Controlling Risk Steps to Reduce Risk, Monitor Improvements and Risk Management - Case Study Example

Risk Management Risk can be thought of as the chance of an event turning out in a way that makes you worse off. However, not everyone views the same set of circumstances as being equally risky. Some folks are naturally more optimistic, while others it seems are always looking for the worst possible outcome to happen. Everyone must decide for themselves what levels of risk they are comfortable living with. Ideally this would involve everyone actively engaged in the management of the operation, especially family operations. Risk is the probability of an event occurring that can impact the current profit level, financial situation (equity position) and satisfaction and well being. Risk management is the practice of managing the resources of the operation in such a way as to maintain an acceptable level of risk. This in turn should generate a corresponding level of return that will allow the goals of the operation and management to be achieved. The use of time, financial and other resources to effectively manage the risks so that goals can be achieved is the risk management. Risk management comprises of risk assessment and risk control. Assessing Risk is identifying and analyzing risk. Controlling Risk is taking steps to reduce risk, provide contingency, monitor improvements. Risk Management is important for ensuring that a computer project isn't scuppered, preventing accidental loss or disclosure of information, avoiding computer fraud, hacking, ensuring the smooth running of an information system and maintaining your career prospects. Sources of Risk: There are five main sources of risk in an operation: production risk, marketing risk, financial risk, legal risk and human resource risks. Production risks include yield and quality variability. Marketing risks include changes in the price and external conditions. Financial risks include variability in debt, equity capital and ability to meet cash demands. Legal risks include responsibilities for contracts, statutory compliance, tort liability and business structure. Human Resource risks include people management and estate transfer. Types of Risk: There are two types of risk that affect the volume of investment. The first is the entrepreneur's or borrower's risk which arises out of doubts in his own mind as to the probability of his actually earning the prospective yield for which he hopes. This is a real social cost, though susceptible to diminution by averaging as well as by an increased accuracy of foresight. If a man is venturing his own money, this is the only risk which is relevant. But when a system of borrowing and lending exists, which means the ranting of loans with a margin of real or personal security, a second type of risk is relevant which we may call the lender's risk. This may be due either to moral hazard, i.e. voluntary default or other means of escape, possibly lawful, from the fulfillment of the obligation or to the possible insufficiency of the margin of security, i.e. involuntary default due to the disappointment of expectation. This is a pure addition to the cost of investment which would not exist if the borrower and lender was the same person. Moreover, it involves in part a duplication of a proportion of the entrepreneur's risk, which is added twice to the pure rate of interest to give the minimum prospective yield which will induce the investment. For if a venture is a risky one, the borrower will require a wider margin between his expectation of yield and the rate of interest at which he will think it worth his while to borrow; whilst the very same reason will lead the lender to require a wider margin between what he charges and the pure rate of interest in order to induce him to lend (except where the borrower is so strong and wealthy that he is in a position to offer an exceptional margin of security). During a boom the popular estimation of the magnitude of both these risks, both borrower's risk and lender's risk, is apt to become unusually and imprudently low. From the day a bank is granted its charter up until its final day of operation, it faces a wide variety of internal and external risks which includes credit, liquidity, market, operational, legal and reputation risks. The following sets out short definitions for each of these risks: Credit risk: The risk that a bank won't receive the principal and interest it is owed. Liquidity risk: The risk that when a bank needs to raise cash for its day-to-day operating needs, it won't be able to do so at a reasonable cost. Market risk: The risk that a bank's earnings and capital might be adversely affected by changes in interest rates, exchange rates or securities prices. Operational risk: The risk of loss or harm from unanticipated internal or external events that occur in the course of conducting business such as equipment breakdowns, customer and employee fraud and undetected software errors. Legal risk - The risk of loss or harm from unenforceable contracts, lawsuits or adverse judgments. Reputation risk - The risk of loss or harm to a bank's public image from negative publicity. These risks are not unique to banks. Governments, businesses and even households encounter these risks. All of these organizations borrow and loan money and require funds to meet their operational or living needs. Although all six categories of risk must be properly managed if the bank is to prosper, this course concentrates mainly on three of them: credit, liquidity and market. These risks are referred to as portfolio risks since they result largely from the mix, or portfolio, of interest-earning assets and interest-bearing liabilities held by a bank. Portfolio risks receive the most attention in this course because they relate to the bank's basic lending and deposit-gathering activities. Systematic Risks: Systematic risk also known as systemic risk, market risk and un-diversifiable risk is risk which applies to whole market or market segment resulting in decline of total portfolio investment value. Systematic risks often originate from political or economical problems, wars, interest rate changes, and calamities. They are usually hard to avoid; and avoidance steps should come from higher authorities like governments. Usually systematic risks cannot be minimized by diversification of investment in a particular market segment; but may be by investing in different market segments, because the factors causing the risk affect different market segments differently. The major ways to reduce these risks are avoiding investments, reducing investments and hedging investments. Systematic risks often trigger a chain reaction in an economy. They necessitate change of plans and strategies by governments, companies, banks, financial markets and individual portfolios. Systematic risks are also a major cause for failure of banks. The beta value of