risk management for mba students

7/31/2019 Risk Management for MBA students

1/28


2/28

The origin of term of the word

RISK can be tracedto the latin word RESCUM meaning of danger at

sea or that which cuts.A modern business is confronted with many risks,

some of which are basic e.g.; loss of property due tonatural calamities, civil unrest etc.

And some strategic exposure to change in foreignexchanges rates or interest or commodity pricesimpacting the expected value or the real cash flowsof the firm.

Introduction


3/28

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 risk are relevant and in what amount.That helps us devising suitable strategies to handle

relevant risks.

Introduction


4/28

The possibility of suffering harm or loss; danger.

The possibility of incurring misfortune or loss;

hazard

Meaning of risk


5/28

Risk management is one of the specialized functions

of general management. As such, risk management

shares many of the characteristics of generalmanagement, and yet is unique in several importantrespects.

Management may be defined as the process of

planning, organization, directing and controlling theresources and activities of an organization in order tofulfill the objective of that organization at the leastpossible cost.

Risk Management Concept


6/28

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/ratevolatilities may have on the organization.

In order to fulfill its more ambitious objective of profit itsmore ambitious objective of profit, growth or publicservices, an organization must first achieve a more basic

goal. Survival in the face potential losses, risk management may be defined as the process ofplanning, organization, directing and controlling theresources and actives of an organization in order tominimize the adverse effects of potential losses at the least

possible cost.

Risk Management Concept


7/28

Though it may be difficult to outline specific targets for

risk management, some broad objective included:

Mere 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 firms sense of social responsibility

desire for a good image etc.

Risk Management Objectives


8/28

COMMON RISK IN FINANCE :

Unfortunately, the concept of risk is not a simple concept in

finance. There are many different types of risk identified andsome types are relatively more or relatively less important indifferent situations and applications. In some theoreticalmodels of economic or financial processes, for example, sometypes of risks or even all risk may be entirely eliminated. For

the practitioner operating in the real world, however, risk cannever be entirely eliminated. It is ever-present and must beidentified and dealt with.

Types Risk


9/28

In the study of finance, there are a number of different

types of risk the has been identified. It is important toremember, however, that all types of risks exhibit the samepositive risk-return relationship.

Some of the most important types of risk are defined below.

o Default risk

o

Interest rate risk1. Price risk

2. Reinvestment risk

o Liquidity risk

Types Risk


10/28

o Inflation risk ( purchasing power risk)

o Market risk

o

Firm specific risko Project risk

o Financial risk

o Business risk

o

Foreign exchange risk1. Translation risk

2. Transaction risk

o Total risk

Types Risk


11/28

The uncertainty associated with the payment of financial

obligations when they come due. Put simply, the risk ofnon-payment.

The event in which companies or individuals will be unableto make the required payments on their debt obligations.Lenders and investors are exposed to default risk invirtually all forms of credit extensions. To mitigate the

impact of default risk, lenders often charge rates of returnthat correspond the debtor's level of default risk. The higherthe risk, the higher the required return, and vice versa.

Default risk


12/28

The uncertainty associated with the effects of changes in

market interest rates.

There are two types of interest rate risk identified; price riskand reinvestment rate risk.

The price risk is sometimes referred to as maturity risk sincethe greater the maturity of an investment, the greater thechange in price for a given change in interest rates.

Both types of interest rate risks are important in bankingand are addressed extensively in Bank Management classes.

Interest rate risk


13/28

Price Risk

The uncertainty associated with potential changes in the priceof an asset caused by changes in interest rate levels and rates of

return in the economy. This risk occurs because changes in interestrates affect changes in discount rates which, in turn, affect thepresent value of future cash flows. The relationship is an inverserelationship. If interest rates (and discount rates) rise, prices fall.The reverse is also true.

Interest rate Present value

Interest rates Present valueSince interest rates directly affect discount rates and present values of future cash flows

represent underlying economic value, we have the following relationships.

Interest Rate risk


14/28

Reinvestment Risk

The uncertainty associated with the impact that changing

interest rates have on available rates of return whenreinvesting cash flows received from an earlier investment. Itis a direct or positive relationship

Interest rate present value

Interest rate present value

Interest Rate Risk


15/28

The uncertainty associated with the ability to sell an asset

on short notice without loss of value. A highly liquid asset

can be sold for fair value on short notice. This is becausethere are many interested buyers and sellers in the market.An illiquid asset is hard to sell because there few interestedbuyers.

