2 INTRODUCTION Distinction between uncertainty Uncertainty: A totally indefinable and unexpected happening. Cannot be predicted as the variables are many and their interaction can be innumerable. For example different people behave and react differently to the same situation and uncertainty arises. Risk: Can be identified as an event which has different probabilities of happening, but the time of the event as well the impact of such event is not known. If expressed mathematically risk is the dispersion of a probability distribution. Example Japan has been a country which has suffered many earthquakes over centuries and risk of earthquake is known or it can be said that Japan is earthquake risk prone.
INTRODUCTION (Contd..) However, when an earthquake will take place is not known and to what extent it is uncertain. While uncertainty cannot be quantified, a risk can be quantified through mathematical models, probability models, correlation, etc. And also measured through quantitative models and technological tools.
OBJECTIVES OF RISK MANAGEMENT Pre-Loss objectives Understanding environment Fulfillment of external obligations – statuary requirements Reduction in anxiety through preventive measures Social obligations to make people aware of the risks Post-Loss objectives Survival of the organization Continuance of the organizations operations Initiate and improve the income /earnings Obligation to society
RISK MANAGEMENT STRATEGY FORMULATION AND IMPLEMENTATION Seven fold of Strategies Hedge risk Retain risk Combine risks Transfer risk Share risk Reduce risk Avoid risk
RISK MANAGEMENT STRATEGY FORMULATION AND IMPLEMENTATION Avoid Risk Is the prevention method and proven method. Results in complete elimination of exposure to loss due to a specific risk. Involve avoidance of an activity which is risky. This can be approached in two ways Do not assume risk: this means that no risky projects are undertaken. This is a proactive avoidance. Discontinuance of an activity to avoid risk: abandoning a project to avoid risk midway
RISK MANAGEMENT STRATEGY FORMULATION AND IMPLEMENTATION Reducing risk Attempt to decrease the quantum of losses arising out of a risky happening through Loss prevention and Loss control
Loss prevention: The most insignificant strategy of dealing with the risk through Using prevention systems (like fire sprinkler systems, burglar alarms, etc., are typical prevention measures) By understanding of the risk as well as relationship of risky activity and environment. This helps to prevent loss by: Modifying the risk involved activity itself through improved design or technology; Isolating through a proper layout or notifying the place where the risky activity is to take place Instituting suitable safe guards through training of people, safety devices and providing knowledge and institute mock exercises, etc.
RISK MANAGEMENT STRATEGY FORMULATION AND IMPLEMENTATION Loss control: Controlling the extent of loss/ due to the risk during or after occurrence of risk ex: Dowsing the fire in the case of fire accident, e.g. Using fire hydrants, fire extinguishers. Through o line process control which operates in the event of a risky happening, e.g., gas leaks fires.
RISK MANAGEMENT STRATEGY FORMULATION AND IMPLEMENTATION (Contd..) Retain Risk Risk retention is adopted when it cannot be avoided, reduced or transferred. It can be a voluntary or involuntary action. Voluntary: risk retained through implied agreements intentionally accepting existence of risk. Involuntary: the organization is unaware of the risk and faces it when it comes up. Combine Risks When the business faces two or three risks the over all risk is reduced by a combination. Prevalent mainly in the area of financial risk. Different financial instruments being negative risk return of co relation like bonds and shares are taken in a single port folio to reduce the risk. A physical risk of non-availability of a particular material is often solved by having more than one supplier
RISK MANAGEMENT STRATEGY FORMULATION AND IMPLEMENTATION Transfer risk Causing another party to accept the risk, typically by contract or for a consideration Liability among construction or other contractors is very often transferred this way. The other agency may have core competency to handle such risk 6 sharing risk Unlike transfer the risk, the sharing is out of mutual benefit
Insurance is a method of sharing risk for a consideration, viz., premium insurance loss, undertakes to share the risk with the companies and share their own risk through re insurance with other companies. Big conglomerates share risk among their own group of companies in proportion to their risk bearing strengths by creating a corpus instead of paying premium to insurance companies.
RISK MANAGEMENT STRATEGY FORMULATION AND IMPLEMENTATION Hedging risk Hedging is done by an agency taking over the risk for a consideration for a period and select band of fluctuation. This is also really risk transfer but specifically used for financial risks. Exposures of funds to fluctuations in foreign exchange rates, interest rates, prices, etc. Bring about financial risks resulting in losses or gains. The downside risk is often taken care of by hedging.
Risk optimization As there is no single type out of the seven above are suitable for entire organization, risk optimization attempts to utilize information on risk to compute precisely what types and combinations of risk to take. It also develops the precise tradeoff between risk and reward and the corresponding appropriate product pricing to reflect the risk taken.
