Risk Management Notes PDF

Risk Management Chapter 1 Introduction to Risk Management Meaning of Risk Risk is a possibility of damage, injury, loss or any other negative occurrences that is caused by external or internal vulnerabilities (inability or weakness). Def...

Risk Management Chapter 1 Introduction to Risk Management Meaning of Risk Risk is a possibility of damage, injury, loss or any other negative occurrences that is caused by external or internal vulnerabilities (inability or weakness). Definition According to mansson and sevenone “Risk is the potential (possibility) of losing something of value against the potential to gain something of value, value such as physical health, social status, emotional well being or financial wealth can be gained or lost”. Uncertainty, Peril, Hazards Uncertainty: this is a situation where a possible outcomes or probability of outcomes is unknown. In other words it is a situation where the future events are not known. Peril: peril is a cause of loss. Peril is the possibility of cause that exposes a person or property to the risk of injury or damage or loss. Types of perils a. Natural perils: natural perils are those perils on which people have little control. b. Human perils: human perils includes causes of loss that lie within peoples control like terrorism, war, theft, environmental pollution etc… c. Economic perils: economic peril causes loss due to changes in economy like changes in customer taste and preferences, technological advances, currency fluctuations… Anil Kumar KY Asst Professor department of Commerce SIMS Page 1 Risk Management Natural perils Human perils Economic perils Insurable Difficulty to Insurable Difficulty to Difficulty to insure insure insure Wind storm Flood Theft War Changes in customer taste & preferences Lighting Earth quake Human Terrorism Technological accidents changes Heart attack Volcanic negligence Civil unrest Currency eruption fluctuations Hazards: hazards is a condition that increases the possibility of loss. Types of Hazards: a. Physical Hazards: It refers to Physical condition or tangible condition that increases the possibility of loss. Example: smoking is a physical hazard that increases the possibility of house fire & illness. Slippery roads which often increases the number of auto accidents. b. Moral / Legal Hazards: Moral hazards are losses that results from dishonesty and fraudulent activities of a individuals. Example: insurance company suffers losses because of fraudulent claims. c. Morale hazards: Morale hazards are losses that do not involve dishonesty but arises attitude of carelessness and lack of concern. Example : careless cigarette smoking Difference between Risk and Uncertainty Risk Uncertainty Possibility of losing or winning It is a situation where future events are something is known not known Chances of outcomes are known Chances of outcomes are not known It can be controllable Uncontrollable Anil Kumar KY Asst Professor department of Commerce SIMS Page 2 Risk Management Types of Risks ( 6 marks or 14 marks) 1. Financial risk 2. Static and dynamic risk 3. Speculative and pure risk 4. Fundamental and particular risk 5. Market risk 6. Interest rate risk 7. Exchange rate risk 8. Liquidity risk 9. Country risk 10.Operational risk 11.Credit risk 12.Business risk 1. Financial risk Financial risk is a possibility of loss when bond issuer will default by failing to repay principle amount and interest in a timely manner. 2. Static and Dynamic risk: Dynamic risks are those risks resulting from changes in the economy such as changes in customer taste and preferences, changes in price level, income and technological changes. Static risks are those risks that would occur even there is no changes in economy. If we hold customer taste, income level and technology some individuals still suffered financial loss. 3. Speculative and pure risk Speculative risk refers to a situation where there is possibility of loss and also a possibility of Gain (profit). Gambling is a good example of speculative risk. Anil Kumar KY Asst Professor department of Commerce SIMS Page 3 Risk Management Pure risk is a situation that involves only the possibility of loss OR no loss. Example: possibility of loss surrounding the ownership of vehicles. The person who buys a vehicle immediately faces the possibility that something may happened and damage or destroy the vehicle. At last the final result will be loss or no loss. 4. Fundamental and particular risk: The fundamental risk is one that affects the entire economy or large number of persons or group within community. It involves losses that are impersonal in origin. Example : cyclical unemployment, war, earth quake, terrorism… Particular risk involves losses that arises out of individual events and it affects only a particular individual and not the entire economy. Example: burning of House 5. Market risk: Market risk is a risk of loss resulting from fluctuations in the market prices of shares or securities or commodities. 6. Interest rate risk: Interest rate risk arises due to variability in the interest rates from time to time. The fluctuation in the interest rate is caused by the changes in government monitory policy. 7. Exchange rate risk: Exchange rate risk is a risk that arises due to changes in Exchange rates. In other words it is form of risk that arises from changes in the price of one country currency against another country currency. 8. Liquidity risk: Liquidity risk is the risk that arises when a company or bank unable to meet its short term financial obligations. Liquidity risk is arises due to inability to convert a security or asset into cash. Anil Kumar KY Asst Professor department of Commerce SIMS Page 4 Risk Management 9. Country risk: Country risk arises from an adverse change in the financial condition of a country or political condition of a country in which a business operates. 10. Operational risk: Operational risk is define has the risk of loss resulting from inadequate or failure of internal process, people and system or from external events. 11.Credit risk: Credit risk is the risk of loss due to debtors non payment of loan or other line of credits either principal amount or interest amount or both. 12.Business risk: The term business risk refers to the possibility of inadequate profits or lower profits or experience a loss rather than making profit due to uncertainties. Example: changes in customer taste & preference, strikes, lockout, increased competition, changes in govt policy etc… Various means of Managing or Handling Risks (6 marks) 1. Risk avoidance ( elimination of risk) 2. Risk reduction ( mitigating risk ) 3. Risk transfer (insuring against risk) 4. Risk retention ( accepting risk ) 5. Non insurance transfer 1. Risk avoidance Risk avoidance is completely avoiding the activity that posses a potential risk. By avoiding risk we are also avoiding a possibility of gain. Because gain or profit will arises after taking a risk. Example: 1. investors can avoid the risk of loss in stock market by not buying stocks. 2. Divorce can be avoided by not marrying. 2. Risk reduction: Anil Kumar KY Asst Professor department of Commerce SIMS Page 5 Risk Management Risk reduction is reducing the possibility of loss, by taking the precautionary measures we can reduce the possibility of loss. Example: installing a security alarms we can reduce the possibility of theft, wearing seat belts or helmets we can reduce the possibility of accidents. 3. Risk transfer: Insurance policies are another methods to manage risks. By taking insurance policy the risk of loss can be transferred from insured person to insurance company. Example: by taking a fire insurance policy the house owner can transfer the risk of loss by fire to insurance company. 