CU-BBA-SEM-IV-Risk management-Second draft

BACHELOR OF BUSINESS ADMINISTRATION SEMESTER-IV RISK MANAGEMENT

First Published in 2021 All rights reserved. No Part of this book may be reproduced or transmitted, in any form or by any means, without permission in writing from Chandigarh University. Any person who does any unauthorized act in relation to this book may be liable to criminal prosecution and civil claims for damages. This book is meant for educational and learning purpose. The authors of the book has/have taken all reasonable care to ensure that the contents of the book do not violate any existing copyright or other intellectual property rights of any person in any manner whatsoever. In the event, Authors has/ have been unable to track any source and if any copyright has been inadvertently infringed, please notify the publisher in writing for corrective action. 2 CU IDOL SELF LEARNING MATERIAL (SLM)

CONTENT Unit – 1: Risk Management.........................................................................................................4 Unit – 2: Management Of Risk..................................................................................................26 Unit – 3: Types Of Risks ...........................................................................................................48 Unit – 4: Methods Of Handling Risk .........................................................................................65 Unit – 5: Insurance And Risk ....................................................................................................77 Unit – 6: Basic Characteristics Of Insurance..............................................................................96 Unit – 7: Insurance And Gambling Or Hedging.......................................................................112 Unit – 8: Risk Management.....................................................................................................123 Unit – 9: Risk Management Process ........................................................................................137 Unit – 10: Risk Control And Risk Financing ...........................................................................156 Unit – 11: Sources And Measurement Of Risk ........................................................................165 Unit – 12: Instruments Of External Techniques Of Risk Management- Part1...........................178 Unit – 13: Instruments Of External Techniques Of Risk Management-Part 2...........................198 Unit – 14: Reinsurance ............................................................................................................212 3 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT – 1: RISK MANAGEMENT STRUCTURE 1.0 Learning Objectives 1.1 Introduction 1.2 Meaning and Definition of risk 1.3 Basic categories of Risk 1.3.1 Credit Risk 1.3.2 Interest Rate Risk 1.3.3 Market Risk 1.3.4 Liquidity Risk 1.3.5 Operational Risk 1.4 Summary 1.5 Keywords 1.6 Learning Activity 1.7 Unit End Questions 1.8 References 1.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Explain that the management of risk is consistent with and supports the achievement of the strategic and corporate objectives.  Interpret and provide a high-quality service to customers.  Initiate action to prevent or reduce the adverse effects of risk.  State the financial and other negative consequences of losses and claims.  Recognize to take inform decisions and make choices on possible outcomes. 4 CU IDOL SELF LEARNING MATERIAL (SLM)

1.1 INTRODUCTION The financial markets all over the world in the past decade have witnessed far reaching changes at an unprecedented pace. Increase in number of banks and financial institutions, simultaneous mergers and an acquisition is the effect of global liberalization of economy. As a result, banks and financial institutions are facing intense competition for acquiring business of both assets as well as liability side. During the period banks have witnessed increasing volatility in both domestic interest rates as well as foreign exchange rates, more particularly since last five years. The long-term health and survival of financial services entity is critically dependent on its ability to understand, appreciate, quantify, and manage the range of risks associated with its line of business, therefore, quantitative, and qualitative competence and regulatory pressure makes it mandatory to an organization to have a wide risk management framework in place. The banks or organizations that do not implement such risk management framework may be unable to compete effectively in the marketplace. The practice and implementation of risk management around the world has already evolved into complex domain, which incorporates sophisticated statistical techniques for forecasting, analyzing, and managing the risk that they are dealing with. From the literature on Risk Management, it is evident that the long-range planning and strategic planning for risk management process in organization/bank through which the future impact of managing the risk is determined and current decisions are made to reach a designed future because the concept of the risk management has far reached influence on the organization. Definition of Risk Management Risk Management refers to the identification, measurement, and treatment of exposure to potential accidental losses almost always in situations where the only possible outcomes are losses. It is a general management function that seeks to assess and address the causes and effects of uncertainty and risk on an organization. The purpose of risk management is to enable an organization to progress towards its goals and objectives in the most direct, efficient, and effective path. Risk Management is the executive function of dealing with specified risks facing the business enterprise. In general, the risk manager deals with pure, not speculative risk. Generally, risk management is defined as a systematic process for the identification and evaluation of pure loss exposures faced by an organization or individuals and for the selection and implementation of the most appropriate techniques for treating such exposures. Many risk managers use the term “loss exposure” to identify potential losses. Loss exposure is a situation or circumstance in which a loss is possible, regardless of a loss occurs. For example, defective products that may result in lawsuits against the company. 5 CU IDOL SELF LEARNING MATERIAL (SLM)

1.2 MEANING AND DEFINITION OF RISK Meaning and Scope Though the term risk has got different connotations from different angles, it can be defined as the potential that events, expected or unexpected may have an adverse impact on a bank’s earnings or capital or both. Both the risks having high probability low impact and low probability high impact are covered under the definition. This working definition would be useful throughout the discussion. It is useful to recall at this stage that risk and expected return are positively related, higher the risk, higher the expected return and vice versa. The scope of risk management function in any organization is to ensure that systems and processes are set up in accordance with the risk management policy of the institution. Objectives of Risk Management Risk management is a technique of controlling and avoiding threats to business organization. It involves determining, analyzing, and mitigating harmful risk to an organization’s capital and earnings. Risk management is a practice which is required and followed by every business irrelevant of their size and nature. It aims at recognizing the potential threats in advance and takes all necessary steps to avoid their adverse effects on business operations. These risks and unfortunate events are faced by every business organization and may harmfully affect its capital or even may lead to its permanent closure. Timely identification and prioritization of these risks are quite important which is all done by implementing risk management techniques. Risk management is a continuous process and works throughout the life of the project towards monitoring all risk factors. It focuses on controlling all possible future events by analyzing various past information like the probability of occurrence, historical data, lessons learned etc. Risk management supports the organization in the achievement of their goals by ensuring that all activities are running on their normal track. It develops a safe and secure work environment for all staff and customers and increases the stability of business operations. Objectives of Risk management are discussed in the following points:  Identifies and evaluate Risks.  Reduce and eliminate harmful risks.  Support efficient use of resources.  Better communication of risk within organization  Reassures stakeholders. 6 CU IDOL SELF LEARNING MATERIAL (SLM)

 Support continuity of organization Figure 1.1: Objectives of Risk Management Identifies And Evaluates Risk Risk management identifies and analysis various risk associated with business. It identifies risk at early stages and takes all necessary steps to avoid their harmful effects. Information from past is analyzed to recognize all possible future unfortunate events. Risk management properly evaluates risk originated in business and develops a proper understanding regarding its real causes. This all help in taking all measures in mitigating the effects of these risks. Reduce And Eliminate Harmful Threats Harmful risks and threat are part of every business organization. They have negative effect on productivity and profitability of business. Risk management techniques helps in avoiding and reducing the effect of these threats to business. Risk manager formulates strategic plans for each department and monitors their performance from time to time. 7 CU IDOL SELF LEARNING MATERIAL (SLM)

These perform series of workshop in organization to develop proper understanding regarding risk causes and how to overcome them among all employees. Managers guide them in avoiding the identified faults and reduces these harmful threats. Supports Efficient Use of Resources Risk management aims at efficient utilization of all resources. Fuller utilization leads to better productivity and increased profits. Risk management techniques support strategic planning for better results. It sets plans for functioning of business and ensures that all activities are going on their planned track. Certain targets are set for each division within organizations and perform routine check-ups from time to time. If any deviations arise, it takes all possible steps. Better Communication of Risk Within Organization Risk management develops better communication network between directors, managers, and employees. It helps in spreading all information regarding risk easily around the organization timely. All people can interact with each other effectively and discuss about core solution about this risk. This helps in better understanding of several threats and taking timely action against them. Reassures Stakeholders Stakeholders are an important part of every business organization. Business must aim at serving the interest of its stakeholders for their support. Risk management helps in increasing the confidence of stakeholders in business and assures them of non-occurrence of any unfortunate incident. They feel safe by the implementation of risk management techniques that will timely control and avoid all harmful risk. This leads to better trust among business and its stakeholders. Support Continuity of Organization Risk management has an efficient role in long term growth and survival of the business. Every business faces several risk and unfortunate events during its life cycle. These unfortunates, if not treated timely, will affect the organization capital and profit, or even leads to its termination. It avoids all these risks by monitoring continuously the operations throughout the life of the project. It reduces anxiety by overcoming all fear of uncertainty and develops a safe working environment within the organization. This increases the productivity and overall stability of business organizations. Risk Management Process The very basic objective of risk management system is to put in place and operate a systematic process to give a reasonable degree of assurance to the top management that the ultimate 8 CU IDOL SELF LEARNING MATERIAL (SLM)

corporate goals that are vigorously pursued by it would be achieved in the most efficient manner. In this way, all the risks that come in the way of the institution achieving the goals it has set for itself would be managed properly by the risk management system. In the absence of such a system, no institution can exist in the long run without fulfilling the objectives for which it was set up. Whether the concern is with a business or an individual situation, the same general steps can be used to analyze systematically and deal with risk. This is known as risk management process. The risk management process has five steps to be implemented by the risk manager:  Risk identification  Risk measurement  Identifying the tools of risk management  Selection of risk tools  Risk implementation Figure 1.2: Risk management process 1. Identifying the Potential Losses: (Risk Identification) Risk identification is the process by which a business systematically and continually identifies property, liability, and personnel exposures as soon as or before they emerge. The risk manager tries to locate the areas where losses could happen due to a wide range of perils. Unless the risk 9 CU IDOL SELF LEARNING MATERIAL (SLM)

