FINANCIAL RISK AND

FINANCIAL RISK
MANAGEMENT
BY STUDENTS OF RAMANUJAN COLLEGE , DU
COURSE : BMS
PARTH ARORA

KARTIK JAIN
SUBJECT :
TANMAY TANDON
INSURANCE & RISK
PRABHAT RAJPUT MANAGEMENT

SUBMITTED TO :

ARNAV KUMAR
Acknowledgement
We would like to express our special thanks of gratitude to our teacher Mr. Arnav Kumar as
wellas our principal Dr. S.P. Aggarwal who gave us the golden opportunity to do this
wonderful project on the topic financial risk which also helped us in doing a lot of research
and we came to know about so many new things we are really thankful to them.Secondly we
would also like to thank our parents and friends who helped us a lot in finalizing this project.
Certificate of Originality
We certify that this research work titled ________ has been submitted as Project Report in
partial fulfillment of the Internal Assessment requirements of the Bachelor of Management
Studies (B.M.S.) Semester I paper titled "Insurance and Risk Management" to Ramanujan
College, University of Delhi, Delhi in the month of November 2016. This has not been
submitted in part or full for degree or diploma of any other university/institute.

The lists of references used have been detailed at the end of the report and the rest of the
document contains our learning, knowledge, thought and recommendations. We also declare
that we have not consciously attempted to plagiarize from any existing
literature/research/work on this topic. We have identified the sources of all information
whether quoted verbatim or paraphrased , all images, and all quotations with citations.
Nothing in this project violates copyright, trademark, or other intellectual property laws.

We further agree that our full name below in italics is intended to be equivalent to our
signature.

Kartik Jain

Parth Arora

Prabahat Rajput

Tanmay Tandon
 TABLE OF CONTENTS

1. INTRODUCTION……………………………………….5 PARTH
2. BUSINESS RISK………………………………………..6 PRABHAT
3. FINANCIAL RISK………………………………………7
4. BUSINESS VS FINANCIAL RISK……………………..8
5. OPERATIONAL RISK………………………………….9
6. MARKET RISK…………………………………………15 KARTIK
7. CREDIT RISK…………………………………………..18
8. LIQUIDITY RISK……………………………………… 22
9. COMPONENTS OF FINANCIAL RISK……………… .24 TANMAY
10. SYSTEMATIC AND UNSYSTEMATIC RISK………..33 PARTH
11.FINANCIAL RISK MANAGEMNT …………………...34
12.DIVERSIFIATION………………………………………34
13.HEDGING……………………………………………….40
14.ARBITRAGE…………………………………………….43
15.CASE STUDY……………………………………………45 TANMAY ,

PARTH

16.CONCLUSION…………………………………………..46 PARTH
17.REFERENCES…………………………………………...47 ALL
 INTRODUCTION

Finance is the most important thing for almost everything , you may be having a good
business idea but to succeed you need finance , to become an entrepreneur you need be
fully aware of the real practicality.In this project we ‗ ll highlight the various types of
financial risk that a country , a person , a company may have to face or can face with the
detailed explanatiom . financial risk is a broad term and has various types of risks like market
risk , credit risk , liquidity risk operational risk . credit risk is further divided inot sovereign ,
settlement risk etc, operational includes fraud , legal risk etc. the main componets of any
fincial risk is basically related to interest rate , inflation rate , amount of credit , cash flow and
monetary risk associated with it .interest rate can hamper the economy but can be controlled
by fiscal and monetary measures , same is the case with money flow in economy . amount of
credit need special attention as the how much credit to take and how much to give depends on
the capacity of the giver and the requirement of the borrower.Many financial crisis have
occurred due various other reasons and everytime we analyse observe or learn something
new for eg dotcom bubble , lesson crisis , sony hack crisis, subprime mortgage etc.whole of
the finance is dependent on two words that are systematic and unsystematic risk . systematic
is which cannot be eliminated by diversification affects many whereas unsysytematic is
diversifiable and affects indivisuals.financial risk management includes diversification ,
hedging and arbitrage. Diversification is used for risk reduction , capital preservation capital
growth , hedging secures the poition and arbitrage is risk free profit situation which is rare,
to take financial decisions technical ananlysis and fundamental analysis is done
.diversification is done industry wise , capitalisation wise , asset relationwise , wheras
hedging ais done between inversely correlated assets .
 Business Risk
Business risk refers to the possibility of the occurrence of profits or even losses due to the
uncertainty. it also means that the possibility of loss occurrence in the business operation's
and environment which also affect the ability of the organization to provide the return on
investment. Business risks implies that the uncertainty in profits or occur of loss and the
events that could pose a risk due to some unforeseen events in future, which causes business
to fail and every business contain some element of risk. Business risk is influenced by
numerous factors, including sales volume, per-unit price, input costs, competition, the overall
economic climate and government regulations.

For e.g.(1):- An owner of an business may face different types of risk like in production , risk
due to supply of raw material and electricity, machinery breakdown, labor unrest ,etc. In
marketing, risks may arise due to different market price fluctuations, changing trends and
fashions, error in sales forecasting, etc. in environment, there may be loss of assets of the firm
due to fire, flood, earthquakes, riots or war and political unrest which may cause unwanted
interruptions in the business operations. Thus business risks may take place in different forms
depending upon the nature and size of the business.

(2) A company with a higher business risk should choose a capital structure that has a
lower debt ratio to ensure it can meet its financial obligation at all times.

TYPES OF BUSINESS RISK

1. Strategic risk

2. Financial risk

3.Operational risk

4.Compliance risk

5.Other risk
 FINANCIAL RISK
Financial risk is the possibility that shareholder will lose money when they invest in a
company that has debt, if the companies cash flows proves inadequate to meet its financial
obligation. when a company use debt financing, its creditors are repaid before its
shareholders if the company before insolvent. financial risk is also refers to the possibility of
a corporation or government defaulting on its bonds, which would cause those bondholders to
lose money.It also refers that if a company cannot cover its debt and enters bankruptcy , the
risk to stakeholders not getting satisfied monetarily is high.

For eg :- The average leverage for the industry is quite high given the issue the industry has
face over the past few years. given the high leverage of the industry, there is extreme
financial risk that one or more of the airlines will face an imminent bankruptcy.

Effect of changes in sales or earnings on EBIT Differing amounts of debt financing cause
changes in EPS and thus a company's stock price.

EBIT=sales - variable costs - fixed costs

EPS=[(EBIT- interest)*(1-tax rate)]/ shares outstanding

TYPES OF FINANCIAL RISK

 Difference Between business risk and financial risk

BASIS FOR BUSINESS RISK FINANCIAL RISK

COMPARISON
Meaning The risk of insufficient Financial risk is a risk
profit, or meet out the which is arise due to the use
expenses is known as of debt financing in the
business risk. capital structure.

Evaluation Variability is EBIT. Leverage multiplier and debt

to asset ratio.

Connected with Economic environment. Use of debt capital.

Minimization This risk cannot be If the firm does not use debt
minimized. funds, there will be no risk.

Types Compliance risk, Credit risk, market risk,

operational risk, liquidity risk , exchange rate
reputational risk, financing risk, etc.
risk, strategic risk etc.

Disclosed by Difference in net operating Difference in the return of

income and net cash flows. equity shareholders.

OPERATIONAL RISK

It is the risk of a change in value caused by the fact that actual losses, incurred for inadequate
or failed internal processes, people and systems, or from external events (including legal
risk), differ from the expected losses". This is a variation from that adopted in the regulations
for banks. In October 2014, the Basel Committee on Banking Supervision proposed a
revision to its operational risk capital framework that sets out a new standardized approach to
replace the basic indicator approach and the standardized approach for calculating operational
risk capital.
It can also include other classes of risk, such as fraud, security, privacy protection, legal risks,
physical (e.g. infrastructure shutdown) or environmental risks.
Operational risk is a broad discipline, close to good management and quality management.

