Class#: 09

MBA (1.5) morning group

Subject: Financial risk management
Submitted to: Dr Nisar

FILL INN THE BLANKS:

1. Peril is the cause of loss
2. Hazard
3. Premature death or pure loss
4. Speculative risk
5. Nonsystematic risk
6. Systematic risk
7. Market risk
8. Credit risk

Question number: 1:
State and explain various types financial and market risks a business entity face?
FINANCIAL RISK:
The probability of losing money on investment or business venture
CAUSES OF FINANCIAL RISK:
Financial risk as the term suggest is the risk that involves financial loss to the
firms. It generally arises due to instability and losses in the financial market.
TYPES OF FINANCIAL RISK:
There are different types of financial risk:
Financial risk:
It is one of high-priority risk types for every business. This is caused due to the
market movements.
CLASSIFICATION OF FINANCIAL RISK:
It is classified into various classes:
 1. MARKET RISK:
This type of risk arises due to the movements in prices of financial
instruments.
Market risk can be classified as:
a. Directional risk: this is caused due to the movement in stock price.
b. Non directional risk: this is volatility risk.

2. CREDIT RISK:
This type of risk arises when one fails to fulfill their obligations towards
their counterparties.
Further the credit risk can be classified into:
a. Sovereign risk: arises due to difficult foreign exchange policies.
b. Settlement risk: when one party makes the payment while the other party
fails to fulfill the obligation.

3. LIQUIDTY RISK:
This type of risk arises due to inability to execute transactions.
This can be further classified into:

a. Asset liquidity risk: this arises due to insufficient buyers or insufficient

sellers
b. Funding liquidity risk

4. OPERATIONAL RISK:
This type of risk arises out of operational failures such as mismanagement or
technical failures. Operational risk can be classified into
a. Fraud Risk: arises due to the lack of controls
b.  Model Risk: arises due to incorrect model application.

5. LEGAL RISK:
This type of financial risk arises out of legal constraints such as lawsuits.
Whenever a company needs to face financial losses out of legal proceedings,
it is a legal risk.

MARKET RISK:
Market risk is the possibility of an investor experiencing losses due to factors that
affect the overall performance of the financial markets in which he or she is
involved. 
SYSTEMATIC RISK:
Market risk, also called "systematic risk," cannot be eliminated through
diversification, though it can be hedged against in other ways
 Market risk, or systematic risk, affects the performance of the entire market
simultaneously.
 Because it affects the whole market, it is difficult to hedge as diversification
will not help.
 Market risk may involve changes to interest rates, exchange rates,
geopolitical events, or recessions.
TYPES OF MARKET RISK:
1. INTEREST RATE RISK:
Interest rate risk covers the volatility that may accompany interest rate
fluctuations due to fundamental factors, such as central bank announcements
related to changes in monetary policy. This risk is most relevant to
investments in fixed-income securities, such as bonds

2. EQUITY RISK:
Equity risk is the risk involved in the changing prices of stock investments

3. COMMODITY RISK:
Commodity risk covers the changing prices of commodities such as crude
oil and corn.

4. CURRENCY RISK OR EXCHANGE RATE RISK:

Currency risk, or exchange-rate risk, arises from the change in the price of
one currency in relation to another. Investors or firms holding assets in
another country are subject to currency risk.

Volatility and Hedging Market Risk

Market risk exists because of price changes. The standard deviation of
changes in the prices of stocks, currencies or commodities is referred to as
price volatility. Volatility is rated in annualized terms and may be expressed
as an absolute number, such as $10, or a percentage of the initial value, such
as 10%.
Investors can utilize hedging strategies to protect against volatility and
market risk. Targeting specific securities, investors can buy put options to
protect against a downside move, and investors who want to hedge a large
portfolio of stocks can utilize index options.

