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Risk Management

By. :By. :1. Erry Febrian, SE., M. Com1. Erry Febrian, SE., M. Com

2. Aldrin Herwany, SE., MM2. Aldrin Herwany, SE., MM

Risk Management

Economic FacultyPadjadjaran

Padjadjaran

University


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Topic cover

What is risk management

Different types of risks

Methods and TOOLS of risks

EVALUATE AND MINIMIZE RISKS

Levels of risks


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What is risk management

The Concept of risk and uncertainty are related but yet are very

different. Uncertainty involves variables that are constantly changing,

whereas risk involves only the uncertain variables that affect or

impact the systems output directly

RISK IDENTIFICATION

RISK EVALUATION

RISK QUANTIFICATION


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Level of risks

Extremely High

High

Medium

Low


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COMMON TYPES OF RISK

MARKET RISKMARKET RISK

CREDIT RISKCREDIT RISK

LIQUIDITY RISKLIQUIDITY RISK

OPERATIONAL RISKOPERATIONAL RISK

SYSTEMIC RISKSYSTEMIC RISK

INTEREST RATE RISKINTEREST RATE RISK



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Foreign Exchange Risk

the risk that exchange rate changes can affect the value of firmsassets and liabilities denominated in foreign currencies

short-term financing decisions

short-term investment decisions

capital budgeting decisions

long-term financing decisions


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Market RiskThe risk of monetary loss arising from an adverse move in market prices or rates

Bonds Equities

Beta

Factor models

Duration and Convexity

Rate sensitivitiesCredit spread sensitivity

Trading/Hedging

Directional

Curve (steepener / flattener; butterfly)

Spread

Relative Value

Options : delta, gamma, vega, theta, rho

Adverse changes in market prices, rates, exchange rates

Risks caused by changes in market prices, exchange rates or interest ratesRisks caused by changes in market prices, exchange rates or interest rates..


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Credit Risk

Methodology for calculating the distribution of possible credit losses from a

portfolio

Credit Spread RiskCredit Spread RiskCredit spread is the excess return demanded by the market for assuming a

certain credit exposure.

Credit spread risk is the risk of financial loss owing to changes in the level

of credit spreads used in the mark-to market of a product.

Credit Default RiskCredit Default Risk Credit default risk is the risk that an obligor is unable to meet its financial

obligations. In the event of a default of an obligor, a firm generally incurs a

loss equal to the amount owed by the obligor less a recovery amount which the firm recovers as a result of foreclosure, liquidation or restructuring

of the defaulted obligor.

All portfolios of exposures exhibit credit default risk, as the default of anobligor results in a loss.

The risk that the promised cash flows from loans and securities

One of the parties entered into a financial contract is not able or willing to

pay its liabilities


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Operational Risk

The risk of monetary loss resulting from inadequate internal processes.

Potential losses due to breakdown in information, communication,

transaction processing, settlement systems, fraud, unauthorized

transactions by employees

the risk that existing technology or support systems may

malfunction or break down

Operational risk is the risk of loss resulting from inadequate or failed internal

processes, people, and systems or from external events.

(Basel II, September 2001)

execution risk: there is a mistake in execution of a transactionexecution risk: there is a mistake in execution of a transaction

fraudfraud

technology risk model risktechnology risk model risk


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Operational Risk

1. Policy1. Policy

2. Risk Identification2. Risk Identification

3. Business Process3. Business Process

4. Measurement Methodology4. Measurement Methodology

5. Exposure Management5. Exposure Management

6. Reporting6. Reporting

7. Risk Analysis7. Risk Analysis

8. Economic Capital8. Economic Capital


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Liquidity risk

Cash flows not sufficient to meet banks financial commitments

the risk that a sudden surge in liability withdrawalsmay require an FI to liquidate assets in a very shortperiod of time and at low prices

The concept is not well defined, it can mean the following two things

liquidity of a financial market instrument: the biggest size of a trade that

does not yet move the market price. If a trade having bigger size is

transacted, then it also changes the market price.

liquidity means also often that a corporation has liquid funds, cash, enough

to make the necessary payments. This type of liquidity risk is related to

cash management and funding problems.


