Risks in Financial Decisions - Investment Decisions, Business Economics & Finance Video Lecture | Business Economics & Finance - B Com

what is financial risk how do we
classify it what does it include
what is it exclude so I want to answer
the question what is financial risk for
a company this is not personal finance
this is business and one way to answer
that is by classifying the risks that a
firm faces and so this classification is
consistent with the financial risk
manager or frm exam that we happen to
teach and is the gold standard so this
is not the only classification but it's
at least consistent with a modern
perspective where the firm faced lots of
different risks but we're going to see
that financial risk is really defined by
these set of risks that I have colored
and by I have colored boxes as opposed
to gray boxes but at the top I've
distinguished between a business and
non-biting it business risks why would I
do that well because we're thinking here
really about a non-financial firm like a
manufacturer or a technology firm that
makes products or a Proctor and Gamble
for that matter we are not really
primarily thinking here about a
financial services firm like Bank of
America or an investment bank like
goldman sachs because financial services
firms are prime Miller primarily already
in the business of managing these
financial variables all of the other
companies really they're primarily in
the business of managing these risks
over here which we say our business
risks and it's a big bucket of a lot of
different complex issues but there are
at least three characteristics here of
these business as opposed to non
business risks these business risks that
are inevitable and the first important
one is that the owners or shareholders
of that business they don't want to
avoid these risks they expect the firm
or a company to assume these risks to
make these decisions in this risk
environment after all if they wanted
risk-free they would invest in US
Treasury bonds for example so that first
thing is that risks are good
shareholders and owner
want the business to assume the B's
business risk the second is related
there's a symmetry there's a reward
expected reward for assuming these risks
that's unlike for example operational
risks for these companies where it's not
as if there's really a return for
assuming these risks there's really just
consequences for breakdowns
so operational risk is something like
well we really just want to get it down
to zero if possible because we're not
making money off of it we just want to
avoid catastrophes and the third is that
the consequences of these inevitable
necessary and ultimately good exposure
to business risk are really driven and
start at the top in theory that's the
board of directors but definitely also
includes the executive team that really
the drivers right that's the CEO the CEO
of the CFO so that's the three least
three characteristics over in the
business side one owners it owners
expected it's good exposure it's good
risk - there's a symmetry there's a
reward for the risk and three it's
driven by it starts by decisions driven
at the top behaviors at the top so then
we have we have those business risks and
then we have the non business that are
divided into non financial versus
financial and non-financial includes at
least two big buckets reputational
regulatory but these are big categories
of risks that are tend to be fuzzy and
hard to define hard to quantify
especially reputational risk this is
huge when it breaks down but until them
it can be difficult to manage so then we
come over to financial risks which are
for these non financial firms these are
non business and then they're the color
buckets that I've got here and they do
match the sequence of the part two of
the frm so if we start at which starts
at topic five and so the sequence really
goes market
then credit then operational then
investment
five six seven eight
where liquidity is actually included in
operational risk but if we start with
credit risk then it's got at least four
major sub classes including downgrade
which we can think about that as credit
aeration and then we can have default
and actually bankruptcy of the company
so these three together can also be
called pre settlement credit risk and
that credit risk is a failure of the
counterparty to perform so that could be
a loan but it can also be a counterparty
in a derivative contract so this credit
risk includes counterparty credit risk
and then default our downgrade default
in bankruptcy can all be considered
pre-settlement risk and what we usually
think of as credit risk but then there's
also settlement risk which is also
called technical term of art earth Hirst
at risk and that's really a much shorter
term risk of settlement or exchange
between the counterparties so classic
example there is forward contract or
foreign exchange contract one party
performs their obligation and they're
just waiting maybe on the same day for
the other party to pay them back
sometimes that's minutes hours or even
within a day and then we're talking
about settlement risk okay so then we
have market risk which also breaks down
into classically into it's these four
types interest rate equity price foreign
exchange and commodity price and market
risk is very different from credit risk
but they are in a related and do plan
each other but just for example if we
think about investing in a bond company
issues a bond to investors credit risk
is the risk that the company doesn't
make those coupon payments or the
principal repayment at the end right
it's the risk of first deterioration in
the credit and then default and and then
includes also if the company goes
bankruptcy where do we stand
hierarchy of claims however our company
that issued the bond can make the coupon
payments be timely with those and so
they're in good credit standing but the
interest rate could rise and nor if this
is a vanilla bond and the interest rate
increases the price or value of our bond
is going to decrease
well that's interest rate risk which is
a market risk which can also be called
price risk so for a typical vanilla bond
we have both credit and market or price
risk then we have liquidity which has
two major subtypes
oh and first I'll just say about
liquidity that at least in the frm it's
a subclass of operational but some would
put it as a subclass of market risk and
then since the global crisis just due to
the fact that there was some benign
neglect of liquidity risk and the global
crisis one of the outcomes of that was
the realization of how important the
quiddity risk was and the realization
that a lot of companies actually weren't
even including modeling liquidity risk
in in their models and so in some
classifications liquidity risk is really
got its own seat at the table here with
the other major risk buckets but at
least in terms of major subclasses here
we have market risk market liquidity
risk hopefully I can get that right and
that would be that would be evidenced in
the bid-ask spread and how easy is it
for me to sell my asset so for example I
happen to own oh let's say I I do own
some shares in Bank of America those are
so liquid its market liquidity I can
really sell them almost instantly
there's a very narrow bid ask spread
that's a real lack of market liquidity
risk as opposed to funding liquidity
risk that is a phenomenon of the balance
sheet so that's when a company doesn't
have enough cash on the balance seat to
meet those short-term obligations and so
market is also called asset price or
transaction risk and funding liquidity
risk is also called balance
risk so--that's liquidity risk as i
mentioned in the frm it happens to be
classified under operational risk
operational risk is itself a huge bucket
this is the newest science art and
science so to speak the other ones are
more mature credit risk is very mature
market risk is relatively mature
operational risk think it's fair to say
we're still figuring that out it's more
difficult to model but obviously very
important but we can break it down we
can follow the Basel regulations and
break it down in terms of in terms of
four areas process people systems and
events or external events and external
events includes external fraud and a
great example of that would be cyber
attacks obviously a big issue but
externally vents also includes natural
disasters so process people systems and
external events and then notice I have
in here also legal risk I've teased that
out specifically because that's
important to us in financial risk
obviously a lot of contingent
liabilities we've also teased it out
because just classically in terms of the
typology legal risk always included but
traditionally reputational risk and
strategy risk and not included in
financial risk and then finally we have
investment risk and so this would be of
interest to Treasury and what the
company is doing with its investable
assets and there we have topics that
overlap with the cfa which is the gold
standard in portfolio manager management
and I'm a CFA as well as an frm and we
have topics such as modern topics like
factor theory how do we go beyond asset
classes and look at factors but also
portfolio construction and also
alternative investments including
private equity and hedge funds and so
the answer to the question what is
financial risk
well financial risk includes at the high
level credit risk myrrh
risk liquidity risk operational risk and
investment risk and so I hope that was
helpful
Thanks