Amulya Rout

Financial Risk
Risk is Multidimensional

Market Risk

Financial Credit Risk

Risks

Operational Risk
 Market Risk
What is Market Risk?
Market Risk is the risk of losses on financial investments caused by
adverse price movements.
Examples of market risk are changes in:
a. Equity prices
b. Commodity prices
c. Interest rate
d. Foreign Currency fluctuations.
➢ Market risk is one of the three core risks that all banks are required
to report and hold capital alongside Credit and Operational Risk.
➢ The standard method for evaluating market risk is Value at Risk
(VaR).
➢ The possibility of loss to a Bank is caused by changes in market
variables.
 Market Risk
What is Market Risk?
▪ Risk to the Bank’s Earnings is due to changes in the market level
(Asset & Liabilities including Contingent Liabilities).
▪ It could be change in Interest rates or prices of Securities,
Inflation, Equities, Foreign Exchange, Commodities & Socio
Political Situation & as well as volatilities in the Equity Index
prices.
▪ Market risk is the most prominent for banks present in
investment banking.

In essence, market risk is the risk arising from changes in the

markets to which the Bank /Financial Institution /Organization
has exposure.
 Market Risk
The six standard Market Risk factors include:
1. Equity Risk
2. Currency Risk
3. Commodity Risk
4. Interest Rate Risk
5. Inflation Risk
6. Socio Political Risk
 Market Risk
Banks & Financial Institutions considers, market risk is the
potential volatility in its income due to changes in market
conditions such as interest rates, liquidity, economic growth etc.
It is typically measured for a time period of one year or less.
Reasons for Market Risk Measurement
1. Management information
2. Setting trading limits
3. Resource allocation
4. Trader and management performance measurement
5. Regulatory capital requirements.
 Market Risk
Two broad types:
▪ Directional risk
▪ Non-Directional Risk
▪ Relative value risk

It can be differentiated into two related risks:

▪ Price risk
▪ Liquidity risk
 Market Risk
Directional risk
➢ Directional risk is caused due to movement in stock price,
interest rates and more.
➢ Directional trading involves making bets on the price
movements of a stock
➢ Directional risks are those risks where the loss arises from an
exposure to the particular assets of a market.
➢ An investor holding a Long Position experiences a loss if
market prices fall and a gain if they rise; one holding a Dhort
Position generates a gain when market prices fall and a loss as
they rise
Example:
An investor holding some shares experience a loss when the
market price of those shares falls down.
 Market Risk
Non-Directional Risk
➢ Non-Directional risk, on the other hand, can be volatility risks.
➢ Non-directional trading is a unique approach that focuses on
generating profits from volatility and time decay in the options
market.
➢ Non-Directional risk arises where the method of trading is not
consistently followed by the trader.
Example:
The dealer will buy and sell the share simultaneously to mitigate
the risk
 Market Risk
Relative value risks
➢ Relative value is a method of determining an asset's
worth that takes into account the value of similar assets
and comparing with the price, yield, or risk of different
assets.
➢ This is in contrast with absolute value, which looks only at
an asset's intrinsic value and does not compare it to
other assets.
➢ There are different ways to measure relative value,
including price-to-earnings ratio, price-to-book ratio, and
yield spreads.
 Market Risk Measurements
Two broad type of measurements:
1. Scenario analysis
2. Statistical analysis
 Market Risk
Scenario Analysis
▪ Scenario analysis is the process of estimating the expected
value of a portfolio after a given change in the values of key
factors take place.
▪ Both likely scenarios and unlikely worst-case events can be
tested in this fashion—often relying on computer simulations
▪ A scenario analysis measures the change in market value that
would result if market factors were changed from their current
levels, in a particular specified way. No assumption about
probability of changes is made.
▪ A Stress Test is a measurement of the change in the market
value of a portfolio that would occur for a specified unusually
large change in a set of market factors.
 Market Risk
Statistical Analysis
▪ Statistical techniques are analytical tools for handling risky
investments. These techniques, drawing from the fields of
mathematics, logic, economics and psychology, enable the
decision-maker to make decisions under risk or uncertainty.
▪ The concept of probability is fundamental to the use of the
risk analysis techniques.
▪ How are probabilities estimated? How are they used in the
risk analysis techniques?
▪ How do statistical techniques help in resolving the complex
problem of analyzing market risk?
 Market Risk: Trading Book
Trading book of a Bank consists of:
a. Debt Securities
b. Equity
c. Foreign Exchange Securities
d. Commodities
e. Derivatives held for trading
 Market Risk: Trading Book
a. Debt Securities
Debt securities are issued by governments and corporations and
sold to investors as fixed-income debt assets with an associated
coupon rate.
➢ Debt securities are debt assets traded between two parties
before their maturity date.
➢ Securities are treated as financial assets that pay a regular
income stream and are therefore referred to as fixed-income
securities.
➢ Government bonds, US treasury bills, and corporate bonds
are the most common examples of securities in the US.
➢ Government bonds are considered the safest form of debt
securities.
 Market Risk: Trading Book
Risk in Debt Securities
Issuer defaults on their debt.
➢ If the issuer experiences financial hardship, they may no
longer be able to make interest payments on their
outstanding debt.
➢ They may also not be able to repurchase their outstanding
debt at maturity, particularly if they go bankrupt.
 Market Risk: Trading Book
Debt Securities vs Equity Securities vs Loans

