Assignment of Managerial Finance

Definition of 'Risk':
The chance that an investment's actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment. Different versions of risk are usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment. A high standard deviation indicates a high degree of risk. Many companies now allocate large amounts of money and time in developing risk management strategies to help manage risks associated with their business and investment dealings. A key component of the risk management process is risk assessment, which involves the determination of the risks surrounding a business or investment. A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this is that investors need to be compensated for taking on additional risk.

For example:
A U.S. Treasury bond is considered to be one of the safest (risk-free) investments and, when compared to a corporate bond, provides a lower rate of return. The reason for this is that a corporation is much more likely to go bankrupt than the U.S. government. Because the risk of investing in a corporate bond is higher, investors are offered a higher rate of return.

Types of Risk
Unfortunately, the concept of risk is not a simple concept in finance. There are many different types of risk identified and some types are relatively more or relatively less important in different situations and applications. In some theoretical models of economic or financial processes, for example, some types of risks or even all risk may be entirely eliminated. For the practitioner operating in the real world, however, risk can never be entirely eliminated. It is ever-present and must be identified and dealt with. In the study of finance, there are a number of different types of risk the been identified. It is important to remember, however, that all types of risks exhibit the same positive risk-return relationship.

Some of the most important types of risk are defined below. Default Risk:
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Assignment of Managerial Finance

The uncertainty associated with the payment of financial obligations when they come due. Put simply, the risk of non-payment. Interest Rate Risk: The uncertainty associated with the effects of changes in market interest rates. There are two types of interest rate risk identified; price risk and reinvestment rate risk. The price risk is sometimes referred to as maturity risk since the greater the maturity of an investment, the greater the change in price for a given change in interest rates. Both types of interest rate risks are important in banking and are addressed extensively in Bank Management classes. Price Risk: The uncertainty associated with potential changes in the price of an asset caused by changes in interest rate levels and rates of return in the economy. This risk occurs because changes in interest rates affect changes in discount rates which, in turn, affect the present value of future cash flows. The relationship is an inverse relationship. If interest rates (and discount rates) rise, prices fall. The reverse is also true.

Since interest rates directly affect discount rates and present values of future cash flows represent underlying economic value, we have the following relationships.

Reinvestment Rate Risk: The uncertainty associated with the impact that changing interest rates have on available rates of return when reinvesting cash flows received from an earlier investment. It is a direct or positive relationship. This type of interest rate risk is also covered extensively in the Bank Management courses.

Liquidity risk:

Assignment of Managerial Finance

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 because there are many interested buyers and sellers in the market. An illiquid asset is hard to sell because there few interested buyers. This type of risk is important in some project investment decisions but is discussed extensively in Investment courses. Risks within the liquidity risk are Asset Liquidity Risk Funding Liquidity Risk

Inflation Risk (Purchasing Power Risk): The loss of purchasing power due to the effects of inflation. When inflation is present, the currency loses its value due to the rising price level in the economy. The higher the inflation rate, the faster the money loses its value. Market risk: Risk of declining prices or volatility of prices in the financial markets will result a loss. There are two types of market risk including Absolute Risk and Relative Risk. Within the market risk following risks are of importance. Absolute Risk Relative Risk Directional Risk (Linear risk exposure) Non directional Risk (Non linear risk exposure) Basis Risk Volatility Risk

Firm specific risk: 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 the investment risk that is eliminated through the holding of a well diversified portfolio. Often referred to as un-systematic risk or diversifiable risk. This type of risk is discussed extensively in Investment courses. Project risk: In the advanced capital budgeting topics, the total risk associated with an investment project. Sometimes referred to as stand-alone project risk. In advanced capital budgeting, project risk is partitioned into systematic and un-systematic project risk.

Financial risk:
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The uncertainty brought about by the choice of a firms financing methods and reflected in the variability of earnings before taxes (EBT), a measure of earnings that has been adjusted for and is influenced by the cost of debt financing. This risk is often discussed within the context of the Capital Structure topics. Business risk: 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 measure has not had financing expenses removed, it reflects the risk associated with business operations rather than methods of debt financing. This risk is often discussed in General Business Management courses. Foreign Exchange Risks: 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 foreign currency denominated accounting statements into the home currency. This risk is extensively discussed in Multinational Financial Management courses. Transactions Risks: Uncertainty associated with the home currency values of transactions that may be affected by changes in foreign currency values. This risk is extensively discussed in the Multinational Financial Management courses.

Credit Risk: Risk of loss due defaulting of counterpart in a financial transaction. Important terms and further classes of risks under credit risk are Exposure Recovery Rate Credit Event Sovereign Risk Settlement Risk

Operational Risk:

Assignment of Managerial Finance

Risk of loss due to inadequate monitoring system, management failure, defective controls, frauds and human errors. This risk is particularly relevant to DERIVATIVE TRADING, because derivatives are inherently highly leveraged instrument, which enable traders to expose a firm to loss using relatively small amount of capital. Following are the classes of operational risk Model Risk People Risk Legal Risk . Total Risk: 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 from what is expected. If we focus on this definition of risk, we can define what is referred to as total risk. In financial terms, this total risk reflects the variability of returns from some type of financial investment.

Measures of Total Risk:

The standard deviation is often referred to as a "measure of total risk" because it captures the variation of possible outcomes about the expected value (or mean). In financial asset pricing theory there is a pricing model (Capital Asset Pricing Model or CAPM) that separates this "total risk" into two different types of risk (systematic risk and unsystematic risk). Another related measure of total risk is the "coefficient of variation" which is calculated as the standard deviation divided by the expected value.

