Understanding risk

CAFTA – Finance with Finesse

Contents
1 Introduction ..................................................................................................................................................... 3
1.1 Non-financial risk ....................................................................................................................................... 3
1.2 Financial risk .............................................................................................................................................. 4

2 Identification of major types of financial risks ................................................................................................... 5

2.1 Market risk................................................................................................................................................. 5
2.2 Credit risk .................................................................................................................................................. 6
2.3 Liquidity risk .............................................................................................................................................. 7

3 Management of risk.......................................................................................................................................... 7
3.1 Introduction ............................................................................................................................................... 7
3.2 Importance of risk management .................................................................................................................. 9
3.3 Risk management process ........................................................................................................................ 10
3.3.1 Identifying the type of risk .................................................................................................................. 10
3.3.2 Assessing and measuring risk ............................................................................................................. 11
3.3.3 Controlling the risk ............................................................................................................................ 15
3.3.4 Monitoring risk exposure .................................................................................................................... 16

4 Case study ..................................................................................................................................................... 16

Understanding risk 2
1 Introduction
Rising uncertainty in the market has led corporations to have departments dedicated to risk management
services. Organisations are increasingly investing considerably in formulating safety measures to protect
themselves from the rising financial and business risks.
Risk is the probability associated with a negative outcome that is associated with an event.
Consider that the treasury department of Atlanta, an oil manufacturing company, decides to invest in a new
project. The uncertainty associated with the success of the project leads to a variability in the potential cash
inflows for Atlanta. The downside of this investment, i.e., the scenario where Atlanta incurs a loss is the risk
faced in this investment decision. Therefore, while making such an investment, Atlanta should ensure
safeguards are in place to protect itself from this uncertainty.
The Oxford dictionary defines risk as ‘the probability of loss, injury, or other adverse or unwelcome
circumstances; a chance or situation involving such a possibility.’ The International Organisation for
Standardization has defined risk as ‘the effect of uncertainty on objectives.’ The definition of risk is concise,
precise and adheres to all dimensions of risk.
Though the definition and concept of risk are often understood differently from uncertainty, the two are
closely related. Risk as a concept has been derived from the notion of uncertainty. While uncertainty can
mean both favourable and unfavourable situations, risk is only associated with the unfavourable side of
events. In the aforementioned example, Atlanta may have a return on investment higher than or lower than
the expected forecast. There can be a situation where it may have a negative return on investment. Outcomes
adverse than expected are construed as risks.
Uncertainty exists because of incomplete information (or lack of knowledge) that makes it impossible to
describe the current state and to predict the possibility of the occurrence of a future event.
The foundation of risk lies in the concept of uncertainty because in the world of business, risk can be defined
as the variability that surrounds uncertain or unexpected negative outcomes.
Risks can be broadly classified under two categories, namely:
 Non-financial risk
 Financial risk

Non-financial risks are events or actions that can adversely affect the operations of a company. The risk
taken by an organisation to hold a competitive edge over other companies in the same sector, to pursue high
growth opportunities that will increase the company’s value to its shareholders is termed as business risk. It
is a component of non-financial risk. The uncertainty associated with a company’s strategies for product
development, acquisition of a new geographical location or the decision taken to invest their surplus cash in
new businesses is termed as strategic risk.
Financial risk is the risk associated with the fluctuations in financial market activities or in the financial
transactions of a company. This includes the inability of a firm to pay off its debt obligations because a
shortage of funds or the losses that a firm may incur because of fluctuations in foreign currency rate or
changes in commodity prices.

1.1 Non-financial risk

Belmart, an emerging retail corporation, decides to undercut its prices to extract a larger portion of the
market than its competitors. In this market segment, Alaskan is the market leader. To disrupt Belmart’s
strategy, it decides to cut its prices even lower. This is a form of business risk. Any situation that threatens a
company's ability to meet its target or achieve its financial goals is called business risk. It is essentially a form
of a risk that causes disruptions in an organisation’s goals and objectives. In today’s time and age, businesses
are constantly becoming more and more volatile, which causes the amount of risk associated with businesses
to increase. Every form of business is constantly surrounded by uncertainty, which makes it difficult to
understand and gauge the amount of risk that potential events entail.

