CONTENTS Chapter reduction to Risk Manogemene wwe Chapter I Introduction to Risk Management Principles of Risk Risk Hedging Instruments and Mechanism= viga's™ Risk Monogemeny ; 5 Introduction to Risk Management b EFINITION: : ww Aki defined as volatility of actual returns Retarss ~ ] Erik i dete expected eae More veturns are, higher is risk associated with oa = 7 Barn ot igi Pi ividends/ Interest maureen | Risk and Return’ relationship with each ot! investment, more will be th her. Higher is the risk pected returns from it, _ To understand this let us consider following examples. ext ple 1: _ An investor brought a share of ABC Ltd. at Rs. 100. After year investor sold the share at Rs. 110. Dividend received the investor during the period is Rs. 5. Calculate Returns earned by the Investor. ‘Solution: RETURNS - L+ (P1- PQ) | Return = HE ; Dividend received is Rs. 5. Capital gains for the Investor Rs. 10; (110 - 100) = RISK | Therefore, Rate of Return (R) = 253° = 0.15 Fig: 11 ; ' Hence, Rate of Return (R) for Investor is 15% (Returns diagram, as Risk increases BS ‘As seen from above De sacs ‘are expressed in percentage) Returns from Investment also increas eae Rerunne "An Investor invested in bond of XYZ Ltd. Coupon of bond Return refers to gain expected by investor investment made by him. Return broadly comprises main parts. One is regular income which is in is 10%. After a year bond will redeem at face value of Rs. 100. Investor bought bond at a discount of 10% to face value. Calculate Returns of investor? dividends or interest, Second iin frm of capital a Rate of Return (R) = + 121= Fa) epintio i! oe ig forms pe cely . terest received is Rs. 10. Capital gains to investor is. Pl = Price of the security at the end of . "Therefore, Rate of Return (R) = 22510 = 0.2222 P2 = Purchase price of security.woe Hence, Rate of Rett (Returns are expressed in mp sete a(R) for Investor an reviewing is comple eis eter corrective be initiated. 13 RISK ORGANEZATSON: Tiss process is explained in figere 1.2. ee i ats otikivar in compliance cu a applicable_ face value (since coupon rate is lower than interest _ Fates). Interest rate risk also affects equity markets, There 3ows methods This risk may also if fixed rate liabil payable on the liabilities may rise earned on the assets remains const (i) Basis Risk: Basis risk is risk due to pos a and options can provide hedge against such risk. (1.4.2 LIQUIDITY RISK: _ This is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or ‘make the required profit), There are 2 kinds of liquidity risk: {a) Asset Liquidity Risk: This risk occurs mainly due to ___ wide difference in bid and asks prices. Bid price is price c hich buyer wants to buy and ask is price at which RD nce between bid and ask isthe share at ray be in liquid stocks only n consideration impact cost of stock in which in is to be made. Impact cost is measure of liquidity of stock. Lesser is impact cost, more is liquidity of, To understand this we consider a simple example order book for a stock: Buy ‘Quantity Price 1000 2000 99, 1000 98 300 Consider that a client wants to buy 1500 100 + 101 2 ‘Than ideal market price is given as: i.e. average of best buy and sell price. However actual buy price: (1000 x 101) + (500 x 102) 1500 Introduction to Risk Monogement vor Impact Cost | Actual Price ~ Ideal Market Price . Ideal Market Price 101.33 ~ 100.5 100.5 = 0.825 Impact cost is most modern method of measuring liquidity risk. Lower is impact cost more is liquidity of 100 asset. 4.4.3 EXCHANGE RATE RISK: currency value of assets and to unanticipated changes in exch: (b) It refers to sensitivity of changes in real domestic ies or operating incomes rates. Three Types of Exchange Rate Risk | J 1 | ‘Transaction Exposure Translation Exposure Operating Exposure ‘Transaction Exposure: This risk arises from foreign currency denominated transactions which an entity is committed to complete. This kind of risk affects present profits of a firm. For e.g. a company has imported 1000 computers from U.S. when prevailing prices of 1 US $ is Rs. 40. However after a month when actual delivery takes place US $ appreciates to Rs. 50. In this scenario company will have to pay Rs. 10, 000 more to purchase 1000 computers from American firm. Similarly if company has exported 1,000 computers it will suffer a loss of Rs. 10,000 in case $ depreciates to Rs. 30. Translation Exposure: Translation exposure arises from the need to convert values of assets & liabilities i in a foreign currency into the domestic currency.currency f preparation of ign currency gets reduce which can affec of the} company. depends upon its expected future cas risk will affect value of a firm. 1.4.4 OPERATIONAL RISK AND LEGAL RISK: An operational risk is risk that arises from funct an organization. This risk includes failure of people, iso includes or processes of an organization. It al: from financial frauds, pending legal i issues etc. Operational risk is much includes every risk that arises from failed inte processes of an organization or failure of people wor with organization. Most commonly known operational risk is legal risk. per Wikipedia legal risk is a type of risk which means counterparty is not legally able to enter into a contract. ‘Another legal risk relates to regulatory risk ie. that effect from April 1, 2003 +2 rolling settlement has — 9 currency. A firm's value]|_ sh flow. Hence this) of det ‘em deliver risk arising jgvantages of T+2 rolling settlement: issues, environmental, wider concept which: www 3 roduced. In T+2 settlement trading takes place on T day, ‘on T+! day validation of trades takes place and on T+2 day pay in and pay out (of both securities as well as funds) takes place. Following table summarizes time schedule of would +2 rolling settlement. | Day itt Description of activity Ht |tradeday __ ‘Confirmation of all trades takes place (by 11.00 am) Pay-in of securities and funds securities and funds In T+? settlement trades are executed on T day. Clearing faxes place on T+1 day which means obligations are 4 on T+l day. On T+2 day final settlement ic. funds and securities takes place. fa) Reduces assumption and helps in better price discovery. (®) Reduced settlement period. Once trade has been executed, final settlement i.e. pay in and pay out of funds and securities takes place after 2 days. fe) Rolling settlement have made trading cycle uniform across all stock exchanges in country. Risk associated with settlement: {a) Counterparty risk: This risk arises when one party fails to fulfil its obligation. This risk can be eliminated by delivery v/s payment mechanism which ensures delivery against payment. {o) System Risk: This risk comprises of operational, legal and systemic risks. To eliminate this risk stock paibnasesimposed by stock exchange are VaR margin, MTM margin (Mark to market Margin) and initial margin (for futures and options). Margins are imposed based on historic volatility and liquidity of stocks. 4.5 CREDIT RISK: "Credit risk, also called default risk, is the risk associated with a borrower going into default (not making payments as Poa Investor losses include lost principal and terest, decreased cash flow, and increased collection ‘costs. "This risk mainly exists due to following reasons: (a) Inability of a consumér in making payments due on loans. | (b) Failure of any business to make timely payments for mortgage, credit card or any other kind of loan. (especially of le: ., detect and prevent price rigging cocks). sk reduction measures by stock exchanges: (1) Capital adequacy requirement: Stock exchanges pl capital adequacy norms for membership of st exchanges. Usually capital sufficiency is 19 form of worth, interest free security deposit and collate security deposit. (2) Trading and exposure limits: Clearing Corporation the exchange places limits on turnover and exposure relation to the base minimum capital of a mem Base minimum capital is the amount of funds securities that a member keeps with the exc! Members are subject to limits on trading volumes ‘exposure at any point of time. For e.g. At NSE gross intraday turnover (buy + ‘ of a member shall not exceed 33.33 times of the cay available with clearing corporation. Similarly, \ exposure (aggregate of cumulative net outst % | (e) A business or government which have issued bonds | fails to make payments of coupon or principal when due. Such risk can be reduced by proper assessment of borrower. For this lender should conduct in-depth analysis of loan repaying capacity of borrower. 