RISK MANAGEMENT

(FOR PRIVATE CIRCULATION ONLY)

2023
COURSE DESIGN AND REVIEW COMMITTEE
Prof. Dalip Mehra Prof. Sudhir Gijre
Prof. Arun Vartak Dr. Swati Oza
Prof. Avinash Nene Dr. N.M. Vechlekar
Dr. Ravi Chitnis Dr. Shruti Jain
Dr. Aditi Singh

COURSE WRITER
Dalip Mehra Rajul Agarwal
Avinash Nene Avinash Tripathi

EDITOR
Mr. Yogesh Bhosle

Published by Symbiosis Skills and Professional University (SSPU), Pune 2023

Copyright © 2023 Symbiosis Open Education Society

All rights reserved. No part of this book may be reproduced, transmitted or utilised in any form or by any
means, electronic or mechanical, including photocopying, recording or by any information storage or retrieval
system without written permission from the publisher.

Acknowledgement
Every attempt has been made to trace the copyright holders of materials reproduced in this book. Should any
infringement have occurred, SSPU apologises for the same and will be pleased to make necessary corrections
in future editions of this book.
 PREFACE

Today almost all the banks in the process of financial intermediation are confronted with various
kinds of financial and non-financial risks, viz. credit, interest rate, foreign exchange rate, liquidity,
equity price, commodity price, legal, regulatory, reputational, operational etc. These risks are highly
interdependent and events that affect one area of risk can have ramifications for a range of other risk
categories.
This course on “Risk Management” has been developed to help distance learners to analyse
why risk management is critical to banks. This course will assist them to understand how risks are
identified, quantified in terms of their impact on earnings and monitored and managed within banks.
This will help them to become better equipped to identify and quantify the bank’s vulnerability to
credit, market, liquidity, operational, regulatory and reputational risks; understand and learn best
practice procedures to monitor and manage these risks and their impact on revenues and relate these
risks to bank capital. This course has been designed to improve the learner’s ability to identify,
measure, monitor and control the overall level of risks undertaken.
We are living in a much dynamic environment; hence, distance learners must keep themselves
updated for changes occurring in bank/financial regulations.

Dalip Mehra
Rajul Agarwal
Avinash Nene
Avinash Tripathi

iii
 ABOUT THE AUTHOR

Dalip Mehra has academic qualifications of M.Sc. LL.B CAIIB, DBM. He is Ex-Deputy General
Manager, Bank of Maharashtra. He has written over 37 books on various subjects such as Banking,
Risk Management, Finance, Economics, Law and Management. Two of his books have been
recognized and awarded by Ministry of Finance and Ministry of Agriculture.
Rajul Agarwal has completed her CA from The Institute of Chartered Accountants of India. She has
also done her Diploma in Information System Audit and holds AMFI Certification. Rajul Agarwal
has over 10 years of domain knowledge and she is well acquainted with the functioning of the Indian
Accounting and Taxation system.
Avinash Nene has vast 40 years of experience. He is an alumnus of Jamnalal Bajaj Institute of
Management Studies Mumbai. His qualifications are B.E. (Mech.), B.E. (Elect.), PGD in Operations
Management and PGD in Managerial Accounting. He had held various senior positions in industries
and now he is visiting faculty to various reputed business schools.
Avinash Tripathi has varied experience and academic qualifications. He possesses UGC-NET,
M.B.A., EPM-IIT(B), M.A.(English), PGD in Banking & Finance, PGD in Financial advising, and
PGD in Higher education. He has more than 12 years of experience in industries and academics.
His areas of research interest are Corporate Finance, e-Financial services, Market Microstructure,
Strategic Management and Corporate Governance.

iv
 CONTENTS

Unit No. TITLE Page No.

1 Risk and Return Concepts 1-20
1.1 Introduction
1.2 Measurement of Return
1.3 Risk
1.4 Types of Risk
1.5 Measurement of Risk
1.6 Risk and Return Relationship
1.7 Portfolio Risk
1.8 Capital Asset Pricing Model
1.9 Beta of an Asset
1.10 Security Market Line
1.11 Risk Reduction through Diversification
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

2 Security Market Indicators 21-36

2.1 Securities Market
2.2 Classification of Securities Market
2.3 Debt Market
2.4 Equity Market
2.5 Derivatives Market
2.6 Stock Market Indices
2.7 Construction of Stock Market Indices
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

v
 Unit No. TITLE Page No.
3 Derivatives: Futures and Options 37-46
3.1 Derivatives
3.2 Futures Contract
3.3 Options
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
Appendix

4 Managing Credit Risk 47-68

4.1 Introduction
4.2 Forms of Credit Risk
4.3 Types of Credit Risk
4.4 Credit Risk Management Process
4.5 Building Blocks of Credit Risk
4.6 Instruments of Credit Risk Management
4.7 Loan Review Mechanism (LRM)
4.8 Credit Risk Models
4.9 Credit Risk and Investment Banking
4.10 Credit Risk in Off Balance Sheet Exposure
4.11 Inter-Bank Exposure and Country Risk
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
Appendix

vi
Unit No. TITLE Page No.
5 Managing Market Risk 69-88
5.1 Introduction
5.2 Classification of Market Risk
5.3 Market Risk Management
5.4  Risk Appetite and Major Considerations in Developing Risk
Management Policies and Procedures
5.5 Senior Management Oversight
5.6 Risk Limits
5.7 Market Risk Management Function
5.8 Market Risk Management Information System
5.9 Market Risk Management Reporting
5.10 Basel Market Risk Charges
5.11 Market Risk Measurement and Assessment Systems
5.11.1 Sensitivity Analysis and Stress Testing
5.11.2 Back-Testing
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

6 Managing Interest Rate Risk 89-108

6.1 Introduction
6.2 Sources of Interest Rate Risk
6.3 Effects of Interest Rate Risk
6.4 Sound Interest Rate Risk Management Practices
6.5 Interest Rate Risk Measurement Techniques
6.6 Principles for Management and Supervision of Interest Rate Risk
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

vii
 Unit No. TITLE Page No.
7 Managing Foreign Exchange Risk 109-122
7.1 Introduction
7.2 Types of Foreign Exchange Risk
7.3 Foreign Currency Exposure of Commercial Banks
7.4 Foreign Exchange Risk Management
7.5 Steps in Management of Foreign Exchange Risk
7.6 Methods of Measuring Foreign Exchange Risk
7.7 Methods of Managing Foreign Exchange Risk
7.8 Foreign Exchange Settlement Risk
7.8.1 Dimensions of FX Settlement Risk
7.8.2 Duration of FX Settlement Exposure
7.8.3 Measurement of FX Settlement Exposures
7.8.4 Contingency Planning
7.8.5 Use of Bilateral Netting
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

8 Derivatives in Banks and Risk Management Strategies 123-144

8.1 Introduction
8.2 Derivatives: Meaning
8.3 Derivative Markets/Contracts
8.4 Types of Derivatives
8.5 Permissible Derivative Instruments in India
8.6 Economic Functions of Derivative Markets
8.7 Application of Derivatives for Risk Management
8.8 Use of Derivatives by Banks
8.9 Reasons for Popularity of Derivatives
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

viii
Risk and Return Concepts
UNIT

1
Structure:

1.1 Introduction
1.2 Measurement of Return
1.3 Risk
1.4 Types of Risk
1.5 Measurement of Risk
1.6 Risk and Return Relationship
1.7 Portfolio Risk
1.8 Capital Asset Pricing Model
1.9 Beta of an Asset
1.10 Security Market Line
1.11 Risk Reduction through Diversification
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Risk and Return Concepts 1

 Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
●● Explain the concept of return and risk.
---------------------- ●● Identify the components of return and risk.
---------------------- ●● Differentiate between various types of risk.
---------------------- ●● Describe the relationship between risk and return.
●● Realize the importance of diversification in reducing risk.
----------------------

----------------------
1.1 INTRODUCTION
----------------------
Investment decisions are backed by various motives. Some people make
---------------------- investment to acquire control and enjoy prestige associated with it, some to
display their wealth and some just for the sake of putting their excess money
---------------------- in some place or the other. But most of the people invest with an aim to get
---------------------- certain benefits in future. These future benefits are the returns you get on the
investment. Return is the driving force behind investment. It represents rewards
---------------------- for making an investment.

---------------------- In the case of a fixed income security like a debenture, the returns you get
are in the form of periodic interest payments and repayment of principal at the
---------------------- end of the maturity period.
---------------------- Similarly, in the case of an equity share, the returns are in the form of
dividends and the price appreciation of the share.
----------------------

---------------------- 1.2 MEASUREMENT OF RETURN

---------------------- Since the game of investment is based on what is your return from the
investment, measuring historical return becomes essential as it is an important
---------------------- input in estimating future returns.
---------------------- Total return is measured by taking the income plus the price change.
Income is either in the form of dividend or interest, and the price change of the
---------------------- security is capital gain or loss. This can be put into formula as under –
---------------------- Return during a period (in %) = 100* [I + (PE – PB)]
PB
----------------------
Here, I = income received during the period.
----------------------
PE = price at the end of the period.
---------------------- PB = price at the beginning of the period.
---------------------- The difference between price at the end of the period and price at the
beginning of the period is called as Price appreciation.
----------------------

2 Risk Management
 For example, if the price of a share at the beginning of the year 2017 is Rs. Notes
80/- and the dividend received at the end of each year is Rs. 5/- per share, and
the price of the share at the end of the year 2017 is Rs. 95/-. What is the rate of ----------------------
return on equity share?
----------------------
In the above example, given is
----------------------
Price of the share at the end of the year 2017 = Rs. 95/- i.e. PE
Price of the share at the beginning of the year 2005 = Rs. 80/- i.e. PB ----------------------
Dividend per share = Rs. 5/- i.e. I ----------------------
Thus by using formula – ----------------------
Return on an equity (%) = I + (PE – PB) * 100
----------------------
PB
----------------------
= 5 + (95 - 80) * 100
----------------------
80
----------------------
= 25%
----------------------
Similarly for a fixed income bearing security the rate of return would be
calculated as under - ----------------------
Return = Interest received + (Principal repayment – Initial investment)
----------------------
*100
during the period ----------------------
Initial investment ----------------------
For example, the initial investment on a bond is Rs. 100 and the interest ----------------------
received during the period is Rs. 10. If at the end of the period the principal is
repaid along with a bonus of Rs. 5, what is the rate of return? ----------------------
Rate of Return ----------------------
(in percentage) = [(10 + (105-100))/100] * 100
----------------------
= 0.15 * 100 = 15%
----------------------
The average return is calculated by using two methods, namely,
arithmetic mean and geometric mean that has already been discussed in ----------------------
previous chapters.
----------------------
Activity 1 ----------------------

----------------------
Pick up any mutual fund or a portfolio returns factsheet. You will notice
the average 5-year or 10-year return number. Use the returns provided for ----------------------
the past 5 or 10 years (as your case may be). Does the average return as
shown in the financial document equal your calculated geometric return or ----------------------
an arithmetic return?
----------------------

Risk and Return Concepts 3

 Notes 1.3 RISK
---------------------- Risk – Just a thought of it gives investor sleepless nights. But by careful
---------------------- planning of Investment this can be reduces to a greater extent by investors. Risk
is something we encounter in our everyday lives. For instance even crossing a
---------------------- busy street involves risk. In case of Investment matching risk & return can be
a thorny task, as all investors want to minimize risk & maximize return. But
---------------------- investment is bound to have risk. Some Investment has more risky while others
---------------------- are less but no Investment is risk free. Still trying to avoid risk by not investing
is the biggest risk; it would be just like standing at the side of the road never
---------------------- crossing it. We will be never reaching to our destination. In Investing just like
crossing the road, we need to consider situation, accept comfortable level of
---------------------- risk and proceed to where we are going. Risk is inherent in any investment.
---------------------- Risk means different things depending on the place and circumstances.
Sometimes, we refer to risk as the likelihood of the occurrence of an event that
---------------------- we do not like to happen. If we are participating in a game of chance, we would
---------------------- refer to risk as the possibility that we would lose the money.
According to David Scott,” Investment Risk refers to an uncertain rate of
---------------------- return.”
---------------------- Thus in investment analysis, risk refers to the likelihood that the actual
return on an investment received is different from the expected return. In other
----------------------
words risk can be referred as the volatility in the return with respect to the
---------------------- expected return. This definition of risk comes from the fact that investors who
buy assets expect to earn specific returns over the time horizon that they hold
---------------------- the asset. Their actual returns over this holding period may be very different
from the expected returns and it is this difference between actual returns and
----------------------
expected returns that is a source of risk.
----------------------
Activity 2
----------------------

---------------------- Can you think of one statistical measure that can measure the variability of
returns? Hint: This statistical measure is also called “Risk”.
----------------------

---------------------- 1.4 TYPES OF RISK

----------------------
Modern investment analysis categorizes the traditional sources of risk
---------------------- causing variability in returns into two general types: systematic risk and non –
systematic risk.
----------------------

----------------------

----------------------

----------------------

4 Risk Management
 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

Their detail explanation is as under – ----------------------

(1) Systematic risk ----------------------
It refers to those risks that are caused due uncontrollable factors. These ----------------------
are virtually impossible to protect and influences large number of assets.
Certain kind of factors tend to affect all sectors of business, government ----------------------
and any other entity and leads to unavoidable affects for the investor,
these risks can be influenced by the investor but cannot be eliminated ----------------------
completely. Such universally applicable uncertainties fall under the ----------------------
category of systematic risks. There are basically three types of systematic
risks: ----------------------
(a) Market risk ----------------------
The market risk is caused due market cycles i.e. demand and supply
----------------------
pressures, sudden movements in the market and change in public
fashions among investment alternatives leading to uncertainty of ----------------------
return. Factors that lead to market risks are recessions, wars, and
structural changes in the economy, tax law changes, even changes ----------------------
in consumer preferences.
----------------------
(b) Purchasing power risk
----------------------
The purchasing power risk is also called as inflation risk. It refers
to change in the real value of return as a result of inflation. Inflation ----------------------
or rise in prices leads to rise in cost of production, lower margins,
lesser profits, etc. These risks are inherent in all the investments and ----------------------
are beyond the control of an investor.
----------------------
(c) Interest rate risk
----------------------
The interest rate risk refers to uncertain returns caused by the
uncertain market rates of interest. The return on an investment ----------------------
depends upon the interest rates promised on it and changes in market
rates of interest from time to time adversely affects the investor’s ----------------------

Risk and Return Concepts 5

 Notes return. Interest rate risk affects bonds more directly than common
stocks and is a major risk faced by all bondholders. As interest rates
---------------------- change, bond prices change in the opposite direction.
---------------------- (2) Unsystematic risks
It refers to those risks that arise out of known or controllable factors. It
----------------------
is also known as “specific risk”. It is that risk that affects a very small
---------------------- number of assets. For example, any news that affects a specific stock such
as a sudden strike by employees, etc. Unsystematic risk can be minimized
---------------------- and even eliminated by careful selection of investment. These risks can
be further classified into:
----------------------
(a) Business risk
----------------------
This risk refers to uncertain return to the investor caused due to
---------------------- uncertain business environment in which it operates. In simple
words, the risk of doing business in a particular industry or
---------------------- environment is called business risk. These risks may arise due to
---------------------- both factors internal and external to business. Business risk caused
due to internal factors leads to poor performance of the company
---------------------- but can be reduced or avoided by some changes in the company’s
policies.
----------------------
(b) Financial risk
---------------------- It refers to risk caused due to inability of the organization to meet its
---------------------- financial obligations. For example obligations such as interest and
principal payment of the funds borrowed. Investment in organization
---------------------- that is heavily into debt may lead to greater uncertainty of return
because of financial risk to their owners.
----------------------
(c) Default risk
----------------------
It is also called as insolvency risk or credit risk. This is the risk
---------------------- that a company or individual will be unable to pay the contractual
interest or principal on its debt obligations. This type of risk is
---------------------- of particular concern to investors who hold bond’s within their
portfolio. Government bonds, especially those issued by the Federal
----------------------
government, have the least amount of default risk and least amount
---------------------- of returns while corporate bonds tend to have the highest amount of
default risk but also the higher interest rates.
----------------------
(d) Liquidity risk
---------------------- The risk of liquidating the assets as and when required is referred
---------------------- to as liquidity risk. Liquidity here means both ability of converting
asset into cash and doing it without compromising on price
---------------------- levels. The more uncertainty about the time element and the price
concession, the greater is the liquidity risk. A treasury bill has little
---------------------- or no liquidity risk, whereas a small OTC stock may have substantial
---------------------- liquidity risk.

6 Risk Management
 Besides this in both uncontrollable and controllable categories there are Notes
many other types of risk can be listed such as marketability risk, management
risk, political risk, reinvestment risk, international risk, foreign exchange risk, etc. ----------------------

----------------------
Check your Progress 1
----------------------
State True or False.
----------------------
1. Interest rate risk is a type of unsystematic risk and can be diversified
away. ----------------------

2. Risk of default is also called Liquidity risk. ----------------------

3. Unsystematic risks arise out of controlled factors. ----------------------

----------------------
Activity 3 ----------------------

Pick up any prospectus for a corporate bond. List the various types of risk, ----------------------
which are listed in the prospectus. Would any of the risks present in this ----------------------
prospectus be absent if you were to invest in securities in the stock market?
----------------------

1.5 MEASUREMENT OF RISK ----------------------

----------------------
As we have seen in Chapter 1, variance or standard deviation is a
measure of dispersion of a distribution. The spread of the actual returns around ----------------------
the expected return is measured by the variance or standard deviation of the
distribution. The greater the deviation of the actual returns from the expected ----------------------
return, the greater the variance.
----------------------
If we draw the probability distributions of returns of investments
exhibiting different variances, these would be as follows – ----------------------

High – variance Investment ----------------------

----------------------

----------------------

----------------------

----------------------
Low – variance Investment ----------------------

----------------------

----------------------
Fig. 1.1
----------------------

Risk and Return Concepts 7

 Notes If the actual return of an investment is always equal to the expected return,
then such an investment is a risk free investment. In this case the probability of
---------------------- actual return being equal to expected return will be 1 and the variance of return
will be zero.
----------------------
Probability = 1
----------------------
Risk-free investment
---------------------- The actual return is always equal to the expected return.
---------------------- Expected return
---------------------- Probability distribution of returns
---------------------- Total risk of any investment can be measured by the concept of variance,
standard deviation, covariance, etc that are explained in earlier chapters.
----------------------

---------------------- Activity 4
---------------------- Identify at least 4 financial instruments that you have learnt about so far
---------------------- which have probability of actual return being equal to expected return and
where the variance of return will be zero.
----------------------

---------------------- 1.6 RISK AND RETURN RELATIONSHIP

---------------------- Investment decisions are vital in portfolio management. The main motive
---------------------- of an investor behind any investment is maximum returns with minimum risk.
Thus we can say that investor likes returns but dislikes risks. But then returns
---------------------- are directly proportional to risk. The returns depend upon the extent of risk
taken by the investor. It is said higher the risk higher is the return. A brief
---------------------- idea about the risk and return relationship of various investment alternatives is
---------------------- shown in the following figure –

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
Fig 1.2
----------------------

8 Risk Management
 Notes
Activity 5
----------------------
Investment in banks is considered to be a low risk investment with low ----------------------
returns. However, if you factor inflation into the returns you end up with
negative returns. Is the safety of your investment more important than your ----------------------
need for real capital gains (i.e. after factoring inflation)? What kind of an
----------------------
investor do you see yourself to be?
----------------------

1.7 PORTFOLIO RISK ----------------------

A portfolio is nothing but a combination of assets or investments. Investing ----------------------

in a portfolio helps us reduce the risk as compared to investing completely in ----------------------
any one asset. When two or more securities are combined in a portfolio, their
covariance or combined risk is to be considered. Thus, if the returns on two ----------------------
assets move together, their covariance is positive and risk increases on such
portfolio. But if the returns move in opposite direction then the covariance is ----------------------
negative and risk is lesser. ----------------------
Now let us understand some important concepts in portfolio risk and
return. ----------------------

(1) Portfolio Returns ----------------------

The return on a portfolio of assets is simply a weighted average of the ----------------------
return on the individual assets. The expected return on a portfolio is also
a weighted average of the expected returns on the individual assets. ----------------------


n
Expected Portfolio Return = Xi * Ri ----------------------
i1

Where, Rp = Expected return on the portfolio ----------------------

Ri = Expected return on the individual asset ----------------------

N = No. of assets in the portfolio ----------------------
Xi = Weight of asset i in the portfolio
----------------------
Here’s a quick example of how to calculate the weight of a stock within
a portfolio. The weight of the asset (stock in this case) equals the stock value ----------------------
divided by the portfolio total. ----------------------
Stock No of Price / Share Stock Weight in
----------------------
Shares Value Portfolio
A 100 60 6000 29.63% ----------------------
B 120 65 7800 38.52%
----------------------
C 150 43 6450 31.85%
Portfolio Total 20250 ----------------------

----------------------

Risk and Return Concepts 9

 Notes (2) Portfolio Variance
The variance on a portfolio consisting of assets 1 and 2 is given by the
----------------------
following formula:
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
As you can see, the covariance is calculated using the summation of the
----------------------
product of two deviations: the deviations of the returns on security 1 from its
---------------------- mean and the deviations of security 2 from its mean. As it is a product of two
different deviations, it can be positive or negative. It will be large when the
---------------------- good outcomes for each stock occur together and when the bad outcomes for
each stock occur together. In the first case, for good outcomes the covariance
----------------------
will be the product of two large positive numbers, which is positive. When
---------------------- the bad outcomes occur together, the covariance will be the product of two
large negative numbers, which is again positive. This will result in a large
---------------------- value for the covariance and a large variance for the portfolio. In contrast, if
good outcomes for one asset are associated with bad outcomes of the other, the
----------------------
covariance is negative.
---------------------- The covariance is a measure of how returns on assets move together. If
---------------------- they have positive and negative deviations at similar times, the covariance is
a large positive number. If they have the positive and negative deviations at
---------------------- dissimilar times, then the covariance is negative. If the positive and negative
deviations are unrelated it tends to be zero.
----------------------
Dividing the covariance between two assets by the product
---------------------- of the standard deviation of each asset produces a variable
with the same properties as the covariance but with a range of
---------------------- –1 to +1. The measure is called the correlation coefficient. It is the correlation
---------------------- coefficient between securities 1 and 2 and it is defined as

----------------------

----------------------

10 Risk Management
 Notes

----------------------

----------------------

----------------------

----------------------

----------------------
The possibility of reduction of risk through the construction of a portfolio ----------------------
thus depends on the value of correlation coefficient between the two assets.
----------------------
Check your Progress 2 ----------------------

State True or False. ----------------------

1. Covariance is a value that does not have any bounds whereas ----------------------
correlation is bounded by an upper and lower value
----------------------
2. The correlation coefficient is bounded by an upper and lower value of
+1 and 1. ----------------------

----------------------
Activity 6 ----------------------

----------------------
Now that the concept of portfolio variance has been introduced, please
review this article that can be found athttps://www.boundless.com/finance/ ----------------------
introduction-to-risk-and-return/portfolio-considerations/implications-for-
variance/. ----------------------

----------------------
1.8 CAPITAL ASSETS PRICING MODEL ----------------------
The risk and return model that has been in use the longest is the Capital ----------------------
Asset Pricing Model (CAPM). This is also the model that is widely used in real-
world analysis. ----------------------
Assumptions ----------------------
The capital asset pricing model assumes that ----------------------
(i) Investors are risk averse.
----------------------
(ii) Investors are known with all the market fluctuations and information.
----------------------
(iii) There are no restrictions and transaction costs on investment.
(iv) Information available in the market will be digested by the capital markets. ----------------------
(v) Investors have identical time horizons. ----------------------

Risk and Return Concepts 11

 Notes (vi) Investors have homogeneous expectations about risk and return of
securities.
----------------------
The effect of the above assumptions is that investors can keep diversifying
---------------------- without additional cost.
To use the capital asset pricing model, we need the following inputs:
----------------------
(a) Risk free Rate
----------------------
The risk free rate is the return on a risk less asset, which is defined as
---------------------- an asset for which the investor knows the expected return with certainty
for the time horizon of the analysis. Such an asset is free from default
---------------------- risk and is not correlated with returns from any other investment in the
---------------------- economy. In practice the rate of return on a government security like a
Treasury bill or a government bond are used for this purpose.
---------------------- (b) Market Risk Premium
---------------------- The Market risk premium is the premium demanded by investors for
investing in the market portfolio. This market portfolio includes all risky
---------------------- assets in the market, instead of investing in a riskless asset. The Market
---------------------- risk premium varies for different economies based on factors like political
risk, state of the economy and market structure (the type of companies
---------------------- listed on the market).
---------------------- (c) Beta of the security
The Beta, is defined as the covariance of the asset with market portfolio
----------------------
divided by the variance of market portfolio and measures the risk added
---------------------- by an investment to the market portfolio.

---------------------- For example, if the risk free rate is 10% and the Beta (β) of the security
is 0.50 also the market risk premium is 8%. How to calculate expected
---------------------- return?

---------------------- tExpected return = rf +b * Market Risk Premium

---------------------- tExpected return = 10% + 0.5 x 8%

= 10 + 4
----------------------
= 14%
----------------------

---------------------- Activity 7

---------------------- Review the 10-year inflation rates and 10-year interest free rates for
---------------------- G-Securities in India using the URL’s provided below. Can you draw any
inference from what your notice in the graphs? You will need to modify the
---------------------- periods so that you get a graph representing the last 10 years (for 1994 - 2018)

---------------------- http://www.tradingeconomics.com/india/government-bond-yield
http://www.tradingeconomics.com/india/inflation-cpi
----------------------

12 Risk Management
1.9 BETA OF AN ASSET Notes

The systematic risk of an asset is measured by Beta of the asset. It shows ----------------------
how price of a security responds to changes in market price. The formula for
----------------------
Beta of an asset is as follows:
Beta of asset j = Covariance of asset j with market portfolio ----------------------
Variance of the market portfolio ----------------------

----------------------

----------------------
The Beta of a stock reflects the slope of a regression relationship in which ----------------------
the return on security j is regressed on the return on the market portfolio. It
indicates the extent of movement of the returns of the stock with respect to the ----------------------
movement of market returns.
----------------------
Assets that are riskier than average will have Betas that exceed 1 and
assets that are safer than average will have Betas lower than 1. The risk less ----------------------
asset will have a value of Beta = o. The Beta of the market portfolio or the ----------------------
average of Betas across all assets in the market is 1. This n obvious since the
covariance of the market portfolio with itself is its variance. ----------------------
For example, if it is given that the covariance of an asset with market ----------------------
portfolio is 85 and the variance of the market portfolio is 100. Then the Beta of
asset can be calculated as under – ----------------------
Beta of an asset = 85/100 ----------------------
= 0.85
----------------------
Check your Progress 3 ----------------------

----------------------
Fill in the blanks.
1. The risk-free security has a beta equal to _________, while the market ----------------------
portfolio’s beta is equal to _____________. ----------------------
2. The greater the beta, the ____________ of the security involved.
----------------------

----------------------

----------------------
1.10 SECURITY MARKET LINE
----------------------
The Security Market Line (SML) is based on a linear relationship between
the expected return on an asset and the Beta of the asset. ----------------------
SML is expressed as: ----------------------

----------------------

Risk and Return Concepts 13

 Notes

----------------------

----------------------

----------------------

----------------------

---------------------- The equation given above states that:

---------------------- Expected return = Risk free rate + [Beta of security i * Market risk
premium] on security i
----------------------
For example, if the risk free rate is 12% and the beta of the security is 1.2,
---------------------- the expected return on the market portfolio is 18%. Then the expected return on
security can be calculated as under –
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
Thus,
---------------------- E (Ri) = 12% + 1.2 * 0.06 = 19.2%
---------------------- Security market line that represents the relationship between expected
return and beta can be shown by figure as below –
----------------------

----------------------
SML
Slope = [E (Rm) – Rf]
----------------------
Expected Return

----------------------
βi [E (Rm) – Rf]

---------------------- Rf

----------------------

----------------------
y
0
---------------------- Beta
Fig 4.3
---------------------- Fig 1.3

----------------------

----------------------

14 Risk Management
1.11 RISK REDUCTION THROUGH DIVERSIFICATION Notes

We have already discussed that there are two types of risks systematic ----------------------
risk and non-systematic risk. Systematic risks are market related while non-
----------------------
systematic risks are firm specific risks. Therefore if we diversify and invest
in a portfolio, we can reduce our exposure to firm specific risk. How does this ----------------------
happen? Each investment in a diversified portfolio is a much smaller percentage
of that portfolio than would be the case if we were not diversified. The effects of ----------------------
firm-specific actions on the individual assets in a portfolio can be either positive
----------------------
or negative for each asset for any period. Thus, in very large portfolios this risk
will average out to zero and will not affect the value of the portfolio. ----------------------
Now let us see how we can reduce our risk by using combination of ----------------------
securities –
Assume an investor has Rs. 1000 to invest. The options open to the ----------------------
investor and the return on these are given in the table 1.1 below: ----------------------
Table 1.1
----------------------
Market Condition Probability Return % Return %
Investment Investment ----------------------
A B ----------------------
Good 1/3 16 1
Poor 1/3 10 10 ----------------------
Average 1/3 4 19 ----------------------
If the investor selects investment A, and the market is good, he will have at
----------------------
the end of the period Rs. 1000 + Rs. 160 = Rs. 1160. If the market performance
is average, he will get Rs. 1000 + Rs.100 =Rs. 1100 and if it is poor he will have ----------------------
Rs. 1000 + Rs. 40 = Rs. 1040. Suppose the investor selects investment B, and
the market is good, he will have at the end of the period Rs. 1000 + Rs. 10 = Rs. ----------------------
1010. If the market performance is average, he will get Rs. 1000 + Rs.100 =Rs.
----------------------
1100 and if it is poor, he will have Rs. 1000 + Rs. 190 = Rs. 1190.
Let us consider an alternative, ----------------------
Suppose the investor invests Rs. 600 in investment A and Rs. 400 in ----------------------
investment B. If the condition of the market is good, the investor will have Rs.
600 + Rs. 96+ Rs.400 + 4 = Rs. 1100 at the end of the period. If the market ----------------------
conditions are average, he will have Rs. 600 + Rs.60 + Rs. 400 + Rs. 40= Rs. ----------------------
1100 at the end of the period, If the market conditions are poor, he will have Rs.
600 + Rs. 24 + Rs. 400 + Rs. 76 = Rs. 1100 at the end of the period. ----------------------

----------------------

----------------------

----------------------

----------------------

Risk and Return Concepts 15

 Notes The possibilities explained above are summarised in the table 1.2 as below:
Amount at the end of Period for alternative investments
----------------------
Table 1.2
----------------------
Condition of Investment Investment B Combination
---------------------- market A (60% in A and 40% in B)
Good Rs. 1160 Rs. 1010 Rs. 1100
---------------------- Average Rs. 1100 Rs. 1100 Rs. 1100
Poor Rs. 1040 Rs. 1190 Rs. 1100
----------------------
From this example we can see how the risk on a portfolio of assets can
---------------------- differ from the risk of the individual investment. The deviations in returns of the
combination of investments A and B was zero because the investments had their
----------------------
highest and lowest returns under opposite market conditions. In general, we can
---------------------- infer that when two investments have their good and poor return at opposite
times, an investor can always find some combination of these investments that
---------------------- yield the same return under all market conditions. This example illustrates
the importance of considering combinations of investments rather than the
----------------------
individual investments themselves. It also illustrates how the distribution of
---------------------- outcomes on combination of investments can be different than the distributions
on the individual investments.
----------------------

---------------------- Activity 8
---------------------- Read this article: https://www.fidelity.com/viewpoints/guide-to-
---------------------- diversification

----------------------
Summary
----------------------
●● Return is the future benefits expected on the investments made today by
---------------------- the investor. It is the reward of investment.