Understanding risk 3
Businesses attempt to minimise or mitigate associated risks by formulating and implementing risk
management practices.
Non-financial risks that a company is typically exposed to are classified into the following categories:
 Business risk: This type of risk is willingly undertaken by a company to ensure business growth. When a
company takes decisions that create advantages for the business and lead to an increase in the value of
the company, there is uncertainty associated with the eventual outcome of the decision. For example,
AZX, an American company, is planning to invest in ZSW Technologies, an Indian company. Considering
that they are venturing into a new market, there is a certain amount of risk associated with the decision
of AZX to invest in ZSW. This is a business decision that has a certain amount of risk associated.

 Operational risk: This is the risk of failure of internal processes, people, systems, policies etc. that affects
the operations of a company. Incidences of fraud in a company, system failures etc. are examples of
operational risks.

 Legal risk: When a company is unable to follow legal restrictions, applicable rules or laws, sanctions etc.,
then it is exposed to a situation that may have legal consequences. If the company does not ensure proper
due diligence and ends up in a situation where an external party sues the company for violation, then it
is said to be facing a legal risk.

 Political risk: It is the risk associated with change in the political scenario of the nation that affects the
business of a company. For example, a change in the governing political party will affect the monetary
policy, fiscal policy, incentives and other opportunities in the economy for the business. Businesses in
countries with unstable political situations often have high amount of political risk exposure. This is
prevalent in all countries and is an essential factor to consider in all decisions.

 Regulatory risk: Regulatory risk is the risk of adverse effect on the firm because of changes in regulatory
policies. Regulatory risk is the risk in which a change in laws and regulations will materially affect the
cashflows and pricing of a security or operations of a business, sector or the market. A change in laws or
regulations by the government or a regulatory body can increase the costs of operating a business,
reduce the attractiveness of the business as an investment or change the competitive landscape.

 Solvency risk: This is the risk associated with the inability of an organisation to meet its debt obligations
in full even after having liquidated all its assets. It is the risk of a firm not having cash and becoming
insolvent.

1.2 Financial risk

Company AZX decides to invest its surplus cash in fixed rate bond. 1 A fixed rate bond (traditional bond) will
give the ‘buyer of the bond’ a fixed rate of interest over a period. If the company AZX invests in a fixed rate
bond, then any increase in the interest rate in the economy exposes it to a risk as the investors will receive
lower rates of interest compared with those existing in the market. Alternatively, the company can invest in
floating rate bonds.2 The advantage of this investment is that, compared with traditional bonds, there is no
risk associated with interest rate fluctuations. If the interest rate in the economy increases, then a floating
rate bond will pay a higher rate of interest. However, they also pay a lower rate of interest if the rates in the
economy decrease. Investing in floating rate security exposes the company to uncertainty in the economy as
their investment becomes dependent on the fluctuations in the market. However, by investing in fixed rate
security, they will know exactly what their stream of income will be through the investment period.

1
Bond is a financial security that will pay the buyer of the bond ‘interest’ for a period. This will be covered in
detail in “Valuation of financial instruments”
2
In a floating rate bond, the interest that the bond will pay is quoted as “interest rate + LIBOR rate”. LIBOR
is a benchmark rate that is used by the banks to make short-term loans to other banks.

Understanding risk 4
Any activity in the financial markets that exposes a company to uncertainty is termed as financial risk. It is
the risk associated with the fluctuations in the financial market activities that lead to the financial transactions
of a company.
Typical forms of financial risk in a company are as follows:

 Market risk: Financial risks are often associated with the overall market risk in the business environment.
Changes in market indicators, such as interest rates, foreign exchange rates, and commodity prices, may
affect the market price of the assets. Adverse movement in these indicators affecting the value of the
financial assets of a company is termed as market risk.

 Credit risk: This is the risk of default or the risk of occurrence of loss because of the unwillingness of the
customer or counterparty to meet its obligations. It is also known as default risk.

 Liquidity risk: This is the risk associated with the unavailability of liquid assets to meet obligations. It
means that, when required, a company is unable to convert its assets into liquid cash. This may also be
because of a change in market conditions, such as inflation, recession, and loss in investors’ confidence,
which leads to the inability of a firm to liquidate its assets to minimise loses. In the market, when there is
a liquidity risk, the difference between the price at which the sellers are willing to sell the assets 3 and the
price at which they are willing to buy the assets4 is very high. In liquid markets, this difference is narrow.

This module will primarily cover different types of financial risks. In the following sections, we will consider the
three major variants of risk and associated sub classes.

