What is Risk Management?
Risk management is the process of identifying, assessing and controlling threats to an organisation’s capital and profitability. Financial risks, legal liabilities, technological obstacles, strategic management failures, accidents and natural disasters are all potential risk factors.
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A thorough risk management programme enables a business to assess all of the threats it faces. Risk management also looks at the link between risks and the potential for them to have a cascade effect on a firm’s strategic goals. This holistic approach to risk management is sometimes referred to as enterprise risk management because of its emphasis on forecasting and analysing risk throughout an organisation.
Enterprise Risk Management (ERM) highlights the necessity of managing positive risk in addition to focusing on internal and external threats. Positive risks are possibilities that, if seized, could boost a company’s value or, on the other hand, harm it if not taken. Any risk management program’s objective is to add to and maintain business value through risk decisions that are well-informed, not to remove all the risk.
Types of Risks
In general, there are two types of risk: systematic and unsystematic. The market unpredictability of an investment is known as systematic risk and it refers to external factors that affect all (or many) enterprises in an industry or group. Unsystematic risk refers to asset-specific risks that can affect an investment’s performance. These two types are discussed below:
Systematic Risks
Risks inherent in the whole market or market sector are referred to as systematic risk. Systematic risk, often known as “irrational risk,” “volatility,” or “market risk,” is a type of risk that affects the entire market rather than just one stock or industry.
Systematic risk can’t be predicted and not possible to eliminate entirely. It can only be minimised by hedging or employing the proper asset allocation strategy, not by diversification.
Other investment hazards, such as industry risk, are based on systematic risk. If an investor has put too much reliance on IT stocks, for instance, he or she can diversify by buying stocks in other industries such as banking and infrastructure. Changes in interest rate, inflation, recessions and wars, among other major changes, are all part of systematic risk. Any type of shifts in these areas can have a large impact on the market and cannot be addressed by altering positions within a public equity portfolio.
To help mitigate systematic risk, investors should diversify their portfolios by including fixed income, cash and real estate, all of which will give results in a different manner in the case of a major systemic change.
Any rise in interest rates, say, will enhance the value of new liquid bonds while decreasing the value of some firm equities if investors believe executive teams are bringing down the spending. If interest rates rise, ensuring that a portfolio has a sufficient amount of income-producing securities will help to cushion the value loss in some shares.
Unsystematic Risk
Unsystematic risk is a risk that is unique to a certain organisation or industry. Unique risk, diversifiable risk and residual risk are all terms for non-systematic risk. Unsystematic risk can be decreased through diversification in an investment portfolio. Unsystematic risk is the uncertainty that comes with investing in a company or sector.
Unsystematic risk can be defined as a new competitor in the market with the potential to take significant market share from the firm invested in, a legislative change (which could reduce company sales), a change in management or a product recall.
While investors can foresee some types of unsystematic risk, it is almost impossible to be aware of all risks. For example, a healthcare stock investor may be aware that a shift in health policy is in the corner, but may not completely understand the details of the new regulations or how businesses and consumers will react.
The following are different types of unsystematic risks:
- Risk in the workplace: Both internal and external challenges can put your company at risk. Internal risks are linked to operational inefficiencies, such as failure on the part of the management to file a patent to protect an innovative product, which could lead to a loss of competitive advantage. An example of external business risk is the Food and Drug Administration (FDA) prohibiting a certain drug that a company sells.
- Financial danger: Financial risk is linked to a company’s capital structure. To continue to develop and pay its financial responsibilities, a firm must maintain an ideal balance of debt and equity. A shaky financial structure can lead to erratic earnings and cash flow, which might make it impossible for a company to trade.
- Operational danger: Unexpected or careless events, such as a supply chain failure or a critical error in the production process, might result in operational hazards. Criminals could gain access to confidential information on customers or other forms of essential proprietary data if a security breach occurs.
- Strategic hazard: If a corporation is trapped providing goods or services in a failing industry without a strong plan to adapt its offerings, it may face a strategic risk. A company may also face this risk if it enters into a shaky collaboration with another company or a rival that jeopardises its future growth chances.
- Regulatory and legal risk: The danger that a change in laws or rules would harm a company is known as legal and regulatory risk. These adjustments may raise operating costs or create legal stumbling blocks. More dramatic legal or regulatory changes may potentially put a company out of existence. Errors in agreements or violations of the law are examples of other legal risks.
Financial Derivatives
Financial derivatives are financial products whose value is ascertained by another asset’s value. Any other product, such as a foreign currency, an interest rate, a share, an index or a commodity, can be used as the underlying asset. Options, warrants, forward contracts, futures and currency and interest rate swaps are all examples of financial derivatives.
Some of these derivatives are explained as follows:
Future
A future is a derivative transaction in which derivatives are exchanged at a fixed price on a fixed date in the future. Futures can easily be traded because they are standardised by an exchange.