manager identifies all the potential losses confronting the firm, he or she will not have any opportunity to determine the best way to handle the undiscovered risks. To identify all the potential losses the risk manager needs first a checklist of all the losses that could occur to any business. Second, he or she needs a systematic approach to discover which of the potential losses included in the checklist are faced by his/her business. The risk manager may personally conduct this two-step procedure or may rely upon the services of an insurance agent, broker, or consultant. Generally, a risk manager has several sources of information that can be used to identify major and minor loss exposures. They are as follows:  Physical inspection of company plant & machineries can identify major loss exposures.  Extensive risk analysis questionnaire can be used to discover hidden loss exposures that are common to many firms.  Flow charts that show production and delivery processes can reveal production bottlenecks where a loss can have severe financial consequences to the firm.  Financial statements can be used to identify the major assets that must be protected.  Departmental & historical claims data can be invaluable in identifying major loss exposures. Risk managers must also be aware of new loss exposures that may be emerging. More recently, misuse of the internet and e-mail transmissions by employees have exposed employers to potential legal liability because of transmission of pornographic material and theft of confidential information. 2. Evaluating Potential Losses (Risk Measurement) The second step in the risk management process is to evaluate and measure the impact of losses on the firm. This involves an estimation of the potential frequency and severity of loss. Loss frequency refers to the probable number of losses that may occur during some given period, while loss severity refers to the probable size of the losses that may occur. Once the risk manager estimates the frequency and severity of loss for each type of loss exposure, the various loss exposures can be ranked according to their relative importance. Both loss frequency and loss severity data are needed to evaluate the relative importance of an exposure to potential loss. However, the importance of an exposure depends mostly upon the potential loss severity not the potential frequency. A potential loss with catastrophic possibilities although infrequent, is far more serious than one expected to produce frequent small losses and no large losses. On the other hand, loss frequency cannot be ignored. If two exposures are 10 CU IDOL SELF LEARNING MATERIAL (SLM)

characterized by the same loss severity, the exposure whose frequency is greater should be ranked more important. There is no formula for ranking the losses in order of importance, and different persons may develop different rankings. The rational approach, however, is to place more emphasis on loss severity. Risk Measurement and Probability Distribution A more sophisticated way to measure potential losses involves probability distributions. However, this method is more difficult to explain, and the data needed to construct the required probability distribution are commonly not available. Nevertheless, probability distributions make possible more comprehensive risk measurements than other techniques; and, they are becoming a more common tool of modern management, and data sources are improving. Furthermore, probability distributions improve one's understanding of the more popular risk measurements and are extremely useful in determining which risk management devices would be best in each situation. A probability distribution shows for each possible outcome, its probability of occurrence. It is used to estimate numerically the potential loss from a risk. Using the probability distribution, it is possible to measure the various aspects of a risk, such as:  The total losses per period  The number of occurrences per period  The total losses per occurrence The probability distribution of the total dollar losses per year shows each of the total dollar losses that the business may experience in the coming year and the probability that each of these totals might occur. For example, assume that: i. a business has five cars, each of which is valued at 10,000 Birr. ii. each car may be involved in more than one collision a year: and iii. The physical damage may be partial or total. Also assume prompt replacement of any car that goes out of service, thus reducing net income losses to a minimal level. A hypothetical probability distribution that might apply in this situation is shown below: 11 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 1.3: A hypothetical probability distribution If the risk manager can estimate accurately the probability distribution of the total dollar losses per year, he or she can obtain useful information concerning:  The probability that the business will incur some dollar loss,  The probability that \"severe (greater or equal to 5,000)\" losses will occur,the average loss per year, and The risk or variation in the possible results. 3. Tools of Risk Management The third step is to identify the available tools of risk management. The major tools of risk management are the following:  Avoidance  Loss control  Retention  Non-insurance transfers  Insurance Avoidance and Loss control are called risk control techniques because they attempt to reduce the frequency and severity of accidental losses to the firm. On the other hand, retention, non- insurance transfers and insurance are called risk financing techniques, because they provide for the funding of accidental losses after they occur.  Avoidance: Avoidance means that a certain loss exposure is never acquired (refusal), or an existing loss exposure is abandoned. For example, a firm can avoid earthquake loss by not building a plant in an earthquake prone area. An existing loss exposure may also be abandoned. For example, a pharmaceutical firm that produces a drug with dangerous side effects may stop 12 CU IDOL SELF LEARNING MATERIAL (SLM)

manufacturing that drug. The major advantage of avoidance is that the chance of loss is reduced to zero if the loss exposure is not acquired. In addition, if an existing loss exposure is abandoned, the possibility of loss is either eliminated or reduced because the activity that could produce a loss has been abandoned. However, avoidance has two disadvantages. First, it may not be possible to avoid all losses. For example, a company cannot avoid the pre-mature death of a key executive. Second, it may not be practical or feasible to avoid the loss exposure. In the above said example, the pharmaceutical company can avoid losses arising from the production of a particular drug. However, without any drug production, the firm will not be in business.  Loss Control: It is another method of handling loss in a risk management program. Loss control measures attack risk by lowering the chance a loss will occur (loss frequencies) or by reducing the amount of damage when the loss does occur (loss severity). Loss control tools can be classified as: loss prevention and loss reduction measures. The following are the examples that illustrate how loss control measures reduce the frequency and severity of losses. Measures that prevent loss frequency are quality control checks, driver examination, strict enforcement of safety rules and improvement in product design. Measures that reduce loss severity are the installation of an automatic sprinkler or burglar alarm system, employing fire extinguishers, early treatment of injuries and rehabilitation of injured workers.  Retention: Retention means that the firm retains part or all the losses that result from a given loss exposure. It can be effectively used when three conditions exist. First, no other method of treatment is available. Insurers may be unwilling to write certain type of coverage. Non-insurance transfers may not be available. In addition, although loss control can reduce the frequency of loss, all losses cannot be eliminated. In these cases, retention is a residual method. If the loss exposure cannot be insured or transferred, then it must be retained. Second, the worst possible loss is not serious. For example, physical damage losses to automobiles in a large firm’s fleet will not bankrupt the firm. Finally, losses are highly predictable. Retention can be effectively used for workers compensation claims, physical damage losses to automobiles, etc. Based on experience, the risk manager can estimate a probable range of frequency and severity of actual losses. 13 CU IDOL SELF LEARNING MATERIAL (SLM)

Determining Retention Levels: If retention is used, the risk manager must determine the firm’s retention level, which is the Dollar / Birr amount of losses that the firm will retain. A financially strong firm can have a higher retention level than one whose financial position is weak. Though there are many methods of determining retention level, the following two methods are very important. First, a corporation can determine the maximum uninsured loss it can absorb without adversely affecting the company’s earnings can dividend policy. One rough rule is that the maximum retention can be set at 5% of the company’s annual earnings before taxes from current operations. Second approach is to determine the maximum retention as a percentage of the firm’s net working capital, such as between 1% and 5%. Although this method does not reflect the firm’s overall financial position for absorbing a loss, it measures the firm’s ability to fund a loss. Paying Losses: If retention is used, the risk manager must have some method for paying losses. Normally, a firm can pay losses by one of the following three methods: The firm can pay losses out of its current net income, with the losses treated as expenses for that year. However, many losses could exceed current net income. Then, other assets may have to be liquidated to pay losses. Another method is to borrow the necessary funds from a bank. A line of credit is established and used to pay losses as they occur. However, interest must be paid on the loan and loan repayments can aggravate cash flow problems the firm may have. Another method for paying losses is an unfunded or funded reserve. An unfounded reserve is a bookkeeping account that is charged with the actual or expected losses from a given risk exposure. A funded reserve is the setting aside of liquid funds to pay losses. Private employers do not use funded reserve, in their risk management programs, because the funds may yield higher return if it is used in the business. Advantages of Retention: The firm can save money in the long run if its actual losses are less than the loss allowance in the insurer’s premium. The services provided by the insurer may be provided by the firm at a lower cost. Some expenses may be reduced, including loss-adjustment expenses, general administrative expenses, commissions, and brokerage, etc. 14 CU IDOL SELF LEARNING MATERIAL (SLM)

