Lesson 2 of 8
In their normal course of business, corporations face a variety of risks. The primary risks involved are business risk, market risk, credit risk, and operational risk.
The corporations are expected to deal with different risk in different ways. They are expected to take business risk, manage market and credit risk, while mitigate operational risk.
Here are a few examples of how these risks can arise:
Business risk: Marketing and sales, Reputation
Market risk: Commodity, foreign exchange, interest rates, equity
Credit risk: Default, concentrations, country exposure, recovery
Operational risk: Controls, systems, data quality, fraud, product delivery, legal, regulatory
Let us look at the how firms should deal with various risks from a shareholder perspective.
Business risk is core to the existence of any business, and it refers to the probability of loss inherent in a firm's operations and environment (such as competition and adverse economic conditions) that may impair its ability to provide returns on investment. From a shareholder perspective, firms are paid to take business risk, and it is inherent in all business decisions, and investments, for example, marketing and promotion, sales strategy, etc.
Both market risk, and credit risk arise because of various business activity, for example, foreign exchange risk for an exporter, or importer, and credit risk in case of credit sales. Both these risks cannot be avoided in the normal course of business but they can be managed by using various techniques. From the market risk perspective, the firms are required to determine effective funding strategies and implement hedging programs for foreign exchange, commodity, or equity exposures that arise from a firm's core business activities. From the credit risk perspective, firms are expected to identify all potential sources of credit risk and also manage concentration risk.
Basel II defines operational risk as the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Although the risks apply to any organization in business, this particular way of framing risk management is of particular relevance to the banking regime where regulators are responsible for establishing safeguards to protect against systemic failure of the banking system and the economy. It is in the best interest of the businesses to identify operational risk and mitigate it. Primary responsibility for mitigating operational risk typically rests with business managers. Internal auditors are charged with identifying operational risk issues in reviewing business activities.
Market risk is the most clearly defined and observed financial risk.
Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices. The associated market risks are:
Equity risk, the risk that stock prices and/or the implied volatility will change.
Interest rate risk, the risk that interest rates and/or the implied volatility will change.
Currency risk, the risk that foreign exchange rates and/or the implied volatility will change.
Commodity risk, the risk that commodity prices (e.g. corn, copper, crude oil) and/or implied volatility will change.