Chapter 2 Risk Management
QUESTION 1
Explain the significance of VAR.
ANSWER
The significance of Value at Risk (VAR) is reflected in its various applications, as it can be
used:
(a) To measure the maximum possible loss on any portfolio or a trading position.
(b) As a benchmark for performance measurement of any operation or trading.
(c) To fix limits for individuals dealing in the front office of a treasury department.
(d) To enable the management to decide trading strategies.
(e) As a tool for Asset and Liability Management, especially in banks.
QUESTION 2
The Financial Risk can be viewed from different perspectives. Explain.
ANSWER
The financial risk can be evaluated from different points of view as follows:
(a) From the stakeholders’ point of view: Major stakeholders of a business are
equity shareholders, and they view financial gearing (i.e., the ratio of debt in the capital
structure of the company) as a risk since, in the event of the winding up of a company,
they will be least prioritized. Even for a lender, existing gearing is also a risk since a
company having high gearing faces more risk of default in the payment of interest and
principal repayment.
(b) From the Company’s point of view: If a company borrows excessively or lends to
someone who defaults, then it can be forced into liquidation.
(c) From the Government’s point of view: Financial risk can be viewed as the failure
of any bank (like Lehman Brothers) or the downgrading of any financial institution,
leading to a spread of distrust among society at large. This risk also includes willful
defaulters and can be extended to a sovereign debt crisis.
QUESTION 3
What is Value at Risk? Identify its main features.
ANSWER
As per Wikipedia, Value at Risk (VAR) is a measure of the risk of an investment. Given
normal market conditions in a set period, say one day, it estimates how much an
investment might lose. This investment can be a portfolio, capital investment, or foreign
exchange, etc. VAR answers two basic questions:
(i) What is the worst-case scenario?
(ii) What will the loss be?
Chapter 2 Risk Management
Main features of VAR:
(i) Components of Calculations: VAR calculation is based on the following three
components: (a) Time Period, (b) Confidence Level (generally 95% and 99%), and (c)
Loss in percentage or in amount.
(ii) Statistical Method: It is a type of statistical tool based on Standard Deviation.
(iii) Time Horizon: VAR can be applied for different time horizons, such as one day, one
week, one month, and so on.
(iv) Probability: Assuming the values are normally distributed, the probability of
maximum loss can be predicted.
(v) Risk Control: Risk can be controlled by setting limits for maximum loss.
(vi) Z-Score: A Z-score indicates how many standard deviations a value is away from
the mean value of a population. When it is multiplied by the Standard Deviation, it
provides the VAR.
QUESTION 4
What is Financial Risk? How it can be evaluated from point of views?
ANSWER
Financial Risk refers to unexpected changes in financial conditions such as prices,
exchange rates, credit ratings, and interest rates, etc.. Although political risk is not a
financial risk in a direct sense, it can be included, as any unexpected political change in
a foreign country may lead to country risk, which may ultimately result in financial loss.
Evaluation of Financial Risk: The financial risk can be evaluated from different points
of view as follows:
(a) From the stakeholders’ point of view: Major stakeholders of a business are
equity shareholders, and they view financial gearing (i.e., the ratio of debt in the capital
structure of the company) as a risk since, in the event of the winding up of a company,
they will be least prioritized. Even for a lender, existing gearing is also a risk, as a
company having high gearing faces more risk of default in the payment of interest and
principal repayment.
(b) From the Company’s point of view: If a company borrows excessively or lends to
someone who defaults, it can be forced into liquidation.
(c) From the Government’s point of view: The financial risk can be viewed as the
failure of any bank (like Lehman Brothers) or the downgrading of any financial
institution, leading to a spread of distrust among society at large. This risk also includes
willful defaulters and can be extended to a sovereign debt crisis.
QUESTION 5
Chapter 2 Risk Management
List out the four methods for Identification and Management of Financial Risk. What are
the parameters to identify the currency risk?
ANSWER
The four categories for the identification and management of financial risk are:
1. Counter Party Risk
2. Political Risk
3. Interest Rate Risk
4. Currency Risk
The parameters to identify currency risk are:
(1) Government Action: The government action of any country has a visual impact on
its currency.
