valuing Assets

Why to Value Assets?...
Investment decisions involve buying / selling a
financial investment
Corporate restructuring involves investing /
disinvesting in a business or M&A
Acquiring an asset by paying a higher price than
the fair value would depress the returns from
the asset
Disposing an asset at a price lower than the fair
value would depress the return from the asset
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11. Risk Adjustment in Valuation Models

A. The classical valuation model
B. Impact of risk
C. Adjustment for risk

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11A: The Classical Valuation

Model
DCF based model
Numerator consists of cash flows
from asset
Denominator consists of the discount
rate
Value of the asset is dependent on
the cash flows over time & discount
rate for making the adjustment for
time
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11B: Impact of Risk

Due to the impact of risk the future
cash flows will become more doubtful
(uncertain)
The providers of capital (equity &
debt) would require a higher
compensation because they are
taking higher risk
In either case the value of the asset
would reduce
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11C: Adjustment for Risk

Adjustment for risk can be done by a
reduction in the estimated expected
cash flows from the asset over the
years
Or by increasing the discount rate
Or by doing both hybrid approach

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