financial risk management
Risk management is the human activity which integrates recognition of risk, risk
assessment, developing strategies to manage it, and mitigation of risk using
The strategies include transferring the risk to another party, avoiding the risk,
reducing the negative effect of the risk, and accepting some or all of the consequences
of a particular risk.
Some traditional risk managements are focused on risks stemming from physical or
legal causes (e.g. natural disasters or fires, accidents, death and lawsuits). Financial
risk management, on the other hand, focuses on risks that can be managed using
traded financial instruments.
Objective of risk management is to reduce different risks related to a pre-selected
domain to the level accepted by society. It may refer to numerous types of threats
caused by environment, technology, humans, organizations and politics. On the other
hand it involves all means available for humans, or in particular, for a risk
management entity (person, staff, organization).
In ideal risk management, a prioritization process is followed whereby the risks with
the greatest loss and the greatest probability of occurring are handled first, and risks
with lower probability of occurrence and lower loss are handled in descending order.
In practice the process can be very difficult, and balancing between risks with a high
probability of occurrence but lower loss versus a risk with high loss but lower
probability of occurrence can often be mishandled.
Intangible risk management identifies a new type of risk
probability of occurring but is ignored by the organization due to a lack of
identification ability. For example, when deficient knowledge is applied to a situation,
a knowledge risk materialises. Relationship risk appears when ineffective
collaboration occurs. Process-engagement risk may be an issue when ineffective
operational procedures are applied. These risks directly reduce the productivity of
knowledge workers, decrease cost effectiveness, profitability, service, quality,
reputation, brand value, and earnings quality. Intangible risk management allows risk
management to create immediate value from the identification and reduction of risks
that reduce productivity.
Risk management also faces difficulties allocating resources. This is the idea of
opportunity cost. Resources spent on risk management could have been spent on more
profitable activities. Again, ideal risk management minimizes spending while
maximizing the reduction of the negative effects of risks.
Steps in the risk management process
Establish the context
Establishing the context involves
- Identification of risk in a selected domain of interest
- Planning the remainder of the process.
- Mapping out the following: the social scope of risk management, the identity and
objectives of stakeholders, and the basis upon which risks will be evaluated,
- Defining a framework for the activity and an agenda for identification.
- Developing an analysis of risks involved in the process.
- Mitigation of risks using available technological, human and organizational
After establishing the context, the next step in the process of managing risk is to
identify potential risks. Risks are about events that, when triggered, cause problems.
Hence, risk identification can start with the source of problems, or with the problem
- Source analysis Risk sources may be internal or
external to the system that is the target of risk
management. Examples of risk sources are:
stakeholders of a project, employees of a
company or the weather over an airport.
- Problem analysis Risks are related to identified
threats. For example: the threat of losing
money, the threat of abuse of privacy
information or the threat of accidents and
casualties. The threats may exist with various
entities, most important with shareholders,
customers and legislative bodies such as the
When either source or problem is known, the events that a source may trigger or the
events that can lead to a problem can be investigated. For example: stakeholders
withdrawing during a project may endanger funding of the project; privacy
information may be stolen by employees even within a closed network; lightning
The chosen method of identifying risks may depend on culture, industry practice and
compliance. The identification methods are formed by templates or the development
of templates for identifying source, problem or event. Common risk identification
- Objectives-based risk identification
Organizations and project teams have
objectives. Any event that may endanger
achieving an objective partly or completely is
identified as risk. Objective-based risk
identification is at the basis of COSO's
Enterprise Risk Management - Integrated
- Scenario-based risk identification In scenario
analysis different scenarios are created. The
scenarios may be the alternative ways to
achieve an objective, or an analysis of the
interaction of forces in, for example, a market
or battle. Any event that triggers an undesired
scenario alternative is identified as risk - see
Futures Studies for methodology used by
- Taxonomy-based risk identification The
taxonomy in taxonomy-based risk identification
is a breakdown of possible risk sources. Based
on the taxonomy and knowledge of best
practices, a questionnaire is compiled. The
answers to the questions reveal risks.
- Taxonomy-based risk identification in software
industry can be found in CMU/SEI- -TR- .
