FINANCIAL

RISK
MANAGEMENT
Ann Jerlyn P. Gonda
  Risk management is the process of
measuring or assessing risk and developing
strategies to manage it.
What is Risk
Management?  It is a systematic approach in identifying,
analyzing, and controlling areas or events
with a potential for causing unwanted
change.
What is Risk Risk Management is the identification,
assessment, and prioritization of risks followed
Management by coordinated and economical application of
as defined resources to minimize, monitor and control the
probability and/or impact of unfortunate events
by ISO 31000? and to maximize the realization of opportunities.
Basic Principles of Risk
Management
Risk Management should:
1. Create value
2. Address uncertainty and assumptions
3. Be an integral part of the organization processes and
decision-making
4. Be dynamic, iterative, transparent, tailorable, and responsive
to change
5. Create capability of continual improvement and enhancement
considering the best available information and human factors
6. Be systematic, structured and continually or periodically
reassessed
Process of Risk Management
1. Establishing the Context. This will involve
a. Identification of risk in a selected domain of interest
b. Planning the remainder of the process

c. Mapping out the following:

i. The social scope of risk management
ii. The identity and objectives of stakeholders
iii. The basis upon which risks will be evaluated,
constraints
d. Defining a framework for the activity and agenda for
identification
e. Developing an analysis of risks involved in the process.

f. Mitigation or solution of risks using available

technological human and organizational resources.
2. Identification of potential risks.
Common risk identification methods
are:
a. Objective-based risk
b. Scenario-based risk
c. Taxonomy-based risk
d. Common-risk checking
e. Risk charting

3. Risk assessment
Elements of Risk Management
1. Identification, characterization, and
assessment of threats
2. Assessment of the vulnerability of critical
assets to specific threats
3. Determination of the risk
4. Identification of ways to reduce those risks
5. Prioritization of risk reduction measures based
on a strategy
 Potential Risk Treatments

AVOIDANC REDUCTIO SHARING RETENTIO

E
This includes N
This involves This means This N
involves
performing an reducing the sharing with accepting the loss
activity that could severity of the loss or benefit of gain,
carry risk. or the likelihood of another party the from a risk when it
the loss from burden of loss or occurs.
occurring. the benefit of gain,
from a risk, and
the measures to
reduce a risk.
Areas of Risk Management
1. Enterprise risk Management
2. Risk management activities as applied to
project management
3. Risk management for megaprojects
4. Risk management of information
technology
5. Risk management techniques in petroleum
and natural gas
INVESTMENT
RISK
Investment risk is defined as
the probability or uncertainty of
losses rather than expected profit
from investment due to a fall in the
fair price of securities such as
bonds, stocks, real estate, etc.
 It is the uncertainty about the rate of
return caused by the nature of the
business.

Business
Risk The most frequently discussed causes
of business risk are uncertainty about
the firm’s sales and operating
expenses.

  The degree of operating leverage at a particular sales level can be measured as:
Financial
Risk It refers to the firm's ability to
manage debt and fulfil
This type of risk typically
arises due to instabilities,
financial obligations. losses in the financial market
or movements in stock prices,
currencies, interest rates, etc.

  The degree of financial leverage at a particular level of operating income can be estimated as:
Liquidity
Liquidity risk is associated with the uncertainty
Risk created by the inability to sell the investment
quickly for cash.
  Default risk is related to the probability that some
or all the initial investment will not be returned.

Default  The degree of default risk is closely related to the

Risk financial condition of the company issuing the
security and the security’s rank in claims on assets
in the event of default or bankruptcy.
  It is the potential that a change in overall interest
rates will reduce the value of a bond or other fixed-
Interest rate investment
 As interest rates rise bond prices fall, and vice versa.
Rate Risk This means that the market price of existing bonds
drops to offset the more attractive rates of new bond
issues.
Management
Risk This is the risk—financial Decisions made by a
or non-financial – firm’s management and
associated with ineffective, board of directors
destructive, or materially affect the risk
underperforming faced by investors.
management. 
  This is the risk that inflation will undermine an
PURCHASING investment's returns through a decline in
purchasing power.
POWER RISK
(INFLATION  Purchasing power risk is perhaps, more difficult to
RISK) recognize than the other types of risk.
COMMONLY USED TECHNIQUES AND MODELS IN
ASSESSING INVESTMENT ALTERNATIVES UNDER
RISK UNCERTAINTY

