risk mg t handouts

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FMEL313-Risk Management

Part IOverview of Risk Management

1. Risk and Its Management:

Risk:

is used to describe any situation where there is uncertainty about what

outcome will occur. May refer to the expected value outcome (or, sometimes, the

probability of a particular outcome). In insurance markets, for example,it is common to refer to high-riskpolicy holders. In this, risk is theexpected value of losses to be paid by the insurer (the expected loss)is high.

exists whenever the future for absolute outcome is not known.Business Risk Management:

is concerned with possible reductions in business value from anysource. usiness value to shareholders, as reflected in the value of thefirm!s common stock, depends fundamentally on the expected si"e,timing and risk (variability) associated with the firm!s future net cashflows (cash inflows less cash outflows).

#nexpected changes in expected future net cash flows are a ma$orsource of fluctuations in business value.

In particular, unexpected reductions in cash inflows or increases n cashoutflows can significantly reduce business value.

Major Types of Business Risks:1. Price Risk:

%efers to uncertainty over the magnitude of cash flows due to possiblechanges in output and input prices.

Output price risk refers to the risk of changes in the prices that afirm can demand for its good and services.

Input price risk refers to the risk of changes in the prices that a firmmust pay for labor, materials, and other inputs to its production

process. &nalysis of price risk associated with the sale and production of

existing and future products and services plays a central role instrategic management.pe!ifi! Types of Pri!e Risk:

Commodity Price Risk

&rises from fluctuations in the prices of commodities, suchas coal, copper, oil, gas, and electricity, that are inputs forsome firms and outputs for others.

Exchange Rate Risk

'iven the globali"ation of economic activity, output andinput prices for many firms also affected by fluctuations inforeign exchange rates.

Interest Rate Risk

utput and input prices also can fluctuate due to changes ininterest rates.

or example, increases in interest rates may alter a firm!srevenues by affecting both the terms of credit allowed andthe speed with which customers pay for products purchasedon credit.

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*hanges in interest rates also affect the firm!s cost ofborrowing funds to finance its operations.

2. Credit Risk:

It is the risk that a firm!s customers and the parties to which it has lentmoney will fail to make promised payments.

Most firms face some credit risk for account receivables.

+he exposure to credit risk is particularly large for financial institutions,such as commercial banks, that routinely make loans that are sub$ectto risk of default by the borrower. hen firms borrow money, they inturn expose lenders to credit risk. &s a conseuence, borrowingexposes the firm!s owners to the risk that the firm will be unable to payits debts and thus be forced into bankruptcy, and the firm generallywill have to pay more to borrow money because of credit risk.

3. Pure Risk:

+he risk of reduction in value of business assets due to physicaldamage, theft, and expropriation (i.e., sei"ure of assets by foreigngovernments).

+he risk of legal liability for damages for harm to customers, suppliers,shareholders, and other parties.

+he risk associated with paying benefits to in$ured workers underworkers! compensation laws and the risk of legal liability for in$uries orother harms to employees that are not governed by workers!compensation laws.

+he risk of death, illness, and disability to employees (and sometimesfamily members) for which businesses have agreed to make paymentsunder employee benefit plans, including obligations to employeesunder pension and other retirement saving plans.

ure risk freuently is managed in part by the purchase of insurance tofinance losses and reduce risk.

"istin!tive #eatures of Pure Risk:

/osses from destruction of property, legal liability, and

employee in$uries or illness often have the potential to be verylarge relative to a business!s resources.

+he underlying causes of losses associated with pure risk, such

as the destruction of a plant by explosion of a steam boiler orproduct liability suits from consumers in$ured by a particularproduct.

T$e Risk Management:

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rice %isk *redit %isk ure %isk

0amage toassets

/egal /iability

orker In$ury

1mployeeenefits

Input price riskutput pricerisk

*ommodity price risk

1xchange rate risk

Interest rate risk


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%egardless of the type of risk being considered, the risk management processinvolves several key steps2

3. Identify all significant risks that can reduce business value (cause loss).4. 1valuate the potential freuency and severity of losses.5. 0evelop and select methods for managing risk in order to increase business

value to shareholders.

6. Implement the risk management methods chosen.7. Monitor the performance and suitability of the firm!s risk managementmethods and strategies on an ongoing basis.

Types of %osses from Pure Risk:

Risk Management Met$ods:1. %oss &ontro'(Risk Contro!

&re actions that reduce the expected costs of losses by reducing thefreuency of losses and8or the severity (si"e) of losses that occur.

"oss pre#ention 9 actions that primarily affect the freuency of losses.

or example2 %outine inspection of aircraft for mechanical problems.

+hese inspectionshelp reduce the freuency: of crashes; they have little impact on themagnitude of losses for crashes that occur.

