Corp Risk Mgmt

7/28/2019 Corp Risk Mgmt

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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 Managers 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


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Different meanings of risk

Pure risk and Speculative riskPure 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 cant

be insured.


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Acceptable Risks and Non-Acceptable RisksCertain risks are acceptable without any prevention being

taken since the potential loss may be minimal.

Certain risks are major and nonacceptable 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.


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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.


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Types of riskInterest rate risk

Interest rate risk is the risk of an adverse effect of interestrate movements on a firms profit.

Exchange Risk

Volatility in the exchange rates will have a direct impacton the values of assets and liabilities, which are denominated

in foreign currencies.

Default Risk(Credit Risk)

Default risk is the risk of nonrecovery of sums due

from outsiders. This risk has to be considered when credit is

extended to any party.


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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.


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Types of risk

Market Risk

Market risk is the risk of the value of a firms

investments going down as a result of market

movements.

Market risk cant 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.


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Types of risk


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Types of risk

Financial risk

Financial risk refers to the risk of bankruptcy

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

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

financial risk faced by a firm.


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Types of risk


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Types of risk

Operational control riskKey personnel risk

Frauds committed by staff

electronic transactions risk.

Other risks

Legal risks

Economic environment risk

Political risks


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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 )


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Risk management Process

Risk management needs to be looked at as an

organisational approach, as management of risks

independently cant have the desired effect over

the long term.

Risks result from various activities in the firm

and the personnel responsible for these activitiesdo not always understand the risk attached to

them.


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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.


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2) Identifying sources of RisksRisks arise from a variety of sources and affect the

value of the assets held by a company

Risks arise due to the possibility that the actual

outcome could be different from the expected

outcome.


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2) Identifying sources of Risks

Economic policies of govt. and resultant budgetdeficits or surplus.

Levels of inflation, interest rates and capital

formation.

Consumption and savings rate and preferences

of individual consumers.

Technological factors that bring in new

productsPolitical, social issues that impact the

availability of a product



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3) Risk evaluation

Once the risks are identified, they need to

be evaluated to know their significance

and classified as

Critical risksleads to bankruptcy

Important risksfinancial distress

Acceptable risksMin. potential loss


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4) Development of policyPolicy 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.


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Interdependence for managing risk



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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.


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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.


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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, likeinsurance premium, loss prevention devices.


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Cost of Risks

Social costs

Costs that an enterprise may have to incur to

compensate the society for damages causedby its actions.

Ex: Union carbide had to pay millions of

dollars as compensation to the victims ofBhopal Gas tragedy


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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.


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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.


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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


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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 typesof instrument is in counter party risk and

liquidity.


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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


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Positive aspects of Forward contracts

A firm can use the forward market to hedge or lockin 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 thesecontracts do not have an initial cost.

As forward contracts are tailor-made, the price risk

exposure can be hedged upto 100%


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Negative aspects of Forward contracts

There is no performance guarantee in a forward

contractalways counter party risk

Forward contracts do not allow an investor to gainfrom favourable price movements or cancel

transactions once the contract is made.

It is difficult to get a counterparty that agrees

completely to ones terms

No ready liquidity since forward contract is not

traded on exchange


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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 orforex at a fixed time in the future at a price agreed

to at the time of entering into the contract.


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Features of futures contracts

Futures are highly standardised contracts that provide fortheir performance either through deferred delivery of the

asset or cash settlement

Future contracts trade on organised exchanges with aclearing association that acts as a middleman between the

contracting parties.

Both the seller and the buyer of a futures contract pay aninitial margin amount to the clearing house, which is used

as a performance bond by the contracting parties.


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Features of futures contracts

Apart from the initial margin, the buyers and sellers offutures 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.


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Distinction between forward and futures contracts

Forwards Futures

Size of contracts Decided b/w buyer &

seller

Standardised by exchange

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

dates & quantity.

Done by using nearest

month and fixed lots

Liquidity No liquidity Highly liquid

Mode of delivery Specifically decided.Some result in deliver .

Standardised. Mostcontracts do not result in


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OPTIONS: INTRODUCTION

Option is one of the variants of derivativecontracts

Option contracts give its holder the right, but notthe obligation, to buy or sell the specified

quantity of the underlying asset for a certainagreed price (exercise/strike price) on or beforesome specified future date (expiration date).

Call option gives its holder the right to buy. Put option gives its holder the right to sell.


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Players/participants in the derivatives market

1) HedgersHedgers 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.


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3) ArbitrageurAn 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 bybuying 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) = FS * 365 * 100

S Days to maturity


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Intermediary participants

4) Brokers

Brokers perform the important function of bringing

buyers and sellers together.

As a member of a Derivatives exchange, a brokerneed not be a speculator, arbitrageur or hedger.

Membership in the exchange confers on the brokerthe right to conduct transactions with other members


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Institutional framework5)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.



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6) Clearing houseThe National Securities Clearing Corporation Ltd( NSCCL) is

the clearing and settlement agency for all deals executed on

NSEs F&O segment.

NSCCL acts as a counter party to all deals on NSEs F&O

segment

NSCCL performs clearing, settlement and risk managementfunctions.


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7) Bank for fund management

Futures and options contracts are settled daily and this requirestransfer 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 dailypayments.

8) Regulatory framework

A regulator creates confidence in the market besides providing

a level playing field to all the concerned participants.

Documents

Corp Risk Mgmt