Tag: University of Mumbai BMS Notes

Currency risk is the financial risk that arises from potential changes in the exchange rate of one currency in relation to another. And it’s not just those trading in the foreign exchange markets that are affected. Adverse currency movements can often crush the returns of a portfolio with heavy international exposure, or diminish the returns of an otherwise prosperous international business venture. Companies that conduct business across borders are exposed to currency risk when income earned abroad is converted into the money of the domestic country, and when payables are converted from the domestic currency to the foreign currency.

The currency swap market is one way to hedge that risk. Currency swaps not only hedge against risk exposure associated with exchange rate fluctuations, but they also ensure receipt of foreign monies and achieve better lending rates.

How Currency Swaps Work?

A currency swap is a financial instrument that involves the exchange of interest in one currency for the same in another currency.

Currency swaps comprise two notional principals that are exchanged at the beginning and end of the agreement. These notional principals are predetermined dollar amounts, or principal, on which the exchanged interest payments are based. However, this principal is never actually repaid: It’s strictly “notional” (which means theoretical). It’s only used as a basis on which to calculate the interest rate payments, which do change hands.

Currency Swaps Beneficial

Recall our first plain vanilla currency swap example using the U.S. company and the German company. There are several advantages to the swap arrangement for the U.S. company. First, the U.S. company is able to achieve a better lending rate by borrowing at 7% domestically as opposed to 8% in Europe. The more competitive domestic interest rate on the loan, and consequently the lower interest expense, is most likely the result of the U.S. company being better known in the U.S. than in Europe. It is worthwhile to realize that this swap structure essentially looks like the German company purchasing a euro-denominated bond from the U.S. company in the amount of €3 million.

The advantages of this currency swap also include assured receipt of the €3 million needed to fund the company’s investment project. Other instruments, such are forward contracts, can be used simultaneously to hedge exchange rate risk.

Investors benefit from hedging foreign exchange rate risk as well.

How Currency Hedging Helps Investors?

Using currency swaps as hedges is also applicable to investments in mutual funds and ETFs. If you have a portfolio heavily weighted towards United Kingdom stocks, for instance, you’re exposed to currency risk: The value of your holdings can decline due to changes in the exchange rate between the British pound and the U.S. dollar. You need to hedge your currency risk to benefit from owning your fund over the long term.

Many investors can reduce their risk exposure by using currency-hedged ETFs and mutual funds. A portfolio manager who must purchase foreign securities with a heavy dividend component for an equity fund could hedge against exchange rate volatility by entering into a currency swap in the same way as the U.S. company did in our examples. The only downside is that favorable currency movements will not have as beneficial an impact on the portfolio: The hedging strategy’s protection against volatility cuts both ways.

Currency Swaps and Forward Contracts

Companies that have exposure to foreign markets can often hedge their risk with currency swap forward contracts. Many funds and ETFs also hedge currency risk using forward contracts.

A currency forward contract, or currency forward, allows the purchaser to lock in the price they pay for a currency. In other words, the exchange rate is set in place for a specific period of time. These contracts can be purchased for every major currency.

The contract protects the value of the portfolio if exchange rates make the currency less valuable protecting a U.K.-oriented stock portfolio if the value of the pound declines relative to the dollar, for example. On the other hand, if the pound becomes more valuable, the forward contract isn’t needed, and the money to buy it was wasted.

So, there is a cost to buying forward contracts. Funds that use currency hedging believe that the cost of hedging will pay off over time. The fund’s objective is to reduce currency risk and accept the additional cost of buying a forward contract.

Currency Swaps and Mutual Funds

A hedged portfolio incurs more costs but can protect your investment in the event of a sharp decline in a currency’s value.

Consider two mutual funds that are made up entirely of Brazilian-based companies. One fund does not hedge currency risk. The other fund contains the exact same portfolio of stocks, but purchases forward contracts on the Brazilian currency, the real.

If the value of the real stays the same or increases compared to the dollar, the portfolio that is not hedged will outperform, since that portfolio is not paying for the forward contracts. However, if the Brazilian currency declines in value, the hedged portfolio performs better, since that fund has hedged against currency risk.

Derivatives serve as financial contracts of a kind, in which their value depends on some underlying asset or a group of such assets. Some of the most commonly used derivatives are bonds, stocks, commodities, currencies, and indices. Since the value of the assets which control the derivative value fluctuates occasionally, the derivative to does not have a fixed value. Market conditions play an important role in deciding the value of a derivative. The basic guiding principle of derivative trading is that the buyer successfully predicts market changes to earn profits from their contracts. When the price of the asset on which the derivative depends falls, you will meet with a loss, whereas a surge in price, results in a profit. Therefore, trading in derivatives is about being able to predict the rise and fall of the asset and timing your exit and entry into the market subsequently.

Why invest in derivative contracts?

Earning profits is not the only reason investors flock towards derivative contracts. One of the biggest reasons investors prefer derivatives is because it gives them an Arbitrage advantage. This comes as a result of buying an asset at a low price and then selling it at a higher price in another market. This way, the buyer is protected by the difference in the value of the product in the different markets, and thereby, gets an added benefit from both markets. Furthermore, certain derivative contracts protect you from market volatility and help shield your assets against fall in stock prices. If that wasn’t enough, derivative contracts are also a great way to transfer risk and balance out your portfolio.

Important Features of Derivatives

Derivative can be defined as a contract or an agreement for exchange of payments, whose value is derived from the value of an underlying asset. In simple words the price of derivative depends on the price of other assets.

Here are some of the features of derivative markets:

• Derivative are of three kinds future or forward contract, options and swaps and underlying assets can be foreign exchange, equity, commodities markets or financial bearing assets.
• As all transactions in derivatives takes place in future specific dates it is easier to short sell then doing the same in cash markets because an individual can take of markets and take the position accordingly because one has more time in derivatives.
• Since derivatives have standardized terms due to which it has low counterparty risk, also transactions costs are low in derivative market and hence they tend to be more liquid and one can take large positions in derivative markets quite easily.
• When value of underlying assets change then value of derivatives also changes and hence one can construct portfolio which is needed by one and that too without having the underlying asset. So for example if one want to buy some stock and short the market then he can buy the future of a stock and at the same time short sell the market without having to buy or sell the underlying assets.

Characteristics of Derivatives

1. Derivatives have the characteristic of Leverage or Gearing. With a small initial outlay of funds (a small percentage of the entire contract value) one can deal big volumes.
2. Pricing and trading in derivatives are complex and a thor­ough understanding of the price behaviour and product structure of the underlying is an essential pre-requisite before one can venture into dealing in these products.
3. Derivatives, by themselves, have no independent value. Their value is derived out of the underlying instruments.