"oss reduction 9 actions that primarily influence the severity of losses thatdo occur.

or example2 +he installation of heat or smoke-activated sprinkler

systems that are designed to minimi"e fire damaged in the event of afire.

(enera' )pproa!$es to %oss &ontro':1.Reducing the e#e o$ risky acti#ity.

*+amp'e: *onsider a trucking firm that hauls toxic chemicals thatmight harm people or the environment in the case of an accident andthereby produce claims for damages. +his firm could reduce thefreuency of liability claims by cutting back on the number ofshipments that it hauls or it could avoid the risk completely by nothauling toxic chemicals and instead hauling non toxic substances.

)n *+amp'e from Persona' Risk Management would be a person

who flies less freuently to reduce the probability of dying in planecrash. +his risk could be completely avoided by never flying.

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0irect /osses Indirect /osses

In$ury and illnessto employees

/iability claimsand defense

costs

0amage toassets

/oss of normalprofit

(net cash flow)

*ontinuing and

extra operatingexpenses


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,.Increasing precautions (e#e care! against oss $or acti#itiesthat are undertaken. Risk )voidan!e exposure to losses can be completely eliminatedby reducing the levelof activity to "ero; that is by not engaging in the activity at all.

,. %oss #inan!ing -Risk #inan!ing

Methods used to obtain funds to pay for or offset losses that occur.

#our Met$ods:1. Retention (%e$&insurance!

& business retains the obligation to pay for part or all of the losses.

2. Insurance

Insurance contracts reduce risk for the buyer by transferring some

of the risk of loss to the insurer. Insurers in turn reduce risk throughdiversification.

3. 'edging

is the practice of taking a position in one market to offset and

balance against the risk adopted by assuming a position in acontrary or opposing market or investment.

*+amp'e: irms that use oil in the production processare sub$ectto loss from unexpected increases in oil prices; oil producers aresub$ect to loss from unexpected decreases in oil prices. oth typesof firms can hedge their risk by entering into a !or"ard contract#or)ard Contract * reuires the oil producer to provide the oiluser with a specified amount of oil on a specified future deliverydate at a predetermined price, known as !or"ard price, regardlessof the market price of oil on that date. ecause the forward price isagreed upon when the contract is written, the oil user and the oilproducer both reduce their price risk.

+. Other Contractua Risk ,rans$ers

&llows businesses to transfer risk to another party. /ike insurance

contracts and derivatives, the use of these contracts also ispervasive in risk management.

/. Interna' Risk Redu!tionTwo Major #orms:

a) -i#ersi$ication (=not putting all of their eggs in one basket>)b) In#estment in In$ormation9 to obtain superior forecasts of expected

losses to improve forecasts of expected cash flows.Risk Management Organi0ations:

Most large companies have a specific department responsible for managingpure risk and is headed by Risk Manager (or 0irectoro! Risk Management$#

'iven the losses can arise from numerous sources, the overall riskmanagement process ideally reflects a coordinated effort between all of thecorporation!s ma$or departments and business units, including production,marketing, finance, and human resources.

Risk

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concerns the deviation of one or more results of one or more future eventsfrom their expected

value.

+echnically, the value of those results may be positive or negative.


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trategies to Manage Risk:

transferring the risk to another party

avoiding the risk,

reducing the negative effect of the risk, and

accepting some or all of the conseuences of a particular risk.

Idea' Risk Management

a prioriti"ation process is followed whereby the risks with the greatest lossand the greatest probability of occurring are handled first, and risks with lowerprobability of occurrence and lower loss are handled in descending order.

In practice the process can be very difficult, and balancing between risks witha high probability of occurrence but lower loss versus a risk with high loss butlower probability of occurrence can often be mishandled.

Intangi2'e Risk Management

identifies a new type of a risk that has a 3BBC probability of occurring but isignored by the organi"ation due to a lack of identification ability.

#or e+amp'e: when deficient knowledge is applied to a situation, aknowledge risk materiali"es.

Re'ations$ip Risk- appears when ineffective collaboration occurs.

Pro!ess3*ngagement Risk - may be an issue when ineffective operationalprocedures are applied.

+hese risks directly reduce the productivity of knowledge workers, decreasecost effectiveness, profitability, service, uality, reputation, brand value, andearnings uality.

Intangible risk management allows risk management to create immediatevalue from the identification and reduction of risks that reduce productivity.

Risk managementalso faces difficulties in allocating resources.

+his is the idea of opportunity cost.

%esources spent on risk management could have been spent on moreprofitable activities. &gain, ideal risk management minimi"es spending andminimi"es the negative effects of risks.