Basis Debt Security Equity Security Loans

Meaning Governments and These are shares of These are
corporations issue a company listed on treated as
bonds and treasury the stock exchange. liabilities.
bills to raise capital.

Significanc It is a loan to the It signifies It is a debt

e issuer. ownership in the agreement
company. between a
lender and a
borrower.
Maturity It usually comes No maturity date is Typically comes
with a maturity applicable. with a fixed
date. loan tenure.
 Market Risk: Trading Book
Debt Securities vs Equity Securities vs Loans
Basis Debt Security Equity Security Loans

Return It yields a fixed Returns vary It comes with

return with a fixed depending on market either a fixed
rate of interest. conditions, stock interest rate or a
performance, and floating interest
dividends. rate.
Rights Securities do not Voting rights are The lender has the
offer voting rights. present are available right to seize the
for equity securities. collateral in case of
default payments.

Example US treasury bills, Stock holdings and Personal loans, car

bonds, T-notes, and company ownership. loans, home loans,
commercial papers. education loans,
etc.
 Market Risk: Trading Book
b. Equity Securities
Equity securities are financial assets that represent shares of
ownership.
➢ The most prevalent type of equity security is the common stock.
➢ Owner(s) of an equity security represent part ownership of the
issuing company.
➢ You expect to gain from what could hopefully be an increase of the
issuing company’s earnings and assets.
➢ If you own 1% of the total shares, or security stocks, issued by a
company, your part ownership of the controlling company is
equivalent to 1%.
➢ Other assets, such as mutual funds or ETFs, may be considered
equity securities as long as their holdings are composed of pooled
equity securities.
 Market Risk: Trading Book
Equity Risk is "the financial risk involved in holding Equity in a
particular investment.”
Equity Risk Premium also referred Equity Premium, is the excess
return that investing in the stock market provides over a risk-free
rate, such as the return from government treasury bonds.
This excess return compensates investors for taking on the
relatively higher risk of equity investing.

Equity Returns comes from

➢ Income
➢ Growth of dividends and /or earnings
➢ Valuation /re-pricing
 Equity Risk Premium (ERP)
ERP is very critical in finance and investment
➢ Equity risk premium is calculated as the difference between
the estimated real return on stocks and the estimated real
return on safe bonds.
➢ It can be calculated by subtracting the risk-free return from
the expected asset return.
➢ ERP is a long-term prediction of how much the stock market
will outperform risk-free debt instruments.

Three steps of calculating the risk premium:

a. Estimate the expected return on stocks.
b. Estimate the expected return on risk-free bonds.
c. Subtract the difference to get the equity risk premium.
 Equity Risk Premium (ERP)
There are multiple ways of estimating it:
a. Earning Based Approach
b. Dividend Based Approach
Calculating the risk premium can be done by taking the
estimated expected returns on stocks and subtracting them from
the estimated expected return on risk-free bonds.