2 Identification of major types of financial risks

Three of the major types of risks that companies may be subjected to are as follows:

2.1 Market risk

Case I: AWZ Ltd. is an Indian company that has entered into a contract to import goods from WZY Ltd. in US
dollar at an exchange rate of $1 = ₹70. Payment is to be made in 6 months from the date of agreement. If in
future, the exchange rate becomes $1 = ₹75, then the company will have to pay a higher amount.
Case II: AWZ Ltd. is an Indian company that wants to import oil. The price of oil today is $70/bbl and the
shipment will arrive after 6 months. The price is decided on the date of shipment. If the price of oil on the
date of shipment is $80/bbl, AWZ must pay a higher amount.
Case III: AWZ Ltd. is a cash rich Indian company with large investments in domestic 10-year floating rate
bonds. Current, 10-year market rate at 7%. Over the next 12 months, the central bank is expected to reduce
the benchmark rates by approximately 1%. If the benchmark rate becomes 6%, the company will earn lower
returns on its investments.
Case IV: ABC Bank is an Indian banking institution accepting short and medium-term deposits from retail
investors in the country. Its loan portfolio consists of long-term project finance loans to corporates. The value
of a bank’s assets and liabilities are sensitive to changes in market interest rates. The mismatch in the
maturity of assets and liabilities of the bank leads to a mismatch in sensitivity to interest rate movements.
These are some examples of market risk.

3
This is also known as the ‘ask’ price of the asset.
4
This is also known as the ‘bid’ price of the asset.

Understanding risk 5
 FIGURE 1.1: Sub-Classes of Market Risk

The risk that a company is subjected to because of the fluctuations in financial markets, such as commodity
prices, foreign exchange rate or interest rate, is termed as market risk.
Financial risk can be managed by using different instruments and strategies. These will be covered in depth
in the Financial Risk Management. For example, hedging is a useful and popularly used method to manage
market risk. It is applicable to mitigate interest rate risk, commodity risk as well as currency or foreign
exchange rate risk.

2.2 Credit risk

Zen Ltd. desires to build up on its investments and hence plans on buying bonds. While the company decides
the bonds to buy, it will look at the credit rating of the bond. A BB 5 rated bond might provide a higher return
than an AAA rated bond. Purchasing a BB rated bond instead of a AAA rated bond exposes the company to a
higher credit risk.
Credit risk is associated with the inability of a party bound by a contractual agreement to pay its obligations.
For example, say Arc and Bay have entered into a contract where Arc has agreed to loan ₹100,000 to Bay.
Bay would pay this loan back in instalments. There is a possibility that Bay might default on his payments.
This is a form of credit risk and is also known as counterparty default risk.
An example of credit risk can also affect a sector. For instance, say that the IT sector has experienced a slump
that has led to IT companies defaulting on their payments. This has exposed Bank A to risk because it has
provided many IT companies with loans for capital expansion, operations, etc. This risk is known as sectoral
credit risk or concentration credit risk and forms a part of credit risk.

FIGURE 1.2: Sub-Classes of Credit Risk

The risk that is associated with the possibility (probability) of a borrower’s failure in repaying a loan or his
inability to meet a debt obligation is called as credit risk.
To manage credit risk, the following points can be noted:

5
These are credit ratings that are given by rating agencies such as Crisil, ICRA, Care etc. The companies are
rated based on different financial strength parameters of the companies. This will be covered in depth in
investment section.

Understanding risk 6
 The credit rating6 of a bond should have been carefully assessed and analysed before investing to avoid
the risk of the security not making payments to its holder.
 In case of a bank, past loan history of a customer/corporate should be properly checked, i.e., the credit
record should be properly evaluated.
 A system of credit limits should be implemented in organisations.
 Encourage banks to diversify potential loan customers to avoid the possibility of sectoral risks.

2.3 Liquidity risk

AZ Ltd. has invested in land at the current market price of ₹10 lakh. Because of an urgent need for money,
they are required to sell the land. The economy is facing a downturn; therefore, they have not been able to
find any interested buyers, and hence, because of their desperate need for money, they are forced to sell it
at a price that is below the market price (₹6 lakhs [0.6 million]). Hence, this lack of liquidity prevalent in the
market, which leads to sales at a less favourable price, is an example of liquidity risk. It arises because of the
inability of a company to liquidate its asset at the market price and its subsequent inability to meet financial
obligations.

