MANAGING RISK IN FINANCIAL MATTERS

• 123
• 0

MANAGING RISK IN FINANCIAL MATTERS

The success of any business depends on the manner in which it deals with uncertainty and risks. W.C.F. Hartley asserts that a manager must learn to live with uncertainty although it must also attempt to put a size to it.

Risk arises from the uncertainty regarding, an entity’s future losses as well as future gains. Therefore, in simplified terms, there is a natural trade-off between risk and return. Risk is not necessarily related to the size of the potential loss. For example, many potential losses may be large, but maybe quite predictable, and, can be provided for, using risk management techniques. The more important concern is, the variability of the loss, especially a loss, that could rise to unexpectedly high levels, or a loss, that suddenly occurs, and that was not anticipated.

As a starting point, Risk Management includes the sequence of activities aimed to reduce or eliminate, an entity’s potential to incur expected losses. On top of that, there is the need to manage the unexpected variability of some costs. In managing both expected and unexpected losses, risk management can be thought of, as a defensive technique. However, risk management, is actually broader, in the sense that, it considers how an entity can consciously determine, how much risk it is willing to take, to earn future uncertain returns, which involves, risk-taking.

<font face="Times New Roman, serif">Risk-taking</font> refers specifically, to the active assumption of increment risk, in order to generate, incremental gains. In this regard, risk-taking, can be thought of, in an opportunist context. The different types of Risks are Physical Risk, Technical Risk, Economic Risk, Political risk, Business Risk, Financial Risk, Cyclical Risk, Purchasing power Risk, Interest rate Risk, Stock price Risk, Tax Law Risk, Foreign Exchange Risk, Risk due to nature of the types of Financing, Risk of misinterpretation, Risk from Bios, and  Risk arising out of estimating procedure.

One of the challenges in ensuring that, Risk Management, will be beneficial to the economy, is that risk must be sufficiently dispersed, among willing and able participants, in the economy. Unfortunately, a notable failure of risk management occurred, during the financial crisis between 2007 and 2009, when it was subsequently discovered, that risk was too much concentrated, among too few participants.

Another challenge of the risk management process is that it has failed to consistently assist, in preventing market disruptions, or, even preventing financial accounting fraud, due to corporate governance failures. For example, the existence of derivative financial instruments, greatly facilitates the ability to assume, high levels of risk, and the tendency of risk managers, to follow each other’s actions. For example, selling risky assets during a market exists, which disrupts the market, by increasing its volatility.

In addition, the use of derivates as complex trading strategies assisted in overstating the financial position, i.e., net assets in the Balance Sheet, of many entities and understating the level of risk assumed by many entities, Even with the best Risk Management policies in place, using such inaccurate information, would not allow the policies to be effective.

Finally, Risk Management may not be effective, on an overall economic basis, because it only involves, the risk transferring by one party, and risk assumption by another party. It does not result in overall risk elimination. In other words, Risk Management can be thought of, as a Zero-sum game in that some “winning” parties will gain at the expense of some “losing” parties. However, if enough parties suffer devastating losses, due to an excessive assumption of risk, it could even lead, to an overall economic crisis.

Economic Capital, refers to holding sufficient liquid reserves, to cover a potential loss. For example, if the one-day, value-at-risk is ₹25 crores, and the entity holds ₹25 crores in liquid reserves, then it is unlikely to go bankrupt, at least that very day.

Expected Loss, considers how much an entity expects to lose, in the normal course of business. It can often be computed in advance, and provided for, with relative ease, because of the certainty involved.

Let me introduce you to various types of risks. Of Course, I will dwell on each one of them, in detail, at a later date. Market Risk, which comprises of four components, viz., Interest Rate Risk, Equity Price Risk, Foreign exchange risk, and commodity price risk, is the first one. Credit Risk, which again comprises of four components, viz., Default Risk, Bankruptcy Risk, Downgrade Risk, and, Settlement Risk, is the second. Liquidity Risk, which is subdivided into two parts, viz., Funding Liquidity risk and Trading Liquidity Risk, is the third. Operational Risk, which is the next one, considers a wide range of “non-financial” problems such as, inadequate computer systems, a technology risk, insufficient internal controls, incompetent management, frauds, human errors, and natural disasters.

Legal and Regulatory Risk, Business Risk, Strategic Risk, and, Reputation Risk are some more examples of fundamental risks.

If you enjoyed reading this article and wish to support us by making a contribution or a small donation click on Razor Pay IIB Donation