Value Of Sensitivity
Probability
Information Analysis

Standard
Deviation And
Simulation Decision Tree
Coefficient Of
Variation

Project Beta
 PROBABILITY
Decision Making Under Decision Making Under
Certainty Uncertainty
It means that for each decision It is when there are many
action there is only one event and unknowns and no possibility of
therefore only a single outcome for each knowing what could occur in the future
action. When an event is certain, there is to alter the outcome of a decision.
a 100% chance of occurrence, hence the
probability is 1.0.
Assigning Probabilities
a. A probability of 0 means the event cannot occur,
whereas a probability of 1 means the event is certain
to occur.

b. A probability between 0 and 1 indicates the likelihood

of the event’s occurrence, e.g., the probability that a
fair coin will yield heads is 0.5 on any single toss.
 Basic Terms Used with Probability

1. Two events are mutually exclusive if they cannot occur simultaneously.

2. The joint probability for two events is the probability that both will occur.
3. The conditional probability of two events is the probability that one will occur
given that the other has already occurred.
4. Two events are independent if the occurrence of one has no effect on the
probability of the other.
a. If one event has an effect on the other event, they are dependent
b. Two events are independent if their joint probability equals the product of
their individual probabilities.
c. Two events are independent if the conditional probability of each event
equals its unconditional probability.
Illustrative Case. DECISION MAKING UNDER
UNCERTAINTY

M & O Corporation is considering two new designs for Event Probability For
their kitchen utensil product - Product A and Product B. (Units
Either can be produced using the present facilities. Each Demanded) Product A Product B
product requires an increase in annual fixed costs of 5,000 0 0.1
P4,000,000. The products have the same selling price of 10,000 0.1 0.1
P1,000 and the same variable costs per unit of P800. 20,000 0.2 0.1
30,000 0.4 0.2
After studying past experience with similar products,
management has prepared the following probability
40,000 0.2 0.4
distribution: 50,000 0.1 0.1
  1.0 1.0
Management would like to know
a. The break-even point for each product.
b. Which product should be chosen, assuming the objective is to maximize expected
operating income?
Solution:

a. Since both products have the same contribution margin per unit of P200 (P1,000 - P800) break-
even point for each product will be the same computed as follows:

Break-even ₱ 4,000,000
=
point
₱ 200
= 20,000 units
b. (1) Determine the expected demand for the two products:

Event Product A Product B

Demand Probability Units Probability Units
5,000 0.0 0 0.1 500
10,000 0.1 1,000 0.1 1,000
20,000 0.2 4,000 0.1 2,000
30,000 0.3 12,000 0.2 6,000
40,000 0.4 8,000 0.4 16,000
50,000 0.5 5,000 0.1 5,000

1.0 30,000 units 1.0 30,500 units

(2) Compute the expected operating income of the two products.

Product A Product B
Sales ₱ 30,000,000 ₱ 30,500,000
Variable Costs 24,000,000 24,400,000
Contribution Margin ₱ 6,000,000 ₱ 6,100,000
Fixed Costs 4,000,000 4,000,000
Operating Income ₱ 2,000,000 ₱ 2,100,000

Product B should be chosen because of the higher expected income compared with Product A.
PAYOFF
(DECISION)
TABLES
Payoff decision tables are the
helpful tools for identifying the
best solution given several
decision choices and future
conditions that involve risk.
Example :

A dealer in luxury yachts may order 0, 1, or 2 yachts for this season's inventory. The
cost of carrying each excess yacht is P50,000, and the gain for each yacht sold is
P200,000. The situation may be described by payoff table as follows:

State of Nature =
Season's Actual Decision = Decision = Decision =
Demand Order 0 Order 1 Order 2
0 yachts 0 ₱ (50,000.00) ₱ (100,000.00)
1 yacht 0 200,000.00 150,000.00
2 yachts 0 200,000.00 400,000.00
 Pr Demand