4. Risk retention: Risk retention involves accepting the risk when risk is not avoided or reduced or transferred then it is retained. Risk retention is accepting the risk because risk is unknown Example: smoking cigarette is considered a form of risk retention, since many people smoke without knowing the many risk of diseases. 5. Non insurance transfers: a. Contract: A common way of transfer risk by contract, by purchasing the warranty extensions the risk of manufacturing defects transferred from customers to manufacturers. b. Hedging: reducing the risk c. Diversification of investments: Instead of investing all funds in one security, invest in different securities. Risk management (2 mark compulsory question) Risk management refers to the practice of identifying potential risks in advance, analyzing them and taking precautionary steps to reduce the risk. Risk management is the identifying, analysis, assessment, control and avoidance, minimization or elimination of unacceptable risks. An organization may use risk avoidance, risk reduction, risk transfer, risk retention or any other strategies to manage the risks Anil Kumar KY Asst Professor department of Commerce SIMS Page 6 Risk Management Process of Risk management or steps in risk management OR Corporate Risk Management Process (14 mark compulsory question) 1. Establishing the context 2. Risk identification 3. Risk analysis 4. Risk evaluation 5. Risk treatment 6. Monitor and review 7. Communication and consult Anil Kumar KY Asst Professor department of Commerce SIMS Page 7 Risk Management 1. Establishing the context: The purpose of this stage is to understand the risk environment in the organization that means to understand the internal and external environment of the organization. Establishing the context means all possible risk are identified and the possible solutions are analysis thoroughly. Various strategies are discussed and decisions will be made for dealing with the risks. The methods of analysis the organization environment are SWOT analysis (strength, weakness, opportunities and threats) and PEST analysis (political, economic, societal and technological) Standard Australia and standard newzeland provides a 5 step process to assist with establishing the context: a. The external context b. The internal context c. Risk management context d. Develop risk evaluation criteria e. Define the structure of risk analysis\ 2. Risk identification: Once the context has been established successfully, the next step is identification of potential threats or risks, this step reveals and determines the possibility of risks which are highly occurring and other risks which are occur very frequently. 3. Risk analysis: Once the risks are identified we should determine level of risk, likelihood (possibility) of risk and consequence (effect) of risk. In this step we should understand the nature of risk to know the effects of risks on organizational goals and objectives. The impact of risk should be considered on the basis of time, equality, benefit and recourses. Anil Kumar KY Asst Professor department of Commerce SIMS Page 8 Risk Management Impact of risk table: 5 CATASTROPHIC : most of the objectives severely affected 4 MAJOR: most of the objectives threatened 3 MODERATE : some objectives affected 2 MINOR: with some effort objectives can be achieved 1 NEGLIGIBLE: very small impact Likelihood of the risk table: 5 ALMOST CERTAIN –occur several times 4 LIKELY – arise once in a year 3 POSSIBLE – arise over a 5 years 2 UNLIKELY – arise over a 5 to 10 years 1 RARE – unlikely but not impossible, over a 10 year period 4. Risk evaluation: This step is deciding whether risks are acceptable or unacceptable or need treatment. The acceptable or unacceptable risk is based on “risk appetite” (the amount of risk they are willing to take). 5. Risk treatment: After analyzing the risk we should determine whether the risk needs treatment or not. Usually an unacceptable risk requires treatment. The treatment of risks includes: a. Risk avoidance b. Risk reduction c. Risk transfer d. Risk retention 6. Monitor and review: Monitor and review is an essential and integral steps in the risk management process. Risks needs to be monitored to ensure the changing environment does not alter risk priorities. Anil Kumar KY Asst Professor department of Commerce SIMS Page 9 Risk Management 7. Communication and consult: Communication and consult aim to identify who should be involved in the assessment of risk ( identification of risk, analysis of risks, evaluation of risks) and who will be involved in the treatment, monitor and review of risks. Importance or benefits of risk management: 1. Effective utilization of resources 2. Enables decision making: regarding accepting or non accepting risk and treatment of risks 3. Helps to avoid reduce and prevent risks 4. Increases the possibility of risks 5. Performance monitoring 6. Helps to identification of possible risks or threats 7. Helps to reduce the effects of risks 8. Reducing the risk creating greater confidence in your activities. Objectives of risk management 1. Pre loss objectives 2. Post loss objectives (a) Pre loss objectives: 1. Economy : Which means the firm should prepare for possible losses in the most economical way. This involves an analysis of the cost of insurance premiums and the cost associated with different techniques for handling losses. 2. Reduction of anxiety: Some losses make greater worries for the risk manager and key executives. Risk management enables the organization to reduce the possibilities of risks and worries. Anil Kumar KY Asst Professor department of Commerce SIMS Page 10 Risk Management 3. Meet any legal obligation: The next objective is to meet legal obligations. For example: the government regulation may require a firm to install safety devices to protect workers from harm & industrial accidents. (b) Post loss objectives: 1. Survival of the firm: Some losses are so extreme that destroys the existence of the organization. Survival means after a loss occurs the ability of a firm to rebuild their operations. 2. Continuation in operation: After the loss it is important for the companies to continue their operations for its survival. 3. Stability of earnings: Some losses directly affect the earnings of the company. A risk management technique helps the organization to earn stable incomes even after the loss. 4. Continue growth of the company Risk management helps the organization to grow by developing new product, market and business strategies. Limitations of risk management 1. Complex calculations: Without any automatic tool each and every calculation regarding risk becomes difficult, 2. Unmanaged losses: Losses can be control to the some extent; beyond that level losses cannot be controlled and managed. 3. Depends on external entities: For managing the risk we require information. For getting the information about the external environment of the organization we depend on external entities. Anil Kumar KY Asst Professor department of Commerce SIMS Page 11 Risk Management 4. Difficulty in implementing: Risk management implementation requires long time to gather the information regarding the risk plan and strategies. 5. Potential threats: Potential threats means possible threats which may or may not be occur. 6. Performance: Risk management tools and techniques is understand by only qualified professionals. It is very difficult to understand by common man. 7. Wastage of time: If identification of risks is not done then it will be wastage of time and money. Important questions from I chapter (22 marks) 2 marks: 1. What is risk management? 6 marks : 1. Various means of managing or handling risks 2. Limitation of risk management 3. Objectives of risk management any one 4. Benefits of risk management 5. Types of risks 14 marks 1. Risk management process or steps in Risk management. 