Contrary to other risks (e.g. credit risk, market risk, insurance risk) operational risks are
usually not willingly incurred nor are they revenue driven. Moreover, they are not
diversifiable and cannot be laid off, meaning that, as long as people, systems and processes
remain imperfect, operational risk cannot be fully eliminated.
Operational risk is, nonetheless, manageable as to keep losses within some level of risk
tolerance (i.e. the amount of risk one is prepared to accept in pursuit of his objectives),
determined by balancing the costs of improvement against the expected benefits.
Wider trends such as globalization, the expansion of the internet and the rise of social media,
as well as the increasing demands for greater corporate accountability worldwide, reinforce
the need for proper operational risk management.
 TYPES OF OPERATIONAL RISK

(1.) FRAUD RISK

A business can lose a significant amount of assets due to fraud. At an extreme level, the
effects of fraud can even shut down a company. Consequently, a business owner should make
ongoing efforts to create an environment in which fraud is less likely to arise.

There are a number of factors that make it more likely that fraud will occur or is occurring in
a business. These fraud risk factors include:

Nature of Items

1. size and value

2.ease of resale

3. cash

Nature of Control Environment

1. separation of duties

2. safeguards

3. documentation

4. time off

5.related parties transaction

6.dominance

7. turnover

8. complexity

(2.) LEGAL RISK

Legal risk is the risk of loss to an institution which is primarily caused by:
(a) a defective transaction.
(b) a claim (including a defense to a claim or a counterclaim example, as a result of the
termination of a contract) .
(c) failing to take appropriate measures to protect assets (for example, intellectual property)
owned by the institution.
(d) change in law.

(3.) MODEL RISK

Model risk is the risk of loss resulting from using models to make decisions, initially and
frequently in the context of valuing financial securities. However, model risk is more and
more prevalent in activities other than financial securities valuation, such as assigning
consumer credit scores, real-time probability prediction of fraudulent credit card transactions,
and computing the probability of air flight passenger being a terrorist. Rebonato in 2002
considers alternative definitions including:

1. After observing a set of prices for the underlying and hedging instruments, different
but identically calibrated models might produce different prices for the same exotic
product.
2. Losses will be incurred because of an ‗incorrect‘ hedging strategy suggested by a
mode.

(4.) PEOPLE RISK

People risk is the uncontrollable side of what people do. We believe that managing the human
side of the equation is an imperative — both for effective leadership and risk management.

It is not the processes or procedures that deliver the customer service, or run the hospitals or
make the financial trades or decisions, it is the people we task with following them that do
that.
And unless you can be sure that the people you task with following the processes and
procedures you put in place, truly understand them and have the confidence and knowledge
to know how and when to apply them, they will fail.
 CASE STUDY (1.)

Sony Pictures Entertainment (SPE ) is the American entertainment subsidiary of Sony

Entertainment Inc., a subsidiary of Japanese multinational technology and media
conglomerate Sony.

Based in Culver City, California, it encompasses Sony's motion picture, television production
and distribution units. Its group sales in March 31, 2016 has been reported to be of $8.3
billion.

There are some successful franchises such as Spider-Man, Men in Black, Underworld, and
Resident Evil.
Everything was going well before the November 24 hack of Sony system which shocked the
entire industry , a group of hackers named guardians of peace had leaked the emails,
important documents , movies like Anne , fury and the interview which were yet to be
released.

The leaked e –mails consisted of corporate emails too which were surprisingly too informal
for a corporate structure which included e-mails bashing Hollywood biggies like Angelina
Jolie and even the criticing of president obama

PROBLEM
The emails, important secret documents of SPE were hacked which made surprising
relevations Which were not very appreciated by the industry plus leak of movies which were
yet to be released made the country incur huge amount of losses .The stock prices of Sony
entertainment fell sharply due to the leaks resulting in less stakeholder‘s trust.
CAUSES
The main cause shared was that the movie ‗THE INTERVIEW ‗ was based on assassination
of north Korean dictator hence there were a lot of speculation of hackers being north Korean
as they were furious about usage of north Korean setting of the movie.

EFFECTS

Bad industry impressions

Lack of support by president Obama
Decline in share prices
Revelations about future projects
Leaked movies causing heavy losses
Media scrutiny
Decline in goodwill public image
Lack of trust by shareholders
$80 million loss recorded

CONTROLLING MEASURES BY MANAGEMENT

February 24, 2015, Tom Rothman was named chairman of SPE's motion picture group to
replace Amy Pascal
Approaching commcore company for crisis management and criris communication
Sent personal apology letters to the victims
Changed the corporate system structure
 released the movies in different digital platforms to recover the losses
On December 17, 2014, Sony cancelled the previously planned December 25 release of The
Interview in response to hacker threats.
Consider using private web-mail addresses instead of addresses on server-based corporate
networks to send and receive ultra-sensitive e-mails.
If the content is that sensitive, make a phone call or walk down the hall and talk about it face-
to-face instead.
Don't make email off-color jokes or controversial comments that can come back to haunt you
or your organization.

CURRENT SITUATION

Current situation of sony pictures is strong and they have already recovered their lossed and
have couple of projects in line like spiderman series and may more which show that they
could control the hack crisis and overcome it by good management decisions . could control
the hack crisis and overcome it by good management decisions .

CASE STUDY (2)

TOYOTA RECALL CRISES

Toyota, a world class automobile company which built its brand name around quality, design
and safety standards was under a huge crisis by the end of 2009. Once the undisputed leader
in its sector it had to recall over 8 million vehicles worldwide to address the issue of
"unintended acceleration". It soon saw its sale sliding by 16% and loses were estimated to be
around 5 billion dollars.

EARLY RESPONSE
The early response by Toyota was weak , the top management was afraid to come out and
accept the challenge but never the less they immediately sent out a PR team to communicate
to the consumers and ensure that no bad image is being made in minds of public. The image
built on safety and security was now being challenged as the media all across the world did
bad TRP for Toyota. The CEO Akio Toyoda went underground and rather taking
responsibility transferred it to the American CEO. This is a good example of bad leadership
shown by him.

TOO BIG TO FALL

Public believed in Toyota's long old reputation . The company after realizing its mistakes
took certain important steps to regain its reputation and market :

1. They offered extended warranties.

2. Poured money in marketing

3. Leveraged into its long term clean track record.

4. Reassured customers about safety measures.

5. Companies executives became more visible and interacted with media and customers
which earlier seemed to be scary for them.

Toyota also turned to Berenson strategy group for further help in PR. This further helped
them in many ways as they could focus on Product and safety rather than on non core
activities , the research and survey done by the consulting group helped in understanding the
market sentiments so that correct actions could be taken in right time and direction.

TURNAROUND
Toyota again gained foothold of the market by its efforts on quality and high brand value.
Though there were many takeaways from this crisis as it was not handled properly . The top
management somewhat failed to take immediate actions which led to further deterioration of
the situation. Here are some of the steps a leader and his company should take in times of
crisis:

1. Face reality, starting with yourself.

2. Don't be Atlas; get the world off your shoulders , delegate the work to the third party as
one cannot handle everything.

3. Dig deep for the root cause.

4. Get ready for the long haul- Short term measures are not fruitful always , long term
changes and adaption are needed to tackle the situation.

5. Never waste a good crisis- Change is necessary and crisis somewhat provides a
opportunity to change things.

At the times of crisis leaders should give their team members new direction and take personal
responsibility to handle the situation. A Leader should never forget the ethics and values of
the company as they only take it to new heights. He should subject himself to questioning
from all directions so as to develop more clear understanding of situation and discuss how the
problem can be solved. He can also get outside counsel as they provide better options to
choose from. Overall a leader at the time of crisis should lead from front and take the
organization away from the storm.
MARKET RISK
Market risk is the probability of experiencing a loss due to factors affecting the overall
performance of the financial markets in which the investor is involved. Market risk is also
known as 'systematic risk'. This risk cannot be eliminated through diversification. Recessions,
political turmoil, changes in interest rates, natural disasters and terrorist attacks can be some
of the sources of market risk.

Market Risk Volatility

Market risk exists because of price changes. The standard deviation of changes in prices of
stocks, currencies or commodities is referred to as price volatility. Volatility is rated in
annualized terms. It is often used to quantify the risk of the instrument over that time period.
It may either be an absolute number ($5) or a fraction of the initial value (5%).

Market Risk- Types or Variations

The two major categories of investment risk are market risk and specific risk. Specific risk,
also called "unsystematic risk," is tied directly to the performance of a particular security and
can be protected against through investment diversification. One example of unsystematic
risk is a company declaring bankruptcy, making its stock worthless to investors.

