CHAPTER 2: RISK MANAGEMENT NOTES

1. IDENTIFICATION OF TYPES OF RISK FACED BY AN ORGANIZATION

1.1 Strategic Risk

• Definition: This risk occurs when a company's strategy becomes less effective, leading to
struggles in achieving its goals. Even well-thought-out plans can become outdated if they
fail to keep pace with the latest trends.

• Causes: Technological changes, entrance of a new competitor, shifts in customer

demand, or increases in raw material costs.

• Learning from Examples:

o Negative Case (Kodak/Nokia): Kodak failed to develop the digital camera, viewing
it as a threat to its core business. Nokia failed to upgrade its technology to touch
screen mobile phones. Both companies paid the price for this delay and were left
behind.

o Positive Case (Xerox): Xerox invented the photocopy machine and successfully
survived strategic risk by quickly adapting its business model to develop laser
printing when that technology emerged, thus escalating its profits.

1.2 Compliance Risk

• Definition: The risk arising from the failure of a business to comply with the necessary
rules, regulations, and guidelines (e.g., Companies Act 2013, SEBI guidelines).

• Consequence: Non-compliance leads to penalties, including fines and imprisonment.

• Key Challenge: Compliance risk heightens when a company ventures into a new
business line or a new geographical area where different laws and regulations apply
(e.g., a cement company entering the sugar business in a different state).

1.3 Operational Risk

• Definition: This risk relates to internal risk or the failure on the part of the company to
cope with day-to-day operational problems.

• Scope: Operational risk relates to both 'people' and 'process' failures.

• Example: An employee mistakenly paying out Rs 1,00,000 instead of Rs 10,000.

• Management Strategies: Employing another person to check the work or installing an

electronic system that flags off unusual amounts.

1.4 Financial Risk

• Definition: Referred to as unexpected changes in financial conditions such as prices,

exchange rate, credit rating, and interest rate.

• Note on Political Risk: Though not directly a financial risk, an unexpected political change
in a foreign country can lead to country risk, which may ultimately result in financial loss,
hence it is often included.
Categories of Financial Risk

Category Description Coverage/Inclusion

Covers Credit Risk (default by the counter party).

Occurs due to the non-
Counter Examples: Failure to deliver goods for payment
honoring of obligations by the
Party Risk already made, or failure to repay borrowings and
counter party.
interest.

Risk faced by overseas

Forms include: Confiscation/destruction of
investors due to adverse
Political properties, rationing remittances, restriction on
actions by the host
Risk currency conversion, restriction on borrowings,
government, potentially
invalidation of patents, price control of products.
leading to huge losses.

Occurs due to a change in More important for banking companies as their

Interest interest rate resulting in balance sheet items are highly interest sensitive.
Rate Risk changes in asset and liability Risk is inherent in both fixed and floating rate
valuations. borrowings.

Affects organizations dealing

Can affect cash flow adversely or favorably.
with foreign exchange, where
Currency Example: Rupee depreciation vis-a-vis US dollar
cash flows change with the
Risk causes gain for exporters (receivables) and loss for
movement in currency
importers (liabilities).
exchange rates.

Arises when the organization is unable to generate

Inability of an organization to
Liquidity adequate cash or due to a mismatch in the period
meet its liabilities whenever
Risk of cash flow generation. Prevalent in banking due to
they become due.
maturity mismatch and deposit receiving patterns.

2. EVALUATION OF FINANCIAL RISK FROM DIFFERENT PERSPECTIVES

The financial risk is viewed differently by major stakeholders and entities.

• From Stakeholder's (Equity Shareholder) Point of View: Equity shareholders view

financial gearing (debt ratio in capital structure) as a risk because they are the least
prioritized during the winding up of a company.

• From Lender's Point of View: Existing high gearing in a company is a risk for the lender,
as it increases the risk of default in payment of interest and principal repayment.

• From Company's Point of View: Excessive borrowing or lending to a defaulter can force
the company into liquidation.