2. Types of risks any one Section A (2mark) Section B (6 marks) Section C (14 marks) 1 1 1 Anil Kumar KY Asst Professor department of Commerce SIMS Page 12 Risk Management Chapter 2 Sources of Risk and Exposure 1. Human factors 1. Economic factor 2. Technological factor 2. Natural factor 3. Physical factor 3. Political factor 4. Operational factor Internal sources of risks: 1. Human factors: Human factors are an important cause of internal risk. They may results from strikes and lockouts by trade unions, negligence & dishonesty of employees, accidents or death in industry, incompetence Of the employees etc…,. 2. Technological factors: Technological factors are important sources of Risk. A sudden change in technology will results in to a huge loss & other business risk to the organization. For example: - if there is some technological advancement which results in Products of higher quality, then a firm which is using the traditional Technique of production may face the risk of facing the market for its poor Quality products. Anil Kumar KY Asst Professor department of Commerce SIMS Page 13 Risk Management 3. Physical factors: These are the factors which results in loss or damage to the property of the firm. They include the failure of machinery & equipment or theft in the industry, damages in transit of goods etc…,. 4. Operational factors: Operational factor is the risk of monitory losses resulting from inadequate or failed internal process, human error & system failure. Ex:- fraud, lack of supervision , technology failure , inadequate document keeping. External sources of risks: 1. Economic factor: These are the most important causes of external risk. They results from changes in economic condition like changes in customers taste & preferences , price fluctuations , changes in the demand for product, changes in income , increased competition etc…,. 2. Natural factors: These are the unforeseen natural calamities over which a person has a very little or no control. They results from events like earthquake, flood, cyclone, lightening etc…, Ex:-Gujarat earthquake caused irreparable damage not only to the business, but also adversely affected the whole economy of the state. 3. Political factors: The risk of loss caused from changes in the political condition of the country like changes in government, changes in government policies, communal violence, civil war, hospitalities with neighboring countries. Anil Kumar KY Asst Professor department of Commerce SIMS Page 14 Risk Management Sources of Risk in Insurance 1) Proposal form 2) Medical examination report 3) Insurance agents report 4) Inspection report 5) Private friends report 6) Neighbors’ and business associates 7) Attending physicians. Types of Risk Exposure 1) Personnel risk exposure: - people or personnel loss exposure includes the possibility of loss to a business firm from death, sickness, disability, unemployment resignation & retirement of the employees. Personnel loss exposure affects the income earning power of an individual. 2) Property loss exposure: - property owners face the risk of having their property stolen, damage, or destroyed by various causes. A property may suffer direct loss, indirect loss. A) Direct loss: - It is a loss when the property is directly damaged, destroyed with the peril. Ex: - Building destroyed by fire or jewels stolen from safety locker. B) Indirect loss: - It is a loss that arises because of prior occurrence of another loss.ex:- Expenditure incurred rebuilding & replacement. 3) Liability loss exposure: - It includes causing damage, injury to others. Ex: - If you injured your neighbor or damage his property, the law would impose fines on you. 4) Catastrophic loss exposure: - A loss that is catastrophic a larger number of exposures in a single location are considered as catastrophic loss. Catastrophic loss exposure affects the whole economy. Anil Kumar KY Asst Professor department of Commerce SIMS Page 15 Risk Management 5) Accidental loss exposure: - It refers to pure risk that arises due to accidental, un intentional & not due to manmade. Pure and speculative risks (14 marks) Pure risk is a situation that involves only the possibility of loss OR no loss. Example: possibility of loss surrounding the ownership of vehicles. The person who buys a vehicle immediately faces the possibility that something may happened and damage or destroy the vehicle. At last the final result will be loss or no loss. Different Types of Pure Risk 1) Personnel risk: - It refers to risk of loss to a business firm due to pre matured death, old age, sickness or poor health, unemployment. Personnel risk effects income earning power of individual, personnel risk can be classified in to 4 types; a) Risk of pre mature death: - It is generally believed that the average life span of human beings is 70 years, anybody who dies before attaining age of 70 years could be regarded as per mature death. Pre mature death usually brings great financial & economic in security to dependents. b) Risk of old age: - Risk of old age is possibility of not getting sufficient income to meet financial needs in old age after retirement. Reasons for old age risk is not making savings & not able to acquire financial assets. c) Risk of poor health: - A sudden & unexpected illness can result into lower & high medical bills to overcome have adequate personnel accident & health. d) Risk of unemployment: - Unemployment is a situation where a person who is willing to work &he is looking for work to do, cannot find work to do. Unemployment always brings financial insecurity to people. Anil Kumar KY Asst Professor department of Commerce SIMS Page 16 Risk Management 2) Property risk: - property owners face the risk of having their property stolen, damage, or destroyed by various causes. A property may suffer direct loss, indirect loss. A) Direct loss: - It is a loss when the property is directly damaged, destroyed with the peril. Ex: - Building destroyed by fire or jewels stolen from safety locker. B) Indirect loss: - It is a loss that arises because of prior occurrence of another loss.ex:- Expenditure incurred rebuilding & replacement. 3) Liability risk: - It includes causing damage, injury to others. Ex: - If you injured your neighbor or damage his property, the law would impose fines on you. Speculative risk refers to a situation where there is possibility of loss and also a possibility of Gain (profit). Ex: - if you buys shares in a company, you would make a gain if the price of shares raises & you would sustain losses if the price of shares decreases or falls. Gambling is the good example for speculative risk. Differences between pure and speculative risk Pure risk Speculative risk 1. It is a situation where there is a It is a situation where there is possibility possibility of loss or no loss. of loss as well as the possibility of gain. 2. It results in no loss or loss. It results in gain & loss. 3. It can be predictable It cannot be predictable 4. It can be insurable. It cannot be insurable. 5. It is not accepted. It is accepted. 6. Society will not benefit from it Society may benefit from it 7. An example of pure risk is the Gambling is the good example of risk of becoming disabled as a speculative risk result of illness or injury. 8. Pure risk occur by chance not Speculative risk is occur by choice of the by choice person. Anil Kumar KY Asst Professor department of Commerce SIMS Page 17 Risk Management Static and dynamic risks (14 marks) Dynamic risks are those risks resulting from changes in the economy such as changes in customer taste and preferences, changes in price level, income and technological changes. Static risks are those risks that would occur even there is no change in economy. If we hold customer taste, income level and technology some individuals still suffered financial loss. Differences between static and dynamic risk Static risk dynamic risk 1. They are present in an They are present in changing Economy. Unchanging economy. 