1.4.6 SYSTEMATIC RISK (MARKET RISK): ‘Systematic risk or market risk is that risk which cannot be diversified. Hence it is called as Undiversifiable risk. Economic, political and sociological changes are mainvignt's™ Rsk Management ( roducion to isk Management aw 2 can be used by company etc. Beside this which may severely affects operat Nationalizing Assets of Business: means forceful acquisition of assets of MNCs by host lizing assets company speci which is uncorrelated wi onsumer preferences country. As it was recently observed in Zimbabwe where several assets of MNCs were forcefully nationalized by government which resulted into huge losses to foreign companies operating there. Restriction on Employing Foreign Nationals: This is done by host countries to promote employment in their ‘own country. But this is a major hurdle in operations of is restricted from employing foreign Labour unrest, chan management are some of the sources 0! Since this risk is company or industry spect ‘4 by diversification. Investor should include stock: jous sectors in order to minimize this risk POLITICAL RISK: risk refers to risk arising from politic in a country or sudden change in policies of ry due to change in government. This risk main! exists for MNCs operating in politically instable country. Political risks also include hurdles or hindrances created the host country. These hurdles include: {a) Restrictions on Remittances of Profit: Many & ‘country puts restrictions on MNCs on remitting full profits to home country. This is done by h country to ensure that money earned by MNCs by i ‘operations in host country is invested again by it in same country. But such unexpected decision of ‘country may act as a barrier in growth of business ‘MNCs. a company as professional with immense potential. Political risk can be reduced by making investments in politically stable countries. Also businesses should __ prefer making investments in more friendly nations. 1.4.9 COMMERCIAL RISK: _ This risk arises due to wrong estimation of demand for products or services before making investments. This risk is ‘mainly due to following reasons: {a) Fall in demand due to decline in income: Due to recession there can be fall in income levels of entire population. With such fall in income levels demand for 4 products can go down. Fall in demand can be more for _ products which have high elasticity of demand. (b) Fall in demand due to cultural variations: Cultural and religious values vary from nation to nation. Each country has its own customs and traditions. Eg. In many Muslim countries eating in public during the month of Ramadan is prohibited during day time. (b) Placing several restrictions on activities of MNCs country: Many a times host country creates form of imposing restriction on movement of ‘MNCs, forcing them to employ local, i _ amount of raw materials and natural :a a gg ~ a ak ence ne Nop ww o | Fer ‘ig a rae ¥ a Cocumisaion o¢ Re. 200 10 /tHe broker earned by the investor: -. Calculate Returh pj _ = Price of the security at the end of holding period 2 = Purchase price of security. Dividend received is Rs. 50 Capital gains for the Investor Solution: belR ie are Rs. 50 (150 - 100}. Return = Te ra ‘Therefore, Rate of Return (R)}= 5g =! Where, 1 = Cash flow in form of P1 = Price of the security P2 = Purchase price of security. Hence, Rate of Return (R) for Investor is 100% (Returns period gre expressed in percentage). [ilustration 1.3: Mr. Ajay purchased 500 shares of ABC Co. Ltd., on idends or Interest the end of holding In this case, 1 = 200 ee | jst January, 2012 at Rs. 150 per share. He sold the shares ae ee on 1st January 2013 at Rs. 160 per share. He paid ipa 1So aoe prokerage of Rs. 500 to the agent. He received Rs. 1,000 as i ion of Rs. 200 ts Additionally client had paid commission of Rs. 200 to thé 4 ping out his capital gain. broker which needs to be deducted from total gain Solution: investor. ; 1+ (P1- Pa Hence Return =F 200 + (4000 - 3000) - 200 Retum Oh 3000 = 0.3333 1 = Cash flow in form of dividends or Interest Hence, Rate of Return (R) for Investor is 33.33% (RzeE P2 Price of the secunty at the end of holding period are expressed in percentage). __ P2. = Purchase price of security. Ilustration 1.2: In this case, I = 1,000 Where, ‘An investor bought 10 shares of ABC Ltd. at P1 = 160 x 500 = 80,000 Rs. 100/share. After 2 years he sold the same at P2 = 150 S00 = 75,000 Rs. 150/share. During the, period he earned divide Additionally client had paid commission of Rs. 500 to the Rs. 50/share. Calculate return earned by the investor. broker which needs to be deducted from total gain to Solution: v "investor. Retum 1+ 21 _ Wlustration 1.4: Mr. Rawal bought 100 debentures of ABC limited at a wes, price of Rs. 95 per debentures. After a year the debentures 1 = Cash flow in form of dividends or Interest ‘Introduction to Risk Management owe B about 12%. Determine the rate at which the debentures ‘were bought by the client. Solution: L+ (P1- Pa) 1 gains to invesgg Return = L*{Pt-P2) Interest received is Rs. 9 per share. (8+5) - 0.1368 oi -2+090=%1 for Investor iS 136g Solving the above equation gives us X = 97.32 tage) Hence rate at which the debentures were bought by the client is Rs. 97.32 ir, Rawal bought 100 debentures of ABC limited: iis deemed at Rs. 100 (at faa Buy Sel J year the debentures were Fe’ po Meiue) per debentures. During the period the debeaiiag Sean rae Sean mee paid a coupon of 8%. The rate of return earned by him wag a a oe hae aevut 14% Determine the rate at which the debentury! i690 98 1000 108 were bought by the client. | Find impact cost if client wants to buy 2000 shares. Solution: 4 a "Solution: Return ~1+ Pal Ideal market price is given as: (101 + 102) / 2 = 101.5 ile, average of best buy and sell price. Interest received is Rs. 8 per share. g+(100-) However actual buy price: x i 1500 x 102) + (500 x 103) 0.14 = is ion git X= 94.73 Solving the above equation gives us See Hence rate at which the debentures were bought 5 Cae oe bought By M Impact Cost: aa a _ Actual Price ~ Ideal Market Price 149 Mlustration 1.6; Ideal Market Price ° Ms. Sonam bought 100 debentures of XYZ lil = 102.25=10155 . 199 101.5 value) per debentures. During the period the Paid a coupon of 9%, The rate of return earned byer share. He solq Rs. 160 per share, q ary 2013 a , 300 to the agent. He reg Find out his capital gain, 7 nt 20 shares of Best Lig ‘er 2 years he sold a sane * the period he earned di se) es ae a A Tolani bought 100 debentures of ABC limite vat iwce of Rs. 85 per, deben After a yea sepentures were redeemed at Rs. 100 per del During the period the debentures paid a coupon of (4) Mr. Singh bought 1000 debentures of XYZ, limiteds a year the debentures were redeemed at Rs. 100 (at value) per debentures. During the period debentures paid a coupon of 7%. The rate of earned by him was about 15%. Determine the which the debentures were bought by the client. (8) Calculate impact cost with the help of fe questions: 100/share. Buy ae ‘Quantity Price peat) 7 3000 102 1000 110 4000 101 2500 109 2000 100,50 3000 Impact cost needs to be calculated under 2 (1) Client wanting to buy 4000 shares. (2) Client wanting to sell 8000 shares. res of XYZ Co, Ltq Js QUESTIONS: -Q(1) Multiple Choice Questions (MCQs): ________ occurs when management evaluates the potential impact of specific risks on the entity. isk assessment (ii) Risk response (lil) Event identification ting broad risk activities or subject isk Identification (i) Risk assessment (il) Monitoring iv) Controlling Risk Management Review (Iv) None of the (@) Managing risk is at the core of managing any organization. (i Financial (i) Educational (i) Political (iv) Non- profit (©) Fisk means (Uncertainty (jl) Unretabity (i) (iv) Confidence Risk is concerned with a decline in the price of a bond or a portfolio of bonds. Predictability ‘are the business process risk falling due to human errors. () Maret risk (i) Cre sk (i) Operational risk (Interest is type of market risk. (i) People risk (ii) Model risk (iii) Legal risk (iv) Equity risk is a type of operational risk. (i) Interest rate risk (ii) Political risk (ill) Currency risk (iv) Marginal risk is commonly known as exchange rate risk. (Operational isk Liiy risk) Curency rk (Legalvor co NT WITH ~ wwe onagement ws Rsk Measurement COMPARING RISK MANAGEME! MEASUREMENT: f managing anaging risk is at the core of is is about making the tactical trol those risks that should be fled and to exploit those opportunities that can be 4. Risk management is the responsibility of all levels of an organization. isk measurement is necessary to support the rent of risk. Risk measurement is the specialized Chapter 2 any financial Risk Management vis Risk Measurement 2.1 Comparing Risk Management with Measut 2.2 Managing Risk 2.3 Diversification 2.4 — Investment Strategies 2.5 Introduction to Quantitative Risk 2.6 Limitations of Quantitative Risk Measurement 2.7 Solved Problems 2.8 Practice Problems 2.9 — Questions ould be consistent throughout the firm, from the lowest jel up to the top management