Types of Risk Faced by a Business Entity

1. Strategic Risk
2. Compliance Risk
3. Operational Risk
4. Financial Risk

Strategic Risk

Strategic Risk is the exposure to loss resulting from a strategy that turns out to be defective or inappropriate. A possible source of loss that might arise from the pursuit of an unsuccessful business plan. For example, strategic risk might arise from making poor business decisions, from the substandard execution of decisions, from inadequate resource allocation, or from a failure to respond well to changes in the business environment.

A successful business always needs a comprehensive and detailed business plan.  Everyone knows that a successful business needs a comprehensive, well-thought-out business plan. But it’s also a fact of life that, if things changes, even the best-laid plans can become outdated if it cannot keep pace with the latest trends. This is what is called as strategic risk. So, strategic risk is a risk in which a company’s strategy becomes less effective and it struggles to achieve its goal. It could be due to technological changes, a new competitor entering the market, shifts in customer demand, increase in the costs of raw materials, or any number of other large-scale changes.

We can take the example of Kodak which was able to develop a digital camera by 1975. But, it considers this innovation as a threat to its core business model, and failed to develop it. However, it paid the price because when digital camera was ultimately discovered by other companies, it failed to develop it and left behind. Similar example can be given in case of Nokia when it failed to upgrade its technology to develop touch screen mobile phones. That delay enables Samsung to become a market leader in touch screen mobile phones.

Strategic risk management (SRM) can be defined as the process of identifying, assessing and managing the risk in the organization’s business strategy including taking swift action when risks are realized. SRM involves evaluating how a wide range of possible events and scenarios will affect the strategy and its execution and the ultimate impact on the company’s value. “Risk” is all-inclusive, encompassing everything from product innovation risk and market risk to supply chain risk and reputational risk. A primary component and foundation of enterprise risk management, SRM requires the organization to define tolerable levels of risk as a guide for strategic decision-making. It is a continual process that should be embedded in strategy setting and strategy execution.

Compliance Risk

Compliance risk is exposure to legal penalties, financial forfeiture and material loss an organization faces when it fails to act in accordance with industry laws and regulations, internal policies or prescribed best practices. Many compliance regulations are enacted to ensure that organizations operate fairly and ethically. For that reason, compliance risk is also known as integrity risk. In many cases, businesses that fully intend to comply with the law still have compliance risks due to the possibility of management failures.

The following are a few examples of compliance risks:

1. Environmental Risk
2. Workplace Health & Safety
3. Corrupt Practices
4. Social Responsibility Risk
5. Quality Risk
6. Process Risk

Every business needs to comply with rules and regulations. For example with the advent of Companies Act, 2013, and continuous updating of SEBI guidelines, each business organization has to comply with plethora of rules, regulations and guidelines. Non-compliance leads to penalties in the form of fine and imprisonment.

However, when a company ventures into a new business line or a new geographical area, the real problem then occurs. For example, a company pursuing cement business likely to venture into sugar business in a different state. But laws applicable to the sugar mills in that state are different. So, that poses a compliance risk. If the company fails to comply with laws related to a new area or industry or sector, it will pose a serious threat to its survival.

Operational Risk

Operational risks are the risks, a company undertakes when it attempts to operate within a given field or industry. Operational risk is the risk not inherent in financial, systematic or market-wide risk. It is the risk remaining after determining financing and systematic risk, and includes risks resulting from breakdowns in internal procedures, people and systems.

This type of risk relates to internal risk. It also relates to failure on the part of the company to cope with day to day operational problems. Operational risk relates to people as well as processes. Operational risk can be summarized as human risk; it is the risk of business operations failing due to human error. It changes from industry to industry, and is an important consideration to make when looking at potential investment decisions. Industries with lower human interaction are likely to have lower operational risk.

Operational risk focuses on how things are accomplished within an organization and not necessarily what is produced or inherent within an industry. These risks are often associated with active decisions relating to how the organization functions and what it prioritizes. While the risks are not guaranteed to result in failure, lower production or higher overall costs, they are seen as higher or lower depending on various internal management decisions.

Financial Risk

Financial risk is the possibility that shareholders or other financial stakeholders will lose money when they invest in a company that has debt if the company’s cash flow proves inadequate to meet its financial obligations. When a company uses debt financing, its creditors are repaid before shareholders if the company becomes insolvent.

Financial risk also refers to the possibility of a corporation or government defaulting on its bonds, which would cause those bondholders to lose money. It is referred as the unexpected changes in financial conditions such as prices, exchange rate, Credit rating, and interest rate etc. Though political risk is not a financial risk in direct sense but same can be included as any unexpected political change in any foreign country may lead to country risk which may ultimately may result in financial loss.

Financial Risk can be divided into following categories:

1. Counter Party Risk
2. Political Risk
3. Interest Rate Risk
4. Currency Risk

The financial risk can be evaluated from different point of views as follows:

• From stakeholder’s point of view: Major stakeholders of a  business are equity shareholders and they view financial gearing i.e. ratio of debt in capital structure of company as risk since in event of winding up of a company they will be least prioritized. Even for a lender, existing gearing is also a risk since company having high gearing faces more risk in default of payment of interest and principal repayment.
• From Company’s point of view: From company’s point of view if a company borrows excessively or lend to someone who defaults, then it can be forced to go into liquidation.
• From Government’s point of view: From Government’s point of view, the financial risk can be viewed as failure of any bank or (like Lehman Brothers) down grading of any financial institution leading to spread of distrust among society at large. Even this risk also includes willful defaulters. This can also be extended to sovereign debt crisis.