Common ways of managing liquidity risk, among other things, include the following:
 Diversification

 This can help manage liquidity risk as the company is not investing all the money in one asset
class/portfolio. Their investment portfolio can be diversified by investing in different sectors,
products, asset types etc.

 Maintain liquidity buffer (contingency funding plan)

 Liquidity buffer in the form of liquid assets, such as cash and liquid funds can be retained to use in
case of any short-term liquidity requirements.

3 Management of risk
3.1 Introduction
Exposure to a certain amount of risk is inevitable because of the increasing amount of volatility surrounding
different business scenarios. Therefore, to control and mitigate these risks, it is necessary to institute risk
management practices by adopting different control measures across departments. The design and
implementation of processes to identify, measure and manage varied risks is termed as risk management.
In India, the Companies Act (2013) requires the board of directors to constitute a risk management
committee. The committee is responsible for implementing a risk management policy for the company, which
includes identifying key risks that may threaten the company’s position and instituting measures to mitigate
them. The risk management committee is also responsible to monitor and review the risk management plan
and to report it to the management.
It also places expectations on the Audit committee of a company, which is required to evaluate the internal
financial controls of the company and the risk managements systems that are in place. Its responsibility is to
ensure that these controls are robust and are regularly reviewed.
The companies are also expected to lay down procedures that inform and regularly update the management
(board of directors) about the risk assessment and mitigation framework of the company.

6
Credit rating are generally given by credit rating companies such as ICRA, CARE Moody’s etc. This is
discussed in detail in investment & portfolio management module

Understanding risk 7
Following is an extract from Bharti Airtel’s annual report (2017–18) that states what is expected from the
Risk Management Committee.

FIGURE 1.3: Extract from Bharti Airtel’s Annual Report (2017–18)

Source: Bharti Airtel Ltd. financial year 2017-18 annual report

The risk identification process described in the annual report of Bharti Airtel is presented in Figure 1.4.

FIGURE 1.4: Risk Identification Process (Extract from Bharti Airtel’s Annual Report (2017–18)

Source: Bharti Airtel Ltd. financial year 2017-18 annual report

While in corporate offices, the regulations imposed in terms of risk management are, to an extent, decided
by the companies, in banks, the risk mitigating techniques are based on Basel Accords. These Accords contain
specific recommendations on banking regulations and have been issued by the Basel committee on banking
supervision since the year 1988 (Basel I). These are recommendations that are used to almost curtail or at
least reduce the amount of risk associated with several functions of a banking institution. Contemporarily,
Basel III is being followed and is based on the following three pillars:

1. Enhanced minimum capital and liquidity requirements

2. Enhanced supervisory review process
3. Enhanced risk disclosure and market discipline

Following is an extract from ICICI Bank’s Annual Report (2018–19).

Understanding risk 8
 FIGURE 1.5: Extract from ICICI Bank Annual Report (2017–18)

Source: ICICI Bank Ltd. financial year 2018-19 annual report

FIGURE 1.6: Extract from ICICI Bank Ltd. Annual Report (2018-19)

Source: ICICI Bank Ltd. financial year 2018-19 annual report

A good risk management strategy should implement a control technique ex-ante. This would require the risk
manager to be a step ahead by being aware of the factors that indicate possible adversities.

3.2 Importance of risk management

Understanding risk 9
Following are the reasons for the necessary implementation of a financial risk management programme:

 It allows companies to become aware of the potential risks it may be exposed to and provides them the
solutions to actively manage them. For example, if ABC Ltd. is aware about a potential foreign exchange
payment that it will have to make in the next 3 months, then it can take steps to reduce the uncertainty
around the amount it will have to pay by hedging its exposure.
 It helps the business entity to identify and assess the various sources of risk, thus helping the entity to
outline its future business plan and strategy to eliminate these risks.
 It provides enough headroom to the senior management to conduct scenario and sensitivity analyses to
assess the effect of risk on the operations of the business and the necessary financial resources required
to cover against the cost of risk in a worst-case scenario.
 It allows the management to evaluate the levels of risks involved by comparing the estimated levels of
risk against the pre-established criteria, which allows risks to be ranked on the basis of their likelihood
and their financial consequences.
 It aids the senior management of the organisation by helping them monitor and review the performance
of business operations and the various significant risks involved.
 It helps in communicating the results of the risk management process to both the internal and external
stakeholders of the company who are likely to be affected if the risks are left unmanaged.
 It helps the management formulate procedures and policies to effectively avoid and control financial risks
and also helps them develop contingency plans to actively manage the financial risks as they occur during
regular operation of the business.