level. k measurement has three goals: Uncovering “known” risks faced by the portfolio or the firm. * Making the known risks easy to see, understand, and compare. ‘Trying to understand and uncover the “unknown” or unanticipated risks. Risk measurement It involves 4a quantifying theSell ee 30 gor Purpose is to reduce ‘overall financial threat to the | company ——— ae Purpose is to support management of risk 4 : 2.2 MANAGING RISK: 3 Managing risk refers to identification, valuation, Grrangement of risks followed by coordinated economical application of resources to minimize, monita ‘and control the happening of ill-fated events or to maximiag tthe returns from opportunities. In ideal risk managemen an arrangement process is followed whereby the risks the greatest loss (or impact) and the greatest probability 4 occurring are hand and risks with lower probabil of occurrence an: s are handled in descending order. In practice the process of assessing overall risk be difficult, and balancing resources used to red between risks with a high probability of occurrence lower loss versus a risk with high loss but lower probabi of occurrence can often be exploited. risk requires different methods of mitigation, (a) Market Risk: One of most widely used technique eliminate this risk is to make portfolio a global one. introducing securities from various countries m: risk of portfolio can be diluted. (b) Foreign exchange risk: Techniques to hi transaction and translation exposure: (i) Exposure Netting: This strategy requires creat an opposite exposure in the currency in which have original exposure. For e.g. a firm has Viput’s™ Risk Management (8M pa nanogement ws Risk Mecsurement ver F] goods worth $1,000 than it should also buy goods worth $1,000. This will create a natural hedge for firm and original exposure gets net off. (ii) Leading and Lagging: Leading means to make advance payment and lagging means to delay a payment. Advance payments can be made in case a firm expects currency (in which payment are to be made} to appreciate in future and payments can be delayed in case firm expects currency to depreciate in future. (iii) Hedging through Derivatives: Forwards, futures and options can be used to hedge currency risk. A firm which have to make payments in foreign currency should take long position in derivatives and firm having foreign currency receivables should take short position in derivatives to hedge exchange risk. Unlike transaction and translation exposure this risk affects future cash flows. Hence it is dif manage this kind of risk with currency deri . Rather it requires various marketing, production and financial management strategies to cope with the risk. (iv) Marketing Strategies: Marketing manager can hedge economic or operating exposure by proper market selection, using proper pricing, promotional and product strategy. For this it is necessary that marketing manager should select country whose currency is likely to appreciate against domestic currency. Also marketing manager should ensureViput’s™ Risk Manoger sk Manogement is Rk Meorurement vor 2 geo motional and enditure on promo! Pro proper ¢xP* another party to provide cash at a predetermined rate when required. rection stategioe: Economic EXPOGUTE gay Frotact py proper selection of InpUE mix tte, Production manager should ie facilities overseas. In case of apprecia, v cost of produetion will increase and y yeerio production manager should > some other country. Also p production manager reduce ciating domestic cus can be p juid securities. It is necessary that investor or fund managers must set a cap to investment made in illiquid assets to reduce illiquidity of portfolio. foc: curren — such sce | production t input mix can help risk. In case of appre’ "inputs required for production can t from outside rather than from domestic (wip Financial Management: This strategy i _ ‘¢reating liabilities in the currency to earnings are exposed. This is much sit exposure netting. For e.g. consider a firm “had sold goods worth $1,000 to a U.S. firm. "firm should also buy goods of same amount US. to hedge its risk. This strategy req somewhat lesser time for implementatio ‘compared to previous two strategies. (e) Liquidity Risk: Some commonly known tec manage liquidity risk are: (i) Storing liquidity: This is most basic soluti __—* Managing liquidity risk as it suggests. keep __ Certain amount of money as cash reserves. Thi be done by allocating a certain amount of ___ Money to money market investments. Wo ites Insurance: Purchasing means entering into an {iv) Investing in open ended funds: It is necessary that investors invest a substantial amount of money in open ended funds. (v) Trading in exchange traded products: Trading in exchange traded products give more liquidity to investors as compared to those which are traded over the counter. {d) Operational and Legal Risk: Operational risk can be reduced if operations of a business are properly _ insured. Also business should diversify its investment to reduce unsystematic risk associated with investments. _ Some of techniques used to overcome legal risk are: (i) Conducting legal audit. (ii) Communicating and educating people associated with business significance of legal compliances. (iii) Having strong compliance and governance policies. (iv) Employing experienced and qualified legal resources.ete. e (FICATION: REDUCTION THROUGH DIVERS! RISK ecessary that risk @ IGecrelation refers to degree of relationship between ta istocks im a portfolio. If two stocks are positively Khan they will move in same direction (both upwards downwards}. Stocks are said to be negatively correlated ‘they move in opposite direction. Founderstand this let us consider a simple example. (give a return of 20% if it rains above normal, if rainfall is normal and 0% returns if rain fall is bel ‘normal. ‘On the other hand stock XYZ will give a return of 20%) "rainfall is below normal, return of 10% if rainfall is no ‘and 0% if rainfall is above normal. This can be presented in tabular form as shown below: above it can be seen that when portfolio is ied with stock ABC and XYZ in equal proportion risk js reduced to zero. In above case ABC and XYZ are perfectly negatively correlated with each other. However in general practice it is | almost impossible to find two stocks which are perfectly negatively correlated with each other. To eliminate this portfolio should consist of securities which have lesser positive correlation with each other. This is because lesser is positive correlation more will be the reduction of Tisk. ADVANTAGES OF DIVERSIFICATION: Diversification has two main advantages. These are Teduction of risk and enhancement of returns: fa) Reduction of risk: Variance of a portfolio is given as: For portfolio consisting of 2 securities: wi28,? + w22s2? + 2 x wis) x W282 « Ria Where wi, w2 refers to proportion of investment made in stock 1 and 2.‘viput's™ Rsk Management (B wr tandard de Si, Sa refers to s' F ieee to correlation coefficient betwee on rig tand the effect of diversification w diagram given below. “at Pe mn of stock 1 and 2 1 and 2 “ath ‘Total Risk of the Portfolio fa) "Number of Securities in the Portfolio go on increasing the number of stocks unsystematic risk reduces. However tion only unsystematic risk reduces, ma tematic risk remains unchanged. ) ly used method by portfolio manager i glo ition of portfolio. th various global researches that have b ducted it has been proven that a well-dive bal portfolio has lower volatility of returns pared to a portfolio which consist only of d of returns: Returns of portfolio is d average of returns of individual the portfolio. ask Management vis Rsk Measurement wr 7 As the number of assets in portfolio increases investors can get benefit of various sectors besides equity. Investor can construct a portfolio which comprises of various assets like equity, bonds, company debentures, real estate, gold ete. With such portfolio investor can enjoy the benefits of economic developments in a particular country and also reduce market risk involved with equities. __ LIMITATIONS OF DIVERSIFICATION: Although diversification plays a vital role in risk _ management it has its own limitations: Systematic risk remains unchanged: With diversification only unsystematic risk can be éliminated however market risk or systematic risk remains unchanged. To eliminate systematic risk either globalisation of portfolio or investing in various assets is essential. However globalisation or investment in various assets is beyond the reach of an average investor. Hence for such investors systematic risk remains unchanged. Increases complexity: As the number of stocks in Portfolio increases it becomes relatively difficult to calculate risk and returns of portfolio. Beside this et of