Identification and Management of Financial Risk

Counter Party Risk

The various hints that may provide counter party risk are as follows:

• Failure to obtain necessary resources to complete the project or transaction undertaken.
• Any regulatory restrictions from the Government.
• Hostile action of foreign government.
• Let down by third party.
• Have become insolvent.

The various techniques to manage this type of risk are as follows:

1. Carrying out Due Diligence before dealing with any third party.
2. Do not over commit to a single entity or group or connected entities.
3. Know your exposure limits.
4. Review the limits and procedure for credit approval regularly.
5. Rapid action in the event of any likelihood of defaults.
6. Use of performance guarantee, insurance or other instruments.

Political Risk

Since this risk mainly relates to investments in foreign country, company should assess country

1. By referring political ranking published by different business magazines.
2. By evaluating country’s macro-economic conditions.
3. By analyzing the popularity of current government and assess their stability.
4. By taking advises from the embassies of the home country in the host countries.
5. Further, following techniques can be used to mitigate this risk.

(i)   Local sourcing of raw materials and labour.

(ii)  Entering into joint ventures

(iii) Local financing

(iv) Prior negotiations

From the following actions by the Governments of the host country this risk can be identified:

1. Insistence on resident investors or labour.
2. Restriction on conversion of currency.
3. Repatriation of foreign assets of the local govt.
4. Price fixation of the products.

Interest Rate Risk

Generally, interest rate Risk is mainly identified from the following:

1. Monetary Policy of the Government.
2. Any action by Government such as demonetization etc.
3. Economic Growth
4. Release of Industrial Data
5. Investment by foreign investors
6. Stock market changes

Currency Risk

Just like interest rate risk the currency risk is dependent on the Government action and economic development. Some of the parameters to identity the currency risk are as follows:

1. Government Action
2. Nominal Interest Rate
3. Inflation Rate
4. Natural Calamities: Any natural calamity can have negative impact
5. War, Coup, Rebellion etc.
6. Change of Government

Value at Risk (VAR)

Value at Risk (VAR) is a measure of the risk of investments. It estimates how much a set of investments might lose, given normal market conditions, in a set time period such as a day. VAR is typically used by firms and regulators in the financial industry to gauge the amount of assets needed to cover possible losses.

Value at risk (VAR) is a statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over a specific time frame. This metric is most commonly used by investment and commercial banks to determine the extent and occurrence ratio of potential losses in their institutional portfolios. VAR calculations can be applied to specific positions or portfolios as a whole or to measure firm-wide risk exposure.

Measuring Value at Risk (VAR) for Single Stock

Step 1:

Determine Volatility in Value

Step 2:

Determine Value at Risk (VAR)

 

Measuring Value at Risk (VAR) for a Portfolio (2 Stocks)

Step 1:

Determine Standard Deviation of the portfolio

Step 2:

Determine Volatility in Value

Step 3:

Determine Value at Risk (VAR)

 

Question 1

Miss Rinky holds shares in NJ Ltd. whose market value is ` 2,00,00,000. The standard deviation of the market price is 2% per day. Assuming 5 trading days in a week, and using 99% confidence level, determine the maximum loss level over the period of:

1 trading day and

2 weeks (10 trading days)

Given that, value of ‘Z’ for 1% significance level from normal table of cumulative area = 2.33

 

Question 2

Aloknath holds shares in Baba Ltd. whose market value is ` 5,00,000. The standard deviation of the market price is 3% per day. Assuming 5 trading days in a week, and using 95% confidence level, determine the maximum loss level over the period of:

1 trading day and

2 weeks (10 trading days)

Given that, value of ‘Z’ for 5% significance level from normal table of cumulative area = 1.645

 

Question 3

You hold stock A with a standard deviation of 2% per day and another stock B with a standard deviation of 3% per day.  You hold these two stocks in a portfolio, with ` 5,00,000 invested in each.  Stock B has a correlation coefficient of 0.6 with stock A. Assuming 5 trading days in a week, and using 95% confidence level, determine the maximum loss level over the period of:

1 trading day and

2 weeks (10 trading days)

Given that, value of ‘Z’ for 5% significance level from normal table of cumulative area = 1.645

 

Question 4

Mr. Lazy holds a portfolio with 2 stocks X and Y. Stock X has a standard deviation of 4% per day and stock Y has a standard deviation of 6% per day.

Mr. Lazy has invested ` 8,00,000 in Stock X and ` 12,00,000 in Stock Y.  Stock X has a correlation coefficient of 0.72 with stock Y. Assuming 5 trading days in a week, and using 99% confidence level, determine the maximum loss level over the period of 2 weeks (10 trading days)

Given that, value of ‘Z’ for 1% significance level from normal table of cumulative area = 2.33

 

Question 5

Consider a portfolio consisting of a ` 2,00,00,000 investment in share XYZ and a ` 2,00,00,000 investment in share ABC. The daily standard deviation of both shares is 1% and that the coefficient of correlation between them is 0.3.

You are required to determine the 10 day, 99% value at risk for the portfolio. Given that, value of ‘Z’ for 1% significance level from normal table of cumulative area = 2.33

 

Question 6

Gippy Murugan Ltd. holds a portfolio of 2 stocks X and Y. The company has invested ` 15,00,000 in Stock X and ` 10,00,000 in Stock Y.  The daily standard deviation in market values of Stock X and stock Y are 8% and 6% respectively.  Stock X has a correlation coefficient of 0.8 with stock Y. Using 95% confidence level, determine the Value at Risk for the portfolio over 1 day. Also explain by how much does the Value at Risk reduces because of diversification.

Given that, value of ‘Z’ for 5% significance level from normal table of cumulative area = 1.645