Chapter 2 - Risk Management

Risk Management
Identification of types of risk faced by an Organization. Or
Financial Risk can be viewed from different view points.
Strategic Risk:
● Definition: Risk impacting a company's strategy, hindering goal achievement.
● Causes: Technological changes, new competitors, shifts in customer demand.
● Example: Kodak's failure to adapt to digital cameras vs. Xerox embracing laser printing.
Compliance Risk:
● Definition: Risk of non-compliance with laws, regulations, or industry standards.
● Consequences: Legal and financial penalties, reputational damage, financial loss.
Operational Risk:
● Definition: Risk of loss due to inadequate or failed processes, systems, or people.
● Causes: Human error, technology malfunctions, fraud, natural disasters.
● Example: Employee paying ₹1,00,000 instead of ₹10,000 from the company's account.
Financial Risk:
● Definition: Unexpected changes in financial conditions like prices, exchange rates, credit rating, and
interest rates.
● Considerations: Political risk indirectly included, as it may lead to financial loss.

Financial risk is classified into the following categories:

1. Counter Party Risk:
● Non-honoring of obligations by the counterparty.
● Failure to deliver items for payments or vice versa.
● Default by the counterparty, leading to credit risk.
2. Political Risk:
● Financial loss or disruption due to disruptive politics.
● Impact on various financial investments (stocks, bonds, commodities, and foreign exchange).
● Examples of political risk include changes in government policy, civil unrest, war, terrorism, or
corruption.
● Possible forms of political risk: confiscation or destruction of overseas properties, rationing of
remittance, currency conversion restrictions, borrowing restrictions, invalidation of patents, and price
control of products.
3. Interest Rate Risk:
● Risk due to changes in interest rates affecting assets and liabilities.
● More significant for banking companies with interest-sensitive balance sheets.
● Two types of interest rates: fixed and floating.
● Impact of interest rate changes on borrowing and lending rates.
● Example: Risks associated with borrowing at a floating rate and implications of rate fluctuations on
fixed-rate liabilities.
4. Currency Risk:
● Affects organizations dealing with foreign exchange.
● Cash flows change with movements in currency exchange rates.
● Can impact cash flow adversely or favorably.
● Example: Impact of rupee depreciation on receivables for exporters like Infosys, and liabilities for
importers like Indian Oil Corporation Ltd.
5. Liquidity Risk:
● Inability to meet liabilities when due.
● Arises when an organization cannot generate sufficient cash or experiences a mismatch in cash flow
periods.
● More prevalent in banking businesses with maturity and deposit patterns mismatch.

Evaluate Financial Risk from Stakeholder’s, Company’s & Goverment’s point of view Or
The Financial Risk can be viewed from different perspective.
The financial risk can be evaluated from different point of views as follows:
From Stakeholder’s point of view –
Major stakeholders of a business are equity shareholders and they view financial gearing i.e. ratio of debt in
capital structure of company as risk since in event of winding up of a company they will be least prioritized.

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Even for a lender, existing gearing is also a risk since company having high gearing faces more risk in default
of payment of interest and principal repayment.
From Company’s point of view –
From company’s point of view if a company borrows excessively or lend to someone who defaults, then it can
be forced to go into liquidation
From Government’s point of view –
From Government’s point of view, the financial risk can be viewed as failure of any bank or (like Lehman
Brothers) down grading of any financial institution leading to spread of distrust among society at large. Even
this risk also includes wilful defaulters. This can also be extended to sovereign debt crisis

Value-At-Risk (Var)
Definition:
VaR is a statistical measure assessing potential losses in an investment or asset portfolio over a specified
time period, quantifying the maximum loss under normal market conditions.
Risk Management Tool:
VaR is commonly used in risk management to limit exposure to various risks in investments.
Scope of Application:
VaR measures risk for diverse assets like portfolios, capital investments, and foreign exchange within a
specific timeframe.
Key Questions Answered:
Worst Case Scenario:
● VaR addresses the worst-case scenario for the investment.
Loss Estimation:
● VaR estimates potential losses during a specified period under normal market conditions.

Features of Value-At-Risk (Var)

Some of the key features of VaR include:
1. Components of Calculations: VAR calculation is based on following three components:
a. Time Period
b. Confidence Level – Generally 95% or 99%, to represent the possibility that the actual loss will not
exceed the estimated VaR.
c. Loss in percentage or in amount
2. Statistical Method: It is a type of statistical tool based on Standard Deviation.
3. Time Horizon: VAR can be applied for different time horizons say one day, one week, one month and so
on.
4. Probability: Assuming the values are normally attributed, probability of maximum loss can be
predicted.
5. Control Risk: Risk can be controlled by selling limits for maximum loss.
6. Z score: Z score indicates how many standard Deviations is away from Mean value of a population.
When it is multiplied with Standard Deviation it provides VAR.

List down main application of Value-At-Risk (Var)

VAR can be applied.
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 front office of a treasury department.
d) To enable the management to decide the trading strategies.
e) As a tool for Asset and Liability Management especially in banks.

Appropriate methods of Identification and Management of Financial Risk

1. Counter Party Risk
The various hints that may provide counter party risk are as follows:
(a) Failure to obtain necessary resources to complete the project or transaction undertaken
(b) Any regulatory restriction from the government
(c) Hostile action of foreign government
(d) Let down by third party
(e) Have become insolvent
The various techniques to manage this type of risk are as follows:

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1. Carrying out due diligence before dealing with any third party
2. Do not over commit to a single entity or group or connected entities
3. Know your exposure limits
4. Review the limit and procedure for credit approval regularly
5. Rapid action in the event of any likelihood of defaults
6. Use of performance guarantee, insurance or other instruments.

