Financial Risk

Management
MBAFT - 7410

By
Narain
narain@fms.edu
Course Objectives

This course will look at banking and

financial markets from a risk
management perspective with
primary focus on measurement,
management and regulation
regarding different components of
risks
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Course Content
❑ Introduction to Financial Institutions
❑ Risk Analysis for FIs

❑ Management of Market Risks

❑ Management of Credit Risks

❑ Management of Liquidity Risks

❑ Management of other Institutional Risks

❑ Integration to Enterprise Risk

Management
Narain
Texts for Reading
❑ Saunders, Cornett & Erhemjamts –
“Financial Institutions Management
– A risk management approach”
❑ Resti & Sironi – “Risk management
and shareholders’ value in banking”
❑ Rose & Hudgins – “Bank
management and financial
services” Narain
Texts for Reading
❑ IIBF-“BankFinancial Management ”
❑ Paul & Suresh – “Management of
Banking and Financial Services ”
❑ Subramanyam – “Investment
Banking ”
❑ Chapter based reading content
❑ https://nptel.ac.in/courses/110106040
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 Internal Assessment
30 marks trifurcated into –
❑ 5 marks for class participation
– Proxied by attendance
– Formula in Course Booklet
❑ 15 marks for assignments
– Will be intimated in due course
❑ 10 marks for class tests
– Post Mid-session

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Finance?

FINANCE is concerned with the process,

institutions, markets, instruments,
technology and services involved in the
transfer of money, among and
between, individuals, businesses and
Governments.

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Segments of Finance

Financial Process

Financial Institutions

Financial Markets

Financial Instruments

Financial Services

Financial Technology

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Financial System perspectives
❑ Basis of segmentation –
– Constituents
– Participants
❑ Economic & Financial Developments
– A Chicken & Egg Problem
❑ Institutionalperspective to look at
the financial system
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Institutional segmentation

Financial
Institutions

Regulators Operators

Non -
Governmental SROs Depository
Depository

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FINANCIAL INTERMEDIATION

Financial intermediation is the

process of facilitating the
flow of funds from entities
that have excess funds to
those entities that need it.

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Kinds of Intermediation
❑ Denomination Intermediation
– Small savings into large loans
❑ Default Risk Intermediation
– Averse savers to risky borrowers
❑ Maturity Intermediation
– Short/long term lenders to tenure borrowers
❑ Liquidity Intermediation
– Liquid savers to less liquid borrowings
❑ Information Intermediation
– Less informed lenders to informed borrowers
❑ Currency Intermediation
– Rupee savings to dollar loans Narain
Intermediary Institutions: Banks

❑ Commercial Banking
– Plain Vanilla banking

❑ Investment Banking
– Capital intermediation

❑ Shadow Banking
– Liquidity intermediation
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Financial intermediaries in India
❑ Commercial Banks
❑ Merchant banking, Underwriting

❑ M&A Advisory

❑ Corporate Advisory

❑ Securities broking

❑ Asset Management Services

❑ Investment Advisory & Wealth

Management
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Financial intermediaries in India
❑ Development Financial Institutions
❑ Insurance Companies

❑ NBFCs

❑ Pension Funds

❑ Private Equity

❑ Hedge Funds

❑ Recent trends: disintermediation

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 FLOW OF
FUNDS
STATEMENT
Financial Assets
❑A financial asset is a paper claim on
some other economic entity
❑ Financial assets are held for –
1. Store of value
2. Returns expected there from
❑ It does not entitle any real assets
– Except equity shares

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Need for Financial Assets
❑ Whenever the investment of an
economic entity in real assets
exceeds its savings
❑ The need arises for external financing
through –
1. Borrowing
2. Issuing Equity shares
3. Issuing money
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Main Economic Sectors

❑ Households

❑ Non-Financial Business Firms

❑ Governments

❑ Financial Institutions
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Forms of Savings by entities
❑ By individuals
– Savings A/c, loan repaid, life
premiums, retirement contributions
❑ By corporations
– Retained earnings, depreciation
❑ By governments
– Budget surplus (or deficit)

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Savings – Investments of Entities
❑ For a given period of time, total use of
funds by an economic entity must equal
its total sources.
Sources of Funds Uses of Funds
Borrowings Real Asset investments
Equity issues Lending
Money issues Equity investments
Depreciation Change in money held
Net savings

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Savings – Investments of an Entity

❑ Net savings for an economic entity

equals
1. Net savings through Financial Assets
2. Net savings through Real Assets

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Saving – Investment of Economy
❑ For the economy as a whole in a time
period, ex post savings must equal ex
post investment in real assets, S≡I
❑ Thus, changes in Financial Assets for
the period must cancel out when
summed for all economic entities in the
economy
– No financial savings for economy

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Saving – Investment of Economy
❑ Ex ante savings need not equal ex
ante investment
❑ The equilibrating process affects –
– Interest rates
– Interaction among entities
❑ The state of equilibrium is depicted
by the Flow of Funds statement
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Flow of Funds Statements
❑ Flow of funds is a system of social
accounting that enables one to
evaluate savings flows among
various sectors in the economy
❑ National income accounts and Flow
of funds accounts
– Real and financial sides of economy

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Structure of Flow of Funds system
❑ Flow of Funds statement of an
economy is prepared for a period
of time by –
1. Preparing Funds flows for each Sector
2. Aggregation of flows for all the
Sectors
3. Presenting the information in a Flow
of Funds matrix

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Sectoring in India

1) Banking
2) Other Financial Institutions
3) Private Corporate Business
4) Government
5) Rest of World
6) Households
7) Unclassified sector
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Sectoral Sources and Uses Statements

❑ Starting point is the opening Balance

Sheet of each sector
❑ Cancel intra – sector financial assets
during aggregation but not real assets
Sector A
As on January 1st of the year ….
Liabilities Assets
Financial Liabilities Money
Net Worth Other Financial Assets
Real Assets
Total Total Narain
Sectoral Sources and Uses Statements

❑ Sources and Uses of Funds statement

of each sector is the statement of
changes in stocks on two Balance Sheet
dates
Sources & Uses of Funds by Sector A
for the year ….
Liabilities Assets
Δ Financial Liabilities Δ Money
Δ Net Worth Savings Δ Other Financial Assets
Δ Real Assets
Total Total Narain
 Flow of Funds Matrix
Business Financial All
Households Governments
firms institutions sectors
S U S U S U S U S U
Net Worth
200 100 10 -8 302
(Savings)
Real Assets
130 160 12 302
(Investments)

Money 25 5 34 4 34 34
Other
Financial 95 15 128 28 266
Assets
Financial
50 80 96 40 266
Liabilities

250 250 180 180 140 140 32 32 602 602

Indian Flow of Funds Accounts
❑ RBI publishes Detailed Flow of Funds
Accounts since 1964
❑ Flow of Funds accounts are published –
1. Sector – wise
2. Instrument – wise
❑ Financial claims are amenable for
grouping into certain Instruments
– Besides the sectors to which it pertains

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Instruments classes in India
❑ Currency & Deposits
❑ Investments
1. Govt. Securities
2. Corporate Securities
3. Bank Securities
4. Mutual Funds
5. Foreign Securities
❑ Loans & Advances

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Instruments classes in India
❑ Small Savings
❑ Life Fund

❑ Provident Fund

❑ Compulsory Deposits – now withdrawn

❑ Trade Debt/Credit

❑ Foreign Claims

❑ Other unclassified items

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 Financial Flows: Sector-wise
Financial
Banking Governments ….. Total
institutions
S U S U S U S U S U
Banking 0 0
Other Financial
Institutions
468 5

Private
Corporate 490 2402
Business
Government 2055 2277
Rest of World 341 3564
Households 4422 1644
Unclassified 529 1381
Total 8305 11273

(sources –uses) -2968 Financial Surplus (-) and Financial Deficit (+)
 Financial Flows: Instrument-wise
Financial
Banking ….. Total Discrepancy
institutions
S U S U S U S U (S – U)
Currency 731 1

Investment 18 541

Loans &
Advances
36 449

Life Fund 0 0
Provident Fund 0 0
….

Unclassified 41 134
Total 830 1127
Flow of Funds 2019-20
Flow of Funds 2020-21
Benefits of Flow of Funds A/c
❑ Identification of surplus/deficit sectors
❑ Sectoral linkages

❑ Judges the efficacy of Monetary Policy

❑ Locates sectors requiring remedial

actions
❑ Indicates pressure points in economy

❑ Meaningful scenario creation by

monetary authorities
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Problems with FoF Statements

Differences in –
– Valuation
– Timing
– Concept
– Classification
– Accounting period
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STATEMENTS OF
A FINANCIAL
INSTITUTIONS
- BANK
Guiding rules for Banks
❑ Third schedule of Section 29 of Banking
Regulation Act
❑ 12 schedules in the Balance Sheet
❑ 4 schedules in the Income Statement
❑ 2 schedules for Provisions & contingencies
and significant accounting policies
❑ A uniform pattern of presentation & disclosure
❑ Cash flow statement, subsidiary accounts etc

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A hypothetical Balance Sheet

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Balance Sheet: Major Assets

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Schedule 8 Investments
A hypothetical Profit & Loss A/c
Profit & Loss A/c: Major Revenues
Schedule 13 Interest Earned
Schedule 14 Other Income
Net Income of FIs
Bank’s net income is dependent on:
❑ Net Interest Income
o Interest from lending – Interest paid on
deposits
❑ Burden
o Non-Interest Income – Overhead expenses
❑ Provisions for loan losses and market risk

❑ Profit or loss from sale of securities / assets

❑ Taxes

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Fund Flow: Application & Uses
Source of Funds
❑ Shareholders’ funds
❑ Reserves

