Definition and Measurement of Risk - Essay Example

Finance Table of Contents Introduction 3 Definition and measurement of risk 3 Managing the risk 6 Conclusion 9 Reference 10 Introduction Risk is inherent in any new project. There lies a risk of non-availability of funds for the project, non-realization of anticipated cash flows, default of debtors, adverse movement of foreign currency for overseas transaction, unfavourable movement in interest rates etc. In the modern financial markets it is possible to insure all such risks by the use of hedging tools. With the advancement in the financial markets various financial instruments have been designed that can be effectively used for managing the risks inherent in the project. Definition and measurement of risk Any organisation plans out its operations based on past analysis and future forecasts. It might happen that the actual results of the business diverts from the planned structure, leading to financial deviation in measurements. When the actual results match with the forecast there is a profit whereas when there is a mismatch it leads to a loss. So at the very outset it is known that the forecasts may not materialize. This is known as risk. The possibility of risk arises when there is an uncertainty regarding the outcome of an event. Suppose, a US based company wants to set up its operations in UK. For this it has to set up a new unit in UK, buy equipments, employ new staff etc. All this requires funds. This can be obtained as loans from financial institutions. But the loan comes at a cost which is the rate of interest that the company has to pay on the amount raised. This exposes the company to interest rate risk. If the rate of interest rises, the interest burden of the company increases putting a strain on the earnings. A new investment has to face the risk of market competition. The existing competitors may have a strong market reputation. This will make it difficult to penetrate the market. If the company’s product is not accepted by the customers this might result in loss of huge revenues. It is important that the management has proper strategies in place to counter this risk. The company accepts a project based on an anticipation of future cash inflows. But there remains an uncertainty about the generation of the future cash flows. If an organization sells goods on credit, there is a possibility of non-payment by the debtors. This will impact the profitability of the project. To ensure that the non-payment does not affect the project performance the company must take the requisite steps. The overseas operations of the company give rise to foreign currency receivables and payables. It has to pay for the purchase of raw material, equipments and other costs in the foreign currency. If the value of the foreign currency appreciates against the domestic currency, it will increase the costs of the company. It will have to shell out more domestic currency to purchase the foreign currency. Similarly, at the time of conversion of the foreign currency receipts in domestic terms the company faces the risk of exchange related loss if the value of the domestic currency appreciates against the foreign currency. Such risks are called currency risk. For the production activities the company needs raw materials and various other inputs. The cost of material forms the basic cost of production. An unexpected rise in its cost can influence the total cost of the output. This will lower the profit margin. It may also happen that the supplier of the raw material has a monopoly in the market. Taking advantage of his monopolistic position he can ask for unjustified prices for the material. As there is no other alternative the company may be forced to acquire them even at the high prices. If the company is new in the market, it cannot pass on the rise in the materials to its customers, as this will affect its sales. It becomes imperative for the company to look for alternatives else the business will suffer. The company has a social image. It must take care that if it makes a product that is not in the interest of the society, it will distort its image in the society. In the intensely competitive market, the company has to take care of its public image else it will result in loss of sales. The company may be using new software in the production process. This gives rise to the possibility that the people in the system may not be well-versed with the use of this software. For this the company must arrange for suitable training programs for the employees. The hardware resources that the company had planned for supporting the project may prove to be inadequate once production resumes. This is especially common in IT projects when there is a problem in the processing performance once the application reaches the production stage. Therefore, there must be sufficient provisions for increasing the hardware resources if the need so arises. Often it happens that certain additions have to be made in the project plan in the later stages. This can lead to schedule delays and also raise the project costs. Besides affecting the existing project, this will also delay other projects of the company. Managing the risk As the possibility of risk cannot be eliminated, it is important that the company devises risk management strategies. Risk has become an integral part of business activities. As mentioned above the company is exposed to various risks such as shortage of funds, financial risk, risk of competition, sudden rise in input costs, risk of losses, etc. The risk relating to fund availability can be resolved if the company has alternative resources that it can tap if it is not able to obtain loans from the financial institutions. If the company has plans of starting a new project, it can use the reserves that it has created over the years. Nowadays the banks provide financial assistance for setting up new projects. These can be easily repaid in annual instalments. But loans may not be the ideal route when there is a financial turmoil. In