---------------------- ●● Total return is measured by taking the income plus the price change.
Income is either in the form of dividend or interest and the price change of
---------------------- the security is capital gain or loss. While the average return is calculated
by using two methods namely arithmetic mean and geometric mean.
----------------------
●● In investment analysis, risk refers to the likelihood that the actual return
---------------------- on an investment received is different from the expected return.
●● Risks are classified into two types: systematic risk and non – systematic
----------------------
risk.
---------------------- Total risk = Systematic risk + Non- systematic risk.
---------------------- ●● Systematic risks are those risks which are caused due uncontrollable
factors that tend to affect all sectors of business, government and any
---------------------- other entity and leads to unavoidable affects for the investor, these risks
are virtually impossible to protect and influences large number of assets.
----------------------

16 Risk Management
 There are basically three types of systematic risks: Market risk, Purchasing Notes
power risk and Interest rate risk.
Systematic risk = Market risk + Purchasing power + Interest ----------------------

risk rate risk ----------------------

●● Non- systematic risk are firm specific risks, caused due to known ----------------------
or controllable factors and can be eliminated or reduced through
diversification. Non – systematic risk can be further divided into: Business ----------------------
risk, financial risk, liquidity risk, credit risk, etc.
----------------------
Non – systematic risk = Business + Financial + Liquidity + Credit
risk risk risk risk ----------------------
●● The risk of an portfolio can be measured by two ways: variability i.e. ----------------------
standard deviation and variance and Beta.
----------------------
●● A portfolio is nothing but a combination of assets or investments.
Investing in a portfolio helps us reduce the risk as compared to investing ----------------------
completely in any one asset.
●● The expected return on a portfolio is also a weighted average of the ----------------------
expected returns on the individual assets. ----------------------

----------------------

----------------------
●● The variance on a portfolio consisting of assets 1 and 2 is given by the
----------------------
following formula:
----------------------

CAPM in essence predicts the relationship between risk of an asset and its ----------------------
expected return. It is important in two ways. One, it produces benchmark ----------------------
for evaluating various assets and two, it helps us to make an informed
guess about return that can be expected from an asset that has not yet ----------------------
been traded in market. To use the capital asset pricing model, we need
the following inputs: Risk-free rate, Market risk premium and beta of ----------------------
security. ----------------------
●● Beta of the asset is the measure of non – diversifiable risk of an asset. It
shows how price of a security responds to changes in market price. The ----------------------
formula for Beta of an asset is as follows: ----------------------
Beta of asset j = Covariance of asset j with market portfolio
----------------------
Variance of the market portfolio
●● The Security Market Line (SML) is based on a linear relationship between ----------------------
the expected return on an asset and the Beta of the asset. ----------------------
Expected return = Risk free return + [Beta of security i * Market risk
----------------------
on security i premium]
----------------------

Risk and Return Concepts 17

 Notes Keywords
----------------------
●● Systematic risks: There are basically three types of systematic risks:
---------------------- Market risk, Purchasing power risk and Interest rate risk.
●● Non- systematic risk: Non- systematic risk are firm specific risks, caused
---------------------- due to known or controllable factors and can be eliminated or reduced
---------------------- through diversification.
●● Portfolio: A portfolio is nothing but a combination of assets or investments.
---------------------- Investing in a portfolio helps us reduce the risk as compared to investing
---------------------- completely in any one asset.

---------------------- Self-Assessment Questions

----------------------
1. Explain the difference between the following terms:
---------------------- (a) Risk and uncertainty.
---------------------- (b) Market specific risk and firm specific risk.

---------------------- (c) Capital market line and security market line.

(d) Variance and standard deviation.
----------------------
2. What is Security market line? How it is expressed?
----------------------
3. What is the relationship between covariance and correlation?
---------------------- 4. Explain how you can reduce risk through diversification. Give illustrations.
---------------------- 5. What is a Market portfolio?

---------------------- 6. Following are the price and other details of two stocks for the year 2017.
You are required to calculate the rate of return for the two stocks.
----------------------
Stock Beginning Price Ending Price Dividend
---------------------- X 75 69 4.50
Y 90 79 5.80
----------------------
7. Explain the following types of risk giving an example:
---------------------- (a) Credit risk.
---------------------- (b) Business risk.

---------------------- (c) Market risk.

(d) Liquidity risk.
----------------------
8. Which of these is not a part of systematic risk? Give reason in support of
---------------------- your answer.
---------------------- (a) Financial risk
(b) Interest rate risk.
----------------------
(c) Market risk.
----------------------
(d) Purchasing power risk.
18 Risk Management
9. What do you mean by total risk? Explain in brief. Notes
10. A portfolio consists of two securities A and B with expected returns of
----------------------
12% and 15% respectively. The proportion of portfolio value invested in
these securities is 0.20 and 0.50 respectively. What is expected return on ----------------------
the portfolio?
----------------------
11. A portfolio consists of two securities X and Y in the proportion of 0.7
and 0.3. The standard deviation on security X and Y is 15 and 21. The ----------------------
covariance is given as 0.10. Find out portfolio variance?
----------------------
12. If the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the
expected market return over the period is 10%. Calculate the expected ----------------------
return on the stock.
----------------------
13. Suppose if the covariance of the asset k with the market portfolio is 65
and the variance of the market portfolio is 80. Calculate Beta? ----------------------

----------------------
Answers to Check your Progress
----------------------
Check your Progress 1
State True or False. ----------------------

1. False ----------------------
2. False ----------------------
3. False
----------------------
Check your Progress 2
----------------------
State True or False.
1. True ----------------------

2. True ----------------------
Check your Progress 3 ----------------------
Fill in the blanks.
----------------------
1. The risk-free security has a beta equal to zero, while the market portfolio’s
beta is equal to one. ----------------------
2. The greater the beta, the greater the unavoidable risk of the security ----------------------
involved.
----------------------

Suggested Reading ----------------------

1. Bodie, Zvi, Alan J. Marcus, Alex Kane. Investments. ----------------------

----------------------

----------------------

----------------------

Risk and Return Concepts 19

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

20 Risk Management
Security Market Indicators
UNIT

2
Structure:

2.1 Securities Market

2.2 Classification of Securities Market
2.3 Debt Market
2.4 Equity Market
2.5 Derivatives Market
2.6 Stock Market Indices
2.7 Construction of Stock Market Indices
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Security Market Indicators 21

 Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
●● Discuss the securities market in India
---------------------- ●● Explain distinctive features of debt, equity and derivatives market
---------------------- ●● Distinguish between primary and secondary market
---------------------- ●● Understand what is stock market index and how it is constructed
●● Describe stock market indices in India
----------------------

---------------------- 2.1 SECURITIES MARKET

----------------------
In previous units, we have seen various investment avenues available
---------------------- to investor for investment. The market in which these securities are traded is
called as Securities Market. These markets serve various purposes like –
----------------------
1. It helps the issuers in raising funds for financing their operations.
---------------------- 2. It provides an opportunity to investors to channel their savings.
---------------------- 3. These markets activate idle funds for productive use and converts savings
into investment leading to growth of fixed asset and productive capacity.
----------------------
4. It promotes the growth of industry and economy in general and of
---------------------- corporate sector in particular.
----------------------
2.2 CLASSIFICATION OF SECURITIES MARKET
----------------------
Securities Market is the market for equity, debt and derivatives. The
---------------------- debt market may be divided into three parts: government securities market,
corporate debt market and money market. While the derivatives market may be
---------------------- divided into two parts: options market and futures market. The structure of the
---------------------- securities market is shown in figure 2.1 as below –
Securities Market
----------------------

----------------------

----------------------
Debt Market Equity Market Derivatives Market
----------------------

----------------------

---------------------- Government Corporate Money Options Futures

Securities Debt Market Market And
---------------------- Market Market Forwards
Market
---------------------- Fig 2.1 Structure of Securities Market

22 Risk Management
 Except for derivatives market each one of the above markets have two Notes
components i.e. primary market and secondary market. Primary market is also
called as new issues market as it is the market where new securities are issued ----------------------
and the market where outstanding securities are traded is called as Secondary
market. ----------------------

----------------------
2.3 DEBT MARKET
----------------------
Debt market as stated above comprises of Government securities market,
corporate debt market and money market which are explained in brief as under– ----------------------

(1) Government securities market ----------------------

It is the largest segment of debt market in India. It accounts for nearly ----------------------
2/3rd of the issues in primary market and 4/5th of the turnover in
secondary market. The issues here are regulated by the “Reserve Bank ----------------------
of India (RBI)” under Public Debt Act. Government securities are issued
----------------------
through an ‘auction mechanism’. These auctions are announced by RBI
through press notification and bids are invited form perspective investors ----------------------
like banks, insurance companies, mutual funds, trusts, provident funds,
etc. As soon as government securities are issued they are deemed to be ----------------------
listed and are eligible for trading. These instruments can be traded in
----------------------
the “Wholesale Debt Market (WDM)” segment of the “National Stock
Exchange (NSE)” that is a fully automated screen based trading system. ----------------------
(2) Corporate debt market
----------------------
The market for corporate debentures revived since mid 1990’s. The
issuance of corporate debt securities are regulated by the “Securities ----------------------
Exchange Board of India (SEBI)”. The issues are made on rights basis
----------------------
or are privately placed. The mechanism for public issue of debentures
is almost same as that of public issue of equity. At present corporate ----------------------
debentures in India are issued through private placement and is managed
by a lead arranger who is also the advisor and investment banker for ----------------------
the issue. The secondary market for corporate debentures has been very
----------------------
dull in terms of liquidity and trading volumes as compared to secondary
market for equity. ----------------------
(3) Money market ----------------------
Money market is the market where short term instruments of credit with a
maturity period of one year or less than that are traded. These instruments ----------------------
are known as ‘near money’. The traders, government and speculators ----------------------
are the borrowers of money market and central bank, commercial banks,
financial institutions and insurance companies, etc serve as lenders in the ----------------------
money market. Money market comprises of the call and notice market,
repo market, bill market, acceptance market, etc. ----------------------

----------------------

----------------------

Security Market Indicators 23

 Notes
Activity 1
----------------------

---------------------- Read more about the trading system in the WDM market at the exchange.
The URL is http://www.nseindia.com/products/content/debt/wdm/trading_
---------------------- system.htm
----------------------
2.4 EQUITY MARKET
----------------------
Equity market in India comprises of primary equity market and secondary
----------------------
equity market, which are explained as under –
---------------------- (1) Primary equity market
---------------------- This market is also called as new issues market where securities are issued
to public for the very first time. The flotation of new issues in primary
---------------------- market is made in four ways:
---------------------- (a) Public issue
---------------------- Public issue involves sale of securities to public at large. It is governed
by the provisions of Companies Act 1956, SEBI guidelines and
---------------------- listing agreement between issuing company and stock exchanges.
The Companies Act states the procedure to be followed in issue of
----------------------
securities and the type of information to be disclosed in prospectus,
---------------------- SEBI guidelines impose certain conditions on the issuers besides
specifying additional information to be disclosed to the investor. The
---------------------- issue of securities to the public is an elaborate process consisting of
various steps right for approval of Board of Directors to the listing
----------------------
of issue.
---------------------- (b) Rights issue
---------------------- A right issue is the issue of capital to the existing shareholders of
the company through letter of offer made in first instance to the
---------------------- existing shareholders on pro rata basis. The shareholders however
---------------------- by a special resolution forfeit this right, partially or fully, to enable
company to issue additional capital to public.
---------------------- (c) Private placements
---------------------- It involves sale of securities to few experienced investors such as
financial institutions, mutual funds, banks, venture capital funds,
---------------------- etc. An unlisted company that requires infusion of funds but is not
---------------------- ready to make an “Initial Public Offering (IPO)” may privately place
its equity instruments with one or more sophisticated investors. The
---------------------- quantity and price of such issues is decided freely as there is no
restriction imposed by SEBI on it. All available instruments like
---------------------- equity shares, preference shares, debentures (convertible and non -
---------------------- convertible) can be privately placed.

24 Risk Management
 (d) Preferential allotment Notes
An issue of the equity instruments by a listed company to pre–
----------------------
identified persons (may or may not be existing shareholders) at a
pre–determined price is called as preferential allotment. Preferential ----------------------
allotment in India is given to promoters or friendly investors to
protect against threat of takeover. Now - a - days it has become a ----------------------
very popular means of raising fresh equity capital.
----------------------
(2) Secondary equity market (Stock exchanges)
----------------------
Stock exchanges are an important part of capital market. They are
the theatres of trading securities. In simple words, it is an organized ----------------------
market place where securities are traded. These securities are issued
by government, semi – government bodies, public sector undertakings, ----------------------
joint stock companies, etc. According to Securities Contract Regulation
----------------------
Act 1956, “Stock exchange is an association, organization or body of
individuals whether incorporated or not, established for the purpose of ----------------------
assisting, regulating, and controlling the business in buying, selling and
dealing in securities.” ----------------------
The first organized stock exchange in India was started in Bombay in 1875 ----------------------
with the formation of “Native Share and Stock Broker’s Association.”
Thus Bombay Stock Exchange is the oldest one in the country, the ----------------------
stock exchanges also made a steady growth and at present there are 23 ----------------------
recognized stock exchanges in India. The most important development
in Indian stock market was establishment of National Stock Exchange ----------------------
in 1994. Within short period it emerged as leading stock exchange in our
country. The distinctive features of Bombay Stock Exchange and National ----------------------
Stock Exchange are shown in table 2.1 below: ----------------------
Table 2.1
----------------------
Bombay Stock Exchange National Stock Exchange
1. Bombay Stock Exchange was 1. National Stock Exchange was ----------------------
established in 1875.it is one of recognized in April-1993 and
----------------------
the oldest organized exchanges operation started in Nov-1994.
in the world. ----------------------
2. The Bombay Stock Exchange 2. NSE index namely Nifty started
(BSE) index namely Sensex was in 1995. The base year for Nifty ----------------------
started in 1986. The base year is 1994 and base value is 1000.
for the Sensex is 1978-79 and It consists of 50 scrips. ----------------------
base value is 100. It consists of ----------------------
30 scrips.
4. BSE switched from open outcry 4. NSE is ringless, national, ----------------------
system to screen-based trading computerized exchange.
in 1995. ----------------------
5. BSE has adopted both ‘quote 5. NSE has opted for an order ----------------------
driven’ system and an ‘order driven system.
driven’ system. ----------------------

Security Market Indicators 25

 Notes
Check your Progress 1
----------------------

---------------------- State True or False.

1. Preferred allotment of shares to pre–identified persons must always
----------------------
be to existing shareholders at a pre–determined price is called as
---------------------- preferential allotment.
2. Sensex is an index for NSE.
----------------------

----------------------
Activity 2
----------------------

---------------------- Research and identify the size of the primary and secondary markets on the
NSE as well as the BSE.
----------------------

---------------------- 2.5 DERIVATIVES MARKET

---------------------- Financial markets are extremely volatile and prone to risk. To reduce
---------------------- this risk concept of derivatives came into existence. The word ‘derivative’
originates from mathematics and refers to a variable, that been derived from
---------------------- another variable. The word derivatives are used because they have no value of
their own but they derive their value from the value of some other asset, which
---------------------- is known as the underlying. Derivatives are specialized contracts which signify
---------------------- an agreement or an option to buy or sell the underlying asset of the derivate up
to a certain time in the future at a predetermined price. The contract also has
---------------------- a fixed expiry period mostly in the range of 3 to 12 months from the date of
commencement of the contract. The value of the contract depends on the expiry
---------------------- period and also on the price of the underlying asset.
---------------------- For example, a farmer fears that the price of soybean (underlying), when
his crop is ready for delivery will be lower than his cost of production.
----------------------
Let’s say the cost of production is Rs 10,000 per ton. In order to overcome
---------------------- this uncertainty in the selling price of his crop, he enters into a contract
(derivative) with a merchant, who agrees to buy the crop at a certain price
----------------------
(exercise price), when the crop is ready in three months time (expiry period).
---------------------- In this case, say the merchant agrees to buy the crop at Rs 12,000 per ton.
Now, the value of this derivative contract will increase as the price of soybean
----------------------
decreases and vice-a-versa. If the selling price of soybean goes down to Rs
---------------------- 8,000 per ton, the derivative contract will be more valuable for the farmer, and
if the price of soybean goes down to Rs 7,000, the contract becomes even more
---------------------- valuable. This is because the farmer can sell the soybean he has produced at Rs
.12, 000 per tone even though the market price is much less. Thus, the value of
----------------------
the derivative is dependent on the value of the underlying.
----------------------

26 Risk Management
 If the underlying asset of the derivative contract is coffee, wheat, pepper, Notes
cotton, gold, silver, precious stone or for that matter even weather, then the
derivative is known as a commodity derivative. If the underlying is a financial ----------------------
asset like debt instruments, currency, share price index, equity shares, etc, the
derivative is known as a financial derivative. Some of the most basic forms of ----------------------
Derivatives are Futures, Forwards and Options.
----------------------
At this point, an introduction to exchange traded transactions and over the
counter (OTC) transactions is important. ----------------------
Exchange Traded: In the case of exchange-traded transactions, the stock ----------------------
exchanges set the institutional rules that govern trading and information flows
about that trading. They are closely linked to the clearing facilities through ----------------------
which post-trade activities are completed for securities and derivatives traded
----------------------
on the exchange. An exchange centralizes the communication of bid and offer
prices to all direct market participants, who can respond by selling or buying ----------------------
at one of the quotes or by replying with a different quote. Depending on the
exchange, the medium of communication can be voice, hand signal, a discrete ----------------------
electronic message, or computer-generated electronic commands. When two
parties reach agreement, the price at which the transaction is executed is ----------------------
communicated throughout the market. ----------------------
Over the counter (OTC): Unlike exchanges, OTC markets have never
been a “place.” They are less formal, although often well-organized, networks ----------------------
of trading relationships centered around one or more dealers. Dealers act as ----------------------
market makers by quoting prices at which they will sell (ask or offer) or buy
(bid) to other dealers and to their clients or customers. That does not mean they ----------------------
quote the same prices to other dealers as they post to customers, and they do
not necessarily quote the same prices to all customers. Moreover, dealers in ----------------------
an OTC security can withdraw from market making at any time, which can
----------------------
cause liquidity to dry up, disrupting the ability of market participants to buy or
sell. Exchanges are far more liquid because all buy and sell orders as well as ----------------------
execution prices are exposed to one another. Also, some exchanges designate
certain participants as dedicated market makers and require them to maintain ----------------------
bid and ask quotes throughout the trading day. In short, OTC markets are less
transparent and operate with fewer rules than do exchanges. The process of ----------------------
negotiating by phone or electronic message, whether customer to dealer or ----------------------
dealer to dealer, is known as bilateral trading because only the two market
participants directly observe the quotes or execution. Others in the market are ----------------------
not privy to the trade, although some brokered markets post execution prices
and the size of the trade after the fact. But not everyone has access to the broker ----------------------
screens and not everyone in the market can trade at that price. Although the
----------------------
bilateral negotiation process is sometimes automated, the trading arrangement
is not considered an exchange because it is not open to all participants equally. ----------------------
The derivatives market is divided into three.
----------------------
(1) Options Market
----------------------
Option contracts give the holder the option to buy or sell the underlying
at a pre-specified price some time in the future. Options are of two types: ----------------------

Security Market Indicators 27

 Notes call and put options. An option to buy the underlying is known as a call
option and option to sell the underlying at a specified price in the future is
---------------------- known as put option. Options can be traded on the stock exchange or on
the OTC market. The options market may have three types of structures –
----------------------
(a) Auction market with jobbers.
----------------------
(b) Order matching electronic trading.
---------------------- (c) Dealers market as in government security
---------------------- (2) Futures market (Exchange Traded)
---------------------- A futures contract is an agreement between two parties to buy or sell an
asset at a certain time in future at a certain price. These are special type of
---------------------- forward contracts in the sense that the former are standardized exchange
traded contracts. There has been remarkable growth in the futures market.
----------------------
Most of this growth has come from the financial futures. In addition to
---------------------- this there has been a significant growth in international futures market.
This growth is the outcome of various reasons:
----------------------
●● The cost of transacting in the futures market is usually far less than
---------------------- the cash markets. That is, the commission for buying a basket of
stocks that resembles the S&P 500 is much higher than buying the
---------------------- S&P 500 futures contract.
---------------------- ●● The speed of transacting is faster. Buying the S&P 500 futures can
be done in a manner of seconds. To buy the basket of stocks could
---------------------- take the entire day.
---------------------- ●● There is one common price. Suppose you wanted to buy a Treasury
bond in the cash market. There are many different bond (different
---------------------- maturities and coupons) trading all over the world. Which one do
---------------------- you choose? Similarly, what is the price of corn? In the cash market,
there are various prices around the country and world. The futures
---------------------- market provides one price. Indeed, the futures market serves as a
benchmark for transactions in the cash market.
----------------------
●● Buying and selling are equally as easy in the futures market. In
---------------------- the stock market, shorting is difficult. Usually, 50% margin must
be posted and a short can only occur on an up tick. The up tick
----------------------
rule may eliminate the short transaction for the entire day! A short
---------------------- futures trade can be executed as quickly as a long position.
(3) Forwards market (OTC)
----------------------
A forwards contract is a contract that is executed “over the counter
---------------------- (OTC)”. These are customized contracts between two parties to buy or
---------------------- sell an asset at a specified price on a future date. A forward contract can
be used for hedging or speculation, although its non-standardized nature
---------------------- makes it particularly apt for hedging. Unlike standard futures contracts,
a forward contract can be customized to any commodity, amount and
---------------------- delivery date. A forward contract settlement can occur on a cash or

28 Risk Management
 delivery basis. Forward contracts do not trade on a centralized exchange Notes
and are therefore regarded as over-the-counter (OTC) instruments.
While their OTC nature makes it easier to customize terms, the lack of ----------------------
a centralized clearinghouse also gives rise to a higher degree of default
risk. As a result, forward contracts are not as easily available to the retail ----------------------
investor as futures contracts. ----------------------
The market for forward contracts is huge, since many of the world’s
----------------------
biggest corporations use it to hedge currency and interest rate risks.
However, since the details of forward contracts are restricted to the buyer ----------------------
and seller, and are not known to the general public, the size of this market
is difficult to estimate. The large size and unregulated nature of the ----------------------
forward contracts market means that it may be susceptible to a cascading
----------------------
series of defaults in the worst-case scenario. While banks and financial
corporations mitigate this risk by being very careful in their choice of ----------------------
counterparty, the possibility of large-scale default does exist.
----------------------
Check your Progress 2 ----------------------

State True or False. ----------------------

1. An exchange provides a centralized place where all OTC transactions ----------------------

are conducted.
----------------------
2. An exchange removes counterparty risk, because it stands on the
other side of all trades. ----------------------

----------------------
Activity 3 ----------------------

(For answering these questions, visit your nearest broker and understand ----------------------
the practical aspects of derivatives.) ----------------------
1. What do you mean by “buying Nifty”? Does it mean that the seller
have to deliver all fifty shares? ----------------------

2. Who are the participants of derivatives market? Explain each one in ----------------------
brief.
----------------------
3. What is the status of futures and options on the equity market in India?
----------------------

2.6 STOCK MARKET INDICES ----------------------

You would have come across the price indices like wholesale price index ----------------------
and consumer price index, which are used to get an idea about the price level of
commodities in the wholesale and retail markets. ----------------------

Similarly stock market indices are used to measure the general movement ----------------------
of the stock market. Stock market indices are used as a proxy for overall market
movement. ----------------------

Security Market Indicators 29

 Notes The major stock market indices in India are:
(1) Bombay Stock Exchange Sensitive Index
----------------------
It was started in 1986 and is the most widely followed stock market index
---------------------- in India. It is popularly known as Sensex (officially it is the S&P BSE
Sensex). It reflects the movements of 30 sensitive shares from specified
----------------------
and non – specified groups. Sensex is constructed on the basis of free float
---------------------- market cap rather than full market cap. Free float market cap is the market
value of that portion of the shares issued by the company for trading in
---------------------- market. The base value is 100 and the base year for the Sensex is 1978-79.
---------------------- (2) S & P CNX Nifty

---------------------- It is the most rigorously constructed stock market index in India that
started in 1995. Known as Nifty Index, it reflects the movements of 50
---------------------- scrips selected on the basis of market capitalization and liquidity. The
base year for nifty is 1995 and base value is 1000.
----------------------
Market capitalization = Market price x Free-floating stock.
---------------------- Base market capitalization = Market price x Issue price of all
---------------------- securities.

---------------------- Check your Progress 3

----------------------
Fill in the blanks.
----------------------
1. Sensex is constructed on the basis of free float market cap rather than
---------------------- _______.

---------------------- 2. Nifty reflects the movements of __________ scrips of NSE.

----------------------
Activity 4
----------------------

---------------------- Research the scrip selection criteria for inclusion in the S&P BSE Sensex.
----------------------
2.7 CONSTRUCTION OF STOCK MARKET INDICES
----------------------
Indices can be constructed for narrower purposes as well for example for
---------------------- specific sectors. While constructing stock market indices some questions are to
be dealt with like: Are the indices based on reliable sample? What is the trade-
----------------------
off between diversification and liquidity? What should be the choice of index?
---------------------- (Whether is should be value weighted index or equal weighted index). All these
issues are to be considered while constructing and index.
----------------------
Now let us see the steps involved in the steps involved in the construction
---------------------- of a stock market index based on market cap weighted are:

---------------------- i) Selecting a set of scrips to be used –

30 Risk Management
 The selection is made in such a way that the selected scrips reflect the Notes
overall market movement. In order to achieve this we will need scrips from
various important industries. The key factors that we have to consider to ----------------------
select the representative scrips are: (a) Market capitalization (b) Trading
volumes. ----------------------

ii) Fixing a starting date. ----------------------

iii) Calculating the market capitalization of all companies in the index based ----------------------
on the closing prices on the starting date. The value of the index on the
starting date is taken as 100. ----------------------
iv) Calculating the market capitalization of all companies in the index based ----------------------
on the closing prices on the required date.
----------------------
v) Calculating the value of the index on the required date by the formula :
Value of the index on = Total Market Capitalization on the required date *100 ----------------------

the required date Total Market Capitalization on the Starting date ----------------------
Example of construction of a stock market index: ----------------------
Share Price on No. Price on Market Market Market ----------------------
of Starting Outstanding required Capitalization Capitalization
date Shares date on starting on required ----------------------
date date
Rs. Millions Rs. Rs. Millions Rs. Millions ----------------------
A 165 1.0 175 165 175
----------------------
B 50 1.5 65 75 97.5
C 350 0.5 355 175 177.5 ----------------------
D 26 2.0 30 52 60
E 920 0.5 910 460 455 ----------------------
F 35 1.5 40 52.5 60
G 115 1.0 110 115 110 ----------------------
H 65 0.75 68 48.75 51 ----------------------
I 85 1.0 90 85 90
Total 1228.25 1276 ----------------------
Here given is,
----------------------
Value of Index on starting date = 100
Total Market Capitalization on starting date = Rs. 1228. 25 M ----------------------

Total Market Capitalization on required date = Rs. 1276 M ----------------------

Now putting the formula – ----------------------
Value of the index on = Total Market Capitalization on the required date *100
----------------------
the required date Total Market Capitalization on the Starting date
----------------------
= 1276.00 *100
1228.25 ----------------------

= 103.89 ----------------------

Security Market Indicators 31

 Notes
Activity 5
----------------------

---------------------- 1. Name the all the major indices of the following stock exchanges:

---------------------- Stock Exchanges Index

i. Bombay Stock Exchange Sensex, Nifty
----------------------
ii. USA Stock Exchange
----------------------
iii. National Stock Exchange
---------------------- iv. New York Stock Exchange
---------------------- v. London Stock Exchange

---------------------- vi. Hong Kong Stock Exchange

vii. Tokyo Stock Exchange
----------------------
viii. Korea Stock Exchange
----------------------

---------------------- Summary
---------------------- ●● The market in which securities are traded is called as Securities Market.
Securities Market is the market for equity, debt and derivatives. The debt
----------------------
market may be divided into three parts: government securities market,
---------------------- corporate debt market and money market. While the derivatives market
may be divided into two parts: options market and futures market.
----------------------
●● Each of the markets above has two components i.e. primary market and
---------------------- secondary market except for derivatives market. Primary market is the
market where new securities are issued and the market where outstanding
---------------------- securities are traded is called as Secondary market.
---------------------- ●● Government securities market is the largest segment of debt market in
India. It accounts for nearly 2/3rd of the issues in primary market and
---------------------- 4/5th of the turnover in secondary market. The issues here are regulated
by RBI under Public Debt Act. Government securities are issued through
----------------------
an ‘auction mechanism’. As soon as government securities are issued they
---------------------- are deemed to be listed and are eligible for trading. These instruments can
be traded in WDM segment of NSE which is a fully automated screen
---------------------- based trading system.
---------------------- ●● Corporate debt market relived since mid 1990’s. The issuance of corporate
debt securities are regulated by SEBI. The issues are made on rights basis
---------------------- or are privately placed. The mechanism for public issue of debentures
is almost same as that of public issue of equity. At present corporate
---------------------- debentures in India are issued through private placement.
---------------------- ●● Money market is the market where short term instruments of credit with
a maturity period of one year or less than that are traded. The traders,
---------------------- government and speculators are the borrowers of money market and

32 Risk Management
 central bank, commercial banks, financial institutions and insurance Notes
companies, etc serve as lenders in the money market.
----------------------
●● Primary equity market is also called as new issues market where securities
are issued to public for the very first time. The flotation of new issues in ----------------------
primary market is made in four ways: public issue, rights issue, private
placement, preferential allotment. ----------------------
●● Public issue involves sale of securities to public at large. It is governed ----------------------
by the provisions of Companies Act 1956, SEBI guidelines and listing
agreement between issuing company and stock exchanges. ----------------------

●● A right issue is the issue of capital to the existing shareholders of the ----------------------
company through letter of offer made in first instance to the existing
shareholders on pro rata basis. The shareholders however by a special ----------------------
resolution forfeit this right, partially or fully, to enable company to issue ----------------------
additional capital to public.
----------------------
●● Private placement involves sale of securities to few experienced investors
such as financial institutions, mutual funds, banks, venture capital funds, ----------------------
etc. An unlisted company which requires infusion of funds but is not
ready to make an IPO may privately place its equity instruments with one ----------------------
or more sophisticated investors. The quantity and price of such issues is
----------------------
decided freely as there is no restriction imposed by SEBI on it.
●● An issue of the equity instruments by a listed company to pre–identified ----------------------
persons (may or may not be existing shareholders) at a pre–determined ----------------------
price is called as preferential allotment. Today preferential allotment has
become a very popular means of raising fresh equity capital. ----------------------
●● Stock exchange is an organized market place where securities are ----------------------
traded. These securities are issued by government, semi – government
bodies, public sector undertakings, joint stock companies, etc. According ----------------------
to Securities Contract Regulation Act 1956, “Stock exchange is an
----------------------
association, organization or body of individuals whether incorporated or
not, established for the purpose of assisting, regulating, and controlling ----------------------
the business in buying, selling and dealing in securities.”
----------------------
●● The first organized stock exchange in India was started in Bombay in 1875
with the formation of “Native Share and Stock Broker’s Association.” ----------------------
At present there are 23 recognized stock exchanges in India. The most
important development in Indian stock market was establishment of ----------------------
National Stock Exchange in 1994. Within short period it emerged as
----------------------
leading stock exchange in our country.
●● Derivatives are specialized contracts which signify an agreement or an ----------------------
option to buy or sell the underlying asset of the derivate up to a certain ----------------------
time in the future at a predetermined price. The contract also has a fixed
expiry period mostly in the range of 3 to 12 months from the date of ----------------------
commencement of the contract. The value of the contract depends on the
expiry period and also on the price of the underlying asset. ----------------------

Security Market Indicators 33

 Notes ●● Option contracts give the holder the option to buy or sell the underlying
at a pre-specified price some time in the future. Options are of two types:
---------------------- call and put options. Options can be traded on the stock exchange or on
the OTC market. The options market may have three types of structures:
---------------------- (a) Auction market with jobbers (b) Order matching electronic trading (c)
---------------------- Dealers market as in government security.
●● A futures contract is an agreement between two parties to buy or sell
----------------------
an asset at a certain time in future at a certain price. There has been
---------------------- remarkable growth in the futures market. Most of this growth has come
from the financial futures. This growth is the outcome of various reasons:
---------------------- the cost of transacting in the futures market is usually far less than the cash
markets, the speed of transacting is faster, there is one common price, and
----------------------
buying and selling are equally as easy in the futures market. This makes
---------------------- futures market attractive for investors.
●● A forwards contract is a contract that is executed “over the counter
----------------------
(OTC)”. These are customized contracts between two parties to buy or
---------------------- sell an asset at a specified price on a future date. A forward contract can
be used for hedging or speculation, although its non-standardized nature
---------------------- makes it particularly apt for hedging.
----------------------
Keywords
----------------------
●● Securities Market: Securities Market is the market for equity, debt and
---------------------- derivatives.
---------------------- ●● Debt: The debt market may be divided into three parts: government
securities market, corporate debt market and money market.
----------------------
●● Money market: Money market is the market where short term instruments
---------------------- of credit with a maturity period of one year or less than that are traded

---------------------- ●● Derivatives: derivatives market may be divided into two parts: options
market and futures market
----------------------

---------------------- Self-Assessment Questions

---------------------- 1. Explain the difference between the following terms:

---------------------- (a) Primary and secondary market.

(b) Bombay stock exchange and national stock exchange.
----------------------
(c) Debt market and equity market.
----------------------
(d) Options and futures contracts.
---------------------- (e) Sensex and nifty.
---------------------- 2. What are the rules and regulations laid down by SEBI for stock brokers?

---------------------- 3. State the steps involved in the process of public issue?