❑ Borrowings
– Inter-bank
– Special agencies
❑ Loanable funds
– Time & Demand deposits – FD/CASA
– Certificate of Deposits – CDs
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Application of Funds
❑ Loans
– Cash credit/overdrafts
– Term loans
– Purchase/discounting of commercial bills
❑ Investments
– Govt. securities
– Approved securities
– Equity / preference shares
– Debentures & bonds
– Subsidiaries and/or joint ventures
– Other investments
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Application of Funds ….
❑ Fixed Assets
– Premises
– Furniture, fixture & other fixed assets
– Assets on lease
❑ Other assets
– Interest accrued
– Assets acquired in ‘satisfaction of debt’
❑ Money at call
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Features of these statements
❑ Short term sources of funds
❑ Higher financial leverage

❑ Lower operating leverage

❑ Proportion of fixed assets is very low

❑ Higher investments in interest rate

sensitive assets – Loans & Advances or
Investments
❑ Cost of funds changes with the change in
the deposit rates
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ANALYSIS OF BANK STATEMENTS
Performance Metrics
❑ For Profit or Not for Profit only
– Value or KPIs

❑ Single or Multiple
– Challenges

❑ Value metric
– For whom

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 Value Spectrum across stakeholders
Value Added Enterprise Net Net Income to
Income Net Income to Net Income to
Investors Shareholders Residual Income
Equity (EVA)

Employees, Govt., Lenders, Preference Equity Equity

Government, Lenders, Shareholders Shareholders, Shareholders Shareholders

Lenders, Shareholders Equity

Shareholders Shareholders

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Value Addition

❑ Value added is the market price of the output

of an enterprise less the price of the goods
and services acquired by transfer from other
firms
❑ This is the total pie that can be divided
among the various contributors
– Employees, owners, creditors and governments
❑ Thus, it includes –
– Wages, interest, taxes, dividends and retentions

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58
Value Addition
Value Added measure represents –
❑ Firm’s contribution to National Income

❑ Productivity of firm

❑ Effective measure of firm size

❑ Co-operating group of stakeholders

❑ Useful in turnaround situations

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59
Statement of Financial Performance

Sales 1,000
Goods & Services bought 500
Wages & Salaries 300
EBITDA 200
Depreciation 100
EBIT 100
Interest 50
PBT 50
Taxes 10
PAT 40
Dividend 5
Earnings Retained 35
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60
Sales 1,000
Goods & Services 500
bought
Depreciation 100
Value Generated 400
Value
Value Distributed: Added
To workforce 300
To Government 10
Statement
To lenders 50
To Shareholders 5
Re-invested in firm 35
400
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Spectrum of Financial Performance
Sales 1,000
Goods & Services bought 500
Depreciation 100
Value Added 400
Wages & Salaries 300
Enterprise Net Income 100
Taxes 10
Net Income to Investors 90
Interest 50
Net Income to Equity Shareholders 40
Cost of equity (in amount 10%x₹60) 6
Residual Income (EVA®) 34

If cost of equity is 10% and Shareholders’ Funds are ₹ 60.

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 Income concepts & recipients
❑ Value Added
– Employees, owners, lenders & governments
❑ Enterprise net income
– Stockholders, bondholders & governments
❑ Net income to investors
– Stockholders & long term debt-holders
❑ Net income to shareholders
– Stockholders (preferred & equity)
❑ Net income to residual equity holders
– Equity shareholders
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63
Economic Value Added
❑ Popular measure to determine whether an
investment, proposed or existing, positively
contributes to the owner’s wealth
– Used in AT&T, Coca-Cola, Quacker Oats, etc.
❑ EVA= Operating Profit After Tax – Cost of funds
used to finance an investment
❑ Positive EVA: increases S/Hs value
❑ Numerous accounting & financial issues involved
❑ Relatively simple & strongly linked to owner’s
wealth
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64
 Stakeholders Vs. Shareholders
❑ Employees, creditors, suppliers, customers,
regulators, governments and others having
direct economic link with the firm.
❑ Stakeholders focuses firm – avoiding actions
detrimental to stakeholders
❑ Does not alters the goal of value/wealth
maximisation
– A part of Governance and Social Responsibility

❑ Minimise stakeholder turnover, conflict and

litigation
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65
Stakeholders vs Shareholders

Equity
Shareholders
Management

Equity
Shareholders
Management
Preference
Employees
Shareholders

Preference
Employees
Shareholders

Government Lenders
Government Lenders

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66
 Stakeholders vs Shareholders
Equity
Sharehold
Equity
Manag Sharehold Manag
ement ers ement

Employ Emplo
ees yees
Preferenc
e
Lender Lende
s rs
Governm Preferenc
Governme

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67
Analysing Bank’s financial statements

Performance Metrics –
❑ Traditional way
– RoE approach
❑ Rating Approach
– CAMELS
❑ Sophisticated models
– RAROC/RORAC approach
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RoE Approach

❑ David Cole’s version of DuPont system

❑ Extended by Koch & Mac Donald

❑ RoE= Net Income/Average total equity

= RoA x Equity Multiplier (EM)
= Profit margin x Asset utilisation x
Equity multiplier
❑ NI = Revenue – Expenses – Taxes

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CAMELS Rating
RBI supervision
❑ On-Site inspection
– Domestic Banks – CAMELS
• Capital Adequacy, Asset quality, Management
factors, Earnings, Liquidity, Systems
– Foreign Banks – CACS
❑ Off-Site monitoring & Surveillance
– OSMOS

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KPI for Banks
❑ Efficiency & Expense control ratios
– Cost of funds ratio, burden ratio, productivity
per employee, tax ratio
❑ Liquidity
– Demand-to-Time deposit, cash to demand
deposit ratio, SLR investment
❑ Risk
– Capital adequacy, NPA ratio, equity multiplier
❑ Profitability
– RoE, NIM, Asset utilisation Narain
Data Envelopment Analysis
❑ Used for measuring relative efficiency
❑ Mapping of inputs w.r.t. outputs
❑ Linear programming formulations to compute
efficiency parameters.
❑ Inefficient units can be projected onto the
efficient frontier by reducing their inputs or
increasing their outputs
❑ Virtual units that close to the real ones but
are on the efficient frontier
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Thanks for your time!
Financial Risk
Management
By Narain
narain@fms.edu
Factors of Institutions’ risks
❑ Interest Rate risk
❑ Market risk

❑ Credit risk

❑ Liquidity risk

❑ Off – Balance Sheet risk

❑ Operational risk

❑ Foreign Exchange risk

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Factors of Institutions’ risks

❑ Sovereign risk
❑ Technology risk

❑ FinTech risk

❑ Insolvency risk

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Market risk factors
Systematic components of -
❑ Interest rate

❑ Inflation

❑ Exchange rate

❑ Stock price

❑ Commodity price

❑ Economic cycles
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INTEREST RATE
DETERMINATION
Interest Rate Factor
❑ Directly affects the FIs
❑ One exogenous macroeconomic variable

❑ The level and changes in the level of

the market rate of interest is explained
by following theories –
1. Classical Theory
2. Loanable Funds Theory
3. Liquidity Preference Theory

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Classical Theory
❑ Proposed by Fisher
❑ Interest rate equilibrates the Saving and
Investment
❑ Savings is determined by –
– Marginal rate of time preference
– Level of income & wealth
– Interest rates
❑ Investment is determined by –
– Gains from investment
• Marginal productivity of capital
• Interest rate
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Savings Choice
Future Consumption

Indifference Curve

Market Line

Current Consumption
Investment Choice
Cost Line

Production function
Output

Investment
Interest determination
Savings

Investment
Rate

Saving & Investment

Factors ignored
❑ Role of government
– In creating money

– Making investment irrespective of int. rate

❑ Role of Businesses
– To invest in cash

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Loanable Funds Theory
❑ Demand for and supply of loanable funds
for a given period of time determine the
nominal level of interest rate
❑ Surplus Spending Units (SSUs) are willing
to lend more for a higher rate of interest.
❑ When SSUs lend, they receive primary or
secondary securities as an evidence of
their claims on deficit spending units
– Equivalent to the Demand for securities.
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 Loanable Funds Theory
❑ DSUs borrow more funds at the lower rate of
interest and, in the process, issue primary
securities.
❑ Equilibrium is established where SL=DL
SL
Interest Rate

I’

L’ DL
Loanable Funds Narain
Factors affecting Supply of Funds
❑ Wealth

❑ Risk

❑ Monetary Expansion
❑ Spending needs

❑ Economic conditions
– Inflation, unemployment , growth
– Relative to other economies
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Factors affecting Demand of Funds

❑ Derived Utility
– Derived demand

❑ Covenants on borrowing

❑ Economic conditions

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Loanable Funds Theory
❑ Changed expectations in these factors
alters the level of interest rate –
– By shifting the supply of loanable funds at
every interest rate
– By shifting the demand for loanable funds at
every interest rate
– By shifting both the schedules

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Impact of Inflation on Loanable
Funds Theory of Interest

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Loanable Funds Theory
❑ By deriving the demand & supply of
funds for each type of security or
sector, the equilibrium interest rate in
each section can be determined.
❑ Flow – of – Funds Statements are used
to identify “pressure points” in the
sector to assist analysts in predicting
interest rates.
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Liquidity Preference Theory
❑ The equilibrium basic interest rate is
derived from the demand for & supply of
money at any given period of time.
❑ The demand for money balances to be held
for liquidity to spend later has an
opportunity cost i.e. interest lost; but is
directly related to the income or wealth
❑ The supply of money is fixed by the Central
Bank by changing the CRR, SLR, etc.
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Liquidity Preference Theory
❑ The equilibrium is established where
SM=DM Interest RateS M

I’

M’ DM

Money Balances Narain

Liquidity Preference Theory
❑ The equilibrium equation requires that
S M = DM
M = f (Y , i )
thus , i = h(Y , M )

Where, Y=GNP
M=money supply
i=int. rate
❑ Money supply effects – Liquidity, Income
and price expectation effect
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INTEREST RATE
RISK
MEASUREMENT
HOW TO VALUE A BOND?
❑ WHY DOES A PERSON PAY FOR BOND?
• BECAUSE IT GIVES FUTURE STREAM OF CASH FLOWS.
❑ Therefore, the value of a bond should be equal to
present value of future cash flows.
c1 c2 cn + MV
V = + + ... +
(1 + r )1
(1 + r ) 2
(1 + r ) n
where
V = value of bond
ci = coupon of i th period
MV = maturity value
r = discount rate or YTM Narain
VALUATION OF BOND …

❑ From the equation given, we can say that

– P = f (C, r, n).