Since the risk exposure is retained, there may be greater care for loss prevention. Cash flow may be increased since the firm can use the funds that normally would be held by the insurer. Disadvantages of Retention: The losses retained by the firm may be greater than the loss allowance in the insurance premium that is saved by not purchasing the insurance. Expenses may be higher as the firm may have to hire outside experts such as safety engineers. Thus, insurers may be able to provide loss control services less expensively. Income taxes may also be higher. The premiums paid to an insurer are income-tax deductible. However, if retention is used, only the amounts actually paid out for losses are deductible. Contributions to a funded reserve are not income-tax deductible.  Non-Insurance Transfers: Non-insurance Transfers is another method of handling losses. Non-insurance transfers are methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party. Examples of non-insurance transfers include contracts, leases, and hold-harmless agreements. For example, a company’s contract with a construction firm to build a new plant can specify that the construction firm is responsible for any damage to the plant which it is being built. A firm’s computer lease can specify that maintenance, repairs, and any physical damage loss to the computer are the responsibility of the computer firm. Otherwise, a firm may insert a hold-harmless clause in a contract, by which one party assumes legal liability on behalf of another party. Thus, a publishing firm may insert a hold-harmless clause in a contract, by which the author and not the publisher is held legally liable if anybody sued the publisher. Advantages of Non-Insurance Transfers: The risk manager can transfer some potential losses that are not commercially insurable. Non-Insurance transfers often cost less than insurance. The potential loss may be shifted to someone who is in a better position to exercise loss control. Disadvantages of Non-Insurance Transfers: The transfer of potential loss would become impossible if the contract language is ambiguous. 15 CU IDOL SELF LEARNING MATERIAL (SLM)

If the party to whom the potential loss is transferred is unable to pay the loss, the firm is still responsible for the claim. Non-Insurance Transfers may not always reduce insurance costs since an insurer may not give credit for the transfers.  Insurance: Insurance is also used in a risk management program. Insurance is appropriate for loss exposures that have a low probability of loss, but the severity of loss is high. If the risk manager uses insurance to treat certain loss exposures, five key areas must be emphasized. They are as follows:  Selection of insurance coverage  Selection of an insurer  Negotiation of terms Dissemination of information concerning insurance coverages. Periodic review of the insurance program 4. Selection of Risk Management Tools: Type of Loss Loss Frequency Loss Severity Appropriate Risk Management Technique 1 Low Low Retention 2 High Low Loss Control & Retention Insurance 3 Low High Avoidance 4 High High Table 1.1: Risk Management Matrix In determining the appropriate method or methods of handling losses, the above matrix can be used. It classifies the various loss exposures according to frequency and severity. The first loss exposure is characterized by both low frequency and low severity of loss. One example of this type of exposure would be the potential theft of a secretary’s Note pad. This type of exposure can be best handled by retention since the loss occurs infrequently and when it occurs it does not cause financial harm. The second type of exposure is more serious. Losses occur frequently, but severity is relatively low. Examples of this type of exposure include physical damage losses to automobiles, 16 CU IDOL SELF LEARNING MATERIAL (SLM)

shoplifting and food spoilage. Loss control should be used here to reduce the frequency of losses. In addition, since losses occur regularly and are predictable, the retention technique can also be used. The third type of exposure can be met by insurance. Insurance is best suited for low frequency, high severity losses. High severity means that a catastrophic potential is present, while a low probability of loss indicates that the purchase of insurance is economically feasible. Examples include fires, explosion, and other natural disasters. Here, the risk manager could also use a combination of retention and insurance to deal with these exposures. The fourth and most serious type of exposure is characterized by both high frequency and high severity. This type of risk exposure is best handled by avoidance. For example, if a person has drunken and if he attempts to drive home in that drunken stage, the chance of meeting with an accident is more. This loss exposure can be avoided by not driving at the drunken stage or by having a driver to drive his car. 5. Risk Administration: The next and the final step in the risk management process is implementation and administration of the risk management program. It involves three important components.  Risk management policy statement  Co-operation with other departments  Periodic review and evaluation  Risk management policy statement: A risk management policy statement is necessary to have an effective risk management program. This statement outlines the risk management objectives of the firm, as well as company policy with respect to the treatment of loss exposures. It also educates top level executives regarding the risk management process and gives the risk manager greater authority in the firm. In addition, a risk management manual may be developed and used in the program. The manual describes the risk management program of the firm and can be a very useful tool for training new employees who will be participating in the program.  Co-operation with other departments: The risk manager must work in co-operation with other functional departments in the firm. It will facilitate to identify pure loss exposures and methods of treating these exposures. The Accounting Department can adopt Internal Accounting Controls to reduce employee’s fraud and theft of cash. The Finance Department can provide information showing how losses can disrupt profits and cash flow. The Marketing Department can prevent liability suits by ensuring accurate packaging. Besides, safe distribution procedures can prevent accidents. The Production Department must ensure quality control and effective safety programs in the plant can reduce 17 CU IDOL SELF LEARNING MATERIAL (SLM)

injuries and accidents. The Personnel Department may be responsible for employee benefit program, pension program and safety program.  Periodic review & evaluation: The risk management program must be periodically reviewed and evaluated to see whether the objectives are being attained or not. Especially, risk management costs, safety programs and loss preventive programs must be carefully monitored. Loss records must also be examined to detect any changes in frequency and severity. Finally, the risk manager must determine whether the firm’s overall risk management policies are being carried out, and whether the risk manager is receiving the total co-operation of the other departments in carrying out the risk management functions. Types of Risk Broadly speaking, there are two main categories of risk: systematic and unsystematic. Systematic risk is the market uncertainty of an investment, meaning that it represents external factors that impact all (or many) companies in an industry or group. Unsystematic risk represents the asset- specific uncertainties that can affect the performance of an investment. Below is a list of the most important types of risk for a financial analyst to consider when evaluating investment opportunities:  Systematic Risk – The overall impact of the market  Unsystematic Risk – Asset-specific or company-specific uncertainty  Political/Regulatory Risk – The impact of political decisions and changes in regulation  Financial Risk – The capital structure of a company  Interest Rate Risk – The impact of changing interest rates  Country Risk – Uncertainties that are specific to a country  Social Risk – The impact of changes in social norms, movements, and unrest  Environmental Risk – Uncertainty about environmental liabilities or the impact of changes in the environment  Operational Risk – Uncertainty about a company’s operations, including its supply chain and the delivery of its products or services  Management Risk – The impact that the decisions of a management team have on a company  Legal Risk – Uncertainty related to lawsuits or the freedom to operate 18 CU IDOL SELF LEARNING MATERIAL (SLM)

 Competition – The degree of competition in an industry and the impact choices of competitors will have on a company TYPES OF RISK Systemati Interest c Risk Rate Risk Unsystematic Political/ Financial Country Risk Regulatory Risk Risk Risk Social Risk Management Legal risk Competition Risk n Environment al Risk Operational Risk Figure.1.4: Flowchart depicting types of risk 1.3 BASIC CATEGORIES OF RISK Banking risks can be broadly categorized as under:  Credit Risk  Interest Rate Risk  Market Risk  Liquidity Risk  Operational Risk 1.3.1Credit Risk: Credit risk is the oldest risk among the various types of risks in the financial system, especially in banks and financial institutions due to the process of intermediation. Managing credit risk has formed the core of the expertise of these institutions. While the risk is well known, growth in the markets, disintermediation, and the introduction of several innovative products and practices has 19 CU IDOL SELF LEARNING MATERIAL (SLM)

changed the way credit risk is measured and managed in today’s environment. Studies carried out on bank failures in the U.S. show that credit risk alone has accounted for 71% of large bank failures in the period from 1980 to 2004. Simon Hills of the British Bankers Association defines credit risk “is the risk to a bank’s earnings or capital base arising from a borrower’s failure to meet the terms of any contractual or other agreement it has with the bank. Credit risk arises from all activities where success depends on counterparty, issuer or borrower performance”. Credit risk enters the books of a bank the moment the funds are lent, deployed, invested, or committed in any form to counterparty whether the transaction is on or off the balance sheet. 1.3.2 Interest Rate Risk: Interest Rate Risk (IRR) arises because of change in interest rates on rate earning assets and rate paying liabilities of a bank. The scope of IRR management is to cover the measurement, control, and management of IRR in the banking book. With the deregulation of interest rates, the volatility of the interest rates has risen considerably. This has transformed the business of banking forever in our country from a mere volume driven business to a business of carefully planning and choosing assets and liabilities to be entered into to achieve targets of profitability. There are two basic approaches to IRR. They are:  Earnings Approach, and  Economic Value Approach. 1.3.3 Market Risk: Traditionally, credit risk management was the primary challenge for banks. With progressive deregulation, market risk arising from adverse changes in market variables, such as interest rate, foreign exchange rate, equity price and commodity price has become relatively more important. Even a small change in market variables causes substantial changes in income and economic value of banks. Market risk takes the form of:  Liquidity Risk,  Interest Rate Risk  Foreign Exchange Rate (Forex) Risk,  Commodity Price Risk, and  Equity Price Risk 1.3.4 Liquidity Risk: Liquidity risk is defined as the possibility that the bank would not be able to meet the commitments in the form of cash outflows with the available cash inflows. This risk arises 20 CU IDOL SELF LEARNING MATERIAL (SLM)