34 Risk Management
4. What is a Stock exchange? State the functions of Stock exchanges in Notes
India.
----------------------
5. Critically compare the Indian stock market with US stock market and
make necessary suggestions. (required if any) ----------------------

Answers to Check your Progress ----------------------

Check your Progress 1 ----------------------

State True or False. ----------------------

1. False ----------------------
2. False
----------------------
Check your Progress 2
----------------------
State True or False.
1. False ----------------------

2. True ----------------------
Check your Progress 3 ----------------------
Fill in the blanks.
----------------------
1. Sensex is constructed on the basis of free float market cap rather than full
market cap. ----------------------

2. Nifty reflects the movements of 50 scrips of NSE. ----------------------

----------------------
Suggested Reading
----------------------
1. BSE Investor Guide
----------------------
2. http://www.bseindia.com/investors/services.aspx?expandable=1
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

Security Market Indicators 35

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

36 Risk Management
Derivatives: Futures and Options
UNIT

3
Structure:

3.1 Derivatives
3.2 Futures Contract
3.3 Options
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Derivatives: Futures and Options 37

 Notes
Objectives
----------------------

---------------------- After going through this unit, you will be able to:
●● Discuss the concept of derivatives market
----------------------
●● Explain what is index futures and its uses
---------------------- ●● Describe options and its types
---------------------- ●● Differentiate between futures and options

----------------------

---------------------- 3.1 DERIVATIVES

---------------------- The primary objectives of any investor are to maximize returns and
minimize risks. Derivatives are contracts that originated from the need to
---------------------- minimize risk.
---------------------- The word ‘derivative’ originates from mathematics and refers to a variable,
which has been derived from another variable. Derivatives are so called because
---------------------- they have no value of their own. They derive their value from the value of some
other asset, which is known as the underlying.
----------------------
For example, a derivative of the shares of Reliance (underlying), will
---------------------- derive its value from the share price (value) of Reliance. Similarly, a derivative
contract on crude oil depends on the price of crude oil.
----------------------
Derivatives are specialized contracts which signify an agreement or an
---------------------- option to buy or sell the underlying asset of the derivate up to a certain time in
the future at a prearranged price, the exercise price.
----------------------
The contract also has a fixed expiry period mostly in the range of 3 to
---------------------- 12 months from the date of commencement of the contract. The value of the
---------------------- contract depends on the expiry period and also on the price of the underlying
asset.
---------------------- For example, a farmer fears that the price of pepper (underlying), when
---------------------- his crop is ready for delivery will be lower than his cost of production.
Let’s say the cost of production is Rs 8,000 per ton. In order to overcome
----------------------
this uncertainty in the selling price of his crop, he enters into a contract
---------------------- (derivative) with a merchant, who agrees to buy the crop at a certain price
(exercise price), when the crop is ready in three months time (expiry period).
----------------------
In this case, say the merchant agrees to buy the crop at Rs 9,000 per ton.
---------------------- Now, the value of this derivative contract will increase as the price of pepper
decreases and vice-a-versa.
----------------------
If the selling price of pepper goes down to Rs 7,000 per ton, the derivative
---------------------- contract will be more valuable for the farmer, and if the price of pepper goes
down to Rs 6,000, the contract becomes even more valuable.
----------------------

38 Risk Management
 This is because the farmer can sell the pepper he has produced at Rs Notes
.9000 per ton even though the market price is much less. Thus, the value of the
derivative is dependent on the value of the underlying. ----------------------
If the underlying asset of the derivative contract is coffee, wheat, pepper, ----------------------
cotton, gold, silver, precious stone or for that matter even weather, then the
derivative is known as a commodity derivative. ----------------------
If the underlying is a financial asset like debt instruments, currency, share ----------------------
price index, equity shares, etc, the derivative is known as a financial derivative.
Derivative contracts can be standardized and traded on the stock exchange. Such ----------------------
derivatives are called exchange-traded derivatives or they can be customized
----------------------
as per the needs of the user by negotiating with the other party involved. The
advantages of derivatives market are as follows: ----------------------
(1) Increased hedge for investors in cash market.
----------------------
(2) Enhance price discovery process.
----------------------
(3) Increases volume of transactions.
(4) Leads to faster execution of trades and arbitrage and hedge against risk. ----------------------

(5) Increased liquidity for investors and growth of savings flowing into these ----------------------
markets.
----------------------
(6) Lower transaction costs.
----------------------
(7) Diversion of speculative instinct from cash market to derivatives.
----------------------
3.2 FUTURES CONTRACT
----------------------
A futures contract is a standardized forward contract. A forward contract is
----------------------
an agreement between two parties exchange an asset for cash at a predetermined
future date for a price that is specified today represents a forward contract ----------------------
There are two types of futures commodity and financial futures: ----------------------
(1) Commodity futures –
----------------------
Futures contract on commodities storable or perishable like gold, oil,
aluminum, cotton, rice, orange juice, etc have been in existence since ----------------------
long time.
----------------------
(2) Financial futures –
----------------------
Although futures have their origin in commodities, financial futures
namely equity futures, interest rate futures and currency futures dominate ----------------------
the market today. Equity futures are of two types: Index futures and
Futures on individual securities. These are explained as under: ----------------------
(a) Index futures ----------------------
Index futures are futures contracts where the underlying is the stock ----------------------
index. In India we have index futures contracts based on S & P
CNX Nifty and the BSE SENSEX. Contracts of 3 months duration ----------------------

Derivatives: Futures and Options 39

 Notes are available at all times. Each contract expires on the last Thursday
of the expiry month. A new contract is introduced for trading
---------------------- simultaneously after the expiry of a contract. The permitted lot size
is 200 or multiples there of for the Nifty and 50 for BSE SENSEX.
----------------------
(b) Futures on individual securities
----------------------
In India futures on individual securities have been introduced from
---------------------- 2001. This has been introduced by both NSE and BSE. Securities
Exchange Board of India has specified the list of securities in which
---------------------- futures contracts are permitted. The features of futures on individual
securities on the NSE are given below.
----------------------
●● The underlying for the futures on individual securities
---------------------- contracts shall be the underlying available for trading in the
capital market segment of the exchange.
----------------------
●● Futures contracts on individual securities will have a
---------------------- maximum of three month trading cycle. New contracts will
be introduced on the trading day following the expiry of the
----------------------
near month contract.
---------------------- ●● Futures contracts on individual securities shall expire on the
last Thursday of the expiry month. If the last Thursday is a
----------------------
trading holiday, the contracts shall expire on the previous day.
---------------------- ●● The permitted size of the futures contracts on individual
securities shall be the same as the lot size of options contract
----------------------
for a given underlying security or such lot size as may be
---------------------- stipulated by the exchange from time to time.
●● The price steps in respect of all futures contracts admitted to
---------------------- the dealings of the exchange shall be Rs. 0.05.
---------------------- ●● The base price of the futures contracts on introduction of
new contracts shall be the previous day’s closing price of
---------------------- the underlying security. The base price of the contracts on
---------------------- subsequent trading days will be the daily settlement price of
the futures contracts.
---------------------- ●● Futures contracts on individual securities shall be cash settled
---------------------- and would be settled in the following manner:
Daily mark-to-market settlement and
----------------------
Final mark-to-market settlement on expiry of a futures
---------------------- contract.
---------------------- ●● The pay-in and pay-out of the mark-to–market settlement is
on T+1 day.
----------------------

----------------------

----------------------

40 Risk Management
 Notes
Check your Progress 1
----------------------
State True or False. ----------------------
1. In a futures contract, the buyer and seller decide the futures price on
----------------------
maturity of the contract.
2. The base price of the futures contracts on introduction of new contracts ----------------------
shall be the previous day’s closing price of the underlying security.
----------------------

----------------------
Activity 1
----------------------
1. Google the term “evolution of derivatives market in India”. There is a ----------------------
good article by “Indian Research Journals” those talks about history,
current state and future prospects for the derivative markets in India. ----------------------
2. Examine the technical charts for the Nifty. Based on your observations ----------------------
regarding past price action etc, would you recommend buying Nifty
Index Futures? ----------------------

----------------------
3.3 OPTIONS
----------------------
An option is a special contract that gives the buyer the right, but not the
obligation to buy or sell shares of the underlying security at a specific price on ----------------------
or before a specific date. Here the owner enjoys right to buy or sell something ----------------------
without obligation to do so.
----------------------
There are two kinds of options: Call options and Put options. A call option
is an option to buy a stock at a specific price on or before a certain date. When ----------------------
you buy a call option, the price you pay for it, called the option premium,
secures your right to buy that certain stock at a specified price called the strike ----------------------
price. If you decide not to use the option to buy the stock, your only cost is the
----------------------
option premium. Put options are options to sell a stock at a specific price on
or before a certain date. With a Put option, you can insure a stock by fixing a ----------------------
selling price. If something happens which causes the stock price to fall, you can
exercise your option and sell it at its insured price level. If the price of the stock ----------------------
goes up, then you need not use the insurance and the only cost that you incur is
----------------------
the option premium.
The payoff diagrams, rights and obligations of the buyer and seller for the ----------------------
Call and Put options are as given below:
----------------------

----------------------

----------------------

----------------------

Derivatives: Futures and Options 41

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
Call option buyer
----------------------
●● Pays premium
---------------------- ●● Right to exercise and buy the shares
---------------------- ●● Profits from rising prices
●● Limited losses, unlimited gain
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

---------------------- Call option seller

---------------------- ●● Receives premium

●● Obligation to sell shares if exercised
----------------------
●● Profits from falling prices or remaining neutral
---------------------- ●● Unlimited losses, limited gain
----------------------

42 Risk Management
 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
Put option buyer ----------------------
●● Pays premium ----------------------
●● Right to exercise and sell shares
----------------------
●● Profits from falling prices
●● Limited losses, unlimited gain ----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
Put option seller
----------------------
●● Receives premium
●● Obligation to buy shares if exercised ----------------------
●● Profits from rising price or remaining neutral ----------------------
●● Potentially unlimited losses, limited gain
----------------------

Derivatives: Futures and Options 43

 Notes There are two basic styles of options, the American and European. An
American (or American-style) option is an option contract that can be exercised
---------------------- at any time between the date of purchase and the expiration date. Most exchange-
traded options are American-Style. All stock options are American style.
---------------------- A European (or European-style) option is an option contract that can only be
---------------------- exercised on the expiration date. Futures contracts (i.e., options on commodities;
see the article elsewhere in this FAQ) are generally European-style options.
----------------------
Every stock option is designated by:
---------------------- ●● Name of the associated stock
---------------------- ●● Strike price
●● Expiration date
----------------------
●● The premium paid for the option, plus brokers commission.
----------------------

---------------------- Check your Progress 2

----------------------
State True or False.
---------------------- 1. An investor that buys a call option has a bearish opinion about the
security.
----------------------
2. An investor that buys put options has a bullish opinion about the
---------------------- security.
---------------------- 3. An investor that has a bullish opinion about a security can either buy
a call option or sell a put option.
----------------------
4. An investor that has a bearish opinion about a security will sell a call
---------------------- option.
----------------------
Activity 2
----------------------

---------------------- Read on the F & O (Futures & Options) markets in India. Place emphasis
on liquidity of futures contracts, the numbers of securities that can be traded
----------------------
in India in the F & O markets. Also, find out if the F & O markets in India
---------------------- issue options using the American/European styles.

----------------------
Summary
----------------------
●● The word ‘derivative’ originates from mathematics and refers to a variable,
---------------------- which has been derived from another variable. Derivatives are so called
---------------------- because they have no value of their own. They derive their value from the
value of some other asset, which is known as the underlying. Derivatives
---------------------- are specialized contracts which signify an agreement or an option to buy
or sell the underlying asset of the derivate up to a certain time in the future
---------------------- at a prearranged price, the exercise price.

44 Risk Management
●● A futures contract is a standardized forward contract. A forward contract Notes
is an agreement between two parties that exchange an asset for cash at a
predetermined future date for a price that is specified today. ----------------------
●● Futures contract on commodities storable or perishable like gold, oil, ----------------------
aluminum, cotton, rice, orange juice, etc have been in existence since
long time. Although futures have their origin in commodities, financial ----------------------
futures namely equity futures, interest rate futures and currency futures
dominate the market today. ----------------------
●● Equity futures are of two types: Index futures and Futures on individual ----------------------
securities. Index futures are futures contracts where the underlying is the
stock index. In India we have index futures contracts based on S & P ----------------------
CNX Nifty and the BSE SENSEX. Contracts of 3 months duration are ----------------------
available at all times. Each contract expires on the last Thursday of the
expiry month. A new contract is introduced for trading simultaneously ----------------------
after the expiry of a contract. The permitted lot size is 200 or multiples
there of for the Nifty and 50 for BSE SENSEX. ----------------------
●● In India futures on individual securities have been introduced from 2001. ----------------------
This has been introduced by both NSE and BSE. Securities Exchange
Board of India has specified the list of securities in which futures contracts ----------------------
are permitted. ----------------------
●● An option is a special contract where owner enjoys right to buy or sell
something without obligation to do so. An option to buy the underlying is ----------------------
known as a Call Option. On the other hand, an option to sell the underlying
----------------------
at a specified price in the future is known as Put Option.
●● There are two basic styles of options, the American and European. An ----------------------
American (or American-style) option is an option contract that can be
----------------------
exercised at any time between the date of purchase and the expiration
date. ----------------------

----------------------
Keywords
----------------------
●● Derivatives: The word ‘derivative’ originates from mathematics and
refers to a variable, which has been derived from another variable. ----------------------
●● Futures: A futures contract is a standardized forward contract. A forward
----------------------
contract is an agreement between two parties exchange an asset for cash
at a predetermined future date for a price that is specified today represents ----------------------
a forward contract.
----------------------
●● Options: An option is a special contract that gives the buyer the right,
but not the obligation to buy or sell shares of the underlying security at a ----------------------
specific price on or before a specific date.
----------------------

----------------------

----------------------

Derivatives: Futures and Options 45

 Notes
Self-Assessment Questions
----------------------
1. Distinguish between the following:
---------------------- a. Options and Futures.
---------------------- b. Call and Put options.

---------------------- c. Commodity and Financial Futures.

d. Forwards and futures.
----------------------
2. Write about equity market in India.
----------------------
3. Comment on “Derivatives as a risk management tool.”
---------------------- 4. Write notes on the following:
---------------------- a. Forward Contract.

---------------------- b. Features of options.

c. Trading mechanisms in futures.
----------------------
5. Explain the working of options?
----------------------

---------------------- Answers to Check your Progress

---------------------- Check your Progress 1

State True or False.
----------------------
1. False
----------------------
2. True
---------------------- Check your Progress 2
---------------------- State True or False.
---------------------- 1. False
2. False
----------------------
3. True
----------------------
4. True
----------------------

---------------------- Suggested Reading

---------------------- 1. http://www.nseindia.com/products/content/derivatives/equities/fo.htm

----------------------

----------------------

----------------------

----------------------

46 Risk Management
Managing Credit Risk
UNIT

4
Structure:

4.1 Introduction
4.2 Forms of Credit Risk
4.3 Types of Credit Risk
4.4 Credit Risk Management Process
4.5 Building Blocks of Credit Risk
4.6 Instruments of Credit Risk Management
4.7 Loan Review Mechanism (LRM)
4.8 Credit Risk Models
4.9 Credit Risk and Investment Banking
4.10 Credit Risk in Off Balance Sheet Exposure
4.11 Inter-Bank Exposure and Country Risk
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Managing Credit Risk 47

 Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Reproduce the concept, forms and types of credit risk
----------------------
• Enlist the essential features of credit risk management process
---------------------- •  xplain the role played by strategy, organisation and operations in
E
---------------------- credit risk management
• Assess various credit risk measurement models used by banks
----------------------
• Comment on loan review mechanism adopted by banks
----------------------
• Identify the techniques of managing credit risk in investment banking,
---------------------- off balance sheet exposure and inter- bank exposure

----------------------

----------------------
4.1 INTRODUCTION
----------------------
The importance of risk management in banking framework is discussed
---------------------- in the previous unit. Banks are exposed to different risks and follow different
techniques to manage them. The main business of banks is to lend to their
---------------------- customers. The process of lending exposes the bank to various types of risks. In
the upcoming units, we are going to cover in detail different types of risks faced
----------------------
by banks and the methods to manage the same. The first and the most common
---------------------- type of risk is credit risk, which is the risk of non-recovery of the amount of
loan, diminution in credit quality of borrower or reduction in the value of asset.
---------------------- Other parameters included in credit risk are pre-payment risk, resulting in the
loss of opportunity to the bank to earn high interest income. Excess exposure
----------------------
to a single borrower, industry or geographical area can also impose credit risk.
---------------------- Credit risk arises when a borrower is expecting to use future cash flows to pay
a current debt and he is unable to get those cash flows.
----------------------

---------------------- 4.2 FORMS OF CREDIT RISK

---------------------- Credit risk is a very wide term and has different dimensions. We may say
that each and every transaction of a bank has some element of credit risk in
---------------------- it. RBI has provided an exhaustive list of some of the very common forms of
credit risk as under:
----------------------
• In the case of direct lending, funds may not be repaid.
----------------------
• In the case of guarantees or letters of credit, funds may not be forthcoming
---------------------- from the customer upon crystallisation of the liability under the contract.

---------------------- • In the case of treasury products, the payment or series of payments

due from the counterparty under the respective contracts may not be
---------------------- forthcoming or ceases.

48 Risk Management
• In the case of securities trading businesses, settlement may not be effected. Notes
• In the case of cross-border exposure, the availability and free transfer of
----------------------
currency may be restricted or ceases.
The diversification of banking system has forced the banks to have ----------------------
intricate systems to protect themselves from a wide variety of risks. Credit risk
----------------------
management enables banks to identify, assess, manage proactively and optimise
their credit risk at an individual level or at an entity level or at the level of a ----------------------
country. Given the fast changing, dynamic world scenario with the pressures of
globalisation, liberalisation, consolidation and disintermediation, it is important ----------------------
that banks have robust credit risk management policies and procedures, which
----------------------
are sensitive and responsive to these changes.
----------------------
4.3 TYPES OF CREDIT RISK
----------------------
After covering the forms of credit risk, we will now see that credit risk
----------------------
can arise due to three main reasons and accordingly, it is classified into the
following three broad headings. ----------------------
1. Credit Default Risk: Risk of loss on account of default on part of the
----------------------
borrower to honor his obligations in terms of repayment of principal or
interest or both. ----------------------
2. Concentration Risk: Risk associated with any single exposure to
----------------------
a particular client, industry segment or geographical location. Such
exposures can threaten the bank’s core operations. ----------------------
3. Country Risk: The risk of loss arising when a sovereign state freezes ----------------------
foreign currency payments (transfer/conversion risk) or when it defaults
on its obligations (sovereign risk). ----------------------

----------------------
4.4 CREDIT RISK MANAGEMENT PROCESS
----------------------
The management of credit risk should receive the top management’s
attention and, as per guidelines issued by RBI, the process should encompass ----------------------
the following:
----------------------
a) Measurement of risk through credit rating/scoring.
b) Quantifying the risk through estimating expected loan losses, i.e. the ----------------------
amount of loan losses that the bank would experience over a chosen time ----------------------
horizon (through tracking portfolio behaviour over 5 or more years) and
unexpected loan losses, i.e. the amount by which actual losses exceed ----------------------
the expected loss (through standard deviation of losses or the difference
between expected loan losses and some selected target credit loss ----------------------
quantile). ----------------------
c) Risk pricing on a scientific basis.
----------------------
d) Controlling the risk through effective Loan Review Mechanism and
portfolio management. ----------------------

Managing Credit Risk 49

 Notes
Check your Progress 1
----------------------

---------------------- State True or False.

1. The process of lending exposes the bank to various types of risks.
----------------------
Fill in the Blanks.
----------------------
1. Credit risk is the risk of __________ the amount of loan, ________ in
---------------------- credit quality of borrower or ________ in the value of asset.

----------------------

---------------------- Activity 1
----------------------
1. Meet a bank manager and enquire about various factors that can
---------------------- expose a bank to credit risk.
---------------------- 2. Interview the Credit Manager of any bank on the steps involved in
credit risk management process of banks.
----------------------

----------------------
4.5 BUILDING BLOCKS OF CREDIT RISK
----------------------
In any bank, the corporate goals and credit culture are closely linked and
---------------------- an effective credit risk management framework requires the following distinct
building blocks:
----------------------
1. Strategy and Policy
---------------------- This covers issues such as the definition of the credit appetite, the
---------------------- development of credit guidelines and the identification and the assessment
of the credit risk.
---------------------- 2. Organisation
---------------------- This would entail the establishment of competencies and clear
accountabilities for managing the credit risk.
----------------------
3. Operations/Systems
----------------------
MIS requirements of the senior and middle management and the
---------------------- development of tools and techniques will come under this domain. We
will now cover each of these building blocks in detail:
----------------------
4. Strategy and Policy
---------------------- Every bank should have its own credit risk strategy clearly defining the
---------------------- following:
• Objectives for the credit granting function.
----------------------
• Credit appetite of the bank.
----------------------

50 Risk Management
• Acceptable risk levels. Notes
• Bank’s willingness to grant loans based on the type of economic activity,
----------------------
geographical location, currency, market, maturity and anticipated
profitability. ----------------------
• Identification of target markets and business sectors.
----------------------
• Preferred levels of diversification and concentration.
----------------------
• The cost of capital in granting credit and the cost of bad debts.
The credit risk strategy should take into account the cyclical aspects of ----------------------
any economy and should be viable in the long run and through various credit ----------------------
cycles.
The policy document should cover issues such as: ----------------------

• Organisational responsibilities. ----------------------

• Risk measurement and aggregation techniques. ----------------------
• Prudential requirements. ----------------------
• Risk assessment and review.
----------------------
• Reporting requirements.
----------------------
• Risk grading, product guidelines, documentation, legal issues and
management of problem loans. ----------------------
Loan policies, apart from ensuring consistency in credit practices, should
----------------------
also provide a vital link to the other functions of the bank. It has been empirically
proved that organisations with sound and well-articulated loan policies have ----------------------
been able to contain the loan losses arising from poor loan structuring and
perfunctory risk assessments. ----------------------
As per RBI, in order to keep the credit risk under control, banks should ----------------------
have the following in place:
----------------------
• Dedicated policies and procedures to control exposures to designated
higher risk sectors such as capital markets, aviation, shipping, property ----------------------
development, defence equipment, highly leveraged transactions, bullion
etc. ----------------------

• Sound procedures to ensure that all risks associated with requested credit ----------------------
facilities are promptly and fully evaluated by the relevant lending and
credit officers. ----------------------

• Systems to assign a risk rating to each customer/borrower to whom credit ----------------------

facilities have been sanctioned.
----------------------
• A mechanism to price facilities depending on the risk grading of the
customer and to attribute accurately the associated risk weightings to the ----------------------
facilities.
----------------------
• Efficient and effective credit approval process operating within the
approval limits authorised by the Boards. ----------------------

Managing Credit Risk 51

 Notes • Procedures and systems that allow for monitoring financial performance
of customers and for controlling outstanding within limits.
----------------------
• Systems to manage problem loans to ensure appropriate restructuring
---------------------- schemes. A conservative policy for the provisioning of non-performing
advances should be followed.
----------------------
• A process to conduct regular analysis of the portfolio and to ensure on-
---------------------- going control of risk concentrations.
The credit policies and procedures should necessarily have the following
----------------------
elements:
----------------------  Banks should have written credit policies that define target
markets, risk acceptance criteria, credit approval authority, credit
----------------------
origination and maintenance procedures and guidelines for portfolio
---------------------- management and remedial management.
 Banks should establish proactive credit risk management practices
---------------------- such as annual / half yearly industry studies and individual obligor
---------------------- reviews, periodic credit calls that are documented, periodic plant
visits and at least quarterly management reviews of troubled
---------------------- exposures/weak credits.
 Business managers in banks will be accountable for managing
----------------------
risk and in conjunction with credit risk management framework
---------------------- for establishing and maintaining appropriate risk limits and risk
management procedures for their businesses.
----------------------
• Banks should have a system of checks and balances in place around the
---------------------- extension of credit, which are:
 An independent credit risk management function
----------------------
 Multiple credit approvers
----------------------  An independent audit and risk review function
---------------------- • The Credit Approving Authority to extend or approve credit will be granted
to individual credit officers based upon a consistent set of standards of
---------------------- experience, judgment and ability.
---------------------- • The level of authority required to approve credit will increase as amounts
and transaction risks increase and as risk ratings worsen.
----------------------
• Every obligor and facility must be assigned a risk rating.
---------------------- • Banks should ensure that there are consistent standards for the origination,
---------------------- documentation and maintenance for extensions of credit.
• Banks should have a consistent approach towards early problem
----------------------
recognition, classification of problem exposures and remedial action.
---------------------- • Banks should maintain a diversified portfolio of risk assets in line with
the capital desired to support such a portfolio.
----------------------
• Credit risk limits include, but are not limited to, obligor limits and
---------------------- concentration limits by industry or geography.

52 Risk Management
• In order to ensure transparency of risks taken, it is the responsibility Notes
of banks to accurately, completely and in a timely fashion, report the
comprehensive set of credit risk data into the independent risk system. ----------------------
Organisation Structure ----------------------
An independent group responsible for credit risk management is one of
----------------------
the most common features of a successful bank. The board of the bank should
ensure that the independence of this department is not compromised at any ----------------------
point of time (Figure 4.1).
----------------------
Depending on the size of the organisation or loan book, the bank may
constitute a high level Credit Policy Committee also called Credit Risk ----------------------
Management Committee or Credit Control Committee. This committee will
deal with issues relating to credit policy and procedures and analyze, manage ----------------------
and control credit risk on a bank wide basis.
----------------------
The Committee should be headed by the Chairman/CEO/ED and should
comprise heads of Credit Department, Treasury, Credit Risk Management ----------------------
Department (CRMD) and the Chief Economist. The Committee should, inter ----------------------
alia, formulate clear policies on standards for the following:
• Presentation of credit proposal. ----------------------

• Financial covenants. ----------------------

• Rating standards and benchmarks. ----------------------
• Delegation of credit approving powers.
----------------------
• Prudential limits on large credit exposures.
----------------------
• Asset concentrations.
• Standards for loan collateral. ----------------------

• Portfolio management. ----------------------

• Loan review mechanism. ----------------------
• Risk concentrations, monitoring and evaluation.
----------------------
• Pricing of loans.
----------------------
• Provisioning.
• Regulatory/legal compliance. ----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

Managing Credit Risk 53

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
(Source: http://www.fujitsu.com)
----------------------
Fig. 4.1: Organisation Structure
----------------------
Concurrently, each bank may also set up Credit Risk Management
---------------------- Department (CRMD), independent of the Credit Administration Department.
The CRMD should enforce and monitor compliance of the risk parameters and
---------------------- prudential limits set by the CPC. The main responsibilities of the credit risk
management team include:
----------------------
• Formulate credit policies, procedures and controls extending to all areas
---------------------- of credit risk.
---------------------- • Provide overview of portfolio trends, concentration risk across banks and
individual lines of business.
----------------------
• Provide inputs to Asset Liability Management Committee.
----------------------
• Conduct industry and sectoral studies.
---------------------- • Provide inputs for strategic and annual operating plans.
---------------------- • Monitor quality of loan portfolio, identify problems and correct
deficiencies.
----------------------
• Protect quality of overall loan portfolio.
---------------------- • Take a periodical review of credit related processes and operating
---------------------- procedures.
The credit risk strategy and policies should be effectively communicated
----------------------
throughout the organisation. All lending officers should clearly understand the
---------------------- bank’s approach to granting credit and should be held accountable for complying
with the policies and procedures.
----------------------
Operations and Systems
---------------------- Banks should have in place an appropriate credit administration,
measurement and monitoring process. As per RBI, the credit process typically
----------------------
involves the following phases:
---------------------- a) Relationship management phase, i.e. business development.
----------------------

54 Risk Management
b) Transaction management phase covers risk assessment, pricing, Notes
structuring of the facilities, obtaining internal approvals, documentation,
loan administration and routine monitoring and measurement. ----------------------
c) Portfolio management phase entails the monitoring of the portfolio at a ----------------------
macro level and the management of problem loans.
----------------------
Successful credit management requires experience, judgment and a
commitment to technical development. Each bank should have a clear, well- ----------------------
documented scheme of delegation of limits. Authorities should be delegated
to executives depending on their skill and experience levels. The banks should ----------------------
have systems in place for reporting and evaluating the quality of the credit
----------------------
decisions taken by the various officers.
The credit approval process should aim at efficiency, responsiveness and ----------------------
accurate measurement of the risk. This will be achieved through a comprehensive
----------------------
analysis of the borrower’s ability to repay, clear and consistent assessment
systems, a process that ensures that renewal requests are analyzed as carefully ----------------------
and stringently as new loans and constant reinforcement of the credit culture by
the top management team. ----------------------
Commitment to new systems and IT will also determine the quality of ----------------------
the analysis being conducted. There is a range of tools available to support the
decision-making process. These are: ----------------------

a) Traditional techniques such as financial analysis. ----------------------

b) Decision support tools such as credit scoring and risk grading. c) Portfolio ----------------------
techniques such as portfolio correlation analysis.
----------------------
The key is to identify the tools that are appropriate to the bank.
Banks should develop and utilise internal risk rating systems in managing ----------------------
credit risk. The rating system should be consistent with the nature, size and
----------------------
complexity of the bank’s activities.
Banks must have an MIS, which will enable them to manage and measure ----------------------
the credit risk inherent in all on- and off-balance sheet activities. The MIS ----------------------
should provide adequate information on the composition of the credit portfolio,
including identification of any concentration of risk. Banks should price their ----------------------
loans according to the risk profile of the borrower and the risks associated with
the loans. ----------------------

----------------------
Check your Progress 2
----------------------
Fill in the blanks. ----------------------
1. The credit approval process should aim at _______, __________ and
----------------------
measurement of the risk.
2. Banks must have an ________, which will enable them to manage ----------------------
and measure the risk inherent in all balance sheet activities.
----------------------

Managing Credit Risk 55

 Notes
Activity 2
----------------------

---------------------- 1. Visit www.bis.org/bcbs/events/b2earoc.pdf and note down your

views on the three pillars of credit risk management.
----------------------
2.  isit a nearby bank and interview the manager to find out what role
V
---------------------- does sound IT system play in managing credit risk.

----------------------

----------------------
4.6 INSTRUMENTS OF CREDIT RISK MANAGEMENT

---------------------- Credit Risk Management encompasses a host of management techniques,

which help the banks in mitigating the adverse impacts of credit risk.
----------------------
Credit Approving Authority
---------------------- Credit approving authority plays a very important role in credit risk
management.
----------------------
The exposure to credit risk starts at this stage and if credit is not sanctioned
---------------------- diligently, then it can have an impact on credit risk of the bank. Following are
the salient features of credit approving authority:
----------------------
a. Carefully formulated scheme of delegation of powers.
----------------------
b. Multi-tier credit approving system where the loan proposals are approved
---------------------- by an ‘Approval Grid’ or a ‘Committee’.
---------------------- c. The credit facilities above a specified limit may be approved by the ‘Grid’
or ‘Committee’, comprising at least 3 or 4 officers. Invariably, one officer
---------------------- should represent the CRMD, who has no volume and profit targets.
---------------------- d. Credit approving committees at various operating levels, i.e. large
branches (where considered necessary), Regional Offices, Zonal Offices,
---------------------- Head Offices etc.
---------------------- e. Delegation of powers for sanction of higher limits to the ‘Approval Grid’
or the ‘Committee’ for better rated / quality customers.
----------------------
f. No credit proposals should be approved or recommended to higher
---------------------- authorities, if majority members of the ‘Approval Grid’ or ‘Committee’
do not agree on the credit worthiness of the borrower.
----------------------
g. Suitable framework for reporting and evaluating the quality of credit
---------------------- decisions taken by various functional groups.

---------------------- h. Well-defined Loan Review Mechanism.

----------------------

----------------------

----------------------

56 Risk Management
Prudential Limits Notes
In order to limit the magnitude of credit risk, prudential limits should be
----------------------
laid down on various aspects of credit:
a. Benchmark current/debt equity and profitability ratios, debt service ----------------------
coverage ratio or other ratios should be clearly defined and there should
----------------------
be sufficient flexibility for deviations. The loan policy document should
clearly mention the conditions under which deviation will be allowed and ----------------------
the authority thereof.
----------------------
b. A filtering mechanism should be established by setting up single/group
borrower limits, which may be lower than the limits prescribed by the ----------------------
Reserve Bank.
----------------------
c. Substantial exposure limit to be set up, i.e. sum total of exposures assumed
in respect of those single borrowers enjoying credit facilities in excess ----------------------
of a threshold limit, say 10% or 15% of capital funds. The substantial
exposure limit may be fixed at 600% or 800% of capital funds, depending ----------------------
upon the degree of concentration risk to which the bank is exposed. ----------------------
d. Maximum exposure limits to industry, sector etc. should be set up. There
must also be systems in place to evaluate the exposures at reasonable ----------------------
intervals and the limits should be adjusted especially when a particular ----------------------
sector or industry faces slowdown or other sector / industry-specific
problems. The exposure limits to sensitive sectors such as advances ----------------------
against equity shares, real estate, etc., which are subject to a high degree
of asset price volatility and to specific industries, which are subject to ----------------------
frequent business cycles, may necessarily be restricted. ----------------------
e. Banks may consider maturity profile of the loan book, keeping in view
the market risks inherent in the balance sheet, risk evaluation capability, ----------------------
liquidity etc. ----------------------
Risk Rating
----------------------
Banks should have a comprehensive risk scoring / rating system that
serves as a single point indicator of diverse risk factors of counterparty and ----------------------
for taking credit decisions in a consistent manner. The following should be the
----------------------
salient features of an efficient risk rating system in a bank:
a. Standardisation in ratings across borrowers. ----------------------
b. Rating system should be designed to reveal the overall risk of lending, ----------------------
critical input for setting pricing and non-price terms of loans as also
present meaningful information for review and management of loan ----------------------
portfolio. ----------------------
c. The rating exercise should facilitate the credit granting authorities some
comfort in its knowledge of loan quality at any moment of time. ----------------------

d. Well-structured rating system should incorporate financial analysis, ----------------------

projections and sensitivity, industrial and management risks.
----------------------

Managing Credit Risk 57

 Notes e. Risk rating mechanism should use various financial ratios and operational
parameters and collaterals as also qualitative aspects of management and
---------------------- industry characteristics that have bearings on the creditworthiness of
borrowers.
----------------------
f. Well-defined level of standards or critical parameters beyond which no
---------------------- proposals should be entertained.
---------------------- g. Separate rating framework for large corporate/small borrowers, traders
etc. that exhibits varying nature and degree of risk.
----------------------
h. Due weightage to the unhedged market risk exposures of borrowers in the
---------------------- rating framework.