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Interest rate risk

Earnings & Returns

Fluctuate with Changesin Interest Rates

Fluctuating

Interest Rates


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Others

Country Risk

Forecasting Risk (Estimation Risk)

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

decisions

Political Risk, war, Bureaucracy, Corruption, revolution,

the risk that repayments from foreign borrowers may be interrupted

because of interference from foreign governments

Legal risks

lawsuits (especially financiallawsuits (especially financial

organisations)organisations)

how legal contracts will behow legal contracts will beinter retedinter reted

Off-Balance-Sheet Risk

Technology Risk

Insolvency Risk


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RISK MANAGEMENT

1. Business RiskThe equity risk that comes from the nature of the firms

operating activities

Systematic Risk has two parts :

Firms Operation

Risks caused by the original business of a corporation: risk related to the

products of a corporation, R & D investment, innovation, change in

demand for the products

A corporation should have competitive advantage to take and

manage these risks.



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2. Financial Risk

The equity risk that comes from the financial policy

External Financing

Internal Financing

Financial leverage

RISK MANAGEMENT

Financial risks, especially on market risk and credit risk.



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Elements of Risk Management

Understand range and magnitude of risks

Know what you dont know

Communicate issues clearly


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ROLE OF RISK MANAGER

MONITOR RISK OF A FIRM

IDENTIFY RISKS

MEASURE RISKS

REPORT RISKS

MANAGE - or CONTROL RISKS

Quantitative factors

Qualitative factors


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Qualitative factors

Owners,Owners, ManagementManagement

InvestmentsInvestments: LT earnings, no over-investment in sector: LT earnings, no over-investment in sector

ProductsProducts: demand, innovation vs. cost leadership or niche: demand, innovation vs. cost leadership or niche

CompetitionCompetition: Market entry barriers, pricing power: Market entry barriers, pricing powerRiskRisk evaluationevaluation

GovernmentGovernment regulationregulation


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Quantitative factors

Growth:Growth: Sales, InvestmentsSales, Investments

Profitability:Profitability: Operating and net margins, ROEOperating and net margins, ROE

Risk:Risk: Sales and profit stability, capital structure, size, liquiditySales and profit stability, capital structure, size, liquidity

Valuation:Valuation: Ratios (P/E, P/S, P/BV, P/CF), Discounted Cash FlowRatios (P/E, P/S, P/BV, P/CF), Discounted Cash Flow(Focus: capital costs)(Focus: capital costs)


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Scenario Analysis

Sensitivity Analysis

SIMULATION ANALYSIS

What If Analysis

The determination of what happens to

NPV estimates when we ask what-if

questions

Investigation of what happens to

NPV when only one variable is

changed

Base, Worst, Best

Optimistic, Pessimistic

Combination of scenario and

sensitivity analysis

Base, Lower, Upper

ASSESS IMPLICATIONS OFPARTICULAR

COMBINATIONS OF EVENTS NO PROBABILITY STATEMENT

Methods and TOOLS of risksMethods and TOOLS of risks


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STATISTICAL ANALYSIS FIND PROBABILITY OF LOSSES

HOW TO ASSESS EVENTS WHICH HAVE NEVER OCCURRED?


Fundamental forecastingis based on the fundamental relationships between economic

variables

Technical forecastinginvolves the use of historical data to predict future values.

E.g. time series models.

quantitative measurements based on regression models and sensitivity

analyses.


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Expected

return

Risk

Risk and return according to the basic

Capital Asset Pricing Model (CAPM)

Expected

return

Risk

Figure 1. Figure 2.

Look ! ..Expected return and risk are interdependent!