2. They are easily predictable They are not easily predictable. 3. It affect only individuals or It affects a large number of individuals. Very few of individuals 4. They are pure risk They are speculative risk. 5. Society will not benefit from it Society may benefit from it 6. Static risks are insurable Dynamic risks are not insurable Acceptable & Non-Acceptable Risk:- Acceptable risk refers to the level of human & property injury or loss from an industrial process that is consider to be tolerable by an individual , house hold , group, organization , community , state or nation in view of the social , political & economic caused benefit analysis. ex:-The risk of flooding can be acceptable once every 500 years but it is not acceptable in every 10 years. Non-acceptable risk is the level of human injury & property damage is not tolerable by individual, group, society, state or nation. Anil Kumar KY Asst Professor department of Commerce SIMS Page 18 Risk Management Fundamental and particular risk: The fundamental risk is one that affects the entire economy or large number of persons or group within community. It involves losses that are impersonal in origin. Example: cyclical unemployment, war, earth quake, terrorism… Particular risk involves losses that arise out of individual events and it affects only a particular individual and not the entire economy. Example: burning of House Various Elements of Cost Of Risk (6 marks) Meaning of cost of risk:- It is the total cost associated with risk management function. In other words, cost of risk is the total cost of insurance premiums retained losses and internal or external risk control cost. Elements of Cost of Risk 1) Insurance premium: - it includes the amount of fund spend on insurance coverage & broker commission. 2) Retained loss: - It is the amount of money that a firm spends out of pocket for loss incurred. 3) Cost of incurred to protect employees from injuries: cost of installing safety devices. 4) Cost incurred with professional firms 5) Productivity loss due to injuries. Components of Cost of Risk 1. Expected losses- It includes both direct losses and indirect losses. 2. Cost of loss control- it is the cost associated with precautionary measures Anil Kumar KY Asst Professor department of Commerce SIMS Page 19 Risk Management 3. Cost of loss financing – cost incurred for taking insurance policy, premiums, brokerage, commission etc… 4. Cost of internal risk reducing- cost incurred for diversification of investments. 5. Cost of residual uncertainty. Enterprise Risk Management It includes the methods & process used by organization to manage risk & seize opportunities associated with rapidly changing business environment. Implementation of Enterprise Risk Management Programme 1. Goals of ERM programme: - ERM is a approach to manage risk related to the achievement of organizational objectives. 2. Typical risk function:- a) Strategic plan: - It identifies external threads & identifies. b) Marketing: - To understand the requirement of targeted customers. c) Compliance & ethics. d) Accounting compliance. e) Law department. f) Insurance. g) Operations management. h) Credit. Anil Kumar KY Asst Professor department of Commerce SIMS Page 20 Risk Management Challenges in ERM Implementation 1. Establish in a common risk language. 2. Describing entities risk appetite (risk it will take & risk it will not take). 3. Implementing risk rating methodology. 4. Establishing ownership for risk responsibilities. 5. Developing consolidated reporting for various stake holders. 6. Monitoring the results of actions. Important questions from II chapter (22 marks) 2 marks: One question from sources of risk, types of risk exposures 6 marks : 1. Various elements of total cost of risk * * * 2. Sources of risk exposure and types of risk exposure any one 3. Difference b/w static and dynamic risk 4. Acceptable and non acceptable risk 14marks 1. pure risk and speculative risk ( meaning, types, differences)* * * any 1 2. Sources of risk exposure and types of risk exposure * * * Section A (2mark) Section B (6 marks) Section C (14 marks) 1 1 1 Anil Kumar KY Asst Professor department of Commerce SIMS Page 21 Risk Management Chapter 3 Corporate Risk Management Meaning of CRM: Corporate risk management refers to all the techniques and methods that a company uses to minimize financial loss. Corporate risk management also relates to external threats to a corporation, such as the fluctuations in the financial market that affect its financial assets. Importance or Objectives of Corporate Risk Management (CRM) 1. Elimination of uncertainty: Identifying the risk and managing the risk before they affect the business. 2. Helps to control both internal and external risks: External risks are those risk which not in the control of management. CRM helps to control both internal and external risks. 3. helps to define its objectives for future: Without taking the risk into consideration it is difficult for the companies to define its objectives for future. 4. Helps to identify, analysis and evaluating the risks. 5. To know the effects of uncertainty on the organizational objectives Guidelines and Tools of Risk Management (14 marks compulsory question) Guidelines for risk management 1. Identify and assess risks 2. Know the number 3. Risks are interrelated 4. Continually reassess risks 5. Commit adequate resources 6. Review the cost of risk mitigation 7. Reduce exposure 8. Assess the risk/return ratio Anil Kumar KY Asst Professor department of Commerce SIMS Page 22 Risk Management 9. Monitor for quantum shifts in risk levels 10.Create a risk aware culture 1. Identify and assess risks: Risk is everywhere, the success of the business is depends upon identifying and managing the risk before it affects potential opportunities and returns of the company. The types of risks are faced by the business is varied from one business to another. The first guidelines to manage the risk are identification of possible risks that affects the company. Risk categories includes: market risk, credit risk, legal risk, political risk, reputational risk etc… 2. Know the numbers: Risk register is used to identify and rank the risk on the basis of magnitude of the risk. The effective risk management strategies typically depend on the quantification of risks. Spend the time and money to get the tools and techniques of risk management in order to manage the risks. 3. Risks are interrelated: Some of the risks are interrelated, while identifying the risk first we should know the interrelated risk for mitigating (reducing) the risks. Example: exposure to credit risk may also affect market price risk. Operational risk such as fraud may create legal risk and reputational risks. Identifying the interrelated risk is one of the best way to managing the risk. 4. Continually reassess risks: Things changes and risk also changes. Changes in market condition, changes in the financial condition of the counter party, changes in physical environment, changes in political environment also cause the changes in the risks. So we should assess the risk on continuation basis in order to update the information. Anil Kumar KY Asst Professor department of Commerce SIMS Page 23 Risk Management 5. Commit adequate resources: Risk management tools and techniques are usually not cheap, before handling the risks the company should ensure to have adequate financial resources. Otherwise it will cause the failure of business. 6. Review the cost of risk mitigation: Transferring the risk through hedging and insurance is effective and advisable risk management technique but risk mitigation (reduction) strategies is largely depends upon the costs. Money spending on risk management tools and techniques should not exceed the benefits derived from the risk management. 