NARASARAOPETA ENGINEERING COLLEGE (AUTONOMOUS): DEPT OF MBA

RISK MANAGEMENT

INTRODUCTION:

The meaning of the word “RISK’ can be traced from the Latin word
“RESCUM” meaning a danger at sea or that which cuts. Managing business in a
highly volatile environment is like navigating a ship on stormy seas. A modern
business is confronted with many risks, some of which are basics-e.g: loss of
property due to natural calamities, civil unrest, etc., and some are strategic.
Strategic risks may manifest themselves in several ways. A firm has a strategic
exposure to changes in foreign exchange rates or interest rates or commodity
prices impacting the expected value or the real cash flows of the firm. Similarly,
changes in prices of financial assets in the capital market can have an adverse
impact on the value of the firm.

In the 1970s and 1980s, financial and commodity asset prices become
quite volatile. This was due to variety of factors, such as the breakdown of the
Bretton Woods system of fixed exchange rates, the oil price shows in 1971 and
1973, excess government spending and inflation policies. These a part, the
exponential increase in the magnitude of world trade and capital flows added by
progressive dismantling of tariff barriers coupled with lifting of exchange controls
in in several countries have also contributed to the increased volatility in the
world economy.

The establishment of the need of risk management for any business is a

part of business strategy as risk management has cost involved and sometimes
makes product line pricing costlier due to risk cost involved in the business. The
source of various kinds of risks depends on the business environment of the
entity, country of business is being regulated by government or partially by the
government has different gravity or risk when compared to a free economy
country.

The purpose of risk management is not necessarily to avoid risk

altogether; complete elimination of risk is not possible. Instead, the purpose of
risk management is to identify which risks are relevant and in what amount. That
helps us devising suitable strategies to handle relevant risks.

CONCEPT OF RISK MANAGEMENT:

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Risk Management is one of the specialized functions of general management. As
such, risk management shares many of the characteristics of general
management and yet is unique in several important respects.

Management may be defined as the process of planning, organizing,

directing and controlling the resources and activities of an organization in order
to fulfill the objectives of that organization at the least possible cost.

Risk management fits within one corner of this broad definition-the corner
which is devoted to minimizing the adverse effects which accidental losses and
price/rate volatilities may have on the organization. In order to fulfill its more
ambitious objectives of profit, growth or public service, an organization must first
achieve a more basic goal; survival in the face of potential losses.

Given the focus on potential losses, ‘Risk Management” may be defined as

the process of planning, organizing, directing and controlling the resources and
activities of an organization in order to minimize the adverse effects of potential
losses at the least possible cost.

What is Risk?

The term Risk is widely used in the day-to-day business for unknown outcome or
the loss arising out of business. Everyone understands the meaning of the word
risk in laymen terms. There is some degree of risk involved in every sphere of
life. We are exposed to either taking or avoiding various kinds of risks in our daily
lives. In a more straight way, the risk can be used describe any situation in which
there is an uncertainty about outcome and the result in the financial market,
risk may be defined as ‘an event or possibility of an event which can
impair corporate earnings or cash flow over short/medium/long term
time horizon”.

Risk can be defined as the impact of a future event that may or may not
happen. Corporate earnings of cash flows have a bearing on the wealth
of the investors through valuation of the company.

In simple words, the probabilities for future returns too vary from the expected
returns in risk. Risk arises in any business transaction where outcome of input
made is not certain. Every business activity has upside and downside risk. If the
same returns could be guaranteed under all circumstances, there would be no
risk, and financial risk management would be an irrelevant phenomenon for

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financial world. However, any such guarantee is not possible in the real financial
world, hence, the need for financial risk management arises.

NATURE OF RISK:

All organizations deal with risks, through that nature and magnitude may
differ for each type of organization. This is especially true for banks/financial
instructions, as they deal with money. They act has financial intermediaries in
any economic system. They help in mobilizing household/corporate savings and
making them available to deficit unit. Since they help in credit creation by means
of loans and advances, they face many risks. In fact, taking risk is the core of the
most of the products and services offered by banks/financial institutions.