---------------------- i. The overall score for risk is to be placed on a numerical scale ranging
between 1-6, 1-8 etc. on the basis of credit quality. For each numerical
---------------------- category, a quantitative definition of the borrower, the loan’s underlying
quality and an analytic representation of the underlying financials of the
---------------------- borrower should be presented.
---------------------- j. Bank should prescribe the minimum rating below which no exposures
would be undertaken. Any flexibility in the minimum standards and
---------------------- conditions for relaxation and authority thereof should be clearly articulated
---------------------- in the Loan Policy.
Risk Pricing
----------------------
Risk-return pricing is a fundamental tenet of risk management (Figure
---------------------- 4.2). In a risk-return setting, borrowers with weak financial position and hence
placed in high credit risk category should be priced high. Thus, banks should
----------------------
evolve scientific systems to price the credit risk, which should have a bearing
---------------------- on the expected probability of default.

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

---------------------- Fig. 4.2: Risk-Return-Supervision Development

---------------------- [Source: http://1.bp.blogspot.com/]

---------------------- The pricing of loans normally should be linked to risk rating or credit
quality. The probability of default could be derived from the past behaviour of
---------------------- the loan portfolio, which is the function of loan loss provision/charge offs for
the last five years or so. Banks should build historical database on the portfolio
---------------------- quality and provisioning / charge off to equip themselves to price the risk.

58 Risk Management
Various factors that need to be taken into account while pricing a loan are as Notes
under:
----------------------
• Probability of default.
• Value of collateral. ----------------------
• Market forces. ----------------------
• Perceived value of accounts. ----------------------
• Future business potential.
----------------------
• Portfolio/industry exposure.
----------------------
Flexibility should also be made for revising the price (risk premia) due to
changes in rating/value of collaterals over time. ----------------------
Portfolio Management
----------------------
The existing framework of tracking the Non-Performing Loans around
the balance sheet date does not signal the quality of the entire Loan Book. ----------------------
Banks should evolve proper systems for identification of credit weaknesses ----------------------
well in advance. Most of international banks have adopted various portfolio
management techniques for gauging asset quality. The CRMD set up at Head ----------------------
Office should be assigned the responsibility of periodic monitoring of the
portfolio. ----------------------
Following techniques could be used for evaluating the portfolio quality. ----------------------
• Tracking the migration (upward or downward) of borrowers from one ----------------------
rating scale to another.
• Stipulate quantitative ceiling on aggregate exposure in specified rating ----------------------
categories, i.e. certain % of total advances should be in the rating category
----------------------
of 1 to 2 or 1 to 3, 2 to 4 or 4 to 5 etc.
• Evaluate the rating-wise distribution of borrowers in various industry, ----------------------
business segments etc.
----------------------
• Exposure to one industry/sector should be evaluated on the basis of
overall rating distribution of borrowers in the sector/group. ----------------------
• Target rating-wise volume of loans, probable defaults and provisioning ----------------------
requirements is a prudent planning exercise. For any deviation/s from the
expected parameters, an exercise for restructuring of the portfolio should ----------------------
immediately be undertaken and if necessary, the entry level criteria could
----------------------
be enhanced to insulate the portfolio from further deterioration.
• Undertake rapid portfolio reviews, stress tests and scenario analysis ----------------------
when external environment undergoes rapid changes (e.g. volatility in
the forex market, economic sanctions, changes in the fiscal/monetary ----------------------
policies, general slowdown of the economy, market risk events, extreme ----------------------
liquidity conditions etc.). The stress tests would reveal undetected areas
of potential credit risk exposure and linkages between different categories ----------------------
of risk. In adverse circumstances, there may be substantial correlation of
various risks, especially credit and market risks. ----------------------

Managing Credit Risk 59

 Notes • Introduce discriminatory time schedules for renewal of borrower limits.
Lower rated borrowers whose financials show signs of problems should
---------------------- be subjected to renewal control twice/thrice a year.
----------------------
4.7 LOAN REVIEW MECHANISM (LRM)
----------------------
LRM is an effective tool introduced by RBI for constantly evaluating
---------------------- the quality of loan book and to bring about qualitative improvements in credit
administration. Banks should, therefore, put in place proper Loan Review
---------------------- Mechanism for large value accounts with responsibilities assigned in various
---------------------- areas such as evaluating the effectiveness of loan administration, maintaining
the integrity of credit grading process, assessing the loan loss provision, portfolio
---------------------- quality etc. The complexity and scope of LRM normally vary based on bank
size, type of operations and management practices. It may be independent of
---------------------- the CRMD or even a separate department in large banks. The main objectives
---------------------- of LRM could be:
• To identify promptly loans, which develop credit weaknesses and initiate
---------------------- timely corrective action.
---------------------- • To evaluate portfolio quality and isolate potential problem areas.
---------------------- • To provide information for determining adequacy of loan loss provision.
• To assess the adequacy of and adherence to loan policies and procedures
----------------------
and to monitor compliance with relevant laws and regulations.
---------------------- • To provide top management with information on credit administration,
---------------------- including credit sanction process, risk evaluation and post-sanction
follow-up.
---------------------- Accurate and timely credit grading is one of the basic components of
---------------------- an effective LRM. Credit grading involves assessment of credit quality,
identification of problem loans and assignment of risk ratings. A proper
---------------------- Credit Grading System should support evaluation of the portfolio quality and
establishment of loan loss provisions. Given the importance and subjective
---------------------- nature of credit rating, the credit ratings awarded by Credit Administration
---------------------- Department should be subjected to review by Loan Review Officers who are
independent of loan administration.
---------------------- Banks should formulate Loan Review Policy and it should be reviewed
---------------------- annually by the Board. The Policy should, inter alia, address the following:
• Qualification and Independence - The Loan Review Officers should
----------------------
have sound knowledge in credit appraisal, lending practices and loan
---------------------- policies of the bank. They should also be well versed in the relevant
laws/regulations that affect lending activities. The independence of Loan
---------------------- Review Officers should be ensured and the findings of the reviews should
also be reported directly to the Board.
----------------------

----------------------

60 Risk Management
• Frequency and Scope of Reviews - The Loan Reviews are designed Notes
to provide feedback on effectiveness of credit sanction and to identify
incipient deterioration in portfolio quality. Reviews of high value loans ----------------------
should be undertaken usually within three months of sanction/renewal or
more frequently when factors indicate a potential for deterioration in the ----------------------
credit quality. The scope of the review should cover all loans above a cut- ----------------------
off limit.
----------------------
• Depth of Reviews - The loan reviews should focus on the following:
 Approval process. ----------------------
 Accuracy and timeliness of credit ratings assigned by loan officers. ----------------------
 Adherence to internal policies and procedures and applicable laws / ----------------------
regulations.
 Compliance with loan covenants. ----------------------

 Post-sanction follow-up. ----------------------

 Sufficiency of loan documentation. ----------------------
 Portfolio quality.
----------------------
 Recommendations for improving portfolio quality.
----------------------
The findings of Reviews should be discussed with line Managers and
corrective actions should be elicited for all deficiencies. Deficiencies that ----------------------
remain unresolved should be reported to top management.
----------------------
Activity 3 ----------------------

----------------------
1.  uppose you are a bank manager. What techniques will you suggest
S
the bank to monitor its portfolio quality? ----------------------
2.  isit www.rbidocs.rbi.org.in/rdocs/notification/PDFs/9492.pdf and
V ----------------------
outline the points mentioned for Risk Management Systems in
Banks. ----------------------

----------------------
4.8 CREDIT RISK MODELS
----------------------
RBI has introduced various credit risk modles to aid banks in quantifying,
aggregating and managing risk across geographical and product lines. The ----------------------
outputs of these models also play increasingly important roles in banks’ risk ----------------------
management and performance measurement processes, including performance-
based compensation, customer profitability analysis, risk-based pricing ----------------------
and active portfolio management and capital structure decisions. Credit risk
modelling may result in better internal risk management and may have the ----------------------
potential to be used in the supervisory oversight of banking organisations. ----------------------

----------------------

Managing Credit Risk 61

 Notes In the measurement of credit risk, models may be classified along three
different dimensions, which are explained below.
----------------------
• The techniques employed.
---------------------- • The domain of applications in the credit process.
---------------------- • The products to which they are applied.

---------------------- Techniques
The following are the more commonly used techniques:
----------------------
(a) Econometric Techniques such as linear and multiple discriminant
---------------------- analysis, multiple regression, logic analysis and probability of default or
the default premium, as a dependent variable whose variance is explained
---------------------- by a set of independent variables.
---------------------- (b) Neural networks are computer-based systems that use the same data
employed in the econometric techniques but arrive at the decision model
----------------------
using alternative implementations of a trial and error method.
---------------------- (c) Optimisation models are mathematical programming techniques that
discover the optimum weights for borrower and loan attributes that
----------------------
minimise lender error and maximise profits.
---------------------- (d) Rule-based or expert systems are characterised by a set of decision rules,
---------------------- a knowledge base consisting of data such as industry financial ratios and
a structured inquiry process to be used by the analyst in obtaining the data
---------------------- on a particular borrower.

---------------------- (e) Hybrid Systems using direct computation, estimation and simulation are
driven in part by a direct causal relationship, the parameters of which
---------------------- are determined through estimation techniques. An example of this is
the KMV model, which uses an option theoretic formulation to explain
---------------------- default and then derives the form of the relationship through estimation.
---------------------- Domain of application
---------------------- These models are used in a variety of domains:
(a) Credit approval: Models are used by themselves or in conjunction with a
----------------------
judgmental override system for approving credit in the consumer lending
---------------------- business. The use of such models has expanded to include small business
lending and first mortgage loan approvals. They are generally not used in
---------------------- approving large corporate loans, but they may be one of the inputs to a
decision.
----------------------
(b) Credit rating determination: Quantitative models are used in deriving
---------------------- ‘shadow bond rating’ for unrated securities and commercial loans. These
ratings in turn influence portfolio limits and other lending limits used
----------------------
by the institution. In some instances, the credit rating predicted by the
---------------------- model is used within an institution to challenge the rating as signed by the
traditional credit analysis process.
----------------------

62 Risk Management
(c) Credit risk models may be used to suggest the risk premiums that should Notes
be charged in view of the probability of loss and the size of the loss given
default. Using a mark-to-market model, an institution may evaluate the ----------------------
costs and benefits of holding a financial asset. Unexpected losses implied
by a credit model may be used to set the capital charge in pricing. ----------------------

(d) Financial early warning: Credit models are used to flag potential ----------------------
problems in the portfolio to facilitate early corrective action.
----------------------
(e) Common credit language: Credit models may be used to select assets
from a pool to construct a portfolio acceptable to investors or to achieve ----------------------
the minimum credit quality needed to obtain the desired credit rating.
----------------------
Underwriters may use such models for due diligence on the portfolio
(such as a collateralised pool of commercial loans). ----------------------
(f) Collection strategies: Credit models may be used in deciding on the best
----------------------
collection or workout strategy to pursue. If, for example, a credit model
indicates that a borrower is experiencing short-term liquidity problems ----------------------
rather than a decline in credit fundamentals, then an appropriate workout
may be devised. ----------------------
Relevance to the decision maker ----------------------
Credit Risk Models have assumed importance because they provide the ----------------------
decision maker with an insight or knowledge that would not otherwise be readily
available or that could be marshalled at prohibitive cost. In a marketplace where ----------------------
margins are fast disappearing and the pressure to low cost is unrelenting, models
give their users a competitive edge. ----------------------

----------------------
4.9 CREDIT RISK AND INVESTMENT BANKING
----------------------
Significant amount of credit risk is inherent in investment banking and
hence investment proposals should be subjected to same degree of risk analysis ----------------------
as a loan proposal. There should be detailed appraisal and rating framework, ----------------------
which takes into account financial and non-financial parameters of issuer,
sensitivity to external developments etc. The investment proposals are not ----------------------
rated and hence special care should be taken while doing risk evaluation. There
should be greater interaction between Credit and Treasury Departments and the ----------------------
portfolio analysis should also cover the total exposures, including investments. ----------------------
The rating migration of the issuers and the consequent diminution in the
portfolio quality should also be tracked at periodic intervals. ----------------------
As a matter of prudence, banks should stipulate entry-level minimum ----------------------
ratings/ quality standards, industry, maturity, duration, issuer wise etc. limits in
investment proposals as well to mitigate the adverse impacts of concentration ----------------------
and the risk of illiquidity.
----------------------

----------------------

----------------------

Managing Credit Risk 63

 Notes 4.10 CREDIT RISK IN OFF BALANCE SHEET EXPOSURE
---------------------- Banks should evolve an adequate framework for managing their exposure
in off-balance sheet products like forex forward contracts, swaps, options, etc.
----------------------
as a part of overall credit to individual customer relationship and subject to the
---------------------- same credit appraisal, limits and monitoring procedures.

---------------------- Banks should classify their off-balance sheet exposures into three broad
categories.
---------------------- 1. Full risk (credit substitutes): standby letters of credit, money guarantees,
---------------------- etc.
2. Medium risk (not direct credit substitutes, which do not support existing
---------------------- financial obligations): bid bonds, letters of credit, indemnities and
---------------------- warranties.
3. Low risk: reverse repos, currency swaps, options, futures, etc.
----------------------
The total exposures to the counterparties on a dynamic basis should be the
---------------------- sum total of the current replacement cost (unrealised loss to the counterparty)
and the potential increase in replacement cost (estimated with the help of VaR
----------------------
or other methods to capture future volatilities in the value of the outstanding
---------------------- contracts/ obligations).
The current and potential credit exposures may be measured on a daily
----------------------
basis to evaluate the impact of potential changes in market conditions on the
---------------------- value of counterparty positions.

---------------------- 4.11 INTER-BANK EXPOSURE AND COUNTRY RISK

----------------------
A suitable framework should be evolved to provide a centralised overview
---------------------- on the aggregate exposure on other banks. Bank-wise exposure limits could be
set on the basis of assessment of financial performance, operating efficiency,
---------------------- management quality, past experience, etc. Like corporate clients, banks should
also be rated and placed in range of 1-5, 1-8, as the case may be, on the basis
----------------------
of their credit quality. The limits so arrived at should be allocated to various
---------------------- operating centres, followed up and half-yearly/annual reviews undertaken at a
single point. Regarding exposure on overseas banks, banks can use the country
---------------------- ratings of international rating agencies and classify the countries into low risk,
moderate risk and high risk. Banks should endeavour for developing an internal
----------------------
matrix that reckons the counterparty and country risks. The maximum exposure
---------------------- should be subjected to adherence of country and bank exposure limits already
in place. While the exposure should at least be monitored on a weekly basis till
---------------------- the banks are equipped to monitor exposures on a real time basis, all exposures
to problem countries should be evaluated on a real time basis.
----------------------
The key financial parameters to be evaluated for any bank are:
----------------------
a) Capital Adequacy: It needs to be appropriate to the size and structure of
---------------------- the balance sheet as it represents the buffer to absorb losses during difficult

64 Risk Management
 times, whereas over capitalisation can impact overall profitability. Related Notes
to the issue of capitalisation is also the ability to raise fresh capital as and
when required. ----------------------
b) Asset Quality: The asset portfolio in its entirety should be evaluated ----------------------
and should include an assessment of both funded lines and off-balance
sheet items. The quality of the loan book will be reflected in the non- ----------------------
performing assets and provisioning ratios, while exposure to the capital
----------------------
market and sensitive sectors will be indicated by high volatility, affecting
both valuations and earnings. ----------------------
c) Liquidity: Commercial bank deposits generally have a much shorter
----------------------
contractual maturity than loans and liquidity management needs to provide
a cushion to cover anticipated deposit withdrawals. The key ratios to be ----------------------
analyzed are Total Liquid Assets/Total Assets ratio (the higher the ratio,
the more liquid the bank is), Total Liquid Assets/Total Deposits ratio (this ----------------------
measures the bank’s ability to meet withdrawals), Loans/Deposits ratio
----------------------
and the inter-bank ratio.
d) Profitability: A consistent year on year growth in profitability is required ----------------------
to provide an acceptable return to shareholders and retain resources to
----------------------
fund future growth. The key ratios to be analyzed are Return on Average
Assets (measures a bank’s growth/decline in comparison to its balance ----------------------
sheet expansion/contraction), Return on Equity (provides an indication
of how well the bank is performing for its owners), Net Interest Margin ----------------------
(measures the difference between interest paid and interest earned and
----------------------
therefore a bank’s ability to earn interest income) and Operating Expenses/
Net Revenue (the cost/income ratio of the bank). ----------------------

Check your Progress 3 ----------------------

----------------------
State True or False.
----------------------
1. Credit Risk Models have assumed importance because they provide
the decision-maker with insight or knowledge that is freely and ----------------------
readily available.
----------------------
Fill in the Blanks.
----------------------
1.  ignificant amount of ___________ risk is inherent in investment
S
banking. ----------------------
2. There should be greater interaction between _________ Departments ----------------------
in a risk management process.
3.  anks should evolve adequate _______ for managing their exposure
B ----------------------
in off- balance sheet products like ________, forward contracts, ----------------------
swaps, options etc.
----------------------

----------------------

Managing Credit Risk 65

 Notes
Activity 4
----------------------

---------------------- Visit any nearby bank and study its loan review policy document.

----------------------

----------------------
Summary

---------------------- ● Credit risk is the risk of non-recovery of the amount of loan, diminution
in credit quality of borrower or reduction in the value of asset.
---------------------- ● Credit risk can be classified as credit default risk, concentration risk and
---------------------- country risk.
● Credit risk management process includes risk measurement, risk
---------------------- quantification, risk pricing and controlling.
---------------------- ● The three most important building blocks of credit risk management are
strategy and policy, organisation and operations/ systems.
----------------------
● The credit risk strategy of the bank should clearly define the objectives,
---------------------- credit appetite, acceptable risk levels, risk measurement, assessment and
review process.
----------------------
● Dedicated policies and procedures, risk rating system, efficient credit
---------------------- approval process and regular portfolio analysis are some of the essential
features to keep credit risk under control.
----------------------
● Depending on the size of the organisation or loan book, the bank should
---------------------- constitute a high level Credit Policy Committee, also called Credit Risk
Management Committee or Credit Control Committee.
----------------------
● The credit management team in the bank is responsible for formulation
---------------------- of policies, overview of portfolio trends, conduct industry and sectoral
studies, provide inputs for strategic decision-making and review credit
---------------------- processes and procedures.
---------------------- ● The credit process involves three phases of relationship management,
transaction management and portfolio management.
----------------------
● The credit approving authority should have proper delegation of authority
---------------------- and power, multi-tier approval system and a well-defined loan review
mechanism.
----------------------
● Benchmark ratios, filtering mechanism, minimum and maximum exposure
---------------------- limits should be clearly defines by banks.
● Banks should have a comprehensive risk scoring / rating system that
----------------------
serves as a single point indicator of diverse risk factors of counterparty
---------------------- and for taking credit decisions in a consistent manner.
● Banks should consider various factors like default probability, value of
----------------------
collateral, market forces, business potential, industry exposure etc while
---------------------- taking loan pricing decisions.

66 Risk Management
● Banks should continuously evaluate portfolio quality by using techniques Notes
such as tracking borrower migration, ceiling on exposure, portfolio
reviews etc. ----------------------
● LRM is an effective tool for constantly evaluating the quality of loan book ----------------------
and to bring about qualitative improvements in credit administration.
----------------------
● The main objectives of loan review mechanism include identification of
areas of credit weakness, isolation of problem areas in portfolio, provide ----------------------
information for loan loss provision, ensure adherence of loan policies and
procedures and provide inputs to top management for strategic decision- ----------------------
making.
----------------------
● The credit risk models are intended to aid banks in quantifying, aggregating
and managing risk across geographical and product lines. ----------------------
● In the measurement of credit risk, models may be classified along three ----------------------
different dimensions- the techniques employed, the domain of applications
in the credit process and the products to which they are applied. ----------------------

● The off balance sheet exposures of the banks should be continuously ----------------------
evaluated and managed and divided into full risk, medium risk and low
risk categories. ----------------------

● Banks consider various parameters such as capital adequacy, asset quality, ----------------------
liquidity and profitability in order to evaluate the performance of other
banks. ----------------------

----------------------
Keywords
----------------------
● Consortium: It denotes a cooperative underwriting of loans by a select
group of banks; also called a syndicate. ----------------------
● Credit concentration risk: It is the risk stemming from a single large ----------------------
exposure or group of smaller exposures that are adversely impacted by
similar variations in conditions, events or circumstances. ----------------------
● Credit event: It can be a default on a loan or similar exposure or delays ----------------------
making full or partial interest and/or principal payments; may also include
the impact of reduced external credit rating. ----------------------

● Credit risk capital: It is capital allocated against possible credit losses. ----------------------
● Credit spread: It is the yield differential between different securities, ----------------------
caused by differences in their credit quality.
----------------------
Self-Assessment Questions
----------------------
1. Explain in your words the concept, forms and types of credit risk.
----------------------
2. What are the essential features of credit risk management process?
----------------------
3. Elaborate on the role played by strategy, organisation and operations in
credit risk management. ----------------------

Managing Credit Risk 67

 Notes 4. Discuss various credit risk measurement models used by banks with
examples.
----------------------
5. Sketch the diagram of the loan review mechanism adopted by banks.
----------------------
Answers to Check your Progress
----------------------
Check your Progress 1
----------------------
State True or False.
----------------------
1. True
---------------------- Fill in the blanks.
---------------------- 1. Credit risk is the risk of non-recovery of the amount of loan, diminution
in credit quality of borrower or reduction in the value of asset.
----------------------
Check your Progress 2
---------------------- Fill in the blanks.
---------------------- 1. The credit approval process should aim at efficiency, responsiveness and
accurate measurement of the risk.
----------------------
2. Banks must have an MIS, which will enable them to manage and measure
---------------------- the credit risk inherent in all on- and off-balance sheet activities.
---------------------- Check your Progress 3

---------------------- State True or False.

1. False
----------------------
Fill in the blanks.
----------------------
1. Significant amount of credit risk is inherent in investment banking.
---------------------- 2. There should be greater interaction between Credit and Treasury
Departments in a risk management process.
----------------------
3. Banks should evolve an adequate framework, for managing their exposure
---------------------- in off-balance sheet products like forex, forward contracts, swaps, options,
---------------------- etc.

---------------------- Suggested Reading

----------------------
1. Baesens, Bart, and Gestel Tony van. 2009. Credit Risk Management:
---------------------- Basic Concepts. USA: Oxford University Press.
2. info.worldbank.org/etools/docs/library/86252/carmichael02[1].ppt
----------------------
3. Risk Management in Banks, www.icai.org/resource_file/11490p841-851.
----------------------

----------------------

----------------------

68 Risk Management
Managing Market Risk
UNIT
Structure:

5.1
5.2
Introduction
Classification of Market Risk
5
5.3 Market Risk Management
5.4 Risk Appetite and Major Considerations in Developing Risk Management
Policies and Procedures
5.5 Senior Management Oversight
5.6 Risk Limits
5.7 Market Risk Management Function
5.8 Market Risk Management Information System
5.9 Market Risk Management Reporting
5.10 Basel Market Risk Charges
5.11 Market Risk Measurement and Assessment Systems
5.11.1 Sensitivity Analysis and Stress Testing
5.11.2 Back-Testing
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Managing Market Risk 69

 Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Analyse the concept of market risk
----------------------
• Classify the variables that constitute market risk
---------------------- • Explain the risk management function and its roles and responsibilities
---------------------- •  ppraise the characteristics, role and importance of risk management
A
information system
----------------------
• Compare the tools and techniques of risk measurement and assessment
----------------------

---------------------- 5.1 INTRODUCTION

----------------------
In the previous unit, we have covered the various parameters of credit risk
---------------------- and measures taken by banks to cover it. In this unit, we will move to the next
parameter of risk, which is market risk. The Bank for International Settlements
---------------------- (BIS) defines market risk as “the risk that the value of ‘on’ or ‘off’ balance
sheet positions will be adversely affected by movements in equity and interest
----------------------
rate markets, currency exchange rates and commodity prices”. Thus we can say
---------------------- that market risk is the probability of possible loss to the bank due to change in
market variables. Such risk is common to an entire class of assets or liabilities.
---------------------- The value of investments may decline over a given period of time due to change
in economic conditions affecting a particular class of assets.
----------------------

---------------------- 5.2 CLASSIFICATION OF MARKET RISK

---------------------- Market risk is the risk to banks’ earnings and capital due to change in
various market variables like securities, foreign exchange, equity and commodity
----------------------
prices as well as the volatility of those changes. Even a small change in any of
---------------------- the variables can have a substantial impact on the income and economic value
of banks.
----------------------
Based on the various variables impacting the market risk, it can be
---------------------- classified into the following categories:
● Liquidity risk: It is the risk of not being able to maintain adequate
----------------------
liquidity in order to meet commitments as and when they are due and
---------------------- undertake transactions at the right time in order to get maximum profit.

---------------------- ● Interest rate risk: It is the risk arising due to fluctuation in interest rates
resulting in loss of revenue for the bank.
---------------------- ● Foreign exchange risk: It is the risk arising on account of maintenance
---------------------- of positions in forex operations.
● Commodity price risk: It is the risk arising on account of fluctuation in
---------------------- commodity prices having an impact on the revenues of the bank.

70 Risk Management
● Equity price risk: It is the risk of loss arising on account of movement in Notes
equity prices.
----------------------
5.3 MARKET RISK MANAGEMENT
----------------------
Management of market risk should be the major concern of the top
----------------------
management of banks. The banks’ board should clearly articulate market risk
management policies, procedures, prudential risk limits, review mechanisms ----------------------
and reporting and auditing systems. The policies should address the bank’s
exposure on a consolidated basis and clearly articulate the risk measurement ----------------------
systems that capture all material sources of market risk and assess the effects
----------------------
on the bank. The operating prudential limits and the accountability of the line
management should also be clearly defined. ----------------------
We have already learnt the functioning of the Asset-Liability Management
----------------------
Committee (ALCO) in Unit 2. The Asset-Liability Management Committee
should function as the top operational unit for managing the balance sheet ----------------------
within the performance/risk parameters laid down by the board. The banks
should also set up an independent middle office to track the magnitude of market ----------------------
risk on a real- time basis. The middle office should comprise experts in market
----------------------
risk management, economists, statisticians and general bankers and may be
functionally placed directly under the ALCO. The middle office should also be ----------------------
separated from the Treasury Department and should not be involved in the day-
to-day management of the Treasury. The middle office should apprise the top ----------------------
management/ALCO/ Treasury about adherence to prudential/risk parameters
----------------------
and also aggregate the total market risk exposures assumed by the bank at any
point of time. ----------------------

5.4 RISK APPETITE AND MAJOR CONSIDERATIONS ----------------------

IN DEVELOPING RISK MANAGEMENT POLICIES ----------------------
AND PROCEDURES
----------------------
Risk appetite refers to the level of risk a bank is willing to take. The bank’s
board is responsible for determining the risk appetite and framing decisions ----------------------
based on that. There is no pre-determined format for risk appetite statement, but
usually it should have the following features: ----------------------

● It should be comprehensive. ----------------------

● It should include appropriate and contingent risk targets. ----------------------
● It should have suitable risk measurement metrics to facilitate effective
----------------------
monitoring and provide responses to adverse events.
● It should be suitable to the size and complexity of the bank’s operations. ----------------------

All relevant risks, quantifiable and unquantifiable, on and off balance ----------------------
sheet, should be covered.
----------------------
The risk appetite should be reviewed by the board on a regular basis (refer
to Figure 5.1). Any change in the market conditions having an impact on the ----------------------

Managing Market Risk 71

 Notes risk appetite should be incorporated in the statement. Any change in the risk
appetite should be well documented along with the reason.
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
Fig. 5.1: Approaches to Risk Appetite
---------------------- Following are the major considerations, which banks should keep in mind
---------------------- while developing market risk management policies and procedures:
● The overall business strategy of the bank and the activities that expose the
----------------------
bank to market risk.
---------------------- ● The nature, size and complexity of operations that expose the bank to
market risk.
----------------------
● The overall risk appetite of the bank related to market risk.
----------------------
● The level of sophistication of monitoring capability, management system
---------------------- and processes related to market risk.

---------------------- ● The level of exposure of the bank to market risk and its impact.
● The results of risk analysis tools like stress test and sensitivity analysis.
----------------------
● Regulatory requirements and best practices followed by others.
----------------------
● Bank’s past experience.
----------------------
Activity 3
----------------------

---------------------- Find out different market risks faced by SBI.

----------------------

----------------------
5.5 SENIOR MANAGEMENT OVERSIGHT

---------------------- The effective implementation and functioning of a risk management

framework depends to a large extent on the level of involvement of the board and
---------------------- senior management of the bank. Market risk management should be considered
as an essential aspect of business and sufficient resources should be allocated
---------------------- by the senior management for the risk control unit. The broad responsibilities
---------------------- of the board and senior management towards market risk management are as
under:
---------------------- ● Approve all key elements and major changes to the bank’s market risk
---------------------- management system.

72 Risk Management
● Have a clear understanding of the design and functioning of the system Notes
and be capable of using the reports generated by the system for strategic
decision- making. ----------------------
● Ensure that the system fulfils all regulatory requirements. ----------------------
● Ensure that there is a reporting system within the bank to provide sufficient
----------------------
information to them regularly. It will enable them to exercise sufficient
oversight and make informed decisions relating to the bank’s market risk ----------------------
exposure.
----------------------
Check your Progress 1 ----------------------

Fill in the blanks. ----------------------

1. Market risk involves risks broadly of ___________ types. ----------------------

2. In the definition of market risk by BIS, ______ or _______ balance ----------------------
sheet positions are considered.
----------------------
3. ALCO is formed mainly with a view to managing balance sheet
within the _____ and ______ parameters. ----------------------

----------------------
5.6 RISK LIMITS
----------------------
Risk limit helps to control a bank’s exposure to various quantifiable limits ----------------------
associated with different risk-taking activities. The risk limits set by a bank
should be: ----------------------
● Documented and approved by senior management. ----------------------
● Regularly reviewed and assessed based on the changes in market
conditions. ----------------------

● Consistent with the risk appetite of the bank. ----------------------

● Compatible to the size and complexity of the bank’s operations. ----------------------
● Clearly communicated to various units.
----------------------
● Stating clearly the person responsible to approve exceptions.
----------------------
Banks use various types of limits simultaneously in market risk
management. Some of them are: ----------------------
1. Value-at-risk limits: It is a sensitivity limit which restricts potential loss ----------------------
to an approved % of projected earnings or capital.
----------------------
2. Loss control limits: It is a type of limit which requires management
action if they are approached or breached. ----------------------
3. Tenor or gap limits: It is a limit designed to reduce price risk by limiting
----------------------
the maturity or controlling the volume of transactions that matures or
reprises in a given time period. ----------------------

Managing Market Risk 73

 Notes 4. Notional or volume limits: It is a limit used for controlling operational
capacity and liquidity risk.
----------------------
5. Options limits: It limits specific to option exposure of the banks.
---------------------- 6. Product concentration limits: It is a type of limit useful to ensure that a
concentration in any one product does not significantly increase the price
----------------------
risk of the portfolio as a whole.
----------------------
Check your Progress 2
----------------------

---------------------- Fill in the Blanks.

---------------------- 1. ____________ is the risk of not being able to maintain adequate
liquidity in order to meet commitments as and when they are due
---------------------- and undertake transactions at the right time in order to get maximum
profit.
----------------------
2. ______________ is the probability of possible loss to the bank due to
---------------------- change in market variables.
----------------------

---------------------- 5.7 MARKET RISK MANAGEMENT FUNCTION

---------------------- Daily coordination and performance of risk management activities

is an essential feature of the risk management mechanism. A dedicated risk
---------------------- management department needs to be set up to ensure the effectiveness of market
risk management function.
----------------------
Features of Risk Management Department
----------------------
The main features of the risk management department are:
---------------------- ● Clearly defined responsibilities and authorities.
---------------------- ● Direct reporting line to the relevant senior management or specialised
committee set up by the board.
----------------------
● Independent from the risk-taking and operational units (e.g., trading unit
---------------------- and settlement unit) that it reviews.
---------------------- ● Direct access to information from risk-taking and operational units in
order for it to carry out the market risk management and control function.
----------------------
● Supported by an effective risk management information system.
---------------------- Responsibilities of Risk Management Department
---------------------- The market risk management function should generally be responsible for:

---------------------- ● Identification, assessment and measurement of all possible market risk

exposures of the bank.
---------------------- ● Design, selection, implementation and effective functioning of bank’s
---------------------- risk management function.