Measuring Market Risk

To measure market risk, investors and analysts use the value-at-
risk (VaR) method. VaR modeling is a statistical risk management method
that quantifies a stock or portfolio's potential loss as well as the probability
of that potential loss occurring. While well-known and widely utilized, the
VaR method requires certain assumptions that limit its precision. For
example, it assumes that the makeup and content of the portfolio being
measured is unchanged over a specified period. Though this may be
acceptable for short-term horizons, it may provide less accurate
measurements for long-term investments.
Beta is another relevant risk metric, as it measures the volatility or market
risk of a security or portfolio in comparison to the market as a whole. It is
used in the capital asset pricing model (CAPM) to calculate the expected
return of an asset.

QUESTION#2
Elaborate various techniques used for managing risk? For good management
practice explain six steps required to risk management process?
Answer:
MANAGING RISK:
Risk management focuses on identifying what could go wrong, evaluating
which risks should be dealt with and implementing strategies to deal with
those risks. Businesses that have identified the risks will be better prepared
and have a more cost-effective way of dealing with them.
 METHODS OF RISK MANAGEMENT:

1. AVOIDANCE:
Avoidance is a method for mitigating risk by not participating in activities
that may incur injury, sickness, or death. Smoking cigarettes is an example
of one such activity because avoiding it may lessen both health and financial
risks. 

According to the American Lung Association, smoking is the leading cause

of preventable death in the U.S. and claims more than 480,000 lives per
year.
Additionally, the U.S. Centers for Disease Control and Prevention notes that
smoking is the No. 1 risk factor for getting lung cancer, and the risk only
increases the longer that people smoke.
Life insurance companies mitigate this risk on their end by raising premiums
for smokers versus nonsmokers. Under the Affordable Health Care Act, also
known as Obamacare, health insurers are able to increase premiums based
on age, geography, family size, and smoking status. The law allows for up to
a 50% surcharge on premiums for smokers.

2. RETENTION:
Retention is the acknowledgment and acceptance of a risk as a given. Usually, this
accepted risk is a cost to help offset larger risks down the road, such as opting to
select a lower premium health insurance plan that carries a higher deductible rate.
The initial risk is the cost of having to pay more out-of-pocket medical expenses if
health issues arise. If the issue becomes more serious or life-threatening, then the
health insurance benefits are available to cover most of the costs beyond the
deductible. If the individual has no serious health issues warranting any additional
medical expenses for the year, then they avoid the out-of-pocket payments,
mitigating the larger risk altogether.

3. SHARING:
Sharing risk is often implemented through employer-based benefits that allow the
company to pay a portion of insurance premiums with the employee. In essence,
this shares the risk with the company and all employees participating in the
insurance benefits. The understanding is that with more participants sharing the
risks, the costs of premiums should shrink proportionately. Individuals may find it
in their best interest to participate in sharing the risk by choosing employer health
care and life insurance plans when possible.

4. TRANSFERING:
The use of health insurance is an example of transferring risk because the financial
risks associated with health care are transferred from the individual to the insurer.
Insurance companies assume the financial risk in exchange for a fee known as a
premium and a documented contract between the insurer and individual. The
contract states all the stipulations and conditions that must be met and maintained
for the insurer to take on the financial responsibility of covering the risk.

By accepting the terms and conditions and paying the premiums, an individual has
managed to transfer most, if not all, the risk to the insurer. The insurer carefully
applies many statistics and algorithms to accurately determine the proper premium
payments commensurate to the requested coverage. When claims are made, the
insurer confirms whether the conditions are met to provide the contractual payout
for the risk outcome.

5. LOSS PREVENTION AND REDUCTION:

This method of risk management attempts to minimize the loss, rather than
completely eliminate it. While accepting the risk, it stays focused on keeping the
loss contained and preventing it from spreading. An example of this in health
insurance is preventative care.

Health insurers encourage preventative care visits, often free of co-pays, where
members can receive annual checkups and physical examinations. Insurers
understand that spotting potential health issues early on and administering
preventative care can help minimize medical costs in the long run. Many health
plans also provide discounts to gyms and health clubs as another means of
prevention and reduction in order to keep members active and healthy.