• From Government's Point of View: Financial risk includes the failure of a major bank
(like Lehman Brothers) or the down-grading of any financial institution, which spreads
distrust among society. This perspective also includes wilful defaulters and sovereign
debt crisis.
3. VALUE-AT-RISK (VAR)

3.1 Definition and Basic Questions

• Definition: VAR is a measure of investment risk that estimates how much an investment
might lose over a set period (e.g., one day), assuming normal market conditions.

• Applicability: VAR can be applied to a portfolio, capital investment, or foreign exchange.

• Basic Questions Answered:

1. What is worst case scenario?

2. What will be loss?

3.2 Features of VAR

• Components of Calculation:

o Time Period

o Confidence Level (Generally 95% and 99%)

o Loss in percentage or in amount

• Methodology: It is a statistical tool based on Standard Deviation.

• Time Horizon: Applicable for various horizons (one day, one week, one month, and so
on).

• Probability: Assuming normal value distribution, VAR predicts the probability of

maximum loss.

• Risk Control: Risk can be controlled by setting limits for maximum loss.

• Z Score: Z Score indicates how many standard deviations an observation is away from
the Mean value. VAR = Z Score X Standard Deviation.

3.3 Application of VAR

VAR is applied to:

• Measure the maximum possible loss on any portfolio or trading position.

• Serve as a benchmark for performance measurement.

• Fix limits for individuals dealing in the front office of a treasury department.

• Enable management to decide trading strategies.

• Function as a tool for Asset and Liability Management, particularly in banks.

3.4 Illustration Analysis: VAR Calculation (Single Asset)

• Scenario: Investment of Rs 2 Crore in shares of X Ltd. Daily market price standard

deviation (SD) is 2%. Determine maximum loss level over 1 trading day and 10 trading
days with a 99% confidence level.

• Underlying Concept/Principle: VAR for a single asset (or portfolio where correlation is
ignored in this simple case) is calculated by multiplying the rupee volatility by the
 corresponding Z-score for the desired confidence level. Volatility for multiple days scales
by the square root of time (Square root T).

• Reasoning Process and Calculation:

1. Z-score for 99% Confidence Level (from Normal Table) = 2.33.

2. Volatility (Daily SD) in Rupees: 2% of Rs 2 Crore = Rs 4 Lakh.

3. Maximum Loss for 1 Day (VAR):

▪ Rs 4 Lakh x 2.33 = Rs 9.32 Lakh.

4. Expected Maximum Loss for 10 Trading Days (VAR):

▪ Square root 10 x Rs 9.32 Lakh = Rs 29.47 Lakh.

• Learning Derived (Key Examinable Area): Calculation involves identifying the initial
volatility (SD in amount) and scaling it using the Z-score and the square root of the time
period for multi-day VAR (Time scaling rule for volatility: Sigma_T = Sigma_daily * Square
root T).

4. IDENTIFICATION AND MANAGEMENT OF FINANCIAL RISK

4.1 Counter Party Risk

• Identification Hints:

o Failure to obtain necessary resources to complete the project/transaction.

o Regulatory restrictions from the Government.

o Hostile action of a foreign government.

o Being let down by a third party.

o Counter party becoming insolvent.

• Management Techniques:

o Carrying out Due Diligence before dealing with any third party.

o Avoiding over-commitment to a single entity or group/connected entities.

o Knowing your exposure limits.

o Regular review of limits and procedures for credit approval.

o Taking rapid action in the event of any likelihood of defaults.

o Use of performance guarantee, insurance, or other instruments.

4.2 Political Risk

• Identification Actions (by Host Government):

o Insistence on resident investors or labour.

o Restriction on conversion of currency.

o Expropriation of foreign assets by the local government.

 o Price fixation of products.

• Assessment of Country Risk (since risk relates to foreign investment):

o Referring to political ranking published by different business magazines.

o Evaluating the country's macro-economic conditions.

o Analyzing the popularity and assessing the stability of the current government.

o Taking advice from the embassies of the home country located in the host
countries.