Liquidity Risk


16/28

The loss of purchasing power due to the effects of

inflation. When inflation is present, the currency loses it's

value due to the rising price level in the economy. Thehigher the inflation rate, the faster the money loses itsvalue.

Inflation risk


17/28


18/28

The uncertainty associated with the returns generated from

investing in an individual firms common stock. Within the

context of the Capital Asset Pricing Model (CAPM), this is theinvestment risk that is eliminated through the holding of awell diversified portfolio. Often referred to as un-systematicrisk or diversifiable risk.

Firm Specific Risk


19/28

In the advanced capital budgeting topics, the total risk

associated with an investment project. Sometimes referred

to as stand-alone project risk. In advanced capitalbudgeting, project risk is partitioned into systematic and un-systematic project risk.

Project Risk


20/28

The uncertainty associated with a business firm's operating

environment and reflected in the variability of earnings

before interest and taxes (EBIT). Since this earnings measurehas not had financing expenses removed, it reflect the riskassociated with business operations rather than methods ofdebt financing.

Business Risk


21/28

Uncertainty that is associated with potential changes in

the foreign exchange value of a currency. There are two

major types: translation risk and transaction risks.Translation Risks:

Uncertainty associated with the translation of foreigncurrency denominated accounting statements into the homecurrency.

Transactions Risks:

Uncertainty associated with the home currency valuesof transactions that may be affected by changes in foreigncurrency values..

Foreign Exchange Risk


22/28

While there are many different types of specific risk, we

said earlier that in the most general sense, risk is the

possibility of experiencing an outcome that is different fromwhat is expected. If we focus on this definition of risk, wecan define what is referred to as total risk. In financialterms, this total risk reflects the variability of returns from

some type of financial investment.

Total Risk


23/28

BUSINESS RISK : Broadly defined risk management is concerned with

possible reductions in business value from any source.

Business value to shareholders, as reflected in the valuefirms common stock, depends fundamentally on theexpected size, timing, and risk ( variability) associated withthe firms future net cash flows (cash inflow less cash outflows) .

Unexpected changes in expected future net cash flows are amajor source of fluctuation in business value.

in particular, unexpected reductions in cash inflows orincreases in cash outflows can significantly reduce business

value

Types of risk facing business

and individuals


24/28

The major business risks that give rise to variation incash flows and business value are price risk, credit risk andpure risk.

Price risk:

Refers to uncertainty over the magnitude of cash flowsdue to possible changes in output and input prices

Output prices risk refers to the risk of changes in theprice that a firm can demand for its goods and services.

Input price risk refers to the risk of changes in the pricesthat a firm must pay for labor, materials, and other inputs toits production process.


and individuals


25/28

Three specific types of price risk are commodity price risk,

exchange rate risk

interest rate risk.

Commodity price risk arises from fluctuation in the pricesof commodities, such as coal, copper, oil, gas and electricity,

that are inputs for some firm and outputs for others.Due to globalization economic activity, output and inputand prices for many firms also are effected by fluctuations inforeign exchange rates.


and individuals


26/28

Out put and inputs price also can fluctuate due to changes ininterest rate.

Credit risk:

The risk that a firms customers and the parties to which ithas lent money will delay or fail to make promised payment isknown as credit risk.

Pure Risk

A risk that is not beneficial to the insurer, as loss is the onlyforeseeable outcome.


and individuals


27/28

Pure riskThe risk management function in medium-to-largecorporation ( and the term risk management) has traditionallyfocused on the management of what is know as pure risk.

Major types of pure risk that affect businesses are as follows.

o The risk of reduction in value of business assets due tophysical damages, theft and expropriation ( i.e., seizure ofassets by foreign governments).

o The risk of legal liability for damages for harm tocustomers, suppliers, shareholders, and other parties.


and individuals


28/28

The risk associated with paying benefits to injured workersunder workers compensation laws and the risk of legalliability for injuries or other harms to employees that are

not governed by workers compensation laws.Personal risk :


and individuals

risk management for mba students

Documents