Investors mostly rely on supply or forecast ERP in order to

evaluate the befit of Riskier Investment.
 Equity Risk Premium (ERP)
Why do I need to calculate equity risk premium?
➢ To avail yourself of stocks that are undervalued, offering a
potential bargain buying opportunity.
➢ To avoid stocks that are overvalued by the many metrics
outlined above.

ERP and market risk premium are often used interchangeably;

however, the former refers to stocks while the latter refers to
all financial instruments.

One might have the right stock in mind, but wouldn’t it be

great if it had some statistical background to catch it at the
right level (undervalued) as opposed to the wrong level
(overvalued).
Equity Risk
Steps to build the portfolio
➢ Determine the appropriate asset allocated
➢ Achieving the portfolio
a. Stock Picking (cherry picking)
b. Bond Picking
c. Mutual Fund
d. Exchange Treaded Funds
➢ Reassessing Portfolio Weightage (small cap, mid cap, large
cap, PSU and sectors like Pharma, Textiles, Cement etc….)
➢ Rebalancing strategically
 Equity Risk
Consider auto Diversification
Particulars Nature of Investment % of Investment

Conservative Fixed Income Securities 70 to 75

Equities 15 to 20

Cash or Cash equivalent 5 to 15

Aggressive Fixed Income Securities 25 to 40

Equities 50 to 55

Cash or Cash equivalent 5 to 10

 Market Risk: Trading Book
c. Foreign Exchange Securities
Foreign exchange reserve or exposure of banks /Fis are termed
as Foreign Exchange Securities.

➢ Foreign Exchange (Forex) venues comprise the largest

securities market in the world by nominal value, with trillions
of dollars changing hands each day.
➢ Forex trading uses currency pairs, priced in terms of one
versus the other.
➢ Forex traders seek to profit from the continual fluctuations of
currency values.
 Trading Risk
a. Front Office (Dealers): Risk origination
b. Mid Office: Risk Management
c. Back Office: Settlements

Risks Involved in Forex Trading

➢ You can lose more than your initial deposit.
➢ Forex trading – like any form of trading – is not without risk.
➢ Some may even suggest that trading in the forex market actually
carries above-average risk.
➢ The one rule you must hold above all else is to trade only using
your risk capital.
➢ In other words, never trade more than you can afford to lose.
 Trading Risk
▪ Leveraged trading carries a high degree of risk
▪ Risks of trading multiple markets
▪ Risks associated with a Margin Close Out
When does a Margin Close Out happen?
➢ If account falls below 50% of the initial margin, all open positions will
be liquidated using the current rates at the time of closing.
➢ Margin Closeouts can help prevent the possibility of a loss exceeding
investment. But in fast moving markets, losses can exceed the capital.
➢ Having multiple trades open concurrently can increase the risk of a
margin closeout due to an inability to follow many open positions
simultaneously.
➢ A sudden or significant movement in one of the instruments may
adversely affect your margin levels for your entire account.
➢ By reducing your account leverage you impose a higher margin
requirement on each trade, which ultimately keeps you further away
from a margin closeout.
 Trading Risk
Risk associated with Volatility and Liquidity
▪ Market Volatility
▪ Liquidity

Deal Only with Reputable Forex Brokers

 Unfortunately, in the early days of online forex trading, fraud was an all-
too common problem.
 Great inroads have been made to clear out unscrupulous brokers, but
you must still exercise caution when selecting a new broker.
Insist Upon Regulation
 When reviewing a forex broker, insist upon regulation.
 You should only trade with a broker that is a member in good standing
with a recognized regulator such as those listed in the table below:
 Trading Risk
Risk Management Techniques For Active Traders
▪ Planning Your Trades
▪ Stop-Loss and Take-Profit Points
▪ Calculating Expected Return
▪ This can be calculated using the following formula

[ (Probability of Gain) x (Take Profit % Gain) ] + [ (Probability of

Loss) x (Stop Loss % Loss) ]

▪ Stop-Loss and Take-Profit Points

▪ The Bottom Line
▪ What Do Other Investors Know That You Don't?
 Commodity Risk
d. Commodity Securities
➢ Commodity Linked Securities also termed as Commodity
Securities are investment instruments or securities that are
linked to one or more commodity prices.
➢ Commodities, which provide no viable income to the owner,
commodity linked securities usually give some payout to
holders.