because of inadequacy of cash available and near cash item including drawing rights to meet current and potential liabilities. Liquidity risk is categorized into two types.  Trading Liquidity Risk; and  Funding Liquidity Risk. Trading liquidity risk arises because of illiquidity of securities in the trading portfolio of the bank. Funding liquidity risk arises because of the cash flow mismatch and is an outcome of difference in balance sheet strategies pursued by different institutions in the same industry. It is perfectly possible for a few banks to have excess funding liquidity while other banks may suffer shortage of liquidity. 1.3.5 Operational Risk: Operational risk is emerging as one of the important risks financial institutions worldwide are concerned with. Unlike other categories of risks, such as credit and market risks, the definition and scope of operational risk is not fully clear. Several diverse professions such as internal control and audit, statistical quality control and quality assurance, facilities management, and contingency planning, etc., have approached the subject of operational risk thereby bringing in different perspectives to the concept. While studies carried out on bank failures in the U.S. show that operational risk has accounted for an insignificant proportion of large bank failures so far, it is widely acknowledged that most of the new, unknown risks are under the category of operational risk. According to the Basel Committee, Operational risk is defined as “the risk of loss resulting from inadequate or failed processes, people and systems or external events. This definition includes legal risk but excludes strategic and reputational risk” (The New Basel Capital Accord, Consultative Document released in April 2003). 1.4 SUMMARY  The art of risk management is to strike a balance with risk limiting rules and ability to develop business between the disclosure of risks and the management incentive in force within the organization..  It is very important for an organisation to frame and implement various risk management policies depending upon the line of business.  The Indian financial markets are passing through a radical change due to opening up of economy.  The spreads are becoming thinner and consequently thinning and risk 21 CU IDOL SELF LEARNING MATERIAL (SLM)

management has attained paramount importance. Risk Management assumes identification of various risks and strategies to cope up with risks. Risk are financial as well as nun-financial. Financial risks include market risk, credit risk, liquidity risk, operational risk and legal risk. Non-financial risk includes, business risk and strategic risk.  Occurrence of risk is stimulated by several factors. Most often the risks faced in any project are financial, environmental (surrounding location of project and overall regulations), time, design and quality. The technology used for Construction and the internal environment also contributes to risk which can have substantial bearing on the outcome of a project.  Risk management is the process of identification, analysis, and acceptance or mitigation of uncertainty in investment decisions.  Risk is inseparable from return in the investment world.  A variety of tactics exist to ascertain risk; one of the most common is standard deviation, a statistical measure of dispersion around a central tendency.  Beta, also known as market risk, is a measure of the volatility, or systematic risk, of an individual stock in comparison to the entire market.  Alpha is a measure of excess return; money managers who employ active strategies to beat the market are subject to alpha risk.  In the financial world, risk management is the process of identification, analysis, and acceptance or mitigation of uncertainty in investment decisions. Essentially, risk management occurs when an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment, such as a moral hazard, and then takes the appropriate action (or inaction) given the fund's investment objectives and risk tolerance. 1.5 KEYWORDS  Liquidity Risk : The funding risk. Liquidity is the ability of a firm, company, or even an individual to pay its debts without suffering catastrophic losses. Conversely, liquidity risk stems from the lack of marketability of an investment that can't be bought or sold quickly enough to prevent or minimize a loss.  Risk : A Risk can be defined as an unplanned event with financial consequences resulting in loss or reduced earnings. Risk is defined in financial terms as the chance that an 22 CU IDOL SELF LEARNING MATERIAL (SLM)

outcome or investment's actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment.  Systemlc Risk : The risk that a specific large counterparty a certain market should experience a crisis and that there will be wide spread spill over into the financial markets. Systemic risk is the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy. Systemic risk was a major contributor to the financial crisis of 2008. Companies considered to be a systemic risk are called \"too big to fail.\"  Derivative : A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset (like a security) or set of assets (like an index). Common underlying instruments include bonds, commodities, currencies, interest rates, market indexes, and stocks.  Counterparty : The term counterparty can refer to any entity on the other side of a financial transaction. ... In any instances where a general contract is met or an exchange agreement takes place, one party would be considered the counterparty, or the parties are counterparties to each other. 1.6 LEARNING ACTIVITY 1. Conduct a survey on nearby store and analyze how they prevent risk. ______________________________________________________________________________ ______________________________________________________________________________ 2. Carry out research on how multinational companies identify and measure any kind of risk. _____________________________________________________________________________ _____________________________________________________________________________ 1.7 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Describe the reduction of risk. 2. Describe risk minimization. 3. Describe transfer of risk. 4. Describe risk elimination. 23 CU IDOL SELF LEARNING MATERIAL (SLM)

5. How does the risk management process start? Long Questions 1. What do you mean by Risk Management? Explain giving reasons. 2. Describe the Risk Management framework. 3. What are the different types of risks that banks are exposed to in the present-day context? 4. What is the difference between non-financial and financial risks? 5. Can a market risk lead to credit risk? If so, under what circumstances? B. Multiple Choice Questions 1. Risk management can be defined as the art and science of _________ risk factors throughout the life cycle of a project. a. Researching, reviewing, and acting on b. Identifying, analysing, and responding to c. Reviewing, monitoring, and managing d. Identifying, reviewing, and avoiding 2. Risk Management includes all the following processes except: a. Risk Monitoring and Control b. Risk Identification c. Risk Avoidance d. Risk Response Planning 3. When should a risk be avoided? a. When the risk event has a low probability of occurrence and low impact b. when the risk event is unacceptable generally one with a very high probability of occurrence and high impact c. When it can be transferred by purchasing insurance d. A risk event can never be avoided 4. A risk response which involves eliminating a threat is called: 24 a. Mitigation b. Deflection c. Transfer CU IDOL SELF LEARNING MATERIAL (SLM)

d. Both b and c 5. Suppose a project has many hazards that could easily injure one or more persons and there is no method of avoiding the potential for damages. The project manager should consider __________ as a means of deflecting the risk. a. abandoning the project b. buying insurance for personal bodily injury c. establishing a contingency fund d. establishing a management reserve Answers 1-a, 2-c, 3-b, 4-d, 5-b 1.8 REFERENCES References  Risk Management Systems in Banks, Guidelines by Reserve Bank of India (1999).  Trivedi and Hassan. Treasury Operations and Risk Munagetneni, Genesis Publishers, Mumbai.  Banking in New Millenium: Report on Conference of Chairman of Bank, NIBM Textbooks  Bhardwaj, H.P. Foreign Exchange Handbook. Bhardwai Publishing Company,Mumbai .  Joel Bessis. (1998). Risk Management in Banking, Mls John Willy Sons, New York,U.S.A.  Rajwade A.V. (2000). Foreign Exchange lnfemalional Finance: Risk Management  Academy of Business Studies, Ansari Road. New Delhi. Websites  https://www.researchgate.net/publication/331783796_Process_of_Risk_Management  http://www.rspa.com  http://www.ieee.org 25 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT – 2: MANAGEMENT OF RISK STRUCTURE 2.0 Learning Objectives 2.1 Introduction 2.2 Managing Risk 2.3 Sources of Risk 2.3.1 Data and Methodology 2.3.2 Results and Discussion 2.3.3 Factor Analysis 2.4 Measurement of Risk 2.4.1 Economic Risks 2.4.2 Industry Risks 2.4.3 Company Risks 2.4.4 Asset Class Risks 2.4.5 Market Risks 2.5 Summary 2.6 Keywords 2.7 Learning Activity 2.8 Unit End Questions 2.9 References 2.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Identify Risk Management Concepts and strategies to manage such risks;  Examine Risk Monitoring, Technology Risk, Risk Components and Drivers, Customer Related Risks;  Elaborate Basic Concepts of Project Scheduling and Tracking, 26 CU IDOL SELF LEARNING MATERIAL (SLM)

 Examine knowledge of Software Testing Fundamentals. 2.1 INTRODUCTION Enterprise Risk Management (ERM) is a field of enormous importance due to its increasing complexity and obvious economic value. More and more companies are paying attention to it, given there is not only a significant economic reward for attending to the various aspects of risk (Kauf, 1978), but that what constitutes Enterprise Risk Management has itself undergone significant change. ERM has witnessed a shift in the way firms manage the many uncertainties that stand in the way of achieving their strategic, operational, and financial objectives. “Band- Aid” approaches to risk management – with each risk considered in isolation and only when it occurs – have been replaced with more holistic methods, looking at risks as they are integrated and interrelated across the entire organization and managing risk response strategies well before they are necessary (Nordblad, 1982). Many organizations have begun to recognize both value in and the need to change to this more complex model and approach. Nevertheless, there are few tools available in the market capable of supporting the complex decision process involved. Every enterprise is unique: their business models differ, the types of products and services lifecycles are context driven, organizational charts are diverse, and their motivation for overall business style are not the same. However, most of them have as their bottom line, the same pursuit for economic success, so their objects of interest may not be the same, but their ultimate aims are. Given that ERM now recognizes that there is greater variety and increasing number and interaction of risks facing organizations (Coopers and Lybrand, 1997), it is surprising that the few software applications which claim to help to manage the risks are not designed to cope with these enormous differences, even though their commonalities are the really important point here. Risk management occurs everywhere in the realm of finance. It occurs when an investor buys U.S. Treasury bonds over corporate bonds, when a fund manager hedges his currency exposure with currency derivatives, and when a bank performs a credit check on an individual before issuing a personal line of credit. Stockbrokers use financial instruments like options and futures, and money managers use strategies like portfolio diversification, asset allocation and position sizing to mitigate or effectively manage risk. Hence, there is a need for a new sort of Risk Management Information System (RMIS) to fill this void. What is needed is a system designed with one important thought in mind: to be powerful enough to model all the complexity and diversity of the risk management process, but also flexible enough to be adapted to any company and therefore any type of risk, not just the familiar ones, regardless of their business domain. 27 CU IDOL SELF LEARNING MATERIAL (SLM)