The different types of market risks include:-

Types of
Market Risk

Interest Currency Commodity

Equity Risk
Rate Risk Risk Risk

Equity risk:-

Equity risk is the risk involved in changing stock prices. Equity risk, at its most basic and
fundamental level, is the financial risk involved in holding equity in a particular investment.

One way to limit this is diversification of stocks. The measure of risk used in the equity
markets is typically the standard deviation of a security's price over a number of periods. The
standard deviation will delineate the normal fluctuations one can expect in that particular
security above and below the mean, or average.

Interest Rate Risk:-

Interest rate risk is the risk that interest rates may change. Interest rate risk covers the
volatility that happens with changing interest rates due to fundamental factors, and other
central bank announcements related to changes in monetary policies. If the central bank
changes interest rates then it can also affect the stock market. This risk arises for bond owners
from fluctuating interest rates. How much interest rate risk a bond has depends on how
sensitive its price is to interest rate changes in the market. The sensitivity depends on two
things, the bond's time to maturity, and the coupon rate of the bond.

Currency Risk:-

An investor is exposed to currency risk if he is holding particular currencies facing volatile

movements, because of fundamental factors such as interest rate changes or unemployment
claims. Currency risk, commonly referred to as exchange-rate risk, arises from the change in
price of one currency in relation to another. Investors or companies that have assets or
business operations across national borders are exposed to currency risk that may create
unpredictable profits and losses. Currency risk can be reduced by hedging, which offsets
currency fluctuations. Investing globally is a prudent strategy for mitigating currency risk.
Having a portfolio that is diversified by geographic regions effectively provides a hedge for
fluctuating currencies.

Commodity Risk:-

Commodity risk refers to the uncertainties of future market values and of the size of the
future income, caused by the fluctuation in the prices of commodities. Commodity risk
covers the changing prices of commodities such as crude oil and corn. These commodities
may be grains, metals, gas, electricity etc. When commodities are part of a company‘s core
business or processes there can be exposures arising from either or both of: 1. Price
fluctuations (commodity price risk); and 2. Lack of availability of the commodity. Both of
these risks are aspects of Commodity risk. When a company has exposure to commodities, it
must decide how to manage the financial risk associated with price movement.

Market Risk Example

Market risk involves the risk of changing conditions in the specific marketplace in which a
company competes for business. One example of market risk could be the increasing
tendency of consumers to shop online. This aspect of market risk has presented significant
challenges to traditional retail businesses. Companies that have been able to make the
necessary adaptations to serve an online shopping public have thrived and seen substantial
revenue growth, while companies that have been slow to adapt or made bad choices in their
reaction to the changing marketplace have fallen by the wayside.
This example also relates to another element of market risk – the risk of being thrown off by
the competitors. In an increasingly competitive global marketplace, often with
narrowing profit margins, the most financially successful companies are most successful in
offering a unique value proposition that makes them stand out from the crowd and gives them
a solid marketplace identity.

Value at Risk Method

Value at risk (VaR) is a statistical technique used to measure and quantify the level
of financial risk within a firm or investment portfolio over a specific time frame. This metric
is most commonly used by investment and commercial banks to determine the extent and
occurrence ratio of potential losses in their institutional portfolios.

To measure market risk, investors and analysts use the value at risk method. The value at risk
method is a well known and established risk management method, but it comes with some
assumptions that limit its correctness. For example, it assumes that the makeup and content of
the portfolio being measured is unchanged over a provided period. Though this may be
acceptable for short-term horizons, it may provide less accurate measurements for long-term
horizons of investments, because it is more exposed to changes in interest rates and monetary
policies.

CREDIT RISK
Credit risk refers to the risk that a borrower may not repay a loan and that the lender may lose
the principal of the loan or the interest associated with it. Credit risk arises because borrowers
expect to use future cash flows to pay current debts; it's almost never possible to ensure that
borrowers will definitely have the funds to repay their debts. Interest payments from the
borrower or issuer of a debt obligation are a lender's or investor's reward for assuming credit
risk.

Assessment Of Credit Risk

Before offering money or credit to a borrower a financial institution will measure the
borrowers likelihood of repaying the loan on time, according to the original terms. It is their
Credit Risk, a common way to identify the credit risk of the borrower is evaluating their
credit score. If a borrower has a high credit score they represent a low credit risk to a lender
and they can be offered lower interest rates. If the borrower has a low credit score lenders
will less likely offer a loan, if they do they would charge higher interest rates. For example, if
a mortgage applicant has a stellar credit rating and a steady income flow from a stable job, he
is likely to be perceived as a low credit risk and will receive a low interest rate on his
mortgage. In contrast, if an applicant has a lackluster credit history, he may have to work
with a subprime lender, a mortgage lender that offers loans with relatively high interest rates
to high-risk borrowers.

Credit Risk is also an important consideration for bonds. When companies raise money by
selling bonds, they are actually asking bond buyers for a loan. One way the investors can
evaluate financial stability of these companies is through bond ratings. Bonds from
companies with strong financials are A, AA, AAA rated bonds. On the other hand bonds
from companies with weaker financials are B or C rated bonds. These ratings measure the
companies credit risk. Companies with higher ratings can pay lower rates because they have
lower credit risk. Companies with lower rated bonds may pay higher interest rates to
compensate high credit risk. Agencies such as Moody's and Fitch evaluate the credit risks of
thousands of corporate bond issuers and municipalities on an ongoing basis.

Bond Rating
Scale

AAA AA A BBB BB B CCC CC C

Credit risk also describes the risk that a bond issuer may fail to make payment when
requested or that an insurance company won't be able to make a claim. To reduce the lender's
credit risk, the lender may perform a credit check on the prospective borrower, may require
the borrower to take out appropriate insurance, such as mortgage insurance, or
seek security over some assets of the borrower or a guarantee from a third party. The lender
can also take out insurance against the risk or on-sell the debt to another company. In general,
the higher the risk, the higher will be the interest rate that the debtor will be asked to pay on
the debt. Credit risk mainly arises when borrowers unable to pay due willingly or unwillingly.

Types of Credit Risk

Default Risk -

Default risk is the risk that the issuer will not be able to pay its obligations of interest and
principle. To help measure this risk, an investor can look at default rates. A default rate is the
percentage of a population of bonds that are expected to default. Another ratio that an
investor can look at is the recovery rate. This rate indicates how much and investor can
expect to get back if a default occurs.

Credit Spread Risk -

This second type of credit risk deals with how the spread of an issue over the treasury curve
will react. For example, a company's five-year bond may trade at 50 basis points above the
current five-year treasury. If the five-year bond is trading at 3.5%, then the company's bonds
are trading at a yield of 4%. If this spread of 50 bps widens out compared to other bond
issues, it would mean that the company's bonds are not performing as well as the other bonds
in the marketplace. Spreads tend to widen in poor performing economies.

Downgrade Risk -

The third type of credit risk deals with the rating agencies. These agencies, such as Moody's,
S&P and Fitch, give an issuer a rating or grade that indicates the possibility of default. On the
more secure side, the ratings range from AAA, which is the best rating to AA, A, BBB. These
are the ratings for investment-grade bonds. Once bonds dip into the BB, B, CCC ranges they
become junk bonds or high yield securities. If one of these rating agencies downgrades a
company's rating, it may be harder for the corporation to pay. This will typically cause its
market value to decrease. That is what this risk is all about.

SUBPRIME MORTGAGE CRISIS

The United States (U.S.) subprime mortgage crisis was a nationwide banking emergency that
contributed to the U.S. recession of December 2007 – June 2009. It was triggered by a large
decline in home prices after the collapse of a housing bubble, leading to mortgage
delinquencies and foreclosures and the devaluation of housing-related securities. Declines in
residential investment preceded the recession and were followed by reductions in household
spending and then business investment. Spending reductions were more significant in areas
with a combination of high household debt and larger housing price declines. It was caused
due to the exposure to the credit risk in the US economy.

The immediate cause or trigger of the crisis was the bursting of the United States housing
bubble which peaked in approximately 2005–2006. An increase in loan incentives such as
easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to
assume risky mortgages in the anticipation that they would be able to quickly refinance at
easier terms. However, once interest rates began to rise and housing prices started to drop
moderately in 2006–2007 in many parts of the U.S., borrowers were unable to
refinance. Defaults and foreclosure activity increased dramatically as easy initial terms
expired, home prices fell, and adjustable-rate mortgage (ARM) interest rates reset higher.

