CAPITAL ASSET PRICING MODEL (CAPM) A CRITICAL TOOL FOR
ASSESSING RISK AND RETURN IN INVESTMENTS
ARIZONA STATE UNIVERSITY
IEE 454 – RISK MANAGEMENT
WEEK 2
A. Introduction:
Everyone faces different choices in determining the proportion of funds or resources they
have to make an investment. The possible deviation from the average expected return can be
statistically measured by the standard deviation. This risk reward ratio means that not all
investors invest in assets that offer the same return. This is because we also need to consider
the level of risk that investors face.
Systematic risk is part of the security risk that cannot be eliminated by forming a portfolio
and unsystematic risk is part of the security risk that can be eliminated by forming a well-
diversified portfolio (Hartono, 2017). To reduce portfolio risk, investors need to diversify.
The principles of diversification can be divided into two, namely random diversification and
Markowitz diversification. Random diversification is a random investment by investors in
different types of stocks or in different types of assets and hopes that the variance as a
measure of portfolio risk will be reduced (Tandelilin, 2001).
Investment returns can only be estimated through estimation. Future investment returns
are expected returns and may differ from the actual returns received. A probability
distribution estimates the rate of return of a security as a single asset, i.e. it considers the
probability of achieving a certain or higher rate of return as the probability of the expected
return.
B. Return:
According to Hartono (2015: 263), stock returns are the results obtained from investment.
Returns can be in the form of realized returns that have occurred or expected returns that have
not yet occurred but which are expected to occur in the future.
Stock return is the rate of return on the investment that has been made. Stock returns can
attract investors to invest their funds in the capital market.
1. Types of stock returns
According to Hartono (2013: 235) stock returns are divided into two types, namely as
follows:
a. Realized return:
Realized return is the return that has occurred. The realized return is calculated using
historical data. Realized return is important because it is used as one of the performance
measures of the company.
Realized return is a return that has occurred and calculated based on historical data and
realized return is important because it is used as one of the performance measures of the
company as a basis for determining expected return and risk in the future. The realized
stock return (Ri,t) is obtained from the daily stock price of security i at time t (Pi,t) minus
the daily stock price of security i at time t-1 (Pi,t-1), divided by the daily stock price of
security i at time t-1 (Pi,t-1).
To get a certain return or profit, an investor must also pay attention to the risks he will
bear. Risk is the possible difference between the actual return received and the expected
return. The greater the possible difference, the greater the risk of the investment.
b. Expected return:
is the return that investors expect to get in the future. Expected stock return is the level
of profit expected by investors. In calculating the Expected return can be measured using
the approach:
1) Capital Asset Pricing Model (CAPM). In 1960, William F. Sharpe, Litner and Mossin
developed it for the first time. Weston, Besley and Brigham (1996) define that CAPM
is a model that benchmarks the risk of certain securities consistent with portfolio
theory. The model calculates the undiversified risk of a single portfolio and compares it
to a well-diversified risk.
Furthermore, the CAPM model explains that the rate of return on an asset or stock is
equal to the risk-free rate of return plus a risk premium. The risk premium is the amount
above the risk-free rate that an investor seeks before he puts his funds in a risky asset.
Therefore, it can be concluded that CAPM is seen as an investor's point of view in
seeing various reactions in the market. These market conditions then encourage an
investor to behave in deciding various conditions such as risk and return and the
equilibrium price of a security.
The CAPM model is a model that can describe the reality in complex markets. The
concept of the relationship between systematic risk (beta) and return is explained by the
SML (Security Market Line). Security risk is indicated by beta, because in the
equilibrium market, the portfolio formed is well diversified so that the relevant risk is
systematic risk (beta).
CAPM Expected return is measured by considering the market return and risk-free
interest rate. The CAPM model used as the basis for calculating expected return is as
follows:
E(Ri) = Ri + β (Rm - Rf)
Where:
Rf is the risk free rate. Rm is the market return which in this case is used the return of
the stock index of the wholesale and retail trade sector.
β is the beta of each stock Beta of each stock calculated using interpolation using data
stock returns in the wholesale and retail trade sector (Husnan, 1998).
The stock return of wholesale and retail trade and the market return of the wholesale
and retail trade sector are calculated based on the traditional formula, which is the
percentage difference from the value of period t to the value of period t-1 divided by
the value of period t-1 and the result is multiplied by one hundred percent.
