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Risk Management

Chapter 1
Introduction to Risk Management
Meaning of Risk

Risk is a possibility of damage, injury, loss or any other negative occurrences that
is caused by external or internal vulnerabilities (inability or weakness).

Definition

According to mansson and sevenone “Risk is the potential (possibility) of losing

something of value against the potential to gain something of value, value such as
physical health, social status, emotional well being or financial wealth can be
gained or lost”.

Uncertainty, Peril, Hazards

Uncertainty: this is a situation where a possible outcomes or probability of

outcomes is unknown. In other words it is a situation where the future events are
not known.

Peril: peril is a cause of loss. Peril is the possibility of cause that exposes a person
or property to the risk of injury or damage or loss.

Types of perils

a. Natural perils: natural perils are those perils on which people have little
control.
b. Human perils: human perils includes causes of loss that lie within peoples
control like terrorism, war, theft, environmental pollution etc…
c. Economic perils: economic peril causes loss due to changes in economy like
changes in customer taste and preferences, technological advances, currency
fluctuations…

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Risk Management

Natural perils Human perils Economic perils

Insurable Difficulty to Insurable Difficulty to Difficulty to insure
insure insure
Wind storm Flood Theft War Changes in
customer taste &
preferences
Lighting Earth quake Human Terrorism Technological
accidents changes
Heart attack Volcanic negligence Civil unrest Currency
eruption fluctuations

Hazards: hazards is a condition that increases the possibility of loss.

Types of Hazards:

a. Physical Hazards:
It refers to Physical condition or tangible condition that increases the
possibility of loss.
Example: smoking is a physical hazard that increases the possibility of house
fire & illness. Slippery roads which often increases the number of auto
accidents.
b. Moral / Legal Hazards:
Moral hazards are losses that results from dishonesty and fraudulent
activities of a individuals.
Example: insurance company suffers losses because of fraudulent claims.
c. Morale hazards:
Morale hazards are losses that do not involve dishonesty but arises attitude
of carelessness and lack of concern.
Example : careless cigarette smoking

Difference between Risk and Uncertainty

Risk Uncertainty
Possibility of losing or winning It is a situation where future events are
something is known not known
Chances of outcomes are known Chances of outcomes are not known
It can be controllable Uncontrollable

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Risk Management

Types of Risks ( 6 marks or 14 marks)

1. Financial risk
2. Static and dynamic risk
3. Speculative and pure risk
4. Fundamental and particular risk
5. Market risk
6. Interest rate risk
7. Exchange rate risk
8. Liquidity risk
9. Country risk
10.Operational risk
11.Credit risk
12.Business risk

1. Financial risk
Financial risk is a possibility of loss when bond issuer will default by failing
to repay principle amount and interest in a timely manner.

2. Static and Dynamic risk:

Dynamic risks are those risks resulting from changes in the economy such as
changes in customer taste and preferences, changes in price level, income
and technological changes.

Static risks are those risks that would occur even there is no changes in
economy. If we hold customer taste, income level and technology some
individuals still suffered financial loss.

3. Speculative and pure risk

Speculative risk refers to a situation where there is possibility of loss and
also a possibility of Gain (profit).
Gambling is a good example of speculative risk.

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Risk Management

Pure risk is a situation that involves only the possibility of loss OR no loss.
Example: possibility of loss surrounding the ownership of vehicles. The
person who buys a vehicle immediately faces the possibility that something
may happened and damage or destroy the vehicle. At last the final result will
be loss or no loss.
4. Fundamental and particular risk:
The fundamental risk is one that affects the entire economy or large number
of persons or group within community. It involves losses that are impersonal
in origin.
Example : cyclical unemployment, war, earth quake, terrorism…

Particular risk involves losses that arises out of individual events and it
affects only a particular individual and not the entire economy.
Example: burning of House

5. Market risk:
Market risk is a risk of loss resulting from fluctuations in the market prices
of shares or securities or commodities.

6. Interest rate risk:

Interest rate risk arises due to variability in the interest rates from time to
time. The fluctuation in the interest rate is caused by the changes in
government monitory policy.

7. Exchange rate risk:

Exchange rate risk is a risk that arises due to changes in Exchange rates.
In other words it is form of risk that arises from changes in the price of one
country currency against another country currency.

8. Liquidity risk:
Liquidity risk is the risk that arises when a company or bank unable to meet
its short term financial obligations. Liquidity risk is arises due to inability to
convert a security or asset into cash.

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Risk Management

9. Country risk:
Country risk arises from an adverse change in the financial condition of a
country or political condition of a country in which a business operates.

10. Operational risk:

Operational risk is define has the risk of loss resulting from inadequate or
failure of internal process, people and system or from external events.

11.Credit risk:
Credit risk is the risk of loss due to debtors non payment of loan or other line
of credits either principal amount or interest amount or both.

12.Business risk:
The term business risk refers to the possibility of inadequate profits or lower
profits or experience a loss rather than making profit due to uncertainties.
Example: changes in customer taste & preference, strikes, lockout, increased
competition, changes in govt policy etc…

Various means of Managing or Handling Risks (6 marks)

1. Risk avoidance ( elimination of risk)

2. Risk reduction ( mitigating risk )
3. Risk transfer (insuring against risk)
4. Risk retention ( accepting risk )
5. Non insurance transfer

1. Risk avoidance
Risk avoidance is completely avoiding the activity that posses a potential
risk. By avoiding risk we are also avoiding a possibility of gain. Because
gain or profit will arises after taking a risk.
Example: 1. investors can avoid the risk of loss in stock market by not
buying stocks. 2. Divorce can be avoided by not marrying.

2. Risk reduction:

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Risk Management

Risk reduction is reducing the possibility of loss, by taking the precautionary

measures we can reduce the possibility of loss.
Example: installing a security alarms we can reduce the possibility of theft,
wearing seat belts or helmets we can reduce the possibility of accidents.

3. Risk transfer:
Insurance policies are another methods to manage risks. By taking insurance
policy the risk of loss can be transferred from insured person to insurance
company.
Example: by taking a fire insurance policy the house owner can transfer the
risk of loss by fire to insurance company.

