Risk is the possibility of something unpleasant happenings or the chance of encountering loss or harm. From Corporate finance aspect, Risk is possibility of actual PAT being different from expected PAT.
Risk is the uncertainty of future cash flows.
• Risk = (the probability that some event will occur) X (the consequences if it does occur)
The magnitude of probable outcomes and the probability of their occurrence together determines the riskiness of an event. Genuine uncertainty, on the other hand, cannot be assigned such a (well grounded) probability
Risk Management is all about handling risks in a manner that adds value to the enterprise. The essence of risk management is increasing exposure to the risks which we understand and eliminating and transferring those risks which we do not understand. Risk management does not always mean risk reduction. In all such cases were risk is imperative, increasing the predictive ability also forms part of risk management
Categories of Risk
1. Pure Risks and Speculative risks
- Pure risks can only lead to loss (no possibility of gain)
- Speculative risks can lead to both profits and losses
2. Acceptable risks and Non Acceptable risks
- Theft of stationary may be acceptable
- Loss of 100 million rupees may not be acceptable
3. Static risks and Dynamic risks
- Pure risks are static and speculative are dynamic risks
Risk Management Tools
Hedging – Find two perfectly correlated assets. You buy one and sell another. You have created a hedge position.
Forwards – a contract between two parties for one party agreeing to buy something from the other at a later date at a price agreed upon today
Futures – a contract between two parties for one party to buy something from the other at a later date at a price agreed upon today; subject to a daily settlement of gains and losses and guaranteed against the risk that either party might default
Options – a contract between two parties giving one party the right to buy or sell something from the other at a later date at a price agreed upon today
Swaps – a contract in which two parties agree to exchange a series of cash flows