(2) Nominal Interest Rate: As per interest rate parity (IRP), the currency exchange
rate depends on the nominal interest of that country.
(3) Inflation Rate: Purchasing power parity theory impacts the value of currency.
(4) Natural Calamities: Any natural calamity can have a negative impact.
(5) War, Coup, Rebellion etc.: All these actions can have a far-reaching impact on
currency’s exchange rates.
(6) Change of Government: The change of government and its attitude towards
foreign investment also helps to identify the currency risk.
QUESTION 6
What are the parameters to identify currency risk? List out the ways to minimize such
risk.
ANSWER
The parameters to identify currency risk are:
(1) Government Action: The government action of any country has a visual impact on
its currency.
(2) Nominal Interest Rate: As per interest rate parity (IRP), the currency exchange
rate depends on the nominal interest of that country.
(3) Inflation Rate: Purchasing power parity theory impacts the value of currency.
(4) Natural Calamities: Any natural calamity can have a negative impact.
Chapter 2 Risk Management
(5) War, Coup, Rebellion etc.: All these actions can have a far-reaching impact on
currency’s exchange rates.
(6) Change of Government: The change of government and its attitude towards
foreign investment also helps to identify the currency risk.
Ways to minimize such risk are:-
(i) Money Market Hedging
(ii) Currency Options
(iii) Forward Contract
(iv) Make Invoice in Home Currency
QUESTION 7
Which type of risk covers the default by the counterparty? List out the ways to manage
this type of risk.
ANSWER
Counterparty Risk occurs due to the non-honoring of obligations by the counterparty,
which can be a failure to deliver goods for a payment already made (or vice versa), or
the failure to repay borrowings and interest. Thus, this risk also covers credit risk, i.e.,
default by the counterparty.
The various techniques to manage this type of risk are as follows:
1. Carrying out Due Diligence before dealing with any third party.
2. Do not overcommit to a single entity or group of connected entities.
3. Know your exposure limits.
4. Review the limits and procedures for credit approval regularly.
5. Rapid action in the event of any likelihood of defaults.
6. Use of performance guarantees, insurance, or other instruments.
QUESTION 8
Risks are inherent and integral part of the market. Discuss.
ANSWER
A business organization faces many types of risks, which are discussed as follows:
Strategic Risk: This is a risk in which a company’s strategy becomes less
effective and it struggles to achieve its goals. It can be caused by technological
changes, a new competitor entering the market, shifts in customer demand, or an
increase in the cost of raw materials.
Compliance Risk: Every business needs to comply with rules and regulations,
such as the Companies Act or SEBI guidelines. Non-compliance leads to penalties
in the form of fines and imprisonment.
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Operational Risk: This relates to internal risk and the failure of the company to
cope with day-to-day operational problems involving both "people" and
"processes".
Financial Risk: This refers to unexpected changes in financial conditions such as
prices, exchange rates, credit ratings, and interest rates. It is broadly divided into
the following categories:
o Counter Party Risk: The risk of default or non-honoring of obligations by a
counterparty.
o Political Risk: Adverse actions by the government of a host country, such
as the confiscation of property or restrictions on currency conversion.
o Interest Rate Risk: Risk occurring due to changes in interest rates;
notably, the risk in both fixed and floating rate types is inherent.
o Currency Risk: This affects organizations dealing with foreign exchange as
cash flows change with the movement in currency exchange rates.
o Liquidity Risk: The inability of an organization to meet its liabilities
whenever they become due.
QUESTION 9
Explain how an organization interested in making investment in foreign country can
assess Country Risk and mitigate this risk.
ANSWER
An organization interested in making an investment in a foreign country can assess and
mitigate country risk as follows:
Assessment of Country Risk: A company should assess country risk by:
(1) Referring to political rankings published by different business magazines.
(2) Evaluating the country’s macro-economic conditions.
(3) Analyzing the popularity of the current government and assessing its stability.
(4) Taking advice from the embassies of the home country in the host countries.
Mitigation of Country Risk: The following techniques can be used to mitigate this risk:
(i) Local sourcing of raw materials and labor.
(ii) Entering into joint ventures.
