Question

Financial risk forms : • Market value risk • interest rate risk, • exchange prices, • Asset prices price • default risk • Risk of liquidity

Non-Financial risk forms: • Business Risk( chances of failure of business) • Operational Risk (misconduct,fraud etc) • Accounting risk (changes in GAAP/IFRS and comparability issues, managed earnings, etc.) • Legal and Regulation risk • Tax risk • environment risk • Strategic risk

Elaborate on each of the risk factors with examples

Answer 1

Market Value Risk: Market Value Risk refer to the risk that the market prices of the assets or underlyings held by an entity or individual may change resulting in a loss of capital to the entity or individual.

For example,if you buy 1 unit of Common Stock of Apple at $100, you are susceptible to risk that the price of Apple Stock may fall below $100. Market Value risk is also considered as Systematic Risk.

Interest Rate Risk: Interest Rate Risk entails change in the rate of interest from the contractually agreed rate of interest resulting in an increased interest cash outflow.

For example, A manufacturing company enters into a contract with a Bank to borrow $100Mn at the rate of LIBOR +2% p.a on 01/01/2019. Assumin the rate of LIBOR to be 4%, the current interest rate would come to 6%. The expected cash outflow on account of interest rate payment for the commpany at the agreed rate would be $6Mn for the year.

However, if the LIBOR changes to 4.5% as on 06/30/2019, the interest that the manufacturer would now have to pay would be 6.5% (4.5% + 2%) resulting in an increase Cash Outflow of $250,000 for the remainder of the year.

In order to hedge Interest Rate Risks, banks and corporations usually enter to hedging contracts like Interest Rate Swaps and Interest Rate Derivatives.

Exchange Prices Risk: Exchange Prices Risk refers to the risk that the exchange rate of any given foreign currency may deteriorate resulting in a loss to the participants in an Foreign Exchange currency contract. FOREX traders dealing in Foreign Exchange contracts and people engaged in Import Export activities are largely exposed to Exchange Prices Risk.

For Example, Mr A enters into a contract with Mr. B to buy 100 CHF(Swiss Francs) by paying equivalent amount of US Dollars and subsequently sell them to MR.C and buy back the Dollars.

As on 01/01/2019, the exchange rate for CHF/USD is 1.05. Therefore in order to buy 100CHF, MR A pays out $95.24. (100/1.05). As on 01/05/2019, MR A sensing that the exchange rates for dollars are deteriorating, quickly approaches Mr. C to sell the CHF's and buy back the dollars when the rate for CHF/USD is 1.07. Accordingly, he receives only $93.46 (100/1.07) resulting in a loss of $1.78 on mere exchange of the same currencies. The risk of such a loss is referred to as Exchange Price Risk.

Fluctuations in the exchange rate risks affect the importers and exporters of goods and serivces the most. An importer is exposed to the risk of increase in Exchange rates while an Exporter is exposed to the risk of decrease in exchange rates.

Few ways to mitigate this risk include Derivative contracts such as Currency Forwards, Currency Swaps and Currency Options Contracts.

Asset prices price risk: This risk refers to the risk that prices of underlying assets (like equities, bonds, commodities, real estate, etc.) may change or deteriorate resulting in a loss.

For Example, you buy a house coosting USD $ 1Mn with an interntion to sell the same in 6 months from now. While you expect the prices to go up, you real estate agent informs you that the prices may also fall by 10% within next 6 months. You are now exposed to the risk that the price of the asset/house that you have bought foor $1Mn may fall and come back to around $900K. This may result in a losss of $100K only withinn a span of 6 months.

The genesis of this type of risk is the volatility in the prices of the underlying asstes.

Default risk: This risk refers to the risk that a borrower may run into financial troubles where he is unable to repay his loans and interest payments. Such a situation is refered to as "Default" in banking paralance. Therefore a risk that a borrower may Default on payment of is contractual obligations is called as "Default Risk".

In the banking paralance, default risk is the most basic types of risk that banks have to mitigate and protect themselves against. In order to do so, Banks rely on Credit ratings provided by ratings agencies and lend only to entities who have strong credit history and credit ratings.

In the wake of the Global Economic crisis of 2008, many banks, financial institutions and Sovereign Governments defaulted on the payments oof their Debt Obligations.

Liquidity Risk: Liquidity risk refers to the situation where for a short period of time, an asset like a Bond or Commercial Paper may not be sold or liquidated against Cash. This type of risk generally manifests into market risk and if one intends to sell assets in a market where there's a liquidity crunch he may have to do so at lower prices resulting in huge losses.