diversification on portfolio is only up to certain poi Beyond this even if we increase the number of stocks in Portfolio unsystematic risk remains unchanged. Increases the cost of managing the portfolio: If a Portfolio comprises of various group of assets then cost of managing the portfolio increases. With such increase in cost returns available to investors decreases.15 Rik Management (Big 38 vor DIVERSIFYING; .ONSIDERED WHILE FACTORS TO BE © ‘Cost: cost of managing i ification of fund adds to cee heaealil cost can significantly impact fung the fund. This ‘om tal returns. So money mat i d. not over diversifie Returns: Although diversification is oné of the keys o successfu sti nds tend to over diver; ve ty Bing in more than required number of stoc investing i 2, tors. So while diversifying it is important and sect yriate number t would be most approp a including more -s to invest in. | Soe accor or socks in fonds can. signa impact returns generated by the fund. {3) Complexity: Complexity is one of the impor to be considered while managing a Por Diversification should not make portfolio too complex else it will become difficult to manage it. Also it will to unnecessary cost. {4) Investment Objectives: Money Managers must en: that investment objectives of the fund are compromised while diversifying. Any violation investment objectives can severely impact credibility the money managers. nagers must ens' g, many fu ant factor 2.4 INVESTMENT STRATEGIES: Some of the most widely used diversification are: (1) Increasing number of sectors and stocks: By increasing number of sectors in portfolio, specific risk can be reduced. If there is downfall i techniques isk Management vis Risk Measurement vw 39 particular sector, than portfolio won't be much affected if it js well diversified among various sectors. Also a portfolio should consist of various stocks from a particular sector This will reduce company specific risk associated with portfolio. However such diversification among sectors and stocks will reduce only unsystematic risk associated with portfolio whereas systematic risk remains unchanged. Also by increasing sectors and stocks even unsystematic risk can be reduced to a certain point after which it remains ‘unchanged and such an increase will add to complexity of portfolio. {2) Use of fixed income securities: In investment management there is a widely known term “Flight to Safety” which means investors tend to invest more in safer securities when there is downfall in equity markets. Fixed Income Securities such as bond are considered to be safest for investors. Such securities help to reduce risk of entire portfolio. To understand this let us consider a simple example. A portfolio consists of shares of ABC and XYZ in equal Proportion. Market value of portfolio is Rs. 10,000. On a particular day ABC and XYZ both decline by 10% than value of portfolio will reduce by Rs. 1,000 i.e. 10% of Portfolio value. Now if same portfolio makes investment equally in equity and bonds than Rs. 5,000 is invested in Shares of ABC and XYZ combined and Rs. 5,000 in fixed income securities. If XYZ and ABC decline by 10% then Portfolio will lose Rs. 500 (10% of Rs. 5,000), however Rs. 5,000 invested in bonds remain unchanged. Hence loss. to portfolio is only Rs. 500 i.e. 5% of initial market value._ v 4 -j Management vis Risk Measurement IVERSIFYIN vow 9 SIDERED WHILE D) i “ACTORS TO BE CON! articular sector, than portfolio won't be much affe d adds to cost of ma : ‘ (2) ca Die noe ne cane ce (rat hs pect ‘So money managers must ensure that ' P reduce aa seessieg eis sector. prtfolio. However such diversification among a mth ocks will reduce only unsystematic risk associated any prtfolio whereas systematic risk remains unchanged i , increasing sectors and stocks even unsystematic we be reduced to a certain point after which it remains changed and such an increase will add to complexity of not over diversified. ication is one of the key (2) Returns: Although diversifi d to over dit successful investing, many funds ten by investing in more than required number of and sectors. So while diversifying it is importa consider what would be most appropriate numb stocks and sectors to invest in. Including more required sectors or stocks in funds can sig impact returns generated by the fund. in investment management there is widely (3) Complexity: Complexity is one of the important fi ight to Safety” which mi investors. tegiigs SA to be considered while managing a po ore in safer securities when there is downfall in equity Diversification should not make portfolio too com s. Fixed Income Securities such as bond are else it will become difficult to manage it. Also it to unnecessary cost. (4) Investment Objectives: Money Managers must en 4 that investment objectives of the fund are’ compromised while diversifying. Any violat investment objectives can severely impact credibil the money managers. 2.4 INVESTMENT STRATEGIES: Some of the most widely used techniques diversification are: 000), (1) Increasing number of sectors and stocks: 5,000 invested in bonds remain unchanged. Henoeloss is only Rs. 500 i.e. 5% of initial market value. By increasing number of sectors in portfolio, specific risk can be reduced. If there is downfallViput’s"™ Risk Management ( wor Management vis Risk Measurem vre 4 it can be seen thal Joss reduces to 5 t by adding fixed incr % as compare to prrelation with stocks they pla xy important role in portfoti xrsification and risk management. or ) Globalization of portfolio: sarity in port when portfolio consisted only of equity srivatives in portfolio: ps are widely It simply means to include stocks and securities of panies from different countries. Such inclusion will not ply reduce market risk associated with portfolio but will (3) Inclusion of de Futures, options, forwards and swal derivatives. products by portfolio managers to hedge tf risk, It is much easier to take position in derivatives now exchange traded. Moreover only initial mar mnt by investors for taking positior s. This makes derivati most are needs to be paid upfro derivatives product like future much cheaper means of hedging risk as compared to o techniques. For hedging through derivatives inves buying in cash market should be bearish in derivatives vice a versa for investors selling in cash market. A quantitative risk analysis is an analysis of the highest jority risks during which a numerical or quantitative ing is assigned in order to develop a probabilistic (4) Alternative investment strategies: Alternative investment refers to making investmen assets other than traditional ones like stocks and One important advantage of these strategies is that low degree of correlation with stocks and bonds. He alternative investment requires comparatively amount for investment and also have higher risk im as historical data regarding risk and ret inadequately available. re are different tools / methods that can be used for ntitative Risk Measurement: ol 1: Sensitivity analysis: Sensitivity refers to change in output with change in one more input variables. For financial assets whenever there is change in any one Put factor, it affect the returns from asset. Alternative investment strategies can be classifie Sensitivity analysis is defined as study of change in financial assets and tangible assets. Financial i i consist of private equity, hedge fund, real estate, pret t variable. In terms of financial assets input variable metal and managed futures. On the other hand ta be any internal or external factor that affects the assets comprises of art, antiques and painting. Alternative investment usually have longer time ‘They are expected to give better returns compared to and equity in long term. Also due to low dvigetts™ Rk Management (iy ay jyonogement vis Risk Measurement or a a or anaiysis it possible to understand HigII| , decision tree is a simplified, tree-shaped diagram used (2) With sensitivity ‘with change in one OF more inpy {4 determine a course of action or show a statistical ‘output will change probability. Each branch of the decision tree represents a mee of prime importance for hedging) possible decision, occurrence or reaction. The tree is made fa) Semaitivity analysis is 0° Pm edging strategies gmp show how and why one choice may lead to the next, with Tt helps develop: — duce risk associated wig qhe use of the branches indicating each option is mutually accordingly ciminate 0 Ba sive pate ts of key significance for VaRigmmmEE Business or project decisions vary with situations, which Sensitivity analysis * " bonds and options. © turn is troubled with threats and opportunities. financial products especially — ) Calculating the Expected Monetary Value of each possible ‘Tool 2: Expected monetary value analysts: | decision path is a way to quantify each decision in tn broad terms, determining the expected monetary vali” Fonetary terms. Calculating Expected Monetary Value by is to multiply the likelihood by the cost impact to obtaimal sing Decision Trees is a recommended Tool and Technique expected value for cach risk, these are then added WHIM G5, Quantitative Risk Analysis. ‘obtain the expected monctary value for the Prolect# 40 to Use Decision Trees Analysis: typical way of calculating EMV is using decision trees. 