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
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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Risk management Process
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
Risk management Process
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Risk management Process
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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Risk management Process
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
Risk management Process
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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.
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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.
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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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Players/participants in the derivatives market
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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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 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.
Players/participants in the derivatives market
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Players/participants in the derivatives market
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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Players/participants in the derivatives market
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.
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