In their role as financial intermediaries, banks and/or financial

institutions are involved in the following activities, which result in
various types of risks.

1. FUNDS MOBILIZATION: Funds are mobilized by accepting term deposits

by issuing securities such as bonds, debentures, credit notes, commercial
papers etc., As well as by allowing customers to operate their checking
accounts by leaving balances in them.
2. FUNDS DEPLOYMENT: The funds that are mobilized are fist subject to
regulatory investment requirements-i.e. banks have to invest a specified
proposition of their funds in certain instruments, often government
securities. The surplus funds are available as loan for various segments of
corporate and retail borrowers.
3. FUND TRANSFER: Banks and financial institutions are key vehicles for
moving funds on behalf of their customers. The core competence of banks
is to act as agents of corporations in supporting their liquidity needs
across various geographical locations. Banks also act as settlement agents
for their corporate clients in the realization and payment of their funds.
With growth in size, geographic expansion and increase in complexity of
corporations, the banks have had to change payment systems to ensure a
rapid turnaround of money.
4. RISK TRANSFER: The bank customers manufacturing and other concerns
are exposed to various risks and some of the risks are very crucial to their
business. They relate to product, business model, distribution channel
etc., These have to be mainly handled by the companies themselves.
However, for risks that arise from financial markets, corporates take

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expertise of their banks to take them over since it is the core competence
to handle them. Along with their own risks, banks also have to handle the
risks passed on by their customers.
5. TRANSACTION SERVICES: Banks assist their customer in carrying out
various trade transactions, both domestic and international. International
transactions involve dealing with multiple currencies. The global network
of the banking system and its relationship constitute the backbone of such
trade.
6. CREDIT ENHANCEMENT SERVICES: In the course of business, it is quite
possible that the concerned parties may not be familiar with each other.
Therefore, suppliers of goods often expect the bank’s help in evaluating or
enhancing the credit worthiness of a customer. The entire bunch of
services offered through letter of credit or guarantee falls under credit
enhancement facility.

All these roles involve dealing with risk of some type. Inadequate risk
management may adversely affect the earnings of the bank/financial institution
in the short run and its survival in the long run. This is also true for organizations
other than banks and financial institutions. The financial performance of most
firms is affected by price changes. These prices relate to commodities, exchange
rates, interest rates and equities.

Firms are adept at taking and managing core business risks-choice of

technology, distribution channel, and research on new product or variations.
However, they may want to avoid or manage price risks.

SOURCES OF RISK:

Risks arise from a variety of sources, and affect the value of the assets held by
any corporation. Risk arises to the possibility that the actual outcome could be
different from the expected outcome. The probability of an outcome is governed
by the availability of certain information. Some of the factors that can expose
any economic entity to various are risks are discussed below.

A. Economic policies of governments and resultant budget deficits or

surpluses; changes in money supply, level of inflation and interest rates
as well as capital formation that takes place in the economy. All these in
turn influence the movement of capital in and out the country; have an

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impact on the relative value of currencies and the value of various debt
instruments.
B. Consumption and savings pattern and the preferences of individual
consumers, which result in certain patters of international trade. In the
process, they create trade surpluses in some economics and deficits in
others.
C. Political, social, racial, and ethnic issues that impact the availability of or
demand for a particular commodity and thus result in disturbances in
various commodity markets.
D. Technological factors that bring in new products and thus having an
effect on the fortunes of the corporations manufacturing and marketing
them.
E. Governance of corporations and their financial performance as well as
the financial structures opted for by the individual organization.

In addition to the factors present in the environment, human nature adds to the
possibilities in the dynamic situation. An individual may be placed in a situation
where her self-interest via-a-vis her professional responsibility are in conflict. The
temptation to opt for self-interest can potentially threaten the interest of
corporation that the individual works for and can create difficulties for it.

Prices

Market
Technology
share
Source
of Risk

Competition Productivity

OBJECTIVES OF RISK MANAGEMENT:

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These are the some broad objectives

 Survival
 Peace of mind
 Lower risk management costs and thus higher profits
 Fairly stable earnings
 Little or no interruption of operations
 Continued growth
 Satisfaction of the firm’s sense of social responsibility desire for a good
image and
 Satisfaction of externally imposed obligations.