3 ‘ , . “ * To use Decision Tree Analysis in Project Risk To calculate the Expected Monetary Value in project. 4 I gecoccit, we deed ‘management, we need to: {) Assign a probability of occurrence for the risk. | (2) Document a decision in a decision tree. (2) Assign a probability of occurrence for the risk pertaining to that decision. (3) Assign monetary value of the impact of the risk when Assign monetary value of the impact of the risk, it occurs. Multiply Step 1 and Step 2 i it occurs. i tree analysis: Tool -— ree 4 {4) Compute the Expected Monetary Value for each ‘These are in the form of a flow diagram where each n6 decision path. le, contains a description off A simple example of decision tree is given in fig. 2.1: isle aspect and its cost. These rectangles are lif fogether via arrows cach arrow leading to another i Tepresenting the percentage probability. These totals Galedlated by multiplying the risk costs by the probal and adding that value to the initial cost.‘Vipul’s™ Risk Management, or nnouse vs Purchase - resource availabilty VS ‘Customization ‘Risk Manogement vis Risk Measurement veo The risks are presented in descending order, with the largest impact on the top and the least impact on the bottom. It allows the team to focus on those risks with the greatest impact on a project objective. 45 A simple example of tornado diagram is shown in fig. 2.2: Delay ners Fig.: 2.1 Here the decision involved is to either produce in ho or to purchase. Tool 4: Tornado diagrams: Tomado diagrams, also called tornado plots or to charts, area special type of Bar chart, where the Categories are listed vertically instead of the si horizontal presentation, and the categories are ordered that the largest bar appears at the top of the chart Second largest appears second from the top, and so They afe~s0 named because the final chart. vi resembles either one ‘comparing the reli A tornado diagran * The longer the objective is to the risk | Consequence these experts may also identify additional ‘Cart fed quid Director ect ihn erly ar we pl eacurcas Eivalriert coos nct meet target S0by Jan Swing seis back ordered Permits came tough aslo tan larva Baan epiaced Fig: 2.2 Tool 5: Modelling and simulation: ‘The most common form of this is Monte Carlo analysis Which is normally calculated by computer by analysing many scenarios for the project schedule and calculating the impact of particular risk events and is helpful in identifying tisks and the effect they have on the project schedule. It is Basically a process that generates hundreds or thousands Of probable performance outcomes based on probability distributions for cost and schedule on individual tasks. The OUtcomes are then used to generate a probability distribution for the project as a whole. Tool 5: Expert judgment: This normally involves asking experts to review the risk data and the manner in which it has been gathered. As @vipul's™ Risk Management ( ger k LIMITATIONS OF QUANTITATIVE Rigy MEASUREMENT: nd common lim 2.6 itations of quantitatiy, below: isk: Quantitative models qa) 1 which needs to be integrates mes fail to properly asgey that some financial assay (1) May not include miss some important ris Further these models the unexpected sensit may have. |" (@) Backward looking: Quantitative models to a lat extent are dependent upon past data which may ng give correct future picture. All quantitative techniqug to measure risk like standard deviation, variance, Valiy at risk, beta etc. are dependent upon past data. Heng risk managers need to incorporate own understanding with these data to produce future results. {) Complex nature: Quantitative techniques are quit ‘complex and only expert professionals with requind understanding have the ability to measure risk Using these techniques. (4) Fails to represent extreme events: Quantitalin techniques many a times fail to catch extreme evenis Extreme events are threatening and hard to predid None of the quantitative techniques have the ability # exactly predict such events, 2.7 SOLVED PROBLEMs: Illustration 1: 4 Mr. XYZ have two options of making investments, Opti Seem 'vestment to be made in equlll sk Monagement ls Rik Measurement wer "7 option two requires equal investment of portfolio in equity and debt. Details of both the options is given below Option 1: Invest Rs. 1,00,000 in equity markets by purchasing stock ABC and PQR in same value. Option 2: Invest Rs. 50,000 in equity by purchasing stock ABC and PQR in same value and Rs. 50,000 in debt market. Calculate value of portfolio and percentage change in portfolio value if there is sudden fall in equity markets and ‘poth ABC and POR fall by 5%. ‘Solution: Option 1: Value of portfolio will reduce to Rs. 95,000 (as. both ABC and PQR have fallen by 5%), Percentage change in portfolio value will be: 95,000 - 1,00,000 1,00,000 x 100) So portfolio value will fall by 5%. Option 2: Value of portfolio will fall by Rs. 2,500 (as only Rs. 50,000 is invested equally in ABC and PQR). Value of Rs. 50,000 invested in debt market will remain same. So the new value of portfolio will be Rs. 97,500. Percentage change in portfolio value will be: 97,500 - 1,00,000 1,00,000 So portfolio value will fall by 2.5% Mlustration 2: Consider stock ABC and PQR. The expected return on ABC and PQR are 20% and 30% respectively. Standard deviation of stock ABC and XYZ is 5% and 10%Vipul’s™ Risk Management e or respectively. Cal the expected return and stam ener vr 0 deviation of a comprising of these two stockg ‘As per CAPM § ent is 0.5. iequall proportion if correlation coefficient 1S Required rate of return on portfolio = 6 + 1.01 x (15-6) Solution: " ile etums on portfolio is weighed average of TEtURIGG) itustration 4: |The following particulars are furnished about Mutual individual stocks in portfolio. Fund Schemes P, Q and R. Expected return (R) = (20 « 0.5) + (30 xO 2) = 25% Particulars Scheme P | Scheme Q | Scheme R Dividend Distributed 175 = = (0.52 x 52) + (0.5? x 102) + (2 x 0 re oe ioe = i af 3 ) + (2 x O.555 Vespitat appreciation 297 3.53 199 0.5% : [Opening NAV 32 27.15 25 = 43.75 [Beta 1.46 Li La o 6.61 Ascertain the alpha of the 3 schemes and evaluate their performance, if Government of India bonds carry an Expected return from portfolio is 25% and si ri # interest rate 6.84% and the Nifty has increased by 12.13%. deviation is 6.61%. Solution: Alpha = Actual Returns ~ Expected Returns as per CAPM Illustration 3: Ms. Sukhi has the followi ts in her portfolio; is. Sukhi has the following scripts in her portfolio: 5 Cada Stocks Beta Proportion of investment Distributed a dations Reliance 0.75 20 pctual Returns” = ‘Opening NAV oe ‘Satyam 09 25 1.7 Wipro 12 an p, 28297. 109 = 14.75% TCS 1d 25 pape Q: 2 ao x100 = 13% Caleulate expected return on portfolio if Ry is 6% 27.1 Rm is 15%. R 134198, 100 = 14% Solution: i ‘ 6 ie "| Expected Returns as per CAPM = Rf + Beta (Rm — Beta of a portfolio is weighted average of beta re ey individual stocks in portfolio. MR: 6.84 + (1.46 * (12.13 - 6.84) = 14.5 Q: 6.84 + (1.1 x (12.13 - 6. = 12.65% = 14.24% Hence of portfolio = (0.75 x 0.2) + (0.9 x 0.25) R: 6.84 + (1.4 « (12.13 - 6.84))= ¥ 13 Risk Monogeme gor oa MIT ces of oor 0 Cd d pen BR. expences ote CGR o> eect Aatet Lsbliy Management Techniqas sims aioe such as Business se ee a fo manage the volume, maturity, rate sensitivity, quality h of the Wg liquidity of assets and liabilities as a whole so as to on grain a predetermined acceptable risk/reward ratio. robability, or likelihood) m al eee ae all ui tt is aimed to stabilize short-term profits, long-term e fe hor and considers the amoung) earnings and long-term substance of the bank. The eps taken to avoid or protect fgg parameters for stabilizing ALM system are: (1) Net Interest Income (NIN) siness risk exposures to consider are: (2) Net Interest Margin (NIM). (a) Economic Equity Ratio. One of the prime objectives of bank is to have sufficient liquidity available at all time. This is necessary so that bank | can meet its commitment at all times. {4) Business Overhead expenses. | {1) General Liabi {2) Errors and 01 {8) Director & Officer Protection. Following factors needs to be analysed to determine {5) Employee Group Benefit plans. B uisity position ofa banks (a) Historical Fund requirement. (b) Current liquidity position. (c) Anticipated future funding needs. 