Forward
A forward is a contract between two parties in which the exchange takes place at a specific price at the end of the contract. Forwards and futures are similar as they both are contracts that provide access to a commodity at a determined price and time somewhere in the future.
However, the only difference is that a forward is traded between two parties directly without using an exchange. The absence of the exchange results in negotiable terms on delivery, size and price of the contract.
In contrast to futures, forwards are usually executed on maturity as they are mostly use as insurance against adverse price movement and actual delivery of the commodity takes place. On the other hand, futures are widely employed by speculators who hope to gain profit by selling the contracts at a higher price and futures are therefore closed prior to maturity.
Options
An option is a contract between two parties that gives the buyer the right to buy or sell a specific number of derivatives at a specific price for a specific length of time but not the obliga- tion to buy or sell an underlying asset at a pre-determined price, somewhere in the future. When you take an option to buy an asset it is called a ‘call’ and when you obtain the right to sell an asset it is called a ‘put’.
Swaps
A swap is an agreement between two parties whereby interest rate is exchanged, i.e., one agrees to accept or pay the other’s interest rate on loan through varied forms of currencies, options and swaps.
What is Credit Rating?
A credit rating is a numerical estimate of a borrower’s creditworthiness in general or in relation to a specific debt or financial obligation. If they desire to borrow money, an individual, a firm, a state or provincial authority or a sovereign government can all be issued a credit rating.
- A borrower’s credit rating determines whether or not he or she is approved for credit and at what interest rate the loan will be repaid.
- Individual consumers’ credit is assessed on a numeric scale based on credit bureaus’ FICO calculations.
- Credit agencies use a letter-based methodology to assess bonds issued by businesses and governments.
Role of Credit Rating Agencies in India
Credit rating firms inform investors about bond and debt instrument issuers’ ability to meet their obligations. Information on sovereign debt is also provided by agencies. Following are some credit rating firms in India:
CRISIL
It is India’s pioneer and largest credit rating institution, founded in 1988. ICICI Ltd. UTI and other financial institutions are promoting it. In 1995, the CRISIL 500 Equity Index was created in collaboration with the National Stock Exchange.
It has evolved into a global analytical firm that assigns corporate ratings, does market research and provides risk and policy advising services to its clientele Standard & Poor’s, the world’s largest credit rating agency, owns a controlling share in CRISIL.
CRA
The Investment Information and Credit Rating Agency of India Limited was its previous name. It is India’s second rating agency, a joint venture between Moody’s and the country’s largest financial/investment institutions, commercial banks and financial services firms.
Corporate debt rating, Financial sector rating, Issuer rating, Bank loan credit rating, Public finance rating, Corporate governance rating, Structured finance rating, SME rating, Mutual fund rating, Infrastructure sector rating, Project finance rating and Insurance sector rating are some of the areas where it is used.
CARE
It is the second-largest rating agency in India. Long-term and short-term debt instruments are the two types of bank loan ratings available. CARE also rates Initial Public Offerings (IPOs), real estate, Renewable Energy Service Company (RESCO), shipyard financial assessments and Energy Service Companies (ESCOs) grades numerous educational courses. It assigns a financial health score to SMEs.
ONICRA
Onida Finance established ONICRA, a private rating agency. Enterprise customers can benefit from Employee Background Assessment and Individual Decision Analytics. It analyses data and makes arrangements for possible rating solutions for SMBs and individuals. The agency seeks out answers and assists businesses in making informed decisions about lending money to individuals, small businesses and other groups.
CIBIL
It Creates information solutions that help businesses grow and people get credit and other services faster and for less money.
SMERA
It is a micro, small and medium enterprise association in India. It has, however, evolved over time to provide ratings to SMEs, as well as mid and large corporations in India. It is collaboration between SIDBI, Dun & Bradstreet India and India’s top banks.
Fitch India
Corporate issuers, financial institutions, banks, insurance firms, urban local authorities, structured finance and project financing are all covered by Fitch India: India Ratings and Research (Ind-Ra). SEBI, NHB and RBI have all approved it. It is entirely owned by the Fitch Group.
Equifax US’s subsidiary, ECIS
Equifax US and UBI, SBI, Bank of Baroda, Bank of India, Kotak Mahindra, Sundaram Finance and Religare have formed a joint venture. It also includes a basic or enhanced consumer information report, Equifax alerts and credit information from microfinance institutions.
Experian Indian
It was the first company in India to be granted a licence under the new Credit Information Companies (Regulation) Act (CICRA) 2005.
Canara Bank promotes BWR
It provides bank loan ratings, SMEs ratings, corporate governance ratings, municipal corporation ratings, capital market instrument ratings and financial institution ratings. NGOs, tourism, real estate investments, hospitals, IREDA, educational institutions and MFIs are also graded.