Commodity Linked Securities are:

▪ Commodity Linked Bonds
▪ Commodity Linked Equities
 Commodity Risk
Commodity Linked Bonds (CLB)
➢ CLB are securities offered by Govts whose yield depends on
the price of a specific commodity or a global inflation index.
➢ Historically, Govts offered loans with coupons or principal
indexed to the price of a specific good or a global inflation
index during times of high inflation.
➢ CLB include an explicit indexation clause, i.e., the bond, by
construction, is linked to the price of a commodity or a set of
commodities.

The United States first offered Inflation-Indexed Securities in 1997 when the
US Treasury introduced the Treasury Inflation Protected Securities (TIPS. The
first TIPS was a 10-year government bond that provided a real return of
3.45%.
 Commodity Risk
Commodity Linked Equities (CLE)
➢ Commodity linked securities is equity issued by companies whose
value depends on the price of a commodity or several
commodities.
➢ Commodity linked equities include an implicit indexation clause,
i.e., the stock is implicitly linked to the price of a commodity or set
of commodities through the market.
➢ Oil companies often take advantage of economies of scale and
reduce such risk through expansion and vertical integration.
➢ Gold mining companies are directly affected by the evolution of
gold prices. Unlike gold-linked bonds that contain an explicit
indexation clause (via a contract), the value of a gold mining
company depends on mining economics, i.e., the cost of extracting
gold vs. the revenue generated by the extracted gold.
 Commodity Risk
Commodity Exchanges in India

1. Multi Commodity Exchange Mumbai

2. National Commodity and Derivatives Exchange, Mumbai
3. National Multi Commodity Exchange (NMCE), Ahmedabad
4. Indian Commodity Exchange (ICEX), New Delhi
5. ACE Derivatives & Commodity Exchange Limited, Mumbai
6. Universal Commodity Exchange Limited, Navi Mumbai.
 Commodity Risk
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.

Commodities generally fall into three categories:

▪ Soft commodities include agriculture products such as

wheat, coffee, sugar, fruit etc
▪ Metals include gold, silver, copper and aluminium.
▪ Energy commodities include gas, oil and coal
 Commodity Risk
Types of commodity risk
➢ Price risk
➢ Quantity risk
➢ Cost (input) risk
➢ Political risk

Groups Exposed to Commodity Risks

➢ Producer
➢ Buyer
➢ Exporter /Seller
 Commodity Risk
Methods to measure commodity risk
➢ Sensitivity analysis
➢ Portfolio approach
➢ Value at Risk (‘VaR’)

Commodity Risk Management:

➢ Trading happens on exchanges with total transparency,
therefore there is little to no danger of counterparty risk.
➢ The exchanges enforce proper risk management protocol
in order to protect the investors.
 Commodity Risk
Producers of Commodities
➢ Strategic Risk Management
▪ Diversification (single product & multiple product)
▪ Flexibility (off season & on season)

➢ Price Risk Management

▪ Production contracts
▪ Pooling
▪ Storing
▪ Off take contracts
 Commodity Risk
Financial Market instruments to manage Commodity Risk
➢ Forward Contracts
➢ Futures contracts
➢ Commodity options
➢ Commodity swaps
Forward contracts are agreements to purchase or sell a specified amount of a
commodity on a fixed future date at a predetermined price. Physical delivery is
expected and actual payment occurs at maturity (the future date agreed to in
the contract).
Futures contracts are similar to forward contracts in that they are agreements to
purchase or sell a given quantity of a commodity at a predetermined price, with
settlement expected to take place at a future date.

However, unlike forward contracts, settlement of a futures contract

does not necessarily require physical delivery.
 Derivatives Held for Trading
e. Derivatives held for trading
Financial derivatives are securities / financial instruments that
are also part of the trading book.
➢ Financial derivatives are linked to a specific financial
instrument or indicator or commodity, and through which
specific financial risks can be traded in financial markets in
their own right.
➢ Transactions in financial derivatives should be treated as
separate transactions rather than as integral parts of the
value of underlying transactions to which they may be
linked.
➢ The value of a financial derivative derives from the price of
an underlying item, such as an asset or index.
 Derivatives Held for Trading
Derivatives held for trading
I. Futures
II. Options
III. Forwards
IV. Swaps
 Derivatives Held for Trading
I. Futures
A Futures Contract on a stock market index represents the right
and obligation to buy or to sell a portfolio of stocks characterized
by the index.