Credit rating agencies and the subprime crisis

Credit rating agencies (CRAs) — firms which rate debt instruments/securities according to
the debtor's ability to pay lenders back — played a significant role at various stages in the
American subprime mortgage crisis of 2007-2008 that led to the Great Recession of 2008-
2009. A large section of the debt securities market were restricted in their bylaws to holding
only the safest securities — i.e. securities the rating agencies designated "triple-A".

The pools of debt the agencies gave their highest ratings to included over three trillion
dollars of loans to homebuyers with bad credit and undocumented incomes through 2007.
Hundreds of billions of dollars' worth of these triple-A securities were downgraded to "junk"
status by 2010, and the writedowns and losses came to over half a trillion dollars. This led "to
the collapse or disappearance" in 2008-9 of three major investment banks (Bear
Stearns, Lehman Brothers, and Merrill Lynch), and the federal governments buying of $700
billion of bad debt from distressed financial institutions.

Biggest Culprit: The Lenders

Most of the blame should be pointed at the mortgage originators (lenders) for creating these
problems. It was the lenders who ultimately lent funds to people with poor credit and a high
risk of default.

When the central banks flooded the markets with capital liquidity, it not only lowered interest
rates, it also broadly depressed risk premiums as investors sought riskier opportunities to
bolster their investment returns. At the same time, lenders found themselves with ample
capital to lend and, like investors, an increased willingness to undertake additional risk to
increase their investment returns.

In defense of the lenders, there was an increased demand for mortgages, and housing prices
were increasing because interest rates had dropped substantially. At the time, lenders
probably saw subprime mortgages as less of a risk than they really were: rates were low, the
economy was healthy and people were making their payments.

Partner In Crime: Homebuyers

While we're on the topic of lenders, we should also mention the home buyers. Many were
playing an extremely risky game by buying houses they could barely afford. They were able
to make these purchases with non-traditional mortgages that offered low introductory rates
and minimal initial costs such as "no down payment". Their hope lay in price appreciation,
which would have allowed them to refinance at lower rates and take the equity out of the
home for use in other spending. However, instead of continued appreciation, the housing
bubble burst, and prices dropped rapidly.

As a result, when their mortgages reset, many homeowners were unable to refinance their
mortgages to lower rates, as there was no equity being created as housing prices fell. They
were, therefore, forced to reset their mortgage at higher rates, which many could not afford.
Many homeowners were simply forced to default on their mortgages. Foreclosures continued
to increase through 2006 and 2007.

Exacerbating the situation, lenders and investors of securities backed by these defaulting
mortgages suffered. Lenders lost money on defaulted mortgages as they were increasingly
left with property that was worth less than the amount originally loaned. In many cases, the
losses were large enough to result in bankruptcy.

The crisis had severe, long-lasting consequences for the U.S. and European economies. The
U.S. entered a deep recession, with nearly 9 million jobs lost during 2008 and 2009, roughly
6% of the workforce. One estimate of lost output from the crisis comes to "at least 40% of
2007 gross domestic product". U.S. housing prices fell nearly 30% on average and the U.S.
stock market fell approximately 50% by early 2009. As of early 2013, the U.S. stock market
had recovered to its pre-crisis peak but housing prices remained near their low point and
unemployment remained elevated. Economic growth remained below pre-crisis levels.
Europe also continued to struggle with its own economic crisis, with elevated unemployment
and severe banking impairments estimated at €940 billion between 2008 and 2012.

LIQUIDITY RISK

Liquidity risk is the risk stemming from the lack of marketability of an investment that
cannot be bought or sold quickly enough to prevent or minimize a loss. With liquidity risk,
typically reflected in unusually wide bid-ask spreads or large price movements, the rule of
thumb is that the smaller the size of the security or its issuer, the larger the liquidity risk.
Drops in the value of stocks and other securities in the aftermath of the 9/11 attacks and the
2007-2008 global credit crisis motivated many investors to sell their holdings at any price,
causing widening bid-ask spreads and large price declines, which further contributed to
market illiquidity.

Liquidity risk includes asset liquidity and operational funding liquidity risk. Asset liquidity
refers to the relative ease with which a company can convert its assets into cash should there
be a sudden, substantial need for additional cash flow. Operational funding liquidity is a
reference to daily cash flow.
General or seasonal downturns in revenue can present a substantial risk if the company
suddenly finds itself without enough cash on hand to pay the basic expenses necessary to
continue functioning as a business. This is why cash flow management is critical to business
success – and why analysts and investors look at metrics such as free cash flow when
evaluating companies as an equity investment.

Liquidity risk occurs when an individual investor, business or financial institution cannot
meet short-term debt obligations. The investor or entity may be unable to convert an asset
into cash without giving up capital and/or income due to a lack of buyers or an inefficient
market. For example, a $500,000 home may have no buyer when the real estate market is
down. When the market goes up, the home may sell above its list price. However, if the
owner needs cash quickly when the market is down, he may sell the home for less and lose
money on the transaction. Due to liquidity risk, investors should consider whether they can
cover their short-term debt obligations into cash before investing in long-term illiquid assets.

Liquidity Risk in Companies

Investors, managers and creditors utilize liquidity measurement ratios when deciding the
level of liquidity risk within an organization. They often compare short-term liabilities and
liquid assets listed on the company‘s financial statements. If a business has too much
liquidity risk, it must sell assets, bring in additional revenue or find another method of
shrinking the difference between available cash and debt obligations.

Liquidity Risk in Financial Institutions

Financial institutions are also scrutinized as to whether they can meet their debt obligations
without realizing great losses. The institutions face heavy compliance issues and stress tests
for remaining economically stable.

In April 2016, the Federal Deposit Insurance Corporation (FDIC) released a proposal creating
a net stable funding ratio that would help increase banks‘ liquidity during financially stressful
times. The ratio indicates whether banks own enough high-quality assets that can easily be
converted into cash within one year rather than within the current 30-day limit. Banks would
rely less on short-term funding, which tends to be more volatile.

During the 2008 financial crisis, many big banks failed or faced insolvency issues due to
liquidity issues. The proposed ratio is in line with the international Basel standard created in
2015 and would reduce banks‘ vulnerability in case of another financial crisis.

HOW IT WORKS (EXAMPLE):

Liquidity risk generally arises when a business or individual with immediate cash needs,
holds a valuable asset that it cannot trade or sell at market value due to a lack of buyers, or
due to an inefficient market where it is difficult to bring buyers and sellers together.

For example, consider a $1,000,000 home with no buyers. The home obviously has value, but
due to market conditions at the time, there may be no interested buyers. In better economic
times when market conditions improve and demand increases, the house may sell for well
above that price. However, due to the home owner‘s need of cash to meet near term financial
demands, the owner may be unable to wait and have no other choice but to sell the house in
an illiquid market at a significant loss. Hence, the liquidity risk of holding this asset.

WHY IT MATTERS:

Purchasers and owners of long term assets must take into account the scalability of assets
when considering their own short term cash needs. Assets that are difficult to sell in
an illiquid market carry a liquidity risk since they can not be easily converted to cash at a
time of need. Liquidity risk may lower the value of certain assets or businesses due to the
increased potential of capital loss.

Types or Variations
Liquidity risk is divided into two types: funding liquidity risk (aka cash-flow risk) and market
liquidity risk (aka asset/product risk).

 Funding (cash flow) liquidity risk is the chief concern of a corporate treasurer who
asks: can we pay our bills, can we fund our liabilities? A classic indicator of funding
liquidity risk is the current ratio (current assets/current liabilities), or for that matter,
the quick ratio. A line of credit (LOC) would be a classic mitigant.

 Market (asset) liquidity risk is asset illiquidity. This is an inability to easily exit a
position. For example, we may own real estate but, owing to bad market conditions, it
can only be sold imminently at a "fire sale" price. The asset surely has value, but as
buyers have temporarily evaporated, the value cannot be realized. Consider its virtual
opposite, a U.S. Treasury bond. True, a U.S. Treasury bond is considered almost risk-
free as few imagine the U.S. government will default. But additionally, this bond
has extremely low liquidity risk: its owner can easily exit the position at the prevailing
market price. Small positions in S&P 500 stocks are similarly liquid. They can be
quickly exited at the market price. But positions in many other asset classes,
especially in alternative assets, cannot be exited with ease.