Functions of Derivatives

1. Derivatives shift the risk from the buyer of the derivative product to the seller and as such are very effective risk management tools.
2. Derivatives improve the liquidity of the underlying instru­ment. Derivatives perform an important economic function viz. price discovery. They provide better avenues for raising money. They contribute substantially to increasing the depth of the markets.

Users of Derivatives

Hedgers, Traders and Speculators use derivatives for different purposes. Hedgers use derivatives to protect their assets/posi­tions from erosion in value due to market volatility. Traders look for enhancing their income by making a two-way price for other market participants. Speculators set their eyes on making quick money by taking advantage of the volatile price movements.

Hedging is a mechanism by which an investor seeks to protect his asset from erosion in value due to adverse market price move­ments. A Hedger is usually interested in streamlining his future cash flows. He is most concerned when the market prices are very volatile. He is not concerned with future positive potential of the value of underlying asset.

A speculator has, normally, no asset in his possession to protect. He is not concerned with stabilising his future cash flows. He is interested only in making quick money by taking advantage of the price movements in the market. He is quite happy with volatility. In fact, volatility is his daily bread and butter.

Arbitrageurs also form a segment of the financial markets. They make riskless profit by exploiting the price differentials in differ­ent markets. For example, if a company’s shares were trading at Rs. 3500 in Mumbai market and Rs.3498 in Delhi market, an arbitrageur will buy it in Delhi and sell it in Mumbai to make a riskless profit of Rs. 2 (transaction cost is ignored for the purpose of this example).

Successive such transactions will iron out the difference in prices and bring equilibrium in the market. How­ever, arbitraging is not a very safe way of making money as was proved in the case of Barings Bank where unscrupulous arbitraging between Osaka and Tokyo exchanges in Nikkei Stock index futures drove the Bank to bankruptcy.

Salient Points of Derivatives

1. Financial Derivatives are products whose values are derived from the values of the underlying assets.
2. Derivatives have the characteristics of high leverage and of being complex in their pricing and trading mechanism.
3. Derivatives enable price discovery, improve the liquidity of the underlying asset, serve as effective hedge instruments and offer better ways of raising money.
4. The main players in a financial market include hedgers, speculators, arbitrageurs and traders.
5. Hedging can be done in two ways viz. fixing a price (the linear way) and taking an insurance (non-linear or asymmetric way).

There are a number of derivative contracts. Basically they are forwards, futures and options. Forwards are definitive purchases and/or sales of a currency or commodity for a future date. Forward contracts are contracted for a particular value and should be transacted on a given date.

Forwards are useful in avoiding liquidity risk, price variations and locking in avoiding a downside. Forward however has the limitation that the contract has to be performed in full and has attendant credit risk and market risk. Forwards are most useful in forex transactions where a spot transaction can be covered by a contrary move in the forward market.

There are hundreds or even thousands of types of contracts that are available in the market. This may make it seem like a difficult and confusing task to deal with derivatives. However, that is not the case. True, that there are hundreds of variations in the market. However, these variations can all be traced back to one of the four categories. These four categories are what we call the 4 basic types of derivative contracts. In this article, we will list down and explain those 4 types:

Type 1: Forward Contracts

Forward contracts are the simplest form of derivatives that are available today. Also, they are the oldest form of derivatives. A forward contract is nothing but an agreement to sell something at a future date. The price at which this transaction will take place is decided in the present.

However, a forward contract takes place between two counterparties. This means that the exchange is not an intermediary to these transactions. Hence, there is an increase chance of counterparty credit risk. Also, before the internet age, finding an interested counterparty was a difficult proposition. Another point that needs to be noticed is that if these contracts have to be reversed before their expiration, the terms may not be favorable since each party has one and only option i.e. to deal with the other party. The details of the forward contracts are privileged information for both the parties involved and they do not have any compulsion to release this information in the public domain.

Type 2: Futures Contracts

A futures contract is very similar to a forwards contract. The similarity lies in the fact that futures contracts also mandate the sale of commodity at a future data but at a price which is decided in the present.

However, futures contracts are listed on the exchange. This means that the exchange is an intermediary. Hence, these contracts are of standard nature and the agreement cannot be modified in any way. Exchange contracts come in a pre-decided format, pre-decided sizes and have pre-decided expirations. Also, since these contracts are traded on the exchange they have to follow a daily settlement procedure meaning that any gains or losses realized on this contract on a given day have to be settled on that very day. This is done to negate the counterparty credit risk.

An important point that needs to be mentioned is that in case of a futures contract, they buyer and seller do not enter into an agreement with one another. Rather both of them enter into an agreement with the exchange.

Type 3: Option Contracts

The third type of derivative i.e. option is markedly different from the first two types. In the first two types both the parties were bound by the contract to discharge a certain duty (buy or sell) at a certain date. The options contract, on the other hand is asymmetrical. An options contract, binds one party whereas it lets the other party decide at a later date i.e. at the expiration of the option. So, one party has the obligation to buy or sell at a later date whereas the other party can make a choice. Obviously the party that makes a choice has to pay a premium for the privilege.

There are two types of options i.e. call option and put option. Call option allows you the right but not the obligation to buy something at a later date at a given price whereas put option gives you the right but not the obligation to sell something at a later date at a given pre decided price. Any individual therefore has 4 options when they buy an options contract. They can be on the long side or the short side of either the put or call option. Like futures, options are also traded on the exchange.

Type 4: Swaps

Swaps are probably the most complicated derivatives in the market. Swaps enable the participants to exchange their streams of cash flows. For instance, at a later date, one party may switch an uncertain cash flow for a certain one. The most common example is swapping a fixed interest rate for a floating one. Participants may decide to swap the interest rates or the underlying currency as well.

Swaps enable companies to avoid foreign exchange risks amongst other risks. Swap contracts are usually not traded on the exchange. These are private contracts which are negotiated between two parties. Usually investment bankers act as middlemen to these contracts. Hence, they too carry a large amount of exchange rate risks.

So, these are the 4 basic types of derivatives. Modern derivative contracts include countless combinations of these 4 basic types and result in the creation of extremely complex contracts.

Advantages of Derivatives

Unsurprisingly, derivatives exert a significant impact on modern finance because they provide numerous advantages to the financial markets:

1. Hedging risk exposure

Since the value of the derivatives is linked to the value of the underlying asset, the contracts are primarily used for hedging risks. For example, an investor may purchase a derivative contract whose value moves in the opposite direction to the value of an asset the investor owns. In this way, profits in the derivative contract may offset losses in the underlying asset.

2. Underlying asset price determination

Derivates are frequently used to determine the price of the underlying asset. For example, the spot prices of the futures can serve as an approximation of a commodity price.

3. Market efficiency

It is considered that derivatives increase the efficiency of financial markets. By using derivative contracts, one can replicate the payoff of the assets. Therefore, the prices of the underlying asset and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities.

