KING’S COLLEGE OF THE PHILIPPINES
COLLEGE OF BUSINESS ADMINISTRATION AND ACCOUNTANCY
Magsaysay Hills, Bambang, Nueva Vizcaya
Financial Management 3
Lecture Notes
Financial Risk Management
Risk Management ---is the process of measuring or assessing risk and developing strategies
to manage it.
---Risk management is a systematic approach in identifying, analyzing and
controlling areas or events with a potential for causing unwanted change.
---Risk management is the act or practice of controlling risk. It includes risk
planning, assessing risk areas, developing risk handling options, monitoring
risks to determine risks have changed and documenting overall risk
management program.
--- is the identification , assessment, and prioritization of risks followed by
coordinated and economical application of resources to minimize, monitor and
control the probability and/or impact of unfortunate events and to maximize
the realization of opportunities( ISO 31000 defined)*
Basic Principles of Risk Management
Risk management should:
1. create value- resources spent to mitigate risk should be less than the consequence
of inaction
2. address uncertainty and assumptions
3. be an integral part of the organizational processes and decision- making
4. be dynamic, iterative, transparent, tailorable, and responsive to change
5. create capability of continual improvement and enhancement considering the best
available information and human factors
6. be systematic, structured and continually or periodically reassessed
Process of Risk Management
1. Establishing the Context. This will involved
a. Identification of risk in a selected domain of interest
b. Planning the remainder of the process.
c. Mapping out the following:
i. the social scope of risk management
ii. the identity and objectives of stakeholders
iii. the basis upon which risks will be evaluated, constraints.
2. Identification of Potential Risks.
Common risk identification methods are:
a. Objective-based risk
b. Scenario-based risk
c. Taxanomy-based risk
d. Common-risk checking
e. Risk charting
3. Risk Assessment.
Elements of Risk Management
1. Identification, characterization, and assessment of threats
2. Assessment of the vulnerability of critical assets to specific threats
3. Determination of the risk
4. Identification of ways to reduce those risks
5. Prioritization of risk reduction measures based on a strategy
Potential Risk Treatments
Risk Avoidance --- includes performing an activity that could carry loss.
Risk Reduction --- involves reducing the severity of the loss or the likelihood of the
occurring
Risk Sharing--- means sharing with another party the burden of loss or the benefit
a risk, and the measures to reduce a risk.
Risk Retention--- involves accepting the loss or benefit of gain, from a risk when it
loss from
of gain, from
occurs.
Investment Risks
Business Risk--- refers to the uncertainty about the rate of return cause by the
nature of business
--- related to sales volatility as well as to the operating leverage of the
firm caused by fixed operating expenses.
Financial Risk --- financial risk is determined based on firm’s capital structure or
sources of financing. If the firm is all equity financed, then any
variability in operating income is passed directly to net income on an
equal percentage basis. If the firm is partially financed by debt that
requires fixed interest payments or by preferred stock that requires
fixed preferred dividend payments, then these fixed charges introduce
financial leverage.
Liquidity Risk --- is associated with the uncertainty created by the inability to sell
investment quickly for cash.
Default Risk --- is related to the probability that some or all of the initial investment will not be
returned.
Interest Rate Risk --- fluctuations in interest rates will cause the value of an investment to
fluctuate also (because money has time value).
Management Risk --- decisions made by a firm’s management and board of directors materially
affect the risk faced by investors. Areas affected by these decisions range from
product innovation and production methods (business risk) and financing (financial
risk) to acquisitions.
Purchasing Power Risk --- it is easy to observe the decline in the price of a stock or bond, but it is
often more difficult to recognize that the purchasing power of the return earned on
an investment has declined (risen0 as a result of inflation (deflation). It is important
to remember that an investor expects to be compensated for forgoing consumption.
Commonly Used Techniques and Models in Assessing Investment Alternatives under Risk or
Uncertainty.
1. Probability
2. Value of Information
3. Sensitivity Analysis
4. Simulation
5. Decision Tree
Probability
 Decision Making under Certainty
--- means that for each decision action, there is only one event and therefore only a single
outcome for each decision.
 Decision Making under Uncertainty
--- involves several events for each action with each probability of occurrence. The decision maker
may know the probability of occurrence of each of the events because of mathematical proofs or the
compilation of historical evidence. In the absence of these two bases, he may resort to the
subjective assignment of probabilities.
Briefly, information is deemed to meet the cost-benefit test if the expected value of a decision (net
of costs of the information) increases as a result of obtaining additional information. The process in
deciding whether the cost-benefit criterion has been met is called information economics.
Assigning Probabilities
~~ A probability distribution describes the chance or likelihood of each of the collectively
exhaustive and mutually exclusive set of events. The probability distribution can be based on past
data if management believes that the same forces will continue to operate in the future.
Probability provides a method for mathematically expressing doubt or assurance about the
occurrence of a chance event.
The probability of an event varies from 0-1.
~~ A probability of 0 means the event cannot occur, whereas a probability of 1 means the event is
certain to occur.
~~ A probability between 0 and 1 indicates the likelihood of the event’s occurrence.
Basic Terms Used with Probability
1. Two events are mutually exclusive if they cannot occur simultaneously.
2. The joint probability for two events is the probability that both will occur.
3. The conditional probability of two events is the probability that one will occur given that the
other has already occurred.
4. Two events are independent if the occurrence of one has no effect on the probability of the other.
~~ If one event has an effect on the other event, they are dependent.
~~ Two events are independent if their joint probability equals the product of their
individual probabilities.
~~ Two events are independent if the conditional probability of each event equals its
unconditional probability.
Expected Value of Perfect Information
Perfect information is the knowledge that a future state of nature will occur with certainty.