This innovative RMIS needs be designed to be a tool for the expert user who will use it to spell out the company’s specific risk situations and their relevant and complex properties from an expert point of view. It should also be important to be able to define the insurance policies contracted to protect those resources from the consequences of potentially harmful events, whichever these might be, for each case. But it would be a tool for the non-expert user as well, the kind of user who must deal with accident reports and tracking for example, having little or no expert knowledge regarding coverage and warranties. Risk is inseparable from return. Every investment involves some degree of risk, which is considered close to zero in the case of a U.S. T-bill or very high for something such as emerging- market equities or real estate in highly inflationary markets. Risk is quantifiable both in absolute and in relative terms. A solid understanding of risk in its different forms can help investors to better understand the opportunities, trade-offs, and costs involved with different investment approaches. An example of risk management is when a bank employee reviews a potential loan to determine what the chances are that the buyer won't pay it back in order to decide how to proceed with granting the loan and how much to charge in interest. 2.2 MANAGING RISKS A software engineering project is expected to produce a reliable product, within a limited time, using limited resources. Any project, however, runs the risk of not producing the desired product, overspending its allotted resource budget, or overrunning its allotted time. Risk accompanies any human activity. Risk analysis and control is a topic of management. Several standard techniques exist for identifying project risks, assessing their impact, monitoring, and controlling them. Knowledge of these techniques allows a project manager to apply them when necessary to increase the chances of success of a project. We have already seen in previous sections, many examples of software development problems that can be viewed from a risk analysis point of view. For example, we have discussed the difficulties of specifying project requirements completely. Given these difficulties, a project runs the risk of producing the wrong product or having the requirements change during development. An effective approach for reducing this risk is prototyping or incremental delivery. A different type of approach to handling the risk of late changes in the requirements is to produce a modular design so that such changes can be accommodated by actual changes to the software. Of these approaches, prototyping tries to minimize changes in the requirements, while modular design tries to minimize the impact of changes in the requirements. Choosing between the two 28 CU IDOL SELF LEARNING MATERIAL (SLM)

alternatives, or deciding to use both, should involve a conscious and systematic analysis of the possible risks, their likelihood, and their impact. Risks exist in all industries. Organizations across different sectors need to understand the various threats they face, now and in the future, and risk management examples to come up with different ways to manage those risks. Different companies have different challenges and priorities when it comes to risk management. For example, when it comes to banks, according to a recent study, it was noted that banks rank their biggest risk management challenges as:  Operational risk, which would include risks to cybersecurity and other third-party risks  Risk dealing with compliance  Credit risk These examples are just a few types of risks that organizations need to consider when they want to implement their risk management system. When companies have their risk management priorities, it will help them find a system that meets their needs best. When it comes to financial institutions, for example, their top risk management priorities are considered to be:  Improving the quality of data  Making the data more readily available  Creating more accurate timeliness of risk data  Improving existing risk information systems as well as the technology infrastructure to combat it Risk Management Now that there is a better understanding of what companies faces types of risks and what is considered to be a priority, it would only be beneficial if companies had a better idea of the examples of risks they could face. Mentioned below in the article, we have some of the most common examples of risk management and what they mean. At different levels of an organization, different levels of risks can be tolerated. For example, a project manager may not want to tolerate any delay in the schedule, while another member at the level of team leader might be more concerned with the reliability of the product. A project manager might not be able to tolerate the risk of running over budget by more than 10% while a higher-level manager who is more aware of the value of early entry into market may be more concerned with the time taken by the project and might be willing to overspend the budget by much more if the product can be produced sooner. 29 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 2.1: Risk management strategic options 2.3 SOURCES OF RISK There is much literature on risk sources that impact farming operations and their risk management strategies. Flaten et al. argued that the assessment of farmers’ perceptions and how they respond to risk are very important because this can describe the decision-making behavior of farmers when faced with risky situations. Similarly, that “the welfare of the farm family and the survival of farm business may depend on how well farming risks are managed”. 30 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 2.2: Sources of risk 2.3.1 Data and Methodology The sources of risk and their preferred risk management strategies are obtained from face to-face interviews of 800 farmers, 400 each in the central and northeast regions of Thailand. The central and north-east regions differ in terms of resources, economic development, and income distribution. The central region has a farming area of 8.61 million acres or 19.2 percent of the total farming area. In 2007, the average monthly income per farm. The central region is known as the ‘rice bowl of Thailand’ and more than half of the country’s irrigation systems are in this region known for wet-rice cultivation. In contrast, the north-east region is defined as the ‘poorest region’ with a long dry season and an annual rainfall that fluctuates widely each year. (13, 18) Approximately 45per cent of the total farming area in Thailand is in this region. In 2007, the average monthly income per farm in this region is 8,344 baht. A smallholder farmer is defined as a farmer who has a farming area less than 30 rai (4.8 ha). Purposive random sampling was employed to classify a particular group of respondents from a certain portion of the population. The sample selection process is as follows. First, the provinces in each region were separated into two main groups: (a) the provinces with large and medium irrigation systems and (b) the provinces in the rain-fed area. Second, purposive sampling was employed to select smallholder farmers in each group. This procedure ensured that the sample covered smallholder farmers of both the irrigated and rain-fed areas in the central and north-east regions. 2.3.2 Results and discussion 31 CU IDOL SELF LEARNING MATERIAL (SLM)

The household and farm characteristics of the central and north-east region farmers are presented in below shows that except for gender, household size and finance used for the farm business, central and north-east region farmers generally differ in terms of personal 454 Risk Management – Current Issues and Challenges and farm characteristics, and income distribution. The age group distribution indicates that most of the farmers in both regions were over 40 years old. Around 40 per cent of the northeast region farmers were over 60 years old, whereas 42 per cent of the central region farmers were between 41-50 years old. The age distribution between the farmers in both regions was significantly different with the north-east region farmers more likely to be older than the central region farmers. Nearly half of the farmers in the north-east had been involved in agricultural work for over 40 years which implies that younger farmers are rare especially in the north-east. This may be a result of the rural-to-urban migration problems in Thailand. Around 75 per cent of the farmers in both regions graduated with a primary education and about three per cent were illiterate. The result indicates that the central region farmers had higher levels of education than the north-east farmers (P<0.01). Mustafa argued that the educational level of farmers affected their decision-making capacity. (30) A higher educated farmer was expected to perform better than an uneducated farmer in terms of management skills and farm resource allocation to maximize farm profitability. The average farm size of the farmers in the central region was 21.40 rai (3.42 ha) of which 30 per cent was self-lease operated. In contrast, farmers in the north-east had an average farm size of 14.80 rai (2.37 ha) of which 90 per cent was self-owned. This result indicates that the central region farmers hold average farm sizes larger than north-east farmers (P<0.01). This is consistent with the Office of Agricultural Economics who reported that farmers in the central region usually had an average farm size larger than the north-east farmers. The results for the average net farm income between the farmers in the central and northeast regions were statistically significant at the one per cent level. This result indicated that the average net farm income of the central farmers was larger than for the north-east farmers. In 2008, the central farmers had an average net farm income of 166,445.05baht/household, whereas the average net farm income of the north-east farmers was only42, 632.80 baht/household. In addition, approximately 63 per cent of the central region farmers worked off-farm, which was significantly more than for the north-east farmers (P<0.01). The results also showed that central farmers had significantly higher annual household incomes than north-east farmers. In terms of farmer access to credit, nearly 70 per cent of the farmers in the central and northeast regions had loans and nearly half of them borrowed from the Bank of Agriculture and Agricultural Cooperatives. Examples of External Sources of Risk Economic o Availability, liquidity, market factors, competition Social  Consumer tastes, citizenship, privacy, terrorism, demographics Equity 32 CU IDOL SELF LEARNING MATERIAL (SLM)

 Social/economic/environmental injustices, racial profiling, unequal access, conscious and unconscious bias, institutional racism, underrepresentation Technology  New entrants/substitutes, interruptions, process, IT innovations, loss of data, system integrations, various security threats (malware, hacking), service downtime Environmental  Natural disaster, energy and waste, sustainable development, effects of climate change Political o Government stability/change, legislation, public policy, regulation Examples of Internal Sources of Risk Infrastructure  Availability/capability of assets, real property, complexity, failures Personnel  Leadership and staff succession, employee capability, fraudulent activity, health and safety Equity  Inequitable hiring practices, acts of discrimination and harassment, unequal access, micro inequities, institutional racism, underrepresentation Finance  Budget/rates, financial loss Process of Capacity, design, execution, suppliers/dependencies, operational efficiencies Technology  Data integrity/availability, system development/selection/deployment/ maintenance, data quality and completeness 2.3.3 Factor Analysis In this section, the results of the factor analysis of sources of risk and risk management strategies are discussed. Exploratory factor analysis with varimax orthogonal rotation. Current Issues and Challenges was applied to the data using SPSS version 15. Exploratory factor analysis is used to Exploratory factor analysis is used to reduce the number of sources of risk and risk management strategies for each group of farmers. Sources of risk The rotated factor loadings of risk sources for all farmers in the central and north-east regions, obtained from the principal component analysis and a varimax orthogonal rotation, are discussed in this section. The KMO measure of data sufficiency was 0.779 and the Bartlett’s Test of Sphericity achieved statistical significance (χ2 = 4927.58, P<0.01), both indicating that the data set was appropriate for factor analysis. However, the preliminary results indicated three sources of risk including ‘accidents or problems with health’, ‘deficiency rainfall’ and ‘changes in technology or breeding’ should be eliminated from the factor analysis because of their low communalities (<0.40). (28) Following this, iteration of varimax orthogonal rotation was performed. 33 CU IDOL SELF LEARNING MATERIAL (SLM)