❑ Thus, it is important to study the relation

between Price of a bond and the factors that

determine its value.

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INTEREST RATE RISK…?
❑ INTEREST RATE RISK is understood in terms of
sensitivity of bond price and thereby of return with
respect to change in interest rate.
❑ When interest rate changes, the price of bond
changes and reinvestment rate also changes. Thus,
interest rate risk means -
– Price Risk; and
– Reinvestment Risk
❑ When interest rate changes, its impact on price and
reinvestment rate is opposite and to some extent
neutralise the effect of each other.
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more precise ways of
measuring interest rate
risk, are based on the
concept of duration ...

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DURATION ...
❑ DURATION is understood in
SOME sense of sensitivity in
bond prices with respect to
changes in interest rate or YTM.

❑ If this sensitivity is higher,

duration is higher and so the
interest rate risk!!!
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EVERY BOND HAS A DURATION!!!

❑ Duration may be-

– Macaulay’s Duration [D]

– Modified Duration [MD]

– Fisher - Weil Duration [Dfw]

– Effective Duration [Deff]

– Empirical Duration [Demp]

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Macaulay’s Duration
❑ Duration = % Change in Price / %
Change in Gross Yield
N
n * Cn

(1 + y )
n
n =1
Duration = N N = Term – to – maturity
Cn
 C = Bond Cash Flow

(1 + y ) y = Yield – to – Maturity
n
n =1

❑ Average time prior to receipt of

payment
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Illustration
For a 7% coupon bond with 3 years of maturity
has the current price = face value (Rs. 1000)

 70   70   1070 
(1)   + ( 2 )   + ( 3)  
 (1.07 )   (1.07 )   (1.07 ) 
2 3

D=    
70 70 1070
+ +
(1.07 ) (1.07 )2 (1.07 )3
D = 2.81 years

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Forms of MACAULAY’S DURATION

❑ MACAULAY’S DURATION HAS OPEN FORM

C C C+M
+ 2 1 + … +
1 + y dP 1+y 1+y 2 1+y n
D=− =
P d 1+y C C C+M
+ + …+
1+y 1+y 2 1+y n

❑ MACAULAY’S DURATION HAS CLOSED FORM

(1 + y ) dP 1 + y (1 + y ) + ( c − y )  n
D=− = −
P d (1 + y ) y c [(1 + y )n − 1] + y
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Duration of special bonds

Duration of –
❑ Zero-coupon bond
➢ Same as Maturity
❑ Perpetual bond
➢ (1+y)/y
❑ Bond trading at par
1+𝑦 1
➢ 1−
𝑦 1+𝑦 𝑛

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Factors influencing Duration
❑ Duration increases as –
– Time to maturity increases
• Except for bonds selling at discount

– Coupon of the bond decreases

• Except for perpetual bonds

– Market yields decreases

• Except for Zero Coupon Bonds
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 Factors influencing Duration
If a bond has a yield of 9% and interest is payable semi
– annually, then its duration will be as follows based on
different terms to maturity and coupon rates:
Term to Coupon Rate
Maturity 0% 8% 10% 12%
6 6 4.85 4.69 4.55
10 10 6.95 6.66 6.43
20 20 9.83 9.43 9.15
30 30 10.95 10.65 10.43
 -- 11.61 11.61 11.61

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Modified Duration
❑ MODIFIED DURATION of a bond means:

• Percentage change in bond price due to absolute

change in yield

• It is defined as
1 dP D
MD = − =
P dy (1 + y )

• It helps in prediction of future bond prices if yields

are changing. Narain

Duration properties
❑ Duration as a relation between bond
price & parallel changes in the interest
rates
%  in Price = - MD*  Interest rate

❑ The longer the duration of a bond, the

greater the price volatility of the bond
for a given change in interest rate.
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 An Example……………..

Face Value Rs. 1,000

Coupon 10% p.a.
Maturity 7 Years
Present YTM 12%
Present Market Value Rs. 908.73
Macaulay's Duration 5.27

❑ Find the Percent Change in Price if YTM has been reduced by

50 basis point.

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Limitations of these predictions
Modified Duration can't be used –
❑ For non-flat yield curves

❑ For large yield changes

❑ For assets with embedded options

❑ For assets more affected by other variables

– E.g. equity shares
– Real estate
To overcome these, practitioners use other
measures of DURATION !!!
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FISHER - WEIL DURATION
❑ This approach to define duration is based on the
assumption that the future rate of interest may be
different for different period and hence, they should
be discounted at those different rates. Therefore, a
meaningful concept of duration should be based
upon the different rates of interest in future.
❑ It is defined as thus:
1𝐶 2𝐶 𝑛(𝐶 + 𝑀)
+ + ⋯+
(1 + 𝑦1 ) 1 + 𝑦2 2 1 + 𝑦𝑛 𝑛
𝐷𝑓𝑤 =
𝑃
❑ It requires one to estimate yield curve first. Narain
EFFECTIVE DURATION
❑ A direct measure of the interest rate
sensitivity of a bond or any asset where
it is possible to use a pricing model to
estimate the market prices surrounding
a change in interest rates.
❑ Effective duration formula is –
( P− ) − ( P+ )
Effective Duration ( DEff ) =
P * y

Narain
EMPIRICAL DURATION
❑ It is used when the asset class does not
have well-specified market price
estimates in response to yield changes
❑ E.g. equity stocks or exotic embedded
options
❑ Empirical Duration is estimated by the
regression equation –
ln( pricet ) =  + DEmp * yt + 
Narain
DURATION OF PORTFOLIO...
❑ Bonds Portfolio can also have DURATION!!!
❑ It is equal weighted average of
to
duration of bonds where weights are
proportionate to the value of a bond in
the portfolio, that is
n
DP =   i Di
i =1
where
N i Pi
i =
Total Price of Portfolio
Narain
REMEMBER

the slope of bond price

curve is NOT DURATION

Narain
 Which bond should
one buy and why?
Bond A
Bond Prices (Rs.)

Bond B

YTM(%)
 Consider the following bonds …

Coupon Yield to
Maturity Price Duration
Rate Maturity
Bond A 9.0% 10 years Rs. 1,000 6.99
9%
Bond B 3.1% 8 years Rs. 673 years

Narain
 (Rs. in thousands)
YTM Bond A Bond B
(Rs.673) (Rs.673)
5% 881 877
6% 822 820
7% 768 767
8% 718 718
9% 673 673
10% 632 632
11% 594 593
12% 559 558
13% 527 525
THIS EXAMLE LEADS US
TO A VERY IMPORTANT
CHARACTERISTIC OF A
BOND …

…………..CONVEXITY
 CONVEXITY
❑ Convexity measures how fast the slope of the bond’s price
curve changes when the interest rate is modified.

❑ It shows at what rate prices of bonds are changing when

interest rate changes.

❑ It is a measure that is based on second derivative and

since second derivative of bond price with respect to
interest rate is positive, it is called CONVEXITY.

❑ Convexity can be rewarding for bond’s owner: the greater

the convexity, the higher the return if interest rates drop;
the smaller the loss if interest rate rises.
 CONVEXITY is measured as...

2
1 d P
CONVEXITY = 2
P dy
1 n
t (t + 1)Ct
=
P (1 + y ) 2 
t =1 (1 + y )
t

Narain
CLOSED FORM FORMULA FOR
CONVEXITY...
CONVEXITY
  C 
 n(n + 1)  M −  
1  2C  1  2nC  y 
= 3 
1− n
− 2 +
P  y  (1 + y )  y (1 + y ) n +1
(1 + y ) n + 2 
 
 

Where C is the Coupon

Amount and not the
Coupon Rate.
Narain
 An Example………………..

Face Value ₹ 1,000

Coupon 1% p.a.
Maturity 10 Years
Present YTM 9%

❑ Find the Price, Duration and Convexity of this Bond.