2) Single Index Market Model (SIMM) Expected return is the expected income of a stock
in the future, which corresponds to the level of risk of the stock. Before calculating the
expected return, first look for the coefficient of alpha and beta values for each stock by
regressing Ri,t as a dependent variable with Rmt as an independent variable during the
period under study. Calculate the normal return using the previously calculated alpha
and beta values, while the market return used is the market return during the study
period. Calculated using the formula:
E(Ri,t) = αi + βi * Rmt
c. Abnormal Return:
Abnormal return is the return earned by investors that is not in accordance with
expectations. Abnormal return is the difference between the expected return and the return
earned. The difference in return will be positive if the return obtained is greater than the
expected return or calculated return. While the return will be negative if the return obtained is
smaller than the expected return or calculated return. Abnormal returns can occur due to
certain events, such as national holidays, the beginning of the month, the beginning of the
year, uncertain political atmosphere, extraordinary events, stock splits, initial stock offerings,
and others. Event studies analyze the abnormal returns of securities that may occur around
the announcement of an event. Abnormal return or excess return is the excess of the actual
return over the normal return.
The actual return is the return that occurs at time t which is the difference between the
current price relative to the previous price, while the expected return is the expected return
(estimated) using the expected return equation above.
2. Factors that affect stock returns:
According to Irham (2012: 87), the factors that influence stock returns are micro and
macroeconomic conditions, company policies in deciding expansion (expansion), sudden
changes in directors from financial performance. Meanwhile, according to Samsul (2015:
200), the factors that influence stock returns are as follows:
a. Macro factors, which are factors that are outside the company, namely:
1) Macroeconomic factors that include interest rates, interest rates or interest rates are the
ratio of returns on a number of investments as a form of reward given to investors
(Husnan, 2009). The interest rate can be one of the guidelines for investors in making
investment decisions in the capital market. As an alternative investment vehicle, the
capital market offers a rate of return at a certain level of risk.
2) General domestic.
3) Inflation rate. The policy of controlling the value of inflation has always been the target
of the government because the value of inflation can lead to slow economic growth,
unemployment and a decline in purchasing power including in the purchase of shares
and property products. From the above ratios, it will be an initial alternative for
investors to assess the company's performance. With the use of these ratios, will it
affect stock returns on the IDX.
4) Foreign exchange rates. According to the IFE (International Fisher Parin) theory,
currency spot rates will change according to the interest rate differential between two
countries. As a result, the average return on uncovered international money market
securities is no more than the return on domestic money market securities especially
from the point of view of investors in the home country (Kuncoro, 2009).
5) International economic conditions.
b. Micro factors are factors that are within the company, namely:
1) Net profit
2) Book value per share
3) Debt-to-equity ratio
4) Other financial ratios
So it can be concluded that the factors that affect stock returns are two factors, namely
micro factors and micro factors, which are in company policies that decide on expansion
(expansion), sudden changes in directors on financial performance.
3. Components of Stock Return:
According to Zulfikar (2016: 235) stock returns consist of two components, namely
Return = yield + capital gain (loss). Capital gain or capital loss is the difference from the
current investment price relative to the price of a certain period. Meanwhile, according to
Eduardus T (2010: 52) stock returns consist of two components, namely as follows:
a. Capital gain (loss), which is an increase (decrease) in the price of a stock that can provide
profits (losses) for investors.
b. Yield, which is the component of return that reflects the cash flow or income earned
periodically from a stock investment.
The two components of stock returns above, namely capital gain (loss) and yield, are
increases or decreases in stock prices that provide profits and losses for investors, this is also
the case if we buy shares, yield will show the amount of dividends we get.
C. Risk:
The concept of risk and return was first popularized by Harry Makowitz (1995).
Markowitz introduced a model known as the two-parameter model, which essentially states
that investors should focus on two things, namely:
a. The expected return of an asset.
b. The risk is seen through the standard deviation of the asset's return.
An investor who can predict or know future returns with certainty, will certainly invest in
only one security, namely the security that has the highest future return (Markowitz, 1999).
However, this is unrealistic because it ignores the risks that may arise and oversimplifies the
investment process, so there will be a trade off in risk and return, which will have an impact
on the selection of several financial decisions that have different risks and returns.