Strategies used by financial managers:

Financial risks, such as market and credit risks, are implicit in corporate operating activities. A company's top leadership implements adequate and functional financial risk management strategies to prevent significant losses. Regulators, such as the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA), usually require firms to establish risk control frameworks. Financial Strategies for the Manager includes a range of financial management issues such as financial statement analysis, a systematic approach to financial performance appraisal, liquidity management and sales growth, working capital management, budgeting, foreign exchange and interest rate risk management, and a most useful tool not normally understood. Following are the strategies Credit Risk Management: Credit risk is the loss expectation originating from a counterparty's (or business partner's) inability to repay a loan on time or fulfill other financial promises when they become due. A business partner defaults because of bankruptcy or temporary cash problems.

Assignment of Managerial Finance

A credit risk manager builds a math-based worksheet and rates counterparties as "high," "medium" and "low," depending on the loss expectation. Corporate credit officers require business partners rated as "high" or "medium" to provide collateral or financial guarantees, before engaging in further transactions. Risk and Control Assessment: Top leadership generally asks department heads and segment managers to periodically prepare "risk and control self-assessment," or RCSA, reports in financial risk systems. An RCSA is a document in which segment staff members list controls and related risks. They also rank those risks as "tier 1," "tier 2" and "tier 3" based on potential losses. Senior managers generally focus on "tier 1" and "tier 2" risks and ensure that department heads provide corrective measures for those risks. Risk Insurance Coverage: Risk insurance coverage is a business practice that helps a company limit financial losses owing to credit or market risks. For example, a large investment bank lends $1 million to a small tire manufacturing company. The bank's chief risk officer believes the automobile industry may experience economic difficulties, and that some tire manufacturers could be forced out of business. Consequently, he purchases a 95 percent risk coverage from an insurance company. After nine months, the tire manufacturer files for bankruptcy. The bank incurs only $50,000 in losses because it receives $950,000 ($1 million times 95 percent) from the insurance company. Quantitative Market Risk Control: Market risk is the loss probability emanating from adverse security price fluctuations with respect to a company's investment portfolio. A market risk manager usually applies math acumen and statistical expertise to build complex tools such as VaR (value at risk), Monte Carlo simulation and stress testing. These tools serve to limit losses in financial transactions. To illustrate, the daily VaR at an investment bank's corporate bond trading desk is $100 million. The firm's traders usually have from $500 million to $750 million in proprietary, or company-owned, trading portfolios. If markets conditions deteriorate on any given day, and total losses reach $100 million, portfolio managers may no longer trade on that day. Capital budgeting: Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures. Many formal methods are used in capital budgeting, including the techniques such as

Assignment of Managerial Finance

Accounting rate of return Payback period Net present value Profitability index Internal rate of return Modified internal rate of return Equivalent annuity Real Options Valuation

These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period. Risk management: Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities. Risks can come from uncertainty in financial markets, project failures (at any phase in design, development, production, or sustainment life-cycles), legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attack from an adversary, or events of uncertain or unpredictable root-cause. Several risk management standards have been developed including the Project Management Institute, the National Institute of Standards and Technology, actuarial societies, and ISO standards. Methods, definitions and goals vary widely according to whether the risk management method is in the context of project management, security, engineering, industrial processes, financial portfolios, actuarial assessments, or public health and safety. The strategies to manage risk typically include transferring the risk to another party, avoiding the risk, reducing the negative effect or probability of the risk, or even accepting some or all of the potential or actual consequences of a particular risk. Financial statement analysis: Financial statement analysis (or financial analysis) the process of understanding the risk and profitability of a firm (business, sub-business or project) through analysis of reported financial information, particularly annual and quarterly reports. Financial statement analysis consists of:

Assignment of Managerial Finance

1) Reformulating reported financial statements. 2) Analysis and adjustments of measurement errors. 3) Financial ratio analysis on the basis of reformulated and adjusted financial statements. The two first steps are often dropped in practice, meaning that financial ratios are just calculated on the basis of the reported numbers, perhaps with some adjustments. Financial statement analysis is the foundation for evaluating and pricing credit risk and for doing fundamental company valuation. Working capital management: Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short. In general this is as follows: the goal of Corporate Finance is the maximization of firm value. In the context of long term, capital investment decisions, firm value is enhanced through appropriately selecting and funding NPV positive investments. These investments, in turn, have implications in terms of cash flow and cost of capital. The goal of Working Capital (i.e. short term) management is therefore to ensure that the firm is able to operate, and that it has sufficient cash flow to service long term debt, and to satisfy both maturing short-term debt and upcoming operational expenses. Quantitative Risk Management: In quantitative risk management, an effort is carried out to numerically ascertain the possibilities of the different adverse financial circumstances to handle the degree of loss that might occur from those circumstances. Commodity Risk Management: Handles different types of commodity risks, such as price risk, political risk, quantity risk and cost risk. Bank Risk Management: Deals with the handling of different types of risks faced by the banks, for example, market risk, credit risk, liquidity risk, legal risk, operational risk and reputational risk. Non-profit Risk Management: This is a process where risk management companies offer risk management services on a nonprofit seeking basis.

Assignment of Managerial Finance

Currency Risk Management: Deals with changes in currency prices. Enterprise Risk Management: Handles the risks faced by enterprises in accomplishing their goals. Integrated Risk Management: Integrated risk management refers to integrating risk data into the strategic decision making of a company and taking decisions, which take into account the set risk tolerance degrees of a department. In other words, it is the supervision of market, credit, and liquidity risk at the same time or on a simultaneous basis. Technology Risk Management: It is the process of managing the risks associated with implementation of new technology. Software Risk Management: Deals with different types of risks associated with implementation of new softwares.

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