(iii) Local financing.
(iv) Prior negotiations.
QUESTION 10
TRC Cables Ltd. (an Indian Company) is in the business of manufacturing Electrical
Cables and Data Cables including Fiber Optics cables. While mainly it exports the
Chapter 2 Risk Management
manufactured cables to other countries it has also established its production facilities at
some African countries’ due to availability of raw material and cheap labour there. Some
of the major raw material such as copper, aluminium and other non-ferrous metals are
also imported from foreign countries. Hence overall TRC has frequent receipts and
expenditure items denominated in Non - INR currencies. Though TRC make use of Long-
Term Debts and Equity to meet its long term fund requirements but to finance its
operations it make use of short-term financial instruments such as Commercial Papers,
Bank Credit and Term Loans from the banks etc. If any surplus cash is left with TRC it is
invested in interest yielding securities. Recently due to stiff competition from its
competitors TRC has relaxed its policy for granting credit and to manage receivables it
has formed a separate credit division. Further to hedge itself against the various risk it
has entered into various OTC Derivatives Contracts settled outside the Exchange.
Required: Evaluate the major risks to which TRC Ltd. is exposed to.
ANSWER
Based on the details of TRC Ltd.’s operations, the major risks the company is exposed to
are evaluated as follows:
Strategic Risk: This is a risk in which a company’s strategy becomes less
effective and it struggles to achieve its goals. It can be caused by a new
competitor entering the market or shifts in customer demand. TRC faces this risk
due to the "stiff competition" that has already forced it to relax its credit policy.
Counterparty Risk: This risk occurs due to the non-honoring of obligations by the
counterparty, which covers credit risk (i.e., default by the counterparty). TRC is
exposed to this through its relaxed credit policy for receivables and its use of OTC
Derivatives settled outside the exchange, where it deals directly with third parties.
Political Risk: This type of risk is faced by overseas investors, as adverse actions
by the government of a host country may lead to huge losses. Because TRC has
production facilities in African countries, it faces risks such as the confiscation of
properties, restrictions on the conversion of local currency into foreign currency, or
rationing of remittances to the home country.
Interest Rate Risk: This risk occurs due to changes in interest rates resulting in
changes in assets and liabilities. TRC’s use of short-term financial instruments like
Commercial Papers and Bank Credit to finance operations, along with its
investments in interest-yielding securities, makes its financial position sensitive to
interest rate fluctuations.
Currency Risk: This affects organizations dealing with foreign exchange as their
cash flows change with movement in currency exchange rates. As TRC is both an
exporter and an importer with frequent receipts and expenditures in non-INR
currencies, its cash flows can be affected both adversely and favorably by currency
movements.
Liquidity Risk: This is the inability of an organization to meet its liabilities
whenever they become due. This risk arises if TRC is unable to generate adequate
Chapter 2 Risk Management
cash to meet its short-term obligations, such as Commercial Papers and Bank
Loans, or if there is a mismatch in the timing of its cash flows.
QUESTION 11
Briefly explain: (a) Compliance risk and (b) Operational risk
ANSWER
(a) Compliance Risk: Every business needs to comply with rules and regulations. For
example, with the advent of the Companies Act, 2013, and the continuous updating of
SEBI guidelines, each business organization must comply with a plethora of rules,
regulations, and guidelines. Non-compliance leads to penalties in the form of fines and
imprisonment. When a company ventures into a new business line or a new geographical
area, the real problem occurs. If the company fails to comply with laws related to a new
area, industry, or sector, it will pose a serious threat to its survival.
(b) Operational Risk: This type of risk relates to internal risk and the failure on the part
of the company to cope with day-to-day operational problems. Operational risk relates to
‘people’ as well as ‘processes’. For example, an employee paying out ₹1,00,000 from the
account of the company instead of ₹10,000 is both a people and a process risk. An
organization can mitigate this by employing another person to check the work or by
installing an electronic system to flag unusual amounts.
QUESTION 12
Explain the main risk that can be faced by an overseas investor.
ANSWER
Political Risk is the main risk generally faced by overseas investors, as adverse action
by the government of the host country may lead to huge losses. This can take any of the
following forms:
Confiscation or destruction of overseas properties.