4. Risk retention:
Risk retention involves accepting the risk when risk is not avoided or
reduced or transferred then it is retained.
Risk retention is accepting the risk because risk is unknown
Example: smoking cigarette is considered a form of risk retention, since
many people smoke without knowing the many risk of diseases.

5. Non insurance transfers:

a. Contract: A common way of transfer risk by contract, by purchasing the
warranty extensions the risk of manufacturing defects transferred from
customers to manufacturers.
b. Hedging: reducing the risk
c. Diversification of investments: Instead of investing all funds in one
security, invest in different securities.

Risk management (2 mark compulsory question)

Risk management refers to the practice of identifying potential risks in advance,

analyzing them and taking precautionary steps to reduce the risk.

Risk management is the identifying, analysis, assessment, control and avoidance,

minimization or elimination of unacceptable risks. An organization may use risk
avoidance, risk reduction, risk transfer, risk retention or any other strategies to
manage the risks

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Risk Management

Process of Risk management or steps in risk management OR Corporate Risk

Management Process (14 mark compulsory question)

1. Establishing the context

2. Risk identification
3. Risk analysis
4. Risk evaluation
5. Risk treatment
6. Monitor and review
7. Communication and consult

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Risk Management

1. Establishing the context:

The purpose of this stage is to understand the risk environment in the
organization that means to understand the internal and external environment
of the organization.
Establishing the context means all possible risk are identified and the
possible solutions are analysis thoroughly. Various strategies are discussed
and decisions will be made for dealing with the risks.
The methods of analysis the organization environment are SWOT analysis
(strength, weakness, opportunities and threats) and PEST analysis (political,
economic, societal and technological)
Standard Australia and standard newzeland provides a 5 step process to
assist with establishing the context:
a. The external context
b. The internal context
c. Risk management context
d. Develop risk evaluation criteria
e. Define the structure of risk analysis\

2. Risk identification:
Once the context has been established successfully, the next step is
identification of potential threats or risks, this step reveals and determines
the possibility of risks which are highly occurring and other risks which are
occur very frequently.

3. Risk analysis:
Once the risks are identified we should determine level of risk, likelihood
(possibility) of risk and consequence (effect) of risk.
In this step we should understand the nature of risk to know the effects of
risks on organizational goals and objectives.
The impact of risk should be considered on the basis of time, equality,
benefit and recourses.

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Risk Management

Impact of risk table:

5 CATASTROPHIC : most of the objectives severely affected
4 MAJOR: most of the objectives threatened
3 MODERATE : some objectives affected
2 MINOR: with some effort objectives can be achieved
1 NEGLIGIBLE: very small impact

Likelihood of the risk table:

5 ALMOST CERTAIN –occur several times
4 LIKELY – arise once in a year
3 POSSIBLE – arise over a 5 years
2 UNLIKELY – arise over a 5 to 10 years
1 RARE – unlikely but not impossible, over a 10 year period

4. Risk evaluation:
This step is deciding whether risks are acceptable or unacceptable or need
treatment.
The acceptable or unacceptable risk is based on “risk appetite” (the amount
of risk they are willing to take).

5. Risk treatment:
After analyzing the risk we should determine whether the risk needs
treatment or not. Usually an unacceptable risk requires treatment.
The treatment of risks includes:
a. Risk avoidance
b. Risk reduction
c. Risk transfer
d. Risk retention

6. Monitor and review:

Monitor and review is an essential and integral steps in the risk management
process. Risks needs to be monitored to ensure the changing environment
does not alter risk priorities.

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Risk Management

7. Communication and consult:

Communication and consult aim to identify who should be involved in the
assessment of risk ( identification of risk, analysis of risks, evaluation of
risks) and who will be involved in the treatment, monitor and review of
risks.

Importance or benefits of risk management:

1. Effective utilization of resources

2. Enables decision making: regarding accepting or non accepting risk and
treatment of risks
3. Helps to avoid reduce and prevent risks
4. Increases the possibility of risks
5. Performance monitoring
6. Helps to identification of possible risks or threats
7. Helps to reduce the effects of risks
8. Reducing the risk creating greater confidence in your activities.

Objectives of risk management

1. Pre loss objectives

2. Post loss objectives

(a) Pre loss objectives:

1. Economy :
Which means the firm should prepare for possible losses in the most
economical way. This involves an analysis of the cost of insurance
premiums and the cost associated with different techniques for
handling losses.
2. Reduction of anxiety:
Some losses make greater worries for the risk manager and key
executives. Risk management enables the organization to reduce the
possibilities of risks and worries.

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Risk Management

3. Meet any legal obligation:

The next objective is to meet legal obligations. For example: the
government regulation may require a firm to install safety devices to
protect workers from harm & industrial accidents.

(b) Post loss objectives:

1. Survival of the firm:
Some losses are so extreme that destroys the existence of the
organization. Survival means after a loss occurs the ability of a firm to
rebuild their operations.
2. Continuation in operation:
After the loss it is important for the companies to continue their
operations for its survival.
3. Stability of earnings:
Some losses directly affect the earnings of the company. A risk
management technique helps the organization to earn stable incomes
even after the loss.
4. Continue growth of the company
Risk management helps the organization to grow by developing new
product, market and business strategies.

Limitations of risk management

1. Complex calculations:
Without any automatic tool each and every calculation regarding risk
becomes difficult,
2. Unmanaged losses:
Losses can be control to the some extent; beyond that level losses cannot be
controlled and managed.
3. Depends on external entities:
For managing the risk we require information. For getting the information
about the external environment of the organization we depend on external
entities.

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Risk Management

4. Difficulty in implementing:
Risk management implementation requires long time to gather the
information regarding the risk plan and strategies.
5. Potential threats:
Potential threats means possible threats which may or may not be occur.
6. Performance:
Risk management tools and techniques is understand by only qualified
professionals. It is very difficult to understand by common man.
7. Wastage of time:
If identification of risks is not done then it will be wastage of time and
money.