3.3 Risk management process

The process of risk management can be essentially divided into the following steps:

3.3.1 Identifying the type of risk

This is the first step of any risk management process.
With the rapid growth of the global investment environment, an increasing number of businesses are
considering their position in the market and are becoming more aware about how the economy affects their
business. They tend to first identify the possible risk types that their company is exposed to as this will help
them identify steps to be taken to mitigate them. For example, companies that have invested in instruments
such as bonds will track the credit rating of the instruments to ensure that they continue to invest in them if
the rating is maintained.
When exposure is ineffectively identified, it can significantly affect profit margins.
For example: An Indian auto ancillary company imports in USD, EUR, JPY and HKD. It is exposed to currency
fluctuations in USD/INR, EUR/INR, JPY/INR and HKD/INR.

Table 1.1: Percentage Share of Currencies in Total

Imports
Amount in Currency of Percentage
Particular
millions (INR) transaction share (%)
Imports 3521.6 USD 82
(FY 2018–
19) Euro 9
JPY 7
HKD 2

Major imports are in USD; therefore, it recognises the currency risk of USD/INR. The risk management plan
of the company requires it to hedge 75% of its total exposures. As a result of this, it takes hedges against the
USD/INR currency movement. However, the company does not factor the currency movement risk of EUR,
JPY and HKD because the percentage share of exposure in these cases is very low. During an internal audit,

Understanding risk 10
it was indicated by the auditors that this approach is not appropriate. They emphasised that though
percentages of EUR, JPY and HKD are small, the risk of currency fluctuation against them must be identified
and recognised. One of the methods suggested was that the company can have a policy where they must
hedge 75% of the exposures for every currency. This will ensure that risk mitigation measures exist against
all currency exposures. It was later approved by the board and added as an additional point in the foreign
exchange (FX)risk management policy of the company.

3.3.2 Assessing and measuring risk

In this step, the company measures the amount of risk or maximum loss that it can incur in adverse situations.
Multiple methods such as standard deviation and Value at Risk (VaR) are used to quantify the maximum
amount of risk exposure of the company.
Following are some measures of risk:

[Link] Standard deviation

The most commonly used measure of risk is standard deviation. It is used to measure the amount of
variability/dispersion. For instance, it can be used to calculate the amount of variability a certain investment
has around its return for a given period (weekly, monthly, quarterly, annually etc.).
If our dataset contains observations 𝑿𝟏 , 𝑿𝟐 , 𝑿𝟑 … , 𝑿𝒏 and the mean of the observations is 𝑿 ̅ , 7 then the
deviations from the mean are expressed as (𝑿𝟏 − 𝑿) ̅̅̅̅, (𝑿𝟐 − 𝑿)
̅̅̅̅, (𝑿𝟑 − 𝑿)
̅̅̅̅, … . (𝑿𝒏 − 𝑿)
̅̅̅̅. The squares of these
deviations are used to calculate the most popularly used measures of spread, i.e., variance and standard
deviation.
̅ )𝟐
∑(𝑿𝒊 − 𝑿
Variance is calculated using the formula 𝑺𝟐 =
𝒏−𝟏
Standard deviation is calculated using the formula 𝑺 = √𝑺𝟐

For example, the consolidated net asset value (NAV) of a debt fund scheme for the period 2000–2005 is
presented in the following Table 1.2. To summarise this, we calculate the mean/arithmetic average of the
data.

Table 1.2: NAV of Debt Fund Scheme From 2000-2005

Year NAV
2000 257.1459
2001 257.3364
2002 258.206
2003 259.1822
2004 259.2305
2005 260.4413

𝑁𝐴𝑉2000+𝑁𝐴𝑉2001+𝑁𝐴𝑉2002+𝑁𝐴𝑉2003+𝑁𝐴𝑉2004+𝑁𝐴𝑉2005
Mean is calculated as = 258.60
5

To calculate the variability using mean, we calculate the difference between NAV of each year and the mean
value. We then square the differences and calculate their average to calculate the standard deviation.

