Module A: IntroductionDefinition of financial risk managementObjectives of financial risk managementDemand for financial risk managementRisk management as a corporate decision making processMeasuring the trade off between risk and returnIntroduction 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 ?

Module A [Introduction]Risk has two components:uncertainty, andexposure.[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.

Module A [Introduction]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.

Module A [Introduction]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

Module A [Introduction]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

Module A [Introduction]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.

Module A [Introduction]Objectives of financial risk managementObjective 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.

Module A [Introduction]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.

Module A [Introduction]How people perceive Risk {remember that risk is basically a personal experience}?ExperienceKnowledgeCulturePositionFinancial statusAbility to influence outcomeAsymmetry ComplacencyInadequate time horizonsRose tinted glassesSingle-mindedness

Module A [Introduction]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.

Module A [Introduction]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.

Module A [Introduction]

Module A [Introduction]

Module A [Introduction]Measuring the trade off between risk and returnFor 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 waysSharpe ratioTryenor ratioJensens Famas decomposition

Module A [Introduction] 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.