As a given point of time, a firm may not be interested in some of these

objectives. Among these objectives in which they are interested that they may
place a higher value on attaining some objectives than others. Conflicts among
the objectives may force the firm either to abandon or to scale down the level of
some of those objectivities.

The risk management objectives are basically a function of

 Corporate goals
 The corporate environment
 Attributes peculiar to a particular organization

Risk Management Policy should reflect the basic corporate goals of

survival and profits adjusted to any specific emphasis on growth or stability. A
stability objective suggests a conservative approach to risk management; a firm
emphasizing growth might take more chances because it needs capital for
expansion. The environment may be stable or shifting and homogeneous or
heterogeneous. Businesses operating in a stable homogeneous condition can
adopt objectives that are complete, specific, all – encompassing, and not subject
to frequent review and evaluation. Businesses operating in an unstable
environment have to select an optimal mix of objectives and make frequent
reviews. Specific Company attributes that affect risk management objectives are:

 The company development and history

 The personalities and experience of present management
 The nature and amount of company assets and

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 The nature of company operations.

Part of the task of risk management is the determine the optimum mix of
objectives. To determine this mix, the risk managers have to examine the
feasibility and desirability of numerous mixes.

BENEFITS OF RISK MANAGEMENT:

 Brings order and system to the process of risk quantification

 Enables the assigning of value to estimated risk of loss
 Flags extreme risky situations for necessary mitigate action by
management
 Improves risk awareness when it is actively seen by the company
 Results in increased valuation and reduced cost of capital
 More objective performance appraisal based on risk-adjusted capital
employed

RISK POLICY:

The policy needs to identify issues in risk management that the business
must address. A number of factors need to be agreed on and defined, which
include:

1. Definitions of the risk management framework, taking into account the

context or background of the organization, its regulatory environment as
well as other organizational policies
2. The level of the organization( strategic, business, operational) at which
risk management is expected to be implemented
3. Identification of risks and their consequences
4. Risk preference of stakeholders
5. Clarity of objectives, in particular those situations that the corporation
hopes to avoid, preserves or bring about through risk management or
particular concerns that risk management could help
6. Identification of internal or external factors that limit application of any
risk management strategies
7. Establishment of ground rules that constitute successful risk management

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8. Tools and techniques two be adopted for the identification and subsequent
management, tracking and reporting of the risks
9. Clarity about measurement of impact

RISK MANAGEMENT APPROACHES:

First of all, it needs to be emphasized that the goal of risk management is not to
eliminate risk, but to ensure that risk remain at a predetermined level of
acceptability. Also, one should keep in mind that risk and reward often go
together. Higher expectations of rewards may expose the organization to a
higher level of risk. Similarly, higher levels of risk should provide a higher
possibility of return. Given this relationship between risk and returns, there are
different approaches to managing risk.

a. Risk Avoidance: This means avoiding the risk altogether. This is an

extreme approach and would result in least incentive for any activity to
even take place.
b. Loss Control: It is an approach to reduce the possibility or quantum of
loss. For example, to manage liquidity risk, a firm may decide to always
keep a certain portion in highly liquid assets.
c. Diversification: This approach follows a ‘Do not put all eggs in one
basket’ policy. This policy works well when the various business lines in
an organization do not involve a higher correlation.
d. Risk Transfer: Under this approach, the original party that is exposed to
risk transfers the same to another party that is willing to be exposed to
that risk.
e. Risk Retention: Under this approach, though the firm is aware about
the risk exposure, it deliberately decides to retain it due to a very high
cost of risk transfer
f. Risk Sharing: This approach is a combination or earlier two approaches,
where a part of the risk is retained and the other part is transferred out.

RISK MANAGEMENT PROCESS:

Risk Management consists of certain logical steps: Identification, measurement

and evaluation, control through reduction or elimination and finance.

STEPS IN RISK MANAGEMENT

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Risk Finance
Risk Control
Risk
Measuremen
Risk t and
Identification Evaluation

RISK IDENTIFICATION:

The risk manager begins by identifying all of the resources for which his
organization is responsible. These resources may be human, financial, material
or environmental. He then considers all the potential exposures to loss.

