Risk Management
June 9, 2022
What is Risk Management?
Risk management is the continuing process to identify, analyze, evaluate, and mitigate threats to an organization’s capital and earnings. These risks stem from various sources, including financial uncertainties, legal liabilities, technology issues, managerial error or incompetence, accidents, and natural disasters. This entails monitoring risk control and financial resources to mitigate the adverse effects of loss. These risks stem from various sources and risk profiles, including financial uncertainties, legal liabilities, technology issues, strategic management errors, accidents, and natural disasters.
Key Learning Points
- Risk management is a continuous process.
- Effective risk management means attempting to control, as much as possible, future outcomes by taking measures proactively rather than reactively.
- Applying controls can help manage risk and uncertainty until both are reduced to an acceptable level.
Types of Risk
There are several different types of risk that need to be considered prior to implementing any investment strategy
Operational Risk
Operational risk results in indirect or direct loss resulting from failed or inadequate internal systems and processes or external events. Operational risk can include security risk, legal risk, fraud, environmental risk, and physical risk (for example, major power failures or infrastructure shutdown). Unlike other types of risk, operational risks are not revenue-driven, incurred knowingly, or possible to eliminate. This risk remains as long as people, processes, and systems remain imperfect and inefficient.
Foreign Exchange Risk
Also known as currency risk, forex risk is assumed when a financial transaction is made in a currency other than the operating currency – often the domestic currency – of a business. The risk arises from the potential for unfavorable changes in the exchange rate between the transactional and operating currencies. An aspect of foreign exchange risk is economic risk or forecast risk, the degree to which an organization’s product or market value is affected by unexpected exchange rate fluctuations. Businesses that rely heavily on the import and export of goods, or which have diversified into foreign markets, are more susceptible to foreign exchange risk.
Credit Risk
Credit risk is the possibility that a borrower or client defaults on a debt or outstanding payments. In addition to the potential loss of principal, additional losses including interest income and increased collection costs should also be taken into account when establishing the magnitude of credit risk. Financial analysts use yield spreads to determine credit risk levels in a market.
One of the simplest ways to mitigate credit risk is to run a credit check on a prospective client or borrower. Other risk mitigation methods include purchasing insurance, holding assets as collateral, or having the debt guaranteed by a third party. Companies may manage credit risk arising from non-payment by asking clients for advance payments, requesting payment on delivery before goods are released, or waiting to extend credit until a relationship has been established.
Reputational Risk
Reputational risk can result in the loss of social capital, market share, or financial capital from damage to an organization’s reputation. Reputational risk is challenging to predict or quantify as reputation is an intangible asset. It is, however, intrinsically tied to trust and can result in financial loss to an organization. Criminal investigations into a company or its executives, ethics violations, lack of sustainability policies, or issues related to the safety and security of either product, customer, or employees can damage an entity’s reputation.
The growth of technology and the influence of social media can now amplify minor issues, making them visible on a global scale. This has led to boycotts as a form of consumer protest. In extreme cases, severe damage to a company’s reputation could even lead to bankruptcy.
Risk Management Strategies
Many of the risks mentioned above can be avoided with an end-to-end integrated risk management system. Each company should include a risk management strategy as an essential part of its business. A comprehensive risk management strategy should incorporate the following steps.
- Identifying risks – significant risks should be reviewed regularly to avoid unexpected disasters. New threats should be immediately added to the list, with mitigating actions taken to prevent loss.
- Accessing impact and probability – as probability and result vary throughout a project timeline, it is necessary to take these factors into account when assessing risk. An original scale should be used to accurately quantify the impact and probability measures.
- Mitigating risk – mitigation measures should be implemented wherever possible to ensure that an efficient risk management team is in place and every precaution is taken.
- Calculating residual impact and probability – If a temporary solution can impose damage control, the risk will become less critical. Calculating residual impact and probability ensures that risk management is functioning well, further reducing risk impact.
- Re-classifying risk – risks are often reassessed to gauge the level of probability and potential damage arising. Once a risk is demonstrated to be less critical, risk managers can permanently shift their focus to mitigating other risks.
- Prioritizing risks – based on the previous two criteria, it is possible to create a risk matrix to rank various threats.
Risk in Project Finance
Directly financing infrastructure and industrial projects includes the following risks:
- Should the sponsor disagree with the terms of the transaction, the financial institution providing the funds can gain control of project assets.
- The project may encounter challenging social and environmental issues due to large and complex operations.
- Halting project operations can lead to legal complications, posing a direct financial risk and threatening the long-term success of the project.
- Furthermore, larger projects can experience budget overruns and can encounter issues such as:
- Delivery delays due to technical problems.
- Budget constraints
- Multiple redesigns.
Examples of Financial Risk
Currency Risk
Let’s say you are running a KFC outlet in India, where the exchange rate is 70 rupees to the USD. The restaurant has sales of ₹14,000,000 per month, or $200,000 in revenue at the current exchange rate.
Due to a deteriorating economy and rising crude oil prices, the INR/USD exchange rate has moved from ₹70 per dollar to ₹73 per dollar.
Unless the KFC outlet raises its prices, it will continue to sell ₹14,000,000 products for the month. However, that will now convert to $191,780 to the US multinational corporation. That’s a loss of 4.1% due to currency devaluation. However, had the rupee strengthened against the dollar, the KFC outlet would have increased dollar-denominated revenue for the multinational.
Credit Risk
Andrew borrows from Banc of Tallahassee. They offer him a loan at an interest rate of 13%.
This 13% interest rate consists of three parts –
- Interest that needs to be paid to depositors whose funds are lent
- Acquisition and servicing costs
- Provision for potential delays or default
The interest rate charged is determined by the credit risk of the borrower. Lending to borrowers with questionable credit ratings can lead to significant losses. High-interest rates compensate for the risk.
Risk Management – MCQ
Download the Excel files for the answer. Learn more about risk management in-depth with our project finance course.