Date/ Time / version15 RISK MANAGEMENT TOOLS FOR RISK MEASUREMENT & EVALUATION
16 DEVELOP TOOLS FOR MEASUREMENT AND EVALUATION Risk measurement Tools for measurement are based on the type of risk. Potential risk management often refers to reducing downside potential and enhances the returns on topside.
Risks are of many types as follows: Physical risk: Like Natural |Calamities: Fire, Tsunami, Floods, Earthquake, etc. Arising out of Political, Economic, Social, Technological and Legal environments often identified through the performance of lead indicators. Social arena - Lead indicators can be pestilence, expediencies, social upheavals, etc., Political area - the change in government policy capitalistic, democratic or totalitarian
DEVELOP TOOLS FOR MEASUREMENT AND EVALUATION Economic front - Foreign Exchange variation, Capital Market fluctuations, Trade Cycles, etc. Legal area- Implication of various Statutes affecting Business, anti Trust bills, Factories Acts, Industrial Disputes Act, and FEMA. Business risk: Inherent to a business due to its nature and susceptibility to environment, e.g., Change of fashion, business cycles, conflicts like war, insurgency, cross border terrorism, technological obsolescence, etc. Financial risk: Arising out of the nature of financial transactions and conduct of business and investment.
MEASUREMENT OF RISK Measurement of physical risks Natural calamities: measured by the application of technological tools. Earthquakes -on the Richter scale. Floods - through level monitoring and marking danger levels. Fire- flash point, fire point, ignition temperatures and propulsion temperatures, spontaneous ignition temperatures (e.g., Coal dumps, oil installations, explosive go downs, etc) Social factors: done on the basis of the impact on the society, i.e., Increase in crimes, violence and accidents, etc. Political factors: by the impact of such government policy on the economic activity, e.g., Government industrial policy and labor policy. Economic : lead indicators are like variation in GDF, IIP, balance of payments, stock market indices, etc. Legal : impact of changes in legislation
MEASUREMENT OF RISK (Contd..) Measurement of Business Risk Refers to variations in earnings due to demand variability, price variability, variability for input prices, etc, that are essentially external and are market driven. Measurement of Financial Risk Arises out of financial leverage. Companies with a high degree of financial leverage will have greater proportion of debt, are exposed to the financial risk which is normally measure as a capability to repay loans and service the loans.
MEASUREMENT OF RISK (Contd..) Risk evaluation Helps in quantifying the possible consequences of risk in value terms Risk evaluation is based on two steps: Bench marking in relation to the importance of the risk to the company Apply this yard stick for evaluation of all risks How to compute the effect of consequences of a risk? It is computed in terms of variable as well as fixed costs. For example, wherever an exposure to risk involves a loss as in the case of a break down in a factory, the direct cost as a result of the breakdown will have to be calculated. At the same time, if the factory comes back to production only after a period, the standing charges during the period of shutdown will be the fixed cost not recovered.
MEASUREMENT OF RISK (Contd..) Mathematical models as well as statistical analysis have been helpful in risk assessment. While applying statistical analysis, two concepts are applied for assessment of risk: Measures of central tendency To arrive at one single value that will denote the characteristics of the total data collected. Such a value is known as the central value or average and can be expressed as mean, median and mode according as the nature of risk being measured. Measures of variation To study the dispersion or scatteredness. The statistical analysis is based on following methods (a) range (b) mean deviation (c) standard deviation (d) variance (e) co efficient of variation.
IMPLEMENT STRATEGY USING TOOLS Quantification of risk is done in the following manner: Using probability distributions (loss distributions) Normal distributions Monte carol simulation of distributions Correlation analysis Discounted cash flow analysis Often analysts focus on characteristics of loss distributions, such as Expected loss Standard deviation of loss Maximum probable loss Sometimes information about the entire probability distribution is available and useful.
IMPLEMENT STRATEGY USING TOOLS (Contd..) Quantifying loss under normal distribution Though most loss distributions are not normal; still from the central limit theorem using the normal distribution will nevertheless be appropriate when Number of exposures is large Losses across exposures are independent For example, Where a firm has large number of employees and workers suffer injury losses and Firms with firms having large fleets of cars suffering automobile accident losses.
RISK POOLING AND DIVERSIFICATION The concept of poling risk is the process of identification of separate risks and put them all together in a single basket, so that the monitoring, combining, integrating or diversifying risk can be implemented. When all the risks have been identified, combined and monitored according to the system drawn up to quantify the total risk with a control figure, monitoring becomes easy. If there are variations from the control figure, deviation can be corrected by combining risks or integrating risks or diversifying risks.