- Common-risk Checking In several industries
lists with known risks are available. Each risk in
the list can be checked for application to a
particular situation. An example of known risks
in the software industry is the Common
Vulnerability and Exposures list found at
- Risk Charting This method combines the above
approaches by listing Resources at risk, Threats
to those resources Modifying Factors which
may increase or reduce the risk and Consequences it is wished to avoid. Creating a
matrix under these headings enables a variety of
approaches. One can begin with resources and
consider the threats they are exposed to and the
consequences of each. Alternatively one can
start with the threats and examine which
resources they would affect, or one can begin
with the consequences and determine which
combination of threats and resources would be
involved to bring them about
Once risks have been identified, they must then be assessed as to their potential
severity of loss and to the probability of occurrence. These quantities can be either
simple to measure, in the case of the value of a lost building, or impossible to know
for sure in the case of the probability of an unlikely event occurring. Therefore, in the
assessment process it is critical to make the best educated guesses possible in order to
properly prioritize the implementation of the risk management plan.
The fundamental difficulty in risk assessment is determining the rate of occurrence
since statistical information is not available on all kinds of past incidents.
Furthermore, evaluating the severity of the consequences (impact) is often quite
difficult for immaterial assets. Asset valuation is another question that needs to be
addressed. Thus, best educated opinions and available statistics are the primary
sources of information. Nevertheless, risk assessment should produce such
information for the management of the organization that the primary risks are easy to
understand and that the risk management decisions may be prioritized. Thus, there
have been several theories and attempts to quantify risks. Numerous different risk
formulae exist, but perhaps the most widely accepted formula for risk quantification
Rate of occurrence multiplied by the impact of the event equals risk
Later research has shown that the financial benefits of risk management are less
dependent on the formula used but are more dependent on the frequency and how risk
assessment is performed.
In business it is imperative to be able to present the findings of risk assessments in
risks in financial terms. The Courtney formula was accepted as the official risk
analysis method for the US governmental agencies. The formula proposes calculation
of ALE (annualised loss expectancy) and compares the expected loss value to the
security control implementation costs (cost-benefit analysis).
Potential risk treatments
Once risks have been identified and assessed, all techniques to manage the risk fall
- Tolerate (aka retention)
- Treat (aka mitigation)
- Terminate (aka elimination)
- Transfer (aka buying insurance)
Ideal use of these strategies may not be possible. Some of them may involve tradeoffs
that are not acceptable to the organization or person making the risk management
Another source, from the US Department of Defense
Defense Acquisition University,
calls this ACAT, for Accept, Control, Avoid, and Transfer. The ACAT acronym is
reminiscent of the term ACAT (for Acquisition Category) used in US Defense
Includes not performing an activity that could carry risk. An example would be not
buying a property or business in order to not take on the liability that comes with it.
Another would be not flying in order to not take the risk that the airplane were to be
hijacked. Avoidance may seem the answer to all risks, but avoiding risks also means
losing out on the potential gain that accepting (retaining) the risk may have allowed.
Not entering a business to avoid the risk of loss also avoids the possibility of earning
Involves methods that reduce the severity of the loss. Examples include sprinklers
designed to put out a fire to reduce the risk of loss by fire. This method may cause a
greater loss by water damage and therefore may not be suitable. Halon fire
suppression systems may mitigate that risk, but the cost may be prohibitive as a
Modern software development methodologies reduce risk by developing and
delivering software incrementally. Early methodologies suffered from the fact that
they only delivered software in the final phase of development; any problems
encountered in earlier phases meant costly rework and often jeopardized the whole
project. By developing in iterations, software projects can limit effort wasted to a
single iteration. A current trend in software development, spearheaded by the Extreme
Programming community, is to reduce the size of iterations to the smallest size
possible, sometimes as little as one week is allocated to an iteration.
Involves accepting the loss when it occurs. True self insurance falls in this category.