7. Reduce exposure: Risk is arise from exposure. The commonly accepted definition of risk is exposure to uncertainty. Reduce the exposure means reduce the risk. Risk awareness in business processes and commercial activities can lead the opportunities to reduce the current and future exposures. 8. Assess the risk/return Ratio: The company to get the high return with lower risk it is one of the guidelines for managing the risks in business. 9. Monitor for quantum shifts in risk levels Monitor and review is an essential and integral step in the risk management process. Risks needs to be monitored to ensure the changing environment does not alter risk priorities. 10. Create risk aware culture: Educate the organization in practical aspects of risk management and that especially includes the most senior business executives and the corporate board of directors. Training and building the awareness in business operations is one of the ways for managing the risks. Anil Kumar KY Asst Professor department of Commerce SIMS Page 24 Risk Management Tools of Risk Management 1. Risk probability and impact assessment: The company should assess the possibility of risks and its effects on business operation are one of the tools for managing the risks. Impact of risk table: 5 CATASTROPHIC : most of the objectives severely affected 4 MAJOR: most of the objectives threatened 3 MODERATE : some objectives affected 2 MINOR: with some effort objectives can be achieved 1 NEGLIGIBLE: very small impact 2. Probability and impact matrix: Rating the risks for further analysis using a probability and impact matrix is another tool for managing the risk. Possibility of the risk table: 5 ALMOST CERTAIN –occur several times 4 LIKELY – arise once in a year 3 POSSIBLE – arise over a 5 years 2 UNLIKELY – arise over a 5 to 10 years 1 RARE – unlikely but not impossible, over a 10 year period 3. Risk categorization: Grouping the risk based on their impact or effects is one of the tools for managing the risks. 4. Risk urgency assessment: 5. Expert judgment: Individuals who have experience with similar projects may use their judgment through interviews or risk facilitation workshops. Anil Kumar KY Asst Professor department of Commerce SIMS Page 25 Risk Management Approaches and processes of Corporate Risk Management (14 marks) Approaches of CRM 1. Top down multi pass approach: This approach can be used from the outset of the project. It is based on the principles that: a. The person should understand the overall risk of the project risks, how to quantify and how to manage. b. The risk management process should address the key risk questions. c. Key risk questions may change from one stage of the risk management process to another stage of risk management process. d. Risk management techniques should select to address the key risk questions. e. The tools and techniques can be used to find a solution to project. Advantages: 1. Can be used from the project commencement 2. Efficient identification of key risks Techniques: 1. NPV risk modeling 2. Decision tree 2. Quantitative risk based forecasting: This approach involves the implication of a project plans. It is used to find out project cost and completion dates. Advantages: 1. Used to identify overall risk of the project 2. Used to find out project cost and completion dates. Techniques: 1. Monte carlo cost risk analysis 2. Product risk modeling Anil Kumar KY Asst Professor department of Commerce SIMS Page 26  Risk Management 3. Risk register This is the common practice approach of using a single pass approach to identifying a list of risks and entering them into a risk register for assessment and risk response planning. Risks are reviewed on a regular basis to update the risk information and verify that risk responses are implemented. Advantages: 1. Required less experience 2. When implemented well, fasters a good team culture Techniques: 1. Risk register 2. Probability – impact matrix Process of CRM (Refer process of risk management page no 07) Asset and liability management(ALM) Asset and liability management can define a mechanism to address the risk faced by bank or an organization due to mismatch between assets and liabilities, either due to liquidity or changes on interest rates. Asset and liability management Asset management liability management How liquid are the assets of the company How easily can the company generate loans from market? Anil Kumar KY Asst Professor department of Commerce SIMS Page 27 Risk Management Objectives or Importance of ALM 1. Liquidity risk management 2. Interest rate risk management 3. Currency risk management 4. Funding and capital management 5. Profit planning and growth projection Management of business risks, currency risks or Interest rate risk Business risk The term business risk refers to the possibility of inadequate profits or lower profits or experience a loss rather than making profit due to uncertainties. Example: changes in customer taste & preference, strikes, lockout, increased competition, changes in govt policy etc… Types of business risk: 1. Strategic risk – risk of loss arising from various strategies used by the company 2. Compliance risk – risk of loss arising from rules and regulations followed by the company. 3. Financial risk 4. Operational risk: risk of loss arising from inadequate of failure of people system and operations. 5. Reputational risk: loss of company reputation or good name by failure of product or negative publicity. Management of business risk 1. Evaluate risk factors and make contingency plan 2. Determine insurance needs 3. Risk management plan 4. Train employees 5. Update plans Anil Kumar KY Asst Professor department of Commerce SIMS Page 28 Risk Management Currency risk Exchange rate risk or currency risk is a risk that arises due to changes in Exchange rates. In other words it is form of risk that arises from changes in the price of one country currency against another country currency. Management of currency risk: The best way for managing currency risk is hedging The following are the steps to hedge against currency risk: 1. Identify ETF ( exchange traded funds) – different country’s currency providers 2. Determine direction – deciding the currency of which country 3. Calculate amount 4. Manage the trade Interest rate risk Interest rate risk arises due to variability in the interest rates from time to time. The fluctuation in the interest rate is caused by the changes in government monitory policy. Riskiness of return  Variability in the return of a security is caused by both internal and external factors.  Variation in Return on asset is affected by both systematic and unsystematic risk  Systematic risk is arises from external factors like economic and political instability, economic recession, macro policy of the government  Unsystematic risk is arises from internal factors. Like raw material scarcity, labour strike etc…  Low level of risk always associate with low return  High level of risks always associated with high return Anil Kumar KY Asst Professor department of Commerce SIMS Page 29 Risk Management  The risk return trade off is the balance between the desire for the lowest risk and highest return.  In the below figure: lower end of the scale represents low risk low return  Upper end of the scale represents high risk high return Important questions from III chapter (22 marks) 2marks: 1. What is corporate risk management? 