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Financial Risk Management

Risk is the chance of encountering loss

Risk is the possibility of something unpleasant


happening

Risk means uncertainty of future cash flows.

Risk Manager’s job involves in ensuring that RISK


is maintained at the desired level.

In all cases where risk is imperative, increasing the


predictive ability also forms part of risk management
Different meanings of risk
Pure risk and Speculative risk
Pure risks are those in which the outcome tends to be a loss
with no possibility of gain.
Speculative risks are those in which there is a possibility of
loss or profit.
Ex: Risk of fire in a warehouse results in a pure risk while the
risk involved in dealing in the stock market is a speculative
risk, because one may either gain or lose.

While it is possible to insure pure risk, speculative risks can’t


be insured.
Acceptable Risks and Non-Acceptable Risks
Certain risks are acceptable without any prevention being
taken since the potential loss may be minimal.

Certain risks are major and non – acceptable too. The mgmt.
Must find ways to reduce, avoid or transfer the risk.

Eg: A major financial loss of Rs.1 crore due to fire in the


warehouse is a non-acceptable risk.
Static risks and Dynamic risks:
There are various risks that depend on changes in the
economic, political, social and other scenarios. Such risks are
known as dynamic risks.
Eg: Speculative risks, Business risks.

Risks that do not depend on various scenarios are known as


static risks. Pure risk is a type of static risk.
Types of risk
Interest rate risk
Interest rate risk is the risk of an adverse effect of interest
rate movements on a firm’s profit.

Exchange Risk
Volatility in the exchange rates will have a direct impact
on the values of assets and liabilities, which are denominated
in foreign currencies.

Default Risk
Default risk is the risk of non – recovery of sums due
from outsiders. This risk has to be considered when credit is
extended to any party.
Types of risk
Liquidity risk

Liquidity risk refers to the risk of a possible bankruptcy


arising due to the inability of the firm to meet its financial
obligations.

A firm may be having huge profits but may have a severe


liquidity crunch because it has blocked its money in illiquid
assets.
Types of risk
Market Risk
Market risk is the risk of the value of a firm’s
investments going down as a result of market
movements.
Market risk can’t be separated from other risks, as
it results from presence of other risks.
Interest rate risk and exchange rate risk contribute
the most to the presence of market risk.
Types of risk
Types of risk
Financial risk

Financial risk refers to the risk of bankruptcy


arising from the possibility of a firm not being to
repay its debts on time.

Higher the debt-equity ratio of a firm, higher the


financial risk faced by a firm.
Types of risk
Types of risk
Operational control risk
Key personnel risk
Frauds committed by staff
electronic transactions risk.

Other risks
Legal risks
Economic environment risk
Political risks
Managing the Risk
1)Avoidance
Avoidance refers to not holding such an
asset/liability which is exposed to risk.

2)Loss control

3)Transfer of risk through hedging (Forwards,


futures,options, swaps )
Risk management Process

Risk management needs to be looked at as an


organisational approach, as management of risks
independently can’t have the desired effect over
the long term.

Risks result from various activities in the firm


and the personnel responsible for these activities
do not always understand the risk attached to
them.
Risk management Process
Risk management process involves a logical
sequence of following steps.
1)Determining Objectives
The objectives of risk management needs
to be decided by the management of an
enterprise.
The objective may be to protect profits or
to develop competitive advantage.
Risk management Process
2) Identifying sources of Risks
Each company faces different risks, based on
its nature of business – like
Degree of competition
Availability of Raw material
Dependence on foreign markets for sales
or finances
Risk management Process
3) Risk evaluation
Once the risks are identified, they need to
be evaluated to know their significance
and classified as
Critical risks – leads to bankruptcy
Important risks – financial distress
Acceptable risks – Min. potential loss
Risk management Process
4) Development of policy
Policy takes the form of a declaration stating
How much risk should be covered ?
How much risk the firm is ready to bear ?

Policy may specify that not more than a specific


sum can be at risk at any point of time.
Risk management Process

Interdependence for managing risk


Risk management Process
5) Development of strategy
Specifies the nature of risk to be managed, tools, techniques
and instruments that can be used to manage these risks.

Specify whether it would be more beneficial for a subsidiary


to manage its own risk or to shift it to the parent company.

Specify whether the company would try to make profits out


of risk management ( from active trading in derivatives
market ) or stick to cover existing risks.
Risk management Process
6) Strategy implementation & Review
Includes finding best deal in case of risk transfer,
providing for contingencies in case of risk
retention

Taking care of details in operations, like back


office work.

Periodic review of risk management function,


depending on costs involved.
Cost of Risks
Risk identifying costs
Costs which an enterprise incurs to identify
and analyse the risks, like consultant fee.

Risk Handling costs


Certain expenses of handling risks, like
insurance premium, loss prevention devices.
Cost of Risks
Social costs
Costs that an enterprise may have to incur to
compensate the society for damages caused
by its actions.
Ex: Union carbide had to pay millions of
dollars as compensation to the victims of
Bhopal Gas tragedy
Limitations of Risk management
Risk management although essential to control risks
and avoid losses cannot guarantee full success.

No money manager can guarantee a foolproof system


against risks because many risks are unexpected.