74 Risk Management
● On-going review and monitoring the use of risk limits in order to ensure Notes
that all quantifiable risks are within the approved limits.
----------------------
● Preparation and analysis of MIS for risk management including evaluation
of the relationship between measures of market risk exposures (e.g., ----------------------
value- at-risk, stress tests) and trading limits.
----------------------
● Prompt reporting of market risk exposures to the senior management
and specialized committees, as well as alerting the board and the senior ----------------------
management to any other matters that may have a significant impact on
the bank’s financial position and risk profile. ----------------------
● Regular testing for verification of bank’s internal models. ----------------------
● Maintenance of comprehensive and clear documentation of internal ----------------------
models and policies, controls and procedures related to market risk
management. ----------------------
● Actively participating in strategic decision-making and development of ----------------------
new products having implication on market risk management.
----------------------
5.8 MARKET RISK MANAGEMENT INFORMATION
----------------------
SYSTEM
An essential prerequisite for effective implementation of risk management ----------------------
system is timely and accurate availability of data for reporting of various risks. ----------------------
Proper information is required for strategic decision-making, setting up the
risk appetite of the bank and managing risks accordingly. The information ----------------------
received should also be in line with the rapidly changing market and economic
conditions. ----------------------

The critical role played by information in risk management makes ----------------------

it essential for banks to establish and maintain a market risk management
----------------------
information system. The system should be supported by adequate technology
and processing capacity to effectively measure and report the market risk ----------------------
exposure of the bank.
----------------------
The key features of an effective market risk management information
system should be: ----------------------
●● Capability to produce timely, accurate and reliable reports for the board,
----------------------
senior management, specialised committees, risk-taking units and risk
management and control units. These reports should be used to support ----------------------
decision-making at different levels, e.g., strategy formulation and risk
budgeting and to enable early identification of emerging market risk. ----------------------
●● Capability to measure market risk of a product or transaction based on the ----------------------
approved measurement models of the bank.
----------------------
●● Supporting customised identification and aggregation of risk concentration
within the bank. ----------------------
●● Aggregating data on a product, trading venue, counterparty, portfolio,
----------------------
trading unit and sub-unit, currency, etc.

Managing Market Risk 75

 Notes ●● Capability to incorporate hedging and other risk mitigation actions.
●● Capability to produce reports at timely intervals and ad-hoc reports in
---------------------- time of stress.
---------------------- ●● Providing transparent and easy access to data, processes, model
specifications and parameters.
----------------------
●● Conducting sensitivity analysis, back-testing of risk measurement, stress
---------------------- testing or other market risk analysis required to be performed by the
market risk management function.
----------------------
The market risk management information system may be developed
---------------------- internally by the bank or purchased from a third-party vendor. When the
information system is purchased from a third-party vendor it should be ensured
---------------------- that the models used are properly validated initially as well as on an on-going
basis. Banks use information system for other business activities and are always
----------------------
exposed to information technology risks. The following precautions should be
---------------------- taken by banks to safeguard the information system from technology risks:

---------------------- ●● A robust authentication and access control security system should be in

place.
---------------------- ●● All system changes should be well documented and controlled.
---------------------- ●● In case of third-party vendors, proper management of technology service
providers is necessary.
----------------------
●● Regular and timely technology audit is a must.
----------------------

---------------------- Activity 2

---------------------- Study more on designing an information system for risk management

---------------------- from www.bis.org/publ/ecsc07f.pdf

----------------------
5.9 MARKET RISK MANAGEMENT REPORTING
----------------------
A bank’s risk management system will work smoothly and efficiently if
---------------------- the risk exposures and strategies are communicated throughout the bank with
---------------------- sufficient frequency. Effective horizontal and vertical communication facilitates
effective decision-making resulting in safe and sound banking and helps prevent
---------------------- decisions that may result in amplifying risk exposures.
---------------------- The formality and frequency of reporting should be directly related to the
level of risk-taking activities and risk exposures. The recipients of these reports
---------------------- may also vary depending on the bank’s organisational structure.
---------------------- Board and senior management
The board and senior management require timely and accurate information
----------------------
in an understandable format in order to make strategic decisions. At times of
---------------------- stress and financial trouble, this becomes all the more important as prompt

76 Risk Management
decisions are required. If the board and senior management have incomplete or Notes
inaccurate information, their decisions may magnify risks rather than mitigate
them. ----------------------
The board should clearly define the type and periodicity of reports it ----------------------
requires for decision-making. The following reports could be suitable for the
board: ----------------------
●● Trends in aggregate price risk. ----------------------
●● Compliance with board-approved policies and risk limits.
----------------------
●● Summary of performance relative to objectives that articulates risk-
adjusted return. ----------------------
●● Results of stress testing. ----------------------
●● Summary of current risk measurement techniques and management
practices (annually). ----------------------
Senior management ----------------------
The following reports could be suitable for the senior management or the ----------------------
specialised committee responsible for the supervision of market risk:
----------------------
●● Trends in exposure to applicable price risk factors, e.g., interest rates,
volatilities, etc. ----------------------
●● Compliance with policies and aggregate limits by major business.
----------------------
●● Summary of performance relative to objectives that articulates risk-
adjusted return. ----------------------
●● Major new product development or business initiatives. ----------------------
●● Results of stress testing including major assumptions.
----------------------
●● Summary of current risk measurement techniques and management
practices, including results of validation and back-testing exercises ----------------------
(annually).
----------------------
Risk-taking units
The following reports could be suitable for the risk-taking units: ----------------------
●● Detailed profit and loss statement by sub-unit (e.g., desk), product or ----------------------
individual.
----------------------
●● Summary of major exposures.
●● Compliance with policies and procedures, including limits, which should ----------------------
detail exception frequency and trends.
----------------------
●● Aggregate exposure versus limits.
----------------------
●● Summary of performance relative to objectives that articulates risk-
adjusted return. ----------------------
●● Valuation reserve summary.
----------------------
●● Major new product development or business initiatives.
----------------------

Managing Market Risk 77

 Notes ●● Results of stress testing including major assumptions.
●● Periodic reports on market risk model development, which should include
---------------------- independent certifications and periodic validation and back-testing of
---------------------- models.
Dealing rooms
----------------------
The following reports could be suitable for dealing rooms of the risk-
---------------------- taking units:
---------------------- ●● Detailed profit and loss report by desk
●● Sensitivity modelling of significant exposures, e.g., position reports,
---------------------- which can be selected by management or the risk control group and should
---------------------- include a sensitivity matrix indicating the vulnerability of the position to
various changes in the variables affecting price.
---------------------- ●● Compliance with limits.
---------------------- ●● Summary of performance versus objectives that articulates risk-adjusted
return.
----------------------
●● New product developments or business initiatives.
---------------------- ●● Errors and omissions.
---------------------- Trading desk

---------------------- The following reports could be suitable for the trading desk level of the
risk- taking units:
---------------------- ●● Detailed breakdown of all positions including cash flows.
---------------------- ●● Detailed profit and loss report by portfolio and trader.
●● Sensitivity modelling of all positions, which should include a sensitivity
----------------------
matrix indicating the vulnerability of the position to various changes in
---------------------- the variables affecting price.
●● Compliance with limits.
----------------------
●● Errors and omissions.
----------------------
●● Product specific detail, e.g., contracts maturing or expiring, pertinent
---------------------- concentration information, etc.
●● Ideally, management reports should be generated by risk management or
---------------------- control functions independent of the risk-taking units. When risk-takers
---------------------- provide information for management reports, senior management should
be informed of the possible weaknesses in the data and these positions
---------------------- should be audited frequently.
----------------------

----------------------

----------------------

----------------------

78 Risk Management
 Notes
Check your Progress 3
----------------------
State True or False. ----------------------
1. Only weekly coordination and performance of risk management
----------------------
activities is an essential feature of the risk management mechanism.
2. An essential prerequisite for effective implementation of risk ----------------------
management system is timely and accurate availability of data for
----------------------
reporting of various benefits.
3. If the board and senior management have complete or accurate ----------------------
information, their decisions may magnify risks rather than mitigate ----------------------
them.
----------------------

5.10 BASEL MARKET RISK CHARGES ----------------------

Increase in the volume of proprietary trading activities of commercial ----------------------

banks forced the regulators to move their focus on market risk. The capital
----------------------
charge can be computed using two methods. The first method is based on the
Standardised Model, similar to the credit risk system with add-ons determined ----------------------
by the Basel rules. This method provides a rough but conservative measure of
the capital charge for market risk. ----------------------
The second method is called the Internal Model Approach (IMA), ----------------------
which is based on banks’ own risk management system and is not governed
by any standardised rules. The regulators relied on the bank’s internal system ----------------------
of determining capital charge for the first time. The internal models approach ----------------------
includes the system of back-testing which is a strong system for verification and
prevents banks from understating their market risk. ----------------------
The Standardised Model ----------------------
The main objective of the market risk amendment was to provide an
appropriate cushion for price risk to which banks are exposed. Banks, if well ----------------------
protected from market risk, will help in strengthening international banking ----------------------
system and financial market.
----------------------
In this model, a bank’s market risk is computed for each portfolio exposed
to interest rate risk, foreign currency risk, equity risk, commodity risk and option ----------------------
risk by following specific guidelines. All these risks are then added together to
assess the bank’s total risk. This model is considered very robust and easy to ----------------------
implement, but it is criticised on the following grounds:
----------------------
●● Arbitrary risk classification: Different currencies, for example, have
different volatilities relative to dollar. However, a uniform capital charge ----------------------
is applied in this method.
----------------------

----------------------

Managing Market Risk 79

 Notes ●● Conservative capital requirements: This method leads to very
conservative capital requirements because risk charges are added up
---------------------- across different risk sources, which ignores diversification. It assumes
that the worst loss will occur across all sources of risk at the same time. In
---------------------- reality, markets are not that perfectly correlated and the worst loss is less
---------------------- than the sum of individual worst losses.
These drawbacks forced the banks to develop a more realistic and flexible
---------------------- approach, which is the Internal Model Approach.
---------------------- Internal Models Approach
---------------------- As compared to the standardised approach, the Internal Models Approach
relies on the risk management system developed by banks internally. However,
---------------------- these internal models need to be approved by the appropriate authority and
have to satisfy certain qualitative requirements with detailed documentations
----------------------
and regular back-testing.
---------------------- The various qualitative standards which need to be satisfied by banks
in order to assure the regulators about the soundness of the risk management
----------------------
system are as follows:
---------------------- ●● The risk control unit should be independent of the trading unit and should
have direct reporting to senior management in order to prevent conflict
---------------------- of interest.
---------------------- ●● The internal models should be subject to continuous back-testing in order
to check accuracy of internal value at Risk (VAR) models.
----------------------
●● Involvement of senior management in the risk management process with
---------------------- sufficient resources is a must.
●● The internal risk models should be well integrated with day-to-day
---------------------- operations and should not be used only for regulatory purpose.
---------------------- ●● Internal trading and exposure limits should be set by banks using the
internal risk measurement systems.
---------------------- ●● Regular stress tests should be conducted and reviewed by senior
---------------------- management and reflected in policies and limits set by top management.
●● Regular independent review of trading units and risk control units should
---------------------- be conducted and verified with back-testing.
---------------------- ●● The policies should be properly documented and complied with. Once
these requirements are satisfied, the market risk charge is computed
---------------------- according to these rules.
---------------------- The computation of daily VAR shall be based on a set of uniform
quantitative inputs. They are:
---------------------- ●● A horizon of 10 trading days or two calendar weeks; banks can, however,
scale their daily VAR by the square root of time.
----------------------
●● A 99% confidence interval.
---------------------- ●● An observation period based on at least a year of historical data or if a
non-equal weighting scheme is used, there should be an average time lag
----------------------
of at least six months.
80 Risk Management
●● At least a quarterly update or whenever prices are subject to material Notes
changes (so that a sudden increase in risk can be picked up).
The general market capital charge shall be set at the higher of the ----------------------
previous day’s VAR or the average VAR over the last 60 business days, times ----------------------
a multiplicative factor K. The exact value of this multiplicative factor is to be
determined by local regulators, subject to an absolute floor of 3. The purpose of ----------------------
this factor is two fold. Without this risk factor, a bank would be expected to have
losses that exceed its capital in one 10-day period out of a 100 or about one in four ----------------------
years. Secondly, the factor serves as a buffer against model misspecifications, ----------------------
for instance, assuming a normal distribution when the distribution has fat tails.
A penalty component, called plus factor, shall be added to the multiplicative ----------------------
factor, K, if verification of the VAR forecasts reveals that the bank systematically ----------------------
underestimates its risks.
----------------------
The banks’ market risk capital requirement will be either (a) the risk
charge obtained by the standardised methodology (the risk charge derived from ----------------------
an arithmetic summation across the five risk categories) or (b) the risk charge
obtained by the internal models approach. It can also be a a mixture of (a) and ----------------------
(b) summed arithmetically.
----------------------

Activity 3 ----------------------

----------------------
Read the article Risk Measurement: An Introduction to Value at Risk
from www.exinfm.com/training/pdfiles/valueatrisk.pdf ----------------------

----------------------
5.11 MARKET RISK MEASUREMENT AND ASSESSMENT ----------------------
SYSTEMS
----------------------
We have seen the importance of the market risk department in a banking
setup. For the smooth functioning of the department, it is essential that the ----------------------
department is able to measure various quantifiable market risks and assess the
----------------------
less quantifiable market risks. Banks should put in place effective systems and
tools in order to assess and monitor various market risks. Any adverse change ----------------------
in the market factors should be quickly assessed and remedial measures should
be taken promptly. The tools used should also predict the probability of future ----------------------
losses in different scenarios.
----------------------
The process of measuring market risk starts with measuring the risk
exposures of transactions at fair value. These valuations are done by persons ----------------------
independent of the risk-taking units. The trading positions are marked-to-
----------------------
market in order to get the latest fair values. Where sufficient market data is not
available, marked-to-model is performed to get the valuation. The system should ----------------------
be capable of providing data on outstanding positions and their unrealised profit
or loss. ----------------------

----------------------

Managing Market Risk 81

 Notes The risk measurement system should be well equipped to take into account
the changes in volume of transactions, method of valuation and launch of new
---------------------- products. The accuracy and reliability of risk measurement models should be
verified against actual results through regular back testing. Different methods
---------------------- and models may be used to measure each type of risk. The following factors
---------------------- need to be kept in mind while deciding upon the method or model to be used for
risk measurement:
----------------------
●● Nature, scale and complexity of business activities.
---------------------- ●● Need and purpose of risk measurement and its implications.
---------------------- ●● General market trend of risk measurement, i.e., practice and tools used by
other banks to measure similar type of risks.
---------------------- ●● Extent of availability of market data which has to be used as input for risk
---------------------- measurement.
●● Capability of the market risk management information system in terms of
---------------------- computational capacity.
---------------------- ●● Expertise and experience of staff.
The various models and tools used by banks for risk assessment should be
----------------------
properly documented covering their theoretical background and limitations.
---------------------- 5.11.1 Sensitivity Analysis and Stress Testing
---------------------- Sensitivity analysis is used to measure the sensitivity of valuation, profit
and loss or other risk measurements as a result of change in one or more market
---------------------- variables like interest rate, exchange rate, etc.
---------------------- Stress test is conducted to identify remote but possible events that can have
an impact on the overall risk profile of the bank thereby impacting its financial
---------------------- position. It also addresses the existing and potential risk concentrations and
---------------------- helps in development of risk mitigation tools under different stress conditions.
The scenarios considered for test should be comprehensive and forward looking
---------------------- and consider those risk factors which can have a significant impact on the bank.
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

---------------------- Fig. 5.2: An Overview of Stress Testing Process for Market Risk

----------------------

82 Risk Management
Stress test falls into three categories: Notes
1. Scenarios requiring no simulation: They include analysis of past losses
----------------------
over recent reporting period in order to understand the vulnerabilities
of the bank. This approach is backward looking and does not take into ----------------------
account changes in portfolio composition.
----------------------
2. Scenarios requiring simulation: They include running simulations of
current portfolio subject to large historical shocks. ----------------------
3. Bank-specific scenarios: They are driven more by the current position of
----------------------
the bank instead of historical experience. For instance, a strategy of going
long the off-the-run bond while shorting the equivalent on-the-run bond ----------------------
may appear safe based on recent historical patterns.
----------------------
Supervisors are required to conduct both sensitivity analysis and stress
test regularly on a firm-wide basis. Operations that increase the risk exposure ----------------------
of banks should be covered under these tests.
----------------------
5.11.2 Back-Testing
All risk measurement models of the bank need to be verified for accuracy ----------------------
at regular intervals. Back-testing, stress testing, independent review and ----------------------
oversight are some of the tools used by banks for verification.
----------------------
Back-testing is a statistical testing framework which checks whether the
actual trading loss is in line with VAR forecasts. Any instance of actual loss ----------------------
exceeding the forecasted VAR is termed as an exception.
----------------------
The Basel Committee has decided that up to four exceptions is acceptable,
which defines a “green” zone. If the number of exceptions is five or more, ----------------------
the bank falls into a “yellow” or “red” zone and incurs a progressive penalty
where the multiplicative factor is increased from three to four. The plus factor ----------------------
is described later in this unit.
----------------------
An incursion into the red zone generates an automatic, non-discretionary
penalty. This is because it would be extremely unlikely to observe more than 10 ----------------------
exceptions if the model was indeed correct. ----------------------
Table 5.1 The Basel Penalty Zones
----------------------
Zone Number of exceptions Potential increase in K
Green 0−4 0.00 ----------------------
Yellow 5
6 ----------------------
7 ----------------------
8
9 ----------------------
0.50 0.40
0.65 ----------------------
0.75
----------------------
0.85
Red >=10 1.00 ----------------------

Managing Market Risk 83

 Notes If the number of exceptions falls within the yellow zone, the supervisor can
exercise his discretion to apply penalty depending upon the cause of exception.
---------------------- The Basel Committee uses the following factors in determining the penalty:
---------------------- If the deviation has occurred due to incorrect reporting of positions or
error in the program code, it is considered as a very serious flaw and penalty
---------------------- should apply and corrective action should be taken.
---------------------- If the deviation has occurred because the model does not cover enough
risk factors, then also it is considered as a serious flaw and calls for a penalty.
----------------------
If the deviation has occurred due to a change in position during the day
---------------------- and is likely to disappear with the hypothetical return, penalty might not be
imposed.
----------------------
Banks operate in a very volatile market and exceptions may occur due to
---------------------- changed correlation or high volatility once in a while. Such exceptions should
not be considered as a deficiency in model and no penalty should be imposed.
----------------------

---------------------- Check your Progress 4

----------------------
Fill in the blanks.
---------------------- 1. The process of measuring market risk starts with measuring the risk
exposures of transactions at ______ value.
----------------------
2. The system should be capable of providing data on outstanding
---------------------- positions and their ________ profit or loss.
---------------------- 3. Banks should put in place effective ______ and _______ in order to
assess and monitor various market risks.
----------------------

---------------------- Summary
---------------------- ● Market risk is the risk that the value of ‘on’ or ‘off’ balance sheet positions
will be adversely affected by movements in equity and interest rate
---------------------- markets, currency exchange rates and commodity prices.
---------------------- ● Based on the various variables impacting the market risk, it is classified
into liquidity risk, interest rate risk, foreign exchange risk, commodity
---------------------- price risk and equity price risk.
---------------------- ● Risk appetite refers to the level of risk a bank is willing to take. The
bank’s board is responsible for determining the risk appetite and framing
---------------------- decisions based on that.
---------------------- ● The risk appetite statement should be comprehensive and should include
contingent risk targets, risk measurement metrics and cover all risks
---------------------- relevant to the nature and size of operations.
---------------------- ● The effective implementation and functioning of a risk management
framework depends to a large extent on the level of involvement of the
----------------------
board and senior management of the bank.

84 Risk Management
● Nature, size and complexity of business, overall market appetite, level Notes
of banks’ exposure to market risk, regulatory requirements and previous
experience are some of the factors that banks keep in mind while drafting ----------------------
risk management policies and procedure.
----------------------
● Risk limit helps to control banks’ exposure to various quantifiable limits
associated with different risk-taking activities. ----------------------
● Risk limits can be classified under value at risk limits, loss control limits, ----------------------
tenor limits, notional, optional and product concentration limits.
----------------------
● Daily coordination and performance of risk management activities is an
essential feature of the risk management mechanism. A dedicated risk ----------------------
management department needs to be set up to ensure effectiveness of
market risk management function. ----------------------
● The critical role played by information in risk management makes it ----------------------
essential for banks to establish and maintain a market risk management
information system. ----------------------

● Risk management information system should produce timely and ----------------------

accurate reports, measure market risk, incorporate hedging and other risk
mitigation actions and provide transparent and easy access to data. ----------------------

● Effective horizontal and vertical communication facilitates effective ----------------------

decision- making resulting in safe and sound banking. It also helps prevent
decisions that may result in amplifying risk exposures. ----------------------

● The board and senior management, risk taking units, dealing rooms and ----------------------
trading desk require different reports at different points of time to control
----------------------
market risk.
● The Basel Committee has introduced capital charge for market risk and ----------------------
it covers two methods of computation of market risk – the standardised
----------------------
model and the internal models approach.
● The risk measurement system should be well equipped to take into account ----------------------
the changes in volume of transactions, method of valuation and launch of ----------------------
new products.
● The accuracy and reliability of risk measurement models should be ----------------------
verified against actual results through regular back-testing. ----------------------
● Sensitivity analysis is used to measure the sensitivity of valuation, profit
and loss or other risk measurement as a result of change in one or more ----------------------
market variables like interest rate, exchange rate, etc. ----------------------
● All risk measurement models of the bank need to be verified for accuracy
----------------------
at regular intervals. Back testing, stress testing, independent review and
oversight are some of the tools used by banks for verification. ----------------------

----------------------

----------------------

Managing Market Risk 85

 Notes Keywords
----------------------
● Market risk: The risk to banks’ earnings and capital due to change in
---------------------- various market variables like securities, foreign exchange, equity and
commodity prices as well as the volatility of those changes.
----------------------
● Interest rate risk: The risk arising due to fluctuation in interest rates
---------------------- resulting in loss of revenue for the bank.
● Commodity price risk: The risk arising on account of fluctuation in
----------------------
commodity prices having an impact on the revenues of the bank.
---------------------- ● Equity price risk: The risk of loss arising on account of movement in
---------------------- equity prices.

---------------------- Self-Assessment Questions

----------------------
1. Elaborate the need and importance of market risk management function
---------------------- in a banking setup.
2. What are the broad responsibilities of the market risk management
----------------------
department?
---------------------- 3. List the variables that constitute market risk.
---------------------- 4. Who are the different users of market risk reports?
----------------------
Answers to Check your Progress
----------------------
Check your Progress 1
---------------------- Fill in the Blanks.
---------------------- 1. Market risks involve risks broadly of five types.
---------------------- 2. In the definition of market risk by BIS, on or off balance sheet positions
are considered.
----------------------
3. ALCO is formed mainly with a view to managing balance sheet within
---------------------- the performance and risk prarameters.
Check your Progress 2
----------------------
Fill in the Blanks.
----------------------
1. Liquidity risk is the risk of not being able to maintain adequate liquidity
---------------------- in order to meet commitments as and when they are due and undertake
transactions at the right time in order to get maximum profit.
----------------------
2. Market risk is the probability of possible loss to the bank due to change in
---------------------- market variables.
----------------------

----------------------

86 Risk Management
Check your Progress 3 Notes
State True or False.
----------------------
1. False
----------------------
2. False
3. False ----------------------
Check your Progress 4 ----------------------
Fill in the Blanks. ----------------------
1. The process of measuring market risk starts with measuring the risk
----------------------
exposures of transactions at fair value.
2. The system should be capable of providing data on outstanding positions ----------------------
and their unrealised profit or loss.
----------------------
3. Banks should put in place effective systems and tools in order to assess
and monitor various market risks. ----------------------

----------------------
Suggested Reading
----------------------
1. Vasudevan, A. 2003. Central Banking for Emerging Market Economics.
----------------------
California: Academic Foundation.
2. Benton E. Gup, and James W. Kolari 2007. Commercial Banking: The ----------------------
Management of Risk. Australia: John Wiley & Sons.
----------------------
3. Bidani, S. N. 2010. Banking Risks Management and Audit. New Delhi:
Vision Books. ----------------------
4. Van Greuning, Hennie, and Bratanovic, Sonja Brajovic 2003. Analyzing ----------------------
and Managing Banking Risk: Framework for Assessing Corporate
Governance and Financial Risk. World Bank Publication. ----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

Managing Market Risk 87

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

88 Risk Management
Managing Interest Rate Risk
UNIT

6
Structure:

6.1 Introduction
6.2 Sources of Interest Rate Risk
6.3 Effects of Interest Rate Risk
6.4 Sound Interest Rate Risk Management Practices
6.5 Interest Rate Risk Measurement Techniques
6.6 Principles for Management and Supervision of Interest Rate Risk
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Managing Interest Rate Risk 89

 Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Analyse the concept of interest rate risk
----------------------
• Distinguish between types of interest rate risk
---------------------- • Examine the essential features of sound interest rate risk management
---------------------- • Appraise the techniques used by banks to measure interest rate risk
---------------------- •  emorise the recommendations of Basel Committee on sound interest
M
rate risk management
----------------------

---------------------- 6.1 INTRODUCTION

----------------------
As covered in the previous unit, adverse movements in interest rates
---------------------- expose the banks to interest rate risk. It refers to potential impact on net interest
income and market value of equity caused by unexpected changes in market
---------------------- interest rates. This risk is considered as an integral part of banking and is well
accepted as a normal part of banking. If managed properly, it can be an important
----------------------
source of profitability and shareholders’ value. At the same time, it can have a
---------------------- significant impact on a bank’s profitability and capital base. Change in interest
rates results in change in interest income, thereby impacting the bank’s earnings.
---------------------- It also has an impact on the underlying value of the bank’s assets, liabilities and
off balance sheet items by changing the present value of cash flows.
----------------------
Deregulation of interest rates has exposed banks to the adverse impacts of
---------------------- interest rate risk. The net interest income, earnings of assets and cost of liabilities
are closely related to market interest rate volatility. Hence management of
----------------------
interest rate risk should be a critical component of market risk management in
---------------------- banks. An efficient risk management process, which maintains the interest rate
limits within prudent limits, is essential for sound banking operations.
----------------------

---------------------- 6.2 SOURCES OF INTEREST RATE RISK

---------------------- Interest rate risk arises because of various factors, internal as well
as external. Some sources can have a greater impact on interest rate risk as
---------------------- compared to other sources. Let us study these sources in detail to understand the
impact of each source on interest rate risk.
----------------------
1. Repricing risk: All banks and financial institutions encounter interest
---------------------- rate risk in various forms, out of which risk arising from timing difference
in maturity for fixed rate loans and re pricing for floating rate loans are the
----------------------
most prominent ones. Repricing differences are unavoidable in banking
---------------------- business but exposure beyond prudent limits can have a major impact on
bank’s income and underlying economic value. For instance, if a bank
---------------------- funds a long-term fixed rate loan with a short term deposit and the interest

90 Risk Management
 rate increases in future, then it can face decline in future interest income Notes
from loan as well as its underlying value. These declines arise because the
cash flows on the loan are fixed over its lifetime, while the interest paid on ----------------------
the funding is variable and increases after the short-term deposit matures.
----------------------
2. Yield curve risk: Repricing mismatches can also expose a bank to
changes in the slope and shape of the yield curve. Yield curve risk arises ----------------------
when unanticipated shifts of the yield curve have adverse effects on a
bank’s income or underlying economic value. For instance, the underlying ----------------------
economic value of a long position in 10-year government bonds hedged
----------------------
by a short position in 5-year government notes could decline sharply if
the yield curve steepens, even if the position is hedged against parallel ----------------------
movements in the yield curve.
3. Basis risk: An imperfect correlation in the adjustment of rates earned ----------------------
and paid on different instruments with otherwise similar repricing ----------------------
characteristics results in another form of interest rate risk called the basis
risk. Change in interest rates results in change in cash flows and earnings ----------------------
spread between assets, liabilities and off balance sheet instruments of
similar maturities. For example if a one year monthly repricing loan is ----------------------
funded by a one-year deposit that reprices monthly, based on one-month
----------------------
LIBOR, then the bank is exposed to the risk of unexpected change in the
spread between the two index rates. ----------------------
4. Optionality: Many bank assets, liabilities and off balance sheet
instruments are embedded with options which become a source of ----------------------
interest rate risk. Typically an option provides the holder the right, but ----------------------
not the obligation, to buy, sell or in some manner alter the cash flow of an
instrument or financial contract. Options may be stand-alone instruments ----------------------
such as exchange-traded options and over-the-counter (OTC) contracts or
they may be embedded within otherwise standard instruments. ----------------------
Examples of instruments with embedded options include various types of ----------------------
bonds and notes with call or put provisions, loans which give borrowers
the right to prepay balances and various types of non-maturity deposit ----------------------
instruments that give depositors the right to withdraw funds at any time,
often without any penalties. If not adequately managed, the optionality ----------------------
features can pose significant risk particularly to those who sell them, since ----------------------
the options held, both explicit and embedded, are generally exercised to
the advantage of the holder and the disadvantage of the seller. ----------------------
6. Price risk: Sale of assets before maturity results in price risk. The price
----------------------
risk is closely associated with the trading book, which is created for
making profit out of short-term movements in interest rates. Banks, which ----------------------
have an active trading book, should therefore formulate policies to limit
the portfolio size, holding period, duration, defeasance period, stop loss ----------------------
limits, marking to market etc.
----------------------
7. Reinvestment Risk: Uncertainty with regard to interest rate at which
the future cash flows could be reinvested is called reinvestment risk. Any ----------------------
mismatches in cash flows would expose the banks to variations in net
interest income as the market interest rates move in different directions. ----------------------

Managing Interest Rate Risk 91

 Notes 6.3 EFFECTS OF INTEREST RATE RISK
---------------------- As discussed above, changes in interest rates can have an adverse impact
both on a bank’s earnings and its economic value. Hence the bank’s interest rate
---------------------- risk exposure is assessed from two perspectives:
1. Earnings perspective: Under this perspective, the impact of change in
----------------------
interest rates on accrued or reported earnings of the bank is analyzed. This
---------------------- is a traditional approach followed by most of the banks for assessment of
their interest rate risk. Variation in earnings is an important focal point for
---------------------- interest rate risk analysis because reduced earnings or outright losses can
threaten the financial stability of an institution by undermining its capital
---------------------- adequacy and by reducing market confidence.
---------------------- The difference between the total interest income and total interest
expense is termed as net interest income and is regarded as an important
---------------------- component of banks earnings. It is directly linked to interest rate changes
and has a direct impact on the overall earnings of the bank.
----------------------
With the diversification in banking services, scope of fee-based and
---------------------- other non- interest incomes has increased and there is a broader focus on
overall net income incorporating both interest and non-interest incomes
---------------------- and expenses. Activities such as loan servicing and asset securitisation
generate non-interest income for banks but are highly sensitive to market
----------------------
interest rates. For example, banks provide the function of loan servicing
---------------------- and administration on mortgage loans and charge a fee based on volume
of assets it administers. With the fall in interest rates, a lot of mortgages
---------------------- prepay, resulting in decline in banks fee income. Even the transaction
processing fee gets impacted by interest rate changes. As a result, banks
---------------------- consider a broader view of potential effects of change in interest rates
---------------------- on banks’ earnings and factor the impact of change in interest rates on
estimated earnings of the bank.
---------------------- 2. Economic value perspective: Variation in market interest rates can
also affect the economic value of a bank’s assets, liabilities and OBS
----------------------
positions. The shareholders, management and supervisors of the bank are
---------------------- equally interested in knowing the sensitivity of a bank’s economic value
to fluctuations in interest rates.
---------------------- The economic value of an instrument is calculated by assessing the present
value of its expected net cash flows, discounted to reflect market rates.
----------------------
Thus the economic value for the bank will be the expected cash flows on
---------------------- assets minus the expected cash flows on liabilities plus the expected net
cash flows on OBS positions. Thus it reflects how sensitive the net worth
---------------------- of the bank is to change in interest rates.
As compared to the earnings perspective, the economic value perspective
----------------------
considers the potential impact of interest rate changes on the present value
---------------------- of all future cash flows. It provides a more comprehensive view of the
potential long-term impact of change in interest rates. The comprehensive
---------------------- view is very important as changes in short term earnings, as reflected by
earnings perspective, may not accurately indicate the impact of interest
---------------------- rate movements on bank’s overall position.