COMPONENTS OF FINANCIAL RISK

Interest Rate
Introduction
An interest rate, or rate of interest, is the amount of interest due per period, as a proportion
of the amount lent, deposited or borrowed (called the principal sum). The total interest on an
amount lent or borrowed depends on the principal sum, the interest rate, the compounding
frequency, and the length of time over which it is lent, deposited or borrowed.
It is defined as the proportion of an amount loaned which a lender charges as interest to the
borrower, normally expressed as an annual percentage. It is the rate a bank or other lender
charges to borrow its money, or the rate a bank pays its savers for keeping money in an
account.
Annual interest rate is the rate over a period of one year. Other interest rates apply over
different periods, such as a month or a day, but they are usually annualised.

Significance
A modern economy is intrinsically linked to interest rates. Interest rates affect consumer
spending. The higher the rate, the higher their loans will cost them, and the less they will be
able to buy on credit. This is how it affects inflation, If consumer spending goes down, there
will be less demand for products and services, thus prices won't rise as rapidly. Interest rates
are used by central banks as a means to control inflation.
It also affects the housing market since it will cause people who have purchased properties on
too highly leveraged loans to be unable to pay as interest rates rise. Thus they will look to
selling their properties. This will cause more property supply on the market, and lower the
property prices. This in turn will lead to others to want to cash out on their property
investments which they have hoped to hold short- term and bought on interest-only loans. If
this happens too quickly, it could cause a steep decline of the housing market. Since most
people's wealth are tied to their properties, it will decrease people's net worth.

Monetary Policy
Interest rate targets are a vital tool of monetary policy and are taken into account when
dealing with variables like investment, inflation, and unemployment. The central banks of
countries generally tend to reduce interest rates when they wish to increase investment and
consumption in the country's economy. However, a low interest rate as a macro-economic
policy can be risky and may lead to the creation of an economic bubble, in which large
amounts of investments are poured into the real-estate market and stock market. In developed
economies, interest-rate adjustments are thus made to keep inflation within a target range for
the health of economic activities or cap the interest rate concurrently with economic
growth to safeguard economic momentum.
Reasons for Interest Rate change

 Political short-term gain: Lowering interest rates can give the economy a short-run
boost. Under normal conditions, most economists think a cut in interest rates will only
 give a short term gain in economic activity that will soon be offset by inflation. The quick
boost can influence elections. Most economists advocate independent central banks to
limit the influence of politics on interest rates.
 Deferred consumption: When money is loaned the lender delays spending the money
on consumption goods. Since according to time preference theory people prefer goods
now to goods later, in a free market there will be a positive interest rate.
 Inflationary expectations: Most economies generally exhibit inflation, meaning a given
amount of money buys fewer goods in the future than it will now. The borrower needs to
compensate the lender for this.
 Alternative investments: The lender has a choice between using his money in different
investments. If he chooses one, he forgoes the returns from all the others. Different
investments effectively compete for funds.
 Risks of investment: There is always a risk that the borrower will go bankrupt, abscond,
die, or otherwise default on the loan. This means that a lender generally charges a to
ensure that, across his investments, he is compensated for those that fail.
 Liquidity preference: People prefer to have their resources available in a form that can
immediately be exchanged, rather than a form that takes time to realize.
 Taxes: Because some of the gains from interest may be subject to taxes, the lender may
insist on a higher rate to make up for this loss.
 Banks: Banks can tend to change the interest rate to either slow down or speed up
economy growth. This involves either raising interest rates to slow the economy down, or
lowering interest rates to promote economic growth.
 Economy: Interest rates can fluctuate according to the status of the economy. It will
generally be found that if the economy is strong then the interest rates will be high, if the
economy is weak the interest rates will be low.

Interest Rate - As a Quantitative Measure of Monetary Policy

Both Bank Rate and Repo Rate are the rates at which the commercial banks can borrow
money from RBI and so RBI can correct economic situations like inflation and deflation
by using these two as measures.By varying these two RBI controls the supply of money
in an economy:

A rise in bank/repo rate discourages the commercial banks to fill their cash reserves,
hence reducing their credit creating capacity and thus supply of money is reduced in the
economy.This corrects inflation.

And to correct deflation RBI just reverses the process and reduces the bank/repo rate,
hence increasing the capacity of commercial banks to create credit and the supply of
money in the economy increases and deflation is curbed.
 Amount Of Credit

Introduction

The amount of credit represents the size of business loans offered to a company. Banks
and lenders commonly review the company & financial history to determine how much
money to loan the business owner. Small business owners receiving copious amounts of
credit may overextend their company by using too much credit. Conversely, small
businesses experiencing high growth and the inability to obtain credit may not grow their
business as quickly as possible. Business owners must carefully review the banking
environment to ensure enough credit is available prior to expanding operations.

Credit Risk
A credit risk is the risk of default on a debt that may arise from a borrower failing to make
required payments.[1] In the first resort, the risk is that of the lender and includes
lost principal and interest, disruption to cash flows, and increased collection costs. The loss
may be complete or partial. In an efficient market, higher levels of credit risk will be
associated with higher borrowing costs.[2]Because of this, measures of borrowing costs such
as yield spreads can be used to infer credit risk levels based on assessments by market
participants.[3][4]
Losses can arise in a number of circumstances, for example:

 A consumer may fail to make a payment due on a mortgage loan, credit card, line of
credit, or other loan.
 A company is unable to repay asset-secured fixed or floating charge debt.
 A business or consumer does not pay a trade invoice when due.
 A business does not pay an employee's earned wages when due.
 A business or government bond issuer does not make a payment on a coupon or principal
payment when due.
 An insolvent insurance company does not pay a policy obligation.
 An insolvent bank won't return funds to a depositor.
 A government grants bankruptcy protection to an insolvent consumer or business.

To reduce the lender's credit risk, the lender may perform a credit check on the prospective
borrower, may require the borrower to take out appropriate insurance, such as mortgage
insurance, or seek security over some assets of the borrower or a guarantee from a third party.
The lender can also take out insurance against the risk or on-sell the debt to another company.
In general, the higher the risk, the higher will be the interest rate that the debtor will be asked
to pay on the debt. Credit risk mainly arises when borrowers unable to pay due willingly or
unwilingly.

Cash Flows

What is 'Cash Flow'

Cash flow is the net amount of cash and cash-equivalents moving into and out of a business.
Positive cash flow indicates that a company's liquid assets are increasing, enabling it to
settle debts, reinvest in its business, return money to shareholders, pay expenses and provide
a buffer against future financial challenges. Negative cash flow indicates that a company's
liquid assets are decreasing. Net cash flow is distinguished from net income, which
includes accounts receivable and other items for which payment has not actually been
received. Cash flow is used to assess the quality of a company's income, that is, how liquid it
is, which can indicate whether the company is positioned to remain solvent

Cash flow analysis

Cash flows are often transformed into measures that give information e.g. on a company's
value and situation:

 to determine a project's rate of return or value. The time of cash flows into and out of
projects are used as inputs in financial models such as internal rate of return and net
present value.
 to determine problems with a business's liquidity. Being profitable does not necessarily
mean being liquid. A company can fail because of a shortage of cash even while
profitable.
 as an alternative measure of a business's profits when it is believed that accrual
accounting concepts do not represent economic realities. For instance, a company may be
notionally profitable but generating little operational cash (as may be the case for a
company that barters its products rather than selling for cash). In such a case, the
company may be deriving additional operating cash by issuing shares or raising
additional debt finance.
 cash flow can be used to evaluate the 'quality' of income generated by accrual accounting.
When net income is composed of large non-cash items it is considered low quality.
 to evaluate the risks within a financial product, e.g., matching cash requirements,
evaluating default risk, re-investment requirements, etc.
Cash flow notion is based loosely on cash flow statement accounting standards. the term is
flexible and can refer to time intervals spanning over past-future. It can refer to the total of all
flows involved or a subset of those flows. Subset terms include net cash flow, operating cash
flow and free cash flow.
Symptoms of cash flow problems
There are many reasons a business can suffer cash flow problems – some are down to
mismanagement and poor decisions, and in some cases factors outside of your control. Any
of the following symptoms can indicate that a business is experiencing cash flow problems:
Factor Why It Causes a Cash Flow Problem
The profit a business makes from trading is the most important
source of cash.
Low profits or (worse)
There is a direct link between low profits or losses and cash flow
losses
problems

Remember - most loss-making businesses eventually run out of cash

This happens when a business spends too much on fixed assets

Over-investment in Problem is made worse if short-term finance is used (e.g. bank

capacity overdraft)

Fixed assets are hard to turn back into cash in the short-run
Holding too much stock ties up cash

+ Increased risk that stocks become obsolete

Too much stock On the other hand...