Met$od

3. identify, characteri"e, and assess threats4. assess the vulnerability of critical assets to specific threats5. determine the risk (i.e. the expected conseuences of specific types of attacks

on specific assets)6. identify ways to reduce those risks7. prioriti"e risk reduction measures based on a strategy

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Prin!ip'es of Risk Management

+he International rgani"ation for @tandardi"ation (I@) identifies thefollowing principles of risk management2

Risk management s$ou'd:

create value

be an integral part of organi"ational processes be part of decision making

explicitly address uncertainty

be systematic and structured

be based on the best available information

be tailored

take into account human factors

be transparent and inclusive

be dynamic, iterative and responsive to change

be capable of continual improvement and enhancement

PROCE%% O RI% /00E/E,:1. *sta2'is$ing t$e !onte+t: 1stablishing the context involves2

a. Identifi!ationof risk in a selected domain of interestb. P'anningthe remainder of the process.c. Mapping outthe following2

o the social scope of risk management

o the identity and ob$ectives of stakeholders

o the basis upon which risks will be evaluated, constraints.

d. "efining a frameworkfor the activity and an agenda for identification.e. "eve'oping an ana'ysisof risks involved in the process.f. Mitigation or o'utionof risks using available technological, human and

organi"ational resources.

2. Identifi!ation: -identify potentia' risks

%isks are about events that, when triggered, cause problems.


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+he chosen method of identifying risks may depend on culture, industry

practice and compliance. +he identification methods are formed by templatesor the development of templates for identifying source, problem or event.

&ommon risk identifi!ation met$ods are:

a. O2je!tives32ased risk identifi!ation- rgani"ations and pro$ect teamshave ob$ectives. &ny event that may endanger achieving an ob$ective partlyor completely is identified as risk.

b. !enario32ased risk identifi!ation- In scenario analysis different scenariosare created. +he scenarios may be the alternative ways to achieve anob$ective, or an analysis of the interaction of forces in, for example, a marketor battle. &ny event that triggers an undesired scenario alternative isidentified as risk - see utures @tudies for methodology used by uturists.

c. Ta+onomy32ased risk identifi!ation9 it is a breakdown of possible risksources. ased on the taxonomy and knowledge of best practices, auestionnaire is compiled. +he answers to the uestions reveal risks.

d. &ommon3risk !$e!kingIn several industries, lists with known risks areavailable. 1ach risk in the list can be checked for application to a particular

situation.e. Risk !$arting 3 +his method combines the above approaches by listing

resources at risk, +hreats to those resources Modifying actors which mayincrease or decrease the risk and *onseuences it is wished to avoid. *reatinga matrix under these headings enables a variety of approaches. ne canbegin with resources and consider the threats they are exposed to and theconseuences of each. &lternatively one can start with the threats andexamine which resources they would affect, or one can begin with theconseuences and determine which combination of threats and resourceswould be involved to bring them about.

3. )ssessment

nce risks have been identified, they must then be assessed as to their

potential severity of loss and to the probability of occurrence. +hese uantities can be either simple to measure, in the case of the value of a

lost building, or impossible to know for sure in the case of the probability of anunlikely event occurring.

+herefore, in the assessment process it is critical to make the best educatedguesses possible in order to properly prioriti"e the implementation of the riskmanagement plan.

+he fundamental difficulty in risk assessment is determining the rate ofoccurrence since statistical information is not available on all kinds of pastincidents.

urthermore, evaluating the severity of the conseuences (impact) is oftenuite difficult for immaterial assets. &sset valuation is another uestion thatneeds to be addressed. +hus, best educated opinions and available statistics

are the primary sources of information. Aevertheless, risk assessment should produce such information for the

management of the organi"ation that the primary risks are easy tounderstand and that the risk management decisions may be prioriti"ed.

+hus, there have been several theories and attempts to uantify risks.Aumerous different risk formula exist, but perhaps the most widely acceptedformula for risk uantification is2

#ormu'a: Rate of o!!urren!emultiplied by the impa!t of t$e eventeuals risk

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Composite Risk Index

+he above formula can also be re-written in terms of a *omposite %isk Index,as follows2

&omposite Risk Inde+ 4 Impa!t of Risk event + Pro2a2i'ity of O!!urren!e

+he impact of the risk event is assessed on a scale of B to 7, where B and 7represent the minimum and maximum possible impact of an occurrence of arisk (usually in terms of financial losses).

+he probability of occurrence is likewise assessed on a scale from B to 7,where B represents a "ero probability of the risk event actually occurring while7 represents a 3BBC probability of occurrence.

+he *omposite Index thus can take values ranging from B through 47, and thisrange is usually arbitrarily divided into three sub-ranges. +he overall riskassessment is then /ow, Medium or

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