Important questions from I chapter (22 marks)

2 marks:

1. What is risk management?

6 marks :

1. Various means of managing or handling risks

2. Limitation of risk management
3. Objectives of risk management any one
4. Benefits of risk management
5. Types of risks

14 marks

1. Risk management process or steps in Risk management.

2. Types of risks any one

Section A (2mark) Section B (6 marks) Section C (14 marks)

1 1 1

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Risk Management

Chapter 2
Sources of Risk and Exposure

1. Human factors 1. Economic factor

2. Technological factor 2. Natural factor
3. Physical factor 3. Political factor
4. Operational factor

Internal sources of risks:

1. Human factors:
Human factors are an important cause of internal risk. They may results
from strikes and lockouts by trade unions, negligence & dishonesty of
employees, accidents or death in industry, incompetence Of the employees
etc…, .

2. Technological factors:
Technological factors are important sources of Risk. A sudden change in
technology will results in to a huge loss & other business risk to the
organization.
For example: - if there is some technological advancement which results in
Products of higher quality, then a firm which is using the traditional
Technique of production may face the risk of facing the market for its poor
Quality products.

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Risk Management

3. Physical factors:
These are the factors which results in loss or damage to the property of the
firm. They include the failure of machinery & equipment or theft in the
industry, damages in transit of goods etc…,.

4. Operational factors:
Operational factor is the risk of monitory losses resulting from inadequate or
failed internal process, human error & system failure.
Ex:- fraud, lack of supervision , technology failure , inadequate document
keeping .

External sources of risks:

1. Economic factor:
These are the most important causes of external risk. They results from
changes in economic condition like changes in customers taste &
preferences , price fluctuations , changes in the demand for product, changes
in income , increased competition etc…, .

2. Natural factors:
These are the unforeseen natural calamities over which a person has a very
little or no control. They results from events like earthquake, flood, cyclone,
lightening etc…,
Ex:-Gujarat earthquake caused irreparable damage not only to the business,
but also adversely affected the whole economy of the state.

3. Political factors:
The risk of loss caused from changes in the political condition of the country
like changes in government, changes in government policies, communal
violence, civil war, hospitalities with neighboring countries.

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Risk Management

Sources of Risk in Insurance

1) Proposal form

2) Medical examination report

3) Insurance agents report

4) Inspection report

5) Private friends report

6) Neighbors’ and business associates

7) Attending physicians.

Types of Risk Exposure

1) Personnel risk exposure: - people or personnel loss exposure includes the
possibility of loss to a business firm from death, sickness, disability,
unemployment resignation & retirement of the employees.

Personnel loss exposure affects the income earning power of an individual.

2) Property loss exposure: - property owners face the risk of having their property
stolen, damage, or destroyed by various causes. A property may suffer direct loss,
indirect loss.

A) Direct loss: - It is a loss when the property is directly damaged, destroyed

with the peril. Ex: - Building destroyed by fire or jewels stolen from safety locker.

B) Indirect loss: - It is a loss that arises because of prior occurrence of

another loss .ex:- Expenditure incurred rebuilding & replacement.

3) Liability loss exposure: - It includes causing damage, injury to others.

Ex: - If you injured your neighbor or damage his property, the law would impose
fines on you.

4) Catastrophic loss exposure: - A loss that is catastrophic a larger number of

exposures in a single location are considered as catastrophic loss. Catastrophic
loss exposure affects the whole economy.
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5) Accidental loss exposure: - It refers to pure risk that arises due to accidental, un
intentional & not due to manmade.

Pure and speculative risks (14 marks)

Pure risk is a situation that involves only the possibility of loss OR no loss.

Example: possibility of loss surrounding the ownership of vehicles. The person

who buys a vehicle immediately faces the possibility that something may happened
and damage or destroy the vehicle. At last the final result will be loss or no loss.

Different Types of Pure Risk

1) Personnel risk: - It refers to risk of loss to a business firm due to pre matured
death, old age, sickness or poor health, unemployment.

Personnel risk effects income earning power of individual, personnel risk can be
classified in to 4 types;

a) Risk of pre mature death: - It is generally believed that the average life span of
human beings is 70 years, anybody who dies before attaining age of 70 years could
be regarded as per mature death.

Pre mature death usually brings great financial & economic in security to
dependents.

b) Risk of old age: - Risk of old age is possibility of not getting sufficient income
to meet financial needs in old age after retirement. Reasons for old age risk is not
making savings & not able to acquire financial assets.

c) Risk of poor health: - A sudden & unexpected illness can result into lower &
high medical bills to overcome have adequate personnel accident & health.

d) Risk of unemployment: - Unemployment is a situation where a person who is

willing to work &he is looking for work to do, cannot find work to do.
Unemployment always brings financial insecurity to people.

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2) Property risk: - property owners face the risk of having their property stolen,
damage, or destroyed by various causes. A property may suffer direct loss, indirect
loss.

A) Direct loss: - It is a loss when the property is directly damaged, destroyed

with the peril. Ex: - Building destroyed by fire or jewels stolen from safety locker.

B) Indirect loss: - It is a loss that arises because of prior occurrence of

another loss .ex:- Expenditure incurred rebuilding & replacement.

3) Liability risk: - It includes causing damage, injury to others.

Ex: - If you injured your neighbor or damage his property, the law would impose
fines on you.

Speculative risk refers to a situation where there is possibility of loss and also a
possibility of Gain (profit).

Ex: - if you buys shares in a company, you would make a gain if the price of shares
raises & you would sustain losses if the price of shares decreases or falls.
Gambling is the good example for speculative risk.

Differences between pure and speculative risk

Pure risk Speculative risk

1. It is a situation where there is a It is a situation where there is possibility
possibility of loss or no loss. of loss as well as the possibility of gain.
2. It results in no loss or loss. It results in gain & loss.
3. It can be predictable It cannot be predictable
4. It can be insurable. It cannot be insurable.
5. It is not accepted. It is accepted.
6. Society will not benefit from it Society may benefit from it
7. An example of pure risk is the Gambling is the good example of
risk of becoming disabled as a speculative risk
result of illness or injury.
8. Pure risk occur by chance not Speculative risk is occur by choice of the
by choice person.

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Static and dynamic risks (14 marks)

Dynamic risks are those risks resulting from changes in the economy such as
changes in customer taste and preferences, changes in price level, income and
technological changes.