4. Access to unavailable assets or markets

Derivatives can help organizations get access to otherwise unavailable assets or markets. By employing interest rate swaps, a company may obtain a more favorable interest rate relative to interest rates available from direct borrowing.

Disadvantages of Derivatives

Despite the benefits that derivatives bring to the financial markets, the financial instruments come with some significant drawbacks. The drawbacks resulted in disastrous consequences during the financial crisis of 2007-2008. The rapid devaluation of mortgage-backed securities and credit-default swaps led to the collapse of financial institutions and securities around the world.

1. High risk

The high volatility of derivatives exposes them to potentially huge losses. The sophisticated design of the contracts makes the valuation extremely complicated or even impossible. Thus, they bear a high inherent risk.

2. Speculative features

Derivatives are widely regarded as a tool of speculation. Due to the extremely risky nature of derivatives and their unpredictable behavior, unreasonable speculation may lead to huge losses.

3. Counter-party risk

Although derivatives traded on the exchanges generally go through a thorough due diligence process, some of the contracts traded over-the-counter do not include a benchmark for due diligence. Thus, there is a possibility of counter-party default.

Hedging

Hedging is a standard practice followed in the stock market by investors to safeguard themselves from the losses that might arise from market fluctuation. In a way, hedging is the insurance that helps the investor to lessen their losses, but it does not prevent the negative things happening in the course of life or business. Hedging is followed in all walks of life like opting for car insurance, life insurance, term insurance and so on.

The technique of hedging is also followed at an institutional level by portfolio and fund management companies to minimize their exposure to different types of risk and to decrease its negative impact.

In the stock market, the hedging technique is used in the following areas:

• Commodities
• Securities
• Currencies
• The interest rate
• Weather

Hedging is also a technique that will help the investor to gain profits by trading different commodities, currencies or securities. Hedging is of three types namely:

• Forward contract: The forward contract is a non-standardized agreement to buy specified assets at a determined price on a date agreed by two independent parties. The forward contract is drawn for various types of assets like commodities, currencies, etc.
• Futures contract: The futures contract is a standardized agreement to buy specified assets at a specified price on a date agreed by two independent parties. The futures contract is drawn for various types of assets like commodities, currencies, etc.
• Money Markets: Money markets cover many types of financial activities of currencies, money market operations for interest, calls on equities where short-term loans, borrowing, selling and lending happen with a maturity of one year or more.

Hedging strategies

When looking for investment options, hedging helps the investor to spread their risks and reduce them to a certain extent. As the market is unpredictable so are the hedging techniques. The hedging technique will have a constant modification as per the market situation and the investment type.

Some of the common strategies followed in hedging are as follows.

• Asset allocation: While investing, the investor can hedge their risks by diversifying their portfolio into asset allocations that carry risk and assets that provide stable returns and balance their portfolio.
• Structuring the portfolio: Another type of hedging is the technique of structuring. Here the investor will invest a portion of their portfolio in debt and some in derivatives. Debt gives stability and derivatives to protect the investor portfolio from risk.
• Hedging by options: This technique involves call and puts options of assets. This helps the investor to safeguard their portfolio directly.

Benefits of hedging

• The basic advantage of hedging is that it limits the losses of the investor.
• Hedging protects the profits of the investor.
• It increases the liquidity of the financial markets as hedging prompts the investor to trade across different markets of commodity, currencies and derivative markets.
• The hedging offers flexible price mechanism as it requires very less margin outlay.

Hedging offers a scalable advantage to investors and traders to effectively trade in the market. As risk is an essential part of the trading cycle and its main motive is to gain profit. However, as the market remains unpredictable, hedging offers a safety net for investors and helps them to protect themselves from market uncertainty.

Forwards

Forwards and futures are very similar as they are contracts which give access to a commodity at a determined price and time somewhere in the future. A forward distinguish itself from a future that it 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 contrary to futures, forwards are usually executed on maturity because they are mostly use as insurance against adverse price movement and actual delivery of the commodity takes place. Whereas 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.

Futures

Futures are exchange organized contracts which determine the size, delivery time and price of a commodity. Futures can easily be traded because they are standardized by an exchange. Per commodity traded there are different aspects specified in a futures contract. First of all is the quality of a commodity. For a commodity to be traded on the exchange, it must meet the set requirements. Second is the size of a single contract. The size determines the units of a commodity that is traded per contract. Thirdly is the delivery date, which determines on which date or in which month the commodity must be delivered. Thanks to the standardization of futures commodities can easily be traded and give manufacturers access to large amounts of raw materials. They can buy their materials on the exchange and don’t need to worry about the producer or take on contracts with multiple suppliers.

Options

Options are a form of derivatives, which gives holders the right, but not the obligation 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’. To determine whether it is profitable to exercise an option, the current market price (spot price) and the price in the option (strike price) need to be compared. By comparing both prices, a choice can be made to either exercise the option or let it expire. When exercising an option there are three positions on which the holder can find themselves. The first is in the money (ITM), where the strike price is more favorable than the spot price and thus it will be advantageous to exercise the option. The second is at the money (ATM) in which the strike and spot price are equal and so no advantage can be gained. The third is out the money (OTM), where the strike price is higher than the spot price. In this case it is better to let the option expire and buy the commodity at the current market price. There are two ways of settling an option between two parties. The first way is to physically deliver the underlying commodity. The other way is to cash settle the option. In this way the difference between the spot and strike price is paid to the holder of the option upon exercising of the option. An option has a few advantages over other derivatives. The most important advantage is that an option is not binding, in the way is does not obligate one to buy a commodity. It gives you the right to buy it and so when the price of the option is higher than the current market price you can just let the option expire and buy at the spot price. The only loss made, will be the premium which is the cost for maintaining the option. Another advantage is the usefulness of options as a hedging tool. Options offer the tools to successfully hedge price movements with a small investment risk.

Swaps

A swap is an agreement between two parties to exchange cash flows on a determined date or in many cases multiple dates. Typically, one party agrees to pay a fixed rate while the other party pays a floating rate. For example, when trading commodities the first party, an airline company relying of kerosene, agrees to pay a fixed price for a pre-determined quantity of this commodity. The other party, a bank, agrees to pay the sport price for the commodity. Hereby the airline company is insured of a price it will pay for its commodity. A rise in the price of the commodity is in this case paid by the bank. Should the price fall the difference will be paid to the bank.

Risk Assessment Tools

A critical but often overlooked aspect of a competent derivatives trading operation are the computer systems and risk assessment tools used to manage risk, account for the positions on a mark-to-market basis, track derivatives-related events (such as expiries and rollovers) and measure Value-at-Risk. Options produce their own problems because of the convexity of these products.

One must have an appreciation of how these risks change with the progress of time and the evolution of prices. It helps to establish a framework for evaluating a financial risk management system and use this framework to assess some of the more common off-the-shelf products on the market.