3.6 RISK IMMUNIZATION: Risk Immunization is a strategy that matches! tit durations of assets and liabilities, thereby minimizing/iit ‘impact of interest rates on the net worth. (a) Sources of funds. BRM le, large banks must protect their cua, (°! OPtions for reducing famding neede- worth, Whereas pension funds have the obligation q (f) Present and anticipated asset quality. payments after a number of years. These institutions # {e) Present and future earning capacity. ‘both concerned about . a about protecting the future value of Once above mentioned factors are analysed liquidity Portfolios and therefore have the i bank known. problem of dealing ##) pos; uncertain future interest rates. a an63 ver policy of bank. ALC' is mostly headed vases of senior bank offcialaagy oie. In order tO avoid ga: ‘ALCO allo fig xy. This ALM Pai § mp! ‘Asset Liabili' drafted based market cond! ‘Success of ALM in (1) Managing Interest rate risk: AS ar major investors ‘will help bank Basel Norms in Banking Industry: matters. Its supervisory iss supervision worldwide. Base 1) Minimum capital requirements (addressing ti (2) Supervisory review. (3) Market discipline, — vviput’s™ Risk Monogemeng ~ = vor 9 x) Minimum capital requirements (addressing isk}: ‘this is first pillar of Basel II. It deals with maintenance of regulatory capital for three major components of risk that bank faces i.e. credit risk, operational risk, and market risk. supervisory review: This second pillar deals with other 2) risks a bank may face, such as systemic risk, pension concentration risk, strategic risk, reputational provides framework {a) Market disofpline: This third pillar mainly focuses on d governance. The aim of pillar 3 is to allow market \e to operate by requiring lenders to publicly ¢ details of their risk management activities, risk rating processes and risk distributions. Risk Immunization by other financial institutions: Large firms and institutions have the ability to protect ‘their portfolios from exposure to interest rate fluctuations by using what is known as an immunization strategy. By using a perfect immunization strategy, firms can nearly guarantee that movements in interest rates will have almost po impact on the value of their portfolios, Immunization can be achieved by cash flow matching, dura\ convexity matching, and trading forwards, options on bonds, Similar strategies can be used to ‘ze other financial risks such as exchange rate risk: managers use hedging , Hedging strategies are edging strategy is in? o Viput's™ Risk Manageme ip papes of isk owe 7 if there is change in interest rates by 100 basis point ation ~ = Ptive:ifvield declines — price if yield rises Duri 2 x (Initial Price) x (Change in yield decimal) | if duration of a bond is 10 it means that for 100 basis 7) point changes in interest rates, price of bond will change by 10%. nis also a measure of time. If a bond has it also means that price sensitivity of bond is ‘at of a 10 year zero coupon bond. ive Duration: One of the major drawbacks of is that it does not take into consideration change cash flow with change in interest rate. Effective uration is a duration calculation for bonds with embedded earth option. It takes into consideration change in cash flow with ‘change in interest rate. This makes it more suitable for measuring sensitivity of bond with embedded option. 3.8.1 MACAULAY DURATION: : ‘The Macaulay duration is the weighted average term to ‘maturity of the cash flows from a bond. The weight of each fash flow is determined by dividing the present value of the fash flow by the price. ; Macaulay duration can be calculated: complete. Simulation pro istration of possible outcome values,n vor a ee vor 2 ¥ = periodic yield Period 6: Rs. 1,030 in = total number of periods ‘i 4 With the periods and the cash flows known, a discount factor must be calculated for each period. This is calculated 1 ‘atm +ap’ Where ris the interest rate and n is the period M = maturity value Current Bond Price = Present value of cash fl The Macaulay duration can be viewed as the) economic balance point of a group of cash flows, ‘way to interpret the statistic is that it is the y average number of years an investor must maint Position in the bond until the present value of the ‘cash flows equals the amount paid for the bond. jumber in question. Thus the discount factors would be: 7 1 Period 1 Discount Factor = 7F7gq7 = 0.9945 __ Period 2 Discount Factor = aad = 0.8734 * i 1 A bond's price, maturity, coupon and yield to m ge Period 3 Discount MARBaR Leprageno eo? all factor into the calculation of duration. All else equaljal. |) Period 4 Discount Factor =——4-— = 0.7628 maturity increases, duration increases. As a bond's éoupy e iad increases, its duration decreases. "Period 5 Discount Factor = tw a = 0.7129 AS interest rates increase, duration decreases 1 | Bond's sensitivity to further interest rate increases Period 6 Discatnt Fa cipesaameuaagies 0-CO6S down. Also, place, a scheduled prep Next, multiply the period's cash flow by the period Before maturity and call provi ta : number and by its corresponding discount factor to find the The caleulation of Macaulay duration is straightforwanl Present value of the cash flow: Assume there is a bond priced at Rs. 1,000 that | Period 1= 1% Rs. 30 x 0.9345=Rs, 28.03 6% coupon and matures in six years, Interest rate Period 2=2% Rs, 30 x 0.8734=Rs. 52.40 ‘Me The bond pays the coupon once a year, : 4 ) Period 3=3x Rs. 30 x 0.8162=Rs. 73.46 Principal on the final pa i yment. Given this, the fol Sesh flows are expected over the next three years: § Petod 4» (egy lan seed Period 1: Rs. 30 Period S=5x Rs. 30 x 0.7129 =Rs. 106.94 Period 2: Rs, 30 Period 6 = 6 x Rs.1,030 * 0.6663 =Rs. 4118 Period 3: Rs. 30 Period 4: Rs. 30 Period 5: Rs. 30yon ae = i _Rs. 4470.40 _ 5 69 ; Macaulay duration "Rs. 809.33 | Modified duration provides a measure of percenta ry paying bond will always have its duration Jey change in Price, for a percentage change in yield Bilis than ifs time to maturity. In the example above, ij two bonds with the same measure of modified duration will uration of 5.52 around half years is less than the'fimey) change in value, in rupee terms, in much different manner, Bc hast years depending on the price at which they are trading. The rupee maturity | change in value of the bond is different across the bonds, and is a function of both modified duration and the price. ‘Therefore rupee price change can be calculated as: Principles of Fisk ror 1s 3.8.3 RUPEE DURATION: 3.8.2 MODIFIED DURATION: Modified duration is a fo that expresses thy security in response duration follows th. Modified duration * yield change (in basis points) « rupee price of the bond. We can standardize the expected price change in rupee terms, for a 100 basis point change in yield as Modified @uration * 0.01(100 basis points) « rupee price of the bond. This value is called the dollar (rupee) duration of a bond, and is comparable across bonds selling at various prices Table 15.6 shows the rupee duration of a set of bonds. Rupee duration represents the change in price for a 100 Dasis point change in yield. An example of Rupee Duration is given in table below: bond prices move i,” ‘opposite directions. This formula is used to determine the effect that a 100-basis-point (1%) change in interest rates will have on the price of a bond. Modified duration is given as: a tion = ee ray | (ee) Price (Rs.) Mduration (Yrs) Rupee Duration 101 0.45 0.4545 wis 037 0.755 ” 5.52 0.38 0.3876 Than Modified Durati ates 102 ae eHee dome 048 0.4920 =5.01 103.5 Dee 0 This shows that for every 1% movement in interest rately °'°-* : : the bond is this example would inversely move in Pi Another important variation to the rupee duration, which, 5.01%.Bice: a f the bond x 0.01 i a Rupee Duration of a bond fa a PVOI is also - we | PVO1 of a bond is a numt ‘anticipated change in yield, to portfolio, multiplied by the value 0. ange in price of bondi a umber in buying hedge products for a portfolio. The An pear of Price Value of a Basis Point is gi _- ~~ 7 ‘Viput's™ Risk Mor vor “ema * Prins of Risk vor n Mduration | Rupee (vrs) Duration Price Va 045 0.4545 037 0.3755 0.38 0.3876 048 0.492 0.55 0.5692 3.9 LINEAR AND orner TECHNIQUES. Ipnalysing several variables, when the focus is on the elationship between a dependent variable and one or more jndependent variables. ‘egression analysis is the most widely used of all Jet X:, ..., Xx denote the “independent” variables. Then the equation for computing the predicted value of Yris: = bo + bi Xi + be Xa +... + be Xe In statistics, nonlinear regression is a form of regression analysis in which observational data are modelled by a function which is a nonlinear combination of the model parameters and depends on one