7
This is explained in Statistics for finance.

Understanding risk 11
 Table 1.3: Calculation of Standard Deviation of NAV
NAV (X) Mean Difference Square of difference
(𝑿𝒊 − ̅𝑿)
̅̅̅
̅
𝑿 (𝑿𝟏 − ̅𝑿)
̅̅̅𝟐

2000 257.1459 258.60 1.4541 2.114407

2001 257.3364 258.60 1.2636 1.596685
2002 258.206 258.60 0.394 0.155236
2003 259.1822 258.60 (0.5822) 0.338957
2004 259.2305 258.60 (0.6305) 0.39753
2005 260.4413 258.60 (1.8413) 3.390386
Total 7.993
Average 1.332

The square root of the average of the sum of the squares of these deviations is 1.154. This number provides
insight into the spread of the data from the mean (average) value. Mean is the central value (representative
value) of the data. Standard deviation indicates how near/far each value is from this central value. A high
value of standard deviation implies that the data is more spread out. A low value of standard deviation implies
that the data is less spread out. A greater standard deviation implies that there is greater uncertainty
surrounding the values, and therefore, a higher risk.
In this case, the value of NAV of the mutual fund, on an annual basis, may deviate by 1.15 above or below
258.6.
The following Figure 1.7 presents the spread of the data that is considered:

FIGURE 1.7: Dispersion/Spread of the Given NAV Data

Standard deviation holds an advantage over all other measures because of its ease of use and understanding.

[Link] Value at risk

VaR is a measure that measures the maximum possible loss that can occur over a period within a specified
confidence interval.
The confidence interval measures the certainty with which the value lies within a given interval. For example,
a 95% confidence interval implies that there is a 95% probability that the true value of the parameter lies
within a given interval.8

8
This is explained in detail in statistics for finance

Understanding risk 12
VaR is the maximum possible loss that can be incurred within a given time horizon and a confidence interval
on an amount.
For example, consider an Indian company that has an outstanding USD exposure of amount M. Because of
fluctuations in the market conditions (such as the USD–INR exchange rate), there is a possibility that the value
of M may change. If we are looking at a 90-day period of fluctuating exchange rates in the economy that can
affect the value of M, we can estimate a value for the maximum loss that can occur in 95% cases using the
VaR model. This will help the company ascertain, with a certain level of confidence, the maximum loss they
may incur over a period.
To calculate the VaR for this exposure, we will use the following:
1. Standard deviation of the past 90-day exchange rates (Annual σ X square root (90))
2. Current market value of the amount (M)
3. Level of significance (α) that would be used to obtain the Z statistic using the cumulative normal
distribution table (suppose it is equal to 1.645 at 95% level of confidence)

𝐕𝐚𝐑 = 𝑴 ∗ 𝒁𝛂 ∗ 𝛔

In this case, the standard deviation is considered for the period it is being evaluated for.
VaR is a useful metric as:

 It is a standard metric for risk across multiple markets such as investment and forex.
 It has high usability and is commonly applied by companies.
 It is also mandated by regulators to measure risks.

Let us look at the following examples to better understand how VaR is calculated.

Example-1

Let us consider an investor who has a portfolio of ₹98 million of equity shares. With one-day standard
deviation being 3%, what will be its one-day VaR considering a 95% confidence interval?
To calculate the one-day VaR, we will use the following variables:
1. Standard deviation = 3%
2. Z-score at 95% confidence interval = 1.645
3. Market value of the portfolio = ₹98 million

Therefore, the VaR can now be calculated by multiplying the following formula:
VaR = ₹98 million* 3% * 1.645 = ₹4,836,300

Over a period of one day, in 95% of the cases, ₹4.8 million is the maximum loss that the investor can incur on
a portfolio whose current market value is ₹98 million. In other words, there is a 5% chance that the loss
incurred will be greater than ₹4.8 million in a single day.
Example-2

Let us consider an investor who has ₹50 million portfolio consisting of long position in bonds. With the
standard deviation being 4.67%, the investor is interested in knowing the VaR of one-day horizon and VaR for
a one-month horizon at a confidence interval of 95%.
To calculate the VaR of one-day horizon, we will be using the following values:
1. Z-score at 95% confidence interval = 1.645
2. Daily standard deviation = 4.67%
3. Market value of the portfolio = ₹50 million

Understanding risk 13
Therefore, the VaR can be calculated by multiplying all the three components.