There needs to be enough stock to meet demand

Bulk buying may mean lower purchase prices

Customers who buy on credit are called "trade debtors"

Offer credit = good way of building sales

Allowing customers On the other hand...

too much credit
Late payment is a common problem – and slow-paying customers
often put a strain on cash flow

Worse still, the debt may go "bad" – i.e. it is not paid at all
Occurs where a business expands too quickly, putting pressure on
short-term finance
Overtrading
Classic example – retail chains
  Keen to open new outlets
 Have to pay rent in advance, pay for shop-fitting, pay for
stocks
 Large outlay before sales begin in new store

Businesses that rely on long-term contracts are also at high risk of

overtrading
These are items or events that are not included in the cash flow
forecast – they are unforeseen. Examples include:

 Internal change (e.g. machinery breakdown, loss of key staff)

Unexpected changes
 External change (e.g. economic downturn, accidents, change
in legislation that requires a business to invest in new
facilities)

Where there are predictable changes in demand & cash flow

Production or purchasing usually in advance of seasonal peak in

Seasonal demand demand = cash outflows before inflows

This can be managed – cash flow forecast should allow for seasonal
changes.

Cash flow problems can be avoided through good credit management.

Steps To Curb Cash Flow Problems

Cash flow is a problem that plagues every small office from time to time. On paper you look
like you're doing OKl. Your sales are higher than last year, and your expenses haven't
increased much. Things look like you should be making a profit. But your creditors are
breathing down your neck and you're always playing catch up. What can you do? Here are
some tips to get you moving in the right direction:
  Follow The Goods. The faster a seller moves goods to a buyer, the faster the buyer
will pay for those goods, and that impacts cash flow. Therefore, businesses must ask
themselves how they can better improve the speed at which their goods exchange
hands. And this goes well beyond the actual transportation of the goods. Rather, it
requires an examination of the entire process--from sales all the way through
invoicing.
It's vitally important for a company's decision-makers--and for small and growing
firms, that usually means the owners--to be plugged into the sales process, examining
the data from the sales staff on a regular basis. How much was sold yesterday, how
much will be sold today, and what about tomorrow? The more accurate this
information, the tighter the inventory. And the tighter the inventory, the better the
cash flow.
 Use The Information.Your next vital key to good cash flow is information, and for
that, you must have visibility of your product shipments. Once your goods leave the
dock en route to your buyers, how much visibility do you have regarding the progress
each shipment is making? Do you have a tracking number for every package? Did you
share the tracking number with the customer? Are you aware that a package was
delayed due to weather? While all these questions primarily reside in the operations
side of the house, they can also have a major impact on customer service, which in
turn can impact cash flow. After all, a customer who feels well treated is more
inclined to pay on time--and buy from you again.
 Doing customer credit checks. Perform credit checks on all new and non-cash customers.
This process can immediately reduce bad debt, since you'll stop offering credit to
customers who haven't proved they deserve it.

 Offering term discounts. To encourage customers to pay on time, consider offering term
discounts. For example, if your invoice terms are "net 30/2/10," customer payment is
expected in 30 days; however, you're offering the customer a 2 percent discount if
payment is made in 10 days.

 Asking customers to pay by cash or credit card. Rather than sell on term payments, sell
on cash or credit card payments. Once you've got the cash in hand, deposit the funds
immediately.

 Charging late fees. Indicate on your invoice when payment is due, and specify the
penalty interest for late payment.

Inflation

Introduction

In economics, inflation is a sustained increase in the general price level of goods and services
in an economy over a period of time. When the price level rises, each unit of currency buys
fewer goods and services. Consequently, inflation reflects a reduction in the purchasing
power per unit of money – a loss of real value in the medium of exchange and unit of account
within the economy. A chief measure of price inflation is the inflation rate, the annualized
percentage change in a general price index, usually the consumer price index, over time. The
opposite of inflation is deflation.

Positive Effects Of Inflation

 Deflation (a fall in prices – negative inflation) is very harmful. During a prolonged

period of deflation and very low inflation, the Japanese economy has suffered lower
growth because of deflationary pressures. When prices are falling people are reluctant
to spend money because they are concerned that prices will be cheaper in the future,
therefore, they keep delaying purchases. Also, deflation increases the real value of
debt and reduces the disposable income of individuals who are struggling to pay off
their debt. When people take on a debt like a mortgage, they generally expect an
inflation rate of 2% to help erode the value of debt over time. If this inflation rate of
2% fails to materialise, their debt burden will be greater than expected.

 Moderate inflation enables adjustment of wages. It is argued a moderate rate of

inflation makes it easier to adjust relative wages. For example, it may be difficult to
cut nominal wages (workers resent and resist nominal wage cut). But, if average
wages are rising due to moderate inflation, it is easier to increase the wages of
productive workers; unproductive workers can have their wages frozen – which is
effectively a real wage cut. If we had zero inflation, we could end up with more real
wage unemployment, with firms unable to cut wages to attract workers.

 Inflation enables adjustment of relative prices. Similar to the last point, moderate
inflation makes it easier to adjust relative prices. This is particularly important for a
single currency like the Eurozone. Southern European countries like Italy, Spain and
Greece became uncompetitive, leading to large current account deficit. Because Spain
and Greece cannot devalue in the Single Currency, they are having to cut relative
prices to regain competitiveness. With very low inflation in Europe, this means they
have to cut prices and cut wages which causes lower growth (due to effects of
deflation). If the Eurozone had moderate inflation, it would be easier for southern
Europe to adjust and regain competitive without resorting to deflation.

 Inflation can boost growth. At times of very low inflation the economy may be
stuck in a recession. Arguably targeting a higher rate of inflation can enable a boost in
economic growth. This view is controversial. Not all economists would support
targeting a higher inflation rate. However, some would target higher inflation, if the
economy was stuck in a prolonged recession.

Negative Effects Of Inflation

  High inflation rates tend to cause uncertainty and confusion leading to less
investment. It is argued that countries with persistently higher inflation, tend to have
lower rates of investment and economic growth.
 Higher inflation leads to lower international competitiveness.
 Menu costs. – Costs of changing price lists.
 Inflation and stagnant wage growth leads to declining incomes.
 Inflation can reduce the real value of savings, which might particularly affect old
people who live on savings. However, it does depend on whether interest rates are
higher than the inflation rate.

Measures To Control High Inflation

Credit Control:

One of the important monetary measures is monetary policy. The central bank of the country
adopts a number of methods to control the quantity and quality of credit. For this purpose, it
raises the bank rates, sells securities in the open market, raises the reserve ratio, and adopts a
number of selective credit control measures, such as raising margin requirements and
regulating consumer credit. Monetary policy may not be effective in controlling inflation, if
inflation is due to cost-push factors. Monetary policy can only be helpful in controlling
inflation due to demand-pull factors.

Demonetisation of Currency:
However, one of the monetary measures is to demonetise currency of higher denominations.
Such a measures is usually adopted when there is abundance of black money in the country.

Issue of New Currency:

The most extreme monetary measure is the issue of new currency in place of the old
currency. Under this system, one new note is exchanged for a number of notes of the old
currency. The value of bank deposits is also fixed accordingly. Such a measure is adopted
when there is an excessive issue of notes and there is hyperinflation in the country. It is a
very effective measure. But is inequitable for its hurts the small depositors the most.

What is 'Systematic Risk'

The risk inherent to the entire market or an entire market segment. Systematic risk, also
known as ―undiversifiable risk,‖ ―volatility‖ or ―market risk,‖ affects the overall market, not
just a particular stock or industry. This type of risk is both unpredictable and impossible to
completely avoid. It cannot be mitigated through diversification, only through hedging or by
using the right asset allocation strategy.