Using Derivatives Risk Assessment Tools

Integration

At the beginning of the global derivatives market’s development, almost every bank pursued derivatives in a stand-alone asset-class-by-asset-class fashion. That is to say, one group managed interest rate derivatives, another group managed equity derivatives and a third group managed foreign exchange derivatives.

However, an increasing number of financial institutions are turning to a more integrated approach, stripping the derivatives desks from each asset class’ cash group and combining them into a more efficient cross-marketing machine. Once you understand interest rate derivatives, it is fairly straightforward to understand equity derivatives or foreign exchange derivatives. Conversely, it is not necessarily the case that a manager who has spent his entire career overseeing spot foreign exchange salespeople will be able to understand the way in which a derivatives book works.

To Buy or to Build

The next question the bank’s senior management must ask itself is whether or not the bank should buy off-the-shelf risk assessment tools or build one using its own internal IT resources.

Buying a system is convenient, particularly if it is one that is in widespread use. Popular systems have been tested and have had all of the kinks worked out. The more popular the system, the less likely that it is vulnerable to internal control irregularities. The more popular the system, the less likely it is possible for individuals to manipulate the bank’s official records for fraudulent purposes. Systems are typically very expensive, with charges for both a site license and individual annual log-ins. Many of the companies that sell these systems make it easy for the user to customize reports, batch files, and pricing modules, among other things.

However, many financial institutions are reticent to relinquish the responsibility for risk management computer systems to a third party. The managers of these institutions would prefer to have their own internal risk management personnel design the system that is then implemented by the bank’s IT staff. Not only is this more expensive than buying an off-the-shelf system in terms of up-front dollar cost and delays in implementation, but the system is vulnerable to the expertise of a handful of individuals, who may not always be available or may choose to leave the company.

Interface

One of the key aspects of a well-designed system is its flexibility. Good risk assessment tools will have a user interface that is customizable. A vast majority use the Internet as their interface platform, as it allows for quick and efficient information exchange across multiple markets. The interface is also the mechanism in which reports are designed.

Asset Class Coverage

Good risk assessment tools will provide the senior management with the ability to immediately access information on all of the derivatives activities in which the financial institution is engaged, across all asset classes.

Covering all of the asset classes also allows for greater overall risk-taking because it allows for the portfolio effects of diversification of risk across the different asset classes.

Pricing Model Flexibility

Model risk refers to the problems associated with discrepancies between the theoretical pricing of a financial instrument and the way in which it actually trades in the market. The difference in price, for a given set of input parameters, is a result of the assumptions that are necessary for solution of the mathematical model of the price of the financial product in question.

For some financial products, particularly the more exotic or novel ones, the choice of pricing model is controversial. A good risk management system will allow management to pick and choose the pricing model it prefers for a particular instrument and compare the model risk in different market environments associated with individual pricing models.

Ability to Link to Other Systems

Derivatives risk assessment tools are only one of a handful of systems with which the dealer at a financial institution must be familiar. Other systems include ticketing systems for cash instruments, accounting systems, credit risk management systems and, possibly, spreadsheets tracking customer portfolios.

A dealer’s life is made much easier when the primary system he uses on a daily basis, the risk management system, can communicate its information to the other relevant systems automatically. Otherwise, the dealer (or more likely his assistant) will have to input multiple tickets for a single transaction. This is not just a question of personal effort. It is also an operational risk issue. Every time the dealer inputs a ticket, there is room for an error. Too many errors and the bank begins to lose customers as well as money.

The following are some of the best risk management tools and techniques that professional project managers use to manage their projects against the inevitable risks, issues and changes.

Brainstorming

To begin the brainstorming process, you must assess the risks that could impact your project. This starts with reviewing the project documentation, looking over historic data and lessons learned from similar projects, reading over articles and organizational process assets. Anything that can provide insight into issues that might occur during the execution of the project. Once you’ve done your research, start brainstorming with anyone who might have insight.

A variant of this is the Delphi technique, which is when a request is sent to experts and they reply anonymously. Or the project manager can interview experts, team members, stakeholders and others with experience in similar projects.

Root Cause Analysis

The root cause is another way to say the essence of something. Therefore, root cause analysis is a systematic process used to identify the fundamental risks that are embedded in the project. This is a tool that says good management is not only responsive but preventative.

Often root cause analysis is used after a problem has already come up. It seeks to address causes rather than symptoms. But it can be applied to assessing risk by going through the goals of any root cause analysis, which ask: What happened? How did it happen? Why did it happen? Once those questions are addressed, develop a plan of action to prevent it from happening again.

SWOT

Begin with strengths and determine what those are as related to the project (though this can work on an organization-level, too). Next, list the weaknesses or things that could be improved or are missing from the project. This is where the likelihood of negative risk will raise its head, while positive risk come from the identification of strengths. Opportunities are another way of referring to positive risks and threats are negative risks.

When collecting SWOT, illustrate your findings in a four-square grid. The top of the square has strengths to the left and weaknesses to the right. Below that is opportunities to the left and threats to the right. The left-hand side is helpful to achieving the objective of the project and those on the right-hand side are harmful to achieving the objective of the project. This allows for analysis and cross-reference.

Risk Assessment Template for IT

While this tool was developed for IT projects, it can be expanded to speak to any project. What a IT risk assessment template offers is a numbered listing of the risks, to keep them in order, and then an out that risk is and the control environment. It basically provides a space in which to collect the risks of a project, which is also helpful when executing the project and tracking any risks that become reality.

One of the aspects of the risk assessment template for IT is that the spreadsheet has a built-in calculator that figures out the likelihood of a risk in fact occurring and then multiples that against the impact it would have on the project or the organization. This way, a project manager knows the potential harm of the risk and so can prioritize their response to it if or when the risk happens.

Risk Register

Similar to the risk assessment template for IT is a risk register. It also is a list to track risk, a tool that can be as simple as a spreadsheet or as dynamic as a project management software like ProjectManager.com. Basically, what a risk register does is identify and describe the list. It then will provide space to explain the potential impact on the project and what the planned response is for dealing with the risk, if it occurs. Furthermore, the risk register allows a project manager to prioritize the risk, assign an owner responsible for resolving it and gives a place to add notes as needed.

The risk register is a strategic tool to control risk in a project. It works to gather the data on what risks the team expects and then a way to respond proactively if they do show up in the project. It has already mapped out a path forward to keep the project from falling behind schedule or going over budget. Pick up a free risk register template here.

Probability and Impact Matrix

Another tool for project managers is the probability and impact matrix. It helps prioritize risk, which is important, as you don’t want to waste time chasing a small risk and exhaust your resources. This technique combines the probability and impact scores of individual risks and then ranks them in terms of their severity. This way each risk is understood in context to the larger project, so if one does occur, there’s a plan in place to respond or not.