6 marks : 2. Managing of business risk currency risk and interest rate risk 3. Asset liability management any 1 4. Riskiness of returns 14 marks 3. Guidelines and tools for risk management. Any 1 4. Corporate risk management approaches and process Section A (2mark) Section B (6 marks) Section C (14 marks) 1 1 1 Anil Kumar KY Asst Professor department of Commerce SIMS Page 30 Risk Management Chapter 4 Derivatives as Risk Management Tools Derivatives: Derivatives is a contract between two parties which derives its values or price from an underline asset. The most common underlying asset includes stocks, bonds, commodities, interest rate, currencies etc… Or Derivates refers to a security whose price is derived from one or more underlying asset. Definition: According to the securities contract regulations act 1996 under sec 2(AC) derivatives refer to “a contract which drives its value from the price of an underlying securities. Characteristics of derivatives: 1. The value of derivatives depends on price of underlying asset. 2. All the transaction in derivatives takes place in future specific dates. 3. The contract have transacted through a recognized exchange or through a clearing house. 4. It requires reliable initial investment. 5. Derivatives has low transaction cost. 6. It is a hedging derivates which reduced the risk involved in transactions. Participants in derivates market: Those who trade in derivates transaction classified into 3 categories: 1. Hedges 2. Arbitrageurs 3. Speculators Anil Kumar KY Asst Professor department of Commerce SIMS Page 31 Risk Management Hedgers Arbitragers Speculators 1. Hedgers: Hedgers are those trades who wish to elimination the price risk associated with the underlying asset being traded, they are not in the derivatives market to mark profit Ex: An investors holding share of ITC co. fearing that the share price will decrease in future. He protected himself by selling the share immediately. 2. Arbitrageurs Arbitrageurs are traders who simultaneously purchase of securities/asset in one market at lower price and sold same security in another market at a higher price. Arbitrageurs make profit from price differential existing in two markets. 3. Speculators: Speculators are those classes of investors who willing take price risk making profit from price changes in the underlying asst. Speculators investing those businesses in which they are expertise. Types of derivatives: 1. Forward 2. Future 3. Options 4. Swaps Anil Kumar KY Asst Professor department of Commerce SIMS Page 32 Risk Management Forward contract: Forward contract is a non –standardized contract b/w two parties to buy or sell an asset at a specified future time at a price agreed upon today. The forward contract transactions have settled by delivery or cash settlement. Features/characteristics of forward: 1. Counter party risk: In forward contract any of the party refuses to buy or sell a particular commodity then opposite party exposed to counter party risk. Ex: trade takes place b/w Mr. A (Buyer) & Mr. B (Seller) the pre specified delivery price rs.100 per kg and maturity is one month after one month the commodity is trading at rs. 120 per kg Mr. A would gain rs. 20 and Mr. B suffer a loss of rs.20. incase B defaults (refuse to sell at rs.100) Mr.A exposed to counter party risk. 2. Underlying asset: In forward contract underlying asst could be stocks, bonds, commoidities etc… 3. Flexibility: It offers flexibility to design the contract in terms of price, quantity, quality. 4. Settlement: It can settle by delivery or cash settlement. 5. Contract price: The contract price is generally not available in public domain. Advantages of forward contract 1. Hedge risk: In forward contract price movements can be expected and it is possible to lock today’s price. 2. No margin requires: It does not require any margin 3. No initial cost: In forward contract margin are have paid so it dose not involve initial cost 4. Negotiability: The terms and conditions of forward contract are negotiable. It can be return for any amount and term. Anil Kumar KY Asst Professor department of Commerce SIMS Page 33 Risk Management Disadvantages: 1. Counter party risk 2. Not traded in stock exchange 3. No transparency in prices Future contract: It is an agreement b/w two party’s i.e.; a buyer and seller to buy or sell a particular commodity at a future date at a specified price. Future contract have traded on recognized stock exchanges there have traded in 3 primary areas. 1. Agriculture commodities 2. Methods or petroleum 3. Financial asset such as share, currencies, interest rates. Characteristics of future contract: 1. Highly standardized: In terms of price, quality, quantity, place and time of delivery of commodity. 2. Future are traded only in organized only in organized exchanges 3. Margin payment (future trading requires margin payment by both the parties in order to eliminate counter party risk). 4. Fluctuation in the prices: Prices of contract changes every day. 5. No counter party risk: In future contract margin amount is collected. 6. Transaction cost: Future contract traded in recognized stock exchanges so it incurred brokerage fees, commission. 7. Mark to market(MTM): In future contract assets are valued at recent market price. Anil Kumar KY Asst Professor department of Commerce SIMS Page 34 Risk Management Advantages: 1. Hedge risk 2. Guarantees performance of contract 3. No counter party risk (bcz margin money is required in future contract). Disadvantages: 1. It incurred transaction cost. 2. It offers only a partial hedge. Options: Option is an agreement that gives the owner the right to buy or sell a specified asset at a specified price but not obligation. The options are basically classified into 2 types: 1. Call option: A call option gives the buyer the right to buy an asset at certain for a price but not the obligation. 2. Put option: A put option gives the seller the right to sell an asset at a certain date for a certain price but not the obligation. Features of options: 1. Premium: To acquire the right of an option the holder should pay premium on option price to opposite party. 2. Right to buy or sell: In option contract the holder has right to buy or sell the asset at a certain price. 3. No counter party risk: In options contract there is no counter party risk because of premiums. 4. The exercise price is fixed. Advantages of options: 1. Limited risk: In option contract the risk is limit to extent of premiums. Anil Kumar KY Asst Professor department of Commerce SIMS Page 35 Risk Management 2. It protect the investors: Option allows investors to protect their position against price fluctuations. 3. Right to exercise: In option contract holder get the right to buy or sell a particular asset at a certain price Disadvantages: 1. Options are very complex and require a great observation and maintenance. 2. Some option positions has unlimited risk 3. Options are not available for all stocks. Types of options 1. Call option: A call option gives the buyer the right to buy an asset at certain for a price but not the obligation. 2. Put option: A put option gives the seller the right to sell an asset at a certain date for a certain price but not the obligation. 3. American option: American options are options that can be expired before the expiration date at any time. 4. European option: European options are options that can be expired only on the expiration date. 5. Index options: It refers an option which has both the feature of American and European option. Index options contracts are cash settled. 6. Vanilla option and exotic option: Vanilla option is a simple or well understood option ex: European and American options. Exotic option is more complex or less easily understood options. Ex: Asian options, look back options 7. Stock option: Stock option gives an employee the right to buy a stock at a discounted rate. Anil Kumar KY Asst Professor department of Commerce SIMS Page 36 Risk Management 8. Exchange traded option: Exchange traded options refers to those options which are settled through a clearing house. Swaps: A swap is an agreement between two parties to exchange future cash flows for a fixed period of time. Types of swap 1. Interest rate swap: It involves swapping the interest related cash flows between the parties in the same currency. 