Many researchers have examined this risk and return trade off. Academics agree that
currently diversifying securities is something that needs to be done to get maximum returns
with less risk from the diversified portfolio.
According to Lekovic (2018), investors today no longer invest their funds in only one
type of security but prefer to invest in various types of securities. Thus, investors will build a
diversified portfolio. Santosa et al. (2011) state that value risk, market risk and trading
activity are positively correlated with stock returns. Likewise, Chen (2013) states based on
his empirical study that there is a relationship between value risk and stock returns positive
relationship between risk and return in the Shanghai and Shenzen stock markets.
1. Risk and Uncertainty:
In finance and in everyday life, we know that in order to achieve something relatively
big, we also have to take big risks. In your working life you will also have to face risks,
both financial and managerial. Financial risk will be related to the failure of the company
to execute the financial plan that has been set, while managerial risk will be related to the
failure of the company's leadership to manage the company, which will ultimately be
measured by financial failure.
Every decision taken in investing will have a strong relationship with the occurrence of
risk, because investment decision-making tools are not always complete and can be said to
be perfect, but there are some things that are not adequately and perfectly analyzed. For
this reason, risk is always the main benchmark in analysis when making investment
decisions.
In general, it can be said that risk is a form of uncertainty about a situation that will
subsequently arise when a decision is made based on a consideration. In Indonesia, the
SBI interest rate is generally used as a reference for risk-free interest rates. The level of
risk included in the investment assessment will affect the amount of return expected by
investors. If investors see that there is a high level of risk in planting investments, then
investors will also demand a high rate of return.
2. Portfolio risk analysis:
In portfolio management, the concept of risk reduction is known as the consequence of
the inclusion of corporate securities in the portfolio. This concept is critical to
understanding portfolio risk. It states that if we continue to add stocks to our portfolio, the
risk reduction benefits we realize will increase until we reach a point where the risk
reduction benefits begin to diminish. This concept corresponds to the large number of
deaths in Statistically, the larger the sample size indicates that the sample mean tends to be
closer to the population expectation. Portfolio risk reduction is almost identical to the
principle of insurance, where insurers reduce risk by taking out as many insurance policies
as possible.
The concept of portfolio risk reduction is based on the assumption that security returns
are independent. Assuming the returns on the portfolio are not mutually exclusive, we can
estimate the portfolio risk by dividing the population standard deviation by the square root
of n (the number of stocks in the portfolio).
3. Systematic and Unsystematic Risks:
a. Definition of Systematic Risk:
Part of the security risk that cannot be eliminated by forming a portfolio is called
Systematic Risk (Hartono, 2014: 308). According to Keown (2011: 201) Systematic
Risk is part of the variation in investment returns that cannot be eliminated through
diversification by investors. Systematic Risk is also called market risk where risk
occurs due to events outside the company, such as recessions, inflation, interest rates,
exchange rates and so on, so this risk is a risk that cannot be diversified.
According to Brealey (2008: 312) Market risk is a source of risk from the entire
economy (macroeconomics) that affects the stock market as a whole. Bodie (2006: 288)
argues that risks that remain after extensive diversification are called market risks, risks
that arise from the market or risks that cannot be diversified. Non-diversifiable means
that the risk cannot be eliminated despite the diversification of stocks by forming a
portfolio. If systematic risk arises and occurs, then all types of stocks will be affected so
that investment in 1 type of stock or more cannot reduce losses (Samsul, 2006: 285).
Based on the above understanding, it can be seen that Systematic Risk is the risk
inherent in a security that arises due to macro factors or events outside the company and
cannot be controlled diversified. Therefore, Systematic Risk must be considered by
investors because it will not disappear even if a portfolio is formed.
b. Definition of Unsystematic Risk:
There are also risks that can be eliminated by forming a portfolio or diversifying
securities. This risk is unsystematic risk. Part of the security risk that can be eliminated
by forming a well-diversified portfolio is called Unsystematic Risk (Hartono, 2014:
308). Unsystematic risk is part of the variation in investment returns that can be
eliminated through diversification by investors (Keown, 2011: 201). Unsystematic Risk
is often referred to as company risk, unique risk and unique risk. According to Brealey
(2008: 312) typical risk is a risk factor that only affects the company. Bodie (2006:
289) suggests that risks that can be eliminated through diversification are called unique
risks, company-specific risks, unsystematic risks. Unsystematic risk or specific risk
only affects a particular stock or sector (Mohamad Samsul, 2006: 286).