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TWO GENERAL APPROACHES



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Market risk

PORTFOLIO STANDARD DEVIATIONPORTFOLIO STANDARD DEVIATION

DOWNSIDE RISK SUCH AS SEMI -VARIANCEDOWNSIDE RISK SUCH AS SEMI -VARIANCE

VALUE AT RISKVALUE AT RISK

EVALUATE AND MINIMIZE

RISKS

The higher the perceived risk, the higher the

discount rate that should be applied to

the projects cash flows.

Portfolio formation


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Horizon

Exposure

Methods

Guess of the

market direction

Compensate

the extra risk!

EVALUATE AND MINIMIZE

RISKS


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How to Value A Firm

Discounted Cash Flow Analysis

Comparable Multiples

Cash Flow Analysis

Price/Book Value

etc


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Investment Analysis

Investment ApproachInvestment Approach

Macroeconomic AnalysisMacroeconomic Analysis

Sector RotationSector Rotation

Balance Sheet AnalysisBalance Sheet Analysis

ValuationValuation

Chart readingChart readingMarket IndicatorsMarket Indicators

Technical IndicatorsTechnical Indicators

Behavioral FinanceBehavioral Finance


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Investment Analysis

Inflation

Currency analysis

Economic structure

FDI, restruct., dereg., taxation

Bond yields

earnings yields

Global scenarios

Others

chart,sentiment,

money flows,

behavioral fin

Macro analysis


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Valuation Techniques

Weighted Avg. Cost of Capital (WACC)

Cash Flow Analysis

Comparable MultiplesP/E (trailing or future)

Price to EBITDA

Price to Cash Flow

Price to Book ValueEnterprise

Value/EBITDA

Discounted Cash Flow


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Valuation Tools

Annual Report and Quarterly Reports

Income Statement

Balance Sheetchanges in net working capital, inventory level

Statement of Cash Flow

Financial Notes


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Discounted Cash Flow Steps

Forecastperforman

ce

Estimatecost ofcapital

Estimate

continuingvalue

Calculate

value andinterpretresults

Analyzehistoricalperformance

1. Calculate historical

margins and ratios

2. Determine valuedrivers

3. Analyze financial

health

1. Understand strategic

position of firm2. Select forecast horizon

(competitive advantage

window)

3. Forecast individual line

items

4. Develop scenarios (best,

worst, likely cases)

5. Check overall forecast for

reasonableness

1. Estimate cost of non-equity

financing

2. Estimate cost of equity

financing

3. Determine target market

weights [or iterate] forWACC

4. Calculate discount rate

1. Choose methodology

WACC

APV

1. Calculate free cash flows2. Discount free cash flow

and continuing value to

present

3. Interpret results

Select appropriate technique

1. Multiples (e.g., EBITDA, free cash flow, net

income)

2. Perpetuity/growing perpetuity

3. Estimate the parameters


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WACC Approach

Historical Projected

1997 1998 1999 2000 ....FCF

WACC

Risk-free rate

Mkt risk premium

Capital structure

Cost of debt

BetaTax rate

PV of

free

cash

flows

PV of

continuing

value

+

Net

debt =-Equity

value

Terminal

value

Discounting


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Value Analysis

Equity Value: Market Value - cash - hidden assets + Debt

EBITDA (Earnings Before Income Tax, Depreciation, and Amortization)

Trailing 4 quarters EBIT + D + A

EV/EBITDA multiple inverted is essentially the pretax cash flow return

on assets of the corporation


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Comparable Company Multiples

Advantages EPS is industry standard Easy to put into historical

context EPS can be measured in nearly

uniform manner

Helps value companies with noearnings

Disadvantages Non-cash differences Financing/capital differences Accounting standards may be

subject to interpretation and vary

across countries

Requires similar companieswith same component revenues

Doesnt tell you how profitablethe revenues are going to be

Other common measuresOther common measures Enterprise Value/EBITDAEnterprise Value/EBITDA

P/E to 5 Year Estimated EPS GrowthP/E to 5 Year Estimated EPS Growth

RateRate

Market Value of Equity/Book Value ofMarket Value of Equity/Book Value of

EquityEquity

P/E Revenue

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