The matrix is a box, broken up in probability on the left, ranging from rare on top to very likely on the bottom. The top is the impact, going from trivial on the left to extreme on the right. The individual boxes then are colored, so that the top left corner is green for low risk. The middle, rising from the bottom left corner to the top right corner is yellow for medium risk. The bottom right corner is red for high risk. This provides a road toward reaching a priority list that gives project managers the head’s up as to when to act and when they can keep a risk on the backburner of a project.

Risk Data Quality Assessment

With a risk data quality assessment technique, project managers use data that has been collated for the risks they’ve identified. This is used to then find the level to which information about the risk is relevant to the project manager. It helps the project manager understand the accuracy, reliability, quality and integrity of the risk as related to the collected data about it.

For each risk listed, the risk data quality assessment requires that the project manager determine the extent of the understanding of the risk, collect what data is available, what the quality and reliability is for that data and its integrity. It is only by examining these parameters of the risk can an accurate assessment be reached.

Asset liability management (ALM) can be defined as the comprehensive and dynamic framework for measuring, monitoring and managing the financial risks associated with changing interest rates, foreign exchange rates and other factors that can affect the organization’s liquidity.

Asset and liability management (often abbreviated ALM) is the practice of managing financial risks that arise due to mismatches between the assets and liabilities as part of an investment strategy in financial accounting.

ALM sits between risk management and strategic planning. It is focused on a long-term perspective rather than mitigating immediate risks and is a process of maximising assets to meet complex liabilities that may increase profitability.

ALM includes the allocation and management of assets, equity, interest rate and credit risk management including risk overlays, and the calibration of company-wide tools within these risk frameworks for optimisation and management in the local regulatory and capital environment.

Often an ALM approach passively matches assets against liabilities (fully hedged) and leaves surplus to be actively managed.

The concept of asset/liability management focuses on the timing of cash flows because company managers must plan for the payment of liabilities. The process must ensure that assets are available to pay debts as they come due and that assets or earnings can be converted into cash. The asset/liability management process applies to different categories of assets on the balance sheet.

Evolution of ALM in Indian Banking System

 In view of the regulated environment in India in 1970s to early 1990s, there was no interest rate risk as the interest rate were regulated and prescribed by RBI. Spreads between deposits and lending rates were very wide.  At that time banks Balance Sheets were not being managed by banks themselves as they were being managed through prescriptions of the regulatory authority and the government.  With the deregulation of interest rates,  banks were given a large amount of  freedom to manage their Balance sheets.   Thus, it became necessary to introduce ALM guidelines so that banks can be prevented from big losses on account of wide ALM mismatches.

Reserve Bank of India issued its first ALM Guidelines in February 1999, which was made effective from 1 st April 1999.  These guidelines covered, inter alia, interest rate risk and liquidity risk measurement/ reporting framework and prudential limits. Gap statements were required to be  prepared by scheduling all assets and liabilities according to the stated or anticipated re-pricing date or maturity date.  The Assets and Liabilities at this stage were required to be divided into 8 maturity buckets (1-14 days; 15-28 days; 29-90 days; 91-180 days; 181-365 days, 1-3 years and 3-5 years and above 5 years), based on the remaining period to their maturity (also called residual maturity)..    All the liability figures were to be considered as outflows while the asset figures were considered as inflows.

As a measure of liquidity management, banks were required to monitor their cumulative mismatches across all time buckets in their statement of structural liquidity by establishing internal prudential limits with the approval of their boards/ management committees. As per the guidelines, in the normal course, the mismatches (negative gap) in the time buckets of 1-14 days and 15-28 days were not to exceed 20 per cent of the cash outflows in the respective time bucket.

 Later on RBI made it mandatory for banks to form ALCO (Asset Liability Committee) as a Committee of the Board of Directors to track, monitor and report ALM.    

It was in September, 2007, in response to the international practices and to meet the need for a sharper assessment of the efficacy of liquidity management and with a view to providing a stimulus for development of the term-money market, RBI fine tuned  these guidelines and it was provided that  the banks may adopt a more granular approach to measurement of liquidity risk by splitting the first time bucket (1-14 days at present) in the Statement of Structural Liquidity into three time buckets viz., 1 day (called next day) , 2-7 days and 8-14 days.   Thus, banks were asked to put their maturing asset and liabilities in 10 time buckets.

Thus as per  October 2007 RBI guidelines, banks were advised that the net cumulative negative mismatches during the next day, 2-7 days, 8-14 days and 15-28 days should not exceed 5%, 10%, 15% and 20% of the cumulative outflows, respectively, in order to recognize the cumulative impact on liquidity. Banks were also advised to undertake dynamic liquidity management and prepare the statement of structural liquidity on a daily basis. In the absence of a fully networked environment, banks were allowed to compile the statement on best available data coverage initially but were advised to make conscious efforts to attain 100 per cent data coverage in a timely manner.     Similarly, the statement of structural liquidity was to be reported to the Reserve Bank, once a month, as on the third Wednesday of every month. The frequency of supervisory reporting of the structural liquidity position was increased to fortnightly, with effect from April 1, 2008. Banks are now required to submit the statement of structural liquidity as on the first and third Wednesday of every month to the Reserve Bank.

Board’s of the Banks were entrusted with the overall responsibility for the management of risks and required to decide the risk management policy and set limits for liquidity, interest rate, foreign exchange and equity price risks.

Asset-Liability Committee (ALCO), the top most committee to oversee the implementation of ALM system is  to be headed by CMD /ED. ALCO considers product pricing for both deposits and advances, the desired maturity profile of the incremental assets and liabilities in addition to monitoring the risk levels of the bank. It will have to articulate current interest rates view of the bank and base its decisions for future business strategy on this view

Progress in Adoption of Techniques of ALM by Indian Banks

ALM process involve in identification, measurement and management of risk Parameter. In its original guidelines RBI asked the banks to use traditional techniques like Gap analysis for monitoring interest rates and liquidity risk. At that RBI desired  that Indian Banks slowly move towards sophisticated techniques like duration , simulation and Value at risk in future.  Now with the passage of time, more and more banks are moving towards these advanced techniques.

Asset- Liability Management Techniques

ALM is bank specific control mechanism, but it is possible that several banks may employ similar ALM techniques or each bank may use unique system.

Gap Analysis

Gap Analysis is a technique of Asset – Liability management . It is used to assess interest rate risk or liquidity risk. It measures at a given point of time the gaps between Rate  Sensitive Liabilities (RSL) and Rate Sensitive Assets (RSA) (including off balance sheet position) by grouping them into time buckets according to residual maturity or next re-pricing period , whichever is earlier. An asset or liability is treated as rate sensitive if;

(i) Within time bucket under consideration is a cash flow.

