risk management

1. Risk Management: An Introduction
Sankarshan Basu
Indian Institute of Management, Bangalore

2. What is Risk
 Risk is broadly defined as a deviation for the
expected – it could be deviation in every
aspect of business
 Risk is omnipresent – cannot do without it
 Can be significantly leveraged

3. Risk Definition
Risk is:
• An event that is likely to occur, which can potentially have an
adverse impact (consequence) on the planned outcomes of a
proposal, project or business decision.
• Can be a result of unintended outcomes of well reasoned
decisions also.
• Normally assessed subjectively and an initial dialogue would
be required to arrive at the Risk level.

4. Sankarshan Basu 4
Why Risk Management?
 Potential Business Threats
 Need to conform to risk management policies
because of requirement to adhere to external
standards
 Use Risk Management as a tool to enable
business growth and competitiveness

5. Risk vs Return
 There is a trade off between risk and
expected return
 The higher the risk, the higher the
expected return
5

6. Example
Suppose Treasuries yield 5% and the returns
for an equity investment are:
6
Probability Return
0.05 +50%
0.25 +30%
0.40 +10%
0.25 –10%
0.05 –30%

7. Example continued
 We can characterize investments by
their expected return and standard
deviation of return
 For the equity investment:
 Expected return =10%
 Standard deviation of return =18.97%
7

8. Combining Two Risky Investments
8
2
1
2
1
2
2
2
2
2
1
2
1
2
2
1
1 2 












 w
w
w
w
w
w P
P
0
2
4
6
8
10
12
14
16
0 5 10 15 20 25 30
Standard Deviation
of Return (%)
Expected
Return (%)
2
.
0
%
24
%
16
%
15
%
10
2
1
2
1











9. Efficient Frontier of Risky Investments
9
Efficient
Frontier
Expected
Return
S.D. of
Return
Investments

10. Efficient Frontier of All Investments
10
Expected
Return
S.D. of Return
RF
E(RM)
M
Previous Efficient
Frontier
F
M
I
J
New Efficient
Frontier

11. Systematic vs Non-Systematic Risk
We can calculate the best fit linear
relationship between return from
investment and return from market
11

 

 M
R
a
R
Systematic Risk
(non-diversifiable)
Non-systematic risk
(diversifiable)

12. The Capital Asset Pricing Model
12
Expected
Return
E(R)
1.0
Beta
RF
E(RM)
]
)
(
[
)
( F
M
F R
R
E
R
R
E 




13. Assumptions
 Investors care only about expected return and
SD of return
 The ’s of different investments are
independent
 Investors focus on returns over one period
 All investors can borrow or lend at the same
risk-free rate
 Tax does not influence investment decisions
 All investors make the same estimates of ’s,
’s and ’s.
13

14. Alpha
 Alpha measure the extra return on a
portfolio in excess of that predicted
by CAPM
so that
14
)
(
)
( F
M
F
P R
R
R
R
E 



)
( F
M
F
P R
R
R
R 






15. Arbitrage Pricing Theory
 Returns depend on several factors
 We can form portfolios to eliminate
the dependence on the factors
 This leads to result that expected
return is linearly dependent on the
realization of the factors
15

16. Risk vs Return for Companies
 If shareholders care only about systematic risk, should
the same be true of company managers?
 In practice companies are concerned about total risk
 Earnings stability and company survival are important
managerial objectives
 The regulators of financial institutions are most
interested in total risk
 “Bankruptcy costs” arguments show that that managers
can be acting in the best interests of shareholders when
they consider total risk
16

17. What Are Bankruptcy Costs?
 Lost sales (There is a reluctance to
buy from a bankrupt company.)
 Key employees leave
 Legal and accounting costs
17

18. 1
Investment, Policy and
business strategies
1
Market
and SCM
risk
(Alliances)
1
Talent related (Competition and
Risk Averse ???)
1
Technology
Risk
2
2
2
2
3
3
3
3 4
Risk Zones
Zone 4 : No risk zone – High
opportunity ( Shorter term)
Zone 3 : Marginal risk – Potential
opportunity ( Longer Term)
Zone 2 : High risk / High
opportunity (strategic decisions)
Zone 1 : No go
18
Sankarshan Basu

19. Sankarshan Basu 19
Key Drivers of Growth
Technology
Risk
Decisions &
Operations
Opportunity
Growth and
Sustainability

20. Risk Management Function
 Risk Management function should include
 Benchmarking itself to international best
practices
 Optimal capital utilization.
 Maximization of shareholder value through
identification, assessment, monitoring and
management of the principal risks.
 Ensuring the adoption of sound practices
and prudential norms – use similar norms
across group entities, if applicable.
February 27, 2024 20

21. Risk Policy: Objective
“Enable Managers to systematically identify,
address, prioritize and communicate to
appropriate levels, the risks that arise in the
course of the business and take Risk Mitigation
decisions and execute such decisions with a risk
aware mind-set in order to continuously reduce
the adverse impacts of the Risks”.

22. Risk Management Philosophy
 Risk is an inherent part of a business, and
effective risk management is critical to
achieving financial soundness and profitability
 Risk management has to be identified as one of
the core competencies
 Goal is to understand, measure and monitor the
various risks that arise
 Dissemination of research on sources of risk and
risk management techniques need to done to all
market participants

23. Risk Management Philosophy
(Continued)
1.Enhance business growth and competitiveness through
strategic and structured Risk taking and sustained risk
mitigation.
2.Implies Risk Management will be applied in a transparent
environment, to sustain the business growth and
profitability in a competitive market through structured risk
taking and risk mitigation processes.
3.Risk Management processes will strengthen Technology
Absorption and Development, product delivery, service and
up-gradation, substantive self-reliance, Product Availability
and affordability.
4.This philosophy will be driven by a risk aware mindset
where risk avoidance is discouraged.

