Introduction to Risk Management Chapter 1.pptx

This document is a valuable course of risk Management

1. Financial Risk Management Dr. Makaran

2. What Is Financial Risk Management? Chapter One

3. After reading this chapter you will be able to • Describe the financial risk management process • Identify key factors that affect interest rates, exchange rates, and commodity prices • Understand the impact of history on financial markets Contents

4. Although financial risk has increased significantly in recent years, risk and risk management are not Current issues. The result of increasingly global markets is that risk may originate with events thousands of miles away that have nothing to do with the domestic market. Information is available instantaneously, which means that change, and subsequent market reactions, occur very quickly The economic climate and markets can be affected very quickly by changes in exchange rates,interest rates,and commodity prices. Introduction

5. There is no Common definition of a risks. Risk is the likelihood of losses resulting from events such as changes in market prices. Risk is something valued to danger, harm, or loss. Risk is an uncertain event that may have negative impacts on business project. Risk is anything that may affect the achievement of an firm’s objective. Risk is the outcome of an action taken or not taken in a particular situation which may result in loss . What Is Risk?

6. Risks are uncertain future events that could influence the achievement of the Bank’s objectives, including strategic, operational, financial and compliance objectives. Uncertain future events could be: • Failure of a borrower to repay a financing • Fluctuation of foreign exchange rates • Fraud, incomplete security documentations, etc • Non-compliance with shariah law and principles • Other events that may result in a loss to the Bank Cont….

7. Financial risk arises through numerous transactions of a financial nature, including sales and purchases, investments and loans, and various other business activities. It can arise as a result of legal transactions, new projects, mergers and acquisitions, debt financing, the energy component of costs, or through the activities of management, stakeholders, competitors, foreign governments, or weather. When financial prices change dramatically, it can increase costs, reduce revenues, or otherwise adversely impact the profitability of an organization. How Does Financial Risk Arise?

8. Financial fluctuations may make it more difficult to plan and budget , price goods and services, and allocate capital. There are three main sources of financial risk : 1. Financial risks arising from an organization’s exposure to changes in market prices (condition), such as interest rates, exchange rates, and commodity prices 2. Financial risks arising from the actions of, and transactions with, other organizations such as vendors, customers, and counterparties in derivatives transactions 3. Financial risks resulting from internal actions or failures of the organization, particularly people, processes, and systems Cont….

9. Financial risk management is a process to deal with the uncertainties resulting from financial markets. It involves evaluating the financial risks facing an organization and developing management strategies consistent with internal priorities and policies. Managing financial risk necessitates making organizational decisions about risks that are acceptable versus those that are not. Organizations manage financial risk using a variety of strategies and products. What Is Financial Risk Management?

10. 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 and then takes the appropriate action given his investment objectives and risk tolerance. Cont….

11. Risk management is the process by which various risk exposures are (1) identified, (2) measured/assessed, (3) mitigated and controlled, (4) reported and monitored. Cont….

12. CONCEPT OF RISK MANAGEMENT IN ISLAM

13. Cont….

14. Strategies for risk management often involve derivatives . Derivatives are traded widely among financial institutions and on organized exchanges. The value of derivatives contracts, such as futures, forwards, options, and swaps, is derived from the price of the underlying asset. Derivatives trade on interest rates, exchange rates, commodities, equity and fixed income securities, credit, and even weather. A derivative is a financial instruments whose value is derived from the value of another asset, which is known as the underlying. Cont….

15. The process of financial risk management is an ongoing one. In general, the process can be summarized as follows: • Identify and prioritize key financial risks. • Determine an appropriate level of risk tolerance. •Implement risk management strategy in accordance with policy. • Measure, report, monitor, and refine as needed. Cont….

16. Diversification is an important tool in managing financial risks. Modern Portfolio theory Diversification is process of adding securities to a portfolio in order to reduce the portfolio’s unique risk and thereby, the portfolio's total risk. Diversification

17. Cont….

18. The process of financial risk management include strategies that enable an organization to manage the risks associated with financial markets. The risk management process involves both internal and external analysis. The first part of the process involves identifying and prioritizing the financial risks facing an organization and understanding their relevance. Risk Management Process

19. Once a clear understanding of the risks emerges, appropriate strategies can be implemented in conjunction with risk management policy. Another strategy for managing risk is to accept all risks and the possibility of losses. Measurement and reporting of risks provides decision makers with information to execute decisions and monitor outcomes, both before and after strategies are taken to mitigate them Cont….

