It refers to probable losses arising from the business partners or from the market. In order to reduce Commercial Risk, It is very important to ensure that the trading partners are reliable. It is also important to take into consideration the trading partner's possible insolvency or indisposition to payback. The method of payment is of high importance.
For example - whenever a tailored product is manufactured, it is recommended you an advance payment or documentary credit is chosen as the method of payment. Various situations can be observed where commercial risk becomes a reality –
The trading partner is unable to deliver or pay for the services/ products as agreed.
The trading partner is not willing to act as per the conditions stated in the agreement.
There are differences in the interpretation of the trade agreement.
There are several ways of identification of Commercial Risk –
Worst Case Scenario – It represents the most disastrous possible outcome. In simple transactions it can be only a sum of money which is lost whereas in big critical business deals it can encompass money, image, trust, brand equity and a lot more.
Volatility – It is the measurement of stability of any variable over time. The most common usage of volatility in commercial risk assessment is in case of stocks. The volatility of stock markets gives a measure of the risk involved in it.
Value at Risk – Value at risk also known as VAR is a mathematical model used by analyst to assign probabilistic values to possible losses. It is closely related to volatility method. It can be used to assign probabilities to a range of losses as well. It gives us a prediction of the transaction as per the model.
Historical Averages – It is a very generic approach where you identify similar transactions done by you, your partner or anyone in the market. One tries to find resemblance in the conditions and takes out an average of outcome of identified transactions to get an idea of risk involved.