Expected value of perfect information (EVPI) is the difference between the expected value without
perfect information and the return if the best action is take given perfect information.
The EVPI is the amount the company is willing to pay for the market analysts’ errorless advice.
Assuming that the market analyst could indicate with certainty which condition would occur, a
manager would decide with complete certainty. Of course, “perfect information” is not perfect in
the sense of absolute predictions.
Sensitivity Analysis
~~ it describes how sensitive the linear programming optimal solution is to a change in any one
number. Sensitivity analysis answers what-if questions about the effect of change in prices or
variable costs; changes in value; addition or deletion of constraints, such as available machine
hours; and changes in industrial coefficients, such as the labor-hours required in manufacturing in
a specific unit.
Trial-and-error method may be adopted in which the sensitivity of the solution to changes in any
given variable, parameter, or other assumption is calculated.
 The risk of the project being simulated may also be estimated.
 The best project may be one that is least sensitive to changes in probabilistic (uncertain) inputs.
 A sensitivity analysis may indicate whether expending additional resources to obtain better
forecasts of future conditions is cost justified.
Simulated
~~ is a technique for experimenting with logical and mathematical models using a computer.
Despite the power of mathematics, many problems cannot be solved by known analytical methods
because of the behavior of the variables and the complexity of their reactions.
Experimentation is organized trial and error using a model of the real world to obtain information
prior to fill implementation.
Models can be classified as:
a) Physical Models—includes automobile mockups, airplane models used for wind-tunnel tests,
and breadboard models of electronic circuits.
b) Abstract Models--- may be pictorial (architectural plans), verbal (a proposed procedure), or
logical-mathematical.
Simulation Procedures
1. Define the objectives. The objectives serve as guidelines for all that follows. The objectives may
be aid in the understanding of an existing system or to explore alternatives. Thus, a
simulation can be designed to ask “what-if” questions, such as whether modifying the
actual system will result in better performance.
2. Formulate the model. The variables to be included, their individual behavior, and their
interrelationships must be defined in precise logical-mathematical terms. The objectives of
the simulation serve as guidelines in deciding which factors are relevant. Moreover, inputs
reflected in the model are of two kinds: controllable and probabilistic. The former are those
subject to the decision-makers’ influence, and the latter involve circumstances beyond their
control, such as a general economic conditions or the acts of competitors.
3. Validate the model. Some assurance is needed that the results of the experiment will be
realistic. This assurance requires validation of the model-often using historical data. if the
model gives results equivalent to what actually happened, the model is historically valid.
Some risk remains, however, that changes could make the model invalid for the future.
4. Design the experiment. Experimentation is sampling the operation of a system. The
experiments also may take the form of asking “what-if” questions, that is, varying an input
or assumption to ascertain the effect on the result.
5. Conduct the simulation-evaluation results. The simulation should be conducted with care. The
results are analyzed using appropriate statistical methods. These results constitute
outcomes that permit evaluation of the probabilities of real world performance.
Advantages and Limitations of Simulation
Advantages
1. Time can be compressed. A corporate planning model can show the results of a policy for 5 years
into the future, using only minutes of computer line.
2. Alternative policies can be explored. With simulations, managers can ask what-if questions to
explore possible policies, providing management with a powerful new planning tool.
3. Complex systems can be analyzed. In many cases, simulation is the only possible quantitative
method for analyzing a complex system such as a production or inventory system, or the
entire firm.
Limitations
1. Cost. Simulation models can be costly to develop. They can be justified only if the information to
be obtained is worth more than the cost to develop the model and carry out the experiment.
2. Risk of error. A simulation results in a prediction of how an actual system would behave as in
forecasting, the prediction may be in error.
Decision Tree
~~ is an analytical tool used in a problem in which a series of decision has to be made at various
time intervals, with each decision influenced by the information by the information that is
available at the time it is made.
~~ is a diagram that shows the several decisions or acts and the possible consequences called
events of each act. Decision trees provide a systematic framework for analyzing a sequence of
interrelated decisions the managers may make over time.
Advantages of Decision Tree Analysis
1. Decision tree is an effective means of presenting the relevant information needed by
management in an investment problem. Such relevant information includes choices, risks,
monetary gains, and objectives.
2. Combination of action choices with different events or results of action that chance or other
uncontrollable circumstances partially affect can be better presented and studied.
3. The interactions of the impact of future events, decision alternatives, uncertain events and their
possible payoffs can be shown with greater ease and clarity.
4. Data are presented in a manner that enables systematic analysis and better decisions.
Limitations of Decision Tree Analysis
1. A decision tree does not give management the answer to an investment problem.
2. It does not identify all the possible events nor does it list all the decisions that must be made on
a subject under analysis.
3. The interactions of such decision with the objective of other parts of the business organization
would be too complicated to compute manually. The use of computers will be suitable when
studying the effect of variations in figures and/or the events involved.
4. Decision tree analysis treats uncertain alternatives as if they were discrete weel-defined
possibilities. It should be remembered that uncertain situations depend not only on one
variable but on several independent or partially related variables subject to such chance
influences.
Steps in Making a Decision Tree
1. Identification of the points and decision and the alternatives available at each point.
2. Determination of the points of uncertainty and the type or range of alternative outcomes at each
point.
3. Estimates of the probabilities of different events or results of actions.
4. Estimates of the cost and gains of various events and actions.
5. Analysis of the alternative values in choosing a course of action.
~~ Because the time between successive decision stages on a decision tree may be long, it would be
more realistic to consider the time value of future earnings and other cash flows. In others the discounted
cash flow approach may be applied on analyzing various investment alternatives.
*ISO- International Organization of Standardization