FOUNDATION OF FINANCIAL RISK

MANAGEMENT
UNIT ONE
 LEARNING OBJECTIVES
• Introduction to Financial Risk management,
• Definition of Financial Risk,
• Systematic (Non diversifiable) and Non-Systematic (Diversifiable)
risks;
• Types of Financial Risks (Market, Liquidity, Operational, Credit
etc.);
• Speculative vs pure risk;
• Sources of Financial Risks.
• Tools for controlling Risk Management-Fundamental, Technical and
Quantitative Analysis.
• Role of Financial Risk Manager
• Financial Risk Management and Economic agents
 Introduction to Financial Risk management
• Financial risk management is the practice of economic value in a firm
by using financial instruments to manage exposure to risk:
• operational risk, credit risk and market risk, foreign exchange risk,
shape risk, volatility risk, liquidity risk, inflation risk, business risk,
legal risk, reputational risk, sector risk etc.
• Similar to general risk management, financial risk management
requires identifying its sources, measuring it, and plans to address
them.
• Financial risk management can be qualitative and quantitative.

• As a specialization of risk management, financial risk management

focuses on when and how to hedge using financial instruments to
manage costly exposures to risk.
• In the banking sector worldwide, the Basel Accords are generally
adopted by internationally active banks for tracking, reporting and
exposing operational, credit and market risks.
 BACKGROUND TO RISK
• Modern life is characterized by risks of different kind: some
threatening all persons and some restricted to the owners of
property, motor cars, etc., while still others are typical for some
individuals or for special occupations.
• The corresponding accidents, losses or claims will occur suddenly
and unexpectedly and may involve considerable financial loss.
• It is quite evident that modern life is a fit subject for risk theory,
and that some results in the pure mathematic theory might have
applications in the study of problems in real life.
 DEFINITION OF FINANCIAL RISK
Risk is the volatility (Unpredictability) of the performance of business and/or
Industry.

•Actual outcomes differs from Expected Returns/Rewards and will be

worse than expected Returns/Rewards.
Risk is a condition in which there exists a quantifiable dispersion in
the possible outcomes from any activity.
It can also be defined as uncertain future events which could
influence the achievement of the organisation's strategic, operational
and financial objectives.

 RISK……
Two aspects to risk to note:
• Uncertainty
• Exposure

Risk is therefore primarily concerned with evaluating potential losses.

There two concepts used in this regard

• Loss frequency
• Loss severity

These concepts are particularly useful in helping a firm to rank loss exposures
according to their relative importance.

In addition, the relative frequency and severity of each loss exposure needs to be
estimated so that an appropriate technique or a combination of techniques can be
selected to treat the loss exposure.
 ……….

 Regardless of the approach used for measuring severity, it must seek to determine
the maximum possible loss and the maximum probable loss.
 The maximum possible loss is the worst loss that could possibly occur to the firm
during its lifetime.
 On the other hand, the maximum probable loss is the worst loss that is likely to
happen to a firm.
 RISK APPETITE & RISK CULTURE
Risks are not always seen in the same way.
Some argue that risk appetite and risk culture largely shape the understanding of the
nature of risk management in a firm.
Risk appetite is the amount of risk an organisation is willing to accept in pursuit of
profit or value.
It is directly related to a firm's strategy and may be expressed as the acceptable
balance between growth, return and risk.

Risk Culture is the set of shared attitudes, values and practices that characterise how
an entity considers risk in its daily activities.

Risk culture is mainly derived from an analysis of organisational practices, namely

rewards or sanctions for risk taking or risk avoiding behaviour.
 FINANCIAL RISK
• Financial risk is a term that can apply to businesses, government
entities, the financial market as a whole, and the individual.
• This risk is the danger or possibility that shareholders, investors, or
other financial stakeholders will lose money.
• Financial risk is a type of danger that can result in the loss of capital
to interested parties.
• For example, for the government, it could mean a failure of monetary
policy and default on bonds or other debt.
• For the companies, it could mean unable to pay a debt, losing value
on investment.
• Similarly, individuals face such risk if their financial decisions
jeopardize their ability to pay the debt.
• Financial markets face such risks due to macroeconomic forces.

• Such risks are essentially the result of market movements.