Static risks are those risks that would occur even there is no change in economy.
If we hold customer taste, income level and technology some individuals still
suffered financial loss.

Differences between static and dynamic risk

Static risk dynamic risk

1. They are present in an They are present in changing Economy.
Unchanging economy.
2. They are easily predictable They are not easily predictable.
3. It affect only individuals or It affects a large number of individuals.
Very few of individuals

4. They are pure risk They are speculative risk.

5. Society will not benefit from it Society may benefit from it

6. Static risks are insurable Dynamic risks are not insurable

Acceptable & Non-Acceptable Risk:-

Acceptable risk refers to the level of human & property injury or loss from an
industrial process that is consider to be tolerable by an individual , house hold ,
group, organization , community , state or nation in view of the social , political &
economic caused benefit analysis .

ex:-The risk of flooding can be acceptable once every 500 years but it is not
acceptable in every 10 years .

Non-acceptable risk is the level of human injury & property damage is not
tolerable by individual, group, society, state or nation.

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Fundamental and particular risk:

The fundamental risk is one that affects the entire economy or large number of
persons or group within community. It involves losses that are impersonal in
origin.

Example: cyclical unemployment, war, earth quake, terrorism…

Particular risk involves losses that arise out of individual events and it affects
only a particular individual and not the entire economy.

Example: burning of House

Various Elements of Cost Of Risk (6 marks)

Meaning of cost of risk:-

It is the total cost associated with risk management function. In other words, cost
of risk is the total cost of insurance premiums retained losses and internal or
external risk control cost.

Elements of Cost of Risk

1) Insurance premium: - it includes the amount of fund spend on insurance

coverage & broker commission.

2) Retained loss: - It is the amount of money that a firm spends out of pocket for
loss incurred.

3) Cost of incurred to protect employees from injuries:

cost of installing safety devices.

4) Cost incurred with professional firms

5) Productivity loss due to injuries.

Components of Cost of Risk

1. Expected losses- It includes both direct losses and indirect losses.

2. Cost of loss control- it is the cost associated with precautionary measures

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3. Cost of loss financing – cost incurred for taking insurance policy,

premiums, brokerage, commission etc…
4. Cost of internal risk reducing- cost incurred for diversification of
investments.
5. Cost of residual uncertainty.

Enterprise Risk Management

It includes the methods & process used by organization to manage risk & seize
opportunities associated with rapidly changing business environment.

Implementation of Enterprise Risk Management Programme

1. Goals of ERM programme: - ERM is a approach to manage risk related to the

achievement of organizational objectives.

2. Typical risk function:-

a) Strategic plan: - It identifies external threads & identifies.

b) Marketing: - To understand the requirement of targeted customers.

c) Compliance & ethics.

d) Accounting compliance.

e) Law department.

f) Insurance.

g) Operations management.

h) Credit.

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Challenges in ERM Implementation

1. Establish in a common risk language.

2. Describing entities risk appetite (risk it will take & risk it will not take).
3. Implementing risk rating methodology.
4. Establishing ownership for risk responsibilities.
5. Developing consolidated reporting for various stake holders.
6. Monitoring the results of actions.

Important questions from II chapter (22 marks)

2 marks:

One question from sources of risk, types of risk exposures

6 marks :

1. Various elements of total cost of risk * * *

2. Sources of risk exposure and types of risk exposure any one
3. Difference b/w static and dynamic risk
4. Acceptable and non acceptable risk

14marks

1. pure risk and speculative risk ( meaning, types, differences)* * * any 1

2. Sources of risk exposure and types of risk exposure * * *

Section A (2mark) Section B (6 marks) Section C (14 marks)

1 1 1

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Risk Management

Chapter 3
Corporate Risk Management
Meaning of CRM:

Corporate risk management refers to all the techniques and methods that a
company uses to minimize financial loss.

Corporate risk management also relates to external threats to a corporation, such as

the fluctuations in the financial market that affect its financial assets.

Importance or Objectives of Corporate Risk Management (CRM)

1. Elimination of uncertainty:
Identifying the risk and managing the risk before they affect the business.
2. Helps to control both internal and external risks:
External risks are those risk which not in the control of management. CRM
helps to control both internal and external risks.
3. helps to define its objectives for future:
Without taking the risk into consideration it is difficult for the companies to
define its objectives for future.
4. Helps to identify, analysis and evaluating the risks.
5. To know the effects of uncertainty on the organizational objectives

Guidelines and Tools of Risk Management

(14 marks compulsory question)

Guidelines for risk management

1. Identify and assess risks

2. Know the number
3. Risks are interrelated
4. Continually reassess risks
5. Commit adequate resources
6. Review the cost of risk mitigation
7. Reduce exposure
8. Assess the risk/return ratio
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9. Monitor for quantum shifts in risk levels

10.Create a risk aware culture

1. Identify and assess risks:

Risk is everywhere, the success of the business is depends upon identifying
and managing the risk before it affects potential opportunities and returns of
the company. The types of risks are faced by the business is varied from one
business to another.
The first guidelines to manage the risk are identification of possible risks
that affects the company. Risk categories includes: market risk, credit risk,
legal risk, political risk, reputational risk etc…

2. Know the numbers:

Risk register is used to identify and rank the risk on the basis of magnitude
of the risk. The effective risk management strategies typically depend on the
quantification of risks. Spend the time and money to get the tools and
techniques of risk management in order to manage the risks.

3. Risks are interrelated:

Some of the risks are interrelated, while identifying the risk first we should
know the interrelated risk for mitigating (reducing) the risks.
Example: exposure to credit risk may also affect market price risk.
Operational risk such as fraud may create legal risk and reputational risks.
Identifying the interrelated risk is one of the best way to managing the risk.

4. Continually reassess risks:

Things changes and risk also changes. Changes in market condition, changes
in the financial condition of the counter party, changes in physical
environment, changes in political environment also cause the changes in the
risks. So we should assess the risk on continuation basis in order to update
the information.

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5. Commit adequate resources:

Risk management tools and techniques are usually not cheap, before
handling the risks the company should ensure to have adequate financial
resources. Otherwise it will cause the failure of business.