20. There are four steps in the risk management process I dentify loss exposures Analyze the loss exposures Select appropriate techniques for treating the loss exposures İmplement and monitor the risk management program Steps in the Risk Management Process

21. Property loss exposures, Liability loss exposures ,Business Income loss exposures, Human resources loss exposures, Crime loss exposure, Employee benefit loss exposures, Foreign loss exposures, Market reputation and public image of the company, Failure to comply with government laws and regulations. A risk manager has several sources of information that he or she can use to identify the loss. They include the following: Risk analysis questionnaires, Physical inspection… 1.I dentify loss exposures

22. This step involves an estimation of the frequency and severity of loss. Loss frequency refers to the probable number of losses that may occur during some given time period. Loss severity refers to the probable size of the losses that may occur. For example, if a plant is totally destroyed in a flood, the risk manager estimates that replacement cost and other costs will total $10 million. The risk manager also estimates that a flood causing more than $8 million of damage to the plant is so unlikely that such a flood would not occur more than in 50 years 2. Analyze the loss exposure

23. These techniques can be classified broadly as either risk control or risk financing. Risk control refers to techniques that reduce the frequency and severity of losses. Risk financing refers to techniques that provide for the funding of losses(Insurance). Major risk control techniques include the following: Avoidance Loss prevention Loss reduction 3.Select the appropriate techniques for treating the loss exposures

24. This step begin with a policy statement This statement outlines the risk management objectives of the firms, as well as company policy with respect to treatment of loss exposures. 4.Implementation and monitor the risk management program

25. Factors that Impact Financial Rates and Prices Financial rates and prices are affected by a number of factors. Factors that Affect Interest Rates Factors that influence the level of market interest rates include: • Expected levels of inflation • General economic conditions • Monetary policy and the stance of the central bank • Foreign exchange market activity Foreign investor demand for debt securities • Levels of sovereign debt outstanding • Financial and political stability

26. The yield curve is a graphical representation of yields for a range of terms to maturity. For example, a yield curve might illustrate yields for maturity from one day (overnight) to 30-year terms. Yield Curve

27. Theories of Interest Rate Determination Term Structure Interest Rate Theory is the relationship between short-long term interest rates. Bond Maturity Theorems There are three possible factors affecting the maturity structure: Expectations theory: suggests forward interest rates are representative of expected future interest rates. Expectations theory :Theory that forward interest rate ( forward exchange rate) equals expected spot rate.

28. Liquidity-preference theory is theory that investors demand a higher yield to compensate for the extra risk of long-term bonds. It is based on the idea that investors will hold long term maturities only if investors are offered a premium to compensate for the future uncertainty in a security’s value, which increases with an asset’s maturity. Liquidity theory suggests that investors will choose longer term maturities if they are provided with additional yield that compensates them for lack of liquidity. Cont….

29. Market segmentation theory suggests that different investors have different investment horizons that arise from the nature of their business or as a result of investment restrictions. Market segmentation theory argues that individual investors have specific maturity preferences. Cont….

30. Factors that influence the level of interest rates also influence exchange rates among floating or market-determined currencies. Foreign exchange rates are determined by supply and demand for currencies. Supply and demand, in turn, are influenced by factors in the economy, foreign trade, and the activities of international investors. Factors that Affect Foreign Exchange Rates

31. Theories of Exchange Rate Determination Several theories have been advanced to explain how exchange rates are determined: Purchasing power parity, based in part on “the law of one price,” suggests that exchange rates are in equilibrium when the prices of goods and services (excluding mobility and other issues) in different countries are the same. LOP state that the price of an same goods should be same in all market. The balance of payments approach suggests that exchange rates result from trade and capital transactions that, in turn, affect the balance of payments.

32. Factors that Affect Commodity Prices Commodity prices may be affected by a number of factors, including: • Expected levels of inflation, particularly for precious metals • Interest rates • Exchange rates, depending on how prices are determined • General economic conditions • Costs of production and ability to deliver to buyers • Availability of substitutes and shifts in taste and consumption patterns • Weather, particularly for agricultural commodities and energy • Political stability, particularly for energy and precious metals

33. No discussion of financial risk management is complete without a brief look at financial market history. Early Markets Financial derivatives and markets are often considered to be modern developments , but in many cases they are not. The later development of formalized futures markets enabled producers and buyers to guarantee a price for sales and purchases. Financial Risk Management: A Selective History

34. Forward contracts vs. Futures contracts A future contract is traded on an exchange. Future have standardized term. Any one buying a future contract must deposit an initial payment , called margin, With the clearinghouse of the exchange. In seventeenth-century Japan, The Dojima rice futures market was established in the commerce center of Osaka in 1688 with 1,300 registered rice traders. Cont….

35. In North America, development of futures markets is also closely tied to agricultural markets, in particular the grain markets of the nineteenth century. Volatility in the price of grain made business challenging for both growers and merchant buyers. The Chicago Board of Trade (CBOT), formed in 1848, was the first organized futures exchange in the United States. North American Developments

36. Increased use of value-at-risk and similar tools for risk management improved risk management dialogue and methodologies. In 1999,a new European currency, the euro, was adopted by Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain, and two years later, Greece. The move to a common currency significantly reduced foreign exchange risk for organizations doing business in Europe as compared with managing a dozen different currencies, and it sparked a wave of bank consolidations. New Era Finance

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