• Therefore, all entities across the world put extensive effort in

managing their financial risks
 Systematic risk
• Systematic risk is due to the influence of external factors on an
organization.
• Such factors are normally uncontrollable from an organization's point
of view.
• It is a macro in nature as it affects a large number of organizations
operating under a similar stream or same domain.
• It cannot be planned by the organization.
 Unsystematic risk
• Unsystematic risk is due to the influence of internal factors
prevailing within an organization.
• Such factors are normally controllable from an organization's point
of view.
• It is a micro in nature as it affects only a particular organization.

• It can be planned, so that necessary actions can be taken by the

organization to mitigate (reduce the effect of) the risk.
• Financial risk generally relates to the odds of losing money.

• The financial risk most commonly referred to is the possibility that a

company's cash flow will prove inadequate to meet its obligations.
• Financial risk can also apply to a government that defaults on its
bonds.
• Credit risk, liquidity risk, asset-backed risk, foreign investment risk,
equity risk, and currency risk are all common forms of financial
risk.
 PURE AND SPECULATIVE RISKS
• Both speculative risk and pure risk involve the possibility of loss.
• However, speculative risk also involves the possibility of gain as
well - even if there is no loss. It involves the possibility of
loss and gain. 
• Speculative risk is a category of risk that can be taken on
voluntarily.
• Almost all financial investment activities are examples
of speculative risk, because such ventures ultimately result in an
unknown amount of success or failure.
 CONT...PURE VS SPECULATIVE RISK
• Pure risk, also called absolute risk, is a category of threat that is
beyond human control and has only one possible outcome if it
occurs: loss. 
• Pure risk includes such incidents as natural disasters, fire or
untimely death, sudden deadly epidemic or pandemic.
• Pure risk is a type of risk that cannot be controlled and has two
outcomes: complete loss or no loss at all.
• There are no opportunities for gain or profit when pure risk is
involved.
• Pure risks involve the possibility of loss only.
 Sources of Financial risk
• Financial risk generally arises due to instability and losses in the
financial market caused by movements in stock prices, currencies,
interest rates and more.
• Financial risk is caused due to market movements and market
movements can include host of factors.
• Based on this, financial risk can be classified into various types such
as Market Risk, Credit Risk, Liquidity Risk, Operational Risk and
Legal Risk.
• Financial risk arises through countless transactions of a financial
nature, including sales and purchases, investments and loans, and
various other business activities.
• It can arise as a result of legal transactions, new projects, mergers and
acquisitions, debt financing, the energy component of costs, or
through the activities of management, stakeholders, competitors,
foreign governments, or weather.
• When financial prices change dramatically, it can increase costs,
reduce revenues, or otherwise adversely impact the profitability of an
organization.
 TOOLS TO CONTROL FINANCIAL RISK
• The most common methods that investment professionals use to analyse risks associated

with long-term investments—or the stock market as a whole:

• Fundamental analysis is the process of measuring a security's intrinsic value by

evaluating all aspects of the underlying business including the firm's assets and its

earnings.

• Technical analysis is the process of evaluating securities through statistics and looks at

historical returns, trade volume, share prices, and other performance data.

• Quantitative analysis is the evaluation of the historical performance of a company using

specific financial ratio calculations.

 Risk Control Tools and Techniques

• 1. Risk reassessment

• 2. Risk audit

• 3. Variance and trend analysis

• 4. Technical performance measurement

• 5. Reserve analysis

• 6. Meetings
 The ROLE of a Financial Risk Manager
• Develop a policy plan that would minimize risks.

• Daily functioning of a business.

• Working with traders to calculate the risk associated with specific

transactions.
• Forecasting and monitoring market trends.

• Studying and analysing the effect of various economic policies on the level
of risk undertaken by that business and develop new long term monetary
plans for the business.
• Conducting Statistical analysis to evaluate risk.

• Reviewing legal documents.

• Carrying out quantitative analysis.

 FINANCIAL RISK AND ECONOMIC AGENTS
• For governments - unable to control monetary policy and default on bonds or other

debt issues.

• Corporations also face the possibility of default on debt they undertake but may also

experience failure in an undertaking the causes a financial burden on the business.

• Individuals face financial risk when they make decisions that may jeopardize their

income or ability to pay a debt they have assumed.

• Financial markets face financial risk due to various macroeconomic forces, changes to

the market interest rate, and the possibility of default by sectors or large corporations.
 QUESTION AND ANSWER
1) What is Financial risk?
2) What is Financial risk Management ?
3) Compare and contrast pure and speculative risk.