Narain
 BOND A
Coupon 1% Par Value Rs. 1,000
Maturity 10 Years YTM 9%

Discounting PV of t X PV of t(t+1) X PV of
Years Cashflows Factor Cashflows Cashflows Cashflows
1 10 0.9174 9.1743 9.1743 18.3486
2 10 0.8417 8.4168 16.8336 50.5008
3 10 0.7722 7.7218 23.1655 92.6620
4 10 0.7084 7.0843 28.3370 141.6850
5 10 0.6499 6.4993 32.4966 194.9794
6 10 0.5963 5.9627 35.7760 250.4323
7 10 0.5470 5.4703 38.2924 306.3392
8 10 0.5019 5.0187 40.1493 361.3437
9 10 0.4604 4.6043 41.4385 414.3850
10 1010 0.4224 426.6349 4266.3491 46929.8406
Total 486.5874 4532.0124 48760.5167
Duration 9.31 Years
2
Convexity 84.34 Years
 BOND B
Coupon 9% Par Value Rs. 100
Maturity 10 Years YTM 9%

Discounting PV of t X PV of t(t+1) X PV of
Years Cashflows Factor Cashflows Cashflows Cashflows
1 9 0.9174 8.2569 8.2569 16.5138
2 9 0.8417 7.5751 15.1502 45.4507
3 9 0.7722 6.9497 20.8490 83.3958
4 9 0.7084 6.3758 25.5033 127.5165
5 9 0.6499 5.8494 29.2469 175.4815
6 9 0.5963 5.3664 32.1984 225.3890
7 9 0.5470 4.9233 34.4632 275.7053
8 9 0.5019 4.5168 36.1344 325.2093
9 9 0.4604 4.1439 37.2947 372.9465
10 109 0.4224 46.0428 460.4278 5064.7056
Total 100.0000 699.5247 6712.3140
Duration 7.00 Years
2
Convexity 56.50 Years
 Special Cases of CONVEXITY
❑ A zero-coupon bond has a convexity which is
equal to –
𝑛 𝑛+1
1+𝑦 2
❑ When maturity tends to infinity, convexity tends
to a value -
2
y2

Narain
Factors influencing Convexity
(Summary) …

Convexity increases as –

❑ Time to maturity increases

– Except for bonds selling at discount
❑ Coupon of the bond decreases
– Except for perpetual bonds
❑ Market yields decreases
❑ Duration increases
Narain
Effective Convexity …
❑ Similar to Effective Duration, effective convexity can
be computed using the following formula:

P− − P+
Effective Duration =
( P0 )( y )
P− + P+ − 2 P0
Effective Convexity =
P0 (y ) 2

❑ These are only approximate estimates of duration

and convexity.

Narain
CONVEXITY OF PORTFOLIO...

❑ Bonds Portfolio also have CONVEXITY!!!

❑ It is equal to weighted average of convexity
of bonds where weights are proportionate to
the value
n
of a bond in the portfolio, that is
C P =   i Ci
i =1

where
N i Pi
i =
Total Price of Portfolio Narain
 PREDICTION OF BOND PRICES USING
CONVEXITY …???
❑ Consider the Taylor’s Series expansion of f(x)
around x0:
f ''
( x )( x − x ) 2
f '''
( x )( x − x ) 3

f ( x ) = f ( x 0 ) + f ' ( x 0 )( x − x 0 ) + 0 0
+ 0 0
+ ...
2! 3!
❑ which can be shown as thus also:

f ''
( x )( x − x ) 2

f ( x ) − f ( x 0 )  f ' ( x 0 )( x − x 0 ) + 0 0

2!
❑ Using this for predicting bond prices,
f ''
( y )y 2

P  f ' ( y 0 )y + 0

2! Narain
 From the above, we obtain the
following that helps in predicting
% change in Bond’s price using
Duration and Convexity...

P f ( y0 )
'
f ( y0 ) y
'' 2
 y +
P P P 2!
P 1
  (-Modified Duration) y + (Convexity )y 2

P 2
80%
Actual Percentage Change in Price

Duration Approximation
60%
Duration & Convexity Approx.

40%

20%

0%
-20% -15% -10% -5% 0% 5% 10% 15% 20%

-20%

-40%

-60%
Thanks for your time!
Financial Risk
Management
By Narain
narain@fms.edu
INTEREST RATE
RISK
MANAGEMENT
Interest Rate Risk
Interest rate risk is the
exposure of a bank’s financial
condition to adverse
movements in interest rates.

Narain
Type of Interest Rate Risk
❑ Rate Level Risk
– Earnings & value changes
❑ Yield Curve Risk
– Impacts due to slope & shape of YC changes
❑ Pre-payment Risk
– Optionality to repay, call back, put etc.
❑ Basis (Spread) Risk
– Rate spread are non-synchronous
❑ Real Interest Rate Risk
– Nominal rates not in-sync with inflation
Narain
Interest Rate Risk Exposure
1. Repricing Gap Model
– Impact on Net income
2. Maturity Gap Model
– Impact on Net income & Market values
3. Duration Gap Model
– Impact on Ownership interest
4. Cash-Flow Mapping Model
– Yield curve changes
❑ Often used in conjunction
Narain
Repricing Gap Model
❑ A book value accounting cash flow analysis
of the interest income earned on an FI’s
assets and the interest expenses paid on
its liabilities over some specified period
❑ Funding Gap in each maturity period is
calculated by estimating the differences in
– Rate Sensitive Assets (RSAs)
– Rate Sensitive Liabilities (RSLs)

Narain
Rate Sensitivity
❑ Rate sensitivity means that the asset/liability
is repriced at or near current market interest
rates within the maturity horizon of the
period under consideration
– Being floating
– By roll over
❑ Cumulative repricing gap over the whole
balance sheet must be zero for all period
segments.
Narain
Classification of items
Classify the following items for their risk sensitivities in
one-year period: (in lac)

Liabilities Assets
Two-year Fixed Deposits 40 Cash & equivalents 5
Current Accounts 40 One-year consumer loans 50
Savings Accounts 30 Two-year consumer loans 25
Three-month CDs 40 Three-month T-bills 65
3-month banker’s cheques 20 Three-year Dated securities 60
Six-month CPs 60 10-year fixed-rate mortgages 20
One-year time deposits 20 30-year floating-rate mortgages 40
Equity capital 20 Land & Buildings 5
Total 270 Total 270
Narain
 Interest rate risk management:
Repricing Gap methodology
1. Compute RSAs & RSLs
– Non-interest earning assets/liabilities
– Rate sensitive within period
– Rate sensitive beyond period
2. Group these into above categories
3. Compute the difference (CGAP)
4. Compute Percentage Gap (% of total assets)
5. Compute average annual % rate of return (cost)
on each asset (liabilities) category & spread
6. Compute categorical & total profit
Narain
 Interest rate risk management:
Repricing Gap methodology
❑ Compute the change in net income
– For equal changes
– For unequal changes
❑ Change in NII over a period depends on –
– Size & sign of Gap
– Size & sign of interest rate change

Narain
The Repricing Model
❑ The change in net interest income for
any given bucket i (ΔNIIi) is measured as:
ΔNIIi = (RGAPi)ΔRi = (RSAi – RSLi)ΔRi
where RGAPi = the amount of the gap between the
book value of rate-sensitive assets and
rate-sensitive liabilities in maturity
bucket i
ΔRi = the change in the level of interest rates
impacting assets and liabilities in the
ith maturity bucket
The Repricing Model
❑ A common cumulative gap of interest to
commercial bank managers is the one-year
repricing gap estimate:

 1− year 1− year

NII =   RSAi −  RSLi Ri
 i =1−day i =1− day 
where ΔNII is the cumulative change in net interest
income from all rate-sensitive assets and liabilities
that are repriced within a year given a change in
interest rates ΔRi
The Repricing Model
❑ The spread effect is the effect that a
change in the spread between rates on
RSAs and RSLs has on net interest
income as interest rates change
ΔNIIi = (RSAi x ΔRRSA) – (RSLi x ΔRRSL)
Illustration
Liabilities Amount Assets Amount
(in lakh) (in lakh)
Equity 200 Investment (<1 yr.) 100 5%

7% Long term debts 500 Advances (<1 yr.) 350 7%

4% Deposits (<1 yr.) 900 Floating rate loans 300 6.5%

Fixed rate loans (>1 yr.) 850 8%

1600 1600

Compute the Repricing Gap and analyse the impact of

interest rate increase by 1 percent.
What if spread effect is negative by 30 basis points.

Narain
Illustration

Given the following balance sheet describing market

yields in parentheses and amounts in millions,
❑ What is the Repricing Gap for the planning periods
30 days, 6 months, 1 year, 2 years and >2 years?
❑ What is the impact over next six months on NII if
interest rate rises by 100 basis points?
❑ What is the impact over the next year on NII if
interest rates on RSAs increase 60 basis points and
on RSLs increase by 40 basis points?

Narain
Weakness of Repricing Model
❑ Ignores market value effects of changes
❑ Ignores cash flow patterns within the
specified period
❑ Ignores reinvestment opportunities of
insensitive assets/liabilities
❑ Ignores cash flows from off-Balance
Sheet activities

Narain
The Maturity Model
❑ Explicitly incorporates market value effects.
❑ For fixed-income assets and liabilities:
– Rise (fall) in interest rates leads to fall
(rise) in market price.
– Longer the maturity, the greater the
effect of interest rate changes on
market price.
– Fall in value of longer-term securities
increases at diminishing rate for given
increase in interest rates.
Narain
Maturity of Portfolio
❑ Maturity of portfolio of assets (liabilities)
equals weighted average of maturities
of individual components of the
portfolio.
❑ Principles stated on previous slide apply
to portfolio as well as to individual
assets or liabilities.
❑ Typically, maturity gap, MA - ML > 0 for
most banks and thrifts.
Narain
Effects of Interest Rate Changes
❑ Size of the gap determines the size of interest
rate change that would drive net worth to
zero.
❑ Immunization and effect of setting
MA - ML = 0.