6. Review the cost of risk mitigation:

Transferring the risk through hedging and insurance is effective and
advisable risk management technique but risk mitigation (reduction)
strategies is largely depends upon the costs. Money spending on risk
management tools and techniques should not exceed the benefits derived
from the risk management.

7. Reduce exposure:
Risk is arise from exposure. The commonly accepted definition of risk is
exposure to uncertainty. Reduce the exposure means reduce the risk. Risk
awareness in business processes and commercial activities can lead the
opportunities to reduce the current and future exposures.

8. Assess the risk/return Ratio:

The company to get the high return with lower risk it is one of the guidelines
for managing the risks in business.

9. Monitor for quantum shifts in risk levels

Monitor and review is an essential and integral step in the risk management
process. Risks needs to be monitored to ensure the changing environment
does not alter risk priorities.

10. Create risk aware culture:

Educate the organization in practical aspects of risk management and that
especially includes the most senior business executives and the corporate
board of directors. Training and building the awareness in business
operations is one of the ways for managing the risks.

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Tools of Risk Management

1. Risk probability and impact assessment:
The company should assess the possibility of risks and its effects on
business operation are one of the tools for managing the risks.
Impact of risk table:
5 CATASTROPHIC : most of the objectives severely affected
4 MAJOR: most of the objectives threatened
3 MODERATE : some objectives affected
2 MINOR: with some effort objectives can be achieved
1 NEGLIGIBLE: very small impact

2. Probability and impact matrix:

Rating the risks for further analysis using a probability and impact matrix
is another tool for managing the risk.
Possibility of the risk table:
5 ALMOST CERTAIN –occur several times
4 LIKELY – arise once in a year
3 POSSIBLE – arise over a 5 years
2 UNLIKELY – arise over a 5 to 10 years
1 RARE – unlikely but not impossible, over a 10 year period

3. Risk categorization:
Grouping the risk based on their impact or effects is one of the tools for
managing the risks.

4. Risk urgency assessment:

5. Expert judgment:
Individuals who have experience with similar projects may use their
judgment through interviews or risk facilitation workshops.

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Approaches and processes of Corporate Risk Management

(14 marks)
Approaches of CRM

1. Top down multi pass approach:

This approach can be used from the outset of the project. It is based on the
principles that:
a. The person should understand the overall risk of the project risks, how to
quantify and how to manage.
b. The risk management process should address the key risk questions.
c. Key risk questions may change from one stage of the risk management
process to another stage of risk management process.
d. Risk management techniques should select to address the key risk
questions.
e. The tools and techniques can be used to find a solution to project.
Advantages:
1. Can be used from the project commencement
2. Efficient identification of key risks
Techniques:
1. NPV risk modeling
2. Decision tree

2. Quantitative risk based forecasting:

This approach involves the implication of a project plans.
It is used to find out project cost and completion dates.
Advantages:
1. Used to identify overall risk of the project
2. Used to find out project cost and completion dates.
Techniques:
1. Monte carlo cost risk analysis
2. Product risk modeling

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3. Risk register
This is the common practice approach of using a single pass approach
to identifying a list of risks and entering them into a risk register for
assessment and risk response planning. Risks are reviewed on a
regular basis to update the risk information and verify that risk
responses are implemented.
Advantages:
1. Required less experience
2. When implemented well, fasters a good team culture
Techniques:
1. Risk register
2. Probability – impact matrix

Process of CRM

(Refer process of risk management page no 07)

Asset and liability management(ALM)

Asset and liability management can define a mechanism to address the risk faced
by bank or an organization due to mismatch between assets and liabilities, either
due to liquidity or changes on interest rates.

Asset and liability management

Asset management liability management

How liquid are the assets of the company How easily can the company
generate loans from market?

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Objectives or Importance of ALM

1. Liquidity risk management

2. Interest rate risk management
3. Currency risk management
4. Funding and capital management
5. Profit planning and growth projection

Management of business risks, currency risks or Interest rate risk

Business risk

The term business risk refers to the possibility of inadequate profits or lower
profits or experience a loss rather than making profit due to uncertainties.

Example: changes in customer taste & preference, strikes, lockout, increased

competition, changes in govt policy etc…

Types of business risk:

1. Strategic risk – risk of loss arising from various strategies used by the
company
2. Compliance risk – risk of loss arising from rules and regulations followed by
the company.
3. Financial risk
4. Operational risk: risk of loss arising from inadequate of failure of people
system and operations.
5. Reputational risk: loss of company reputation or good name by failure of
product or negative publicity.

Management of business risk

1. Evaluate risk factors and make contingency plan

2. Determine insurance needs
3. Risk management plan
4. Train employees
5. Update plans

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Currency risk

Exchange rate risk or currency risk is a risk that arises due to changes in Exchange
rates. In other words it is form of risk that arises from changes in the price of one
country currency against another country currency.

Management of currency risk:

The best way for managing currency risk is hedging

The following are the steps to hedge against currency risk:

1. Identify ETF ( exchange traded funds) – different country’s currency

providers
2. Determine direction – deciding the currency of which country
3. Calculate amount
4. Manage the trade

Interest rate risk

Interest rate risk arises due to variability in the interest rates from time to time. The
fluctuation in the interest rate is caused by the changes in government monitory
policy.

Riskiness of return
 Variability in the return of a security is caused by both internal and
external factors.
 Variation in Return on asset is affected by both systematic and
unsystematic risk
 Systematic risk is arises from external factors like economic and
political instability, economic recession, macro policy of the
government
 Unsystematic risk is arises from internal factors. Like raw material
scarcity, labour strike etc…
 Low level of risk always associate with low return
 High level of risks always associated with high return

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 The risk return trade off is the balance between the desire for the
lowest risk and highest return.
 In the below figure: lower end of the scale represents low risk low
return
 Upper end of the scale represents high risk high return

Important questions from III chapter (22 marks)

2marks:

1. What is corporate risk management?

6 marks :

2. Managing of business risk currency risk and interest rate risk

3. Asset liability management any 1
4. Riskiness of returns

14 marks

3. Guidelines and tools for risk management. Any 1

4. Corporate risk management approaches and process

Section A (2mark) Section B (6 marks) Section C (14 marks)

1 1 1

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Chapter 4
Derivatives as Risk Management Tools
Derivatives:

Derivatives is a contract between two parties which derives its values or price from
an underline asset. The most common underlying asset includes stocks, bonds,
commodities, interest rate, currencies etc…

Or

Derivates refers to a security whose price is derived from one or more underlying
asset.

