Financial Risk Management

MB 8210

by: Mr. Anil Kr. Singh Guest-Faculty, CMS NERIST

Financial Risk Management

=
Finance

+
Risk + Management

Finance Risk

= art and science of managing money = probability of an undesired outcome and/or and/or management as a subject

Management = act of managing resources

team of executives running an enterprise

Financial Risk = A financial situation when the organisations earnings are not sufficient enough to meet its various financial obligations in time.

Techniques of potential risk treatment

1.Risk Avoidance / Risk Elimination
2.Risk Reduction / Risk Mitigation 3.Risk Retention

4.Risk Transfer

Types of Risks
May be characterised on the basis of being:
1. Uncontrollable, external factors and broad impact
= Systematic Risk 2. Controllable, internal factors and specific impact = Unsystematic Risk

Systematic Risk
1.Market Risk

2.Interest Rate Risk

3.Purchasing Power Risk

Unsystematic Risk
1.Business Risk / Operating Risk 2.Financing of the firm

Market Risk
Indicator: Stock prices of a company falling
from time to time, while the companys earnings are rising & the vice-versa.

Reasons: a) change in investors attitude

towards equities in general, or towards certain types & groups of securities in particular. b) Investors reactions to tangible as well as intangible events. c) Market psychology.

Interest Rate Risk

Indicators: Fluctuations in the general level
of interest rates.

Cause: Interest rate rivalry between riskfree securities and other private securities.

Unsystematic Risk
It is that portion of the total risk that is unique to a firm or an industry. Factors such as management capability, consumer preferences, labour strikes, etc can cause unsystematic variability of return for a companys stocks. Types of unsystematic risks: 1. Business risk

2. Financial risk

Business risk
Business risk is a function of the operating conditions faced by a firm and the variability these conditions inject into operating income and expected dividends.

Business risk can be divided into two broad categories:

1.External business risk 2.Internal business risk

Financial Risk
Financial risk is associated with the way in which a company finances its activities.

Financial risk can be gauged by looking at the capital structure of a firm.

The presence of interest commitments and fixed dividends causes the amount of residual earnings available for common stock dividends more variable than if no interest payments were required. A FIRM WITH NO DEBT FINANCING HAS NO FINANCE RISK.

Financial Risk Management

It is the practice of creating economic value in

a firm by using financial instruments to

manage exposure to risk, particularly credit risk and management risk. Financial risk management focuses on when and how to hedge using financial instruments to manage costly exposures to risk.

Objectives of Financial Risk Management

1. To reduce different risks related to a preselected domain to the level accepted by investors. 2. To provide with a structured approach to manage uncertainty related to risk situations. 3. To focus on some traditional risk stemming

from physical or legal causes.

Principles of Risk Management

Risks with greatest loss & greatest probability of

occurrence are handled first, and those with lower

probability of occurrence & lower loss are handled

in descending order.

International Organisation for Standardisation identify the following principles of risk management: 1. Risk management should create value. 2. Risk management should be an integral part of organisational process. 3. It should be a part of decision making.

4. It should explicitely address uncertainty.

5. It should be systematic and structured.

6. It should be based on the best available information.

7. It should be tailored. 8. It should take human factor into account. 9. It should be transparent and inclusive.

10. It should stand by dynamic, interactive and responsive to change.

11. It should be capable of continual improvement and enhancement.

Credit Risk Management

Risk is a situation which would lead to negative consequences. Financial risk is a situation that the cash inflows of a firm will not be adequate to meet financial obligations. Credit risk is a component of financial risk of an organisation. It is the risk that a firm will be unable to meet its financial obligations due to awaiting payments by the customers.

Credit Risk Assessment

The procedure which a lender follows in evaluating a borrowers credit worthiness, repayment ability and collateral position relative

to the borrowers intended use of the credit is

known as credit risk assessment.

Credit Rating
The credit risk rating is the relative degree/amount of credit risk associated

with a credit transaction.

Steps of credit risk assessment and rating

1. Identify the negative impacts of the credit.
2. Decide what might be affected by the credit

factor and how.

3. Evaluate the risk and decide on precautions.

4. Record your findings and implement them.

5. Review your risk assessment and update if

necessary.

Difficulties in risk assessment

Determining the rate of risk occurrence. Evaluating the severity of impact.