Based on the description above, it can be seen that Unsystematic Risk is the risk
inherent in a security that arises because of events or events that occur in the company.
For example, employee strikes, failed research and so on. Unsystematic risk can be
diversified by forming a portfolio. Risks that can be diversified in the portfolio can
certainly minimize the risk without having to reduce the return received.
D. Diversification:
To reduce investment risk, investors should "diversify". Diversification in (portfolio)
means that investors should form a portfolio by selecting a combination of several assets to
reduce risk without reducing the expected return. The easiest way to diversify is by placing
all asset classes in one portfolio. Asset classes here include stocks, bonds, currencies,
property, and others.
1. Random Diversification:
Random diversification or naive diversification occurs when investors invest their
funds randomly in a variety of different stocks or in a variety of different assets and
expect that the variance of returns as a measure of portfolio risk will be reduced. In this
case, the investor chooses the assets to be included in the portfolio without paying much
attention to the characteristics of the assets (e.g. expected return rate or industry
classification of the asset). In the mind of a randomly diversified investor, the more types
of assets included in the portfolio, the greater the risk reduction benefit that will be
obtained. The diversification benefits obtained by adding more stocks will decrease over
time. If we increase the number of stocks in the portfolio continuously, then at a certain
level the marginal risk reduction will decrease.
2. Markowitz Diversification:
The most efficient random diversification is the diversification based on Henry
Markowitz's model around the 1950s and is known as Markowitz diversification.
Markowitz's very important advice in portfolio diversification is not to put all your eggs
in one basket, because if the basket falls, all the eggs in the basket will break. In the
context of investing, this teaching can be interpreted as not investing all your funds in
one asset, because if that asset fails, all the funds you have invested will be lost. At first
glance, this lesson seems simple, but Markowitz's portfolio theory quantitatively shows
why and how diversification can reduce portfolio risk. An important contribution of
Markowitz's teachings is his discovery that asset returns are interrelated and not
independent.
E. Estimated return:
Knowing exactly how much return we will get and invest in the future is a lot of work is
very difficult or even impossible. Investment returns can only be estimated through
forecasting. The future return on our investment is the expected return and is very likely to
differ from the actual return received.
If a scoting investor typically expects a 10% return on investment, then it is likely that the
real rate of return that will be obtained is not equal to 10%, it may be lower or higher, the
expected rate of return of 10% is only an estimate which may actually be lower or higher than
that figure. In addition to the expected return of a security, we must also calculate the amount
of risk associated with investing in the security in question. Risk, as the flip side of return,
represents the possible deviation of the expected return from the actual return earned.
1. Calculating the Expected Return:
In estimating the return of a security as a stand alone risk, investors must consider
the likelihood or probability of achieving a certain return. The result of the expected rate
of return and its probability is called the probability distribution. In other words, the
probability distribution shows the specification of what level of return will be obtained
and what is the probability of the return occurring.
2. Calculating Risk:
Investors must be able to calculate the risk of an investment. Since the level of risk is
the possible deviation of the actual return from the expected return of the average return,
statistically this level of risk can be represented by a measure of deviation or a measure
of data spread. Two measures of dispersion that are often used to represent it are the
variance and standard deviation values. To calculate the variance or standard deviation
which is the square root of the variance, we must first calculate the expected return
distribution using the expected return equation of a security.
In measuring the risk of a security, we also need to calculate the relative risk of the
security. This is necessary because risk information that is only in the form of variance
and standard deviation will be problematic, first when you want to compare the level of
risk between assets that each have unequal expected returns.
In measuring the risk of a security we also need to calculate the relative risk of the
security. This relative risk shows the risk per unit of expected return.
This is necessary because risk information that is only in the form of variance and
standard deviation can sometimes be misleading, especially if there is a very large
expected return deviation. The measure of relative risk that can be used is the coefficient
of variation.
F. Summary Material:
1. Return and risk are in a positive relationship, the greater the risk accepted, the greater the
return that must be compensated. Conversely, the lower the expected return, the lower the
accepted risk.
2. Systemic risk is the risk inherent in a security that arises due to macro factors or events
outside the company and cannot be diversified. Unsystematic Risk is the risk inherent in a
security that arises because of an event or events that occur in the company.