VaR (one-day horizon) = 1.645*4.67%*₹50 million = ₹3,841,075

To calculate the VaR for a one-month horizon, we will be considering the following variables:
1. Total number of trading days (T) = 20 (This is an assumed value. In practice, there are 22 trading
days in a month)
2. Daily standard deviation = 4.67%
3. Z-score at 95% confidence interval= 1.645
4. Market value of the portfolio = ₹50 million

To calculate the VaR of a one-month time, we will use the following formula:

𝝈𝑴𝒐𝒏𝒕𝒉𝒍𝒚 ≅ 𝝈𝑫𝒂𝒊𝒍𝒚 ∗ √𝑻

The result is multiplied with the market value of the portfolio and the Z-score at 95% CI.
The calculation will be as follows:
VaR (one-month horizon) = ₹50 million*(4.67%*4.472)*1.645 = ₹17, 177, 287.4

The measure of VaR, though flexible enough to provide an absolute measure or even a measure relative to a
benchmark, it assumes normal distribution, 9 and this assumption may not old true in all cases.

[Link] Scenario analysis

Scenario analysis is a process of analysing possible future events by considering alternative possible
outcomes. Thus, scenario analysis, which is one of the main forms of projection and of measuring the amount
of associated risk, tries to predict multiple future scenarios.
For example, if a company is expected to import raw materials from a US company at an exchange rate of
₹70 after 3 months, then depreciation of Indian currency will result in a loss for the company as it will increase
the cost and reduce the profit margin of the company. To monitor the profit margin, the company can conduct
scenario analysis which will present the different plausible exchange rate scenarios that can occur and
consequently the profit it will earn. This will help them prepare for these scenarios.
For example:
For a jewellery company that imports silver, how much would be the likely amount of loss if the price of silver
fluctuates, given that the current price of silver in the market is ₹42,000? (Given that it must procure 1000
kg silver after 3 months.)

Table 1.4: Scenario Analysis for Fluctuations in Price of Silver

Scenario Percentage Amount Price Price to be paid Scenario
increased (%) change (1000 kg)
Current scenario - - 42,000 4,20,00,000 -
Increase by 5% 5 2100 44,100 4,41,00,000 21,00,000
Increase by 10% 10 4200 46,200 4,62,00,000 42,00,000
Increase by 15% 15 6300 48,300 4,83,00,000 63,00,000
Increase by 20% 20 8400 50,400 5,04,00,000 84,00,000

9
The concept of normal distribution will be covered in the module “Statistical methods for finance”.

Understanding risk 14
This illustration shows the different loss amounts the company may incur in different scenarios if the price of
silver increases by a certain percentage.

3.3.3 Controlling the risk

This step forms a vital part of the risk management process. It involves prioritising the risks that need to be
controlled and applying the most appropriate measures to mitigate risks and avoid intrinsic losses to the
business.
Risk can be controlled in the following contexts:
 In a Proactive context, a business entity has already successfully integrated a risk management system
to identify, assess and monitor risk creating activities of the business.
 In a Reactive context, a business entity looks retrospectively at the risk creating business decisions and
activities to remedy any risk treatments deemed necessary.

For the risk mitigation method to be effective, the senior management of the company must implement
actions that aim to reduce risk exposure of the company. Such measures or actions require consideration on
whether:
 The risk is being controlled to a level that is reasonably achievable.
 It would be cost-effective to control the risk.
 The company can tolerate the current risk and control measure.

It is usually not cost-effective or even desirable to implement control frameworks against all risks. It is,
however, necessary to choose, prioritise and implement the most appropriate combination of risks and
controls. In many cases, the risk is identified by the company and loss provisioning is done in case of loss
occurrence where capital is maintained separately by the organisation. Decision is made by considering
factors such as costs and benefits, effectiveness and other criteria of relevance to the business activity of the
company.
The different levels of risk faced by a company can be classified as follows:
1. Low-level risk: It includes risks on which any control is not necessary as they are very basic
in nature and pose a low threat to the business activities of the company.
2. Significant-level risk: It includes risks that should be controlled as and when they arise.
3. High-level risk: These are the risks that require specific control plans as they pose high
potential threat to the business activities of the company.

