What is Risk ?
•Risk is related to uncertainties •
•Risks can be defined as uncertainties resulting in adverse outcome in relation to planned objective or expectations. • •Uncertainties associated with risk elements impact the net cash flow of any business or investment. This could be favourable as well as unfavorable . The possible unfavorable impact is the RISK of the business. •
•Lower risk implies lower variability in net cash flow with lower upside and downside potential.
•Higher risk would imply higher upside and downside potential.
•Zero-Risk would imply no variation in net cash flow. Return on zero-risk investment would be low as compared to other opportunities available in the market.
Relation among Risk , Capital & Return
•Capital required for a business should be such that it is able to meet the maximum loss that may arise from the business to avoid bankruptcy.
•Business with large variation in cash flow would be a business with higher risk . Therefore , capital requirement is also higher.
•If risk is higher than it is expected that return should also be higher.
•Therefore it is desirable to know the risk adjusted return on Capital i.e. RAROC .
•High Loss ~~~ High Capital •
•Low Loss ~~~ Low Capital • •Therefore, •High Risk business require High Capital •Low Risk business require Low Capital
Why Risk need to be managed
•The loss potential of a business is correlated to the risks in the business, and therefore ,risk exposure of a business needs to be managed so as to limit potential losses in adverse situations to a level that can be absorbed by the organisation without affecting its continuity.
•Controlling the level of risk to an organisation’s capacity to bear the risk is the essence of Risk Management and it requires not only identification of risks but also its measurement , control, mitigation and estimating the cost of risk.