The results are presented in Table 5. Latent root criteria (eigenvalues > 1) were specified for six actors (AS1-6) from the 16 sources of risk variables for all farmers in both regions. These six factors can explain almost 71.2 per cent of the total variance. The Cronbach’s Alpha values for factors AS1-5 ranged from 0.671 to 0.899, which exceeded the minimum requirement of 0.6. This demonstrates an adequate reliability among those factors. However, the alpha value was somewhat lower (0.426) for factor AS6. Factors AS1-6 can be labelled in accordance with the significant loading variables that were obtained for each factor. The model procedure of risk management within the traditional concept Risk management is usually defined as the procedure aiming at identifying, measuring, and treating of exposures to potential accidental losses (Williams and Heins, 1989, p. 4). This procedure is believed to be directed toward company’s main goal which is nowadays associated with the multiplication of the owners’ wealth (Neale and McElroy, 2004, p. 7, 10; Baker and Powell, 2005, p. 11; Arnold, 2002, p.11-12). Undoubtedly, a properly conducted risk management procedure helps to achieve this goal in numerous ways. It applies company’s operations following the loss (it means post loss) or prior to a loss (it means pre-loss). In the post-loss context, risk management helps to keep costs below a threshold beyond which they could threaten the continued survival of the company. Also, it helps to achieve earnings stability, which means limitation of unforeseen reductions in earnings or cash flows caused by losses to “acceptable” amounts. This is possible because risk management helps to assure the continuity of operations, which means resuming normal business operations with minimum delay following a loss. As a result, risk management helps a company to grow continually. In the pre loss context, risk management increases value through keeping total risk management costs to the lowest practical level. Also, it helps to build corporate social responsibility (Williams and Heins, 1989,). The awareness of the risk management functions on pre- and post-loss basis is needed for a few reasons. First, it gives a sense of the ways in which a good risk management may support company’s operations. Secondly, it helps to understand that the risk management objectives should be coherent with the primary goal of company’s existence. Risk management procedure should always begin with precise identification what the company expects and want to achieve thanks to risk management process. Traditionally, the risk management procedure includes a few clearly defined steps, with two fundamental stages: risk analysis and risk treatment, as presented (Williams and Heins, 1989). The procedure should always begin with a clear definition of risk management objective. As mentioned above, this objective should correspond to the main goal of company’s activity. Then, the risk identification stage should be conducted. This stage includes: 1. identification of loss exposures, 2. measurement of potential losses. The identification of loss exposures is perhaps the most difficult function that the risk manager must perform. If the company files to identify the exposures, it will have no opportunity to deal with unknown (unidentified) exposures efficiently. Here the different techniques might be applied (e.g., check lists, decisive trees) (Chapman, 2006,). The next step within risk analysis is 34 CU IDOL SELF LEARNING MATERIAL (SLM)

the measurement of the potential losses during the budget period associated with the identified exposure. The risk measurement process includes determination of the probability or chance that the identified exposures will cause the loss – the loss frequency, determination of the impact of these losses on the financial stability of the company – the loss severity. Loss frequency and loss severity may be assessed with both quantitative and qualitative techniques. The properly conducted risk measurement indicates the risk exposures that require a closer attention, which is often depicted with the help of so called “risk matrix” (Baranoff, 2004,). This step aims at identifying the most serious risk exposures that can threaten company’s financial stability. The risk treatment stage requires the selection of the best combination of tools that can be used to handle the risk. The decision is back grounded by appropriate risk analysis. Traditionally, risk treatment techniques are divided into two major groups, as presented on paper. 2.4 MEASUREMENT OF RISK Investment risk is the idea that an investment will not perform as expected, that its actual return will deviate from the expected return. Risk is measured by the amount of volatility, that is, the difference between actual returns and average (expected) returns. This difference is referred to as the standard deviation. Returns with a large standard deviation (showing the greatest variance from the average) have higher volatility and are the riskier investments. Based on data from Standard & Poor’s, Inc., (accessed November 24, 2009). Figure 2.3: Showing S&P 500 Average Annual Return As Figure 2 shows, an investment may do better or worse than its average. Thus, standard deviation can be used to define the expected range of investment returns. For the S&P 500, for 35 CU IDOL SELF LEARNING MATERIAL (SLM)

example, the standard deviation from 1990 to 2008 was 19.54 percent. So, in any given year, the S&P 500 is expected to return 9.16 percent, but its return could be as high as 67.78 percent or as low as −49.46 percent, based on its performance during that specific period. What risks are there? What would cause an investment to unexpectedly over- or underperform? 2.4.1 Economic risks, Economic risk is referred to as the risk exposure of an investment made in a foreign country due to changes in the business conditions or adverse effect of macroeconomic factors like government policies or collapse of the current government and significant swing in the exchange rates. Types of Economic Risk Many factors can be a cause of economic risk, although the chances mentioned below are not an exhaustive one. The following are types of Financial Risk.  Sovereign Risk This type of economic risk is one of the most critical risks that can have a direct impact on the investment since the repercussions arising out of these risks can trigger other troubles that are related to the business. Sovereign Risk is the risk that a government cannot repay its debt and default on its payments. When a government becomes bankrupt, it directly impacts the businesses in the country. Sovereign Risk is not limited to a government defaulting but also includes the political unrest and change in the policies made by the government. A change in government policies can impact the exchange rate, which might affect the business transactions, resulting in a loss where the business was supposed to make a profit. Example  The debt crisis of the Greek government during early 2009 to late 2018, which occurred as an aftermath of the financial crisis of 2007, had occurred because of improper management of funds and lack of flexibility in the monetary policies. The Greek banks could not repay their debts and, as a result, lead to a crisis. The government had to levy increased taxes and reduce the facilities provided to its citizens, which triggered an outrage. The crisis not only disturbed the wellbeing of the local people but also impacted international trade. It brought the turmoil under control by negotiating a 50% haircut for its existing debts owed and by new loans provided by European banks.  Imagine a new left-of-center political party wins the general elections in a country where your oil & gas company, XYZ Inc. operates and has invested heavily. After two years, the party’s policies shift further to the left, and the president and cabinet members start 36 CU IDOL SELF LEARNING MATERIAL (SLM)

aiming their rhetoric at the private sector, particularly foreign-owned companies. One day the president announces that the oil & gas industry will be nationalized. Your company is offered compensation which significantly undervalues its true worth. The risk of losing that operation abroad due to nationalization has become a reality. Your company loses a lot of money and is unlikely to recoup its investment, even if you take the foreign government to international tribunals.  Unexpected Swing in Exchange Rate This type of sovereign risk is the risk if the market moves drastically to impact the exchange rate. When the market moves considerably, it affects international trade. This can be due to speculation or the news that can cause a fall in demand for a particular product or currency. Oil prices can significantly impact the market movement of other traded products. As mentioned above, government policies can also result in a dip or hike in the market movement. Change in inflation, interest rates, import-export duties, and taxes also impact the exchange rate. Since this directly impacts trade, exchange rates risk seeming to be a significant economic risk. Example A US microchip manufacturer imports electrical circuits from a Chinese manufacturer places an order for CNY 300,000 today and agrees to pay after 90 days. At the current market price, it would be roughly $43,652, which is CNY 6.87 per dollar. If the market price for yen moves above 6.87, the payment to be made will be above $43,652, whereas if the market price for yen moves below 6.87, the cost to be made will fall below $43,652.  Credit Risk This type of sovereign risk is the risk that the counterparty will default in making the obligation it owes. Credit risk is entirely out of control since it depends on another entity’s worthiness to pay its debts. The counterparty’s business activities need to be monitored on a timely basis so that the business transactions are closed at the right time without the risk of counterparty default to make it payments. Example In 2016, Invexstar Capital Management failed to make payments for the trades it had done. The company’s sole trader only settled those trades which were profitable for his company and refused to make payments for any of the loss-making transactions. This resulted in a chain reaction of losses for the banks dealing with an investor. Market-making banks were impacted economically, which summed up to £120 million. This rogue trading caused 37 CU IDOL SELF LEARNING MATERIAL (SLM)

regulatory repercussions and resulted in traders from the banks being sacked for bad KYC checks being done for the clients. The impact of counterparty default might result in a collapse in the whole market, causing market conditions to worsen and stricter trade laws being implemented to curb such payment defaults. 2.4.2 Industry risks, Industry risk is the exposure a company or organization must factor(s) that will lower its profits or lead it to fail. Anything that threatens a company's ability to achieve its financial goals is considered a business risk. There are many factors that can converge to create business risk. Sometimes it is a company's top leadership or management that creates situations where a business may be exposed to a greater degree of risk. However, sometimes the cause of risk is external to a company. Because of this, it is impossible for a company to completely shelter itself from risk. However, there are ways to mitigate the overall risks associated with operating a business; most companies accomplish this through adopting a risk management strategy.  For example, you obviously wouldn't compare a fast-food taco truck to an upscale five-star restaurant. Large industry segments characterized by intense global price competition are particularly risky. Risk of product substitution. ... If customers can easily switch to a substitute product, the industry's risk is greater.  When a company experiences a high degree of business risk, it may impair its ability to provide investors and stakeholders with adequate returns. For example, the CEO of a company may make certain decisions that affect its profits, or the CEO may not accurately anticipate certain events in the future, causing the business to incur losses or fail.  Industry risk is influenced by several different factors including:  Consumer preferences, demand, and sales volumes  Per-unit price and input costs  Competition  The overall economic climate  Government regulations 2.4.3 Company Risks Two factors cause company-specific risks: 38 CU IDOL SELF LEARNING MATERIAL (SLM)