Narain
Maturities and Interest Rate Exposure

❑ If MA - ML = 0, is the FI immunized?
– Suppose liabilities consist of 1-year
zero coupon bond with face value
Rs100. Assets consist of 1-year loan,
which pays back Rs 99 shortly after
origination, and Re 1 at the end of the
year. Both have maturities of 1 year.
– Not immunized, although maturity gap
equals zero.
– Reason: Differences in duration

Narain
Maturity Model
❑ Leverage also affects ability to eliminate
interest rate risk using maturity model
– Example:
Assets: Rs100 crore in one-year 10-
percent bonds, funded with Rs 90
crore in one-year 10-percent deposits
(and equity)
Maturity gap is zero but exposure to
interest rate risk is not zero.

Narain
Duration
❑ The average life of an asset or liability
❑ The weighted-average time to maturity using
present value of the cash flows, relative to
the total present value of the asset or liability
as weights.
❑ Combines the effects of differences in coupon
rates and differences in maturity.
❑ Based on elasticity of bond price with respect
to interest rate.
Narain
Duration Model
❑ Even if FG for all periods are set to zero (i.e.
no change in profit) but –
– Present value of profit (i.e. Equity
value) may not remain unchanged due
to rate changes
❑ Change in the market value of Equity is –
i
E = −( DA − k .DL )  A 
1+ i
– Where k = Liabilities to Asset ratio
Narain
Change in Net Worth
❑ Changein net worth of the
bank depends on
– Leverage adjusted duration
– Bank size
– Relative change in interest rate

Narain
Illustration
Liabilities Amount Assets Amount
(in lakh) (in lakh)
Equity 10 Investments 100 5

3 Deposits 90

100 100

Compute the Duration Gap and analyse the impact of

interest rate change if current interest rate is 10% and
it is likely to rise to 11%.

Narain
 Immunization and Regulatory Concerns

❑ Regulators set target ratios for an FI’s

capital (net worth):
– Capital (Net worth) ratio = E/A
❑ If target is to set (E/A) = 0:

– DA = D L
❑ But, to set E = 0:

– DA = kDL

Narain
Illustration
Particulars Duration (in years) Amount (‘000)
T-bills 0.5 90
Short term securities 0.9 55
6% Dated govt. bonds 4.393 176
Loans & Advances 7 2724
Deposits 1 2092
Reserve funds 0.01 238
Equity 715

1. What is the FI’s leverage-adjusted duration gap? What is its interest

rate risk exposure?
2. If the entire yield curve shifted upward 0.5% (i.e. Δi/(1+i) = 0.0050),
what is the impact on the FI’s market value of equity?

Narain
Exercise
Assets Value Modified duration
Open credit lines 1000 0
Floating rate securities 600 0.25
Fixed rate loans 800 3
Fixed rate mortgages 1200 8.5
Total assets 3600 3.54
Liabilities Value Modified duration
Checking accounts 1200 0
Fixed rate CDs 600 0.5
Fixed rate bonds 1000 3
Total liabilities 2800 1.18
Compute the Duration Gap and estimate the impact of a
50 basis points increase in yield on Bank’s net equity
value.
Narain
Exercise
Liabilities Amount Assets Amount
(in Crores) (in crores)
Equity 20 Cash 30

8.5% Repo Funds 50 8.5% Reserve funds 20

8% Fixed Deposits – 2yr 20 15% Floating loans 105

9% Euro CDs 130 12% Fixed loans – 5yr. 65

220 220

The average duration of floating loans & Reserve funds is

0.36 years. The average duration of Euro CDs & Repo
funds is 0.401 year. Compute duration gap for the bank.
What impact 1% relative increase in interest rate will leave
on market value of bank’s equity?
(PVAF8%,2 = 1.7833 and PVAF12%,5 = 3.6048) Narain
Convexity Adjustments
Assets Value Modified duration Convexity
Open credit lines 1000 0 0
Floating rate securities 600 0.25 0.1
Fixed rate loans 800 3 8.5
Fixed rate mortgages 1200 8.5 45
Total assets 3600 3.54 16.91
Liabilities Value Modified duration Convexity
Checking accounts 1200 0 0
Fixed rate CDs 600 0.5 0.3
Fixed rate bonds 1000 3 6.7
Total liabilities 2800 1.18 2.46
Compute the Duration Gap and estimate the impact of a
50 basis points increase in yield on Bank’s net equity
value.
Narain
Duration Measure: Other Issues

❑ Default risk
❑ Floating-rate loans and bonds

❑ Duration of demand deposits and

passbook savings
❑ Mortgage-backed securities and
mortgages
– Duration relationship affected by
call or prepayment provisions.
Narain
Weakness of Duration model
❑ Duration matching can be costly & time
consuming
❑ Immunisation is a dynamic process

❑ Large rate changes & convexity

❑ Changes in spread & yield curve

❑ Problems as to incorporation of
defaults, prepayments, call features,
etc.
Narain
Thanks for your time!
Financial Risk
Management
By Narain
narain@fms.edu
MARKET RISK
Market Risk
Market risk is the uncertainty of an
FI’s earnings on its trading portfolio
caused by changes, and particularly
extreme changes, in market
conditions such as price of an asset,
interest rates, market volatility and
market liquidity

Narain
Market risk factors

❑ Exchange rate risk

❑ Interest rate risk

❑ Equity risk

❑ Commodity risk

❑ Volatility risk

Narain
MARKET RISK
Measurement
Market risk measurement
❑ Provides information to management
❑ Setting limits to exposures & position
limits
❑ Allows better resource allocation for risk
assumed
❑ Risk adjusted performance evaluation

❑ Stipulations by regulators via capital

adequacy
Narain
Value at Risk (VaR)

❑ Value at Risk measures the potential loss in value

of a risky asset or portfolio over a defined period
for a given confidence interval
❑ Computed as an extreme percentile (at confidence
levels) from the return distribution (for a time span)
❑ It is the worst loss that might occur over a given
time horizon with a specified probability
❑ Daily VaR of ₹15m at 95% confidence level –
– 95% of the days, the loss will not exceed
₹15m

Narain
Expected Shortfall (ES)

❑ Average of the losses beyond VaR level

❑ More desired due to mathematical
elegance for further analysis

Narain
Illustration
From the following 16 worst scenarios of daily changes in portfolio values
out of 1000 observations, compute the 99% and 99.5% 1-day VaR and
Expected Shortfall of the portfolio:

Scenario Rank Daily Change Scenario Rank Daily Change

1 -4250 9 -2313
2 -3500 10 -2226
3 -3342 11 -2175
4 -3126 12 -2142
5 -2940 13 -2052
6 -2626 14 -2020
7 -2520 15 -1982
8 -2337 16 -1980

Narain
For Normally Distributed variable

❑ For 𝑥~𝑁(𝜇, 𝜎 2 ), the Value at Risk at the significance

level, α (1-Confidence Level) shall be
𝑉𝑎𝑅 = 𝜇 − 𝜎𝑁 −1 (𝛼)

❑ For 𝑥~𝑁(𝜇, 𝜎 2 ), the Expected Shortfall at the

significance level, α (1-Confidence Level) shall be
𝑧2
𝑒− 2
𝐸𝑆 = 𝜇 + 𝜎
2𝜋 ∗ 𝛼

Narain
MARKET RISK
MANAGEMENT
Market risk exposure
Three major approaches to market
risk models –
❑ JPM RiskMetrics Approach

❑ Historic or Back Simulation

❑ Monte Carlo Simulation

Narain
RISKMETRICS model
❑ Market risk is estimated potential loss under
adverse circumstances
– Daily earnings at risk (DEAR)
❑ Daily earnings at risk = Market value of
position X Price sensitivity of position X
Potential adverse move in factors
═Market value X Price volatility
❑ DEAR is composite value of individual trading
areas like Fixed Income, Foreign Exchange or
Equities
Narain
Market risk of Fixed Income securities

❑ DEAR = Market value X Price volatility

❑ Daily price volatility = Modified Duration X Adverse
daily yield move
❑ Adverse daily yield move is computed with VaR
– A 5% probability that yield is extremely
adverse
❑ N-day market value at risk (VaR) = DEAR X 𝑁
– N= For days FI made to hold the security
– N= Position in security/median daily
turnover of trading
– N=10 as per BIS(1998)
Narain
Confidence Intervals: Example

Suppose that we are long in 7-year zero-coupon

bonds and we define “bad” yield changes such
that there is only 5% chance of the yield change
being exceeded in either direction. Assuming
normality, 90% of the time yield changes will be
within 1.65 standard deviations of the mean. If
the standard deviation is 10 basis points, this
corresponds to 16.5 basis points. Concern is
that yields will rise. Probability of yield increases
greater than 16.5 basis points is 5%.
Narain
Adverse 7-Year Rate Move

Narain
Market risk of Foreign exchange

❑ DEAR = Market value X Exchange

rate volatility

❑ Exchange rate volatility = 1.65 X

St. dev. of daily % change in
exchange rate
Narain
Market risk of Equities
❑ DEAR = Market value X Price volatility
❑ Price volatility = Beta X 1.65 X St. dev. of market
portfolio
❑ In well-diversified portfolio
– Unsystematic component is negligible
❑ In less diversified portfolio
– Need to add effects of unsystematic risks
❑ Even then, applicability of CAPM is rebuttable
– Extensions of CAPM
– APT
Narain
Portfolio Aggregation
❑ DEAR of portfolio of trading activities of Fixed
Income, Foreign exchange, equities and
derivatives
– Convert a derivatives into a position in
underlying
❑ Need to recognize the interaction effects of
trading segments i.e. covariances
– Markowitzian portfolio formation
❑ Most FIs set limit for VaR, DEAR, Position
limits, Amount trading loss limit
Narain
DEAR for some banks
Average DEAR Minimum DEAR Maximum DEAR
Name
for the Year during year during year
2008 (in millions of dollar)
Bank of America 111 64 256
Citigroup 292 220 393
J. P. Morgan Chase 196 96 420
KeyCorp 2 1 3
Wells Fargo 19 10 52
Sun Trust 29 17 42
2005 (in millions of dollar)
Bank of America 62 38 92
Citigroup 109 78 157
J. P. Morgan Chase 86 53 130
KeyCorp 2 1 5
Wells Fargo 18 11 24
Sun Trust 4 2 Narain 6
Drawbacks of RiskMetrics approach

❑ It assumes symmetric distribution for all asset

returns
❑ It does not considers ‘fat tails’ anomaly
❑ It ignores risk in payments of accrued interest
on securities
❑ It focuses on risk only and ignores the
opportunity cost of return forgone to
minimize risk
❑ Requires large no. of estimates of correlations
& standard deviations.
Narain
Historic or Back Simulation
❑ Basic idea: Revalue portfolio based on
actual prices (returns) on the assets that
existed yesterday, the day before, etc.
(usually previous 500 days).