Risk pooling & monitoring There are various risk covering insurances in a business say executing a project Marine insurance - taken for shipping the various plant and machinery from the manufacturers to the port near the project site, Transit insurance – during transshipment of goods from port to the project site (the carrier takes care of this insurance on companys behalf) Storage insurance – for the material at site until erection Erection insurance - during erection of different plant and machinery, mechanical, electrical, Risks for commercial run: during testing and trial runs of the erected plant and machinery for performance guarantee All these risks put together is pooling Each separate policy has a risk value and premium & the insurer and insured have to carry out the obligations as per the insurance contract.. Process of monitoring is to ensure about the execution of the obligations
RISK POOLING AND DIVERSIFICATION (Contd..) Risk Combining To reduce risk after pooling it can be combining through a comprehensive policy from the plant and machinery FOB to the completion of final commercial guarantee run. Risk integration Integrating risks will be to take care of similar risks in the entire organization (all the foreign shipments together, inland transit risks together) Risk diversification This involves identifying that fraction, which is systematic and the remaining unsystematic.
RISK POOLING AND DIVERSIFICATION Systematic risk Inherent and peculiar to the type of business or the organization Can be reduced or diversified by acting with in the organization, which is through functional level strategy. Unsystematic risk Also known as market risk is external to an organization and is also termed as market risk. The identification of characteristics of market risk through statistical correlation beta, which can be manipulated through portfolio management.
IMPACT OF MACRO ECONOMIC FACTORS AND RISK General principle is that higher the risk the return needs to be higher However, risk perceptions of investors tend to be different with the onset of business cycles. In recession investors tend to be conservative as their appetite for risk is reduced and they go after growth sectors which have lower risk. In a security market, low risk growth sector has always been the biggest gainer in terms of returns. Thus onset of recession upsets the risk return balance. Macro economic factors like change in interest rates, inflation, money supply and index of industrial production have a big impact on the investors risk perception. Analysis has shown that in a regime of high interest rates and high inflation low risk sectors perform better than high risk stocks. As the interest rates and inflation decline the high risk sectors tend to do better.
INSURANCE, INSURABILITY OF RISK AND INSURANCE CONTRACTS Transferring or lifting of risk from one individual to a group and sharing of losses on an equitable basis by all members of the group. In legal terms insurance is a contract (policy) in which one party (insurer) agrees to compensate another party (insured) of its losses for a consideration (premium). Insurance is a means whereby a large number of people agree to share the loss which a few of them are likely to incur in the future. Insurance is also a means for handling risk. The business of insurance is related to the protection of the economic value of any asset. So, every asset that has a value needs to be insured. Both tangible goods and intangibles can be insured. (Contd..)
Date/ Time / version32 RISK MANAGEMENT CORPORATE RISK MANAGEMENT
33 INTRODUCTION An individual is risk averse and prefers to keep his money safely at a place where it is risk free, say a scheduled bank for which he gets an interest rate called risk free rate. The incentive to invest this money in an activity involving risk could be to get a higher return for the increased risk. This is known as risk premium. Risk in a traditional sense The risk is understood as the sacrifice made by an individual by deferring the use of money to a future day by investing that money in a venture promising a higher return which has uncertainty. The forces that contribute to the variations in return can both be external or internal to a company in which an individual has invested. These forces can partly be controllable and the remaining uncontrollable. The uncontrollable portion, which is essentially external, is known as systematic risk and the controllable internal risk is known as unsystematic risk.
SYSTEMATIC RISK Market Risk: Variability in ROI in the market is referred to as market risk. This is caused by investor reaction to the tangible as well as intangible events. Tangible events like economic, political, social events And intangible events arising out of a market psychology or the other factors like interest rates and inflation also form part of the forces behind market risk. Interest Rate Risk: This risk refers to the uncertainty of market volumes in the future and the quantum of future income caused by the variations in the interest rates. These interest rates are normally controlled by the RBI in our country and the exigencies for changing the interest rates arise out of many economic factors which are monitored by the |Central Bank. Normally, when the interest rates increase the companies with higher quantum of borrowed money will have to pay out higher quantum of interest reducing their earnings and vice versa.
SYSTEMATIC RISK (Contd..) Purchasing power risk: Is the uncertainty of the purchasing power of the monies to be received, in the future. In short purchasing power risks refers to the impact of inflation or deflation on an investment. Prudent investors normally include a premium for purchasing power risk in their estimate of expected return. Exchange risk: With the globalization of market cross border transactions are on the increase. Balance of payments comprising the net effect of exports and imports are subject to fluctuation in the various currencies. The need to recognize this exchange risk is obvious as the international trade operations may be profitable or loss-making unless this risk is taken care of.