3. Random diversification allows investors to invest in different types of stocks or the
variance, which measures the risk of a portfolio across different types of assets, is
expected to decrease. Markowitz diversification combines assets in a portfolio with returns
that are less strictly positively correlated and aims to reduce the risk (variance) of the
portfolio without reducing returns.
4. The expected return of a security can be estimated by calculating the expected rate of
return on that security. The expected return is calculated by averaging all possible returns.
Practice And Evaluation:
1. Why does an investor need to analyze return and risk before making an investment?
2. How is covariation used in portfolio theory?
3. Why can't systematic risk be eliminated by diversification? Give an example of
systematic risk and unsystematic risk!
4. In Markowitz diversification, why should portfolio risk not be calculated from the sum of
the assets in the portfolio?
5. Risk and return are always closely related, is the relationship always linear or not?
Explain why!
BUSINESS RISK CONTROL
Risk Trends and Control Measures :
Risk control activities have long been recognized in human life. In the era where humans
still lived by relying on hunting activities, humans had already started planning. For example,
how humans in the past calculated the results of hunting large animals which were certainly
very balanced with the results of getting meat from the hunting activity. They took the trouble
to spend money to cultivate rice fields to get the maximum harvest.
Business in the post-pandemic era and the world security crisis situation triggered by the
war between Russia and Ukraine have caused various negative impacts on the business
world. In the energy sector, European and American countries are now starting to feel the
impact of the energy crisis, due to the interruption of gas supplies from Russia. Another result
is that the supply of wheat from Ukraine to the world market has also decreased due to the
war.
This situation will slowly but surely have a domino effect on economies around the
world. This is inseparable from the world economic system that places an interdependent
position between one country and another. Actually, it is not only at the macro level that is
affected. In a more micro environment at the company level, various businesses are now also
facing the pressure of external factors (externalities). Companies such as NETFLIX, for
example, suddenly experienced a drop in market value after investors Its strategic
shareholding was abruptly released in the face of Netflix's declining stock market price over
the last six months since the beginning of 2022. Netflix also faced another problem with the
suspension of operations in Russia, as a result of which thousands of subscribers in that
country also stopped their subscriptions.
Domestically, the tourism and hospitality industry has had to face an unprecedented
reality. The Covid-19 pandemic has caused a halt in operations followed by a halt in cash
flow, as a result of the movement restriction and social distancing policies. Where these
policies have triggered a decline in tourist travel from both foreign and domestic tourists. The
cessation of operations and cash flow is a loss for the sector. In anticipation of prolonged
losses, hotel owners have had to completely close their businesses and even divest ownership
by selling assets to new owners.
What Netflix and the tourism and hospitality industry experienced above shows how
important early efforts to identify risks are. Regardless of the form of risk faced, control
efforts will determine the success of the company in dealing with the crisis and minimizing
the impact of the risk of loss that may occur.
A. Basic Principles and Complexity of Control Risk:
Risk management and control activities are not only centralized in business, financial,
operational and technical activities, but also cover all parts of human life. The presence of a
new environment leads to relatively new uncertainties and challenges (Pereira et al., 2000).
For example, in the financial world, the emergence of cryptocurrencies as a means of
investment and digital assets, on the one hand, has provided opportunities for investors to
deposit their funds on this platform with the opportunity to earn relatively large margins.
However, the high rate of fluctuation in the value of cryptocurrencies raises concerns about
their stability. The vulnerability of crashes in cryptocurrencies crypto money has led many to
view investment in this sector as extremely risky.
Business risk control activities are not easy problems. Risk control activities have high
complexity and challenges. Therefore, almost all organizations and companies have a risk
management unit (Yu et al., 2008). Where this unit works in managing, identifying,
controlling and anticipating business risks even including non-operational risks faced by the
company.
B. Control Aspects Risk:
Some aspects of risk control in the company include: 1) Investment risk control; 2)
Operational risk control; 3) Risk control in times of crisis.
1. Investment risk control:
The introduction illustrated how investors control the risk of their stock portfolio
investment in the company NETFLIX. The decision to sell NETFLIX shares that were
previously acquired through strategic purchases was the right one. The aim is to prevent the
tendency of deeper losses due to NETFLIX's stock position that continues to be in the red
zone on the US exchange.