2. Currency swaps: In currency swaps one currency is exchanges for another currency on specified terms and conditions for specified time. Features of swap: 1. Basically a forward 2. Double coincidence of wants 3. Necessity of an intermediary 4. Long term settlement Advantages: 1. Hedging risk 2. Tool to correct asset liability mismatch 3. Additional income to financial intermediary 4. No premium paid to enter into swap. Disadvantages: 1. It is difficult to identify a counter party to take the opposite side of the transaction 2. Termination of swap contract requires mutual consent of both the parties. 3. Early terminations of swap before its maturity incur brokerage cost. 4. Secondary market for swap is still not fully developed- because trading in secondary market requires standardized documentation Anil Kumar KY Asst Professor department of Commerce SIMS Page 37 Risk Management Difference between forward contract and future contract (6 marks) Basis Forward Future Meaning Forward contract is a non – It is an agreement b/w two party’s standardized contract b/w i.e.; a buyer and seller to buy or sell two parties to buy or sell an a particular commodity at a future asset at a specified future date at a specified price. time at a price agreed upon today Trading Forward contracts are over Futures traded through stock the counter contracts (OTC) exchanges Counter There is counter party risk No counter party risk party risk Margin Margin payment not required Margin payment is required payment Settlement Settled by delivery or cash Most of the contracts are settled by settlement cash MTM Mark to market is not done Mark to market is done Prices Prices remain fixed until Prices fluctuate everyday maturity Standardized Non standardized contracts Highly standardized Transparency No transparency of prices bcz Transparency in prices of prices contract price is not available in public domain Initial / No initial cost Initial cost is required transaction cost Terminologies used in derivatives 1. Long position ( buyer): The party or person who agrees to buy an underlying asset on a future date is said to have a long position. 2. Short position ( seller): The person who agrees to sell an underlying asset on a future date is said to have short position. Anil Kumar KY Asst Professor department of Commerce SIMS Page 38 Risk Management 3. Hedging: It is the process of reducing the exposure of risk 4. Margin : The amount deposited in the margin account at the time of entering into a contract. 5. Mark to market :( MTM) It refers to valuing the asset at the recent market price. Or in the future market at the end of the each trading day the margin account is adjusted to reflect investors gain or loss depending on the future closing price. 6. LIBOR ( London interbank offered rate): It is an interest rate at which banks can borrow from other banks in the London interbank offered rates. 7. Over the counter (OTC): In OTC derivatives contracts are traded directly between two parties without going through an exchange or any other intermediary. Importance of derivatives 1. Hedging : We can reduce the risk, by discovery of future price or current price of the commodity. 2. Price discovery: A derivative helps to discover future and current price movements of commodities. 3. Management of risks: Risks can be reduced by making different strategies like hedging, arbitragers, etc… 4. Increased in the volume of transactions: For entering in to a derivative contract margin amount is required there is no need to settle the full amount at the time of entering into contract. It increases the volume of transactions. Anil Kumar KY Asst Professor department of Commerce SIMS Page 39 Risk Management 5. Speculation &arbitrage: Derivatives can be use to acquire risk rather than reduce risk. Some individuals and institutions will enter into a derivative contract for speculation purpose. 6. Liquidity and reduce transaction cost: As we know that in derivative contracts no immediate full amount of the transaction is required, since most of them based on margin trading. As a result large number of traders, speculators operates in such market. So derivative trading enhances liquidity. 7. Gearing value ( leverage): Small movement in the underlying value can cause large difference in the value of the derivatives. 8. Increase savings and investments: 9. Price stabilization function: By discovering future and current prices 10.It requires negligible initial investment for trading. 11.Develop the complete market 12.Encourage competition. Classification of derivatives 1. Based on linear and non linear Linear derivatives: those derivatives whose value depends linearly on the underlying value ex: forward, future, swap Non linear: those derivatives whose value is not depends linearly on the underlying value ex: options Anil Kumar KY Asst Professor department of Commerce SIMS Page 40 Risk Management 2. Based on financial and non financial: Financial derivatives: financial derivatives are those derivatives which are financial in nature. Non financial: non financial derivatives are those derivatives which are not financial in nature. 3. On the basis of market where they trade OTC: In OTC, derivative contracts are traded directly between two parties without going to an exchange or any other intermediary. Ex: forward Exchange traded derivatives: derivative contracts traded only in recognized stock exchanges ex; future contracts Derivatives as risk management tools There are 3 different types of risk tool, two have identified by their approach i.e. capital asset pricing model(CAPM), and risk analysis of alternative (AOA) 1. Capital asset pricing model (CAPM) 2. Risk analysis of alternative (AOA) 3. Probabilistic risk assessment (PRA) 1. Capital asset pricing model : The capital asset pricing model is a model that describes the relationship between systematic risk and expected return for asset particularly stock. CAPM is widely used in finance are for: a. Pricing of risky securities b. Generating expected return on assets c. Calculating cost of capital The formula for calculating the expected return of assets is as follows: Ra = Rp + β ( Rm –Rf) Anil Kumar KY Asst Professor department of Commerce SIMS Page 41 Risk Management Where Ra = return on asset Rf = risk free return Rm = expected market return Β = beta of security The CAPM says that the expected return of asset = risk free return + risk premium. If expected return does not meet the required return then the investment should not be undertaken. Example of CAPM: Using the CAPM and following assumption we can compute the expected return for assets. The risk free rate 2% beta of a stock is 2 and the expected market return over the period is 10%. So it means that the market risk premium is 8% (10%-2%) i.e. after subtracting the risk free rate from expected market return. Ra = Rp + β ( Rm –Rf) = 2% + 2(10% -2%) = 2% + 2(8%) = 2% + 16% = 18% (expected return) Anil Kumar KY Asst Professor department of Commerce SIMS Page 42 Risk Management Expected return SML – security market line Rm = 10% Rf= 2% 0 1 2 beta 2. Risk analysis alternatives Risk AOA is a predictive tool used to discriminate between proposals, choices or alternatives by expressing risk for each as a single number. The results are made between alternatives based on their cost schedule time and risk. 3. Probabilistic Risk Assessment (PRA) PRA is a systematic and comprehensive methodology to evaluate risk associated with complex engineered technological entity. Ex: air lines or a nuclear power plant. The PRA risk is characterized by two quantities. 1. The magnitude of the possible adverse consequence: Expressed numerically ex: no of people hurt or kill 2. Possibility of occurrence of each consequences: Expressed in their number of occurrences Anil Kumar KY Asst Professor department of Commerce SIMS Page 43 Risk Management PRA usually answer 3 basic questions: 1. What can go wrong? 