or more independent variables. The data are fitted by a method of successive approximations. Some other statistical techniques widely used are standard deviation, variance, coefficient of determination, correlation coefficient ete. .10 SOLVED PROBLEMS: Illustration 1: Find out: Expected Rate of Return.8 vow Viput’s™ Risk Monagement (iy 4.1 DERIVATIVES DEFINITION AND sk Hedging Instruments ond Mechanism owe a of exchange or clearing corporation: As forwards are not exchange settled it is possible to enter into such contract without the need of any exchange or clearing corporations, 4.2 FUTURES: FUTURES: Futures is an agreement between two people or entities where settlement takes place on future date at (a) Exchange traded: Futures are exchange traded, hence counterparty risk don't exist. {b) Standardized in nature: They are standardized in _ nature where all terms related to contracts are decided by exchange. {c) Cash or delivery based settlement: Final settlement can either be cash based or delivery based. Advantages of Futures: (a) Exchange traded: As futures are exchange traded counterparty risk does not exist. (b) Electronic trading platform: As most stock exchanges Provide electronic trading platform it is possible for People to easily take positions in futures contract. (a) Exposed to counterparty risk: Forward are nol exchange traded and are hence exposed to counte tisk. {b) Customized in nature: Contracts __ depending upon needs of entities. Hence ¢ ~ is unique in term of contract type etc. {e) Delivery base settlement: Usually on expiry cont are settled by physical delivery of underlying asset.ux Heda Instrument nd Mechanism ow 91 margin account to the initial margin level before trading commences on the next day. r which contrag, 4.3. OPTIONS: IONS: Options is an agreement which gives buyer wat not ot mn to buy or sell a specific quantity of lying asset on a future date at a pre-determined Options are of two type call and put. Call option buyer or holder right but not obligation to buy ing asset on a future date at a pre-determined Put option gives right but not obligation to. sell ing asset on a future date at a pre-determined t Thursday of every ing last Thursday a ney ing. & prices. Important Characteristic of Options: (a) Exchange traded: Like futures, options are also exchange traded hence counterparty risk don't exist. (>) Standardized in nature: Again like futures, options are standardized in nature where all terms related to contract are decided by exchange. | (¢) Gives right but not obligations: Options gives its holder right but not obligation to buy or sell given quantity of asset on a future date. Advantages of options: (9) Exchange traded: As options are exchange traded counterparty risk does not exist. (0) Electronic trading platform: As most stock exchanges Provide electronic trading platform it is possible for eo es2 ore hot obligation to buy or sell given quantity of asset on future date at a pre-determined p 0 known as writer is the Vipul’ Risk Management iy ok Hedging Instruments and Mechanism row i 0 ee (ATM): These are options which cash flow for holder if they are exercised Hately. Both call and put will be ATM if spot is ‘0 strike, ( value of option: It is amount by which an option is ITM. If option is OTM than intrinsic value is zero. (a) Time value of option: It is difference between option price and intrinsic value of option. sell underlying asset on a future date at a phe determined prices. {e) Option price: Option price or option premi ‘amount paid by option buyer to option seller to buy the 6 : 4.4 SWAPS: TY ‘Swap is defined as an agreement where two parties agree to exchange cash flow on a future date according to a predetermined arrangement. ) is last date on which options ‘will be Some important features of swaps are as follows: (a) Termination of contract: Here if one party defaults, the other party can terminate the contract and claim for damages. (>) No effect on balance sheet: It does not appear as a liability on the balance sheet as it is not a loan. (c) Higher liquidity: Currency swaps have higher liquidity and hence many banks participate in swap transaction. ‘Swaps are used to convert assets or liabilities in formBette: income it is called asset swap. Working of IRS: 4 J i requires initial exchange of principal (optional), they exchange of interest and re-exchange of principal amount at beginning). A simple led plain vanilla swaps, 00,000. Following are rates given to firm A andB Firm Fixed rate (°%) Floating rate (%) a 8 MIBOR + 3) B 10 MIBOR + 6 "From above it can be seen that firm A have absolut | advantage in both fixed and floating rate. However fixed ‘rate for firm B is only 2% more than firm A whereas floati rate is 3% more. Therefore firm B have a com! po neg Insert ard Mahon 3% + MIBOR + 6 = MIBOR + 14%, ie. firm B borrows in fixed rate and firm A ‘ows in floating rate then total cost of borrowing ‘Thus both firms can enter into a swap agreement where firm B borrows fix and firm A floating then exchange their int is beneficial to both of them. Valuation of IRS: Value of IRS is gives as: V = Fb-Ff Where V = Value of the swap Fb = Value of fixed coupon bond. Ff = Value of floating rate note. Currency Swaps: 8 It is defined as an agreement between two parties to exchange interest payments on loan in one currency to an equivalent loan in another currency. In currency swaps Principal amount may or may not be currency swaps is "e-exchanged_ aaa | Heding Instruments end Mihm rr ” counter "Party, swap dealer need to be red! who usually charges a part of profit from Secondary markets for swaps are not and most swaps are traded over the isk: As swaps are OTC traded, there are high of counterparty default, 4.5 ARBITRAGE TECHNIQUES: 3X isViput's™ Risk Management fj gx Heding Instruments ond Mechonsm wow ie 's of internal control to facilitate supervision ‘oring, prevent and detect suspicious Measure ongoing performance, maintain adequate business records and to promote operational productivity. Internal auditors review the design of the internal controls and informally propose improvements, uument any material irregularities to enable further ‘tion by management if it is warranted under the ‘an example calculation, assume a ‘The following four factors have been identified, along wit, ‘h factor and the risk premium Gross domestic product growth: b = 0.6, rp = 4% | inflation rate: b = 0.8, rp = 2% ‘Gold prices: b = -0.7, rp = 5% Standard and Poor's 500 index return: b = 1.3, rp = 9% The risk-free rate is 3%. Using the above APT formula, the expected retum js system audit is an examination of the management controls. within an Information Technology (IT) infrastructure. Role of System Audit in Risk Mitigation: «The primary functions of an IT audit are to estimate the systems that are in place to watch an organization's, information. + Information technology audits are used to calculate the organization's ability to protect its information assets and to properly distribute information to authorized parties. + IT audit ensure that there is no leakage of information and that information is available only with authorized personnel. 2]. system audit moderates risk by | __ organization's internal control design and 4%) + (0.8 x 2%) + (0.6 x 5.2% €0.7 x 5%) + (1.3 « 99 4.9 SYSTEM AUDIT SIGNIFICANCE IN RISK MITIGATION: | Auditing is a means of assessing the effectiveness of 8lo Vipuns™ Rok Manogement (ay 1: ‘An Indian firm M/s Pranjal and co have imported goods $1,00,000 which is payable on 1 Dec. Today it is 29 | Firm wants to hedge its positions by trading in g Following are rates available on 20 Nov: ‘Cash market Rs. /$ = 44 Futures market Rs. /$ = 45.5 (On 1 Dec there is 60% probability that prices will be: Cash Rs. /$= 46 Futures market Rs. /$ = 47 ‘On 1 Dec there is 40% probability that prices will be: Cash market Rs. /$ = 42 Futures market Rs. /$ = 42.5 of out: Strategy to be adopted by firm. * No of futures contract firm should take position if 1 contract is for $50,000. Profit/loss to firm. And expected payments to be mad® RRM foreign currency payable it shoulda Jong position in futures to hedge risk in spot market. No of. ~ 100,000 _ future contract 50,000 ~2 en rattan Sea ee wre oy Since client have forei nave appreciated tw sus es nee es which will be in cash market = (46 ~ 44) x 100,000 = 2,00,000 However client will make profit in futures = (47 - 45.5) x 1,00,000 = 1,50,000 Total loss = 2,00,000 - 1,50,000 = (60,000) Total payment to be made = (46 x 1,00,000) - 1,50,000 = 44,50,000 Hence there is 60% probability that client will have to pay 44,50,000 If prices on 1 Dec are: Cash market Rs. /$ = 42 Futures market Rs. /$ = 42.5 Here $ have depreciated and since client have payable it will earn profit in cash market = (44 42) x 1,00,000Viputte™ Risk Manogement (ig) ax Hedging Instruments and Mechanan ooo = (4.25-4) x 50,000 = 12,500 Net profit = 37,500 ~ 12,500 = 25,000 ‘Total payment farmer will receive = (4.25 x 50,000) - 12,500 = 2,00,000 Illustration 3: Ms. Madhu had bought 1, 000 shares of XYZ Itd on 1 The Spot price is 3.50 per bushel. Which is 4 month from now, if the isVipul’s Risk Management ya n «Fee 5.1 RISK MANAGEMENT V/S ENTERPRIsp “RISK MANAGEMENT: s) Set up 8 Process to report these risks. (6) Regularly monitor risk policies and limits. 