❑ Then calculate 5% worst-case (25th lowest

value of 500 days) outcomes.

❑ Only 5% of the outcomes were lower.

Narain
Main step of a historic simulation
1. Selecting a sample of historic returns of the
relevant market factor(s), relating to a given period
2. Revaluing the individual position or the portfolio at
each of the historical market factor return values
3. Reconstructing the empirical frequency distribution
of the resulting position
4. Cutting the distribution at the percentile
corresponding to the desired confidence level
5. Computing VaR as the difference between the
above percentile and the current position

Narain
Estimation of VaR: Example
A bank has a current portfolio equally consisting
of British (FTSE 100), Indian (Nifty) and US
(S&P 500) stock Index.
Assuming that bank’s current portfolio of
equally-weighted portfolio experience historical
returns observed by these three indices for the
500-day period.
Compute VaR of this portfolio and compare it
with variance-covariance model.

Narain
Historic or Back Simulation
Advantages:
❑ Simplicity & communicable

❑ Does not require normal distribution of returns

❑ Does not need correlations or standard

deviations of individual asset returns.
❑ Allows to capture non-linear sensitivity to
market factor changes
❑ Tends to generate stable VaR measures
(especially with high confidence level)
Narain
Weaknesses
❑ Disadvantage: 500 observations is not
very many from statistical standpoint.
❑ Stationarity of distribution of market factor
changes
❑ Increasing number of observations by
going back further in time is not desirable.
❑ Could weight recent observations more
heavily and go further back.

Narain
Monte Carlo Simulation
❑ To overcome problem of limited number of
observations, synthesize additional
observations.
– Perhaps 10,000 real and synthetic
observations.
❑ Employ historic covariance matrix and random
number generator to synthesize observations.
– Objective is to replicate the distribution
of observed outcomes with synthetic
data.
Narain
Steps for Monte Carlo simulated VaR

1. Selecting the probability density function f(x) which

best approximates the distribution of the returns of
the market factor.
2. Estimating the parameters (mean, S.D. etc.) of
distribution
3. Simulating N market factor scenarios from distribution
4. Calculating the change in the position’s market value
at each of the simulated scenarios
5. Cutting off the resulting probability distribution at the
percentile corresponding to the desired confidence
level.
Narain
Regulatory Models
❑ BIS (including Federal Reserve) approach:
– Market risk may be calculated using
standard BIS model.
• Specific risk charge.
• General market risk charge.
• Offsets.
– Subject to regulatory permission, large
banks may be allowed to use their
Proprietary Models as the basis for
determining capital requirements.
Narain
BIS Standardised Model: Fixed Income

❑ Specific risk charge:

– Risk weights × absolute values of long and
short positions
❑ General market risk charge:
– reflect modified durations  expected interest
rate shocks for each maturity
❑ Vertical offsets:
– Adjust for basis risk
❑ Horizontal offsets within/between time zones

Narain
BIS Standardised Model: Forex & Equity

❑ Market risk for Foreign exchange

– Convert the exposure in home currency at
spot rate
– Capital charge is Risk weights × maximum
absolute values of aggregate long or short
positions
❑ Market risk for Equities
– For unsystematic element (x factor)
• Risk weights x Gross long or short position
– For systematic element (y factor)
• Risk weights x Net long or short position
Narain
BIS model: Forex example

Narain
BIS model: Equity example
Large Banks: BIS vs. Proprietary
❑ In calculating DEAR, adverse change in rates
defined as 99th percentile (rather than 95th
under RiskMetrics)
❑ Minimum holding period is 10 days (means
that RiskMetrics’ daily DEAR multiplied by
10).
❑ Capital charge will be higher of:
– Previous day’s VAR (or DEAR  10 )
– Average Daily VAR over previous 60 days
times a multiplication factor  3.
Large Banks: BIS vs. Proprietary
❑ Types of capital to support –
– Tier 1: Equity + Reserves & Surplus
– Tier 2: Subordinated debt (>5 yr.)
– Tier 3: ST subordinated debt (>2 yr.)
❑ Incremental capital charge be higher of:
– Latest available Stressed VaR
– Average Stressed VaR over previous 60 days
times a multiplication factor  3.
Thanks for your time!
Financial Risk
Management
By Narain
narain@fms.edu
CREDIT RISK
MANAGEMENT
Credit Risk
❑ Risk that promised cash flows from
loans and securities held by Financial
Institution may not be paid in full.
❑ Credit risk measurement depend on
– Exposure
• Quantum of loans provided
• More for long maturity loans than short term loans
– Probability of default
• Affected by systematic as well as unsystematic
factors
Narain
Credit risk management

❑ Collect information about borrowers

whose assets are in their portfolios
❑ Monitor these borrowers overtime

❑ Diversify credit risk exposure of firm-

specific credit defaults
❑ Charge credit risk premium on the loans
with commensurate risk
Narain
Credit Analysis
1. Building the “Credit File”
2. Project and Financial Appraisal
3. Qualitative Analysis
4. Due diligence
5. Risk Assessment
6. Making the recommendation

Narain
Loan kinds for credit analysis
❑ Commercial & Industrial
– Syndicated, Secured & unsecured
❑ Real Estate
– Mortgage loans, Loan against property
❑ Consumer loans
– Credit card, personal, auto loans, etc.
❑ Others
– Agricultural, broker margin loans,
guarantees, forward contracts, etc.
Narain
Sectoral Credit Provision
❑ Priority sector (40% of lending)
– Agriculture & Agri products
– Small scale industries
– Micro-finance
– Housing (upto Rs. 10 lacs)
– Funds provided to RRBs
– Investment in bonds of REC, NABARD, NHB, SFCs,
SEBs
❑ Sensitive sectors
– Real estate
– Capital market
– Commodities
❑ Other sectors: Public sector, Banks, etc.
Narain
Pricing of loan
❑ Pricing factors –
– Base rate set for loans
– Credit risk premium
– Fees & charges
– Collateral backing
– Other non-price terms
❑ RoA on loan (k) = Base Rate + Credit risk
Premium + Processing Fee
❑ Present value consideration in collection of
cash flows from loans
Narain
Contractual vs. Expected return
❑ Expected return on loan depends on –
– Contractual return on loan (k)
– Probability of full repayment (p)
– Loss given default (LGD)
❑ k and p depend on Base rate
❑ Thus, dimensions of credit risk mgt.
– Price dimensions (k)
– Quantity dimensions (rationing)
• Wholesale and retail loan sensitivity
Narain
Measurement of credit risk

Default risk models –

❑ To reach a credit pricing or loan

quantity rationing decision

❑ Two types of models –

– Qualitative models
– Quantitative models
Narain
Qualitative models
1. Borrower specific factors –
– Reputation
– Leverage
– Volatility of earnings
– Collaterals
2. Market specific factors –
– Business cycle
– Level of interest rates
❑ Subjective weights assigned to these
– Expert Systems Narain
Five C’s of credit

1. Character of customer – willingness to pay

2. Capacity – ability to pay

3. Conditions – external economic trends

4. Capital – leverage condition of borrower

5. Collateral – security backing the loan

Narain
Collaterals & loan security
❑ Unsecured
❑ Secured : creation of charge
– Pledge: Bailment of goods as security for payment of a
debt e.g. pawn broker
– Hypothecation: Charge created on the asset without
transferring custody e.g. P&M
– Assignment: Charge created on actionable claims such
as receivables etc. e.g. insurance policy assigned
– General Lien: Right to retain securities or proceeds
which can be applied to adjust debt e.g. FDs with
bank
– Set-off: Bank can use its own debt obligation to the
borrower to set off debt e.g. export realisations
Narain
Quantitative models

Credit scoring models using

observable loan applicant’s
characteristics either to calculate a
score representing the applicant’s
probability to default or to sort
borrowers into different default risk
classes.
Narain
Credit Scoring system
❑ Mathematical models used to calculate
scores that represents the applicant’s
probability of default –
– Traditional quantitative models
– Sophisticated quantitative models
❑ It also helps in –
– Reducing ambiguity & increases transparency
– Reduces turnaround time

Narain
> <
Modeling Credit Risk
1. Traditional Quantitative models
– Discriminant Analysis
– Regression models
– Heuristic inductive models
2. Sophisticated Quantitative models
– Reduced form models
– Mortality rate approach
– Structural models
❑ Big banks uses these models for active
credit risk management Narain
Financial distress models
❑ Discriminant models
– Altman’s Z score
– Multiple discriminant models
❑ Regression models
– Linear probability models
– Logit & Probit
❑ Heuristic inductive models
– Neural networks
– Genetic algorithms
Narain
Altman’s Z score model
Z = 1.2X1+1.4X2+3.3X3+0.6X4+1.0X5
Where X1 = working capital to asset (%)
X2 = retained earnings to asset (%)
X3 = EBIT to asset (%)
X4 = market value of equity to book
value of debt (%)
X5 = sales to asset (times)
❑ Z-score less than 1.81 indicate financial distress
❑ Z-score more than 2.99 indicate financial soundness