Rationing of remittances to the home country.
Restrictions on the conversion of the local currency of the host country into foreign
currency.
Restrictions as to borrowings.
Invalidation of patents.
Price control of products.
QUESTION 13
What do you mean by term “Counter Party Risk”? Explain various hints that may provide
an indicator of the same risk.
ANSWER
Counterparty Risk occurs due to the non-honouring of obligations by the counterparty,
which can be a failure to deliver the goods for a payment already made (or vice versa),
Chapter 2 Risk Management
or the failure to repay borrowings and interest. Thus, this risk also covers credit risk, i.e.,
default by the counterparty.
The various hints that may provide an indicator of this risk are as follows:
(a) Failure to obtain necessary resources to complete the project or transaction
undertaken.
(b) Any regulatory restrictions from the Government.
(c) Hostile action of a foreign government.
(d) Being let down by a third party.
(e) The counterparty has become insolvent.
QUESTION 14
Mr. PK imports raw materials from China, processes them in India and manufactures
finished goods which are then sold in the American market. In this transaction what
types of risk faced by Mr. PK?
ANSWER
Based on the details of Mr. PK's operations, he is exposed to the following major risks:
Currency Risk: This risk mainly affects organizations dealing with foreign
exchange as their cash flows change with the movement in currency exchange
rates. Since Mr. PK imports from China and sells in America, his cash flows can be
affected both adversely and favorably by movements in these currencies.
Counterparty Risk: This occurs due to the non-honoring of obligations by the
counterparty, which covers credit risk. Mr. PK faces this if his Chinese suppliers fail
to deliver raw materials for payments made or if his American buyers fail to pay
for finished goods.
Political Risk: This is faced by those dealing with foreign countries, as adverse
actions by host governments (like China or the USA) may lead to huge losses. This
can include restrictions on the conversion of local currency into foreign currency or
changes in the government's attitude toward foreign trade.
Strategic Risk: This is a risk in which a company’s strategy becomes less
effective and it struggles to achieve its goals. This could be due to new
competitors entering the market or shifts in customer demand in the American or
Indian markets.
Compliance Risk: Every business needs to comply with rules and regulations. As
Mr. PK operates across different geographical areas, he must comply with a
plethora of guidelines; failure to do so in any of these countries poses a serious
threat to his survival.
Chapter 2 Risk Management
Operational Risk: This relates to internal risk and the failure of the company to
cope with day-to-day operational problems involving both "people" and
"processes" within his Indian processing facilities.
QUESTION 15
How can a company identify and manage counterparty risk effectively?
ANSWER
A company can effectively identify and manage counterparty risk as follows:
Identification of Counterparty Risk: The various hints that may provide an indicator
of this risk are:
(a) Failure to obtain necessary resources to complete the project or transaction
undertaken.
(b) Any regulatory restrictions from the government.
(c) Hostile action of a foreign government.
(d) Being let down by a third party.
(e) The counterparty has become insolvent.
Management of Counterparty Risk: The techniques to manage this type of risk are:
(1) Carrying out due diligence before dealing with any third party.
(2) Do not overcommit to a single entity or group of connected entities.
(3) Know your exposure limits.
(4) Review the limits and procedures for credit approval regularly.
(5) Rapid action in the event of any likelihood of defaults.
(6) Use of performance guarantees, insurance, or other instruments.
QUESTION 16
Explain the various actions of the Governments of the foreign (host) country by which
Country Risk can be identified. Also explain how a company should assess this risk.
ANSWER
The actions of the governments of the host country by which country risk can be
identified are:
1. Insistence on resident investors or labor.
2. Restriction on the conversion of currency.
3. Expropriation of foreign assets by the local government.
4. Price fixation of the products.
Chapter 2 Risk Management
Assessment of Country Risk: Since this risk mainly relates to investments in a foreign
country, a company should assess country risk:
(1) By referring to political rankings published by different business magazines.
(2) By evaluating the country’s macro-economic conditions.
(3) By analyzing the popularity of the current government and assessing its stability.
(4) By taking advice from the embassies of the home country in the host countries.