92 Risk Management
3. Embedded losses: We have seen that the earnings and economic value Notes
perspectives discussed till now emphasise on predicting the impact of
future changes in interest rates on bank’s financial performance. The bank ----------------------
should also consider the impact of past interest rates on future performance
in order to make a correct assessment of interest rate risk. In particular, ----------------------
instruments that are not marked to market may already contain embedded ----------------------
gains or losses due to past rate movements. For example, a long-term,
fixed-rate loan entered into when interest rates were low and refunded ----------------------
more recently with liabilities bearing a higher rate of interest will, over its
remaining life, represent a drain on the bank’s resources. ----------------------

----------------------
Activity 1
----------------------
Visit the RBI website and give your views on different perspectives of ----------------------
measuring interest rate risk exposure of a bank.
----------------------

6.4 SOUND INTEREST RATE RISK MANAGEMENT ----------------------

PRACTICES ----------------------
Sound interest rate risk management involves the application of four ----------------------
basic elements in the management of assets, liabilities and OBS instruments, as
explained below: ----------------------
1. Appropriate board and senior management oversight. ----------------------
2. Adequate risk management policies and procedures. ----------------------
3. Appropriate risk measurement, monitoring and control functions.
----------------------
4. Comprehensive internal controls and independent audits.
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
Fig. 6.1: Sound Interest Rate Risk Management Practices ----------------------

Managing Interest Rate Risk 93

 Notes 1. Appropriate board and senior management oversight: Like all risk
management processes, effective oversight and guidance by the board
---------------------- of directors and senior management is critical for sound interest rate
risk management. The board should have a clear understanding of the
---------------------- nature and level of interest rate risk taken by bank and should approve
---------------------- strategies and policies governing interest rate risk. Lines of authority and
responsibility for managing interest rate risk exposures should be clearly
---------------------- defined. The board should ensure that proper steps have been taken by the
management to identify, measure, monitor and control interest rate risk.
---------------------- They should also encourage discussions between its members and senior
---------------------- management and with others in the bank regarding risk exposure and
management processes. Periodical review and re-evaluation of policies
---------------------- and procedures is also the responsibility of the bank’s board.
---------------------- The senior management is responsible for ensuring that the risk
management policies and procedures are followed by all in the system
---------------------- on a long-term basis as well as day-to-day basis. They are responsible for
maintaining:
----------------------
• Limits on risk taking.
----------------------
Adequate standards of risk measurement.
---------------------- • Standards for valuing positions and measuring performance.
---------------------- Comprehensive risk reporting and management review process.
• Sound internal controls.
----------------------
Management should ensure that safeguards are in place to minimise
---------------------- inappropriate influencing of key control functions by individuals
initiating risk-taking positions. The nature and scope of such safeguards
---------------------- should be based on the size and structure of the bank as well as volume
---------------------- and complexity of transactions. The personnel charged with measuring,
monitoring and controlling interest rate risk should have a well-founded
---------------------- understanding of all types of interest rate risk faced throughout the bank.
---------------------- 2. Adequate risk management policies and procedures: Policies and
procedures should be clearly defined for limiting and controlling interest
---------------------- rate risk. Some salient features of policies and procedures are as under:
---------------------- • Consolidated application.
• Clearly defined authority and responsibility.
---------------------- • Clearly defined authorised instruments, hedging strategies and
---------------------- position taking opportunities.
• Quantifiable parameters for risk measurement.
----------------------
• Periodical review and revision.
---------------------- • Clearly defined tolerable risk limits.
• Clear set of institutional procedures for acquiring specific
----------------------
instruments, managing portfolios and controlling the bank’s
---------------------- aggregate interest rate risk exposure.

94 Risk Management
 Bank should be extra careful before dealing in products and activities that Notes
are new to the bank. A careful pre acquisition review should be done to
ensure understanding and incorporation of all interest rate risks factors. ----------------------
Prior to introducing a new product, hedging or position-taking strategy,
management should ensure that adequate operational procedures and risk ----------------------
control systems are in place. ----------------------
3. Risk measurement, monitoring and control functions: Depending
----------------------
on the nature, size and complexity of operations, banks should have
appropriate interest rate risk measurement systems for measuring impact ----------------------
on both earnings and economic value. The risk measurement system
should be able to assess all material interest rate risks, utilise generally ----------------------
accepted financial concepts and risk measurement techniques and should
----------------------
be well- documented. We will cover the various risk measurement
techniques used by banks later in this unit. ----------------------
The goal of interest rate risk management is to maintain bank’s interest
----------------------
rate risk exposure within pre-defined limits. Banks should have a well
defined system to set boundaries for the level of interest rate risk and ----------------------
it should be allocated amongst individual portfolios, activities and
business units. The limits should be consistent with the overall approach ----------------------
to measuring interest rate risk and any deviation should receive prompt
----------------------
management attention. The limits so decided should be communicated to
the appropriate mangers in time. ----------------------
The risk measurement system should also support a meaningful evaluation
----------------------
of the effect of stressful market conditions on the bank. Stress testing
should be designed to provide information on the kinds of conditions ----------------------
under which the bank’s strategies or positions would be most vulnerable
and thus may be tailored to the risk characteristics of the bank. Possible ----------------------
stress scenarios might include abrupt changes in the general level of
----------------------
interest rates, changes in the relationships among key market rates (i.e.
basis risk), changes in the slope and the shape of the yield curve (i.e. yield ----------------------
curve risk), changes in the liquidity of key financial markets or changes in
the volatility of market rates. ----------------------
4. Interest rate risk monitoring and reporting: An accurate and timely ----------------------
information system is essential for the efficient interest rate risk
management. There should be regular reporting of risk measures and ----------------------
current exposures should be compared with policy limits and past forecasts ----------------------
with actual results to highlight the shortcomings of risk modelling, if any.
The risk reports should be reviewed by the board regularly and should ----------------------
include the following: ----------------------
• Summary of aggregate exposures.
----------------------
• Policy and limit compliance report.
----------------------
• Key assumptions.
• Stress test results. ----------------------

Managing Interest Rate Risk 95

 Notes • Summary of findings of review of interest rate risk policies and
procedures.
----------------------
Internal Controls
---------------------- Adequate internal controls should be in place to ensure integrity of interest
rate risk management process. They should promote effective and efficient
----------------------
operations, compliance with laws and regulations and should be an integral part
---------------------- of overall internal control system. An effective internal control system should
include the following:
----------------------
• Strong control environment.
---------------------- • Adequate process of identifying and evaluating risk.
---------------------- • Adequate information system.
---------------------- • Continuous review of established policies and procedures.
An important element of a bank’s internal control system over its interest
----------------------
rate risk management process is regular evaluation and review. This includes
---------------------- ensuring that personnel are following established policies and procedures, as
well as ensuring that the procedures that were established actually accomplish
---------------------- the intended objectives. Such reviews and evaluations should also address any
significant change that may impact the effectiveness of controls, such as changes
----------------------
in market conditions, personnel, technology and structures of compliance with
---------------------- interest rate risk exposure limits and should ensure that appropriate follow-up
with management has occurred for any limits that were exceeded.
----------------------

---------------------- Check your Progress 1

---------------------- State True or False.

---------------------- 1. Interest rate risk refers to potential impact on net interest income
and market value of equity caused by unexpected changes in market
---------------------- interest rates.
---------------------- 2. If managed properly, the interest rate risk can be an important source
of profitability and shareholders’ value.
----------------------
3. Interest rate risk is considered an integral part of banking and is well
---------------------- accepted as a normal part of banking.
----------------------

---------------------- Activity 1
----------------------
Visit a nearby bank and interview the bank officer about the sound interest
---------------------- rate risk management practices followed there.

----------------------

----------------------

96 Risk Management
6.5 INTEREST RATE RISK MEASUREMENT Notes
TECHNIQUES
----------------------
Banks follow various techniques to measure the exposure of earnings and
economic value to changes in interest rates. Techniques such as sample maturity ----------------------
and repricing tables, static simulations based on current on- and off-balance-
----------------------
sheet positions and dynamic modelling techniques incorporating assumptions
about behaviour of customer and bank in response to change in interest rates. ----------------------
Some general approaches are used to calculate exposure to interest rate risk
both from earnings and economic value perspective while some approaches are ----------------------
typically associated with only one of the two perspectives.
----------------------
The approaches also vary, based on their ability to capture different forms
of interest rate exposures, wherein the simplest methods capture the risks arising ----------------------
from maturity and repricing mismatches, while the more sophisticated methods ----------------------
can more easily capture the full range of risk exposures.
Each approach has its own strengths and weaknesses based on its ----------------------
capability to provide accurate and reasonable measure of interest rate risk. The ----------------------
approach followed by a bank towards measurement and hedging of interest rate
risk depends upon the segmentation of balance sheet. ----------------------
Before we continue to study the different approaches for interest rate risk ----------------------
measurement, we will study the concept of trading book and banking book.
----------------------
1. Trading Book: Assets in trading book are held for generating profits on
short term differences in prices. The banks management should lay down ----------------------
policies specifying the volume, maturity, holding period, duration, stop
loss, rating standards etc. for classifying securities in trading book. ----------------------
The VaR (Value at Risk) method is employed to assess potential loss ----------------------
that could crystallise on trading position or portfolio due to variations in
market interest rates and prices, using a given confidence level, usually ----------------------
95% to 99%, within a defined period of time. The VaR models require
----------------------
extensive use of historical data to estimate future volatility and may not
give good results in extremely volatile market conditions. Stress tests on ----------------------
the other hand provide management with a view on potential impact of
large market movements and estimated loss due to stress events. Scenario ----------------------
analysis can also be conducted by banks with specific possible stress
----------------------
situations.
2. Banking Book: The banking book comprises assets and liabilities, which ----------------------
are contracted on account of relationship or for steady income and are
----------------------
generally held till maturity. Interest rate changes have an impact on
the earnings and economic value of banking book. Depending on the ----------------------
complexity of the balance sheet and the range of products, banks should
have adequate risk measurement system to assess the effect of rate change ----------------------
on both earnings and economic value.
----------------------
Having understood the concept of trading book and banking book, we will
now go through the different interest rate risk measurement techniques. ----------------------

Managing Interest Rate Risk 97

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

---------------------- Fig. 6.2: Internet Rate Risk Measurement Techniques

A. Repricing schedules
----------------------
The simplest techniques for measuring a bank’s interest rate risk exposure
---------------------- begin with a maturity/repricing schedule that distributes interest-sensitive
---------------------- assets, liabilities and OBS positions into a certain number of predefined
time bands according to their maturity (if fixed-rate) or time remaining to
---------------------- their next repricing (if floating-rate). Those assets and liabilities lacking
definitive repricing intervals (e.g. sight deposits or savings accounts)
---------------------- or actual maturities that could vary from contractual maturities (e.g.
---------------------- mortgages with an option for early repayment) are assigned to repricing
time bands according to the judgement and past experience of the bank.
---------------------- 1. Gap analysis: Use of simple maturity/repricing schedules to assess the
---------------------- interest rate risk of current savings is termed as gap analysis. It is amongst
the first methods developed to measure bank’s exposure to interest rate
---------------------- risk and is most widely used by banks. Interest rate-sensitive liabilities
in each time band are subtracted from the corresponding interest rate-
---------------------- sensitive assets to produce a repricing “gap” for that time band. This
---------------------- gap can be multiplied by an assumed change in interest rates to yield an
approximation of the change in net interest income that would result from
---------------------- such an interest rate movement. The size of the interest rate movement
used in the analysis can be based on a variety of factors, including historical
---------------------- experience, simulation of potential future interest rate movements and the
---------------------- judgement of bank management.
A negative or liability-sensitive gap occurs when liabilities exceed
---------------------- assets (including OBS positions) in a given time band. This means that
---------------------- an increase in market interest rates could cause a decline in net interest

98 Risk Management
 income. Conversely, a positive or asset-sensitive gap implies that the Notes
bank’s net interest income could decline as a result of a decrease in the
level of interest rates. ----------------------
Although gap analysis is a very commonly used approach to assessing ----------------------
interest rate risk exposure, it has a number of shortcomings.
----------------------
• It does not take into account variation in the characteristics of
different positions within a time band. ----------------------
• It ignores differences in spreads between interest rates that could
----------------------
arise as the level of market interest rates changes.
• It does not take into account any changes in the timing of ----------------------
payments that might occur as a result of changes in the interest rate ----------------------
environment.
• It fails to capture variability in non-interest revenue and expenses, ----------------------
a potentially important source of risk to current income. ----------------------
Hence, we can say that the gap analysis approach provides only a rough
approximation of actual change in net interest income. ----------------------

2. Duration analysis: Impact of change in interest rates on bank’s economic ----------------------

value can be evaluated using a maturity/repricing schedule by applying
----------------------
sensitivity weights to each time band. As per BIS (Bank for International
Settlements) such weights are based on the estimated duration of the ----------------------
assets and liabilities that fall in each time band. Duration is a measure of
the % change in the economic value of a position that will occur given a ----------------------
small change in the level of interest rates.
----------------------
In its simplest form, duration measures changes in economic value resulting
from a % change of interest rates under the simplifying assumption that ----------------------
changes in value are proportional to changes in the level of interest rates
----------------------
and that the timing of payments is fixed. Higher duration implies that a
given change in the level of interest rates will have a larger impact on ----------------------
economic value.
----------------------
Duration-based weights can be used in combination with a maturity/
repricing schedule to provide a rough approximation of the change in ----------------------
a bank’s economic value that would occur given a particular change in
the level of market interest rates. Specifically, an “average” duration ----------------------
is assumed for the positions that fall into each time band. The average ----------------------
durations are then multiplied by an assumed change in interest rates to
construct a weight for each time band. In some cases, different weights are ----------------------
used for different positions that fall within a time band, reflecting broad
differences in the coupon rates and maturities (for instance, one weight ----------------------
for assets and another for liabilities). In addition, different interest rate ----------------------
changes are sometimes used for different time bands, generally to reflect
differences in the volatility of interest rates along the yield curve. The ----------------------
weighted gaps are aggregated across time bands to produce an estimate
----------------------

Managing Interest Rate Risk 99

 Notes of the change in economic value of the bank that would result from the
assumed changes in interest rates.
---------------------- B. Simulation Approaches
---------------------- Many banks (especially those using complex financial instruments or
otherwise having complex risk profiles) employ more sophisticated
---------------------- interest rate risk measurement systems than those based on simple
---------------------- maturity/repricing schedules. These simulation techniques typically
involve detailed assessments of the potential effects of changes in interest
---------------------- rates on earnings and economic value by simulating the future path of
interest rates and their impact on cash flows.
----------------------
It involves a more detailed breakdown of various categories of on- and
---------------------- off-balance-sheet positions, so that specific assumptions about the interest
and principal payments and non-interest income and expense arising
---------------------- from each type of position can be incorporated. In addition, simulation
---------------------- techniques can incorporate more varied and refined changes in the interest
rate environment, ranging from changes in the slope and shape of the yield
---------------------- curve to interest rate scenarios derived from Monte Carlo simulations.
1. Static simulation: In static simulations, the cash flows arising solely from
----------------------
the bank’s current on- and off-balance-sheet positions are assessed. For
---------------------- assessing the exposure of earnings, simulations estimating the cash flows
and resulting earnings streams over a specific period are conducted based
---------------------- on one or more assumed interest rate scenarios. Typically, although not
always, these simulations entail relatively straightforward shifts or tilts
----------------------
of the yield curve or changes of spreads between different interest rates.
---------------------- When the resulting cash flows are simulated over the entire expected lives
of the bank’s holdings and discounted back to their present values, an
---------------------- estimate of the change in the bank’s economic value can be calculated.
---------------------- 2. Dynamic simulation: In a dynamic simulation approach, the simulation
builds in more detailed assumptions about the future course of interest
---------------------- rates and the expected changes in a bank’s business activity over that time.
For instance, the simulation could involve assumptions about a bank’s
----------------------
strategy for changing administered interest rates (on savings deposits, for
---------------------- example), about the behaviour of the bank’s customers (e.g. withdrawals
from sight and savings deposits) and/or about the future stream of business
---------------------- (new loans or other transactions) that the bank will encounter. Such
simulations use these assumptions about future activities and reinvestment
----------------------
strategies to project expected cash flows and estimate dynamic earnings
---------------------- and economic value outcomes. These more sophisticated techniques
allow for dynamic interaction of payments streams and interest rates and
---------------------- better capture the effect of embedded or explicit options.
---------------------- As with other approaches, the usefulness of simulation-based interest rate
risk measurement techniques depends on the validity of the underlying
---------------------- assumptions and the accuracy of the basic methodology. The output of
sophisticated simulations must be assessed largely in the light of the
----------------------
validity of the simulation’s assumptions about future.

100 Risk Management

 Notes
Check your Progress 2
----------------------
Fill in the Blanks. ----------------------
1. The approach followed by bank towards measurement and hedging of
----------------------
interest rate risk depends upon the segmentation of ____________.
2. Adequate ____________ should be in place to ensure integrity of ----------------------
interest rate risk management process.
----------------------
3. An important element of a bank’s internal control system over its
interest rate risk management process is regular ____________ and ----------------------
____________. ----------------------

----------------------
Activity 2 ----------------------

Read more on Internet about various simulation techniques used by banks ----------------------
for measurement of interest rate risk.
----------------------

6.6 PRINCIPLES FOR MANAGEMENT AND ----------------------

SUPERVISION OF INTEREST RATE RISK ----------------------
As part of its ongoing efforts to address international bank supervisory ----------------------
issues, the Basel Committee on Banking Supervision issued a paper on principles
for the management of interest rate risk in September 1997. ----------------------

The principles are intended to be of general application, based as they ----------------------

are on practices currently used by many international banks, even though
their specific application will depend to some extent on the complexity and ----------------------
range of activities undertaken by individual banks. Under the new capital ----------------------
framework, they form minimum standards expected of internationally active
banks. The principles set out here should be used in evaluating the adequacy ----------------------
and effectiveness of a bank’s interest rate risk management, in assessing the
extent of interest rate risk run by a bank in its banking book and in developing ----------------------
the supervisory response to that risk. ----------------------
Board and senior management oversight of interest rate risk
----------------------
Principle 1 In order to carry out its responsibilities, the board of directors
in a bank should approve strategies and policies with respect ----------------------
to interest rate risk management and ensure that senior
management takes the steps necessary to monitor and control ----------------------
these risks consistent with the approved strategies and policies.
----------------------
The board of directors should be informed regularly of the
interest rate risk exposure of the bank in order to assess the ----------------------
monitoring and controlling of such risk against the board’s
guidance on the levels of risk that are acceptable to the bank. ----------------------

Managing Interest Rate Risk 101

 Notes Principle 2 Senior management must ensure that the structure of the
bank’s business and the level of interest rate risk it assumes are
---------------------- effectively managed, that appropriate policies and procedures
---------------------- are established to control and limit these risks and that resources
are available for evaluating and controlling interest rate risk.
---------------------- Principle 3 Banks should clearly define the individuals and/or committees
responsible for managing interest rate risk and should ensure
----------------------
that there is adequate separation of duties in key elements of
---------------------- the risk management process to avoid potential conflicts of
interest. Banks should have risk measurement, monitoring and
---------------------- control functions with clearly defined duties that are sufficiently
independent from position-taking functions of the bank and
----------------------
which report risk exposures directly to senior management and
---------------------- the board of directors. Larger or more complex banks should
have a designated independent unit responsible for the design
---------------------- and administration of the bank’s interest rate risk measurement,
monitoring and control functions.
----------------------
Adequate risk management policies and procedures
---------------------- Principle 4 It is essential that banks’ interest rate risk policies and
procedures are clearly defined and consistent with the nature
---------------------- and complexity of their activities. These policies should be
---------------------- applied on a consolidated basis and, as appropriate, at the
level of individual affiliates, especially when recognising legal
---------------------- distinctions and possible obstacles to cash movements among
affiliates.
----------------------
Principle 5 It is important that banks identify the risks inherent in new
---------------------- products and activities and ensure these are subject to adequate
procedures and controls before being introduced or undertaken.
---------------------- Major hedging or risk management initiatives should be
approved in advance by the board or its appropriate delegated
----------------------
committee.
---------------------- Risk measurement, monitoring and control functions
Principle 6 It is essential that banks have interest rate risk measurement
----------------------
systems that capture all material sources of interest rate risk and
---------------------- that assess the effect of interest rate changes in ways that are
consistent with the scope of their activities. The assumptions
---------------------- underlying the system should be clearly understood by risk
managers and bank management.
----------------------
Principle 7 Banks must establish and enforce operating limits and other
---------------------- practices that maintain exposures within levels consistent with
their internal policies.
---------------------- Principle 8 Banks should measure their vulnerability to loss under
---------------------- stressful market conditions - including the breakdown of key
assumptions - and consider those results when establishing and
---------------------- reviewing their policies and limits for interest rate risk.

102 Risk Management

Principle 9 Banks must have adequate information systems for measuring, Notes
monitoring, controlling and reporting interest rate exposures.
Reports must be provided on a timely basis to the bank’s ----------------------
board of directors, senior management and, where appropriate, ----------------------
individual business line managers.
Internal controls ----------------------
Principle 10 Banks must have an adequate system of internal controls over ----------------------
their interest rate risk management process. A fundamental
component of the internal control system involves regular ----------------------
independent reviews and evaluations of the effectiveness of
----------------------
the system and, where necessary, ensuring that appropriate
revisions or enhancements to internal controls are made. The ----------------------
results of such reviews should be available to the relevant
supervisory authorities. ----------------------
Information and supervisory authorities ----------------------
Principle 11 Supervisory authorities should obtain from banks sufficient
and timely information with which to evaluate their level of ----------------------
interest rate risk. This information should take appropriate
----------------------
account of the range of maturities and currencies in each
bank’s portfolio, including off-balance sheet items, as well as ----------------------
other relevant factors, such as the distinction between trading
and non-trading activities. ----------------------
Capital adequacy ----------------------
Principle 12 Banks must hold capital commensurate with the level of
interest rate risk they undertake. ----------------------
Disclosure of interest rate risk ----------------------
Principle 13 Banks should release to the public information on the level of
interest rate risk and their policies for its management. ----------------------
Supervisory treatment of interest rate risk in the banking book ----------------------
Principle 14 Supervisory authorities must assess whether the internal
measurement systems of banks adequately capture the interest ----------------------
rate risk in their banking book. If a bank’s internal measurement ----------------------
system does not adequately capture the interest rate risk,
the bank must bring the system to the required standard. To ----------------------
facilitate supervisors’ monitoring of interest rate risk exposures
across institutions, banks must provide the results of their ----------------------
internal measurement systems, expressed in terms of the threat ----------------------
to economic value, using a standardised interest rate shock.
Principle 15 If supervisors determine that a bank is not holding capital ----------------------
commensurate with the level of interest rate risk in the banking ----------------------
book, they should consider remedial action, requiring the bank
either to reduce its risk or hold a specific additional amount of ----------------------
capital or a combination of both.
----------------------

Managing Interest Rate Risk 103

 Notes
Check your Progress 3
----------------------

---------------------- Fill in the Blanks.

1. Banks must have adequate information systems for measuring,
----------------------
monitoring, controlling and reporting interest rate ______________.
---------------------- 2. Major hedging or risk management initiatives should be approved
in advance by the ______________ or its appropriate delegated
----------------------
committee.
---------------------- 3. Banks should have risk measurement, monitoring and control
---------------------- functions with clearly defined duties that are sufficiently independent
from position- taking functions of the bank and which report risk
---------------------- exposures directly to ______________ and the ______________.

---------------------- 4. The board of directors in a bank should approve ______________

with respect to interest rate risk management.
----------------------

---------------------- Summary
----------------------
● Interest rate risk is the potential impact on net interest income and market
---------------------- value of equity caused by unexpected changes in market interest rates.
● Deregulation of interest rates has exposed banks to the adverse impacts of
----------------------
interest rate risk.
---------------------- ● Repricing risk, yield curve risk, basis risk, optionality, price risk and
---------------------- reinvestment risk are the different forms of interest rate risk.
● The bank’s interest rate risk exposure is assessed from two perspectives:
---------------------- Earnings perspective and Economic Value perspective.
---------------------- ● Earnings perspective analyses the impact of change in interest rates on
accrued or reported earnings of the bank.
----------------------
● Economic Value perspective measures the impact of variation in market
---------------------- interest rates on the economic value of a bank’s assets, liabilities and OBS
positions.
----------------------
● Management oversight, adequate policies and procedures, adequate risk
---------------------- measurement, monitoring and control and effective internal controls are
the sound interest rate risk management practices.
----------------------
● The senior management is responsible for ensuring that the risk
---------------------- management policies and procedures are followed by all in the system on
a long-term basis as well as day-to-day basis.
----------------------
● Consolidated application, clearly defined authority and responsibility,
---------------------- quantifiable parameters, regular review and clear procedures are some of
---------------------- the salient features of sound policies and procedures.

104 Risk Management

● An accurate and timely information system is essential for the efficient Notes
interest rate risk management.
----------------------
● Adequate internal controls should be in place to ensure integrity of interest
rate risk management process. ----------------------
● Assets in trading book are held for generating profits on short term
----------------------
differences in prices.
● The banking book comprises assets and liabilities contracted on account ----------------------
of relationship or for steady income and are generally held till maturity.
----------------------
● Techniques like sample maturity and repricing tables, static simulations
based on current on- and off-balance-sheet positions, dynamic modelling ----------------------
techniques incorporating assumptions about behaviour of customer and ----------------------
bank in response to change in interest rates.
● Use of simple maturity / repricing schedules to assess the interest rate risk ----------------------
of current savings is termed as gap analysis. ----------------------
● Impact of change in interest rates on banks economic value can be
evaluated using a maturity/repricing schedule by applying sensitivity ----------------------
weights based on duration to each time band. ----------------------
● Simulation techniques involve detailed assessments of the potential
----------------------
effects of change in interest rates on earnings and economic value by
simulating the future path of interest rates and their impact on cash flows. ----------------------
● The Basel Committee on Banking Supervision has issued principles
----------------------
for management and supervision of interest rate risk, which serve as
guidelines for banks for effective management of interest rate risk. ----------------------

----------------------
Keywords
----------------------
● Cost of credit: The interest rate, required return or other compensation
associated with securing and using credit. ----------------------
● Fixed interest rate: An interest rate that does not change over the life of ----------------------
a loan, bond or other form of credit.
----------------------
● Fixed interest rate loan: A loan where the interest rate on the loan does
not change during the maturity of the loan. ----------------------
● Floating interest rate: An interest rate other than a fixed interest rate,
----------------------
which may change depending on the performance of an underlying index.
● Prime lending rate: The rate the banks typically charge their best ----------------------
customers.
----------------------
● Rate sensitive assets: Bank assets, mainly bonds, loans and leases and
the value of these assets is sensitive to changes in interest rates; these ----------------------
assets are either repriced or revalued as interest rates change. ----------------------
● Rate sensitive liabilities: Bank liabilities, mainly interest-bearing
deposits and other liabilities and the value of these liabilities is sensitive ----------------------

Managing Interest Rate Risk 105

 Notes to changes in interest rates; these liabilities are either repriced or revalued
as interest rates change.
----------------------

---------------------- Self-Assessment Questions

---------------------- 1. What do you mean by interest rate risk? Why is it an essential component
of market risk management?
----------------------
2. Write short notes on:
---------------------- i. Basis risk
---------------------- ii. Repricing risk
---------------------- iii. Earnings perspective of interest rate risk
iv. Importance of internal controls in IRR management
----------------------
3. What are the various areas covered in the principles of management and
---------------------- supervision of interest rate risk issued by Basel Committee?
---------------------- 4. How do banks use gap analysis and duration analysis techniques to
measure interest rate risk? What are the drawbacks of each of them?
----------------------
5. Highlight the importance of management oversight and policies and
---------------------- procedures in management of interest rate risk.
---------------------- 6. What are the essential features of sound interest rate risk management?
7. Which are the different techniques used by banks to measure interest rate
----------------------
risk?
---------------------- 8. Make a list of the recommendations of Basel Committee on sound interest
---------------------- rate risk management.

---------------------- Answers to Check your Progress

---------------------- Check your Progress 1
---------------------- State True or False.

---------------------- 1. True
2. True
----------------------
3. True
----------------------
Check your Progress 2
---------------------- Fill in the Blanks.
---------------------- 1. The approach followed by a bank towards measurement and hedging of
interest rate risk depends upon the segmentation of balance sheet.
----------------------
2. Adequate internal controls should be in place to ensure integrity of interest
---------------------- rate risk management process.
----------------------

106 Risk Management

3. An important element of a bank’s internal control system over its interest Notes
rate risk management process is regular evaluation and review.
----------------------
Check your Progress 3
Fill in the Blanks. ----------------------
1. Banks must have adequate information systems for measuring, monitoring, ----------------------
controlling and reporting interest rate exposures.
----------------------
2. Major hedging or risk management initiatives should be approved in
advance by the board or its appropriate delegated committee. ----------------------
3. Banks should have risk measurement, monitoring and control functions ----------------------
with clearly defined duties that are sufficiently independent from position-
taking functions of the bank and which report risk exposures directly to ----------------------
senior management and the board of directors.
----------------------
4. The board of directors in a bank should approve strategies and policies
with respect to interest rate risk management. ----------------------

----------------------
Suggested Reading
----------------------
1. www.bis.org
----------------------
2. www.garp.org
3. www.rbi.org ----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

Managing Interest Rate Risk 107

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

108 Risk Management

Managing Foreign Exchange Risk
UNIT

7
Structure:

7.1 Introduction
7.2 Types of Foreign Exchange Risk
7.3 Foreign Currency Exposure of Commercial Banks
7.4 Foreign Exchange Risk Management
7.5 Steps in Management of Foreign Exchange Risk
7.6 Methods of Measuring Foreign Exchange Risk
7.7 Methods of Managing Foreign Exchange Risk
7.8 Foreign Exchange Settlement Risk
7.8.1 Dimensions of FX Settlement Risk
7.8.2 Duration of FX Settlement Exposure
7.8.3 Measurement of FX Settlement Exposures
7.8.4 Contingency Planning
7.8.5 Use of Bilateral Netting
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Managing Foreign Exchange Risk 109

 Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Discuss the concept of foreign exchange risk
----------------------
• Evaluate the different types of foreign exchange risk
---------------------- • Write the essential features of sound foreign exchange risk management
---------------------- • Discuss the techniques of measuring foreign exchange risk
---------------------- •  nalyse the concept of foreign exchange risk settlement and its
A
dimensions
----------------------
• Appraise the use of bilateral netting in hedging FX
----------------------

----------------------
7.1 INTRODUCTION
----------------------
Foreign exchange risk or forex risk is the risk that a bank may suffer
---------------------- losses because of adverse exchange rate movements during a period in which it
has an open position, either spot or forward or a combination of the two, in an
---------------------- individual foreign currency. In simple words, foreign exchange risk arises when
---------------------- a bank holds assets or liabilities in foreign currency and the earnings and capital
of the bank are impacted by an upward or downward movement in currency
---------------------- rates.

---------------------- Foreign exchange risk can take various forms:

• Mismatched foreign currency positions that can lead to interest rate risks.
----------------------
• Even in cases where spot and forward positions in individual currencies
---------------------- are balanced, the maturity pattern of forward transactions may produce
mismatches.
----------------------
• In forex business, banks also face the risk of default of the counterparties
---------------------- or settlement risk.
---------------------- • Banks also face another risk called time-zone risk which arises out of
time lags in settlement of one currency in one centre in one time zone and
---------------------- the settlement of another currency in another time zone.
---------------------- • Forex transactions with counterparties from another country also trigger
country risk.
----------------------

---------------------- 7.2 TYPES OF FOREIGN EXCHANGE RISK

---------------------- Prediction of future exchange rates with accuracy is very difficult. The
volatility in forex rates has heightened the risk inherent in running open foreign
---------------------- exchange positions in recent years, thereby adding a new dimension to the risk
---------------------- profile of bank’s balance sheet.

110 Risk Management

Foreign currency exposures are generally categorised into the following Notes
three distinct types: transaction exposure, economic exposure and translation
exposure. ----------------------
• Transaction exposure: It arises as a result of unfavourable movement ----------------------
in exchange rate impacting the profitability from transactions in foreign
currency. It can be hedged using different techniques. ----------------------
• Translational risk: It is the accounting risk arising because of translation ----------------------
of assets held in foreign currency or abroad. It is usually retrospective and
short term in nature. ----------------------
• Economic exposure/Operating exposure: A firm has economic exposure ----------------------
(also known as operating exposure) to the degree that its market value is
influenced by unexpected exchange rate fluctuations. It arises because ----------------------
of currency fluctuations combined with price level changes resulting in
----------------------
alteration of future revenues and costs. It is usually prospective and long
term in nature and impacts the present value of future cash flows of the ----------------------
bank.
----------------------
7.3 FOREIGN CURRENCY EXPOSURE OF COMMERCIAL - - - - - - - - - - - - - - - - - - - - - -
BANKS
----------------------
Commercial banks are involved in various trading and non-trading foreign
exchange activities which continuously expose them to foreign exchange risk. ----------------------
A commercial bank is involved in the purchase and sale of foreign currencies ----------------------
for any of the following purposes:
• To allow customers to deal in international commercial trade transactions. ----------------------

• To allow customers to make various foreign real estate and financial ----------------------
investments.
----------------------
• To hedge customers’ exposure in foreign currency.
----------------------
• For speculative purpose.
These activities expose a bank to foreign exchange risk only to the extent ----------------------
it has not hedged or covered its position. Any unhedged position in a particular ----------------------
currency gives rise to forex risk and is termed as an open position. If a bank has
sold more foreign currency than what it has purchased, it is called net short and ----------------------
if it has purchased more foreign currency than what it has sold, it is called net
long. In either case, the bank is exposed to risk as the value of foreign currency ----------------------
may fall as compared to local currency, thereby resulting in substantial losses. ----------------------

----------------------

----------------------

----------------------

----------------------

Managing Foreign Exchange Risk 111

 Notes
Check your Progress 1
----------------------

---------------------- Fill in the Blanks.

