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“Risk, in traditional terms, is viewed as a negative. The dictionary defines risk as “exposing to danger or hazard.”
“ You cannot have opportunity without risk and that offers that look too good to be true (offering opportunity with little or no risk) are generally not true. By emphasizing the upside potential as well as the downside dangers, this definition also serves the useful purpose of reminding us of an important truth about risk.”

Classifications of Risks



  • Operational Risk
    • Operating and verification (accuracy)
    • Business risk
  • Financial Risk
  • Internal Risk
    • Insolvency
    • Counterparty
    • Financial structure planning
  • External Risk
  • Interest rate
  • Currency exchange rate
  • Inflation
  • Market Based Risk




  • Financial Risk
    • Credit (default, downgrade)
    • Price (commodity, interest rate, exchange rate)
    • Liquidity (cash flow)
  • Operational Risk
  • Business operations (efficiency, supply chain, business cycles)
  • Information technology
  • Reputational (i.e., bad publicity)
  • Demographic and social/cultural trends
  • Regulatory and political trends
  • Fire and other property damage
  • Theft and other crime, personal injury
  • Diseases
  • Strategic Risk
  • Hazard Risk



Risk Profile

  • Listing out all of the risks that a firm is potentially exposed to is called a risk profile
  • After creating the risk profile, the risks should be sub-divided into the following:
  • Risk that should be allowed to pass through the firm to its owners
  • Risk that should be hedged
  • Risk that should be exploited

Risk Governance in a Corporation

  • Risk governance is defined as in firms as the ways in which directors authorize, optimize, and monitor risk taking in an enterprise. It includes the skills, infrastructure (i.e., organization structure, controls and information systems), and culture deployed as directors exercise their oversight
  • Good risk governance provides clearly defined accountability, authority, and communication/reporting mechanisms.

Enterprise Risk Management (ERM)

  • Enterprise Risk Management (ERM) emphasizes a comprehensive, holistic approach to managing risk, shifting away from a “silo-ed” approach of separately handling each organizational risk. ERM also views risk management as a value-creating activity, and not just a mitigation activity
  • ERM addresses issues, focusing on coordination and value addition
  • For example, in a conglomerate in which one division is long in currency A and another division is short in the same sum in the same currency, responsible division managers might decide to purchase separate currency hedges. This represents a silo-ed approach, which does not enhance value. Taking an enterprise-wide approach instead, using ERM, renders such actions unnecessary, because the conglomerate already has a natural hedge
  • ERM’s coordinated function is often vested in a chief risk officer and in increased risk governance, including board oversight. This evolving portfolio approach is aided by improved tools for risk measurement, pricing and trading

How are Risks Adjusted

  • For risk management purposes, many would point out that using the Capital Asset Pricing Model (CAPM) for calculating risk-adjusted capital has a double benefit of already accounting for all the risk that a firm’s decision makers need concern themselves about—the market risk. All other risks are firm risks and can be diversified away by the individual investor in the firm’s shares.

Risk Adjusted Value



The value of a risky asset can be estimated by discounting the expected cash flows on the asset over its life at a risk-adjusted discount rate


Process to estimate RaV

Step 1: Estimate the expected cash flows from a project / asset / business. For a risky asset, consider / estimate cash flows under different scenarios, attach probabilities to these scenarios and estimate an expected value across scenarios.


Step 2: Estimate a risk-adjusted discount rate, comprised of two components, the risk-free rate and the risk premium. Risk-adjusted rate = Risk-free rate + Risk premium = Rf + Beta (Rm-Rf)

Step 3: Take the present value of the cash flows at the risk-adjusted discount rate.



  • Where the asset has a n-year life, E(CFt) is the expected cash flow in period t and r is a discount rate that reflects the risk of the cash flows.

Valuation of Risky Assets

  • We generally price an asset as the present value of the future cash flows. i.e.


  • That would be the asset price if the cash flows are absolutely certain.
  • In case, multiply each cash flow with a CE (certainty equivalents), and discount at the risk-free rate, the value of the asset becomes

Problems with Beta

  • It is Backward looking: It does not consider the current business mix or financial leverage
  • It is estimated with error: There is a standard error of beta, so the actual may be higher or lower than the reported
  • Dependent on how the regression is structured and whether the stock is publically traded in the first place

Risk Adjusted Weights for a Project

  • The weights for computing the risk-adjusted cost of capital should be market value weights, since the business has to raise debt and equity in the market to fund its projects at market rates. It also is worth noting that the risk-adjusted discount rate for an individual project may be based on target weights for the entire business, instead of a reflection of the actual funding mix for the project

4 Steps in AIRMIC Risk Management Process

The process certified by AIRMIC requires the analysis to be carried out in four stages:

  • Identification of risk management and enterprise objectives
  • Risk Assessment
  • Risk Treatment
  • Risk Monitoring


AIRMIC Enterprise Risk Management Process



Risk Treatment Strategies




Probabilistic Approaches to Estimate Value

  • Sensitivity Analysis
  • Scenario Analysis
  • Decision Trees
  • Simulations
  • VaR

When is it Appropriate to Hedge?


Financial Products used in Hedging

  • Over The Counter (OTC) Derivatives
    • Non-deliverable forwards
    • Currency Swaps
    • Interest Rate Swaps
  • Exchange Traded Derivatives
    • Currency Options
    • Interest Rate Futures
    • Commodity Futures
  • Securitizations
    • CDO
    • MBS
  • Exotic Options, Structured Products and Non-Traditional Derivatives
    • Weather Options
    • Electricity Options
    • Asian Options


Using Risk to your Advantage

  • Cash Flow from existing Assets
  • Higher Expected Growth Rate
  • Length of Competitive Advantage Growth Period
  • Discount Rate

Rewarding Risk Takers



Basic Steps in Building a Good Risk Management System

  • Make an inventory of possible risks. The process has to begin with an inventory of all the potential risks to which a firm could be exposed. This will include firm-specific risks, risks that affect the entire sector, and macroeconomic risks that have an influence on the value.
  • Measure and decide which risks to hedge, avoid, or retain based on impact on enterprise value. Risk hedging is not always optimal and can reduce value in many cases. Having made an inventory of risks, the firm has to decide which risks it will attempt to hedge and which ones it will allow to flow through to its investors. The size of the firm, the type of stockholders that it has and its financial leverage (exposure to distress) will all play a role in making this decision. In addition, the firm has to consider whether investors can buy protection against the risks in the market on their own
  • For the risk to be hedged, select appropriate risk-hedging products and decide how to manage and monitor retained risks. If a firm decides to hedge risk, it has a number of choices. Some of these choices are market traded, such as currency and interest rate derivatives; some are customized solutions, such as those prepared by investment banks to hedge against risk that may be unique to the firm; and some are insurance products. The firm has to consider the effectiveness of each of the choices as well as the costs
  • Determine the risk dimensions that provide an advantage over the competitors and select an organizational structure suitable for risk taking. Here, the firm moves from risk hedging to risk management and from viewing risk as a threat to risk as a potential opportunity. Why would one firm be better at dealing with certain kinds of risk than its competitors? It might have to do with past experience. A firm that has operated in emerging markets for decades clearly has a better sense of what to expect in a market meltdown and how to deal with it. It also might come from the control of a resource—physical or human—that gives the company an advantage when exposed to the risk. Having access to low cost oil reserves might give an oil company an advantage if oil prices drop. A superior legal team might give a tobacco company a competitive advantage when it comes to litigation risk. Firms also must recognize that risk taking happens within an organizational context, and the appropriate risk systems, processes, and culture must be built

Examples of Corporate Risk Governance




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