Main Techniques of Risk Analysis - Example

Objectives of Risk Analysis and the main techniques of Risk Analysis An Assignment Submitted by Name of Student Name of Establishment Class XXXX, Section XXXX, 2012 Introduction The foreign exchange market also referred to as the currency market is a global financial market of converting and trading in the currencies. This market provides a platform where individuals or firms can buy, sell or exchange currencies (Dun & Bradstreet 2007). As a result of the increasing trends of globalisation and liberalisation of markets, foreign exchange has become a very lucrative business. However, firms engaged in foreign exchange transactions are susceptible to many risks due to unexpected changes in exchange rates. Additionally, foreign exchange firms face the risk of political climate, economic environment and financial conditions. Therefore, it is crucial for firms as well as individuals to evaluate the possible risks in the foreign exchange markets and subsequently make suitable decisions that will expose them to limited risks. Risk analysis is the procedure followed to define and analyze the possible dangers posed to businesses, individuals and government bodies & agencies by events caused naturally or artificially by humans (Levi, 2005; Moffet, Stonehill & Eiteman, 2009). The key aim of this paper is to examine the objectives of risk analysis and the main techniques used in risk analysis. Foremost, this paper will examine what risk analysis entail. Secondly, it will examine the objectives of risk analysis. Lastly, this paper will examine the techniques used in risk analysis. Risk Analysis As earlier stated, the foreign exchange market is characterised by numerous risks. Most of the risks in this market stem from unexpected changes in exchange rates between one country’s currencies to another. Moreover, the foreign exchange market is characterised by numerous complexities brought about by a country’s political climate, economic environment and financial conditions and regulations. The various complexities and the risks that this market is susceptible to, can bring about adverse financial consequences. It is the therefore crucial for firms or individuals to effectively assess possible risks before making any decisions (Levi, 2005; Moffet, Stonehill & Eiteman, 2009). Basically, there are two aspects of risk analysis namely; the quantitative and qualitative aspects. Qualitative risk analysis defines non – numerical possible threats, determines the extent of vulnerable circumstances and seeks for possible solutions to curb or prevent the occurrences from happening. Quantitative risk analysis on the other hand, determines numerical possibilities of adverse events occurrence. It measures the extent of loss that would be incurred if an adverse event happens (Bartlett, 2004). Objectives of risk analysis Risk analysis is conducted by many organizations for various reasons. Some of organizations conduct risk analysis because it is mandatory and a regulation that is stated in the law. Often such mandatory regulations are aimed at providing information security both for the organizations and clients especially in business transactions and IT infrastructure. A properly stipulated security process in an organization ensures protection of significant information, threat detection and provides considerable response to any occurrence of risk to minimize risk exposure and benefit of both client and organization. This ensures prevention, detection and response processes of security in risk assessment (Shani, 2003). Risk analysis is often conducted to enable effective budgeting and planning on the risk threats and vulnerabilities according to prioritization. Once the analysis has been conducted, one can have a broader scope of the possible risks that may exist and hence carry out a more accurate budget rather than estimates. Secondly, the objective of risk analysis is to combine the effects of various risks into effective risk estimates and hence enabling one to make decisions as per the goals and objectives. This is triggered by the better understanding of the risk estimates after the risk analysis has been carried out. It is also useful in the case of assessment and recommendation an organization or any other involved party general goals and objectives (Yoe, 2011). Another objective of risk analysis is to allow compliance with new laws, mandates and regulations for information security since security is primarily concerned with prevention, detection and response. This will enable an organization to understand the various ways that can be used to counter any occurrence of risks, for example losses. Moreover, risk analysis enables the employers to take the measures necessary for the protection of workers. Since any risk that may occur in the long run may even cause hazardous consequences that can never be dealt with completely and therefore carrying out a comprehensive risk analysis will be of great importance to the organization (Aven, 2011; Yoe, 2011). The purpose of risk analysis in the foreign exchange markets is mainly to determine, define and quantify the possible impact of various specified challenges anticipated in disaster occurrence in order to plan ahead of the possible responses. For instance, in project implementation, risk assessment is done to determine contingency schedule values and costs related. Hence, quantifying the effect of risk events (Yoe 2011). Foreign exchange analysts have to assess the sovereign risk associated with foreign transactions. In this regard, the sovereignty risk concerns the risk that the host government can default on its payment obligations. This mostly affects multinational corporations. A host government can also prevent local firms