Analyzing various risks and evaluating risk exposure are vital to an organizatio
ID: 2715349 • Letter: A
Question
Analyzing various risks and evaluating risk exposure are vital to an organization's success and allows managers to effectively manage risk. Discuss each of the various types of risk examined this week and relate the impact of each (if any) to your current employer. Which is the primary risk your business faces? Why is this risk more prevalent than the others? How might such a risk be mitigated? Your 3- to 4-page paper should reflect the application of the Resources presented this week as well as knowledge gained from previous weeks' Required or Optional Readings.
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Explanation / Answer
Risk is volatility of unexpected outcomes (change in value of assets, equity or earnings),Uncertainty Risk.Major sources of risk are Human/accident like regulatory,natural disaster and economic growth. There are business and financial risks.business risks are Deliberate, necessary to create Shareholder value.For e.g. Business decisions (investments, products) & Business environment (competition & economy).Financial risks are Losses due to financial market activities For example Interest rate exposure,Defaults on financial obligations and Accounts receivables.
Firm being a Software firm faces the exchange rate risk which is a major financial risk.Business environment also creates the business risk which shall also be mitigated.As major source of revenue of the firm is foreign currency thre is exchange rate risk that the foreign currency might devalue and affect firms revenues and profits. Also competition in Business environment can result in eroding of profits with major and minor players eating out the market share.
Financial risk management is the design and implementation of procedures for … identifying, measuring, and managing financial risks.Its important for the firm to identify, measure, and manage financial risks as exchange rate risks,interest rate risk and other.
There are various types of risks that organization faces mainly the market risks,operational risks,credit risk.
Market Risk “Price level risk”
•Absolute vs. Relative:Market risk can be Absolute is in Dollar (or currency) terms and focus is Volatility of total returns.Relative Market risk is Versus a benchmark ,Focus is Deviation from benchmark or tracking error.The total exchange rate lossees can arise in dollars and teh volatility of the exchange rate can be risky as the losses arising out of adverse movements can be large enough.
•Directional vs. NonDirectional:Directional is Movements in financial variables. For example:Stock price moves down,Interest rates drop,Commodity prices change.Non Directional the risks that remain, including hedged positions Nonlinear exposures,Basis risk,Volatilities.Volatility risk is Unanticipated movements in relative prices of assets in a hedged position, such as cash and futures or interest-rate spreads.The firm faces the Directional risk of exchange rate adverse movement in a direction.Thre are basis risk and volatility risk present in the hedges that firm creates to hedge its exchange rate exposures.
Market Risk > Liquidity Risk
•Asset-liquidity (market liquidity):Cannot exit position at prevailing market prices due to size of the position
•Varies by…
–Asset class
–Prevailing market conditions
•Funding-liquidity (cash-flow) Cannot meet payment obligations,Balance sheet issue, typically concern of CFO.
Credit Risk
•Default
•Credit deterioration (downgrade)
•M2M loss in value
A credit event occurs when there is a change in the counterparty’s ability to perform its obligations.Sovereign risk is Country-specific (unlike default risk which is generally company-specific).The firm has no Bonds outstanding but still faces credit risk from its creditors.
Settlement risk: when two payments are exchanged the same day. Risk that counterparty may default after the institution already made its payment.Under a software project agreement a revenue to be paid is settled and this setttlement has risk of not being carrying out.
–Pre-settlement exposure: only netted value
–On settlement day: full value of payments due
Operational Risk “Almost everything else”
•Internal processes
•Model risk
•People risk
•Legal risk
Firm also faces this below Operational risks can lead to market or credit risks
–A settlement fail can create market risk because cost may depend on movement in market prices
Operational risk > Model risk
–Model risk is risk of losses owing to the fact that valuation models may be flawed
–“Very insidious” and requires intimate knowledge of modeling process
Operational risk > People risk
–People risk includes internal or external fraud
–For example:
•Rogue traders
Operational risk > Legal risk
–Legal risk arises from exposure to fines, penalties or punitive damages resulting from supervisory actions, as well as private settlements
–Examples
•Counter parties sue to invalidate credit losses [related to credit risk]
•Shareholders lawsuits against corporations
A risk profile is
–A list of all risks to which the firmis potentially exposed,
–Grouped into categories;e.g., financial risks, market risks, operational risks
•Once a company (Board and Executives) have developed the Risk Profile, the next step is to divide the various risks into three groups:
1.Risks that should be allowed to pass through the firm to its owners,
2.Risks that should be hedged,
3.Risks that should be exploited
Risk governance in firms as the ways in which directors authorize, optimize, and monitor risk taking in an enterprise. Includes
–Skills, infrastructure (i.e., organization structure, controls and information systems), and culture deployed as directors exercise their oversight.
–Good risk governance provides clearly defined accountability, authority, and communication/reporting mechanisms.
•Key players:
–Shareholders
–Board of Directors
–Managers
Enterprise Risk Management (ERM) essence is the management (requires measurement) of risk with a comprehensive and holistic approach:
–Emphasis on comprehensive, holistic approach shift away from a “silo” effects
–Risk management is (or should be) a value-creating activity, not just “mitigation activity.”
–ERM is an evolving concept
All risks that are identified, estimated, and evaluated are subject to a risk treatment decision with four potential outcome:
•Risk avoidance
•Risk transfer
•Risk reduction
•Risk retention
Risk Avoidance
•Project creates risk not consistent with the company’s risk policy
Risk Transfer; a.k.a., Risk Hedging
•As alternative to avoidance, management may assume but “pass along” the risk to a third-party via hedging. Typically” achieved:
–By the purchase of insurance policies, or
–With financial derivatives (e.g., futures, options, and swaps) or other “more innovative” financial products (e.g., such as risk-linked securities and contingent capital)
Risk Retention
•Retention is the decision to keep the risk, typically in one of two ways:
–Deliberate: A firm expressly retains a risk when it fits with the firm’s risk strategy; or
–Accidental: The risk is inadvertently retained simply because it has not been identified
Risk Reduction, Diversification and Other Policies
•The risk manager also can pursue a risk reduction behavior by engaging in a policy of investment portfolio diversification.