Managing risk tools may prove to be very costly and


investment in such tools may not justify the returns.
Introduction to Futures & Options As
Derivative Instruments

Derivative instruments are financial instruments


whose value is derived from the value of an
underlying asset

An underlying asset can be a commodity, Bond,


foreign exchange, equity shares or share indices.
Introduction to Futures & Options As
Derivative Instruments
The main instruments clubbed under the general
term derivatives are
Forwards
Futures
Options
Option on futures
Forward rate agreements(FRAs)
Swaps
Types of Derivative instruments

Derivative instruments are of two types


1) Those that are traded in an exchange, such as
futures and options
2) Those that are traded over the counter(OTC),
such as forwards, FRAs, swaps.

An important difference between these two types


of instrument is in counter party risk and
liquidity.
Forward contracts

Forward contracts are the oldest and simplest form of


derivative contracts.

A forward contract is an agreement between two


persons for the purchase and sale of a commodity or
financial asset at a specified price to be delivered at a
specified future date
Positive aspects of Forward contracts
A firm can use the forward market to hedge or lock
in the price of purchase or sale of the
commodity/financial asset on a future date.
Margins are not generally paid on forward contracts
and there is also no up-front premium, hence these
contracts do not have an initial cost.
As forward contracts are tailor-made, the price risk
exposure can be hedged upto 100%
Negative aspects of Forward contracts

• There is no performance guarantee in a forward


contract – always counter party risk
• Forward contracts do not allow an investor to gain
from favourable price movements or cancel
transactions once the contract is made.
• It is difficult to get a counterparty that agrees
completely to one’s terms
• No ready liquidity since forward contract is not
traded on exchange
Futures contracts

A futures contract is an agreement between a


buyer and a seller that requires delivery of a
specified quantity of a security, commodity or
forex at a fixed time in the future at a price agreed
to at the time of entering into the contract.
Features of futures contracts

Futures are highly standardised contracts that provide for


their performance either through deferred delivery of the
asset or cash settlement

Future contracts trade on organised exchanges with a


clearing association that acts as a middleman between the
contracting parties.

Both the seller and the buyer of a futures contract pay an


initial margin amount to the clearing house, which is used
as a performance bond by the contracting parties.
Features of futures contracts
Apart from the initial margin, the buyers and sellers of
futures contracts also have to pay a daily mark to market
margin(MTM margin) to the clearing house through their
respective brokers.

Individual stocks and stock index derivatives have a


maturity date of the last Thursday of the contract month. If
the last Thursday happens to be a holiday, the previous day
will be the maturity day.

Every futures contract represents a specific quantity known


as Lot size.
Distinction between forward and futures contracts

Forwards Futures

Size of contracts Decided b/w buyer & Standardised by exchange


seller for each lot
Price of contract Remains fixed till maturity Changes everyday

Marking to market Not done Marked to market daily

Margin No margin is required To be paid by both parties

Counter party risk Present Not present

No. of contracts in a year Any no. of contracts Fixed by the exchange

Hedging Tailor made for specific Done by using nearest


dates & quantity. month and fixed lots
Liquidity No liquidity Highly liquid

Mode of delivery Specifically decided. Standardised. Most


Some result in delivery. contracts do not result in
Players/participants in the derivatives market
1) Hedgers
Hedgers are attracted to derivatives market to reduce a risk
that they already face.
In the commodity market, hedging may be done by a
producer or a miller or a stockist of goods.
2) Speculators
Speculators have a view on the future price of a commodity,
shares, stock index, interest rates or currency.
In contrast to hedgers who want to reduce their risk,
speculators take a position in the market.
Speculators provide hedgers an opportunity to manage their
risk by assuming their risk.
Players/participants in the derivatives market
3) Arbitrageur
An arbitrageur is risk averse and enters into those contracts
where he can earn riskless profits.

In imperfect markets, it is possible to make risk less profits by


buying at a lower price in one market and selling at a higher
price in another market or vice versa.
Eg: Spot price of HDFC Bank is Rs.1000/- and its 3-month
futures are at Rs.1040/-.
Cost of carry (C) = F – S * 365 * 100
S Days to maturity
Players/participants in the derivatives market
Intermediary participants
4) Brokers
Brokers perform the important function of bringing
buyers and sellers together.
As a member of a Derivatives exchange, a broker
need not be a speculator, arbitrageur or hedger.

Membership in the exchange confers on the broker


the right to conduct transactions with other members
Players/participants in the derivatives market
Institutional framework
5)Exchange
An exchange acts a guarantor for the performance of the
contract entered by a seller and a buyer, through its member
broker.
In an online trading system, the exchange provides its
members with real time access to information and allows
them to execute their orders.
Players/participants in the derivatives market
6) Clearing house
The National Securities Clearing Corporation Ltd( NSCCL) is
the clearing and settlement agency for all deals executed on
NSE’s F&O segment.

NSCCL acts as a counter party to all deals on NSE’s F&O


segment

NSCCL performs clearing, settlement and risk management


functions.
Players/participants in the derivatives market
7) Bank for fund management
Futures and options contracts are settled daily and this requires
transfer of funds from members to clearing house.

A bank can make the daily accounting entries in the accounts of


the members of the exchange, clearing house and facilitate daily
payments.
8) Regulatory framework
A regulator creates confidence in the market besides providing
a level playing field to all the concerned participants.