from honouring their foreign exchange obligations. Country risk analysis encompasses sovereignty risk analysis and entails various aspects with regards to business and foreign exchange matters. For instance, the foreign exchange analysts would strive to determine how mature the political climate is and how it impact on foreign exchange fluctuations. They can therefore offer advice to firms before making foreign exchange decisions (Aven, 2011; Yoe, 2011). Risk Analysis Techniques Several risk analysis techniques can be used to determine the viability of a foreign exchange project or a certain event occurrence in an organization. Some of these techniques include; value of risk technique, CAMELS Approach, Monte Carlo Simulation and Sensitivity Analysis among many others. Value at risk technique (VAR) This is a mathematical technique of quantifying the level or amount of financial risk in a foreign exchange transaction. Foreign exchange risk managers can make use of value at risk analysis to estimate the risk that a multinational corporation undertakes in the course of doing foreign exchange business. The variables used in this technique include the potential loss amount, the probability of the loss amount and the time duration in which the loss can occur (Jorion, 2006). CAMELS Approach CAMELS approach is a risk analysis technique commonly used in banks. This approach enables firms to evaluate factors that affect their credit worthiness. Basically CAMELS is an acronym that represents capital adequacy, asset quality, management quality, earnings, liquidity and sensitivity to market risk. This approach reviews the various financial components of a foreign exchange transaction in a firm based on capital adequacy, asset quality, management quality, earnings, liquidity and sensitivity to market risk. The review can make use of different sources of data such as sources of funds, financial statements, macroeconomic data and cash flow. This can be utilized in monitoring the risk in a foreign exchange deal (Grier, 2007). Sensitivity Analysis This is a simple technique that measures the effects of a specific value or variable in implementation of a project. Risk and uncertainty is determined by a variety of change in each component of base estimate case. Sensitivity analysis is beneficial because it creates an impression to management that there is a possible outcome. This enables realistic decision making even though sometimes it can involve complex situation. Sensitivity analysis does not specify a distribution probability for each agent of change. This technique seeks to put a value on the effect of change of a single variable within a project by analyzing that effect on the project plan. It determines how sensitive a risk is to a variable assumption made by an organization. One must come up with a base case scenario to begin a sensitivity analysis (Krayenbuehl, 2001). Monte Carlo Simulation This is a quantitative risk analysis technique that simulates the probabilistic values of data by picking variable values randomly. The technique provides a powerful yet simple method of incorporating probabilistic data. This is by assessing the range of the variables chosen randomly and running a deterministic analysis using the combination of the values selected for each one of the variables and these steps are done repeatedly. Firstly, the range of numbers considered to define distribution in the probability must complement one another. Secondly, random selection of a variable number within specific range of variable is done. A determinist analysis run or check is done using values of combinations from the complementary range of variables. Finally, repetition of the above process is done in order to determine the probability distribution. The higher the number of repetition, the higher the level of accuracy of the combinations (Krayenbuehl, 2001). Conclusion Basically, this paper has examined what risk analysis entails, some of its objectives and techniques that can be used in risk analysis. It is established in this paper that, firms engaged in foreign exchange transactions are susceptible to many risks due to unexpected changes in exchange rates. Therefore, it is crucial for firms as well as individuals to evaluate the possible risks in the foreign exchange markets and subsequently make suitable decisions that will expose them to limited risks (Levi, 2005; Moffet, Stonehill & Eiteman, 2009). Some of the techniques that can be used for risk analysis include; sensitivity analysis, Monte Carlo Simulation, CAMELS Approach and Value at risk technique References Aven, T. (2011). Assessing Uncertainties beyond expected values and probabilities. New York: John Wiley and Sons. Baker, H. & Powell, G. (2009). Understanding Financial Management: A Practical Guide. New York: John Wiley and Sons. Dun & Bradstreet (2007). Foreign Exchange Market. New Delhi: Tata McGraw-Hill Education. Grier, W. (2007). Credit Analysis of Financial Institutions. 2nd Ed. New York: Euromoney Books. Krayenbuehl, T. (2001). Cross-Border Exposures and Country Risk: Assessment and Monitoring. London: Woodhead Publishing. Jorion, P. (2006). Value at Risk: The New Benchmark for Managing Financial Risk, 3rd Ed, New York: McGraw-Hill. Levi, M. (2005). International Finance. 4th Ed. New York: Routledge. Moffet, M. Stonehill, A. & Eiteman, D. (2009). Fundamentals of Multinational Finance. 3rd Ed. Boston, MA: Addison-Wesley. Shani, S. (2011).A Foreign Exchange Primer. London: John Wiley & Sons. Rowe, G. & Wright, G. (1999). “The Delphi technique as a forecasting tool: issues and analysis”. International Journal of Forecasting 15 (4), pp. 353-375. Yoe, C. (2011). Principles of risk analysis: Decision making under uncertainty. New York: CRC Press Read More