• Mitigation Techniques:

o Local sourcing of raw materials and labour.

o Entering into joint ventures.

o Local financing.

o Prior negotiations.

4.3 Interest Rate Risk

• Identification Parameters:

o Monetary Policy of the Government.

o Any action by the Government (e.g., demonetization).

o Economic Growth.

o Release of Industrial Data.

o Investment by foreign investors.

o Stock market changes.

• Management Note: The management of Interest Rate Risk is discussed in detail in a

separate chapter.

4.4 Currency Risk

• Identification Parameters:

o Government Action: Has a visual impact on its currency (e.g., UK Govt decision
on Brexit negatively impacted the Pound).

o Nominal Interest Rate: Currency exchange rate depends on the nominal interest
rate of that country, as per Interest Rate Parity (IRP).

o Inflation Rate: Impacts the value of currency as per Purchasing Power Parity
theory.

o External Events: Natural Calamities, War, Coup, Rebellion (all have far-reaching
impact).

o Change of Government: The attitude of a new government towards foreign

investment helps identify the risk.
 • Management Note: The management of Currency Risk is covered in detail in a separate
chapter.

5. PRACTICAL QUESTION ANALYSIS: PORTFOLIO VAR

• Question Scenario: Portfolio consists of Rs 200,00,000 in share XYZ and Rs 200,00,000

in share ABC. Total investment = Rs 400,00,000. Daily standard deviation (SD) of both
shares is 1%. Coefficient of correlation (rho) between them is 0.3. Determine the 10-day
99% Value-at-Risk (VAR) for the portfolio.

Underlying Concepts and Formulas

1. Individual Volatility: Daily SD in amount for each investment.

o Rs 200 Lakhs x 1% = Rs 2 Lakhs.

2. Portfolio Variance (V): Since the assets are correlated (rho = 0.3), portfolio variance
must be calculated using the covariance term.

o Formula in amounts (where SD_A and SD_B are standard deviations in amount): V
= (SD_A)^2 + (SD_B)^2 + 2 * rho * SD_A * SD_B

3. Portfolio Daily Standard Deviation (Sigma_Daily): Sigma = Square root (V).

4. Multi-Day Standard Deviation: Sigma_T = Sigma_Daily * Square root (T).

5. VAR: VAR = Z-score * Sigma_T.

Reasoning Process and Calculation

1. Calculate Portfolio Daily Variance (V) in Rupees (Lakhs):

o V = (2)^2 + (2)^2 + 2 * (0.3) * (2) * (2)

o V = 4 + 4 + 2.4 = 10.4

2. Calculate Portfolio Daily Standard Deviation (Sigma_Daily) in Rupees:

o Sigma = Square root (10.4) = Rs 3.22 Lakhs

o Alternative Method (Using Percentages, where weights are 0.50 each):

▪ V (in percent squared) = (1)^2 * (0.50)^2 + (1)^2 * (0.50)^2 + 2 * (1) * (1) *

(0.3) * (0.50) * (0.50) = 0.65% (squared).

▪ Sigma (in percent) = Square root (0.65) = 0.80623%.

▪ Sigma (in Amount) = Rs 400 Lakhs * 0.80623% = Rs 3.22 Lakhs.

3. Calculate 10-Day Standard Deviation (Sigma_10):

o Sigma_10 = Rs 3.22 Lakhs x Square root (10)

o Sigma_10 = Rs 10.18 Lakhs

4. Determine Z-score:

o Z-score for 99% confidence (1% tail) = 2.33.

5. Calculate 10-Day 99% VAR:

 o VAR = 2.33 x Rs 10.18 Lakhs = Rs 23.72 Lakhs

Learning Derived (Key Examinable Area)

• Portfolio Volatility: When calculating VAR for a portfolio, the standard deviation must
account for the correlation (rho) between the assets, significantly impacting the portfolio
variance.

• Scaling: VAR must be correctly scaled both for the portfolio (by using the combined
variance formula) and for the time period (by multiplying the daily standard deviation by
the square root of the number of days, Square root T).