a stock gives information about the systematic risk it faces. Unsystematic Risk:'Unsystematic risk is sometimes'referred to as "specific risk".'This kind of risk'affects a very small number of assets. An example is news that affects a specific stock such as a sudden strike by employees. Diversification is the only way to protect you from unsystematic risk. Country Risk:'Country'risk'refers to the risk that a country won't be able to honor its financial commitments. When a country'defaults on its obligations,'this can harm the performance of all other financial instruments in that country as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country. This type of risk is most often seen in'emerging markets or countries that have a severe deficit. Foreign-Exchange Risk: When investing in foreign countries you must consider the fact that currency exchange rates can change the price of the asset as well.'Foreign-exchange risk applies to all financial instruments that are in a currency other than your domestic currency. As an example, if you are a resident of America and invest in some Canadian stock in Canadian dollars, even if the share value appreciates, you may lose money if the Canadian dollar depreciates in relation to the American dollar. Interest Rate Risk:'Interest rate risk is the risk that an investment's value will change as a result of a change in interest rates. This risk affects the value of bonds more directly than stocks. Political Risk:'Political risk'represents the financial risk that a country's government will suddenly change its policies. This is a major reason why developing countries lack foreign investment. Financial Crisis and its roots: The current global financial crisis has now lasted more than a year, with no immediate end in sight. The crisis was triggered by increasing defaults on subprime mortgages and subsequently, the credit ratings of structured products, wholly or partly based on these mortgages were significantly downgraded, raising uncertainty about the valuation of such products. It was at this point that the banks at the centre of the financial system were hit much more speedily than most had envisaged before the crisis. Thus the drying-up of the market for asset-backed commercial paper created pressure on banks' funding liquidity. The reason was that the banks needed for legal or reputational reasons to provide their special purpose vehicles with liquidity or to bring them back onto their balance sheets. Thus, the banks needed to make more use of their own funding liquidity at the same time as their future liquidity needs were becoming both bigger and more uncertain. On top of this, they were becoming more uncertain about the creditworthiness of other banks, as they did not know where the exposure to the toxic subprime and structured product stuff was, or which banks might face problems because they would be forced into a distressed sale of assets due to a lack of funding liquidity. The result was a generalised hoarding of funding liquidity, which might have been rational from the standpoint of individual banks but was disastrous for the system as a whole. We are currently in a phase of this crisis where significant parts of the financial system in advanced economies are being forced to reduce their assets relative to capital, that is, to reduce what is called leverage. The reason is that the current level of leverage of many financial institutions implies a higher level of risk than they can manage in this environment of higher funding costs, increased volatility of most financial prices and more uncertainty. The deleveraging can take place through the raising of additional capital, which is currently becoming more difficult, or the disposal of assets and use of the proceeds to repay debt. However, a deleveraging of the whole financial sector, as distinct from individual institutions in normal market conditions, is a painful process involving asset price deflation and a lack of market liquidity. The metamorphosis of the crisis from its initial stages to now is easier to understand when we realise that it had deeper causes than the faults in US subprime loan origination and the associated securitisation process. The crisis was preceded by a period of low real interest rates and easy access to credit, which fuelled risk-taking and debt accumulation. In the United States, it was the case both for households and for the financial sector itself. However, although the increased indebtedness of the US household sector was plain for everybody to see, the increased leverage of the financial sector was somewhat hidden. One reason was that the leverage was partly accumulating in what is now being called the shadow banking system. Another reason was that the focus on risk metrics like value-at-risk and the use of short time series as inputs allowed the low recent volatility of asset prices to mask the increase in leverage. Last but not least, financial innovation contributed to debt accumulation. In particular, the originate-to-distribute model made it possible to originate loans - especially mortgages - to households, securitise them in large quantities, slice and dice them into differently rated tranches, and then sell them all over the world to both risk-averse and risk-seeking investors. The effect was that loan origination was less constrained by the balance sheet capacity of banks. One result of this setup was that risk was apparently spread away from the institutions that are critical for the overall functioning and stability of the financial system, which should be good from the standpoint of financial stability. However, as it turned out, the distribution was less then met the eye, as the asset-backed securities were often held by special purpose vehicles closely associated with the banks originating them. Some commentators have for this reason called the arrangement "originate and pretend to distribute". Furthermore, as the value of structured products was potentially unstable and would become very uncertain at the first sign of stress and illiquidity in financial markets, what was distributed was not only risk, but also uncertainty and fear. The upshot of all of this was the underpricing of risk. This underpricing was widely recognised in the central banking community, and by others, and was expected to result in significant repricing, which would in all probability be associated with lower asset values and a downturn in the credit cycle. What nobody knew, of course, was the timing of this repricing; nor did anyone anticipate the speed and ferocity of the change or the degree to which it would, in the first round, affect the core of the financial system. The following figures demonstrate the change in attitude towards two key risks, before and during the crisis, which are leverage liquidity risk. These were mostly ignored before the crisis but have since been the focus of markets . Risk Minimisation Methods: Risk Management Strategies that help investors'to increase probability of having cash when they need it are as follows. 