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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
Different types of risks
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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.
Different types of 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.
Different types of risks
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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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ROLE OF RISK MANAGER
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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ROLE OF RISK MANAGER
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?
Methods and TOOLS of risks
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!
Methods and TOOLS of risks
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TWO GENERAL APPROACHES
Methods and TOOLS of risks
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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