a crisis situation, the banks often raise the interest rates. It may not be feasible for the company to obtain the loans at such high rate of interest. To avoid the loan market the company can raise capital from the equity market. It can get itself listed for issue of fresh equity. If it already has a presence in the capital market then it can opt for Further Public Offer (FPO). Alternatively, it can issue right shares to its existing shareholders. As it has already established itself in the eyes of its investors, it will not face any difficulty in raising money from this source. The use of loans exposes the bank to interest rate risk. A rise in the lending rate will also raise the interest burden of the company. An effective way of managing interest rate risk is through interest rate derivatives like swaps, Forward Rate Agreement (FRA), interest rate cap etc. If the company has taken a floating rate loan and is afraid of interest rates rising in the near term, it can enter into a fixed to floating rate swap where it has to pay a fixed amount as interest and will receive a floating payment. In this situation, even if the interest rate rises the outflow of the company will be limited as any rise in the interest payment on the loan will be compensated by its floating receipts in the swap arrangement. If the company wants to start the project in a span of three months and is afraid of interest rates rising during this period, it can buy an FRA. By buying the FRA it will be compensated on any rise in the interest rate during the period. For all these contracts the company does not have to pay an upfront premium but has to bear the risk if there is a fall in the interest rates. To avoid this, the company can buy interest rate caps where it has to pay an amount of premium. By virtue of this even if the rate of interest rises in the future its interest obligations will be limited to the cap rate. Conversely, if the interest rate falls, the company can enjoy the fall in the market rate of interest. The currency risk arising out of the overseas receipt and payments can be mitigated using foreign currency options. If the company has foreign currency receivables and is afraid of depreciation of the foreign currency, it can buy put option on the currency. This will give the company the right to sell the foreign currency at an agreed exchange rate irrespective of the market movements. It protects the company in case of any adverse movement in the exchange rate. For keeping the value of its foreign currency payments intact, it can buy call option on the currency. This will give the company the right to buy the foreign currency at a fixed rate irrespective of the exchange rate prevailing in the market. A sudden rise in the price of necessary inputs is a potential risk that the company has to face. For protecting itself from this the company must find out the substitutes that can be used in place of this input. If it is costly for the company to procure the equipments from external sources it can opt for inhouse manufacturing. For reducing the uncertainty associated with the project cash flows the company must be careful while selecting its debtors. To mitigate default risk it can create the necessary provisions. As it is difficult to enter a market that already has strong players, the company must devise strategies that will help it in market acquisition. It has to keep its strategies ready that it can use when it enters a new market. For attracting customers it can employ various marketing techniques like extensive advertisement and promotion, giving cash discounts, after sales services, etc. It can also distribute free samples for creating awareness about its product. This will help it in establishing itself in the market. It can keep its market price low initially for entering the market. In the current environment, the company has to concentrate on its public image. Nowadays business is not merely a profit making unit. The good-will of the business plays a major role in generating sales. A company that is already established in one industry say tobacco diversifies into another industry say FMCG might have to face market opposition. The negative public image of the industry can impact its performance in the FMCG as well. To avoid this, the company must undertake extensive advertisement campaigns. There remains the possibility of surprises in every project. It may not always meet the forecasted requirements and specifications. Therefore, it is mandatory to be prepared for such a possibility in the future and discuss the matter with the people in charge (Tinnirello, 2002). For handling this kind of risk, the company can maintain a Contingency fund that can be used only in the case of an emergency. Conclusion As risk is an inevitable part of the business it is important that the management plans for it well in advance. The modern financial markets provide various hedging techniques that can be used to handle risk. Infact, the companies today have a separate risk management department that takes care of the uncertainty associated with the cash flows. It uses the services of specialized professionals who have an extensive knowledge about the risk management techniques. The task of risk management is to co-ordinate between the function of risk management and production department. There are some risks that cannot be expressed quantitatively such as market competition but the management can control it to an extent through various marketing techniques. There may be a limited probability of occurrence of a risk but this cannot negate the management of risk. An event that can derail a project is treated as risk before its occurrence. It is an unforeseen event and therefore it is important to identify the risk and manage it effectively. The purpose of risk management is to postpone an undesirable outcome permanently thus making it a continuous process and not a one time phenomenon. Reference Tinnirello, C.P. 2002. New directions in project management. CRC Press. Read More