The probabilities of the season's demand are 0.10 0

0.50 1
0.40 2

The dealer may calculate the expected value of each decision as follows:

Order 0 Order 1 Order 2

0.1 x 0 0.1 x ₱ (50,000.00) 0.1 x ₱ (100,000.00)
0.5 x 0 + 0.5 x 200,000.00 + 0.5 x 150,000.00
0.4 x 0 + 0.4 x 200,000.00 + 0.4 x 400,000.00
EV (0) = 0 EV (1) = ₱ 175,000.00 EV (1) = ₱ 225,000.00
Expected Value of Perfect Information

Perfect information is the knowledge that a future state of nature will occur with certainty, i.e., being
sure of what will occur in the future.

Expected value of perfect information is the difference between the expected value without perfect
information and the return if the best action is taken given perfect information.

Information can be obtained from various sources, such as the following:

1. Market research surveys
2. Other surveys and questionnaire
3. Conducting a pilot test
4. Building a prototype model
Sensitivity Analysis
It describes how sensitive the linear programming
optimal solution is to a change in any other number. It
answers what-if questions about the effect of change in
prices or variable costs; changes value; addition or deletion
of constraints, such as available machine hours; and
changes in industrial coefficients, such as the labor-hours
required in manufacturing in a specific unit.
Illustrative Case. Application of Sensitivity Analysis

Mirmo Company has prepared the following budgeted profitability statement for
the current year operations:
           
  Sales (2,500 units x P40) ₱100,000 
  Variable Cost:  
  Materials ₱40,000  
  Labor ₱30,000 ₱70,000 
  Contribution margin ₱30,000 
  Less: Fixed cost ₱20,000 
  Profit ₱10,000 
           

Required:
Make sensitivity analysis based on the above data.
Solution:

The changes in the sales revenue and costs on profit can be analyzed with the help of
sensitivity analysis as follows:

1. If selling price is reduced by more than 10% budgeted, the company would incur
loss.

2. If the sales are reduced by more than 10% of the budgeted sales of 2,500 units, the
company would incur loss.

3. If labor costs increase by more than 33.33% above the budgeted, the company
would make a loss.

4. If material cost increase by 25% or more of the budgeted cost, the company would
make a loss.

5. If fixed costs increase by more than 50% of budgeted fixed cost, the company
would incur loss.
 Simulation
It is a technique for experimenting with logical and mathematical models
using a computer.
 Define Define the objectives

Formulate Formulate the model

Steps of
Simulation Validate Validate the model

Procedure Design Design the experiment

Conduct Conduct the simulation – evaluation results

Advantages and Limitation of Simulation
Advantages

a. Time can be
compressed a. Cost
b. Alternative policies
can be explored b. Risk of error

Limitations
c. Complex systems
can be analyzed
Decision Tree
It is an analytical tool used in problem
in which a series of decision has to be
made at various time intervals, with
each decision influenced by the
information that is available at the time
it is made.

It is a diagram that shows the several

decision and the acts of the possible
consequences called events of each act.
 1. It is an effective means of presenting the
relevant information needed by management in
an investment problem.

2. Combination of action choices with different

Advantages events or results of action that chance or other
uncontrollable circumstances partially affect
can be better presented and studied.
3. The interactions of the impact of future events,
decision alternatives, uncertain events and their
possible payoffs can be shown with greater
ease and clarity.
4. Data are presented in a manner that enables
systematic analysis and better decisions.
 1. A decision tree does not give management the
answers to an investment problem.

2. It does not identify all the possible events, or

Limitations does it list all the decisions that must be made
on a subject under analysis.
3. The interactions of such decision with the
objective of other parts of the business
organization would be too complicated to
compute manually.
4. Decision tree analysis treats uncertain
alternatives as if they were discrete well-
defined possibilities.
 Steps In Making Decision Tree

Determination
Identification Estimates of
of the points Analysis of
of the points the Estimates of
of uncertainty the alternative
and decision probabilities the costs and
and the type values in
and the of different gains of
or range of choosing a
alternatives events or various events
alternative course of
available at results of and actions.
outcomes at action.
each point. action.
each point.