(ii) The interest rate resets/reprices contractually during time buckets

(iii) Administered rates are changed and

(iv) It is contractually pre-payable or withdrawal allowed before contracted maturities.

 Thus;

 GAP = RSA-RSL

GAP Ratio = RSAs/RSL

• Mismatches can be positive or negative
• Positive Mismatch: M.A.>M.L. and vice-versa for Negative Mismatch
• In case of +ve mismatch, excess liquidity can be deployed in money market instruments, creating new assets & investment swaps etc.
• For –ve mismatch,it can be financed from market borrowings(call/Term),Bills rediscounting, repos & deployment of foreign currency converted into rupee.

Currency Risk

Currency risk, commonly referred to as exchange-rate risk, arises from the change in price of one currency in relation to another. Investors or companies that have assets or business operations across national borders are exposed to currency risk that may create unpredictable profits and losses. Many institutional investors, such as hedge funds and mutual funds, and multinational corporations use forex, futures, options contracts, or other derivatives to hedge the risk.

Currency Risk, sometimes referred to as exchange rate risk, is the possibility that currency depreciation will negatively affect the value of one’s assets, investments, and their related interest and dividend payment streams, especially those securities denominated in foreign currency. Corporations with operations in overseas markets are also exposed to currency risk since their foreign financial results must be consolidated into the company’s home currency. Corporate treasurers and investment managers, particularly with larger multi-national firms where the risk is material, attempt to manage this risk with various hedging techniques where appropriate. Typically, a Treasury Policy exists that states that currency risk must be mitigated where economically justified by using a specified list of financial instruments that may be employed for the purpose. Generally, a combination of forex forwards and options allow the company to fix country risk within acceptable levels as along as premiums are reasonable. These hedging techniques are not consistently effective, but diversification into many major currencies can help limit this risk.

Examples of Currency Risk

To reduce currency risk, investors can consider investing in countries that have strong rising currencies and interest rates. Investors need to review a country’s inflation, however, as high debt typically precedes inflation. This may result in a loss of economic confidence, which can cause a country’s currency to fall. Rising currencies are associated with a low debt-to-gross domestic product (GDP) ratio.

The Swiss franc is an example of a currency that is likely to remain well-supported due to the country’s stable political system and low debt-to-GDP ratio. The New Zealand dollar is likely to remain robust due to stable exports from its agriculture and dairy industry that may contribute to the possibility of interest rate rises. Foreign stocks sometimes outperform during periods of U.S. dollar weakness, which typically occurs when interest rates in the United States are lower than other countries.

Investing in bonds may expose investors to currency risk as they have smaller profits to offset losses caused by currency fluctuations. Currency fluctuations in a foreign bond index are often double a bond’s return. Investing in U.S. dollar-denominated bonds produces more consistent returns as currency risk is avoided. Meanwhile, investing globally is a prudent strategy for mitigating currency risk, as having a portfolio that is diversified by geographic regions provides a hedge for fluctuating currencies. Investors may consider investing in countries that have their currency pegged to the U.S. dollar, such as China. This is not without risk, however, as central banks may adjust the pegging relationship, which would be likely to affect investment returns.

Interest Rate Risk

Interest rate risk is the risk that arises for bond owners from fluctuating interest rates. How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes in the market. The sensitivity depends on two things, the bond’s time to maturity, and the coupon rate of the bond.

Interest-rate risk is the risk, taken by bond investors, that interest rates will rise after they buy. Stated another way, it is the risk that a bond’s yield will rise (as its price falls) after it has been purchased.

All bonds involve interest-rate risk, but some involve more than others. The more interest-rate risk a bond involves, the more its price will fall as its yield rises. Duration quantifies the amount of interest-rate risk a bond involves.

Interest rate risk in a bond or a bond portfolio arises on account of the vulnerability of the value of the bond or the portfolio to the changes in interest rates.

When interest rates change, it has an impact on new and existing bonds. New bonds will now pay a coupon rate that reflects the prevailing interest rates, while existing fixed-rate bonds will not see a change in their coupon rates. However, the price of the bond will adjust so that the yield will reflect the new levels of interest rates.

If interest rates go up, existing bonds that pay a lower coupon will see a decline in the prices so that the yield from them will adjust upwards to the current market rates.

How to Mitigate Interest Rate Risk?

Similar to other types of risks, the interest rate risk can be mitigated. The most common tools for interest rate mitigation include:

1. Diversification

If a bondholder is afraid of interest rate risk that can negatively affect the value of his portfolio, he can diversify his existing portfolio by adding securities whose value is less prone to the interest rate fluctuations (e.g., equity). If the investor has a “bonds only” portfolio, he can diversify the portfolio by including a mix of short-term and long-term bonds.

2. Hedging

The interest rate risk can also be mitigated through various hedging strategies. These strategies generally include the purchase of different types of derivatives. The most common examples include interest rate swaps, options, futures, and forward rate agreements (FRAs).

Business Risk management is a subset of risk management used to evaluate the business risks involved if any changes occur in the business operations, systems and process. It identifies, prioritizes and addresses the risk to minimize penalties from unexpected incidents, by keeping them on track. It also enables an integrated response to multiple risks, and facilitates a more informed risk-based decision making capability.

Businesses today are unpredictable, volatile and seem to become more complex every day. By its very nature, it is filled with risk. Businesses have viewed risk as an evil that should be minimized or mitigated, whenever possible. However, risk assessment provides a mechanism for identifying which risks represent opportunities and which represent potential pitfalls. Risks can have negative impact, positive impact, or both. Risks with a negative impact can prevent value creation or erode existing value. Risks with positive impact may offset negative impacts or represent opportunities.

The risk management process involves:

• Identifying risks: Spotting the evolving risks by studying internal and external factors that impact the business objectives
• Analyzing risks: It includes the calibration and, if possible, creation of probability distributions of outcomes for each material risk.
• Responding to risk: After identifying and analyzing the potential risk, appropriate strategy needs to be incorporated. Either by establishing new processes or eliminating, depending on kind and severity of the risk.
• Monitoring risk and opportunities: Continually measuring the risks and opportunities of the business environment. Also keep a check on performance of management strategies.

Types of risks

• Hazard risk: A hazard is anything in the workplace that has the potential to harm people. Hazard risk includes factors which are not under the control of business environment, such as fallout of machinery or dangerous chemical, natural calamities.
• Financial risk: A large number of businesses take risk with their financial assets, quite regularly. Sometimes choosing a wrong supplier or distributor can backfire. Financial risk also includes risk in pricing, currency exchange and during liquidation of any asset. Business risk management should say how much risk is too much in financial relationship.
• Operational risk: Evaluation of risk loss resulting from internal process, system, people or due to any external factor through which a company operates.
• Strategic risks: Might arise from making poor or wrong business plans and losing the competition in the market. Failure to respond to changes in the business environment or inadequate capital allocation also represents strategic risk.