Narain
Z-score calculation
A loan applicant for Rs. 5 lac has sales = Rs. 5,00,000;
cost of goods sold = Rs. 3,60,000; interest payments =
Rs. 40,000; taxes = Rs. 56,000; net income equals Rs.
44,000; dividend payout ratio = 50% and the market
value of equity is equal to its book. Compute z-score.
Liabilities Assets
Equity capital 4,00,000 Cash 20,000
Long term debt 1,50,000 Accounts receivables 90,000
Creditors 30,000 Inventory 90,000
Bills payables 90,000 Plant & machinery 5,00,000
Accruals 30,000
Total 7,00,000 Total 7,00,000

Narain
Linear probability model
Problems with Traditional models
❑ Extreme dichotomy of default
– No default vs. default
❑ Stationarity
– Weights stability
– Independence of variables
❑ Undue importance
– Qualitative & macro factors somewhat ignored
❑ Database on defaulted loans not
centralized
Narain
Credit VaR Models
Approaches Sponsor Models

Credit Migration JP Morgan CreditMetrics

Approach McKinsey CreditPortfolio

Option Pricing KMV Corporation Kealhofer McQuown

Approach (Moody’s) Vasicek (KMV)

Credit Suisse Financial

Actuarial Approach CreditRisk+
Products (CSFP)

Reduced Form Jarrow Turnbull

Approach Duffien Singleton
Narain
Reduced form models
❑ Also called term structure of credit risk
❑ Risk neutral probability of default is
dependent upon –
– Spread across rating classes
– Loss given default (LGD)
❑ Probability of default –
– Marginal probability
– Cumulative probability

Narain
Term structure of credit risk
Historical mortality rates
❑ Mortality rate is the historic default rate experience of
a bond or loan
❑ Being historic, it is sensitive to sample period, no. of
issues and relative size of issue in each investment
grade

Narain
RAROC approach
❑ A loan is approved only when RAROC is
higher than cost of equity or RoE
❑ RAROC = One year net income on the loan /
Loan risk
❑ Loan risk can be calculated using either –
– Value at risk for credit risk
– Unexpected default rate X LGD
❑ It could be historic or futuristic depending on
the basis of Capital at risk

Narain
Loan concentration risks
❑ Migration analysis
– By tracking credit rating of firms in particular
sector or rating class for unusual declines
❑ Widely used to analyse credit card
portfolios and consumer loans

Narain
KMV portfolio manager model
❑ Extension of portfolio theory
❑ Loan returns = contractual return –
expected loss
❑ Loan risk is computed with binomial
distribution assumption
❑ Considers correlations among loans
– Extracted from KMV Credit Manager’s model

Narain
KMV portfolio manager model
❑ Compute loan portfolio risk and returns

Ri = AISi – (EDFi × LGDi)

σi = [EDFi (1-EDFi)]½ × LGDi

Narain
SUGGESTIONS & FEEDBACK ARE
INVITED AT
narain@fms.edu
Financial Risk
Management
By Narain
narain@fms.edu
LIQUIDITY RISK
MANAGEMENT
Liquidity Risk

The risk that a particular

banking asset cannot be
converted into cash within a
specific time frame and at a
specific price level
Narain
Nature of liquidity risk
❑ Liquidity risk can transcend the individual
bank
❑ Liquidity risk is partly confounded with other
risk
❑ Liquidity risk cannot be eliminated or
transferred
❑ Liquidity risk can occur in perfectly normal
times
❑ Liquidity risk can affect both the short term
profitability and long-term survival Narain
Causes of Liquidity Risk
1. Unexpected withdrawals of liabilities
– When FI’s liability holders
(depositors, policyholders) seek
to cash in their financial claims
2. Unexpected increase in assets
– When FI’s asset creators (cash
credit holders, guarantee
holders) exercise their right to
seek funds Narain
Liability Side Liquidity Risk
❑ Banks knows that normally only a small
proportions of its demand deposits will
be withdrawn on any given day
❑ Deposit withdrawals are in part may
offset by the inflow of new deposits.
❑ What needs to be monitored are net
deposit drainage.

Narain
Managing deposit drainage

1. Purchased liquidity management

– Relied on most heavily by the
largest banks with access to
money market
2. Stored liquidity management
– Relied on most heavily by
community banks
Narain
Purchased Liquidity Management
❑ Access to money market instruments –
– Repo funds
– Inter-bank funds
– CDs etc.
❑ Cost of financing is the market rate of
borrowing
❑ This involves change in the composition
of liabilities only
Narain
Stored Liquidity Management
❑ Tapping internal funds in –
– Vaults
– Reverse repo funds
– Additional SLR
❑ Cost of financing is the interest lost on tying
funds less-interest bearing assets
– Also, Fire-sale price charges
❑ It involves both side adjustment in Balance
Sheet
Narain
Income impact & liquidity
Liabilities Amount Assets Amount
(in lakh) (in lakh)
Equity 80 Cash 20 0%

6% Short term loans 160 Securities 230 7%

4% Deposits 560 Advances 550 10%

800 800

Forthcoming interest rate hike is likely to result in 35

lakh withdrawal of deposit in the next week. SLR
requirement is 15 lakh. Money market rate is 6%.
What if immediate sale of securities will fetch 97%.

Narain
Exercise
Liabilities Amount Assets Amount
(in lakh) (in lakh)
Equity 20 Cash 10 0%

7.5% Short term loans 20 Advances 90 8%

6% Deposits 60

100 100

Forthcoming interest rate hike is likely to result in 20

lakh withdrawal of deposit in the next quarter. Money
market rate is 7.5%.
Which form of liquidity management is preferred?
Narain
Asset Side Liquidity Risk
❑ Loan requests committed by the bank
can also put the bank in illiquid position
❑ This side of liquidity risk is also
managed with stored or purchased
liquidity
❑ Unlike liability side liquidity risk, stored
or purchased liquidity has different
impact on size of the bank
Narain
Measures of Liquidity Exposure

1. Net liquidity statement

2. Peer group ratio comparison

3. Liquidity index

4. Financing gap analysis

5. Maturity ladder analysis

Narain
Net Liquidity Statement
❑ It lists the sources and uses of funds tracked
on daily basis.
❑ Major sources are –
– Selling liquid assets
– Borrowal of funds upto maximum limit
– Excess reserves over required
❑ Major uses are –
– Repo funds borrowed from RBI
– Money market funding already taken
Narain
Assessing liquidity needs

Narain
Liquidity Ratios

❑ Peer group ratio comparisons are used

to compare a bank’s liquidity position
against its competitors
❑ Ratios are often compared with those of
banks of a similar size and in the same
geographic location
❑ However these historical ratios say little
about the future liquidity scene
Narain
Common Liquidity Ratios

1. Loan to Deposit Ratio

2. Borrowed Funds to Total Assets Ratio

3. Deposit to Total Assets Ratio

4. Commitment To Lend to Total Assets

Ratio.

Narain
Liquidity Index
❑ Liquidity Index is the ratio of the
fire sale price required to liquidate
assets in an emergency situation
divided by the fair market value of
the assets liquidated.
❑ The lower the index the greater the
liquidity risk.
Narain
Liquidity index measurement
❑ It is a measure of potential losses from fire-sale
disposal of assets compared to the amount to be
received at a Fair Market price established under
normal market conditions.
𝑃𝐹𝑆𝑖
𝐿𝐼 = ෍ 𝑤𝑖
𝑃𝐹𝑀𝑖
where wi = the percent of each asset i in the FI’s portfolio
PFSi = the price it gets if an FI liquidates asset i today
PFMi = the price it gets if an FI liquidates asset i under
normal market conditions
Narain
Illustration

The asset side of a banks shows following

assets to meet its liquidity calls.
Price if sold Price if sold at the
Securities Face Value
today end of month
T – Bills 30D 1,00,000 99% 100%
Real Estate loans 1,00,000 85% 92%

Compute Liquidity Index for the bank.

What change will it make if today’s price of real
estate loan is 65%?

Narain
Exercise

Compute the liquidity index of a bank having

following securities for financing its emergent
liquidity needs.
Securities Value if Fair market % invested in
liquidated value each (at FMV)
immediately
T – Bills 97,00,000 98,50,000 38.58%
Bonds 1,50,00,000 1,56,75,000 61.42%

Narain
Liquidity Index

Liquidity index is a better

measure of the cost of liquidity
risk than the likelihood of
occurrence of liquidity problems.