Stock Index Futures are cash settled.

▪ That is, there is no delivery of the underlying stocks.
▪ The contracts are marked to market daily.
▪ On the last trading day, the futures price is set equal to the
spot index level and there is a final mark to market cash flow.

Stock index futures were introduced in 1982 on domestic futures

exchanges and have since grown to become perhaps the 2nd most
significant sector, after interest rates, within the futures trading
community.
 Derivatives Held for Trading
Stock Index futures have revolutionized the art and science of
equity portfolio management as practiced by:

▪ Mutual funds
▪ Pension plans
▪ Endowments
▪ Insurance company
▪ Other money managers
 Future Index Risk
There are three main reasons why index futures are being
traded:
▪ Leveraged Speculation
▪ Hedging
▪ Arbitrage.
Risks of Index Futures
▪ The single most significant risk of trading Index Futures is
that fact that you can lose more than the money you initially
started the trade with.
▪ If you are long a Index Futures position and the stock drops
drastically in a single day.
▪ This is how many multi-billion dollar companies collapsed
overnight trading futures.
 Derivatives Held for Trading
II. Options:
Options are derivative contracts that give the buyer a right to
buy/sell the underlying asset at the specified price during a
certain period of time.
➢ The buyer is not under any obligation to exercise the option.
➢ The option seller is known as the option writer.
➢ The specified price is known as the strike price.
➢ You can exercise American options at any time before the
expiry of the option period.
➢ European options, however, can be exercised only on the date
of the expiration date.
 Derivatives Held for Trading
III. Forwards:
Forwards are like futures contracts wherein the holder is under
an obligation to perform the contract.
➢ Generally forwards are un-standardised and not traded on
stock exchanges.
➢ These are available over-the-counter and are not marked-to-
market.
➢ These can be customized to suit the requirements of the
parties to the contract.
 Derivatives Held for Trading
IV. Swaps:
Swaps are derivative contracts wherein two parties exchange
their financial obligations.
➢ The cash flows are based on a notional principal amount
agreed between both parties without exchange of principal.
➢ The amount of cash flows is based on a rate of interest.
➢ One cash flow is generally fixed and the other changes on the
basis of a benchmark interest rate.
➢ Interest rate swaps are the most commonly used category.
➢ Swaps are not traded on stock exchanges and are over-the-
counter contracts between businesses or financial
institutions.
 Expected Loss
 The expected loss (EL) is the amount that an institution
expects to lose on a credit exposure over a given time horizon.
 EL = PD x LGD x EAD
 If we ignore correlation between the LGD variable, the EAD
variable and the default event, the expected loss for a
portfolio is the sum of the individual expected losses.
 How should we deal with expected losses?
 In the normal course of business, a financial institution
should set aside an amount equal to the expected loss as a
provision.
 Expected loss can be built into the pricing of loan products.

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 Unexpected loss

 Unexpected loss is the amount by which potential credit

losses might exceed the expected loss.
 Traditionally, unexpected loss is the standard deviation of the
portfolio credit losses.
 But this is not a good risk measure for fat-tail distributions,
which are typical for credit risk.
 To minimize the effect of unexpected losses, institutions are
required to set aside a minimum amount of regulatory
capital.
 Apart from holding regulatory capital, however, many
sophisticated banks also estimate the necessary economic
capital to sustain these unexpected losses.

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 Stress Losses
 Stress losses are those that occur in the tail region of the
portfolio loss distribution.
 They occur as a result of exceptional or low probability events
(a 0.1% or 1 in 1,000 probability in the distribution below).
 While these events may be exceptional, they are also plausible
and their impact is severe.

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 Stress Testing
What happens when price changes are extreme?
➢ Extreme movements in the basic market factors are more
frequent than under Normal distribution
➢ Uncertainty on the correlation between the basic market
factors
➢ Extreme events rarely repeat themselves in the same
way
➢ Changing distributions over time
➢ Set of hypothetical extreme markets scenarios, and they
price effect

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Thank You