5.2 INTEGRATED ENTERPRISE _ RISK MANAGEMENT: ed Enterprise risk management (ERM or E.R.M.) shareholder value by optimizing risk taking. + ERM allows the firm to take a holistic view of risk. an organization. ER. at additional risks such 2 it cial and strategic. ERM is+ Mixer of ERM in the institution + Risk Assessment + Risk Response .¢ four objectives categories are: + Strategy: high level goals, aligned with and supporting the organization's missionver Vipui’s™ Rsk Manogement (yg ‘As outlined by COSO, the framework provides igh ating ERM: t ‘The organization identifies cay relevant information from in Pot and communicates ernal sources in a across 1% involves is functioning of enterpri es both the presence and management components andBt Rk Me wr ons emergency plan that ‘addresses possible risks ‘show to deal with them, s to increase sales and market share, wh Competitive advantage in terms of scale.ae il a ill Th Hi rH f “i ' vF 5.8 QUESTIONS: (1) Multiple Choice Questions (MCQs): (a) Monitoring and measuring is the (c)_ ERM includes (i) 3 Objective (ii) 4 Objective (i) & Objective (iv) 7 Objective (d)_ Which of the following is the objective of integrated enterprise * Countermeasures: Actions to be taken to pI 5g reduce, or transfer the risk. This may include makin emergency planswm oor Veput’s™ Risk Management fyi Policymakers have subsequently become increasingly aware of the importance of risk communication and g meeting public expectations of risk governance. Importance of Risk Governance: * edundancy and in competenci r ae capital to bogie eee aes , Improved effectiveness: GRC activities are directed to improve overall competence of people and ~ . Protected reputation: When risks are managed more effectively, company reputation is enhanced, |» Reduced costs: Effective GRC activities results into lower costs which contribute to the overall ROI (Return on Investment) gains SCOPE OF RISK GOVERNANCE: ‘The scope of the Company's risk management policies, rocedures and controls is to: ink the identification and management of risk to the achievement of business strategy and objectives; + Analytically identify and proactively manage risk; + Train employees to take responsibility for managing risk and be trusted to make risk management * Itis concerned in particular with the roles of the board, Senior management, and risk management control the processes by which risk analysed and communicated to yr management decisions. * It is also concerned with the effects of organizational culture on risk-taking behaviours and sensitivities of tisk in the institution. * It deals with increasingly complex business operations ed with the capacity of institutions to respond swiftly to changes in the Operating environment and developments in th institution’s business strategies,mw ww Vina Rk Monagemen ye Some of the key policies processes oF contra, adopted by the Company for management of materia business risks are: = Arisk management policy approved by the Board) ang performance and significant including comparisons with prior viewer soraViput’s™ Risk Mar verance 146 ger mae (FC : 2 k management is forecast (2) Second line of defence , isl : ‘The second line that could delay the Bi es managing risks 2 objectives. 0 /achiowe itn | compliance with the company's notes procedures, laws and regulations, ees die i: " . ficient governance iS considered key to an success. Seanteation's: risk management practices by nd assists the risk owners jy reporting tolerable risk related information up and down |. GRC is a discipline that aims to coordinate i ; the organisation. information and activity across governance, risk management and ice in order to operate more efficiently, enable information sharing, more effectively report risk-based approach to Although intra differently in various i organizations, GRC typically include activities such as corporate governance, enterprise risk management (ERM) and corporate compliance with applicable laws and regulations. It includes all elements of an instituti + Organizations reach a size where coordinated control framework and all cat over GRC activities is required to operate successfully. Such as Strategic, ct : Each of these three disciplines creates information of i value to the other two, and all three impacts the same technologies, people, processes and information. Basic Concept of GRC: 6.3 RISK MANAGEMENT AND CORPORATE GOVERNANCE: * Governance, Risk Management, and Cx* Governance of risk management is the attention iver 148 or making and provide the control mechanisms to engin, that strategies, directions and instructions, Management are carried out systematically gut effectively. Viput’s™ Risk Monogement (ayy to preventing excessive risk management by Keeping jn mind the organization's capacity for risk. Suffeieny Gountermeasures are required rather than excessive uunnecessary and pointless measures. The threat ig thay the good intentions become wasteful expenditure op barriers to growth, innovation and opportunity, India. The next significant event was the Confederation of Indian Industry (Cll) Code for Desirable Corporate Governance developed by @ committee chaired by Rahul Bajaj. The Birla committee submitted its report in early Risk management is the set of processes through which management identifies, analyses, and, where necessary, Fesponds appropriately to risks that might unfavourably affect realization of the organization's business objectives. The response to risks typically depends on their perceived seriousness, and involves controlling, avoiding, accepting or transferring them to @ third party. Whereas organizations routinely manage @ wide range of risks (e.g. technological risks, commercial/ financial risks, information security risks @te.), external legal and regulatory compliance risks are certainly the key issue in GRC. o Compliance means conforming to stated requirements. At an organizational level, it is achieved management processes which identi requirements (defined for ¢3 contracts, strategies and compliance and asses 2000 and the second committee submitted its report in 2003. The recommendation of these two committees had been instrumental in bringing major changes in the corporate governance through the formulation of Clause 49 of the Listing Agreement. Along with SEBI, the Department of Company Affairs and the Ministry of Finance, Government of India, also took some initiatives for improving corporate governance in India.Virus Rik Monoremen yy scam in the history m Computer Servicgs ia, was founded jy The company was offering vices crossing various New York Stock Exchange ork covered 67 countries ‘across six continents. The company employed 40,000 Ip professionals across development centres in India, the United States, the United Kingdom, the United Arab Emirates, Canada, Hungary, Singapore, Malaysia, China, Japan, Egypt and Australia. It was serving over 654 global companies, 185 of which were Fortune 500 corporations, Satyam had tactical technology and marketing alliances with over 50 companies. Apart from Hyderabad, it had development centres in India at Bangalore, Chennai, Pune, Mumbai, Nagpur, Delhi, Kolkata, Bhubaneswar, and Visakhapatnam. In September 2008 the World Council for ‘Corporate Governance honoured the Satyam with a “Golden Peacock Award” for global excellence in corporate governance. On January 7, 2009, Satyam scandal was publicly announced & Mr. Ramalingam confessed and notified SEB ‘of having falsified the account. Raju confessed that Satyam’s balance sheet as on 30 September 2008 understated liability of Ry funds. 1,230 ‘Crore on account (4) An overstated debtors position of inst Rs. 2,651 reflected in the ea oe “a an actual operating margin of Rs. 61 crore (3% of revenues). This has resulted in artificial cash and bank balances going up by Rs. 588 crore in Q2 alone. acknowledged that the gap in the balance sheet had of investor's to prevent an attempt by the minority cholding promoters to use the firm’s cash reserves to buy two companies owned by them i.e. Maytas Properties and Maytas Infra, Raju wanted to buy the entire stake in Maytas Properties for $1.3 billion and 51% stake in Maytas Infra for $300 million to cover the scam he was cooking,” “an attempt of © 7 rn led to a downfall