Risk retention is a viable strategy for small risks where the cost of insuring against the
risk would be greater over time than the total losses sustained. All risks that are not
avoided or transferred are retained by default. This includes risks that are so large or
catastrophic that they either cannot be insured against or the premiums would be
infeasible. War is an example since most property and risks are not insured against
war, so the loss attributed by war is retained by the insured. Also any amounts of
potential loss (risk) over the amount insured is retained risk. This may also be
acceptable if the chance of a very large loss is small or if the cost to insure for greater
coverage amounts is so great it would hinder the goals of the organization too much.
Means causing another party to accept the risk, typically by contract or by hedging.
Insurance is one type of risk transfer that uses contracts. Other times it may involve
contract language that transfers a risk to another party without the payment of an
insurance premium. Liability among construction or other contractors is very often
transferred this way. On the other hand, taking offsetting positions in derivatives is
typically how firms use hedging to financially manage risk.
Some ways of managing risk fall into multiple categories. Risk retention pools are
technically retaining the risk for the group, but spreading it over the whole group
involves transfer among individual members of the group. This is different from
traditional insurance, in that no premium is exchanged between members of the group
up front, but instead losses are assessed to all members of the group.
Outsourcing is another example of Risk transfer where companies outsource
IT,BPO,KPO etc. In IT, some companies will outsource only development work and
product is made at offshore locations where as business requirements are handled at
onshore/client site. This way, companies can concentrate more on business
development rather than managing large group of IT development team.
Create a risk mitigation plan
Select appropriate controls or countermeasures to measure each risk. Risk mitigation
needs to be approved by the appropriate level of management. For example, a risk
concerning the image of the organization should have top management decision
behind it whereas IT management would have the authority to decide on computer
The risk management plan should propose applicable and effective security controls
for managing the risks. For example, an observed high risk of computer viruses could
be mitigated by acquiring and implementing anti virus software. A good risk
management plan should contain a schedule for control implementation and
responsible persons for those actions.
According to , the stage immediately after completion of the Risk
Assessment phase consists of preparing a Risk Treatment Plan, which should
document the decisions about how each of the identified risks should be handled.
Mitigation of risks often means selection of Security Controls, which should be
documented in a Statement of Applicability, which identifies which particular control
objectives and controls from the standard have been selected, and why.
Follow all of the planned methods for mitigating the effect of the risks. Purchase
insurance policies for the risks that have been decided to be transferred to an insurer,
avoid all risks that can be avoided without sacrificing the entity's goals, reduce others,
and retain the rest.
Review and evaluation of the plan
Initial risk management plans will never be perfect. Practice, experience, and actual
loss results will necessitate changes in the plan and contribute information to allow
possible different decisions to be made in dealing with the risks being faced.
Risk analysis results and management plans should be updated periodically. There are
two primary reasons for this:
- to evaluate whether the previously selected
security controls are still applicable and
- to evaluate the possible risk level changes in the
business environment. For example,
information risks are a good example of rapidly
changing business environment.
If risks are improperly assessed and prioritized, time can be wasted in dealing with
risk of losses that are not likely to occur. Spending too much time assessing and managing unlikely risks can divert resources that could be used more profitably.
Unlikely events do occur but if the risk is unlikely enough to occur it may be better to
simply retain the risk and deal with the result if the loss does in fact occur.
Prioritizing too highly the risk management processes could keep an organization
from ever completing a project or even getting started. This is especially true if other
work is suspended until the risk management process is considered complete.
It is also important to keep in mind the distinction between risk and uncertainty. Risk
can be measured by impacts x probability.
Areas of risk management
As applied to corporate finance, risk management is the technique for measuring,
monitoring and controlling the financial or operational risk on a firm's balance sheet.
See value at risk.
The Basel II framework breaks risks into market risk (price risk), credit risk and
operational risk and also specifies methods for calculating capital requirements for
each of these components.
Enterprise risk management
In enterprise risk management, a risk is defined as a possible event or circumstance
that can have negative influences on the Enterprise in question. Its impact can be on
the very existence, the resources (human and capital), the products and services, or the
customers of the enterprise, as well as external impacts on society, markets, or the
environment. In a financial institution, enterprise risk management is normally
thought of as the combination of credit risk, interest rate risk or asset liability
management, market risk, and operational risk.