Firms face liquidity risks if there is a sudden outflow of cash due to events like ratings downgrade, Asset Liability mismatches and excessive withdrawals by depositors.

For example, Several investors have bought $100 Mn worth of Bonds maturing in 1 year issued by Bank X having strong credit ratings. However, the bank defaults in 3 months time and the rating of the bank deteriorates. Due to this the bond prices start tumbling and the depositors intend to sell the bonds fearing further defaults. However, no one in the markets is willing to by these bonds. Such a situation is a resultant risk of liquidity.

Business Risk: Risk that the business may run into a situation where it is generating revenues, short of what it had anticipated or projected. This may be due to various reasons ranging from adverse legislations to changing consumer tastes and choices. The gravest forms of business risk represents a stuation where a business may not be able to make any revenues or sale any of the products it makes. Business Risk could crystalise for internal reasons like faiure of management or external reasons like banning of products being sold by the firm.

For example, A company selling plastic bottles faces a business risk that the goverments across globe may impose a ban on use of Plastic Bottles. Another example could be constant risk that technology companies face. Consumers may switch to use new technology rendering the producers of current technology useless. Globally diesel engine manufacturers face a risk that there engines could be replaced by electric car batteries.

Operational Risk : Operational Risk refers to the risk that the internal controls within a entity fall short of preventing, detecting or rectifying ommissions, alterations caused due to errors or frauds resulting in huge economic and reputational losses.

For example, a gold jewellery store faces huge operational risk. Even a petty theft by any of the employees in the store can result in a economic loss for the store.

Accounting risk (changes in GAAP/IFRS and comparability issues, managed earnings, etc.) : This type of risk refers to the risk that the financial statements may be impacted adversely due to changes in the standards, policies, guidance notes in the accounting standards prescribed under various GAAP's like US GAAP/ IFRS GAAP. This may have a huge impact on the way earnings are reported, assets are represented and the way various accounting ratios are calculated which may impact the funds raising ability of a firm for further expansion, etc.

For Example, recent changes in Lease accounting policies. The new policy requires almost all operating leases to be classified as Finance Lease. This would have a huge impact on the Asset Turnover ratios and Debt Equity ratios for Firms. This is a very critical change for entities operating on the Lease models like retailers, airline companies, hospitality industry, etc.

Legal and Regulation risk : The risk that the legislations may change and adversely affect the sales of products and revenue generating abilities of the businesss.

An example of this could be imposition of sanctions by the US Government on Iran. As a result of this no products can be exported from US to Iran. An exporter who exports products having huge demand in Iran is affected adversely because of imposition of sanctions.

Another example could be ban on use of Plastics by way of enacting laws and inflicting punitive damages for anyone who uses plastics. This may adversely impact firms who are engaged in manufacturing, selling of plastics.

Tax risk : Risk that the taxation policies and laws may change resulting in an adverse business impact or imposition of higher tax rates. This is a grave risk for investors investing in emerging market economies who are enticed by governments too invest and are gradually exposed to higher tax rates by enacting, ammending tax laws.

For example, in India foreign investors investing in Indian equity markets through participatory notes were initially subjected to nil tax rates. The number of such investors was very low then. However, subsequently when Indian ecoonomy started growing and Indian markets started growing, more and more foreing investors started investing in India. The government sensed that the demand for Indian Markets is growning amongst Foreing Investors and imposed a Capital Gain Tax on the investors investing through Participatory Notes.

Environment risk : Risk that business operations of firms may pollute the environment and cause enormous damage to the environment is referred to as Environmental Risk. Development of basic manufacturing industries like Steel, Power, Iron cause enormous environmental damage and pose a risk of depletion of environmental resources.

For Example, construction of Dams poses a huge environmental threat as the backwaters due to construction of dams results in submerging of huge land mass. This may further result in extinction of loacal flora and fauna. Another example could be Global Warming. Use of products emiting green gases in huge quantities pose a grave threat to environment in the form of Global Warming.

Strategic risk: Risk that a formulated, designed and implemented strategy in business may not bear the fruits that were anticipated with implementation of such a strategy.

For example a company may devise a strategy to sell goods at huge discounts to increase its sales. However, such a strategy may pose a risk that people may perceive the product to be of inferior quality due to low costs and may not buy the products at all. As a result the sales decline further instead of increasing on the back of strategy.

Strategic risk is a function of Management Decisions and requires meticulous planning and execution to be mitigated.