Process of Risk Management | Spot Market and Forward Market

Risk management is the process of identifying, quantifying, and managing the risks that an organization faces. As the outcomes of business activities are uncertain, they are said to have some element of risk. These risks include strategic failures, operational failures, financial failures, market disruptions, environmental disasters, and regulatory violations.

While it is impossible that companies to remove all risks from the organization, it is important that they properly understand and manage the risks that they are willing to accept in the context of the overall corporate strategy.

Process of risk management

1. Identify the Risks: as a group, list the things that might inhibit your ability to meet your objectives. You can even look at the things that would actually enhance your ability to meet those objectives e.g. a fund-raising commercial opportunity.

2. Identify the Causes: try to identify what might cause these things to occur eg. The key team member might be disillusioned with his/her position and might be head-hunted to go elsewhere.

3. Identify the Controls: identify all the things (Controls) that you have in place that are aimed at reducing the Likelihood of your risks from happening in the first place and, if they do happen, what you have in place to reduce their impact.

4. Establish you’re Risk Rating Descriptors: i.e. what is meant by a Low, Moderate, High, or Extreme Risk needs to be decided upon ahead of time. Because these are more generic in terminology though, you might find that the University’s Strategic Risk Rating Descriptors are applicable.

5. Add other Controls: generally speaking, any risk that is rated as High or Extreme should have additional controls applied to it in order to reduce it to an acceptable level.

6. Make a Decision: once the above process is complete, if there are still some risks that are rated as High or Extreme, a decision has to be made as to whether the activity will go ahead.

7. Monitor and Review: the monitoring of all risks and regular review of the unit’s risk profile is an essential element for a successful risk management program.

Tools involved in managing risks

1) Prevention and Safety Procedures: Wearing hard hats in construction areas, keeping borrowing to reasonable levels, and insisting that passwords not be shared are all ways to manage risk.

2) Control Environment: The control environment is the overall set of policies and procedures that apply to transactions, accounts, and financial and other information. A controlled environment can be strong, weak, or in between.

3) Insurance: Property and casualty, life, health, and other types of insurance all work on the same principle. The insurer agrees, in exchange for premium payments, to pay the insured a certain amount or up to a certain amount to compensate for a loss arising from a specific type of risk.

4) Hedging: Hedging is used to offset financial and currency risk. A hedge is usually a contract to purchase or sell a security, currency, or commodity for a specific price on or by a specific date.

5) Response Plans and Resilience: Response plans enable an organization to recover from a risk event. Contingency and backup plans help to ensure the resilience of operations and systems.

Tools used to minimize risks

1) Familiarize yourself with the different types of risk: Most financial risks can be categorized as either systematic or non-systematic. Systematic risk affects an entire economy and all of the businesses within it; an example of systematic risk would be losses due to a recession.

2) Determine the level of risk associated with your varied investments: Before reducing risk, you must understand how much risk you can expect from each type of investment.

3) Determine the level of risk you are willing to shoulder: When deciding on an overall level of risk, you need to assess how you want to use the money from your investments in the future.

4) Reduce your portfolio’s risk level by allocating assets widely: The first key to lowering risk is to allocate your money between different investment classes.

5) Lower each asset type’s risk through diversification: Diversifying your portfolio means buying a single type of asset from many different companies. This hedges against the risk that a single company or industry will perform poorly or go bankrupt.

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The different types of foreign exchange risks of a multinational corporation (MNC) based in India.

1. Transaction risk
Transaction risk is the in-built risk in foreign exchange transactions. It consists of a number of trading items such as foreign currency, invoiced trade receivables, and payables along with capital items such as foreign currency dividends and loan payments. Whenever a cash flow is affected in a specific transaction this risk is present.

It is the risk of adverse exchange rate movements occurring in the course of international trading transactions. This risk arises when export prices are fixed in foreign currency terms or imports are invoiced in foreign currencies.

2. Position risk
Bank transactions, both on-spot and forward-based, result in positions being created in the currencies in which these transactions are denominated. A position risk arises when a dealer in a bank is having an overbought (long) or an oversold (short) position. Dealers enter into these positions in expectation of a positive movement.

3. Settlement or credit risk
Settlement risk is the risk of a counterparty failing to meet the obligations in a financial deal after the bank has fulfilled the obligations on the date of settlement of the contract. Settlement risk exposure possibly exists in foreign exchange or in local currency money market business.

Settlement risk arises mainly due to the way foreign currency deals are settled. Settlement necessitates a cash transfer from one bank’s account to the other for the currencies involved in the transaction.

4. Mismatch or liquidity risk
In the foreign exchange business, it is not possible to be in an ideal position always, where sales and purchases are according to maturity and there are no mismatched circumstances. Some mismatching of maturities is inevitable, as a result of which the bank may lose or gain.

There could be a situation where the mismatch cannot be corrected within the same month and the alteration takes place in subsequent months. In these circumstances, the number of risks increases.

5. Sovereign risk
One more kind of risk that banks and other agencies that deal in foreign exchange face are sovereign risk. Sovereign risk is based on the government of a country. Although an importer in the country agrees to pay for his imports, the central bank of the country may not allow the importer to do so.

This has happened in a number of African and South American countries on account of economic volatility and political uncertainties.

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