What is 'Unsystematic Risk'

Company- or industry-specific hazard that is inherent in each investment. Unsystematic risk,
also known as ―nonsystematic risk,‖ "specific risk," "diversifiable risk" or "residual risk," can
be reduced through diversification. By owning stocks in different companies and in different
industries, as well as by owning other types of securities such as Treasuries and municipal
securities, investors will be less affected by an event or decision that has a strong impact on
one company, industry or investment type. Examples of unsystematic risk include a new
competitor, a regulatory change

FINANCIAL RISK MANAGEMENT

Financial risk management means reducing your risk or reducing your possible loss with a
chance of gaining profits also.

Various ways of risk management are:

1) DIVERSIFICATION

2) HEDGING

3) ARBITRAGE
DIVERSIFICATION

In finance, diversification is the process of allocating capital in a way that reduces the
exposure to any one particular asset or risk. A common path towards diversification is to
reduce risk or volatility by investing in a variety of assets.

Options available to one for diversification are

 stocks
 mutual funds
 gold
 futures
 forwards
 options
 commodity
 ppf
 debentures
 real estate
 insurance
 bonds
 Money market instruments like treasury bills , COD etc

diversification is basically a mixture of options available to you which includes some

which are highly risky which are very less risky , some which are fixed return giving
some which are not , some which have high returns and some which have less returns
etc.

 stocks are the underlyers and are spot prices and are highly volatile
 mutual funds are controlled and guided by big names and experts still are subject to
market risks
 gold is considered to be the safest asset as it will rise in the long term
 futures are a good alternative it gives you a lot of scope to either earn a lot or earn
more with less money and as it requires 5 % margin it allows you to hold a big
position.
 Forwards are for basically getting secured
 Options are a kind of agreements , in some options your gain chance is unlimited and
loss chance is limited and in some vice versa
 Commodity is good alternative as it diversifies by field
 Ppf are also considered to be one of the best investments and safest too.
  Real estate if at boom can be a good diversifying medium but it is along term
alternative
 Insurance can also serve as diversification medium, for eg like life insurance
 Govt bonds are of various types but return is low and are generally safe
 Money market instruments like treasury bills , COD are short term , low interest rate
and safe instruments generally .

So basically you have to mix the selected alternatives and secure yourself with a aim
of minimising the loss and risk and maximising the profit /gain.

Now the approach of a person can be of 2 types

 Aggressive
 defensive

aggressive approach

Here you can see that the person is taking high risk by investing more into equities and less in
fixed income securities, so his risk bearing capacity is also high and his maximum gain is
high at the same time maximum loss is also high

Defensive approach
In this case the person has low risk bearing capacity and his max gain is not very high but the
favourable thing in this type of approach is that chance of loss is very less plus if by chance
if loss occurs most of it can be covered by fixed income sec interest.

STRATEGIES
There are around 36 mixing the option types that are call and put options .

MATHEMATICAL EXAMPLE OF DIVERSIFICATION

Buy rs 50000 shares ( bluechip company , volatility around + - 10 %

Buy rs 50000 debentures @ 10 %

CASE 1) no loss no profit : 5000 ( debenture interest) - 5000( share loss)

=0

CASE 2) profit : 5000 (deb int) + 5000( share inc)

= 10,000

In the above case the maximum estimated range is set

That is max loss is 0 and max profit is 10,000

DIVERSIFICATION BASICS
 Spread portfolio among multiple investment vehicles such as
cash, stocks, bonds, mutual funds, GOLD and some real estate.
 Diversify in stocks also like some bluechip company shares , some mid
capitalisation companies ( higher ROI) , low cap companies also . for eg nifty 50 and
junior nifty
 Vary your securities by industry. This will minimize the impact of industry-specific
risks.Industry wise diversification advisable , eg when congress was in power in 2013
the infrastructure sector was growing share prices were rising and now when bjp govt
is in power the situation is completely different.
 Investing credit rating wise like AAA+ or BBB- , india is currently BBB-

Basis of selection
1) technical analysis(short term investing)
2)fundamental analysis ( long term investing)
Technical analysis- using various break out patterns, golden cross, sma, ema, etc

Fundamental analysis- takes into account P/E if it is low it is good, then EPS , financial
statements,

Takes into account various ratios.

CAPITALIZATION AND LEVERAGE RATIO ANALYSIS

Indicators that measure the proportion of debt in a company‘s capital

structure. Capitalization ratios include the debt-equity ratio, long-term debt to capitalization
ratio and total debt to capitalization ratio. The formula for each of these ratios is shown
below.

 Debt-Equity ratio = Total Debt / Shareholders' Equity

 Long-term Debt to Capitalization = Long-Term Debt / (Long-Term Debt +
Shareholders‘ Equity)
 Total Debt to Capitalization = Total Debt / (Total Debt + Shareholders' Equity)

While a high capitalization ratio can increase the return on equity because of the tax shield of
debt, a higher proportion of debt increases the risk of bankruptcy for a company.

Also known as leverage ratios.

The amount of debt in the overall capital is also called financial leverage .Taking correct
decision in terms of proportion of debt is important as it can increase or decrease the
financial fortune of the company

Example:

Total
Eps = EAT / NO. OF SHARES* SHARE PX

This shows that proper financial analysis is done for eps , there is a limit upto which if you
increase the debt proportion the EPS rises but at the same time risk also rises as interest
payment becomes binding .

In this example you can see that that increases the proportion of debt is lowering the eps
which is unfavourable
So this is also a type of financial risk and leverage ratio is a type of analysis that the investor
and the company should do .This analysis should be done before taking the decision this can
prevent the company from taking the wrong decision.

BENEFTIS OF DIVERSIFICATION
 Risk reduction
 Capital preservation and increase
 Hedging

1. Risk Reduction
You can't eliminate risk completely, but you can manage your level of risk. Every investment
has some amount of risk. Young investors should embrace risk because the long-term
rewards can make it worthwhile. Older investors may view risk as an enemy, because too
much risk can annihilate retirement plans. In fact, many senior citizens experienced great
losses to their retirement portfolios during the economic downturn.
Some investors failed to diversify amongst asset classes, and were far too exposed to stock
market risk. Diversifying into safer fixed income assets may have helped to reduce their risk
and maximize their returns. Using capital preservation and diversification as investment
strategies can also reduce investment portfolio risk.

2. Capital Preservation
Some investors strive for capital appreciation, while some investors use capital preservation
as an investment strategy. Capital preservation allows you to protect the capital you have,
rather than focusing on the rate of return for your investments. Diversification makes it much
easier for an investor to protect their capital, allocating money to different investments.
Investing in a variety of assets reduces risk, especially when compared to investing in a
limited number of stocks. You do not have to worry about a Lehman Brothers or Enron
crushing your retirement portfolio, if you lessen the impact that these stocks have on your
portfolio by diversifying your investments. In addition to investment risk management and
capital preservation, you can also hedge your portfolio when you employ diversification as an
investment strategy.
3. Ability to Hedge Your Portfolio
Diversification can enable a portfolio to grow both when markets boom and returns crumble
in one sector. Investors who have had 100% equity portfolios over the past eleven years have
likely seen very poor returns. If these investors had diversified their portfolios to include
investing in metals, commodities, and bonds, their portfolios would have experienced greater
returns. Diversification gives an investor the chance to achieve positive returns in one market
when another market is generating negative returns.

HEDGING
A hedge is an investment position intended to offset potential losses or gains that may be
incurred by a companion investment. In simple language, a hedge is used to reduce any
substantial losses or gains suffered by an individual or an organization.
A hedge can be constructed from many types of financial instruments,
including stocks, exchange-traded funds, insurance, forward contracts, swaps, options,
gambles,[1] many types of over-the-counter and derivative products, and futures contracts.

A perfect hedge is one that eliminates all risk in a position or portfolio. In other words, the
hedge is 100% inversely correlated to the vulnerable asset.
For eg stock prices and gold price

Following ar some examples of assets having inverse relation

STOCK PRICE AND GOLD

US DOLLAR AND GOLD

 OIL PRICES AND US DOLLAR

Examples

1) If an investor holding reliance shares and is worried about adverse future prices so if he
wants to safeguard himself what he can do is take a selling position or short position in
derivative market that is sell a future , which implies that if the share prices prices of reliance
falls , the investor will lose money in share market but gain the same amount in derivative
market or vice versa.