Definition:

According to the securities contract regulations act 1996 under sec 2(AC)
derivatives refer to “a contract which drives its value from the price of an
underlying securities.

Characteristics of derivatives:

1. The value of derivatives depends on price of underlying asset.

2. All the transaction in derivatives takes place in future specific dates.
3. The contract have transacted through a recognized exchange or through a
clearing house.
4. It requires reliable initial investment.
5. Derivatives has low transaction cost.
6. It is a hedging derivates which reduced the risk involved in transactions.

Participants in derivates market:

Those who trade in derivates transaction classified into 3 categories:
1. Hedges
2. Arbitrageurs
3. Speculators

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Hedgers Arbitragers

Speculators

1. Hedgers:
Hedgers are those trades who wish to elimination the price risk associated with the
underlying asset being traded, they are not in the derivatives market to mark profit
Ex: An investors holding share of ITC co. fearing that the share price will
decrease in future. He protected himself by selling the share immediately.

2. Arbitrageurs
Arbitrageurs are traders who simultaneously purchase of securities/asset in one
market at lower price and sold same security in another market at a higher price.
Arbitrageurs make profit from price differential existing in two markets.

3. Speculators:
Speculators are those classes of investors who willing take price risk making profit
from price changes in the underlying asst.
Speculators investing those businesses in which they are expertise.

Types of derivatives:
1. Forward
2. Future
3. Options
4. Swaps

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Forward contract:
Forward contract is a non –standardized contract b/w two parties to buy or sell an
asset at a specified future time at a price agreed upon today.
The forward contract transactions have settled by delivery or cash settlement.

Features/characteristics of forward:
1. Counter party risk:
In forward contract any of the party refuses to buy or sell a particular
commodity then opposite party exposed to counter party risk.
Ex: trade takes place b/w Mr. A (Buyer) & Mr. B (Seller) the pre specified
delivery price rs.100 per kg and maturity is one month after one month the
commodity is trading at rs. 120 per kg Mr. A would gain rs. 20 and Mr. B
suffer a loss of rs.20. incase B defaults (refuse to sell at rs.100) Mr.A exposed
to counter party risk.
2. Underlying asset:
In forward contract underlying asst could be stocks, bonds, commoidities etc…
3. Flexibility:
It offers flexibility to design the contract in terms of price, quantity, quality.
4. Settlement:
It can settle by delivery or cash settlement.
5. Contract price:
The contract price is generally not available in public domain.

Advantages of forward contract

1. Hedge risk:
In forward contract price movements can be expected and it is possible to
lock today’s price.
2. No margin requires:
It does not require any margin
3. No initial cost:
In forward contract margin are have paid so it dose not involve initial cost
4. Negotiability:
The terms and conditions of forward contract are negotiable. It can be return
for any amount and term.

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Disadvantages:
1. Counter party risk
2. Not traded in stock exchange
3. No transparency in prices

Future contract:
It is an agreement b/w two party’s i.e.; a buyer and seller to buy or sell a particular
commodity at a future date at a specified price.

Future contract have traded on recognized stock exchanges there have traded in 3
primary areas.

1. Agriculture commodities
2. Methods or petroleum
3. Financial asset such as share, currencies, interest rates.

Characteristics of future contract:

1. Highly standardized:
In terms of price, quality, quantity, place and time of delivery of commodity.
2. Future are traded only in organized only in organized exchanges
3. Margin payment (future trading requires margin payment by both the parties in
order to eliminate counter party risk).
4. Fluctuation in the prices:
Prices of contract changes every day.
5. No counter party risk:
In future contract margin amount is collected.
6. Transaction cost:
Future contract traded in recognized stock exchanges so it incurred brokerage
fees, commission.
7. Mark to market(MTM):
In future contract assets are valued at recent market price.

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Advantages:

1. Hedge risk
2. Guarantees performance of contract
3. No counter party risk (bcz margin money is required in future contract).
Disadvantages:
1. It incurred transaction cost.
2. It offers only a partial hedge.

Options:
Option is an agreement that gives the owner the right to buy or sell a specified
asset at a specified price but not obligation.
The options are basically classified into 2 types:
1. Call option:
A call option gives the buyer the right to buy an asset at certain for a price
but not the obligation.
2. Put option:
A put option gives the seller the right to sell an asset at a certain date for a
certain price but not the obligation.

Features of options:
1. Premium:
To acquire the right of an option the holder should pay premium on option
price to opposite party.
2. Right to buy or sell:
In option contract the holder has right to buy or sell the asset at a certain
price.
3. No counter party risk:
In options contract there is no counter party risk because of premiums.
4. The exercise price is fixed.

Advantages of options:
1. Limited risk:
In option contract the risk is limit to extent of premiums.

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2. It protect the investors:

Option allows investors to protect their position against price fluctuations.
3. Right to exercise:
In option contract holder get the right to buy or sell a particular asset at a
certain price

Disadvantages:
1. Options are very complex and require a great observation and maintenance.
2. Some option positions has unlimited risk
3. Options are not available for all stocks.

Types of options
1. Call option:
A call option gives the buyer the right to buy an asset at certain for a price
but not the obligation.
2. Put option:
A put option gives the seller the right to sell an asset at a certain date for a
certain price but not the obligation.
3. American option:
American options are options that can be expired before the expiration date
at any time.
4. European option:
European options are options that can be expired only on the expiration date.
5. Index options:
It refers an option which has both the feature of American and European
option.
Index options contracts are cash settled.
6. Vanilla option and exotic option:
Vanilla option is a simple or well understood option ex: European and
American options.
Exotic option is more complex or less easily understood options. Ex: Asian
options, look back options
7. Stock option:
Stock option gives an employee the right to buy a stock at a discounted rate.