2. Political Risk
From the following action by the governments of the host country this risk can be identified:
1) Insistence on resident investors or labour.
2) Restriction on conversion of currency
3) Expropriation of foreign assets by the local government.
4) Price fixation of the products.
Since this risk mainly relates to investments in foreign country, company should assess country risk
1) By referring political ranking published by different business magazines.
2) By evaluating country’s macro economic conditions.
3) By analysing the popularity of current government and assess their stability
4) By taking advice from the embassies of the home country in the host countries.
Further following techniques can be used to mitigate this risk
1) Local sourcing of raw materials and labour
2) Entering into joint ventures
3) Local financing
4) Prior negotiations

3. Interest Rate risk

Generally, interest rate risk is mainly identified from the following:
1. Monetary Policy of the government
2. Any action by Government such as demonetization etc
3. Economic Growth
4. Release if industrial Data
5. Investment by foreign investors
6. Stock market changes

4. Currency Risk
1. Government Action: The Government action of any country has visual impact in its currency. For
example, the UK Govt. decision to divorce from European Union i.e. Brexit brought the pound to its
lowest since 1980’s.
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 discussed in later chapters impact the value of currency.
4. Natural Calamities: Any natural calamity can have negative impact.
5. War, Coup, Rebellion etc.: All these actions can have 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.

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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 manufactured cables to other
countries it has also established its production facilities at some African countries’ due availability
of raw material and cheap labour there. Some of the major raw material such as copper, aluminum
and other non – ferrous metal 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 makes 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 competitor TRC
has relaxed its policy for granting credit and to manage receivables has formed a separate credit
[Link] to hedge itself against the various risk it has entered into various OTC Derivatives
Contracts settled outside the [Link] :Evaluate the major risk to which TRC Ltd. Is
exposed to.
Ans: Following are the main categories of risks to which TRC cables is exposed to
[Link] Risk: TRC is exposed to following financial risk.
● Currency Risk: Since most of the receipts and payments of TRC are denominated in NON – INR
Currencies it is exposed to Currency Risk.
● Commodity Risk: As major constituents of Production of TRC are commodities such copper,
aluminium etc. it is subject to commodity risk.
● Interest Rate Risk: As TRC borrows and invest money in short term instruments it is exposed to
Interest rate risk.
● Counter Party Risk: Due to relaxation of norms for granting credits certainly the receivable
amount must have increased resulting in increased in credit risk.
● Liquidity Risk: Since for short term funding requirement TRC is using Commercial paper etc
they are exposed to Liquidity Risk as in time of need if funds are not available from these
sources, then securities shall be sold at discounted price.
● Political Risk: As TRC is operating in various other countries it is also exposed to Political Risk
such as Restriction on Conversion of local earnings into foreign currency, restriction on
remittance etc.

ii. Settlement Risk: The use of OTC Derivatives by TRC also expose it to the settlement risk as the parties with
whom it has entered the contract may not honour the same.

Question 1.
Suppose you hold worth Rs 2 crore shares of X Ltd. whose market price standard deviation is 2% per day.
Assuming 252 trading days a year, determine maximum loss level over the period of 1 trading day and 10
trading days with 99% confidence level.
Answer
Assuming share prices are normally distributed for level of 99%, the equivalent Z score from Normal table of
Cumulative Area shall be 2.33
Volatility in terms of rupees shall be:
2% of Rs 2 Crore = Rs 4 lakh
The maximum loss of 1 day at 99% Confidence Level shall be:
Rs 4 lakh x 2.33 = Rs 9.32 lakh
and expected maximum loss for 10 trading days shall be:
√10 x Rs 9.32 lakh = 29.47 lakhs.

Question 2.
Consider a portfolio consisting of a Rs 2,00,00,000 investment in share XYZ and a Rs 2,00,00,000 investment
in share ABC. The daily standard deviation of both shares is 1% and that the coefficient of correlation between
them is 0.3. You are required to determine the 10-day 99% value at risk for the portfolio?
Solution.
The standard deviation of the daily change in the investment in each asset is Rs 2,00,000 i.e. 2 lakhs. The
variance of the portfolio’s daily change is
V = 22 + 22 + 2 x 0.3 x 2 x 2 = 10.4
σ (Standard Deviation) = = Rs 3.22 lakhs

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Alternatively, it can also be computed as follows:

= (1)2 (0.50)2 + (1)2 (0.50)2 + 2(1)(1)(0.3)(0.50)(0.50)
= 0.25 + 0.25 + 0.15 = 0.65%
σ (Standard Deviation) = = 0.80623%
σ (Standard Deviation) in Amount = Rs 400 lakhs x 0.80623% = Rs 3.22 lakhs
Accordingly, the standard deviation of the 10-day change is Rs 3.22 lakhs x = Rs 10.18 lakh
From the Normal Table we see that z score for 1% is 2.33. This means that 1% of a normal distribution lies
more than 2.33 standard deviations below the mean. The 10-day 99 percent value at risk is therefore
2.33 x Rs 10.18 lakh = Rs 23.72 lakh

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