1. Setting the investment goals and conducting reviews periodically. 2. Diversify your portfolio to temper the effect of market swings. 3. Prepare yourself by doing homework before buying a stock or bond. 4. Avoid concentrating on stocks or bonds of one industry or sector. 5. Develop and maintain a sell discipline. 6. Understand that bonds provide certainty, not long-term security. 7. Match bond maturities to your future cash needs. 8. Diversify bond purchases and stagger maturities to cut interest rate, prepayment and reinvestment risks. 9. Track political and currency risks that can affect your foreign investments. 10. Rebalance your portfolio regularly. Efficient Market Hypothesis - EMH An investment theory'that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, this means that stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.'As such, it should be'impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing risky investments. Some investors may overreact and some may underreact. All that is required by the EMH is that investors' reactions be random and follow a normal distribution pattern so that the net effect on market prices cannot be reliably exploited to make an abnormal profit, especially when considering transaction costs (including commissions and spreads). Thus, any one person can be wrong about the market indeed, everyone can be, but the market as a whole is always right. There are three common forms in which the efficient-market hypothesis is commonly stated, each of which have different implications for how markets work. Weak-form efficiency: Excess returns cannot be earned by using investment strategies based on historical share prices. Technical analysis techniques will not be able to consistently produce excess returns, though some forms of fundamental analysis may still provide excess returns. Share prices exhibit no serial dependencies, meaning that there are no "patterns" to asset prices. This implies that future price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random walk. Semi-strong-form efficiency: Semi-strong-form efficiency implies that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information. Semi-strong-form efficiency implies that neither fundamental analysis nor technical analysis techniques will be able to reliably produce excess returns. To test for semi-strong-form efficiency, the adjustments to previously unknown news must be of a reasonable size and must be instantaneous. To test for this, consistent upward or downward adjustments after the initial change must be looked for. If there are any such adjustments it would suggest that investors had interpreted the information in a biased fashion and hence in an inefficient manner. Strong-form efficiency: Share prices reflect all information, public and private, and no one can earn excess returns. If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored. To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. Even if some money managers are consistently observed to beat the market, no refutation even of strong-form efficiency follows: with hundreds of thousands of fund managers worldwide, even a normal distribution of returns (as efficiency predicts) should be expected to produce a few dozen "star" performers. Hedging: Hedging means reducing or controlling risk. This is done by taking a position in the futures market that is opposite to the one in the physical market with the objective of reducing or limiting risks associated with price changes. Hedging is a two-step process. A gain or loss in the cash position due to changes in price levels will be countered by changes in the value of a futures position. For Instance, a wheat farmer can sell wheat futures to protect the value of his crop prior to harvest. If there is a fall in price, the loss in the cash market position will be countered by a gain in futures position. In this type of transaction, the hedger tries to fix the price at a certain level with the objective of ensuring certainty in the cost of production or revenue of sale. Example - Case of steel An automobile manufacturer purchases huge quantities of steel as raw material for automobile production. The automobile manufacturer enters into a contractual agreement to export automobiles three months hence to dealers in the market. This presupposes that the contractual obligation has been fixed at the time of signing the contractual agreement for exports. The automobile manufacturer is now exposed to risk in the form of increasing steel prices. In order to hedge against price risk, the automobile manufacturer can buy steel futures contracts, which would mature three months. In case of increasing or decreasing steel prices, the automobile manufacturer is protected. Increasing steel prices: If steel prices increase, this would result in increase in the value of the future contracts, which the automobile manufacturer has bought. Hence, he makes profit in the future transactions. But the automobile manufacturer needs to buy steel in the physical market to meet his export obligation. This means that he faces a corresponding loss in the physical market. But this loss is offset by his gains in the futures market. Finally, at the time of purchasing steel in the physical market, the automobile manufacturer can square off his position in the futures market by selling the steel futures contract, for which he has an open position. Decreasing steel prices: If steel prices decrease, this would result in a decrease in the value of the future contracts, which the automobile manufacturer has bought. Hence, he makes losses in the future transactions. But the automobile manufacturer needs to buy steel in the physical market to meet his export obligation. This means that he faces a corresponding gain in the physical market. The loss in the futures market is offset by his gains in the physical market. Finally, at the time of purchasing steel in the physical market, the automobile manufacturer can square off his position in the futures market by selling the steel futures contract, for which he has an open position. This results in a perfect hedge to lock the profits and protect from increase or decrease in raw material prices. It also provides the added advantage of just-in time inventory management for the automobile manufacturer. Bibliography: 1. (2006), Sources of Risk, http://agecon.uwyo.edu/RiskMgt/Features/Introductions/StrategicPlanning/sld003.htm, 05/01/2009. 2. (2007), Risk and Diversification, http://www.investopedia.com/university/risk/risk2.asp, 05/01/2009. 3. Investopedia, Efficient Market Hypothesis, http://www.investopedia.com/terms/e/efficientmarkethypothesis.asp, 05/01/2009. 4. Chiragra Chakrabarthy, 2007, What is Hedging, http://www.rediff.com/money/2007/jun/23hedge.htm, 05/01/2009. Read More