2. How likely it is? 3. What are its consequences? Techniques of PRA 1. Risk register 2. Risk radar enterprise 3. Simple risk based on NIST 800-30. Important questions from IVchapter (24 marks) 2marks: 1. Hedging 2. Forward, future, swap, option 3. Call option, put option, currency swap, interest rate swap 4. Expand OTC, LIBOR, ETF 5. derivatives 6 marks : 6. difference between forward and future any 1 7. participants in derivative contracts 8. types of derivatives ( forward, future, option swap) 14 marks 9. derivatives as risk management tool ( CAPM,AOA,PRA) any 1 10. importance of derivatives 11.Types of derivatives Section A (2mark) Section B (6 marks) Section C (14 marks) 2 1 1 Anil Kumar KY Asst Professor department of Commerce SIMS Page 44 Risk Management Chapter 5 Hedging and options Fundamental concept of hedging and options Hedging: Hedge is a risk reduction technique used to reduce any substantial losses or gains suffered by an individual or an organization. Objectives of hedging: 1. Reduce the risks 2. Helps to increase liquidity in financial markets 3. It limits the loss for an individual. Disadvantages 1. Hedging associated with cost like brokerage, commission 2. It limits the profits for an individual 3. All risks cannot be hedged Concept of hedging An investor holding shares of ITC Company fearing that the shares prices will decrease in future, by taking the opposite position means selling the shares immediately an investor can reduce the some extent of loss Options: Option is an agreement that gives the owner the right to buy or sell a specified asset at a specified price but not obligation. The options are basically classified into 2 types: 1. Call option: A call option gives the buyer the right to buy an asset at certain for a price but not the obligation. Anil Kumar KY Asst Professor department of Commerce SIMS Page 45 Risk Management 2. Put option: A put option gives the seller the right to sell an asset at a certain date for a certain price but not the obligation. Concept of call option (buy option) Assume Mr A (Buyer) and Mr B (seller) enters into a contract to buy and sell a particular commodity at Rs. 200 each. Mr. A paid Rs. 50 to Mr B as a premium to get buying rights. On the maturity of the contract that commodity traded at Rs. 400 in the market. Now Mr A has the rights to buy that commodity at Rs, 200 as stated in the contract. And Mr. B has the obligation to sell that commodity to Mr A at Rs. 200. Here the profit for Mr A is Rs 400 – Rs 200 = Rs. 200 – Rs.50( premium paid) = Rs. 150. In case that commodity traded at Rs. 100 in the market, then Mr A is not Going to Exercise that contract. Because Mr.A has right to Buy but not the obligation. And here maximum loss for Mr A is Rs. 50 premium. Concept of put option (sell option) Assume Mr A (Buyer) and Mr B (seller) enters into a contract to buy and sell a particular commodity at Rs. 200 each. Mr. B paid Rs. 50 to Mr A as a premium to get selling rights. On the maturity of the contract that commodity traded at Rs. 100 in the market. Now Mr B has the rights to sell that commodity at Rs, 200 as stated in the contract. And Mr. A has the obligation to Buy that commodity from Mr B at Rs. 200. Here the profit for Mr B is Rs 200 – Rs 100 = Rs. 100 – Rs.50( premium paid) = Rs. 150. Anil Kumar KY Asst Professor department of Commerce SIMS Page 46 Risk Management Fundamental concept of currency swaps and Interest rate swaps Or risk management with Swaps: swaps A swap is an agreement between two parties to exchange future cash flows for a fixed period of time. Types of swap 1. Interest rate swap: It involves swapping the interest related cash flows between the parties in the same currency. 2. Currency swaps: In currency swaps one currency is exchanges for another currency on specified terms and conditions for specified time. Concepts of currency swaps An American company (company A) wants to expand their business in Europe. Simultaneously a European company (company B) is seeking entrance into America. Company A Requires 10000 Euro but it is very difficult for the company to raise 10000 Euro in Europe because cost of borrowing is very high for company A because company A is not well Known in Europe. In the same way company B also facing same problem i.e. company B requires 10000 American dollars. Now company A & B decided to Exchange their currency. Both the companies borrowed funds from their domestic banks. Company A taken 10000 $ at the rate of 4% and company B taken 10000 euro at the rate of 5%. Both company exchanged their currency each other based on terms & condition for certain period of time. 10000 US$ Company A Company B 10000 euro Anil Kumar KY Asst Professor department of Commerce SIMS Page 47 Risk Management Concept of Interest rate swap Assume Mr. Raghu invested 1000000 US $ that pays him floating interest rate i.e. LIBOR + 1%. As LIBOR goes up and down, the payment Raghu receives changes. Mr. manjunath invested 1000000 US $ that pays him fixed interest rate of 4% every month. The payment manjunath receives never changes. Now Raghu decided to get Fixed Income and Manjunath Decided to get Floating Income. Both are decided to exchange their incomes. Under the terms of their contract, Raghu agrees to pay Manjunath LIBOR + 1% and manjunath agrees to pay raghu 4% of fixed Income Raghu LIBOR + 1% Manjunath Fixed 4% Invested 1000000 $ invested 1000000 $ Receives LOBOR+1% receives 4% fixed rate Anil Kumar KY Asst Professor department of Commerce SIMS Page 48 Risk Management Fundamental concept of value at risk (VAR) Value at risk (VaR) is a statistical technique designed to measure the maximum loss that portfolio of asset could suffer over a given time horizon with a specified level of confidence. According to philippe Jorion “ VaR measures the worst expected loss over a given horizon under normal market conditions at a given level of confidence”. Features of VAR 1. it is a measure of risk of loss 2. it controls and monitors the risk 3. it is exclusively used in banks 4. it describes the total risk of investment 5. horizon under normal market conditions. VAR answers the question, “ what is my worst case scenario?” or “ how much could I lose in a really bad month”? VAR has three components: 1. time period : ( a day , a month, a year) 2. confidence level: 90% confidence 95% confidence 99% confidence 3. loss amount or loss % ( expressed in dollar) Keep these three parts in mind as we give some examples of variations of the question that VAR answers: 1. What is the most I can – expect to lose amount over the next month? with 95% or 99% confidence level 2. What is the maximum % I can expect to lose over the next year? with 95% or 99% confidence level Anil Kumar KY Asst Professor department of Commerce SIMS Page 49 Risk Management Advantages of VAR 1. It measures the financial risk 2. It controls the risk 3. It helps banks in setting capital requirements 4. It easy to understand and explain 5. it describes the total risk of investment 6. it is a measure of risk of loss Disadvantages 1. it is unable to prevent heavy losses 2. value at risk is very difficult to calculate with large portfolio 3. different value at risk methods leads to different results 4. multivariate factors affect VAR who does use VAR what for 1. bank risk manager measure operational risk 2. bank executives set limits of capital requirements 3. exchanges compute margins 4. regulators fore cast systematic risk Important questions from V chapter 2 marks 1. Hedging 2. VAR 3. Objectives Of Hedging or features of hedging 6 marks/ 14 marks 1. Fundamental concept of hedging and options 2. Fundamental concept of currency swap and interest rate swap 3. Value at risk (VAR) Anil Kumar KY Asst Professor department of Commerce SIMS Page 50