The risk manager is required to develop an intelligence network among fellow

employees that will continuously feed appropriate risk data. Methods used to
identify risk include: regular meetings with line managers and supervisors, site
inspections, surveys, examination of written contracts, analysis of financial
reports, risk management committee meetings, insurance company loss
prevention report, analysis of historical loss experience and a close awareness of
operational developments within the specific industry.

The process of identification may be relatively simple or highly complicated,

depending on the size and nature of the organization. Risks tend to fall into one
of two broad categories; pure risks and financial risks. Pure risks in turn
divided into property risk and legal liability risks. Asset or property
risks are highly visible and are usually easy to identify. These are loss
exposures from fire or explosion, or from natural disasters, such as floods,
hurricanes, theft are other forms of property risks, as are oil spills and plane
crashes.

Legal liability risks are often the hardest to identify and potentially the most
devastating. Consumer lawsuits resulting the compensatory damages of crores
of rupees are now common and in class action suits involving plane crashes etc.,

The major sources of financial risk include business cycles, stock market
volatility, change in interest/inflation rates, foreign exchange rate fluctuation
etc.,

RISK MEASUREMENT AND EVALUATION:

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The second step in the risk management process is measurement and evaluation
of risk in order to project the frequency and severity of future losses. It is
appropriate to consider property risks separately from other risks. For example,
the maximum property loss that might be caused by fire is the current value to
replace all physical assets that could be damaged or destroyed from a single
event plus the consequential loss of income caused to impaired operations. This
maximum loss estimate is referred by property insurance underwriters as the
Probable Maximum Loss or Possible Maximum Loss.

Liquidity losses are more difficult to measure in advance. Probability and

Standard deviation are popular expressions of degree of risk associated with
investments. Some companies now maintain detailed computer-based data on
all losses, including such information as location, time, cause and financial
impact. In many industries, “incident reports” have become a key element in
identifying loss trends.

Mathematical formulas can be used to project the probability and severity of

loss. Sophisticated techniques such as Monete Carlo Simulation, Correlation and
Regression analysis can also be helpful.

RISK CONTROL:

Risk control through elimination or reduction is the third step in the process of
risk management. Some risks can actually be eliminated- by deciding not be
build a plant in an earthquake zone, or by not manufacturing products with
substances that are harmful to workers or consumers. Risk that cannot be
eliminated can reduce through loss prevention programmes.

Employee injuries can be reduced through preventive maintenance by posting

clearly written instructions for the operation of machinery and by requiring
workers to wear hard hats, goggles and gloves in dangerous areas.

Financial risks are non-insurable. These risks can be hedged using derivative
instruments such as futures, options and swaps.

Although loss control programmes may seem to be expensive, they are actually
far less costly than the losses that might occur if no preventive measures were
taken.

RISK FINANCE:

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Developing a suitable financial plan to meet risk management objectives is the
final but crucial step in risk management. It involves deciding how much of pure
risk the company should retain and how much it should transfer to an insurer.
The goal of risk finance is to have enough funds available to sustain potential
loss so that the organization can continue to function and maintain a reasonable
level of earning.

INTEGRATED RISK MANAGEMENT:

Risk Management needs to be looked at holistically. A piecemeal approach can

provide a false satisfaction that risk management is in place, ignoring the flows.it
is a process and should not views as a programme. The process again is not
independent, but needs to be surrounded in the business. It is an issue that has
to be dealt with by business managers; the risk manager and risk department
can only direct the efforts and ensure that risk gets escalated at appropriate
levels and there is adequate follow up.

Board Level Attention:

Risk policies need to be framed at the board level. If necessary, the Board could
delegate the reasonability to a committee of directors, particularly those who are
independent. Active attention and involvement of the Board along with proper
understanding should be demonstrated to the staff to get them involved.

Risk Organization Structure:

There should be a proper management structure is place to deal with risks.

Often, organizations appoint a Chief Risk Officer(CRO) to provide necessary
attention to this. The CRO might also set up risk control objectives, a risk
framework, and design ways to measure risk.

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