To control the identified levels of risk that pose significant threat to business activities, companies can adopt
the following two strategies:
 Avoidance strategies: These are aimed at minimising the emergence of risk and consist of the following
four options:

 Transfer - It represents procedures aimed at reducing/eliminating risks by transferring them from

one entity to another. For example: buying insurance.
 Reduction - It aims at reducing the likelihood of the occurrence of risks through effective
management control, formulating procedures to reduce the frequency of errors or to reduce the
consequence of risks by ensuring that all controls are in place to reduce the effect of adverse
consequences.
 Elusion - It includes options that can help the management of a company to elude risk by not going
ahead with the project or activity that would involve risks or to choose alternatives for the activity
to help them achieve the same result.
 Diversification - It consists of attempting to spread the risk from a specific area to different sections
to prevent the entire project from suffering a loss.

 Minimisation strategies: These are applied when the risks have already adversely affected the business,
thus leaving scope only for taking corrective measures to reduce the effect of adverse consequences. The

Understanding risk 15
 only corrective measure that can be taken in such a situation is to use a contingency plan. A contingency
plan is used to define the alternative procedures and processes that must be undertaken in an
organisation when a risk occurs.

3.3.4 Monitoring risk exposure

In this step, we constantly monitor, reassess and modify (when and where required) the risk management
techniques that we had adopted to mitigate risks. It includes the following:
 Reassessing the existing risks, verifying that the assumptions are still valid and modifying them as
and when necessary
 Determining if the risk exposures have changed, evolved or declined because of emerging business
trends
 Determining if the risk responses are enough or should be updated
 Confirming if the policies and procedures formulated are effective in mitigating risks
 Monitoring the emergence of new risks
 Identifying the risk triggers, i.e., events that cause a risk to occur and the risk plan put in place to
address adverse consequences
 Tracking residual risks
 Checking if the contingency reserves are adequate
 Taking corrective measures to address risks occurred
 Retiring risks whose potential to affect company’s business activities has reduced or whose risk level
is considerably low

4 Case study
Objective:
The objective of this case study is to understand the incidences of different types of financial risks in a
company and the mitigation plan instituted by the company.
Company information:

Name: Walda Pvt. Ltd.

Revenue: ₹100 crores
Product: Tyre manufacturing company

Geographical presence: Headquartered in India

Business problem:
Walda is a tire manufacturing firm that imports its raw material from Europe. It must make Euro payments at
the end of 3 months of a production cycle. It is a cash rich company with surplus cash of ₹1000 crore.
According to their investment policy, they invest 50% of their investible surplus in different securities such as
bonds of different companies and fixed deposits. The fixed deposits that they invest in are generally for a
shorter period (15–20 days). The company can only invest in AAA rated bonds. It runs a large surplus as it
has few debt obligations and is expected to pay its suppliers after long periods. Though it has few debt
obligations, it has borrowed ₹10 crores at a floating rate from the market for a new business objective.
Discussion:
The company must pay its suppliers in Euro every 3 months. It is an Indian company, the currency of
operations is INR, and they must pay in Euro; therefore, they are exposed to fluctuations in Euro–INR rate.
However, this is a recurring payment. Therefore, the company is exposed to foreign exchange risk. To avoid
this risk and protect themselves with the currency movement, they should fix with the bank the rate at which
they will convert the INR into Euro.
According to their investment policy, they must invest only 50% of their surplus. Considering that it is a cash-
rich company, almost 50% of the surplus that amounts to ₹500 crores is not invested and is idle. This entails

Understanding risk 16
an opportunity cost to the company where they are not generating a return on this cash. It is, therefore,
losing out the opportunity of earning a return on their surplus cash.
The rest 50% (₹500 crores) is invested in bonds and fixed deposits.
1. Investing in AAA rated bonds protects Walda from credit risk exposure. However, if the bond issuing
company defaults on its payments, then Walda is exposed to credit risk.
2. Considering that in the economy, the rates of interest are currently falling, investing in Fixed Deposits
(FD) for a short period of time may expose them to a reinvestment risk where the company is unable
to reinvest the FD amount at the initial rate.
3. The company can also face liquidity risk if it is unable to convert its assets into cash at the market
price at which they were bought and subsequently is unable to fulfil its debt obligations.
4. Walda has also borrowed at a floating rate from the bank. Investing at a floating rate implies that they
are exposed to interest rate risk in the market.

Questions:
1. What are the different types of risks that the company is exposed to?
2. What are the different methods to mitigate them?
3. Suggest some key controls that they can institute to make their policy more robust?

Understanding risk 17
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