Running a business comes with many different types of risk. Some of these potential hazards can destroy a business while others can cause serious damage that can be costly and time-consuming to repair. Despite the risks implicit in doing business, CEOs and risk management officers can anticipate and prepare for potential risks regardless of the size of the business.

Identifying Risks

If and when a risk becomes a reality, a well-prepared business can minimize the impact on earnings, the lost time and productivity, and the negative impact on customers. For startup businesses and established organizations, the ability to identify which risks pose a threat to successful operations is a key component of strategic business planning. Business risks are identified using various methods, but each identifying strategy relies on a comprehensive analysis of specific business activities that could present challenges to the company. Under most business models, organizations face preventable, strategic, and external threats that can be managed through either acceptance, transfer, reduction, or elimination.

 Hiring a risk management consultant is a good investment for most companies. A consultant can analyze a business and determine which risks should be covered by insurance.

Below are the main types of risk that firms face:

Physical Risks

Building risks are the most common type of physical risk. Fire or explosions are the most common risk to a building. To manage building risk, and the risk to employees, it is important that organizations do the following:

• Make sure all employees know the exact street address of the building to give to the 911 operator in case of emergency.
• Make sure all employees know the location of all exits.
• Install fire alarms and smoke detectors.
• Install a sprinkler system to provide additional protection to the physical plant, equipment, documents, and, of course, personnel.
• Inform all employees that in the event of emergency their personal safety takes priority over everything else. Employees should be instructed to leave the building and abandon all work-associated documents, equipment, and/or products.

Location Risks

Among the location hazards facing a business are nearby fires, storm damage, floods, hurricanes or tornados, earthquakes, and other natural disasters. Employees should be familiar with the streets leading in and out of the neighborhood on all sides of the place of business. Individuals should keep sufficient fuel in their vehicles to drive out of and away from the area. Liability or property and casualty insurance are often used to transfer the financial burden of location risks to a third-party or a business insurance company.

Human Risks

Alcohol and drug abuse are major risks to personnel in the workforce. Employees suffering from alcohol or drug abuse should be urged to seek treatment, counseling, and rehabilitation, if necessary. Some insurance policies may provide partial coverage for the cost of treatment.

Protecting against embezzlement, theft, and fraud may be difficult, but these are common crimes in the workplace. A system of double-signature requirements for checks, invoices, and payables verification can help prevent embezzlement and fraud. Stringent accounting procedures may discover embezzlement or fraud. A thorough background check before hiring personnel can uncover previous offenses in an applicant’s past. While this may not be grounds for refusing to hire an applicant, it would help HR to avoid placing the new hire in a critical position where the employee is open to temptation.

Illness or injury among the workforce is inevitable and a persistent problem. To prevent loss of productivity, assign and train backup personnel to handle the work of critical employees when they are absent due to a health-related concern.

Technology Risks

A power outage is perhaps the most common technology risk. Auxiliary gas-driven power generators are a reliable back-up system to provide electrical energy for lighting and other functions. Manufacturing plants use several large auxiliary generators to keep a factory operational until utility power is restored.

Computers may be kept up and running with high-performance back-up batteries. Power surges may occur during a lightning storm (or randomly), so organizations should furnish critical business systems with surge-protection devices to avoid loss of documents and destruction of equipment. Establish offline and online data back-up systems to protect critical documents.

Although telephone and communications failure are relatively uncommon, risk managers may consider providing emergency-use-only company cell phones to personnel whose use of the phone or internet is critical to their business.

Strategic Risks

Strategy risks are not altogether undesirable. Financial institutions such as banks or credit unions take on strategy risk when lending to consumers while pharmaceutical companies are exposed to strategy risk through research and development for a new drug. Each of these strategy-related risks is inherent in an organization’s business objectives. When structured efficiently, the acceptance of strategy risks can create highly profitable operations.

Companies exposed to substantial strategy risk can mitigate the potential for negative consequences by creating and maintaining infrastructures that support high-risk projects. A system established to control the financial hardship that occurs when a risky venture fails often includes diversification of current projects, healthy cash flow, or the ability to finance new projects in an affordable way, and a comprehensive process to review and analyze potential ventures based on future return on investment.

Making a Risk Assessment

After the risks have been identified, they must be prioritized in accordance with an assessment of their probability.

Establish a probability scale for purposes of risk assessment.

For example, risks may be:

• Very likely to occur
• Have some chance of occurring
• Have a small chance of occurring
• Have very little chance of occurring

Other risks must be prioritized and managed in accordance with their likelihood of occurring. Actuarial tables—statistical analysis of the probability of any risk occurring and the potential financial damage ensuing from the occurrence of those risks—may be accessed online and can provide guidance in prioritizing risk.

Insuring Against Risks

Insurance is a principle safeguard in managing risk, and many risks are insurable. Fire insurance is a necessity for any business that occupies a physical space, whether owned outright or rented, and should be a top priority. Product liability insurance, as an obvious example, is not necessary for a service business.

Some risks are an inarguably high priority, for example, the risk of fraud or embezzlement where employees handle money or perform accounting duties in accounts payable and receivable. Specialized insurance companies will underwrite a cash bond to provide financial coverage in the event of embezzlement, theft, or fraud.

When insuring against potential risks, never assume a best-case scenario. Even if employees have worked for years with no problems and their service has been exemplary, insurance against employee error may be a necessity. The extent of insurance coverage against injury will depend on the nature of your business. A heavy manufacturing plant will, of course, require more extensive coverage for employees. Product liability insurance is also a necessity in this context.]

If a business relies heavily on computerized data—customer lists and accounting data, for example—exterior backup and insurance coverage are mandatory. Finally, hiring a risk management consultant may be a prudent step in the prevention and management of risks.

Risk Prevention

The best risk insurance is prevention. Preventing the many risks from occurring in your business is best achieved through employee training, background checks, safety checks, equipment maintenance, and maintenance of the physical premises. A single, accountable staff member with managerial authority should be appointed to handle risk management responsibilities. A risk management committee may also be formed with members assigned specific tasks with a requirement to report to the risk manager.

The risk manager, in conjunction with a committee, should formulate plans for emergency situations such as:

• Fire
• Explosion
• Hazardous materials accidents or the occurrence of other emergencies

Employees must know what to do and where to exit the building or office space in an emergency. A plan for the safety inspection of the physical premises and equipment should be developed and implemented regularly including the training and education of personnel when necessary. A periodic, stringent review of all potential risks should be conducted. Any problems should be immediately addressed. Insurance coverage should also be periodically reviewed and upgraded or downgraded as needed.

The coordination of the risk management process should be centralized: the risk office analyses and draws up information related to each process phase, and proceeds with strategic planning, in coordination with the organization’s board.