 Business Risk: Internal or external issues may cause business risk. Internal risk relates to the operational efficiency of the business. Management failing to protect a new product with a patent would be an internal risk, resulting in a loss of competitive advantage. The FDA banning a specific product that a company sells is an example of external business risk  Financial Risk: This relates to the capital structure of a company. A company needs to have an optimal level of debt and equity to continue to grow and meet its financial obligations. A weak capital structure may lead to inconsistent earnings and cash flow. Examples of company-based risk includes  damage by fire, flood or other natural disasters.  unexpected financial loss due to an economic downturn, or bankruptcy of other businesses that owe you money.  loss of important suppliers or customers.  decrease in market share because new competitors or products enter the market. 2.4.4 Asset Class Risks An asset class is a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations. Asset classes are made up of instruments which often behave similarly to one another in the marketplace. Simply put, an asset class is a grouping of comparable financial securities. For example, IBM, MSFT, AAPL are a grouping of stocks. Asset classes and asset class categories are often mixed. There is usually very little correlation, and in some cases a negative correlation, between different asset classes. This characteristic is integral to the field of investing. Historically, the three main asset classes have been equities (stocks), fixed income (bonds), and cash equivalent or money market instruments.1 Currently, most investment professionals include real estate, commodities, futures, other financial derivatives, and even crypto currencies to the asset class mix. Investment assets include both tangible and intangible instruments which investors buy and sell for the purposes of generating additional income on either a short- or a long-term basis. Financial advisors view investment vehicles as asset class categories that are used for diversification purposes.1 Each asset class is expected to reflect different risk and return investment characteristics and perform differently in any given market environment. Investors interested in maximizing return often do so by reducing portfolio risk through asset class diversification. 39 CU IDOL SELF LEARNING MATERIAL (SLM)

Financial advisors focus on asset class to help investors diversify their portfolio. Different asset classes have different cash flows streams and varying degrees of risk. Investing in several different asset classes ensures a certain amount of diversity in investment selections. Diversification reduces risk and increases your probability of making a return.  Equities (stocks), fixed Income (bonds), cash and cash equivalents, real estate, commodities, futures, and other financial derivatives are examples of asset classes. There is usually very little correlation, and in some cases a negative correlation, between different asset classes. 2.4.5 Market risks. Market risk is the possibility that an individual or other entity will experience losses due to factors that affect the overall performance of investments in the financial markets. Financial markets play a vital role in facilitating the smooth operation of capitalist economies by allocating resources and creating liquidity for businesses and entrepreneurs. The markets make it easy for buyers and sellers to trade their financial holdings. Financial markets create securities products that provide a return for those who have excess funds (Investors/lenders) and make these funds available to those who need additional money (borrowers). The stock market is just one type of financial market. Financial markets are made by buying and selling numerous types of financial instruments including equities, bonds, currencies, and derivatives. Financial markets rely heavily on informational transparency to ensure that the markets set prices that are efficient and appropriate. The market prices of securities may not be indicative of their intrinsic value because of macroeconomic forces like taxes. Some financial markets are small with little activity, and others, like the New York Stock Exchange (NYSE), trade trillions of dollars of securities daily. The equities (stock) market is a financial market that enables investors to buy and sell shares of publicly traded companies. The primary stock market is where new issues of stocks, called initial public offerings (IPOs), are sold. Any subsequent trading of stocks occurs in the secondary market, where investors buy and sell securities that they already own. Economic risks are risks that something will upset the economy. The economic cycle may swing from expansion to recession, for example, inflation or deflation may increase, unemployment may increase, or interest rates may fluctuate. These macroeconomic factors affect everyone doing business in the economy. Most businesses are cyclical, growing when the economy grows and contracting when the economy contracts. Consumers tend to spend more disposable income when they are more confident about economic growth and the stability of their jobs and incomes. They tend to be more willing and able to finance purchases with debt or with credit, expanding their ability to purchase durable goods. So, 40 CU IDOL SELF LEARNING MATERIAL (SLM)

demand for most goods and services increases as an economy expands, and businesses expand too. An exception is businesses that are countercyclical. Their growth accelerates when the economy is in a downturn and slows when the economy expands. For example, low-priced fast- food chains typically have increased sales in an economic downturn because people substitute fast food for more expensive restaurant meals as they worry more about losing their jobs and incomes. Industry risks usually involve economic factors that affect an entire industry or developments in technology that affect an industry’s markets. An example is the effect of a sudden increase in the price of oil (a macroeconomic event) on the airline industry. Every airline is affected by such an event, as an increase in the price of airplane fuel increases airline costs and reduces profits. An industry such as real estate is vulnerable to changes in interest rates. A rise in interest rates, for example, makes it harder for people to borrow money to finance purchases, which depresses the value of real estate. Company risk refers to the characteristics of specific businesses or firms that affect their performance, making them vulnerable to economic and industry risks. These characteristics include how much debt financing the company uses, how well it creates economies of scale, how efficient its inventory management is, how flexible its labor relationships are, and so on. The asset class that an investment belongs to can also bear on its performance and risk. Investments (assets) are categorized in terms of the markets they trade in. Broadly defined, asset classes include.  corporate stock or equities (shares in public corporations, domestic, or foreign);  bonds or the public debts of corporation or governments;  commodities or resources (e.g., oil, coffee, or gold);  derivatives or contracts based on the performance of other underlying assets;  real estate (both residential and commercial);  fine art and collectibles (e.g., stamps, coins, baseball cards, or vintage cars). Within those broad categories, there are finer distinctions. For example, corporate stock is classified as large cap, mid cap, or small cap, depending on the size of the corporation as measured by its market capitalization (the aggregate value of its stock). Bonds are distinguished as corporate or government and as short-term, intermediate-term, or long-term, depending on the maturity date. Risks can affect entire asset classes. Changes in the inflation rate can make corporate bonds valuable, for example, or able to create valuable returns. In addition, changes in a market can 41 CU IDOL SELF LEARNING MATERIAL (SLM)

affect an investment’s value. When the stock market fell unexpectedly and significantly, as it did in October of 1929 1987, and 2008, all stocks were affected, regardless of relative exposure to other kinds of risk. After such an event, the market is usually less liquid; that is, there is less trading and less efficient pricing of assets (stocks) because there is less information flowing between buyers and sellers. Examples of market risk are:  Sources of market risk include recessions, political turmoil, and changes in interest rates, natural disasters and terrorist attacks. Systematic, or market risk, tends to influence the entire market at the same time. This can be contrasted with unsystematic risk, which is unique to a specific company or industry.  Market risk is the risk of losses on financial investments caused by adverse price movements. Examples of market risk are: changes in equity prices or commodity prices, interest rate moves or foreign exchange fluctuations. ... The standard method for evaluating market risk is value-at-risk. 2.5 SUMMARY  An appropriate organization may have to take into account goals other than speed of development. Among these other important goals are: lower life-cycle costs, reduced personnel turnover, repeatability of the process, development of team members at junior level into senior members, and widespread dissemination of specialized knowledge and expertise among personnel.  At different levels of an organization, different levels of risks can be tolerated. For example, a project manager may not want to tolerate any delay in the schedule, while another member at the level of team leader might be more concerned with the reliability of the product. A project manager might not be able to tolerate the risk of running over budget by more than 10% while a higher level manager who is more aware of the value of early entry into market may be more concerned with the time taken by the project and might be willing to overspend the budget by much more if the product can be produced sooner.  Benchmarks can be run in almost all types of systems environments including batch and on-line jobs streams and with the users linked to the system directly or through other methods.  Risk measures are statistical measures that are historical predictors of investment risk and volatility, and they are also major components in modern portfolio theory (MPT). 42 CU IDOL SELF LEARNING MATERIAL (SLM)

MPT is a standard financial and academic methodology for assessing the performance of a stock or a stock fund as compared to its benchmark index.  A common definition of investment risk is a deviation from an expected outcome. We can express this deviation in absolute terms or relative to something else, like a market benchmark.  Stockbrokers use financial instruments like options and futures, and money managers use strategies like portfolio diversification, asset allocation and position sizing to mitigate or effectively manage risk.  That information may be helpful, it does not fully address an investor's risk concerns. The field of behavioral finance has contributed an important element to the risk equation, demonstrating asymmetry between how people view gains and losses.  Risk is quantifiable both in absolute and in relative terms. A solid understanding of risk in its different forms can help investors to better understand the opportunities, trade-offs, and costs involved with different investment approaches.  That deviation may be positive or negative, investment professionals generally accept the idea that such deviation implies some degree of the intended outcome for your investments  Inadequate risk management can result in severe consequences for companies, individuals, and the economy  There are five principal risk measures, and each measure provides a unique way to assess the risk present in investments that are under consideration. The five measures include the alpha, beta, R-squared, standard deviation, and Sharpe ratio. 2.6 KEYWORDS  Establish context. Understand the circumstances in which the rest of the process will take place. The criteria that will be used to evaluate risk should also be established and the structure of the analysis should be defined.  Risk identification. The company identifies and defines potential risks that may negatively influence a specific company process or project.  Risk analysis. Once specific types of risk are identified, the company then determines the odds of them occurring, as well as their consequences. The goal of risk analysis is to further understand each specific instance of risk, and how it could influence the company's projects and objectives. 43 CU IDOL SELF LEARNING MATERIAL (SLM)