1. Forex transactions with counterparties from another country also
----------------------
trigger ____________ risk.
---------------------- 2. In forex business, banks also face the risk of ____________ of
counterparties or settlement risk.
----------------------
3. Foreign exchange risk arises when a bank holds ____________ or
---------------------- ____________ in foreign currency and the earnings and capital of the
---------------------- bank are impacted by an upward or downward movement in currency
rates.
----------------------

---------------------- Activity 1
----------------------
Commercial banks are involved in various trading and non-trading foreign
---------------------- exchange activities, which continuously expose them to foreign exchange
---------------------- risk. Comment.

----------------------
7.4 FOREIGN EXCHANGE RISK MANAGEMENT
----------------------
Banks are required to put in place adequate risk management systems
---------------------- and other appropriate internal control mechanisms and procedures to identify,
measure, monitor and control foreign exposure on both on and off balance sheet
----------------------
positions.
---------------------- An effective foreign exchange risk management system should have the
following features:
----------------------
1. Board of directors and senior management oversight: The board of
---------------------- directors of a bank should:
---------------------- • Approve foreign exchange risk policy.

---------------------- • Periodically review the policy, techniques, procedures and

information system referred to in that policy.
----------------------
• Ensure adherence to the policies, procedures and techniques.
---------------------- • Ensure foreign exchange risk is managed by qualified and competent
staff.
----------------------
• Require senior management to submit report on foreign exchange
---------------------- risk management at periodic time intervals.
----------------------

----------------------

112 Risk Management

2. Policy on foreign exchange operations: Banks should have a clearly Notes
documented and detailed policy to manage and control foreign exchange
risk exposures. As highlighted above, it is the responsibility of the board of ----------------------
directors of a bank to issue and review these policies and practices. It should
clearly define the internal approval and position limits for each foreign ----------------------
currency transaction and establish and maintain adequate accounting and ----------------------
information system as well as internal compliance controls. A bank should
have an internal audit system, which should be responsible for conducting ----------------------
internal audits at least on quarterly basis in order to ensure that foreign
exchange risk management policies and procedures are adhered to. The ----------------------
findings of the audit should be communicated to the appropriate authority ----------------------
and suitable action should be taken to keep the risk under control.
----------------------
Following are the salient features of the policy on foreign exchange risk:
• Well-defined principles and objectives governing the extent to ----------------------
which a bank is willing to take foreign exchange risk.
----------------------
• Clearly defined prudent limits on a bank’s exposure to foreign
exchange risk. ----------------------
• Clearly defined level of authority and responsibility for personnel ----------------------
dealing in foreign currency.
----------------------
• Proper identification of approved currencies for transactions within
the bank. ----------------------
3. Limits: Banks should set the minimum specific limit on their foreign ----------------------
exchange exposure in the following areas:
----------------------
• Overall foreign exchange exposure.
• Single currency exposure. ----------------------
• Intraday foreign exchange risk exposure. ----------------------
• Consolidated limits. ----------------------
• Risk Management
----------------------
4. Monitoring and control: Techniques should be developed and
implemented by banks for accurately and continuously measuring the ----------------------
exposure of banks to foreign exchange risk. It should also be capable of
----------------------
providing information of net foreign exchange gain or loss. An efficient
information system should be in place to incorporate these techniques and ----------------------
assist in foreign exchange risk management.
----------------------
5. Internal audit: In order to minimise risk, all foreign exchange and
settlement processes should be covered by internal audit. The board ----------------------
should ensure that the scope and frequency of foreign exchange internal
audit programme is appropriate to the risks involved. ----------------------
The audit findings should be communicated to the concerned personnel ----------------------
and corrective action should be taken and well documented. This should be
regularly reviewed by the board of directors and if required a follow-up audit ----------------------

Managing Foreign Exchange Risk 113

 Notes should be conducted. The audit findings should also mention other areas, which
are likely to be impacted by the areas of improvement identified for foreign
---------------------- exchange risk. This could include credit risk management, reconciliation
accounting, information system development etc.
----------------------
In an automated settlement processing, the internal audit department
---------------------- should have some level of specialisation in information technology auditing,
especially if the bank maintains its own computer facility.
----------------------

---------------------- 7.5 STEPS IN MANAGEMENT OF FOREIGN EXCHANGE

RISK
----------------------
Step 1: It involves identification and measurement of foreign exchange
----------------------
exposure of a bank. Various techniques are used by banks to measure foreign
---------------------- exchange risk. Once the foreign exchange risk exposure is determined then
the bank’s board defines the policies and procedures governing FX (foreign
---------------------- exchange) transactions in step two.
---------------------- Step 2: There are various factors which are considered while deciding the
policies and procedures in this step and they should be clearly communicated
---------------------- to the risk-taking departments. Various parameters like types of exposure, tools
---------------------- and instruments to be used to measure risk, lines of authority and responsibility,
measurement of performance of hedging action, reporting requirements etc. are
---------------------- covered in the policies and procedures. The first two steps provide inputs for
determining the foreign exchange risk exposure after which the risk is hedged
---------------------- in step three.
---------------------- Step 3: Various hedging techniques like natural hedge, financial hedge,
options, swaps etc. are used in this step by banks to hedge their foreign exchange
---------------------- risk.
---------------------- Step 4: Since the global banking scenario is very dynamic, banks have
to evaluate their exposure periodically and make adjustments on need basis.
---------------------- It should also evaluate if hedging is properly reducing a bank’s exposure or a
---------------------- change is required in the hedging techniques.

----------------------

----------------------

---------------------- Fig. 7.1: Steps in Management of Foreign Exchange Risk

---------------------- 7.6 METHODS OF MEASURING FOREIGN EXCHANGE

---------------------- RISK

---------------------- There are many ways to measure foreign exchange risk, ranging from
simple to quite complex. Sophisticated measures, such as value-at-risk, may be
---------------------- mathematically complex and require significant computing power. Following
are some simple measures used by banks to determine their foreign exchange
---------------------- risk:

114 Risk Management

1. Register of foreign currency exposures: One of the simplest methods is Notes
to maintain a register of foreign currency exposures and their associated
foreign exchange hedges. This type of approach is in line with the ----------------------
requirements of accounting standards and each hedge is recorded against
its relevant exposure. ----------------------

2. Table of projected foreign currency cash flows: Since banks deal ----------------------
in different currencies and there are both inflows and outflows in each
----------------------
currency, it is essential to measure the net surplus or deficit in each
currency. This can be done by preparing a projected foreign currency cash ----------------------
flow statement. Apart from giving information on surplus and deficit, it
also gives information on the timing of currency flows. ----------------------
3. Sensitivity analysis: Sensitivity analysis is the measurement of the ----------------------
potential impact of an adverse movement in exchange rate on the cash
flows and liquidity position of a bank. Movement in exchange rate can ----------------------
either be arbitrary or based on history.
----------------------
4. Value-at-risk: Banks extensively use the probability approach while
undertaking sensitivity analysis. This is known as value-at-risk. The ----------------------
value- at-risk indicates the risk that a bank is exposed due to uncovered
----------------------
position of mismatch and these gaps are to be valued on daily basis at the
prevalent forward market rates. ----------------------

Check your Progress 2 ----------------------

----------------------
Fill in the Blanks.
----------------------
1. Banks should set the _______ specific limit on their foreign exchange
exposure. ----------------------
2. A bank should have an _______ audit system, which should be ----------------------
responsible for conducting internal audits at least on quarterly basis
in order to ensure that foreign exchange risk management policies ----------------------
and procedures are adhered to.
----------------------
3. It is the responsibility of the _______ of a bank to issue and review
internal policies and practices. ----------------------
4. Banks should have a clearly _______ and _______ policy to manage ----------------------
and control foreign exchange risk exposures.
----------------------

----------------------
7.7 METHODS OF MANAGING FOREIGN EXCHANGE
RISK ----------------------

Having identified and measured the foreign exchange exposure, the next ----------------------
step is to manage it. There are various methods for hedging foreign exchange ----------------------
risk and selection of the best method depends upon the risk appetite of the bank.
Hedging refers to entering into an offsetting currency position so that the gain ----------------------

Managing Foreign Exchange Risk 115

 Notes or loss on the original currency exposure is offset by corresponding gain or loss
on the currency hedged. It can also be termed as coordinated buying and selling
---------------------- of currency to minimise exchange rate risk.
---------------------- Banks should design the hedging strategy very carefully as cost is
associated with it. It should be evaluated carefully considering the aspects of
---------------------- cost and tax benefit.
---------------------- Some of the commonly used methods of managing foreign exchange risk
are as follows:
----------------------
1. Forward exchange contract: These contracts enable a bank to protect
---------------------- itself from adverse movements in exchange rates by locking in an agreed
exchange rate up to an agreed date. All transactions take place at the
---------------------- agreed price within that lock-in time. The major disadvantage of this
method is that in case of advantageous rate movements, the bank is still
----------------------
under obligation to enter into transactions at the agreed price.
---------------------- 2. Foreign currency options: These enable an entity to purchase or sell
---------------------- foreign currency under an agreement that allows for the right but not the
obligation to undertake the transaction at an agreed future date.
---------------------- 3. Perfect hedge: It is a simple method to match any outgoing foreign
---------------------- currency payments against foreign currency inflows received at exactly
the same time. This method is rarely used due to the uncertainty of timing
---------------------- of the cash flows. The inflow and the outflow must occur at exactly the
same time to provide a perfect hedge.
----------------------

---------------------- Activity 2
----------------------
Visit the website of RBI and read more on the techniques used by banks
---------------------- to manage foreign exchange risk.

----------------------
7.8 FOREIGN EXCHANGE SETTLEMENT RISK
----------------------
Foreign exchange settlement risk is the risk of loss when a bank in a
----------------------
foreign exchange transaction pays the currency it sold but does not receive
---------------------- the currency it bought. There are various reasons for settlement failure like
counterparty default, operational problem, market liquidity constraint and other
---------------------- factors. Settlement risk exists for any traded product. However, the size of
the forex market makes FX transactions the biggest source of settlement risk
----------------------
for many market participants. It involves daily exposures of tens of billions
---------------------- of dollars for the largest banks. Most significantly, for banks of any size, the
amount at risk to even a single counterparty could, in some cases, exceed their
---------------------- capital.
---------------------- As compared to other forms of risks, banks should be well aware of how
FX settlement risk arises and based on this understanding, they need to draft
---------------------- policies and procedures to manage it. The risk measurement system should

116 Risk Management

be capable of providing appropriate and realistic estimates of FX settlement Notes
exposures on a timely basis. The procedures should enable the banks to take
prompt actions on problems and failed transactions. ----------------------
7.8.1 Dimensions of FX Settlement Risk ----------------------
FX settlement risk can take the following dimensions:
----------------------
1. Credit risk dimension: In a FX settlement transaction, there is always
a risk that the counterparty will default outright and the principal will ----------------------
be lost. Hence, banks should treat the FX exposure as an equivalent to
----------------------
credit exposures of the same size and duration. Under current market
practices, banks cannot make the payment of currency it sold conditional ----------------------
upon its final receipt of the currency it bought. Hence, the risk of losing
the full principal value will always be there. Such exposures can either be ----------------------
intraday or overnight or may even last for several days.
----------------------
2. Liquidity risk dimension: A temporary delay in settlement can create
liquidity pressure on the receiving bank. Banks have pre-plans of use of ----------------------
funds and delay in settlement of funds may result in difficulty to meet ----------------------
obligations to other parties. If the amount is large the extent of liquidity
risk can be severe and the bank may need to arrange funds from alternate ----------------------
sources at unreasonable price.
----------------------
3. Legal risk dimension: The liquidity or credit risk arising from FX
settlements can further worsen the situation if the bank gets involved ----------------------
in a legal issue as a result of FX settlement failure. Legal risk is more
complicated in foreign exchange transactions due to involvement of ----------------------
different jurisdictions. ----------------------
4. Systemic risk dimension: The size of some banks’ FX exposures relative
to their capital creates the real danger. The failure of foreign exchange ----------------------
transactions of a bank’s counterparty could lead to that bank’s insolvency. ----------------------
7.8.2 Duration of FX Settlement Exposure
----------------------
An FX payment transaction usually takes place in two steps: sending
payment order and actual transmission of funds. The first step is an instruction to ----------------------
make payment and is usually affected one or two days before the settlement date.
----------------------
The second step involves exchange of credit and debit between correspondent
accounts and accounts of central banks of currencies involved. The second ----------------------
step takes place on the settlement date itself. Hence, a bank’s FX settlement
exposure runs from the time the payment order is released with certainty and ----------------------
cannot be cancelled till the time currency purchased is received with certainty.
----------------------
7.8.3 Measurement of FX Settlement Exposures
A bank’s minimum FX settlement exposure at a specified time includes ----------------------
the value of all outstanding trades where payment is irrevocable; it also includes ----------------------
any known failed receipts since, by definition, the fact that the trade has failed
to settle means the funds have not yet been received. Since the irrevocable ----------------------
period can last for several days, the minimum measure of exposure can be equal
to several days’ worth of trade. ----------------------

Managing Foreign Exchange Risk 117

 Notes FX settlement exposures should be subject to adequate credit control
process including credit evaluation and review and determination of the
---------------------- maximum exposure the bank is willing to take with a particular counterparty.
Banks should use the same procedures as used for other exposures for setting
---------------------- up FX settlement exposure limits. Banks should ensure that all FX settlement
---------------------- deals should be within those limits.

----------------------

----------------------

----------------------

----------------------

----------------------
Fig. 7.2: Foreign Exchange Settlement Process
----------------------
7.8.4 Contingency Planning
---------------------- Contingency planning and stress testing should be an integral part of the
FX settlement risk management process. The contingency plan should include
----------------------
a wide variety of stress tests and should cover events ranging from internal
---------------------- operational failure to counterparty failure to broad market-related events. An
ideal contingency plan for FX settlement exposure should have the following
---------------------- key features:
---------------------- • Timely access to key information.

---------------------- • Well-developed procedures for obtaining information from correspondent

institutions.
---------------------- • Continuity of FX settlement operations even if main production site
---------------------- becomes unusable.
• Well documented and supported by contracts with outside vendors.
----------------------
• Well coordinated with planning for other problems.
----------------------
• Periodically tested.
---------------------- 7.8.5 Use of Bilateral Netting
---------------------- Banks can reduce the size of their counterparty exposures by entering into
legally binding agreements for bilateral net settlement of payments. A legally
---------------------- binding payment netting arrangement permits banks to offset trades against
---------------------- each other so that only the net amount in each currency is paid or received by
each institution. Such payment netting arrangements are contemplated in the
---------------------- industry standard bilateral master agreements covering FX transactions.

---------------------- Depending on trading patterns, bilateral payment netting can significantly

reduce the value of currencies settled. It also reduces the number of payments to
---------------------- one per currency either to or from each counterparty. Bilateral payment netting
is most valuable when the counterparties have a considerable two-way flow of
---------------------- business; consequently, it may only be attractive to the most active banks. To

118 Risk Management

take advantage of risk reducing opportunities, banks should be encouraged to Notes
establish procedures for identifying payment-netting opportunities.
----------------------
Use of bilateral payment netting requires some modification to the method
of measuring settlement exposures explained earlier. When bilateral payment ----------------------
netting is used, all the transactions with a particular counterparty due to settle
on that day have to be considered together. The bank will make a single payment ----------------------
to the counterparty in each of the currencies where it has a net debit position
----------------------
and receive a single payment in each of the currencies where it has a net credit
position. The maximum value of the resulting settlement exposure is equal to ----------------------
the sum of the amounts due to be received from the counterparty. However,
measuring the actual duration of the exposure is more complicated because ----------------------
netted transactions result in a set of payments in a number of currencies, no two
----------------------
of which can be paired to calculate the period of irrevocability.
Some banks use informal payment netting, i.e., where there is no ----------------------
formal netting contract between the counterparties, the back offices of each
----------------------
counterparty confer by telephone before settlement and agree to settle only the
net amount of the trades falling due. Since there may not be a sound legal basis ----------------------
underpinning such procedures, banks should ensure that they fully understand
and appropriately manage the legal, credit and liquidity risks of this practice. ----------------------

----------------------
Check your Progress 3
----------------------
State True or False. ----------------------
1. A bank’s minimum FX settlement exposure at a specified time excludes
the value of all outstanding trades where payment is irrevocable. ----------------------

2. An FX payment transaction usually takes place in two steps: sending ----------------------

payment order and actual transmission of funds.
----------------------
3. The liquidity or credit risk arising from FX settlements can further
improve the situation if the bank gets involved in a legal issue as a ----------------------
result of FX settlement failure.
----------------------
4. In an FX settlement transaction there is always a benefit that the
counterparty will default outright and the principal will be lost. ----------------------

----------------------
Summary ----------------------
● Forex risk is the risk that a bank may suffer losses as a result of adverse ----------------------
exchange rate movements during a period in which it has an open position,
either spot or forward or a combination of the two, in an individual foreign ----------------------
currency. ----------------------
● Transactional risk arises with the unfavourable movement in exchange
rate impacting the profitability from transactions in foreign currency. It ----------------------
can be hedged using different techniques. ----------------------

Managing Foreign Exchange Risk 119

 Notes ● Translational risk is the accounting risk arising because of translation of
assets held in foreign currency or abroad.
----------------------
● Some of the key features for an effective foreign exchange risk management
---------------------- system are board and senior management oversight, well-defined policies
and limits, effective monitoring and control and internal audit.
----------------------
● Steps in FX risk management include identification and measurement
---------------------- of risk, development of policy, hedging and periodical evaluation and
adjustment.
----------------------
● Some of the methods adopted by banks to measure foreign exchange risk
---------------------- are maintaining a register of foreign currency exposure, preparing a table
of projected foreign currency cash flows, sensitivity analysis and using
---------------------- value at risk.
---------------------- ● Foreign exchange risk can be managed by various hedging techniques
like forwards, options, perfect hedges etc.
----------------------
● Foreign exchange settlement risk is the risk of loss when a bank in a
---------------------- foreign exchange transaction pays the currency it sold but does not receive
the currency it bought.
----------------------
● FX settlement risk can take various dimensions like credit risk, liquidity
---------------------- risk, legal risk and systemic risk.
---------------------- ● An FX payment transaction usually takes place in two steps: sending
payment order and actual transmission of funds.
----------------------
● Contingency planning and stress testing should be an integral part of the
---------------------- FX settlement risk management process.

---------------------- ● Banks can reduce the size of their counterparty exposures by entering into
legally binding agreements to net settlement payments bilaterally.
----------------------

---------------------- Keywords

---------------------- ● Hedging: A hedging transaction is one, which protects an asset or liability

against a fluctuation in the foreign exchange rate.
----------------------
● Translational risk: The accounting risk arising because of translation of
---------------------- assets held in foreign currency or abroad.
● Contingency plan: A plan devised for an outcome other than in the usual
----------------------
(expected) plan.
---------------------- ● Stress testing: A form of testing that is used to determine the stability of
a given system or entity.
----------------------

----------------------

----------------------

----------------------

120 Risk Management

 Notes
Self-Assessment Questions
----------------------
1. What are the major types of foreign exchange risks?
2. Explain the different steps in management of foreign exchange risk ----------------------
followed by banks with the help of a diagram.
----------------------
3. How are the various methods of measuring foreign exchange risk
beneficial to banks? ----------------------

4. Elaborate the various dimensions of FX settlement risk. ----------------------

5. What is the duration of a typical FX settlement exposure and how can you ----------------------
measure it?
----------------------
6. Rewrite the salient features of the contingency plan of banks for FX
settlement risk. ----------------------

Answers to Check your Progress ----------------------

Check your Progress 1 ----------------------

Fill in the Blanks. ----------------------

1. Forex transactions with counterparties from another country also trigger ----------------------
country risk.
----------------------
2. In forex business, banks also face the risk of default of the counterparties
or settlement risk. ----------------------
3. Foreign exchange risk arises when a bank holds assets or liabilities in ----------------------
foreign currency and the earnings and capital of the bank are impacted by
an upward or downward movement in currency rates. ----------------------
Check your Progress 2 ----------------------
Fill in the Blanks.
----------------------
1. Banks should set the minimum specific limit on their foreign exchange
exposure. ----------------------
2. A bank should have an internal audit system, which should be responsible ----------------------
for conducting internal audits at least on quarterly basis in order to ensure
that foreign exchange risk management policies and procedures are ----------------------
adhered to.
----------------------
3. It is the responsibility of the board of directors of a bank to issue and
review internal policies and practices. ----------------------

4. Banks should have a clearly documented and detailed policy to manage ----------------------
and control foreign exchange risk exposures.
----------------------

----------------------

----------------------

Managing Foreign Exchange Risk 121

 Notes Check your Progress 3
State True or False.
----------------------
1. False
----------------------
2. True
---------------------- 3. False
---------------------- 4. False

----------------------
Suggested Reading
----------------------
1. Vasudevan, A. 2003. Central Banking for Emerging Market Economics.
---------------------- California: Academic Foundation.
---------------------- 2. Benton E. Gup, and James W. Kolari 2007. Commercial Banking: The
Management of Risk. Australia: John Wiley & Sons.
----------------------
3. Bidani, S. N. 2010. Banking Risks Management and Audit. New Delhi:
---------------------- Vision Books.
---------------------- 4. Van Greuning, Hennie, and Bratanovic, Sonja Brajovic 2003. Analyzing
and Managing Banking Risk: Framework for Assessing Corporate
---------------------- Governance and Financial Risk. World Bank Publication.
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

122 Risk Management

Derivatives in Banks and Risk Management Strategies
UNIT

8
Structure:

8.1 Introduction
8.2 Derivatives: Meaning
8.3 Derivative Markets/Contracts
8.4 Types of Derivatives
8.5 Permissible Derivative Instruments in India
8.6 Economic Functions of Derivative Markets
8.7 Application of Derivatives for Risk Management
8.8 Use of Derivatives by Banks
8.9 Reasons for Popularity of Derivatives
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Derivatives in Banks and Risk Management Strategies 123

 Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Define the concept of derivative instruments
----------------------
• Describe the various derivative products
---------------------- • Explain the application of derivatives for risk management in banks
---------------------- • Discuss the benefits of using derivatives
---------------------- • Identify the reasons for the popularity of derivatives

----------------------
8.1 INTRODUCTION
----------------------
Deregulation, liberalisation and globalisation have exposed the markets
----------------------
and its players to various types of risks, such as exchange rate risk, interest rate
---------------------- risk, economic risk and political risk. It is well known that every asset whether
commodity or metal or share is subject to depreciation in its value, which may be
---------------------- due to certain inherent factors or due to external factors like market, economic or
political conditions. In addition to the above, securitisation has brought with it
----------------------
the risk of default or counter-party risk. Under such situation, risk management
---------------------- becomes a must for survival. There is, thus an imperative need for the market
players to protect their profits by shifting some of the uncontrollable financial
---------------------- risks to those who are able to bear and manage them. In this context, derivatives
occupy an important place as risk-reducing machinery. Derivatives enable the
----------------------
users to transfer their financial risks to third parties, thus protecting them from
---------------------- unforeseen risks.
In general terms, derivatives are instruments that derive their value from
----------------------
an underlying asset. The features of the derivative instruments are:
---------------------- 1. They can be designed so as to cater to the varied requirements of the
---------------------- users either by simply using any one of the instruments or by using a
combination of two or more such instruments.
---------------------- 2. They can be traded based on the expectations regarding the future price
---------------------- movements of the underlying assets.
3. They are all off-balance sheet instruments.
----------------------
4. They are used as a device for reducing the risks of fluctuations in asset
---------------------- values.
---------------------- As the name suggests, a derivative instrument is one the value of which
is derived from something backing it. This “something” could be a loan, asset,
---------------------- currency flow, share, interest rate, trade flow or commodity. In our context when
we talk about derivatives, we usually mean only financial derivatives, namely
----------------------
forward/ futures/options/swaps etc.
----------------------

124 Risk Management

 Based on the above discussion, we may describe derivative instruments as Notes
financial instruments, which derive their value from the value and characteristics
of one or more underlying entities, such as an asset, index or interest rate. ----------------------

----------------------
8.2 DERIVATIVES: MEANING
----------------------
As per Reserve Bank of India, derivative means a financial instrument to
be settled at a future date, whose value is derived from change in some other ----------------------
variable, such as interest rate, foreign exchange rate, market index, credit index,
price of securities or goods, index of prices etc. (called underlying). In other ----------------------
words, derivatives are financial instruments/contracts whose value depends ----------------------
upon the value of an underlying.
The term “derivative” indicates that it has no independent value, i.e., ----------------------
its value is entirely derived from the value of the underlying asset. The term ----------------------
“derivative” means a forward, future, option or any other hybrid contract of pre-
determined fixed duration, linked for the purpose of contract fulfilment to the ----------------------
value of a specified real or financial asset of an index of securities. Similarly, in
the financial sense, a derivative is a financial product, which has been derived ----------------------
from a market for another product. ----------------------
The International Monetary Fund (IMF) defines derivatives as financial
----------------------
instruments that 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. The value of a financial derivative is derived from
the price of an underlying item, such as an asset or index. ----------------------
The Indian Securities Contracts (Regulation) Act, 1956 defines derivative ----------------------
instruments to include a security derived from a debt instrument, share, secured/
unsecured loan, risk instrument or contract for differences or any other form of ----------------------
security and a contract that derives its value from the prices/index of prices of
----------------------
underlying securities.
----------------------
8.3 DERIVATIVE MARKETS/CONTRACTS
----------------------
There are two distinct groups of contracts:
----------------------
i. Over-the-Counter (OTC) derivatives: Traded directly between two
eligible parties, with/without use of an intermediary and without going ----------------------
through an exchange.
----------------------
ii. Exchange-traded derivatives: Derivative products that are traded on an
exchange. ----------------------

----------------------

----------------------

----------------------

----------------------

Derivatives in Banks and Risk Management Strategies 125

 Notes
Check your Progress 1
----------------------

---------------------- Multiple Choice Multiple Response.

1. Following are derivative instruments:
----------------------
i. Interest rate
---------------------- ii. Foreign exchange rate
iii. Market index
----------------------
iv. Equity Shares
---------------------- v. Credit index
---------------------- vi. Convertible Debentures
2. Following are the characteristics of derivatives:
----------------------
i. Derivative instruments have their own value
---------------------- ii. Designed by using any one of the existing instruments or by
using a combination of two or more instruments
----------------------
iii. Can be traded in the market
---------------------- iv. Committed returns on derivative instruments can be claimed
----------------------

---------------------- Activity 1

---------------------- From a financial daily, note down the movement of one derivative
instrument- book value, market value, highest quoted price, volatility, etc.
----------------------

---------------------- 8.4 TYPES OF DERIVATIVES

---------------------- The most common types of derivative contracts are as under:
---------------------- 1. Forward contracts: A forward contract is a customised contract between
two entities, where settlement takes place on a specified future date at
---------------------- today’s pre-agreed price. A forward contract is an agreement to buy or
---------------------- sell an asset on a specified date for specified price. One of the parties to
the contract assumes a long position and agrees to buy the underlying
---------------------- asset on a certain specified future date for a certain specified price. The
other party assumes a short position and agrees to sell the asset on the
---------------------- same date for the same price. The parties to the contract negotiate other
---------------------- contract details like delivery date, price and quantity bilaterally. Forward
contracts are normally traded outside stock exchanges. They are popular
---------------------- on the OTC market.

---------------------- Some of the salient features of forward contracts are as follows:

They are bilateral contracts and hence exposed to counterparty risk.
----------------------
 Each contract is customer designed and hence unique in terms of
---------------------- contract size, expiration date and asset type and quantity.

126 Risk Management

  The contract price is generally not available in public domain. Notes
 On the expiry date, the contract has to be settled by delivery of the
----------------------
asset.
A typical hedging application of the forward contract may pertain to an ----------------------
exporter who expects to receive payment in US dollars, three months
----------------------
later. He is exposed to the risk of exchange rate fluctuations. By using
the currency forward market to sell dollars forward, he can lock-on a rate ----------------------
today and reduce his uncertainty. Similarly, an importer who is required
to make a payment of US dollars forward can reduce his exposure to ----------------------
exchange rate fluctuations by buying dollars forward.
----------------------
2. Futures: A futures is a standard contract based on an agreement to buy or
sell an asset at a certain price at a certain time in future. It is an obligation ----------------------
on the buyer to purchase the underlying instrument and the seller to sell it. ----------------------
The delivery under a futures contract is not a must. The buyers and sellers
can set-off the contract by packing the different amount at the current ----------------------
rate/ price of the underlying.
----------------------
As stated above, a futures contract is an agreement between two parties
to buy or sell an asset at a certain time in future, at a certain price. ----------------------
However, unlike forward contracts, futures contracts are standardised and
traded in stock exchanges. To facilitate liquidity in the futures contracts, ----------------------
the exchange specifies certain standard features for the contract. It is ----------------------
a standardised contract with a standard underlying instrument. The
standardised items in a futures contract are: (a) Quality and quantity of ----------------------
the underlying, (b) Date/month of delivery, (c) Units of price quotation
and minimum price change and (d) Location of settlement. ----------------------

3. Options: It is a contract that provides a right but does not impose any ----------------------
obligation to buy or sell a financial instrument (say a share or a security).
Options are fundamentally different from forward and futures contracts. ----------------------
An option gives the holder of the option the right to do something. The ----------------------
holder does not have to necessarily exercise this right. In contrast, in a
forward or futures contract, the two parties commit themselves to do ----------------------
something. It costs nothing (except margin requirements) to enter into a
future contract, the purchase of an option requires an up-front payment. ----------------------

The person who buys the option from option seller by making payment ----------------------
of option premium is known as the owner or buyer of the option. His
----------------------
obligation under the option is up to payment of premium on option. The
person who sells the option to the option buyer by charging the option ----------------------
premium is known as the writer or seller of the option.
----------------------
There are two variants of options (a) European option, where the holder
can exercise the right on the expiry date and (b) American option, where ----------------------
the holder can exercise the right anytime between the purchase date and
the expiry date. ----------------------

----------------------

Derivatives in Banks and Risk Management Strategies 127

 Notes Options have two components: (a) Call option, where the owner (buyer)
has the right to purchase and the seller has the obligation to sell and (b)
---------------------- Put option, where the owner or the buyer has the right to sell and the seller
has the obligation to buy.
----------------------
The cost of the option charged upfront from the buyer of the option is
---------------------- called a premium. In other words, it is the fee paid for the option contract.
---------------------- 4. Swap: A swap is a contract that binds two counterparties to exchange the
different streams of payments over the specified period at specified rate. In
---------------------- the context of foreign exchange, it means simultaneous sale and purchase
of one currency for another. In the context of financial derivatives, swap
----------------------
means exchange of two streams of cash flows over a definite period.
----------------------  Currency swap: When pre-determined streams of payments in
different currencies are exchanged on a pre-fixed period at pre-fixed rate.
----------------------
 Interest rate swap: It is exchange of different streams of interest
---------------------- structures (and not the principal amount)
----------------------
Check your Progress 2
----------------------
Multiple Choice Multiple Response.
----------------------
1. What are the characteristics of a forward contract?
----------------------
i.  hey are bilateral contracts and hence exposed to counterparty
T
---------------------- risk.