Portfolio risk control is one of the most important tools for investors in order to minimize
potential losses that may arise from stock trading activities on the stock exchange. This
control can be used as a basis for decision making whether to continue investing in an
existing stock portfolio or stop investing in other stocks that are far more profitable. This risk
control activity can be carried out through stock market analysis activities and stock portfolio
analysis both fundamentally and technically.
Philosophically, risk control in the stock portfolio sector is often illustrated as an
inherently egg-carrying activity. There is a potential loss if the egg breaks on the way. On
that basis, then came the expression that the eggs should not be placed in just one basket.
Because, if the basket falls, the risk is that all the eggs will also break. The practice of
carrying all the eggs in one basket is a risk-averse behavior. Therefore, the adage developed
is that the eggs should be placed in different baskets, so that even if something breaks in one
basket, there is still a supply of eggs in other baskets.
The approach to analyzing investment risk can be done using fundamental and technical
models. In the fundamental model, efforts to predict the value of shares and investment
returns are measured based on the company's accounting data available in the financial
statements. According to Abad et al. (2004) the fundamental approach can be done with two
events:
1) Predictive models, by analyzing the financial information contained in the financial
statements to produce a forecast of the market value (shares) of a company.
2) The normative model uses information in the financial statements to optimally calculate
the stock market value of a company under certain conditions. Forecasts using the
normative model are considered much more realistic.
In technical analysis, all fundamental factors can be seen directly in the stock price.
Therefore, technical analysis focuses on measuring stock price and trading volume using the
medium of tables and charts. With technical analysis of stock price data in tables, it is
possible to identify trends in stock price movements and the formation of future price
changes. One of the most commonly used charts is the candle stick. However, the use of
technical analysis is more appropriate in short trading activities.
By using the above two approaches to investing, the possible risk of loss due to
investment can be anticipated. Where the decision to invest is more emphasized on the
companies The company fundamentally has good assets, return on investment, and dividend
payout ability. Technically, the stock has a tendency to generate profits in the short term.
2. Operational risk control:
Operational risk today has undergone drastic changes. The influence of external factors
such as globalization, financial sector deregulation, and advances in information technology,
has changed the approach to managing operational risk. In the context of banking, for
example, the Bassel Committee on Banking Supervision has published a framework that
guides the management of operational risk (Shevchenko, 2014). The framework introduces a
category of operational risk and capitalization requirements for operational risk losses.
Operational risk control is the most urgent thing for companies. Where success in
handling operational risk can have an impact on reducing potential losses (Sunarjo &
Yuniarti, 2017).
In operational risk control, there are four types of frequency and impact that need to be
considered. The four things based on Pyle's (1997) view are as follows:
1. Frequency of risk events is low/impact of risk is high
2. Frequency of risk events is high/impact of the risk is also high
3. Frequency of risk occurrence is low/impact of the risk is also low
4. The frequency of risk events is high / the impact of the risk is low The operational risk
control model is as follows:
a. Risk Register in Organizational Risk Management Framework:
In the literature of enterprise (organizational) risk management is commonly
known as Enterprise Risk Management (ERM) which generally focuses on risk issues
related to the management of financial and other financial assets. ERM is defined as
the process of identifying and analyzing risks at all levels of the
organization/company (Lai & Samad, 2010).
In the ERM approach, all company risks are identified and then collected,
evaluated and finally compiled in a risk register (Bačun, 2015). The use of risk
registers is no longer unfamiliar to companies or organizations that use formal
approaches in managing risks of both financial and operational nature.
According to Bacun (2015), even one risk register can contain up to several
thousand risk items that must be managed by the company. The structure and design
of the risk register are standardized. Every newly recognized risk cannot necessarily
be combined with existing risks in the list, because both have different risk structures.
This is for example in risk control in the construction services sector. Where the
company implementing construction services in each project has a different set of
risks. The process of compiling the risk register starts with the assessment and
identification of strategic risks. In a collaborative approach, the preparation cannot be
done by an individual or an adhoc team, because it covers all elements in the
organization.
