Risk Management

By. : 1. Erry Febrian, SE., M. Com 2. Aldrin Herwany, SE., MM

Risk Management

Economic Faculty

Padjadjaran Padjadjaran University

Topic cover
What is risk management Different types of risks Levels of risks Methods and TOOLS of risks

EVALUATE AND MINIMIZE RISKS

FIRM VALUE

What is risk management

The Concept of risk and uncertainty are related but yet are very different. Uncertainty involves variables that are constantly changing, whereas risk involves only the uncertain variables that affect or impact the systems output directly RISK IDENTIFICATION

RISK EVALUATION

RISK QUANTIFICATION

Level of risks
Extremely High High Medium Low

Different types of risks

MARKET RISK CREDIT RISK

COMMON TYPES OF RISK

OPERATIONAL RISK LIQUIDITY RISK SYSTEMIC RISK INTEREST RATE RISK

Foreign Exchange Risk

the risk that exchange rate changes can affect the value of firms assets and liabilities denominated in foreign currencies short-term financing decisions short-term investment decisions capital budgeting decisions long-term financing decisions

Market Risk
The risk of monetary loss arising from an adverse move in market prices or rates Adverse changes in market prices, rates, exchange rates

Bonds
Duration and Convexity Rate sensitivities Credit spread sensitivity Trading/Hedging Directional Curve (steepener / flattener; butterfly) Spread Relative Value

Equities
Beta Factor models

Options : delta, gamma, vega, theta, rho Risks caused by changes in market prices, exchange rates or interest rates.

Credit Risk
The risk that the promised cash flows from loans and securities Methodology for calculating the distribution of possible credit losses from a portfolio One of the parties entered into a financial contract is not able or willing to pay its liabilities Credit Spread Risk Credit spread is the excess return demanded by the market for assuming a certain credit exposure. Credit spread risk is the risk of financial loss owing to changes in the level of credit spreads used in the mark-to market of a product. Credit Default Risk Credit default risk is the risk that an obligor is unable to meet its financial obligations. In the event of a default of an obligor, a firm generally incurs a loss equal to the amount owed by the obligor less a recovery amount which the firm recovers as a result of foreclosure, liquidation or restructuring of the defaulted obligor. All portfolios of exposures exhibit credit default risk, as the default of an obligor results in a loss.

Operational Risk
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. (Basel II, September 2001) The risk of monetary loss resulting from inadequate internal processes. Potential losses due to breakdown in information, communication, transaction processing, settlement systems, fraud, unauthorized transactions by employees the risk that existing technology or support systems may malfunction or break down execution risk: there is a mistake in execution of a transaction fraud technology risk model risk

Operational Risk
1. Policy 5. Exposure Management

2. Risk Identification

6. Reporting

3. Business Process

7. Risk Analysis

4. Measurement Methodology

8. Economic Capital

Liquidity risk
Cash flows not sufficient to meet banks financial commitments the risk that a sudden surge in liability withdrawals may require an FI to liquidate assets in a very short period of time and at low prices

The concept is not well defined, it can mean the following two things liquidity of a financial market instrument: the biggest size of a trade that does not yet move the market price. If a trade having bigger size is transacted, then it also changes the market price. liquidity means also often that a corporation has liquid funds, cash, enough to make the necessary payments. This type of liquidity risk is related to cash management and funding problems.

Interest rate risk

Fluctuating Interest Rates

Earnings & Returns Fluctuate with Changes in Interest Rates

Others
Insolvency Risk Off-Balance-Sheet Risk Technology Risk

Country Risk
the risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments Political Risk, war, Bureaucracy, Corruption, revolution,

Forecasting Risk (Estimation Risk)

The Possibility that errors in projected cash flows will lead to incorrect decisions

Legal risks
lawsuits (especially financial organisations) how legal contracts will be interpreted

Different types of risks RISK MANAGEMENT

Systematic Risk has two parts :

1. Business Risk
The equity risk that comes from the nature of the firms operating activities Firms Operation Risks caused by the original business of a corporation: risk related to the products of a corporation, R & D investment, innovation, change in demand for the products A corporation should have competitive advantage to take and manage these risks.

Different types of risks RISK MANAGEMENT

2. Financial Risk
Financial risks, especially on market risk and credit risk.
External Financing

The equity risk that comes from the financial policy

Internal Financing Financial leverage

Elements of Risk Management

Understand range and magnitude of risks Know what you dont know Communicate issues clearly

ROLE OF RISK MANAGER

MONITOR RISK OF A FIRM IDENTIFY RISKS MEASURE RISKS REPORT RISKS MANAGE - or CONTROL RISKS

Quantitative factors Qualitative factors

ROLE OF RISK MANAGER

Qualitative factors
Owners, Management Investments: LT earnings, no over-investment in sector Products: demand, innovation vs. cost leadership or niche Competition: Market entry barriers, pricing power Risk evaluation Government regulation