24. The business of ‘Risk’
Product Risk
Macro Economic Risk
Technological Risk
Business Risk
Legal Risk
Reputational Risk
Disaster Risk
Political / Regulatory Risk
Event Risk
Market Risk
Credit Risk
Liquidity Risk
Operational Risk
Financial Risk
Non Business Risk
Firm Wide Risk

25. Galaxy of Risks
 Accounting risk
 Bankruptcy risk
 Basis risk
 Call risk
 Capital risk
 Collateral risk
 Commodity risk
 Contract risk
 Currency risk
 Curve construction risk
 Daylight risk
 Equity risk
 Extrapolation risk
 Hedging risk
 Horizon risk
 Interest rate risk
 Interpolation risk
 Knowledge risk
 Legal risk
 Limit risk
 Liquidity risk
 Market risk
 Modeling risk
 Optional risk
 Personnel risk
 Political risk
 Prepayment risk
 Publicity risk
 Raw data risk
 Regulatory risk
 Reinvestment risk
 Rollover risk
 Suitability risk
 Systemic risk
 Systems risk
 Tax risk
 Technology risk
 Time lag risk
 Volatility risk
 Yield curve risk

26. Credit Ratings
Moody’s S&P and Fitch
Aaa AAA
Aa AA
A A
Baa BBB
Ba BB
B B
Caa CCC
Ca CC
C C
26
Investment
grade bonds
Non-investment
grade bonds

27. Subdivisions
 Moody’s divides Aa into Aa1, Aa2,
Aa3.
 S&P and Fitch divide AA into AA+, AA,
and AA−
 Other rating categories are
subdivided similarly except AAA (Aaa)
and the two lowest categories.
27

28. Approaches to (Bank) Risk Management
 Risk aggregation: aims to get rid of
non-systematic risks with
diversification
 Risk decomposition: tackles risks one
by one
 In practice (banks) use both
approaches
28

29. What is Risk Management
Risk Management includes the following:
 Identify: What type of risk?
 Sources of Risk
 Measurement: What do we measure?
 Individual and portfolio
 Monitor: How do we measure?
 Methods to estimate ‘risk’ of a security or portfolio
 Control: How do we control?
 Allocation
 Supervision

30. Ways to manage risk
 Take no position
 Always be completely hedged and try
and make money by means of an
arbitrage opportunity
 Do dynamic hedging

31. Sankarshan Basu 31
Broad Objectives of the Enterprise Risk
Management (ERM)
 ERM should help in value creation and preservation by enabling
the management to:
 Evaluate and establish strategies in a firm wide risk aware mindset
 Align risk appetite and strategy and support strategic and business
planning through appropriate structures
 Link growth, risks and return
 Be able to grasp new opportunities quickly
 Drive formal, proactive risk management processes downward to
operational levels
 Support effective usage of resources towards market opportunities
 Develop risk mitigation plans to deal effectively with potential
future events that create uncertainty to prevent value erosion or
minimize the impact of hazards or adverse events
 Proactively respond in a manner that reduces the likelihood of
downside outcomes and increases the upside

32. Sankarshan Basu 32
Key Focus of ERM
 Risk aware mindset
 Structures
 Link growth, risks and return
 New Market Opportunities
 Drive formal, proactive ……. Downward
 Risk mitigation

33. Sankarshan Basu 33
Some of the Key Risks identified – I
 Strategic
 Competitors
 Business Model
 Planning horizon
 Risk in the decision making process
 Delay in the decision making process
 Risk averse approach
 Contractual Issues

34. Sankarshan Basu 34
Some of the Key Risks identified – II
 Supply Chain
 Issues in the ordering process
 Inventory risk
 Availability of the database for uniform visibility across the organization
 Technology
 Appropriateness of the chosen technology
 Technology transfer
 Evaluation of the standards
 Evaluation of the technology transfer process
 Replacement cycle time due to replacements caused by product
obsolescence
 Human Resources
 Attraction / Retention
 Competitiveness

35. Sankarshan Basu 35
Some of the Key Risks identified – III
 Financial Risk
 Risks arising out of cost fluctuations and fixed price
 Asset Management
 Compliance / Governance
 Knowledge Management
 Information Technology / Information Technology security
 Security
 Organization Structure

36. Risk Management Steps
1. Identify Risk events
2. Qualitative Risk Analysis
3. Plan Risk Responses
4. Monitor and control

37. Risk Assessment Cube
HIGH
MEDIUM
LOW
CONSEQUENCE
LIKELIHOOD

38. A Typical Risk Management Structure
in a Bank / Financial Institution
February 27, 2024 38
Risk Management Group is completely independent
of business operations
Managing Director & CEO
Chief Risk Officer
Audit Committee
of the Board
Credit Risk
Management
Market Risk
Management
Risk
Analytics
Risk Audit
Operating
Units

39. Risk in itself is not Bad
It becomes bad when
…Unintended
…Misunderstood
…Mismanaged
Risk Identification and Quantification is not always Trivial.
But this is not an excuse for ignoring it.

40. “A firm’s ability to weather storms will depend
on how seriously risk management is embraced
by the executives when the sun is shining and
no clouds are on the horizon” – Robert Kaplan
and Anette Mikes.
“Smart Companies match their approach to the
nature of the threats they face” – Robert Kaplan
and Anette Mikes

41. Thank You