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8. Exchange traded option:

Exchange traded options refers to those options which are settled through a
clearing house.

Swaps:
A swap is an agreement between two parties to exchange future cash flows for a
fixed period of time.
Types of swap
1. Interest rate swap:
It involves swapping the interest related cash flows between the parties in
the same currency.
2. Currency swaps:
In currency swaps one currency is exchanges for another currency on
specified terms and conditions for specified time.

Features of swap:
1. Basically a forward
2. Double coincidence of wants
3. Necessity of an intermediary
4. Long term settlement

Advantages:

1. Hedging risk
2. Tool to correct asset liability mismatch
3. Additional income to financial intermediary
4. No premium paid to enter into swap.

Disadvantages:

1. It is difficult to identify a counter party to take the opposite side of the

transaction
2. Termination of swap contract requires mutual consent of both the parties.
3. Early terminations of swap before its maturity incur brokerage cost.
4. Secondary market for swap is still not fully developed- because trading in
secondary market requires standardized documentation

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Difference between forward contract and future contract (6 marks)

Basis Forward Future
Meaning Forward contract is a non – It is an agreement b/w two party’s
standardized contract b/w i.e.; a buyer and seller to buy or sell
two parties to buy or sell an a particular commodity at a future
asset at a specified future date at a specified price.
time at a price agreed upon
today
Trading Forward contracts are over Futures traded through stock
the counter contracts (OTC) exchanges
Counter There is counter party risk No counter party risk
party risk
Margin Margin payment not required Margin payment is required
payment
Settlement Settled by delivery or cash Most of the contracts are settled by
settlement cash
MTM Mark to market is not done Mark to market is done
Prices Prices remain fixed until Prices fluctuate everyday
maturity
Standardized Non standardized contracts Highly standardized
Transparency No transparency of prices bcz Transparency in prices
of prices contract price is not available
in public domain
Initial / No initial cost Initial cost is required
transaction
cost

Terminologies used in derivatives

1. Long position ( buyer):
The party or person who agrees to buy an underlying asset on a future date is
said to have a long position.
2. Short position ( seller):
The person who agrees to sell an underlying asset on a future date is said to
have short position.

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3. Hedging:
It is the process of reducing the exposure of risk
4. Margin :
The amount deposited in the margin account at the time of entering into a
contract.
5. Mark to market :( MTM)
It refers to valuing the asset at the recent market price. Or in the future
market at the end of the each trading day the margin account is adjusted to
reflect investors gain or loss depending on the future closing price.
6. LIBOR ( London interbank offered rate):
It is an interest rate at which banks can borrow from other banks in the
London interbank offered rates.
7. Over the counter (OTC):
In OTC derivatives contracts are traded directly between two parties without
going through an exchange or any other intermediary.

Importance of derivatives
1. Hedging :
We can reduce the risk, by discovery of future price or current price of the
commodity.

2. Price discovery:
A derivative helps to discover future and current price movements of
commodities.

3. Management of risks:
Risks can be reduced by making different strategies like hedging,
arbitragers, etc…

4. Increased in the volume of transactions:

For entering in to a derivative contract margin amount is required there is no
need to settle the full amount at the time of entering into contract. It
increases the volume of transactions.

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5. Speculation &arbitrage:
Derivatives can be use to acquire risk rather than reduce risk. Some
individuals and institutions will enter into a derivative contract for
speculation purpose.

6. Liquidity and reduce transaction cost:

As we know that in derivative contracts no immediate full amount of the
transaction is required, since most of them based on margin trading. As a
result large number of traders, speculators operates in such market. So
derivative trading enhances liquidity.

7. Gearing value ( leverage):

Small movement in the underlying value can cause large difference in the
value of the derivatives.
8. Increase savings and investments:

9. Price stabilization function:

By discovering future and current prices

10.It requires negligible initial investment for trading.

11.Develop the complete market

12.Encourage competition.

Classification of derivatives
1. Based on linear and non linear
Linear derivatives: those derivatives whose value depends linearly on the
underlying value ex: forward, future, swap
Non linear: those derivatives whose value is not depends linearly on the
underlying value ex: options

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2. Based on financial and non financial:

Financial derivatives: financial derivatives are those derivatives which are
financial in nature.
Non financial: non financial derivatives are those derivatives which are not
financial in nature.
3. On the basis of market where they trade
OTC: In OTC, derivative contracts are traded directly between two parties
without going to an exchange or any other intermediary.
Ex: forward
Exchange traded derivatives: derivative contracts traded only in recognized
stock exchanges ex; future contracts

Derivatives as risk management tools

There are 3 different types of risk tool, two have identified by their approach i.e.
capital asset pricing model(CAPM), and risk analysis of alternative (AOA)

1. Capital asset pricing model (CAPM)

2. Risk analysis of alternative (AOA)
3. Probabilistic risk assessment (PRA)

1. Capital asset pricing model :

The capital asset pricing model is a model that describes the relationship
between systematic risk and expected return for asset particularly stock.
CAPM is widely used in finance are for:
a. Pricing of risky securities
b. Generating expected return on assets
c. Calculating cost of capital

The formula for calculating the expected return of assets is as follows:

Ra = Rp + β ( Rm –Rf)

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Where
Ra = return on asset
Rf = risk free return

Rm = expected market return

Β = beta of security

The CAPM says that the expected return of asset = risk free return + risk premium.

If expected return does not meet the required return then the investment should not
be undertaken.

Example of CAPM:

Using the CAPM and following assumption we can compute the expected return
for assets.

The risk free rate 2% beta of a stock is 2 and the expected market return over the
period is 10%.

So it means that the market risk premium is 8% (10%-2%) i.e. after subtracting the
risk free rate from expected market return.

Ra = Rp + β ( Rm –Rf)
= 2% + 2(10% -2%)

= 2% + 2(8%)

= 2% + 16%

= 18% (expected return)

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Expected return

SML – security market line

Rm = 10%

Rf= 2%

0 1 2 beta

2. Risk analysis alternatives

Risk AOA is a predictive tool used to discriminate between proposals,
choices or alternatives by expressing risk for each as a single number.
The results are made between alternatives based on their cost schedule time
and risk.

