BBK3253 | Risk ManagementPrepared by Dr Khairul Anuar

L1: Introduction to Risk Management

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Assessment

• Two assignments

Assignment 1 -individual 30%

Assignment 2 –individual 30%

• Final exam 40%

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100%

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What is Risk?

• Risks are uncertain future events that could influence the

achievement of an organisation’s objectives, including

strategic,

operational,

financial and

compliance objectives.

• Events are potential incidents or occurrences resulting from

internal/external sources that effect implementation of

strategies or achievement of objectives.

• Events can be both positive and negative.

Organizational Objectives

Organizational objectives are:

1. Reliable financial reporting.

2. Efficiency and Effectiveness of operations.

3. Safeguarding of assets.

4. Compliance with laws and regulations.

Examples of Risks

Business or operational

risks

Financial risks

Fraudrisks

Reputational risks

Examples of Risk

Non-compliance

Environmental

Examples of Risks

• Business or operational risks: related to activities of

business-functions

• Financial risks: relating to financial operations.

• Environmental Risks: related to changes in the

political, economic, social and financial environment.

• Reputational Risks: a threat or danger to the good

name or standing of a business or entity.

1. Business or Operational Risk

• Relates to activities carried out within the company

arising from structures, systems, people, products or

processes.

• In banking, BASEL committee on banking supervision

defined it as the risk of loss resulting from inadequate

or failed internal processes, people, systems and

external events.

1. Business or Operational Risk

• These includes

business interruptions,

errors or omissions,

product failure,

health and safety,

failure of IT system,

fraud, loss of key people,

litigation,

loss of suppliers etc.

• Generally these are within control of the company through risk management practices including internal controls and insurance

2. Financial Risk

• Financial risk is an umbrella term for any risk associated

with any form of financing.

• Typically, in finance, risk is synonymous with downside

risk and is intimately related to the shortfall or the

difference between the actual return and the expected

return (when the actual return is less)

• Financial risks arise from an organization’s exposure to

financial markets, its transactions with others, and its

reliance on processes, systems, and people.

2. Financial Risk

• Financial risk arises through countless transactions of a financial

nature, including

sales and purchases,

investments and loans, and

various other business activities.

• It can arise as a result of

legal transactions

new projects

mergers and acquisitions

debt financing

or through the activities of management,

stakeholders

competitors or

foreign governments.

2. Financial Risk

• There are three main sources of financial risk:

• Financial risks arising from an organization’s 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,

Such as failure of people, processes, and systems.

2. Financial Risk

• Organizations manage financial risk using a variety of

strategies and products.

• It is important to understand how these products and

strategies work to reduce risk within the context of the

organization’s risk tolerance and objectives.

2. Types of Financial risk

1. Interest Rate Risk

2. Foreign Exchange Risk

3. Commodity prices Risk

4. Credit Risk

5. Liquidity Risk

2.1 Interest Rate Risk

• Interest rates are a key component in many market prices and an important economic barometer. They are comprised of the real rate plus a component for expected inflation, since inflation reduces the purchasing power of a lender’s assets.

• Higher risk=higher interest rate

• The greater the term to maturity, the greater the uncertainty.

• Interest rates are also reflective of supply and demand for funds and credit risk.

2.1 Interest Rate Risk

• Interest rates are particularly important to companies

and governments because they are the key ingredient

in the cost of capital.

• Most companies and governments require debt

financing for expansion and capital projects.

• When interest rates increase, the impact can be

significant on borrowers. Interest rates also affect

prices in other financial markets, so their impact is far-

reaching.

2.1 Interest Rate Risk

• Other components to the interest rate may include a

risk premium to reflect the creditworthiness of a

borrower.

• For example, the threat of political or sovereign risk

can cause interest rates to rise, sometimes

substantially, as investors demand additional

compensation for the increased risk of default.

2.2 Foreign exchange rates

• Foreign exchange rates are determined by supply and

demand for currencies.

• Supply and demand, in turn, are influenced by factors

in the economy, foreign trade, and the activities of

international investors, capital flows, given their size

and mobility, are of great importance in determining

exchange rates.

2.2 Foreign Exchange Risk

• Factors that influence the level of interest rates also influence exchange rates among floating or market-determined currencies.

• Currencies are very sensitive to changes or anticipated changes in interest rates and to sovereign risk factors. Some of the key drivers that affect exchange rates include:

Interest rate differentials net of expected inflation

Trading activity in other currencies

International capital and trade flows

International institutional investor sentiment

Financial and political stability

Monetary policy and the central bank

Economic fundamentals

2.3 Commodity prices risk

• Physical commodity prices are influenced by supply

and demand.

• Unlike financial assets, the value of commodities is

also affected by attributes such as physical quality and

location.

2.4 Credit Risk

• Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised.

Such an event is called a default. Another term for credit risk is default risk.

• Higher credit risk reduce value of securities.

• It increases as time to maturity, settlement or expiry increases.

• Organizations are exposed to credit risk because of business and financial transactions

2.4 Credit Risk-examples

• Investor losses include lost principal and interest, decreased cash flows and increased collection costs which arise in a number of circumstances:

A consumer does not make a payment due on a mortgage, credit card, line of credit or other loan.

A business does not make a payment due on a mortgage, credit card, line of credit, or other loan

A business or consumer does not pay a trade invoice when due.

A business does not pay an employee's earned wages when due

A business or government bond issuer does not make a payment on a coupon or principal payment when due.

An insolvent insurance company does not pay a policy obligation

An insolvent bank won't return funds to a depositor.

2.5 Liquidity Risk

• Asset Liquidity - risk that a given security or asset

cannot be traded quickly enough in the market to prevent

a loss (or make the required profit).

• Funds Liquidity - Risk that liabilities cannot be met

when they fall due.

Liquidity risk arises from situations in which a party

interested in trading an asset cannot do it because

nobody in the market wants to trade that asset.

Liquidity risk becomes particularly important to parties

who are about to hold or currently hold an asset,

since it affects their ability to trade.

3. Reputational Risk

• A threat or danger to the good name or standing of a business or entity.

• Reputational risk can occur through a number of ways:

directly as the result of the actions of the company itself;

indirectly due to the actions of an employee or employees; or

tangentially through other peripheral parties, such as joint venture partners or suppliers.

• In addition to having good governance practices and transparency, companies also need to be socially responsible and environmentally conscious to avoid reputational risk.

3. Reputational Risk

Risk classification

• Grouping of different risks according to their estimated cost or likely impact, likelihood of occurrence, countermeasures required, etc.

• Example: credit risk is classified according to the likelihood of the collection or accounts.

• There is no one widely accepted set of categories, it can vary according to the nature of business and its industry.

• List of risks can be endless.

Advantages of risk classification

• By grouping risks, they can be managed in common

by use of similar controls.

• Categorization forces managers to be more proactive

for managing risks.

• Categorization helps manager to use their past

experience applied to one category before.

Advantages of risk classification

• This provides a framework that can be used to

define who is responsible, design controls and

assist in simplified and consistent risk reporting.

• It can help identify which risks are inter related.

• Use of framework ensure risk management

activities are focused.