Narain
Financing Gap
❑ Financial Gap is the difference between
bank’s average loans and average deposit.
FG = Average Loans – Average Deposits

❑ If financing gap is positive, (as it is for the

typical bank) the bank must obtain additional
financing either by borrowing or liquidating
assets.
Narain
Financing Requirement
❑ Financing requirement is the amount of funds
that must be borrowed.
FR = FG + Required liquid asset holdings

❑ An increasing financing requirement may

indicate future liquidity problems for a bank
since this indicates greater borrowing
requirements for the bank.
Narain
Maturity Ladder Analysis
❑ BIS recommends banks to follow a maturity
ladder approach to manage its liquidity
❑ It involves measuring cash inflows and
outflows over short (daily) & longer (six
months) time periods and calculating
cumulative funding needs over the different
time periods
❑ It helps managers to –
– Understand upcoming liquidity needs
– And plan for it
Narain
Maturity ladder and scenarios
❑ BIS also recommends banks to construct
liquidity analyses under various scenarios –
– Normal scenario
– General market crises
– Bank specific crises

❑ Banks needs to assign a timing and size of

cash flows for each type of asset & liability by
assessing probabilities of the behaviour
Narain
Liquidity Planning
❑ BIS also recommends banks to have a
contingency plan to obtain liquidity in
the event of the worst case scenario
happening.
❑ This lowers the costs of funds by
determining an optimal funding mix
❑ It also minimizes the amount of excess
reserves that a bank needs to hold

Narain
Liquidity Planning components
1. Delineation of managerial details &
responsibilities
2. Detailed list of fund providers likely to withdraw
3. Identification of potential size and timing of
deposit withdrawals and private sources of
financing
4. Internal limits on separate subsidiaries’ and
branches’ borrowings
5. Sequencing of assets for disposal to
accommodate various withdrawal sizes.
Narain
Bank run & Liquidity risk
❑ Abnormally higher deposit drain –
– Concerns about bank’s solvency
– Failure of another bank (contagion
effect)
– Sudden changes in investor preference
for non-bank financial assets
❑ Bank run led liquidity risk is unique nature of
demand deposit contract
Narain
Regulatory insulation mechanism
❑ Central banks oversees banking –
– To nurture the payment
mechanism in the economy
– To help banking industry by
avoiding situations of bank runs
❑ Liquidity risk insulation mechanisms –
– Deposit insurance
– Discount window
Narain
Deposit insurance
❑ To ensure stability of banking system in
the economy
❑ To protect depositors from incurring
large losses due to bank failures
❑ Deposit Insurance & Credit Guarantee
Corporation provides it in India
❑ Insurance coverage is limited by the
amount
Narain
Discount window
❑ Central banks have traditionally provided a
discount window facility to meet banks’ short
term non-permanent needs
❑ FIs take such loans by discounting ST high-
quality securities with the central bank
❑ Use of discount window is not to implement
the monetary policy
– Rather reduces volatility in repo rates

Narain
Reserve Requirements
❑ The amount of liquid assets to be maintained
by the bank in the form of –
– Cash in Vault
– Balances with current account with central
bank
– Investment in Govt. Securities
❑ Reserve Ratio is the amount of liquid assets to
be maintained as a percentage of customer
deposits in the bank’s books
– Demand Deposits
– Time Deposits Narain
Reserve Requirements
Barring some (e.g. US), those regulators who
have pegged their reserve requirements to both
Demand & Time deposits have two-tier system
1. Cash Reserve

– Physical Cash held in vault

– Balances with Central Bank
2. Statutory Liquidity Reserve

– Investments in Govt. securities

Narain
Net Demand & Time Liabilities (NDTL)

1. Demand Deposits
➢ Current A/cs and Savings A/cs
2. Time Deposits
➢ FDs, CDs, etc.
3. Net Inter Bank Liabilities (NIBL)
➢ Borrowing from Banking system – Loans to
the banking system
➢ If negative, doesn’t form part of NDTL
➢ CRR are pegged as a notified percentage of
fortnightly average of daily NDTL by RBI
➢ Friday to next-to-next Thursday
Narain
 ASSET
SECURITISATION
Asset Securitisation

❑ The process that transforms financial

assets into ‘securities’ that can be
traded in the financial markets
– Home mortgages (RMBS), automobile
loans, Credit Card Securitisation
❑ Results in creation of ‘Asset Backed
Security’ (ABS)
– Credit Derivatives like CDS
– Structured Products like CDO
Narain
Lending Process & Securitisation
Banks typically –
❑ Originate the loan (remains the same)
– Connects to the borrower
❑ Fund the loan (Refinanced)

– From deposits or other liabilities

❑ Service the loan (remains the same)

– Monthly loan repayments

❑ Monitor the loan (becomes complex)

– Timely repayments & initiate early corrective

action
Narain
Asset attributes for Securitisation
Any portfolio of assets that is to be securitised is
evaluated for –
1. Quality of the underlying assets as well as the
future receivables
2. Average size of the receivables in the portfolio
3. Periodicity of the future receivables
4. Homogeneity of the assets that make up the
portfolio
5. The maturity composition of the future
receivables against those assets
Narain
Securitisation Compositions
Portfolio Composition
Total No. of Loans 100
Range of Individual loan ₹ 5,00,000 to ₹ 40,00,000
value
Average Loan Size ₹ 25,00,000
Total Portfolio Size = ₹ 25 crores

Asset Backed Securities (ABS)

No. of ABS 1,25,000
Face Value ₹ 2,000
Narain
Steps in Securitisation
 Structure of Securitisation Portfolio
❑ Initial feasibility
❑ Key appointments – Investment Banker, Rating
agency, lawyer, Servicer/Administrator, etc.
❑ Asset analysis & selection of portfolio
❑ Legal and Financial feasibility
❑ Due diligence audit
❑ Credit rating
❑ SPV structuring
– Pass thru / Pay thru / Pay Down structures,
credit enhancements, constitution of SPV, with
recourse or without
Narain
 Payment Structures of SPV
Pass-through
• Immediate credit of repayments (EMIs + pre-payments)
from securitised loans to ABS investors
• After deducting SPV expenses

Pay-through
• Credit of repayments is done on pre-specified dates
• Until then invest in approved assets – G-secs.
Pay-down
• Interest part of EMI repayments are paid net of expenses
• Principal parts may be paid according to tranches
Narain
Principal payment under Pay-down structure

Principal payment patterns under Pay-down structure

may be –
❑ Sequential Pay Down
– Full payment to Senior Tranche before
anything to Junior Tranche
❑ Pro-rata Pay Down
– Proportional Payment to Senior & Junior
Tranche
❑ Fast Pay – Slow Pay
– More payment to Senior Tranche & less to
Junior Tranche holders
Narain
Originator’s Cashflows in Securitisation

❑ Initial Cashflows
– Discounted value of future receivables
– Initial expenses for legal fees, stamp
duty, credit rating, etc.
– Initial corpus to set up SPV
– Subscription to any junior notes
– Tax on accelerated income

Narain
Cashflows in Securitisation …
❑ Intermediary Cashflows
– Expenses incurred in collecting the
receivables
– Servicing fees (if acts as Servicing
agent too)
– Cost of credit enhancements
❑ Terminal Cashflows
– Redemption of junior interests
– Buyback of the tail cashflows
Narain
Credit Rating under Securitisation
❑ Rating of ABS is demanded w.r.t. –
– Quality of loans forming securitized portfolio
– Solvency of issuer
– Legal structure of SPV providing protection to
investors
– Sovereign risk of country of issuer
– Prepayment risk from premature closure of
loans
❑ Credit Enhancement
– Based on ratings, investors demand
‘protection’ against these risks Narain
Credit Enhancements
1. Cash Collateral
– Set aside cash based on prob. of default and LGD by
originator
2. Third-party Guarantees
– Insurances or
– Bank guarantees
3. Structural Credit Enhancement
– Junior class investors firstly absorbing default risk
following next senior class
– More popular mechanism
4. Credit Derivatives
– Credit default Swaps (CDS), credit spread put options
(CSPO), credit linked notes (CLN), etc. Narain
RESIDENTIAL MORTGAGE BACKED
SECURITIES (RMBS)
 Residential Mortgage Backed Securities
(RMBS)
❑ Underlying loans are home mortgages
❑ SPV (trustees) are custodian of loan pool
❑ Generally have pass-through structure
❑ Insurance, pension funds, etc. actively buys these
securities
❑ Default risks commonly handled using Credit
Enhancements or CDS
❑ Foreclosures are modelled using Conditional
Prepayment Rate (CPR)
– Converted into Single Monthly Mortality Rate (SMMR)

Narain
Illustration
Consider a home loan of ₹5,00,000 to be repaid
in 15 equal instalments with an annual interest
rate of 8% p.a. The SPV issues 500 securities
backing this home loan, levying a service
charge of 0.15%. Compute the amortisation
schedule with prepayments of SMMR @3% for
all months. Also, calculate the cash flow to the
PTC and IRR if PTC sells at ₹950, ₹1000 and
₹1025.
What would be the IRR if SMMR is 6%.
Narain
Illustration …
Further, the SPV has created two tranches. The
total par value of the two tranches is equal to the
par value of the collateral with same coupon rate
of 6.2%
Tranche A B Collateral
Outstanding Principal 3,50,000 1,50,000 5,00,000

The payment rules state that all scheduled and

unscheduled principal payments will be made to
Tranche A until fully paid off.
Compute Average life and Cash flows of Tranches
Narain
COLLATERALISED DEBT OBLIGATIONS
(CDOs)
Collateralised Debt Obligations (CDOs)

❑ A structured financial instrument that converts

a portfolio of loans or bonds or mortgage
backed securities into a pool which is then
repackaged into ‘tranches’ that are sold to
investors
– Collateralised Loan Obligation (CLOs)
– Collateralised Bond Obligation (CBOs)
– Collateralised Mortgage Obligation (CMOs)
❑ Akin to mutual funds of structured instruments
❑ Have subordinated payment structures
Narain
Types of CDOs
1. Balance Sheet CDO
– Used by banks to offload their risk-
weighted assets
– Obtain relief from regulatory capital

2. Arbitrage CDO
– Comprise high yield instruments
– Structured by managers

Narain
Regulations of CDOs
❑ Mostly self-regulations in this market by
measures like OC test

❑ Overcollateralisation Test (OC Test)

– Measures the extent of leverage
relative to every subordinate
structure in the CDO

Narain
SUGGESTIONS & FEEDBACK ARE
INVITED AT
narain@fms.edu