 Risk assessment and evaluation. The risk is then further evaluated after determining the risk's overall likelihood of occurrence combined with its overall consequence. The company can then make decisions on whether the risk is acceptable and whether the company is willing to take it on based on its risk appetite.  Risk mitigation. During this step, companies assess their highest-ranked risks and develop a plan to alleviate them using specific risk controls. These plans include risk mitigation processes, risk prevention tactics and contingency plans in the event the risk comes to fruition.  Risk monitoring. Part of the mitigation plan includes following up on both the risks and the overall plan to continuously monitor and track new and existing risks. The overall risk management process should also be reviewed and updated accordingly.  Communicate and consult. Internal and external shareholders should be included in communication and consultation at each appropriate step of the risk management process and in regards to the process as a whole. 2.7LEARNING ACTIVITY 1. Examine and study that the company’s risk reporting provide management and the board information they need about the top risks and how they are managed? _______________________________________________________________________ ________________________________________________________________________ Conduct a survey on a company and understand the key assumptions underlying its strategy and align its competitive intelligence process to monitor external factors for changes that could alter those assumptions? _____________________________________________________________________________ _____________________________________________________________________________ 2.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What do you mean by Risk Management? Explain giving reasons. 2. Describe the Risk Management framework. 3. What are the different types of risks that banks are exposed to in the present-day context? 44 CU IDOL SELF LEARNING MATERIAL (SLM)

4. What is the difference between non-financial and financial risks? Can a market risk lead to credit risk? If so, under what circumstances. Long Questions 1. What are the company’s top risks, how severe is their impact and how likely are they to occur? 2. How often does the company refresh its assessment of the top risks? 3. Who owns the top risks and is accountable for results, and to whom do they report? 4. Is the company prepared to respond to extreme events? 5. Does the board have the requisite skill sets to provide effective risk oversight? B. Multiple Choice Questions 1. Within an organization, when attempting to manage and control risk, the organization should beware that. a. Consideration of risk perception is not required. b. Consideration should be given to internal controls only. c. Uncertainty must be taken into account. d. Uncertainty need not be considered. The Chief Risk Officer within a large manufacturing organization has been asked by the Board of Directors to provide an example of a pure risk. A suitable example would be. a. A fire occurring in a new manufacturing process line. b. Entering into a contract to purchase a new factory. c. Making a strategic decision that affects the long-term future of the organisation. d. The purchase of a currency derivative When a bank borrower, or counter party, fails to meet its payment obligations regarding the terms agreed with the bank it is called. a. market risk b. operational risk c. liquidity risk d. credit risk 45 CU IDOL SELF LEARNING MATERIAL (SLM)

When a bank chooses the wrong strategy or follow a long-term business strategy which might lead to its failure, it is called. a. credit risk b. operational risk c. market risk d. business risk ---------------refers to the characteristics of specific businesses or firms that affect their performance, making them vulnerable to economic and industry risks. a. Company risk b. Securities c. Funding d. Management Answers 1-c, 2-a, 3-d, 4-d, 5-a 2.9 REFERENCES References  Altman, E. I. (1968). Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy, Journal of Finance, September  Altman, E. I. and Kishore, V. M. (1996). Almost Everything You Wanted to Know about Recoveries on Defaulted Bonds, Financial Analysts Journal, November/December  Gamma E., Helm R., Johnson R., Vlissides J., Design Patterns: Elements of Reusable Object-ARM, “ARMISTICE Project”, http://www.madsgroup.org/armistice, 2007 Textbook  Booch G., Jacobson I., Rumbaugh J., The Unified Modeling Language, Addison Wesley,1998.  Braude E., Software Engineering. An Object-Oriented Perspective, John Wiley and Sons,2001. 46 CU IDOL SELF LEARNING MATERIAL (SLM)

 ERM, “The Enterprise Risk Management Annual Conference”, http://www.conferenceboard. Websites  https://www.researchgate.net/publication/240305382  http://www.rspa.com  http://www.ieee.org  http://www.ncst.ernet.in 47 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT – 3: TYPES OF RISKS STRUCTURE 3.0 Learning Objectives 3.1 Introduction 3.2 Pure Risk 3.2.1 Understanding Pure Risk 3.3 Types of Pure Risk 3.3.1 Personal risk 3.3.2 Property risk 3.3.3 Liability risk 3.4 Other Types of Risk 3.5 Summary 3.6 Keywords 3.7 Learning Activity 3.8 Unit End Questions 3.9 References 3.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Explain and acquaint with basic concepts objectives to manage the risk,  Identify framework of managing risk and its process,  Evaluate how to distinguish different types of risks and to manage those efficiently,  llustratete the structure of different types of risk, and  Evaluate the implications of risk 3.1 INTRODUCTION In the banking universe numerous risks show their impact on profitability 48 CU IDOL SELF LEARNING MATERIAL (SLM)

These multiple sources of risk, raise the issue of defining the risk. In a universe where the quantitative management of risks has become a major banking function, generic concepts are not of much use. The different types of risks must be carefully defined, and such definitions provide a first basis for measuring risks and implementing risk management. Accordingly, risk definition has gained precision over the years. However, risk is defined as the degree of uncertainty of future returns. Thus, given the importance of risk management, today receiving something from the world's top banking regulators, Bank for International Settlement (BIS), the Federal Reserve in the United States, Bundes Bank in Germany, Reserve Bank of India have all indicated their concern at the risk-taking activities of banks. The regulatory bodies have expressed their serious concern that not only does the environment become a lot riskier with exchange rules and interest rates being extremely volatile also a large amount of bank capital is spread internationally looking for the returns. The currencies and corporates are really under pressure, the regulators are understandably concerned about the banks’ ability to withstand these pressures. To cover this, it was felt necessary that regulation for covering capital and reporting requirement must be put in place. The need to cover and study the impact of recent volatility and appropriate measures and control required, takes us to the very root, what does risk mean and where can it reside in commercial operations. The financial markets all over the world in the past decade have witnessed far reaching changes at an unprecedented pace. Increase in number of banks and financial institutions, simultaneous mergers and acquisitions is the effect of global liberalization of economy. As a result, banks and financial institutions are facing intense competition for acquiring business of both assets as well as liability side. During the period banks have witnessed increasing volatility in both domestic interest rates as well as foreign exchange rates, more particularly since last five years. The long-term health and survival of financial services entity is critically dependent on its ability to understand, appreciate, quantify, and manage the range of risks associated. With its line of business, therefore, quantitative, and qualitative competence and regulatory pressure makes it mandatory to an organization to have a wide risk management framework in place. Inadequate risk management can result in severe consequences for companies, individuals, and the economy. For example, the subprime mortgage meltdown in 2007 that helped trigger the Great Recession stemmed from bad risk-management decisions, such as lenders who extended mortgages to individuals with poor credit; investment firms who bought, packaged, and resold these mortgages; and funds that invested excessively in the repackaged, but still risky, mortgage- backed securities (MBS). 49 CU IDOL SELF LEARNING MATERIAL (SLM)

3.2 PURE 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. There are four basic ways of dealing with risk: reduce it, avoid it, accept it or transfer it. Pure risk is often transferred by purchasing insurance coverage, which transfers the risk to an insurance company. 3.2.1 Understanding Pure Risk Personal risks affect individuals and involve losing or reducing personal assets. For example, unemployment is a pure risk resulting in financial loss when income and benefits are taken away. There are numerous other types of personal, pure risks, however: Poor health runs the risk of large medical bills, and the risk of an unforeseen, permanent disability could end a person's career and, as a result, dramatically reduce their income. The pure risk of premature death also impacts the deceased family members who might struggle to pay household bills if the breadwinner unexpectedly dies. Pure risk to property includes fires, wind damage, flooding and other natural disasters that cause damage to personal belongings. Liability risks are also considered pure risks and pertain to potential litigation against a person or organization. For example, a homeowner could be sued by a person who slipped on their walkway for medical expenses, lost income, or other damages.  Pure vs. speculative risk While pure risk is beyond human control and can only result in a loss if it occurs, speculative risk is taken on voluntarily and can result in either a profit or loss. Speculative risks are undertaken through a conscious choice, and they are considered a controllable risk. Almost all financial investment activities, for example, are considered speculative risk because they ultimately result in an unknown amount of success or failure. Betting on sports is also considered a speculative, controllable risk. A person betting on an NFL game could see either a financial gain or financial loss from the bet, depending on which team wins. Unlike pure risk that will only result in a loss, betting on the game could result in either a gain or a loss for the person undertaking the bet, or in this case, the risk.  Pure risk insurance Pure risks are insurable through commercial, personal or liability insurance policies. In these polices, individuals or organizations transfer part of the pure risk to the insurer. For example, home insurance policies protect against natural disasters by providing money for rebuilding. For 50 CU IDOL SELF LEARNING MATERIAL (SLM)