2) same is the case wth chocolate manufacuturer …for eg his chocolate price is 100 and out
of that 50 is the cost of sugar

55 , profit 5

Bought future at 50

45 , loss 5

Now explaining this example if px rises to 55 that means in future 5 rs profit but in real life
you will have to give 5 rs extra that means 100 – 55 =45 instead of 50 so you lose rs 5 which
implies + 5 - 5 = 0

And vice versa

3) long hedge ( person wants to buy the underlying asset in future at decide price) spot px of
wipro is 250 an investor wants a buy and will arrange till the end of the month but does not
want to wait that long as he expecting that share price will increase and so he buys future

Case 1 price rises to 300 at expiry of future

300 – 250 = 50 now he can sell futures @ 300 and buy shares in spot for

300 his invt cost = 300 – 50( profit) = 250

Case 2 if price is 250

250 – 250 = 0 invt cost = 250

Case 3 if price is at 200

Loss 50 , invt cost = 200 + 50 (loss) = 250

ARBITRAGEURS
They attempt to profit from pricing inefficiencies in the market by making simultaneous
trades that offset easch other and capture risk free profit .

For eg if share price of xyz is 100 in spot and 110 in future so this creates a opportunity of
risk free profit = 10

DOTCOOM BUBBLE CRISIS

When: March 11, 2000 to October 9, 2002

Where: Silicon Valley (for the most part)

Percentage Lost From Peak to Bottom: The Nasdaq Composite lost 78% of its value as it fell
from 5046.86 to 1114.11.

Synopsis: Decades before the word "dotcom" slipped past our lips as the answer to all of our
problems, the internet was created by the U.S. military, who vastly underestimated how much
people would want to be online. Commercially the internet started to catch on in 1995 with
an estimated 18 million users. The rise in usage meant an untapped market--an international
market. Soon, speculators were barely able to control their excitement over the "new
economy."

Companies underwent a similar phenomenon to the one that gripped Seventeenth century
England and America in the early eighties: investors wanted big ideas more than a solid
business plan. Buzzwords like networking, new paradigm, information technologies, internet,
consumer-driven navigation, tailored web experience, and many more examples of empty
double-speak filled the media and investors with a rabid hunger for more. The IPOs of
internet companies emerged with ferocity and frequency, sweeping the nation up in euphoria.
Investors were blindly grabbing every new issue without even looking at a business plan to
find out, for example, how long the company would take before making a profit, if ever.

Obviously, there was a problem. The first shots through this bubble came from the companies
themselves: many reported huge losses and some folded outright within months of their
offering. Siliconaires were moving out of $4 million estates and back to the room above their
parents' garage. In the year 1999, there were 457 IPOs, most of which were internet and
technology related. Of those 457 IPOs, 117 doubled in price on the first day of trading. In
2001 the number of IPOs dwindled to 76, and none of them doubled on the first day of
trading.

When an earthquake shook Kobe, Japan in 1995, it also broke open an ongoing scandal
within the walls of Barings Bank. At the epicenter of the financial earthquake was Nick
Leeson, a derivatives trader who, by the age of 28, had risen through the ranks of Barings to
head its operations on the Singapore International Monetary Exchange (SGX).

How Nick Leeson Caused the Failure of Barings Bank

Nick Leeson opened a secret trading account that was numbered ―88888‖ to facilitate his
surreptitious trading. Risk Glossary says of Leeson:

He lost money from the beginning. Increasing his bets only made him lose more money. By
the end of 1992, the 88888 account was under water by about GBP 2MM. A year later, this
had mushroomed to GBP 23MM. By the end of 1994, Leeson‘s 88888 account had lost a
total of GBP 208MM. Barings management remained blithely unaware.

As a trader, Leeson had extremely bad luck. By mid February 1995, he had accumulated an
enormous position—half the open interest in the Nikkei future and 85% of the open interest
in the JGB [Japanese Government Bond] future. The market was aware of this and probably
traded against him. Prior to 1995, however, he just made consistently bad bets. The fact that
he was so unlucky shouldn‘t be too much of a surprise. If he hadn‘t been so misfortunate, we
probably wouldn‘t have ever heard of him.

Betting on the recovery of the Japanese stock market, Nick Leeson suffered monumental
losses as the market continued its descent. In January 1995, a powerful earthquake shook
Japan, dropping the Nikkei 1000 points while pulling Barings even further into the red. As an
inexperienced trader, Leeson frantically purchased even more Nikkei futures contracts in
hopes of winning back the money that he had already lost. Most successful traders, however,
are quick to admit their mistakes and cut their losing trades.
Surprisingly, Nick Leeson effectively managed to avert suspicion from senior management
through his sly use of account number 88888 for hiding losses, while he posted profits in
other trading accounts. In 1994, Leeson fabricated £28.55 million in false profits, securing his
reputation as a star trader and gaining bonuses for Barings‘ employees (Risk Glossary).
Despite the staggering secret losses, Leeson lived the life of a high roller, complete with a
$9,000 per month apartment and earning a bonus of £130,000 on his salary of £50,000,
according to ―How Leeson Broke the Bank.‖

The horrific losses accrued by Nick Leeson were due to his financial gambling as he placed
his trades based upon his emotions rather than through taking calculated risks. After the
collapse of Barings, a worldwide outrage ensued, decrying the use of derivatives. The truth,
however, is that derivatives are only as dangerous as theNick Leeson was placed on trial in
Singapore and was convicted of fraud. He was sentenced to six and a half years in a
Singaporean prison, where he contracted cancer (Risk Glossary). He survived his cancer, and,
while imprisoned, wrote an autobiography called ―Rogue Trader,‖ detailing his role in the
Barings scandal. ―Rogue Trader‖ was eventually made into a movie of the same name. Nick
Leeson was released from prison in July 1999 for good behavior.
 CONCLUSION

Business risk refers to the possibility of the occurrence of profits or even losses due to the
uncertainty. it also means that the possibility of loss occurrence in the business operation's
and environment which also affect the ability of the organization to provide the return on
investment. Financial risk is the possibility that shareholder will lose money when they invest
in a company that has debt, if the companies cash flows proves inadequate to meet its
financial obligation. The major difference between business and financial risk is in the name
itself finance , the difference is of monetary degree .operation risk is associated with
operations of a company , if the company wants to overcome the risk it should do proper
model analysis , follow full legal regulations etc.market risk is not at all constant , t=includes
volatility risk and basis risk , to overcome these risks , proper analysis should be employed
who can carry out the feasibility studies and predict the attitude , sentiment and technology in
future.credit risk includes settlement and sovereign risk , settlement risk and credit risk go
hand in hand as both are connected and the link is the borrower , in order to avoid settlemet
risk , proper terms should be set and loan or credit should be carefully sanctions seeing the
creditworthiness of the perosn/company.liquidity risk is very common risk now adays , assets
are purchased either for operation , use or reselling wih profit but reseling with profit
becomes difficult to achieve due to illiquidity and so proper analysis should be done before
acquiring any asset plus analysing its future prospects , most common eg is Gurgaon area
where people bought houses a cheap rate but now neither they are complete for possession
or have any market value .Finance is very much related to interest rate which has huge role
in financial leverage ,inflation rate which is an important aspect in compounding concept and
investing purpose,cash flow which is related to money supply of country and maintains the
financial fortune of the company, amount of credit which is very much related to bad loans,
NPA problems an dos these are important components of financial risks. Systematic and
unsystematic risk are the base for the financial education .financial risk management is
important for corporate sector , hence diversification , hedging and arbritage are imoortant
concepts , diversifivation Important for growth , aggressive approach is not followed by
prudent people and defensive is followed by prudent people. Technical analysis came from
japan is used for low sum investments sadn is considered to be 70 % accurate where as for
big investors fundamental analysis is more dependable, arbitrage I s inefficiency opportunity
hence it should be minimised and occurs very rarely ,hedging I sused by product
manufacturers for constant profitability or stability , leverage ratio decisions are very
importanat for company heads to take take finance related decisions . looking at the case
studies sub prime , dotcom bubble , lesson , sony crisis , we surley learnt a lot , first three
were had securities in common and were big financial crisis due to economy suffered and
sony hack is related to more of operational risk . so the main conclusion that we derive is that
we should be fully aware of our decisions and their impacts financially , economically .
globally an socially and if the decion seems to be feasible then we should proceed and proper
analysis should be done beforehand .
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