ROLE OF RISK MANAGER

Quantitative factors
Growth: Sales, Investments Profitability: Operating and net margins, ROE Risk: Sales and profit stability, capital structure, size, liquidity Valuation: Ratios (P/E, P/S, P/BV, P/CF), Discounted Cash Flow (Focus: capital costs)

Methods and TOOLS of risks

Scenario Analysis
What If Analysis
The determination of what happens to NPV estimates when we ask what-if questions ASSESS IMPLICATIONS OF
PARTICULAR COMBINATIONS OF EVENTS NO PROBABILITY STATEMENT

SIMULATION ANALYSIS
Combination of scenario and sensitivity analysis

Sensitivity Analysis
Investigation of what happens to NPV when only one variable is changed

Base, Worst, Best Optimistic, Pessimistic Base, Lower, Upper

Methods and TOOLS of risks

STATISTICAL ANALYSIS
FIND PROBABILITY OF LOSSES HOW TO ASSESS EVENTS WHICH HAVE NEVER OCCURRED?

Technical forecasting
involves the use of historical data to predict future values. E.g. time series models.

Fundamental forecasting
is based on the fundamental relationships between economic variables quantitative measurements based on regression models and sensitivity analyses.

Methods and TOOLS of risks

Figure 1. Figure 2.
Risk and return according to the basic Capital Asset Pricing Model (CAPM) Expected return Expected return

Risk

Risk

Look ! ..Expected return and risk are interdependent!

Methods and TOOLS of risks

TWO GENERAL APPROACHES FACTOR MODELS --- AS IN RISKMETRICS

PORTFOLIO MODELS --- AS IN ROLLING HISTORICAL QUANTILES

EVALUATE AND MINIMIZE RISKS

Portfolio formation
PORTFOLIO STANDARD DEVIATION

Market risk

DOWNSIDE RISK SUCH AS SEMI -VARIANCE VALUE AT RISK

The higher the perceived risk, the higher the discount rate that should be applied to the projects cash flows.

EVALUATE AND MINIMIZE RISKS

Horizon Exposure

Methods

Guess of the market direction

Compensate the extra risk!

How to Value A Firm

Discounted Cash Flow Analysis

Comparable Multiples

Cash Flow Analysis

Price/Book Value etc

Investment Analysis
Investment Approach Macroeconomic Analysis Sector Rotation Balance Sheet Analysis Valuation Chart reading Market Indicators Technical Indicators Behavioral Finance

Investment Analysis
Macro analysis

Others Inflation Currency analysis Economic structure

FDI, restruct., dereg., taxation chart, sentiment, money flows, behavioral fin

Bond yields
earnings yields

Global scenarios

Valuation Techniques
Discounted Cash Flow
Weighted Avg. Cost of Capital (WACC)

Cash Flow Analysis

Comparable Multiples
P/E (trailing or future) Price to EBITDA Price to Cash Flow Price to Book Value Enterprise Value/EBITDA

Valuation Tools
Annual Report and Quarterly Reports Income Statement Balance Sheet
changes in net working capital, inventory level

Statement of Cash Flow Financial Notes

Discounted Cash Flow Steps

Analyze historical performanc Forecast e performan Calculate historical ce
margins and ratios 1. Determine value drivers 2. Analyze financial health 3. 4. 5.

1. 2. 3.

Understand strategic position of firm Select forecast horizon (competitive advantage window) Forecast individual line items Develop scenarios (best, worst, likely cases) Check overall forecast for reasonableness

Estimate cost of capital

Estimate Calculate continuing value and interpret value results

1. 1. 2. 3. Choose methodology WACC APV Calculate free cash flows Discount free cash flow and continuing value to present Interpret results

1. 2. 3. 4.

Estimate cost of non-equity financing Estimate cost of equity financing Determine target market weights [or iterate] for WACC Calculate discount rate

Select appropriate technique 1. Multiples (e.g., EBITDA, free cash flow, net income) 2. Perpetuity/growing perpetuity 3. Estimate the parameters

WACC Approach
Historical 1997 1998

. . .

Projected 1999 2000 .

WACC
Terminal value

FCF

Risk-free rate Mkt risk premium Capital structure Cost of debt Beta Tax rate

Discounting
PV of free cash flows

PV of + continuing value

Net debt

Equity value

Value Analysis
Equity Value: Market Value - cash - hidden assets + Debt EBITDA (Earnings Before Income Tax, Depreciation, and Amortization) Trailing 4 quarters EBIT + D + A EV/EBITDA multiple inverted is essentially the pretax cash flow return on assets of the corporation

Comparable Company Multiples

P/E
Advantages

Revenue

EPS is industry standard Helps value companies with no Easy to put into historical earnings context EPS can be measured in nearly uniform manner Non-cash differences Financing/capital differences Accounting standards may be subject to interpretation and vary across countries Requires similar companies with same component revenues Doesnt tell you how profitable the revenues are going to be

Disadvantages

Other common measures

Enterprise Value/EBITDA P/E to 5 Year Estimated EPS Growth Rate Market Value of Equity/Book Value of Equity