The risk committee, with the risk manager playing the role of coordinator, sets up the criteria to select the most relevant information coming from the risk management information system (selective approach). Significant risks in terms of impact or strategic level are reported by the office supporting the risk manager on a regular, specific and exceptional basis. The risk manager gives directions on translating strategies into risk management objectives, and monitors their achievement by divisions/offices and managers within their own competence. The risk manager therefore finalizes the information received, by adapting it to the organizational context (down to the any single office level), in order to correct possible deviations from strategic priorities.

Risk register development involves detailing organizational risks (corporate as well as project and operational ones), and setting up specific risk registers on particular topics (work health and safety, fraud, IT security, environment, etc.).

Three kinds of approach can be followed for involving management and stakeholders in identifying risks:

• Top down-approach: The decision-making process is centralized at governance level. This approach can show two modes: a) Full top-down mode, where the business units’ risks are listed at department level, meaning that heads of unit cannot add risks themselves at unit level. There is no need of risk escalation, except at departmental level. b) Prevailing top-down mode, where a corporate risk register is directly created from a detailed operational risk register.
• Bottom-up approach: The decision-making process is done at management level. Operational risks are identified by any staff member while performing his or her daily work (e.g., in order to encourage the staff to be more active in defining non-conformities, an opportunity to register them online has been provided).
• Mixed approach: The board entity states the criteria (top-down) by which the heads of unit identify and manage risks (bottom-up). Risks may be viewed and assessed throughout the organization at any level (e.g., group, program, office, project, etc.). In order to set the framework, the hierarchy of risks on which attention is focused corresponds to the enterprise, operational and project levels.

Such approaches are not mutually exclusive, and a combination of approaches to the management of processes is desirable to achieve effective integration of risk management at any level within the organization.

These risk management approaches are also a way of cutting across the organization hierarchy and overcome organizational barriers.

The figure below outlines the risk management process according to the top-down perspective; it also highlights the information flows related to decision-making processes, according to the different roles involved.

Processes of Corporate Risk Management

The risk management process is a framework for the actions that need to be taken. There are five basic steps that are taken to manage risk; these steps are referred to as the risk management process. It begins with identifying risks, goes on to analyze risks, then the risk is prioritized, a solution is implemented, and finally, the risk is monitored. In manual systems, each step involves a lot of documentation and administration.

Step 1: Identify the Risk

The first step is to identify the risks that the business is exposed to in its operating environment. There are many different types of risks – legal risks, environmental risks, market risks, regulatory risks, and much more. It is important to identify as many of these risk factors as possible. In a manual environment, these risks are noted down manually. If the organization has a risk management solution employed all this information is inserted directly into the system. The advantage of this approach is that these risks are now visible to every stakeholder in the organization with access to the system. Instead of this vital information being locked away in a report which has to be requested via email, anyone who wants to see which risks have been identified can access the information in the risk management system.

Step 2: Analyze the risk

Once a risk has been identified it needs to be analyzed. The scope of the risk must be determined. It is also important to understand the link between the risk and different factors within the organization. To determine the severity and seriousness of the risk it is necessary to see how many business functions the risk affects. There are risks that can bring the whole business to a standstill if actualized, while there are risks that will only be minor inconveniences in analyzed. In a manual risk management environment, this analysis must be done manually. When a risk management solution is implemented one of the most important basic steps is to map risks to different documents, policies, procedures, and business processes.

Step 3: Evaluate or Rank the Risk

Risks need to be ranked and prioritized. Most risk management solutions have different categories of risks, depending on the severity of the risk. A risk that may cause some inconvenience is rated lowly, risks that can result in catastrophic loss are rated the highest. It is important to rank risks because it allows the organization to gain a holistic view of the risk exposure of the whole organization. The business may be vulnerable to several low-level risks, but it may not require upper management intervention. On the other hand, just one of the highest-rated risks is enough to require immediate intervention.

Step 4: Treat the Risk

Every risk needs to be eliminated or contained as much as possible. This is done by connecting with the experts of the field to which the risk belongs to. In a manual environment, this entails contacting each and every stakeholder and then setting up meetings so everyone can talk and discuss the issues. The problem is that the discussion is broken into many different email threads, across different documents and spreadsheets, and many different phone calls. In a risk management solution, all the relevant stakeholders can be sent notifications from within the system. The discussion regarding the risk and its possible solution can take place from within the system. Upper management can also keep a close eye on the solutions being suggested and the progress being made from within the system. Instead of everyone contacting each other to get updates, everyone can get updates directly from within the risk management solution.

Step 5: Monitor and Review the risk

Not all risks can be eliminated – some risks are always present. Market risks and environmental risks are just two examples of risks that always need to be monitored. Under manual systems monitoring happens through diligent employees. These professionals must make sure that they keep a close watch on all risk factors. Under a digital environment, the risk management system monitors the entire risk framework of the organization. If any factor or risk changes, it is immediately visible to everyone. Computers are also much better at continuously monitoring risks than people. Monitoring risks also allows your business to ensure continuity.

The basics of the risk management process stay the same

Even under a digital environment, the basics of the risk management process stay the same. What changes is how efficiently these steps can be taken, and as it should be clear by now, there is simply no competition between a manual risk management system and a digital one.

Risk management

Risk management is an important business practice that helps businesses identify, evaluate, track, and mitigate the risks present in the business environment. Risk management is practiced by the business of all sizes; small businesses do it informally, while enterprises codify it.

Businesses want to ensure stability as they grow. Managing the risks that are affecting the business is a critical part of this stability. Not knowing about the risks that can affect the business can result in losses for the organization. Being unaware of a competitive risk can result in loss of market share, being unaware of a financial risk can result in financial losses, being aware of a safety risk can result in an accident, and so on.

Businesses have dedicated risk management resources; small businesses may have just one risk manager or a small team while enterprises have a risk management department. People who work in the risk management domain monitor the organization and its environment. They look at the business processes being followed within the organization and they look at the external factors which can affect the organization one way or the other.

A business that can predict a risk will always be at an advantage. A business which can predict a financial risk will limit its investments and focus on strengthening its finances. A business which can assess the impact of a safety risk can devise a safe way to work which can be a major competitive advantage.

If we think of the business world as a racecourse then the risks are the potholes which every business on the course must avoid if they want to win the race. Risk management is the process of identifying all the potholes, assessing their depth to understand how damaging they can be, and then preparing a strategy to avoid damages. A small pothole may simply require the business to slow down while a major pothole will require the business to avoid it completely.

Knowing the severity of a risk and the probability of a risk helps businesses allocate their resources effectively. If businesses understand the risks that affect them then they will know which risks need the most attention and resources and which ones the business can disregard. Risk management allows businesses to act proactively in mitigating vulnerabilities before any major damage is incurred. There are different types of risk management strategies and solutions for different types of risks.