In the more general case, every probable risk can have a pre-formulated plan to deal
with its possible consequences (to ensure contingency if the risk becomes a liability).
From the information above and the average cost per employee over time, or cost
accrual ratio, a project manager can estimate
- the cost associated with the risk if it arises,
estimated by multiplying employee costs per
unit time by the estimated time lost (cost
impact, C where C = cost accrual ratio * S).
- the probable increase in time associated with a
risk (schedule variance due to risk, Rs where Rs
= P * S):
- Sorting on this value puts the highest
risks to the schedule first. This is
intended to cause the greatest risks to
the project to be attempted first so that
risk is minimized as quickly as possible.
o This is slightly misleading as schedule
variances with a large P and small S and
vice versa are not equivalent. (The risk
of the RMS Titanic sinking vs. the
passengers' meals being served at
slightly the wrong time).
- the probable increase in cost associated with a
risk (cost variance due to risk, Rc where Rc = P*C = P*CAR*S = P*S*CAR)
o sorting on this value puts the highest
risks to the budget first.
o see concerns about schedule variance as
this is a function of it, as illustrated in the equation above.
Risk in a project or process can be due either to Special Cause Variation or Common
Cause Variation and requires appropriate treatment. That is to re-iterate the concern
about extremal cases not being equivalent in the list immediately above.
Risk management activities as applied to project management
In project management, risk management includes the following activities:
- Planning how risk management will be held in
the particular project. Plan should include risk
management tasks, responsibilities, activities
- Assigning a risk officer - a team member other
than a project manager who is responsible for
foreseeing potential project problems. Typical
characteristic of risk officer is a healthy
- Maintaining live project risk database. Each risk
should have the following attributes: opening date, title, short description, probability and
importance. Optionally a risk may have an
assigned person responsible for its resolution
and a date by which the risk must be resolved.
- Creating anonymous risk reporting channel.
Each team member should have possibility to
report risk that he foresees in the project.
Preparing mitigation plans for risks that are
chosen to be mitigated. The purpose of the
mitigation plan is to describe how this particular
risk will be handled what, when, by who and
how will it be done to avoid it or minimize
consequences if it becomes a liability.
- Summarizing planned and faced risks,
effectiveness of mitigation activities and effort
spend for the risk manageme
Risk management and business continuity
Risk management is simply a practice of systematically selecting cost effective
approaches for minimising the effect of threat realization to the organization. All risks
can never be fully avoided or mitigated simply because of financial and practical
limitations. Therefore all organizations have to accept some level of residual risks.
Whereas risk management tends to be pre-emptive, business continuity planning
(BCP) was invented to deal with the onsequences of realised residual risks. The
necessity to have BCP in place arises because even very unlikely events will occur if
given enough time. Risk management and BCP are often mistakenly seen as rivals or
overlapping practices. In fact these processes are so tightly tied together that such
separation seems artificial. For example, the risk management process creates
important inputs for the BCP (assets, impact assessments, cost estimates etc). Risk
management also proposes applicable controls for the observed risks. Therefore, risk
management covers several areas that are vital for the BCP process. However, the
BCP process goes beyond risk management's pre-emptive approach and moves on
from the assumption that the disaster will realize at some point.
financial risk management
Finance theory (i.e. financial economics) prescribes that a firm should take on a
project when it increases hareholder value. Finance theory also shows that firm
managers cannot create value for shareholders, also called its investors, y taking on
project that shareholders could do for themselves at the same cost. When applied to
financial risk anagement, this implies that firm managers should not hedge risks that
investors can hedge for themselves at the same cost. This notion is captured by the
hedging irrelevance proposition: In a perfect market, the firm cannot create value by
hedging a risk when the price of bearing that risk within the firm is the same as the
price of bearing it outside of the firm. In practice, financial markets are not likely to
be perfect markets. This suggests that firm managers likely have many opportunities
to create value for shareholders using financial risk management. The trick is to
determine which risks are cheaper for the firm to manage than the shareholders. A
general rule of thumb, however, is that market risks that result in unique risks for the
firm are the best candidates for financial risk management.