STEPS INVOLVED IN THE RISK MANAGEMENT PROCESS:

Step 1: Hazard identification:

This is the process of examining each work area and work task for the
purpose of identifying all the hazards which are “inherent in the job”. Work
areas include (but are not limited) to machine workshops, laboratories, office
areas, agricultural and horticultural environments, stores and transport,
maintenance and grounds. Tasks can include (but may not be limited to)
using screen based equipment, audio and visual equipment, industrial
equipment, hazardous substances and/or dangerous goods, teaching/dealing
with people, driving a vehicle, dealing with emergency situations,
construction, etc

Step 2: Risk identification

Examples of risk identification
Hazard: Frayed wires on electrical items
Risk: Operator may be electrocuted
Hazard: Unguarded rollers on printing machine
Risk: Operator’s hand may be drawn in and crushed
Once a hazard to health and safety has been identified, the risk associated
with that hazard must be examined. As a prelude to Risk Assessment, it is
useful to identify factors that may be contributing to the risk. A review of
existing health and safety information, such as local workplace accident
records and / or information about the hazard / risk that is available from
national or other jurisdiction authoritative sources will assist in
understanding the risk associated with the hazard in question.

Step 3: Risk assessment

Two key factors
It is then necessary to evaluate the likelihood of an injury occurring along
with its probable consequences. Risk assessments are therefore based on 2
key factors:
The likely severity or impact of any injury/illness resulting from the hazard,
and
The probability or likelihood that the injury/illness will actually occur.
A simple risk matrix, which cross references likelihood and impact, enables
risks to be assessed against these two factors and identified as one of the
following:
1. a critical risk
2. a high risk
3. a moderate risk
4. a low risk
5. A very low risk.
Step 4: Risk control
 Urgent action is required for risks assessed as Critical or High risks. The
actions required may include:
1. Instructions for the immediate cessation of the work, process, activity,
etc.
2. Isolation of the hazard until more permanent measures can be
implemented.
Documented control plans with responsibilities and completion dates may
need to be developed for Moderate risks.
Having established the relative importance of dealing with the identified
risk, the risk control hierarchy ranks possible risk control measures in
decreasing order of effectiveness. Risk control measures should always aim
as high in the list as practicable. Control of any given risk generally involves
a number of measures drawn from the various options (except if option 1 is
selected).
Step 5: Documenting the process
Documenting the process will help ensure that identified control measures
are implemented in the way that they were intended. It will also assist in
managing other hazards and risks that may be in some way similar to ones
already identified and dealt with.
Adequate record keeping of the risk management process will also help
demonstrate to the Regulator, or in litigation that you have been actively
working to ensure safety at your workplace. Records should show that the
process has been conducted properly including information about the
hazards, associated risks and control measures that have been implemented.
Information should include:
1. hazards identified
2. assessment of the risks associated with those hazards
3. decisions on control measures to manage exposure to the risks
4. how and when the control measures are implemented
5. evidence of monitoring and review of the effectiveness of the controls 
6. Any checklist used in the process.
Step 6: Monitoring and reviewing
Whichever method of controlling the hazard is determined, it is essential that
an evaluation of its impact on the use of the equipment, substance, system or
environment is carried out to ensure that the control does not contribute to
the existing hazard or introduce a new hazard to the area. It is also essential
that all people concerned be informed about the changes and where
necessary provided with the appropriate information, instruction, training
and supervision as are reasonably necessary to ensure that each employee is
safe from injury and risks to health. It is also recommended that after a
period of time the area supervisor carry out a review of the system or control
to determine its suitability.
Hazard identification and risk assessment and control are ongoing processes.
Make sure that you undertake a hazard identification and risk assessment
and control process when there is a change to the workplace, including when
work systems, tools, machinery or equipment changes occur, or simply
when the existing process was done some time ago and is potentially out of
date or no longer valid.

THE END