In a simple example, let's say a company has operational risk in terms of shipping
products to customers in large quantities via container ships. The risk that may occur
is delays in delivery caused by the lack of shipping frequency and the number of
container ships, so that the volume of products that can be shipped is not maximized.
b. Prioritized Risk Score
There are many operational risk control models applied in organizations. One
model used especially in manufacturing companies is the Risk Priority Number
(RPN). This RPN is a calculation model that uses a linguistic approach, to measure by
ranking the probability of risk occurrence (O), the level of damage produced (S), and
the probability of detection (D) on a scale of numbers 1-10. In this RPN model, each
potential risk or failure is given a weighted value, making it easier to rank risks based
on their order of importance. The results of this RPN calculation will later be used as
a basis for management for decision making.
c. Total Quality Management:
Shevchenko (2014) argues that one of the tools used by companies in controlling
risk is by implementing total quality control (Total Quality Management). This view
is based on the initial findings put forward by Bergman (1985) which revealed that the
implementation of total quality control has a positive impact on efforts to improve
product quality and minimize the risk of loss.
The application of total quality control in the company, the main goal is to
improve quality at all stages of the process. Where by using resources optimally, the
quality of the final product produced by the company can be improved. El Khatib et
al. (2020) state that the application of total quality control has an effect on increasing
the company's capacity in risk management.
d. Risk control in times of natural disaster crisis
The crisis caused by natural disasters has recently become a growing concern in
the business world. If a few decades ago, disasters were not a factor that was taken
into account in the company's planning and operational processes, but not today. Facts
show that the world today is increasingly faced with crisis situations due to natural
factors, as well as those caused by pandemic factors such as the spread of the Covid-
19 virus at the end of 2019.
These crises and disasters are not only a threat and uncertainty to the continuity of
the company, but can also cause prolonged problems if the company does not have
anticipatory policies and the ability to survive (resilience) to crises and disasters.
The company's efforts in initiating the continuation of its business in the midst of the
threat of crisis in the literature are known as the concept of business continuity management.
In this context, company management does not focus on immediate response and recovery,
but has also developed pre- and post-crisis plans. The company's emphasis is on the aspect of
how business continuity can be done especially on fundamental operational aspects
(Sahebjamnia et al., 2015). One of the business continuity models introduced is the
Integrated Business Continuity and Disaster Recovery Plan (ICBDRP). This framework is
generally applied to manufacturing companies, which have many sets of operational
activities.
This framework combines a business recovery and continuity plan with a model for
handling disrupted company operations in the aftermath of a crisis. Sahebjamnia et al. (2015)
say that this framework involves decision-making at three levels, namely: strategic, tactical
and operational.
At the strategic level, management conducts external and internal analysis to identify
possible disruptive events, establish IBDCRP objectives and determine business continuity
systems.
At the tactical level, the decision made is to develop a plan for the sustainability and
recovery of the company's operations. Because every time there is a disruptive event such as
a crisis or natural disaster, it will reduce the operational capacity and resources of the
company as a whole. As a solution, the operational division must develop a mathematical
formula to determine the optimal allocation of resources to resume the company's operations
even if it has to sacrifice between the recovery plan and business continuity.
Once the sustainability and recovery plan is established, the next step is to implement it
operationally to test whether it is satisfactory and able to realize the company's operational
sustainability. If the plan is valid, it can continue to be used. If not, then the plan needs to be
modified based on feedback from operational testing.
C. Summary Material:
1. Risk control involves all aspects of the company at the strategic, tactical and operational
levels.
2. There are various models that can be used to anticipate and control risks, both financial
and operational. The choice of risk control model is based on managerial decisions and the
conditions and situations faced.
3. In normal situations, when facing the possibility of operational losses, there are several
models to choose from, such as: risk register, risk priority number, or total quality control.
4. When facing the threat of crises and natural disasters that come from external factors,
management can use a business continuity management model to develop recovery plans
and operational continuity in the pre- and post-crisis period.
Practice And Evaluation:
1. The use of fundamental and technical approaches in investing is a strategy that can be
used to minimize the risk of losses due to declining stock values. Briefly explain how to
use both approaches to avoid risk!
2. The use of risk registers in controlling company risks requires the ability to determine
the chances of risk occurrence and the level of risk. If a mining company is involved in
gold mining activities, analyze the potential risks and the frequency of occurrence!
3. When faced with crisis and natural disaster situations, companies need to have strategies
and readiness in anticipation. Briefly explain what approaches can be used to anticipate
the disruption of company operations during crises and natural disasters!