---------------------- ii. The contract has to be executed at the time of agreement.

iii. Each contract is customer designed.
----------------------
iv.  hey are Unique in terms of contract size, expiration date and
T
---------------------- asset type and quantity.
---------------------- Match the following.
i. Options a. Exchange of payment streams
----------------------
ii. Futures b. Right but no obligation
---------------------- iii. Snap c. Standard contract
----------------------

---------------------- 8.5 PERMISSIBLE DERIVATIVE INSTRUMENTS IN

INDIA
----------------------
Presently, the following types of derivative instruments are permitted by
---------------------- RBI.
---------------------- Interest Rate Derivatives
---------------------- Interest Rate Derivatives are of the following different types as permitted
by the Reserve Bank of India. Interest Rate Swap (IRS), Forward Rate
---------------------- Agreement (FRA) and Interest Rate Future (IRF):

128 Risk Management

1. Interest rate swap: It is a financial contract between two parties Notes
exchanging or swapping a stream of interest payments for a “notional
principal” amount on multiple occasions during a specified period. Such ----------------------
contracts generally involve exchange of “fixed to floating” or “floating
to floating” rates of interest. On each payment date occurring during the ----------------------
swap period, cash payments based on fixed/floating rates are made by the ----------------------
parties to one another.
----------------------
2. Forward rate agreement: A forward rate agreement is a financial
contract between two parties to exchange interest payments for a “notional ----------------------
principal” amount on settlement date, for a specified period from start
date to maturity date. Accordingly, on the settlement date, cash payments ----------------------
based on contract (fixed) and the settlement rates are made by the parties
----------------------
to one another.
3. Interest rate future (IRF): It is a standardised, exchange-traded ----------------------
contract with an actual or notional interest-bearing instrument as the
----------------------
underlying asset. RBI introduced IRF on a notional coupon bearing 10-
year Government of India security and issued a direction in this regard. ----------------------
The standardised IRF contract has the following features:
----------------------
i. The contract shall be on 10-year notional coupon bearing
Government of India security. ----------------------
ii. The notional coupon shall be 7% per annum with semi-annual ----------------------
compounding.
iii. The contract shall be settled by physical delivery of deliverable ----------------------
grade securities using the electronic book entry system of the ----------------------
depositories, National Securities Depository Limited (NSDL) or
CDSIL and Public Debt Office of RBI. ----------------------
iv. Deliverable grade securities shall comprise GOI securities maturing ----------------------
at least 7.5 years but not more than 15 years from the first day of the
delivery month with a minimum total outstanding stock of ` 10,000 ----------------------
crore.
----------------------
Interest Rate Futures (Reserve Bank) (Amendment) Directions, 2015
----------------------
The Reserve Bank of India having considered it necessary in public
interest and to regulate the financial system of the country to its advantage, ----------------------
in exercise of the powers conferred by section 45W of the Reserve Bank
of India Act, 1934 and of all the powers enabling it in this behalf, hereby ----------------------
amends the Interest Rate Futures (Reserve Bank) Directions, 2013 dated
----------------------
December 5, 2013 (the Directions).
1. Short Title and Commencement ----------------------
These directions shall be referred to as the Interest Rate Futures ----------------------
(Reserve Bank) (Amendment) Directions, 2015
----------------------
These directions come into force with effect from June 12, 2015.
----------------------

Derivatives in Banks and Risk Management Strategies 129

 Notes 2. Eligible Instruments
In paragraph 3, in sub-paragraph (iii) of the Directions, after the words
----------------------
“Government of India security”, the following words shall be inserted:
---------------------- “with residual maturity between 4 and 8 Years, 8 and 11 years and 11 and
15 years”
----------------------
3. Necessary conditions of the Interest Rate Futures contract
----------------------
The 10-Year cash settled Interest Rate Futures contracts shall have two
---------------------- options as under:

---------------------- Option A: The underlying shall be a coupon bearing Government of India

security of face value ` 100 and residual maturity between 8 and 11 years
---------------------- on the expiry of futures contract.
---------------------- Option B: The underlying shall be coupon bearing notional 10- year
Government of India security with a face value of ` 100. For each
---------------------- contract, there shall be basket of Government of India securities, with
residual maturity between 8 and 11 years on the day of expiry of futures
---------------------- contract, with appropriate weight assigned to each security in the basket.
---------------------- The 6-Year cash settled Interest Rate Futures contracts shall have two
options as under:
----------------------
Option A:
----------------------
The underlying shall be a coupon bearing Government of India security
---------------------- of face value ` 100 and residual maturity between 4 and 8 years on the
expiry of futures contract.
----------------------
Option B:
---------------------- The underlying shall be coupon bearing notional 6-year Government of
---------------------- India security with a face value of ` 100. For each contract, there shall be
basket of Government of India securities, with residual maturity between
---------------------- 4 and 8 years on the day of expiry of futures contract, with appropriate
weight assigned to each security in the basket.
----------------------
The 13-Year cash settled Interest Rate Futures contracts shall have two
---------------------- options as under:
---------------------- Option A:
The underlying shall be a coupon bearing Government of India security
----------------------
of face value ` 100 and residual maturity between 11 and 15 years on the
---------------------- expiry of futures contract.

---------------------- Option B:
The underlying shall be coupon bearing notional 13-year Government of
---------------------- India security with a face value of ` 100. For each contract, there shall be
---------------------- basket of Government of India securities, with residual maturity between
11 and 15 years on the day of expiry of futures contract, with appropriate
---------------------- weight assigned to each security in the basket.

130 Risk Management

 Other requirements for cash settled 6-year, 10-year and 13-year Interest Notes
Rate Futures contracts shall be:
----------------------
Option A:
a. The underlying security shall be decided by stock exchanges in ----------------------
consultation with the Fixed Income Money Market and Derivatives
----------------------
Association (FIMMDA).
b. The contract shall be cash-settled in Indian rupees. ----------------------
c. The final settlement price shall be arrived at by calculating the ----------------------
volume weighted average price of the underlying security based on
prices during the last two hours of the trading on Negotiated Dealing ----------------------
System-Order Matching (NDS-OM) system. If less than 5 trades ----------------------
are executed in the underlying security during the last two hours of
trading, then FIMMDA price shall be used for final settlement. ----------------------
Option B: ----------------------
a. The underlying security shall have coupon with semi-annual
compounding. ----------------------

b. Exchanges shall disclose criteria for including securities in the ----------------------

basket and determining their weights such as trading volumes in
----------------------
cash market, minimum outstanding etc.
c. The contract shall be cash-settled in Indian rupees. ----------------------
d. The final settlement price shall be based on average settlement yield ----------------------
which shall be volume weighted average of the yields of securities
in the underlying basket. For each security in the basket, yield shall ----------------------
be calculated by determining weighted average yield of the security ----------------------
based on last two hours of the trading in NDS-OM system. If less
than 5 trades are executed in the security during the last two hours ----------------------
of trading, then FIMMDA price shall be used for determining the
yields of individual securities in the basket. ----------------------
Source: RBI ----------------------
Foreign Currency Derivatives ----------------------
As there is a variety of derivative instruments in local market to facilitate
----------------------
international transactions, there are some derivative instruments, which are
traded in international market. These instruments are in respective foreign ----------------------
currencies. They are Foreign Currency Forward, Currency Swap and Currency
Option. ----------------------
1. Foreign exchange forward: It is an over-the-counter contract under ----------------------
which a purchaser agrees to buy from the seller and the seller agrees
to sell to the purchaser, a specified amount of a specified currency on a ----------------------
specified date in the future − beyond the spot settlement date − at a known
----------------------
price denominated in another currency (known as the forward price) that
is specified at the time the contract is entered into. ----------------------

Derivatives in Banks and Risk Management Strategies 131

 Notes 2. Currency swap: It is an interest rate swap where the two legs of the
swap are denominated in different currencies. Additionally, the parties
---------------------- may agree to exchange the two currencies normally at the prevailing spot
exchange rate with an agreement to reverse the exchange of currencies, at
---------------------- the same spot exchange rate, at a fixed date in the future, generally at the
---------------------- maturity of the swap.
3. Currency option: It is a contract where the purchaser of the option has
----------------------
the right but not the obligation to either purchase (call option) or sell (put
---------------------- option) and the seller of the option agrees to sell (call option) or purchase
(put option) an agreed amount of a specified currency at a price agreed in
---------------------- advance and denominated in another currency (known as the strike price)
on a specified date (European option) or by an agreed date (American
----------------------
option) in the future.
---------------------- 4. Currency futures: It is a standardised foreign exchange derivative
contract traded on a recognised stock exchange to buy or sell one currency
----------------------
against another on a specified future date at a price specified on the date of
---------------------- contract (it excludes a forward contract). The currency futures market in
India functions subject to the directions issued by RBI and Securities and
---------------------- Exchange Board of India (SEBI). The Currency Futures (Reserve Bank)
Directions, 2015.
----------------------

---------------------- 8.6 ECONOMIC FUNCTIONS OF DERIVATIVE MARKETS

---------------------- Derivative markets provide three essential economic functions:
---------------------- • Risk management
• Price discovery
----------------------
• Transactional efficiency
----------------------
Risk management refers to the ability of the users to offset financial
---------------------- risks through derivatives. The process is known as hedging. The hedgers
use derivative contracts to shift unwanted price risk to third parties (usually
---------------------- speculators) who are willing to assume risks in order to make profits.
---------------------- Derivatives can be used to hedge both credit and market risks. While
credit risk represents the conventional counterparty risk, market risk refers to
---------------------- all those market forces/variables, which may adversely affect an institution’s
---------------------- profitability and economic values. Market risk is characteristically represented
by price risk of all types − interest rate risk, exchange rate risk, commodity
---------------------- price risk, equity price risk etc.
---------------------- As stated above, derivatives are means of managing risks. They enable
transfer of various financial risks to entities who are more willing or better
---------------------- suited to take or manage them. The users can undertake derivative transactions
to reduce or extinguish an existing identified risk or for transformation of risk
----------------------
exposure. Market makers undertake transactions to act as counterparties in
----------------------

132 Risk Management

derivative transactions with users and also amongst themselves. The parties Notes
managing risks in the market are known as hedgers. Some people/organisations
are in the business of taking risks to earn profits. Such entities represent the ----------------------
speculators. The fourth type of players in the market are known as the arbitragers
who take advantage of the market mistakes. ----------------------

Derivatives can, therefore, be used in several ways by the following ----------------------

individuals and institutions:
----------------------
1. Market makers: Market makers are those who provide two-way quotes
for a given product and thereby run a position in that product. All ----------------------
commercial banks (excluding local area banks and regional rural banks)
----------------------
and primary dealers are market makers.
2. Hedgers: Hedgers are those who wish to protect their existing exposures ----------------------
and essentially are safety-driven. Hedging is the process of stabilising the
----------------------
value (including cash flows) of a given portfolio by neutralising adverse
market movements. ----------------------
3. Speculators: Speculators are willing risk-takers who are expectation- ----------------------
driven.
4. Arbitragers: Arbitragers are traders who deal in buying and selling ----------------------
derivative contracts hoping to profit from price differentials between ----------------------
different markets.
Hedging risks through derivatives is not similar to speculation. The gain ----------------------
or loss on a derivative deal is likely to be offset by an equivalent loss or gain in ----------------------
the values of underlying assets. Offsetting of risks is an important property of
hedging transactions. However, in speculation one deliberately takes up a risk ----------------------
knowingly. Some of the major differences between hedging and speculation are
summarised in the table below. ----------------------

Table 8.1: Distinctions between Hedging and Speculation ----------------------

No. Criterion Speculation Hedging ----------------------

1 Objectives Capture market Neutralise adverse market
----------------------
movements movements
2 Need to identify Market opportunities Specific exposures ----------------------
3 Decision based upon Expectations of Fear of market
----------------------
market movements movements
4 Effective execution Increases Stabilises cash flows and ----------------------
profitability reduces cost of capital
----------------------

----------------------

----------------------

----------------------

----------------------

Derivatives in Banks and Risk Management Strategies 133

 Notes
Check your Progress 3
----------------------

---------------------- Multiple Choice Multiple Response.

1. What type of investors generally use derivative instruments?
----------------------
i. Market makers
----------------------
ii. Subscribers to IPO
---------------------- iii. Hedgers
---------------------- iv. Speculators
---------------------- v. Brokers

----------------------

---------------------- Activity 2
---------------------- Select any derivative instrument trading in the market and state at least
---------------------- three criteria for which it is generally put to use.

----------------------
8.7 APPLICATION OF DERIVATIVES FOR RISK
----------------------
MANAGEMENT
----------------------
Derivatives have increasingly become important in the world markets as
---------------------- a tool for management of risks. Regardless of the type of institution where
derivatives are used for managing risks, some basic elements need to be kept in
---------------------- mind. Some of them are as under:
---------------------- 1. Internal education: There needs to be an on-going process of
systematically improving board, management and staff literacy regarding
---------------------- the various types of risks inherent in conducting business and how those
---------------------- risks can be managed. The primary focus of this educational effort should
be to assist the internalisation of the competence to make and implement
---------------------- risk management decisions in a normal, reliable and closely controlled
manner on a continuous basis.
----------------------
2. Risk identification and quantification: In case of financial intermediaries,
---------------------- there are five main risk types. These risks include: (a) Interest rate risk,
(b) Exchange rate risk, (c) Credit risk, (d) Price risk and (e) Prepayment
---------------------- risk. All these risks are capable of being managed to acceptable levels.
---------------------- Once the type of risk to be managed has been identified, the next issue
becomes the objective quantification of that risk. A few key elements
---------------------- need to be included in the quantification effort to enable subsequent risk
management decisions. These include:
----------------------
i. Underlying assets and liabilities creating the risk exposure: It is
---------------------- necessary to examine both the asset and liability side of the risk

134 Risk Management

 exposure to enable an understanding of the individual portfolio Notes
exposure as well as the net exposure created by the combination.
----------------------
ii. Term of risk exposure: Another key issue is to determine the length
of time the exposure is expected to exist. An important sub-issue ----------------------
is to determine if the exposure is a one-time event or if it is a
continuing series of events. ----------------------
iii. Direction of risk exposure: In addition to the above, one must ----------------------
also determine the directional interest rate, price or exchange
rate movement to which the underlying risk position is exposed. ----------------------
This is not a forecast; it is simply a determination of the market
----------------------
environment within which the underlying risk position is negatively
and/or positively impacted. ----------------------
3. Decision to manage or accept the risk exposure: The driving force of
----------------------
any effort to manage risk is the conscious decision by management to
either accept or modify the risk exposure quantified as being inherent in ----------------------
the underlying balance sheet or portfolio. Naturally, this type of decision
needs to be made within the context established by the goals and objectives ----------------------
that make up the institution’s business plan and the environment within
----------------------
which the resulting risk management strategies will be implemented.
4. Risk management alternatives: Once a conscious decision has been ----------------------
made to manage a given risk exposure, management’s attention should ----------------------
then turn to an evaluation of the effectiveness (risks, costs and benefits) of
the various risk management alternatives. As a rule, there are three main ----------------------
alternative risk management categories from which to draw. They are as
follows: ----------------------

i. Policy decisions: This category is made up of the business policy ----------------------

decisions management makes in their on-going effort to achieve
their competitive position and financial performance objectives. ----------------------
These are usually the least costly to implement, but are somewhat ----------------------
limited in their utility to manage all the exposure to be managed
without eliminating profit potential. Regardless of this limitation, ----------------------
this alternative, at minimum, should be exhausted before utilising
derivatives. ----------------------

ii. Cash market transactions: This category is made up of the usual ----------------------
transactions the institution employs to manage its balance sheet in
conformity with the industry practices and regulatory guidelines. ----------------------
For financial intermediaries these are usually money market, fixed ----------------------
income, mortgage-backed and equity securities related transactions.
These alternatives are best utilised when there is exposure remaining ----------------------
to be managed after management has exhausted policy decision
alternatives and before utilising derivatives. ----------------------

iii. Derivatives: These instruments include forward, futures, option, ----------------------

swap etc. Since this category tends to have more inherent risks,
----------------------

Derivatives in Banks and Risk Management Strategies 135

 Notes derivative alternatives should be utilised only when there is risk
remaining to be managed after management has exhausted all
---------------------- policy decision and cash market transaction alternatives.
---------------------- It is important to note that even though management may make a
conscious decision to manage a given portion of the institution’s risk exposure
---------------------- and may consciously act to carefully exhaust all policy decision and cash
market transaction alternatives, there still may remain some exposure yet to
----------------------
be managed. When this occurs, management’s attention needs to be focused
---------------------- on evaluating the risk/reward profile associated with utilising derivatives to
manage the remaining exposure.
----------------------
There are two markets where derivatives are traded. These are organised
---------------------- exchanges and over-the-counter (OTC). They are similar in many respects, but
do have important distinguishing features as illustrated in the table below.
----------------------
Table 8.2: Differences between Over-the-Counter and Exchange-Traded
---------------------- Derivatives

---------------------- Features Over-the-Counter (OTC) Exchange Traded

Market Networks of market makers who Organised exchanges in
---------------------- exchange price information and capital markets around the
negotiate transactions world
----------------------
Agreements Custom-tailored to meet specific Standardised contracts
---------------------- needs of counter- parties within
accepted guidelines
----------------------
Risk Default/credit risk to the Guaranteed contract
---------------------- counterparties performance
Ability to Varies by market some have Daily settlement
---------------------- Value electronic posting, others require and intraday prices
---------------------- individual inquiry and valuation electronically posted
Examples Forwards, caps, floors, collars, Futures and options
---------------------- swaps etc.
---------------------- 5. Strategic applications of derivatives: Derivatives, like most tools,
are neutral until utilised. It is with utilisation that positive and negative
---------------------- attributes can be identified. The main utilisation issue related to the use
of derivatives is the use to which management is applying derivative
----------------------
strategies − hedging or speculating. Hedging is generally perceived to
---------------------- be good and speculation is generally perceived to be bad. Regardless
of whether management is hedging or speculating, there is one very
---------------------- dominant consideration inherent in both, which is prudent management
of the risks associated with the underlying activity.
----------------------
6. Benefits to banks: Financial institutions, such as banks, have assets
---------------------- and liabilities of different maturities and in different currencies and they
---------------------- are exposed to different risks of default from their borrowers. Thus,
they are likely to use derivatives on interest rates and currencies and to
---------------------- manage credit risk. Risk management through derivative securities has

136 Risk Management

 been an avenue for banks to refine risk management practices. Similar Notes
to other international markets, price and interest rate volatility in Indian
financial markets is also high; hence, the implications of not hedging the ----------------------
bank portfolio may prove to be disastrous. Derivatives give banks an
opportunity to manage their risk exposure and to generate revenue. ----------------------

The intensity of derivatives’ usage by any institutional investor is a ----------------------

function of its ability and willingness to use derivatives for one or more of the
----------------------
following purposes:
• Risk containment: Using derivatives for hedging and risk containment ----------------------
purposes.
----------------------
• Risk trading/market making: Running derivatives’ trading book for
profits and arbitrage. ----------------------
• Covered intermediation: On-balance sheet derivatives’ intermediation ----------------------
for client transactions, without retaining any net risk on the balance sheet
(except credit risk). ----------------------

----------------------
8.8 USE OF DERIVATIVES BY BANKS
----------------------
The core activities of banks can be summarised as under:
----------------------
1. Accepting deposits for the purposes of lending and investment.
2. Borrowing from other banks for the purpose of lending and investment. ----------------------

3. Transferring money from one place to another within and outside the ----------------------
country.
----------------------
4. Maintaing Cash Reserves Ratio (CRR) and Statutory Reserves Ratio
(SLR). ----------------------
The major risks faced by banks in its core activities are: ----------------------
• Interest rate risk on their deposits, advances and investments. ----------------------
• Foreign exchange risk on their activities involving conversion of rupee
into foreign currency and vice versa. ----------------------

Bank’s balance sheets have items, which are sensitive to interest rate ----------------------
movements and exchange rate fluctuations. As a result, importance of derivatives,
which have interest rates and exchange rates as the “underlying” come to the ----------------------
fore. Broadly, derivatives with interest rate as the underlying are used for ----------------------
the management of interest rate risks associated with deposits, advances and
investments, while derivatives with exchange rates as the underlying are used ----------------------
for management of risks associated with foreign exchange transactions. The
derivative instrument used to manage interest rate risk is known as the interest ----------------------
rate swap. ----------------------
The following example will illustrate how asset liability mismatch can be
----------------------
managed by a bank and what is its effect on return on funds.
----------------------

Derivatives in Banks and Risk Management Strategies 137

 Notes Example 1
A bank, which is cash surplus has long-term liabilities and it lacks assets.
----------------------
It lends its surplus funds overnight and hence, runs asset liability mismatches
---------------------- and gets lower returns on funds. The bank can use Overnight Index Swap (OIS)
to park its surplus overnight funds. Let us presume the bank receives a deposit
---------------------- for one year at 10%. The options available to the bank are as under:
---------------------- Options Returns Liquidity ALM
Lend it in overnight market Low High Mismatch
----------------------
Buy one-year asset locked High Funds No mismatch
---------------------- Enter into an OIS (pay floating, High High No mismatch
receive fixed and continue to lend in
---------------------- overnight market)
---------------------- Overnight Index Swap is perhaps the most liquid segment in the Indian
swap market. The benchmark being the overnight index rate representing
----------------------
Mumbai Interbank Offered Rate (MIBOR), the OIS is widely used by banks
---------------------- and primary dealers for hedging their call rate funding risk as well as their bond
portfolio.
----------------------
Example 2
---------------------- Let us now take up a case of the use of derivatives in a situation where
banks garner deposits under a falling interest rate scenario. Let us assume
----------------------
that the term deposit interest rate for a three-year term deposit is 8%. In a
---------------------- falling interest rate scenario, the borrowers do not want to lock in their cost of
borrowing for a three- year period and prefer to ask for loans at floating rate
---------------------- of interest linked to interbank call money or MIBOR. If the MIBOR or the
Interbank Call Money rate is say 6% and the borrower is willing to pay 2.5%
----------------------
above the MIBOR for a three-year term loan and if no other avenue is available
---------------------- to the bank for deployment of the three-year term deposit mobilised at 8% p.a.,
the following options are available to the bank:
----------------------
i. Deploy the money in the call money market at 6% p.a. with the risk of
---------------------- call money rate falling lower to say 5% p.a. because of continued surplus
liquidity in the system and borrowers looking for borrowing at lower and
---------------------- lower rates.
---------------------- ii. Lend to the borrower at a floating rate of 2.5% plus MIBOR, which would
work out to 8.5% if the MIBOR rules at 6%. The risk in this transaction
---------------------- is that if the MIBOR falls to say 5%, the return to the bank would drop
---------------------- to 7.5% p.a. A third option available to the bank is to consider the loan as
above and to cover itself with an OIS.
---------------------- In the present case, the bank has mobilised a deposit at 8% p.a. when the
---------------------- MIBOR is 6% p.a. and the borrower is looking for a floating rate loan linked to
MIBOR. If the market-quoted rate for a three-year interest rate swap known as
---------------------- OIS is say 7.90%−8.00%, which means that the bank can receive fixed 7.90%
and pay floating MIBOR for three years. If the bank enters into a three-year OIS
----------------------

138 Risk Management

interest rate swap with another bank, it can lend to its borrower at MIBOR+2.5% Notes
p.a., while receiving a fixed rate of 7.90% from the other bank.
----------------------
The profitability of the bank A in the first year would be as under:
On Floating Leg: From Borrower Receive: MIBOR+2.5% To Swap Bank B ----------------------
Pay: MIBOR
----------------------
Inflow: (MIBOR+2.5% − MIBOR) = 2.5%
----------------------
On Fixed Leg From Swap Bank B Receive: 7.90% fixed To the depositor,
Pay: 8.00% fixed Outflow: 0.10% ----------------------
Net Result: Inflow-Outflow = (2.5% − 0.10% = 2.40%) ----------------------
The above interest rate swap fully protects the bank’s interest margin at
2.40% whether the interest rate falls or rises as long as the bank has a full three- ----------------------
year term deposit from its customer. ----------------------
Example 3
----------------------
In order to fund its investment in one year Government Treasury bills
(T-Bills), a bank borrows in the interbank call money market. The bank expects ----------------------
MIBOR to be volatile over the next 30 days. It can hedge this risk through OIS
----------------------
(pay fixed- receive floating) and continue to enjoy carry by locking into the
swap rates. ----------------------
Example 4 ----------------------
Bank A raises USD foreign currency floating rate funds based on six-
month London Interbank Offered Rate (LIBOR) for a period of five years and ----------------------
decides to lend in Indian rupees to a corporate client at a fixed interest rate of say ----------------------
9%. Bank A would approach Bank B, which would give a quote for swapping
the USD into Indian rupees, which is foreign exchange swap. Since USD is at a ----------------------
premium to Indian rupee, Bank A would have to pay a premium for the dollars it
sells spot and purchases six-month forward to enable it to pay the interest on the ----------------------
USD borrowing and also purchase the principal at the end of the fifth year, if the ----------------------
principal is paid at the end of the tenure of the loan. To enable Bank A to meet
the USD/Indian rupee premium payable, Bank A would simultaneously take a ----------------------
five-year Mumbai Interbank Forward Offered Rate (MIFOR) quote from Bank
C, wherein it would pay a fixed 7.20% (to say) and receive six-month MIFOR. ----------------------

As MIFOR is constituted from six-month LIBOR and six-month USD/ ----------------------

INR premium, the six-month LIBOR received will be paid to the bank from
whom the five- year dollar loan was raised. The six-month USD/INR premium ----------------------
received would be used to pay the six-month USD/INR premium to Bank B, ----------------------
which quoted the FX Swap.
----------------------
As per this arrangement, Bank A can now lend the USD swapped into
rupees to a corporate client in India for five years at 9% and make a profit ----------------------
of 1.80%, i.e., the difference between the fixed rate of 9% received from the
corporate client and the fixed rate of 7.20% paid to Bank C. ----------------------

----------------------

Derivatives in Banks and Risk Management Strategies 139

 Notes
Check your Progress 4
----------------------

---------------------- Fill in the Blanks.

1. Two important options available to bankers for ALM are buy ____
----------------------
and enter into a _____.
----------------------

---------------------- 8.9 REASONS FOR POPULARITY OF DERIVATIVES

---------------------- During the recent years, derivatives have become increasingly important
for the following reasons:
----------------------
1. Increased volatility in asset prices in financial markets.
---------------------- 2. Increased integration of national financial markets with the international
markets.
----------------------
3. Marked improvement in communication facilities and sharp decline in
---------------------- their costs.
---------------------- 4. Development of more sophisticated risk management tools, which provide
economic agents a wider choice of risk management strategies.
----------------------
5. Innovations in the derivatives markets, which optimally combine the risks
---------------------- and returns over a large number of financial assets, which lead to higher
returns, reduced risks and transaction costs as compared to individual
----------------------
financial assets.
---------------------- 6. So far as the equity derivatives are concerned, futures and options on stock
indices have gained more popularity than individual stocks, especially
----------------------
among institutional investors, who are the major users of index-linked
---------------------- derivatives.
7. The lower costs associated with index derivatives vis-à-vis derivative
----------------------
product based on individual securities is another reason for their growing
---------------------- use.

---------------------- Summary
---------------------- ● Financial products like asset-backed securities, derivatives, credit-default
swaps and collateralised debt obligations is the innovation of 21st century.
----------------------
● These instruments are used to hedge their risks and manage their regulatory
---------------------- and economic capital more effectively.
---------------------- ● The term derivative indicates that it has no independent value, i.e., its
value is entirely derived from the value of the underlying asset.
----------------------
● There are two distinct groups of derivative contracts: (a) traded directly
---------------------- between two eligible parties, with/without use of an intermediary and
without going through an exchange known as OTC products and (b)
---------------------- products that are traded on an exchange.

140 Risk Management

The most common types of derivative contracts are as under: Notes
● Forward contract is a customised contract between two entities, where
----------------------
settlement takes place on a specified future date at today’s pre-agreed
price. A forward contract is an agreement to buy or sell an asset on a ----------------------
specified date for specified price. Forward contracts are popular on the
Over-the-Counter (OTC) market. ----------------------
● Futures are standard contracts based on an agreement to buy or sell an ----------------------
asset at a certain price at a certain time in future. It is an obligation on the
buyer to purchase the underlying instrument and the seller to sell it. The ----------------------
delivery under a futures contract is not a must. The buyers and sellers can
----------------------
set-off the contract by packing the different amount at the current rate/
price of the underlying. ----------------------
● Options are contracts that provide a right but do not impose any obligation
----------------------
to buy or sell a financial instrument (say a share or a security). Options
are fundamentally different from forward and future contracts. There are ----------------------
two variants of options (a) European option where the holder can exercise
the right, on the expiry date and (b) American option where the holder ----------------------
can exercise the right anytime between purchase date and the expiry date.
----------------------
Options have two components i.e. (a) Call Option wherein the owner
(buyer) has the right to purchase and the seller has the obligation to sell ----------------------
(b) Put Option where the owner or buyer has the right to sell and the seller
has the obligation to buy. ----------------------
● Swap is a contract that binds two counterparties to exchange the different ----------------------
streams of payments over the specified period at specified rate. In the
context of foreign exchange, it means simultaneous sale and purchase of ----------------------
one currency to another. In the context of financial derivatives, the swap ----------------------
means the exchange of two streams of cash flows, over a definite period.
Currency swap means when pre-determined streams of payments in ----------------------
different currencies are exchanged on a pre-fixed period at pre-fixed rate.
Interest Rate swap is exchange of different streams of interest structures ----------------------
(and not the principal amount). ----------------------
● Derivatives are means of managing risks. They enable transfer of various
financial risks to entities who are more willing or better suited to take or ----------------------
manage them. The users can undertake derivative transactions to reduce ----------------------
or extinguish an existing identified risk or for transformation of risk
exposure. ----------------------

----------------------
Keywords
----------------------
● Derivative: A financial instrument to be settled at a future date, whose
value is derived from change in some other variable such as interest rate, ----------------------
foreign exchange rate, market index, credit index, price of securities or
----------------------
goods, index prices etc.
----------------------

Derivatives in Banks and Risk Management Strategies 141

 Notes ● Over-the-counter derivatives: Derivatives traded directly between two
eligible parties, with/without use of an intermediary and without going
---------------------- through an exchange.
---------------------- ● Exchange-traded derivatives: Derivative products that are traded on an
exchange.
----------------------
● Forward contract: A customised contract between two entities, where
---------------------- settlement takes place on a specified future date at today’s pre-agreed
price.
----------------------
● Futures: A standard contract based on an agreement to buy or sell an
---------------------- asset at a certain price at a certain time in future. It is an obligation on the
buyer to purchase the underlying instrument and the seller to sell it.
----------------------
● Options: A contract that provides a right but does not impose any
---------------------- obligation to buy or sell a financial instrument.

---------------------- ● European option: An option contract where the holder can exercise the
right, on the expiry date.
---------------------- ● American option: An option where the holder can exercise the right
---------------------- anytime between the purchase date and the expiry date.
● Call option: An option wherein the owner (buyer) has the right to
----------------------
purchase and the seller has the obligation to sell.
---------------------- ● Put option: An option where the owner or buyer has the right to sell and
the seller has the obligation to buy.
----------------------
● Swap: A contract that binds two counterparties to exchange the different
---------------------- streams of payments over the specified period at specified rate.
---------------------- ● Currency swap: Pre-determined streams of payments in different
currencies are exchanged on a pre-fixed period at pre-fixed rate.
----------------------
● Interest rate swap: It is exchange of different streams of interest
---------------------- structures and not the principal amount.
---------------------- ● Market makers: Those who provide two-way quotes for a given product
and thereby run a position in that product.
----------------------
● Hedging: The process of stabilising the value (including cash flows) of a
---------------------- given portfolio by neutralising adverse market movements.
● Speculators: Those who are willing risk takers and are expectation
----------------------
driven.
---------------------- ● Arbitragers: Traders who deal in buying and selling derivative contracts
---------------------- hoping to profit from price differentials between different markets.

----------------------

----------------------

----------------------

142 Risk Management

 Notes
Self-Assessment Questions
----------------------
1. Explain the term “Derivative Instruments”.
2. Distinguish between futures and forwards. ----------------------
3. List the points of distinction between options and futures. ----------------------
4. Mention at least three reasons for the popularity of derivatives. ----------------------
5. Explain the various steps to be followed while arriving at a decision on
the use of derivatives for risk management. ----------------------

6. Explain the benefits of using derivatives. ----------------------

7. Write short notes on: ----------------------
i. Forward contracts ----------------------
ii. Speculation
----------------------
iii. Application of derivatives for risk management
----------------------
iv. Currency futures
----------------------
Answers to Check your Progress
----------------------
Check your Progress 1
----------------------
Multiple Choice Multiple Response.
----------------------
1. Following are derivative instruments:
i. Interest rate ----------------------
ii. Foreign exchange rate ----------------------
iii. Market index ----------------------
v. Credit index
----------------------
2. Following are the characteristics of derivatives:
----------------------
i. Designed by using any one of the existing instruments or by using
a combination of two or more instruments. ----------------------
ii. Can be traded in the market. ----------------------
Check your Progress 2
----------------------
Multiple Choice Multiple Response.
----------------------
1. What are the characteristics of a forward contract?
i. They are bilateral contracts and hence exposed to counterparty risk. ----------------------
iii. Each contract is customer designed. ----------------------
iv. They are unique in terms of contract size, expiration date and asset ----------------------
type and quantity.
----------------------

Derivatives in Banks and Risk Management Strategies 143

 Notes Match the Following.
i. b.
----------------------
ii. c.
----------------------
iii. a.
---------------------- Check your Progress 3
---------------------- Multiple Choice Multiple Response.
---------------------- 1. What type of investors generally use derivative instruments?
i. Market makers
----------------------
iii. Hedgers
----------------------
v. Speculators
---------------------- Check your Progress 4
---------------------- Fill in the Blanks.
---------------------- 1. Two important options available to bankers for ALM are to buy one-year
asset and enter into a QIS.
----------------------

---------------------- Suggested Reading

---------------------- 1. Vasudevan, A. 2003. Central Banking for Emerging Market Economics.
California: Academic Foundation.
----------------------
2. Benton E. Gup, and James W. Kolari. 2007. Commercial Banking: The
---------------------- Management of Risk. Australia: John Wiley & Sons.
---------------------- 3. Bidani, S. N. 2010. Banking Risks Management and Audit. New Delhi:
Vision Books.
----------------------
4. Van Greuning, Hennie, and Bratanovic, Sonja Brajovic. 2003. Analyzing
---------------------- and Managing Banking Risk: Framework for Assessing Corporate
Governance and Financial Risk. World Bank Publication.
----------------------

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144 Risk Management