UNSYSTEMATIC RISK That fraction of total Risk which is unique to a Company or an Industry due to Inherent internal factors like managerial capabilities, consumer responsiveness, lab our unrest, etc. The operating environment of the business R( Business Risk) and The financing modalities (Financial Risk) Business risks Can be again divided into internal and external business risks. Internal business risk is mainly due to the variations in the operational efficiency of the company. External business risks arise out of circumstances imposed on the company by external forces like business cycle, certain statutory restrictions or sops
UNSYSTEMATIC RISK (Contd..) Financial risk Associated with the modalities adopted by a company to finance its activities. Financial Leverage like the Debt/ Equity Ratio, Managing financial risk by Asset Liability Management A composite risk picture to be drawn by an approach known as Building Block, accumulation is done at 3 successive levels. Level 1: Standalone Risks within a single risk factor (ex, credit risk) Level 2: Risks of different risk factors with in a single business area Level 3: Risks across all the business lines in a Corporate Helps to isolating the incremental effects due to diversification. (Normally, effects of diversification are the highest in level 1, lower in level 2 and lowest in level 3.)
RISK MANAGEMENT TOOLS Type of riskNarrationTools Market Risk arising due to change in market factors like asset prices, exchange rates, interest rates, etc Value at risk (var), scenario analysis Credit Risk arising out of the failure to honor obligations for payments Expected loss, unexpected loss BusinessDue to change in conditions in revenue recognition and exposure such as fluctuation in demand, competition etc. Historical earnings volatility, analogues
RISK MANAGEMENT MODELING PROCESS Relates to the methodology adopted for measuring risk and performance. The two general classes of stochastic risk models are either Statistical Analytic models & Structural Simulation models. Analytic methods Often require a restrictive set of assumptions and certain assumed probability distribution. Easy and speedy. Simulation methods (Monte Carlo): Require a large number of computer generated trials to estimate a solution. Robust and flexible and can deal with complex problems but data requirement is a challenge.
PROJECT RISK MANAGEMENT Need : Project is one time process unique in nature, has a long gestation period and based on many assumptions to be realized at a future point as also regarding environment and statutory policies. With a gestation period running into a few years any change or revision in assumptions can transform itself into a big risk. Management of such risks can be difficult and would require special tools and models. Normally, projects are considered as dynamic, iterative and often chaotic systems.
PROJECT RISK MANAGEMENT (Contd..) Types of project risks, measurement and models The project risks can be classified under three different head: Standalone risks: This is quantification of risk of a project when it is viewed in isolation. Corporate risks: When the project is taken as part of a corporate entity its contribution towards the total risk of the company Systematic risks: This represents the market risk of the project These risks can be measured statistically by applying: Range Mean absolute deviation Standard deviation Coefficient of variance Semi-variance (Contd..)
PROJECT RISK ASSESSMENT IN PRACTICE In r eality, the risk assessment is done through considering the various components of the financial estimates and developing certain judgmental approaches: Estimation of revenues: revenues projected for a project need to be justified on the basis of real data available and then the projections are made conservatively. This avoids optimistic projections of income Cost estimates: always include a margin of safety to take care of impact of inflation over the time horizon for which the projections are being made. Here again the margin of safety is computed on the basis of trend analysis of inflation over the recent past and the lead indicators that are available from fundamental analysis Acceptable return on investment: this is the prime measure and as such it should be arrived at on the basis of certain consensus. It will depend on the payback period to be assumed, the industry experience and the companys norm for return on any new project on the basis of the current experience
PROJECT RISK ASSESSMENT IN PRACTICE (Contd..) Overall certainty index: the critical risks of the project are identified and the certainty index of each of these risks is quantified. Then the overall certainty index is developed as an average of the critical indices already computed. For instance, raw material availability, power availability, intensity of competition is a few of the risks, which are quantified in terms of certainty indices. The cumulative average is the overall certainty index Judgmental perceptions: Three different estimates of return on the investment are developed – pessimistic, most likely and optimistic on the basis of the stage at which the particular industry is in its life cycle. On the basis of the three estimates and comparing them with the earlier methods available on certainty equivalent coefficient, a judgmental decision can be taken
PROJECT RISK ASSESSMENT IN PRACTICE (Contd..) Approaches to project risk management Are six fold as follows: Decisioneering to assess and mitigate risk Build robust strategic systems Instilling govern ability Shaping institutions Hedging and diversifying risks through portfolios Embracing risks