3. Probabilistic Risk Assessment (PRA)

PRA is a systematic and comprehensive methodology to evaluate risk
associated with complex engineered technological entity.
Ex: air lines or a nuclear power plant.
The PRA risk is characterized by two quantities.
1. The magnitude of the possible adverse consequence:
Expressed numerically ex: no of people hurt or kill
2. Possibility of occurrence of each consequences:
Expressed in their number of occurrences

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PRA usually answer 3 basic questions:

1. What can go wrong?

2. How likely it is?
3. What are its consequences?

Techniques of PRA

1. Risk register
2. Risk radar enterprise
3. Simple risk based on NIST 800-30.

Important questions from IVchapter (24 marks)

2marks:

1. Hedging
2. Forward, future, swap, option
3. Call option, put option, currency swap, interest rate swap
4. Expand OTC, LIBOR, ETF
5. derivatives

6 marks :

6. difference between forward and future any 1

7. participants in derivative contracts
8. types of derivatives ( forward, future, option swap)

14 marks

9. derivatives as risk management tool ( CAPM,AOA,PRA) any 1

10. importance of derivatives
11.Types of derivatives

Section A (2mark) Section B (6 marks) Section C (14 marks)

2 1 1

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Chapter 5
Hedging and options
Fundamental concept of hedging and options
Hedging:
Hedge is a risk reduction technique used to reduce any substantial losses or gains
suffered by an individual or an organization.

Objectives of hedging:

1. Reduce the risks

2. Helps to increase liquidity in financial markets
3. It limits the loss for an individual.

Disadvantages

1. Hedging associated with cost like brokerage, commission

2. It limits the profits for an individual
3. All risks cannot be hedged

Concept of hedging

An investor holding shares of ITC Company fearing that the shares prices will
decrease in future, by taking the opposite position means selling the shares
immediately an investor can reduce the some extent of loss

Options:
Option is an agreement that gives the owner the right to buy or sell a specified
asset at a specified price but not obligation.

The options are basically classified into 2 types:

1. Call option:
A call option gives the buyer the right to buy an asset at certain for a price
but not the obligation.

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2. Put option:
A put option gives the seller the right to sell an asset at a certain date for a
certain price but not the obligation.

Concept of call option (buy option)

Assume Mr A (Buyer) and Mr B (seller) enters into a contract to buy and sell a
particular commodity at Rs. 200 each. Mr. A paid Rs. 50 to Mr B as a premium to
get buying rights. On the maturity of the contract that commodity traded at Rs. 400
in the market. Now Mr A has the rights to buy that commodity at Rs, 200 as stated
in the contract. And Mr. B has the obligation to sell that commodity to Mr A at Rs.
200. Here the profit for Mr A is Rs 400 – Rs 200 = Rs. 200 – Rs.50( premium
paid) = Rs. 150.

In case that commodity traded at Rs. 100 in the market, then Mr A is not Going to
Exercise that contract. Because Mr.A has right to Buy but not the obligation. And
here maximum loss for Mr A is Rs. 50 premium.

Concept of put option (sell option)

Assume Mr A (Buyer) and Mr B (seller) enters into a contract to buy and sell a
particular commodity at Rs. 200 each. Mr. B paid Rs. 50 to Mr A as a premium to
get selling rights. On the maturity of the contract that commodity traded at Rs. 100
in the market. Now Mr B has the rights to sell that commodity at Rs, 200 as stated
in the contract. And Mr. A has the obligation to Buy that commodity from Mr B at
Rs. 200. Here the profit for Mr B is Rs 200 – Rs 100 = Rs. 100 – Rs.50( premium
paid) = Rs. 150.

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Fundamental concept of currency swaps and Interest rate swaps

Or risk management with Swaps:
swaps
A swap is an agreement between two parties to exchange future cash flows for a
fixed period of time.
Types of swap
1. Interest rate swap:
It involves swapping the interest related cash flows between the parties in
the same currency.
2. Currency swaps:
In currency swaps one currency is exchanges for another currency on
specified terms and conditions for specified time.

Concepts of currency swaps

An American company (company A) wants to expand their business in Europe.

Simultaneously a European company (company B) is seeking entrance into
America. Company A Requires 10000 Euro but it is very difficult for the company
to raise 10000 Euro in Europe because cost of borrowing is very high for company
A because company A is not well Known in Europe. In the same way company B
also facing same problem i.e. company B requires 10000 American dollars.

Now company A & B decided to Exchange their currency. Both the companies
borrowed funds from their domestic banks. Company A taken 10000 $ at the rate
of 4% and company B taken 10000 euro at the rate of 5%. Both company
exchanged their currency each other based on terms & condition for certain period
of time.

10000 US$
Company A Company B

10000 euro

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Risk Management

Concept of Interest rate swap

Assume Mr. Raghu invested 1000000 US $ that pays him floating interest rate i.e.
LIBOR + 1%. As LIBOR goes up and down, the payment Raghu receives changes.

Mr. manjunath invested 1000000 US $ that pays him fixed interest rate of 4%
every month. The payment manjunath receives never changes.

Now Raghu decided to get Fixed Income and Manjunath Decided to get Floating
Income. Both are decided to exchange their incomes.

Under the terms of their contract, Raghu agrees to pay Manjunath LIBOR + 1%
and manjunath agrees to pay raghu 4% of fixed Income

Raghu LIBOR + 1% Manjunath

Fixed 4%

Invested 1000000 $ invested 1000000 $

Receives LOBOR+1% receives 4% fixed rate

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Risk Management

Fundamental concept of value at risk (VAR)

Value at risk (VaR) is a statistical technique designed to measure the maximum
loss that portfolio of asset could suffer over a given time horizon with a specified
level of confidence.

According to philippe Jorion “ VaR measures the worst expected loss over a given
horizon under normal market conditions at a given level of confidence”.

Features of VAR

1. it is a measure of risk of loss

2. it controls and monitors the risk
3. it is exclusively used in banks
4. it describes the total risk of investment
5. horizon under normal market conditions.

VAR answers the question, “ what is my worst case scenario?” or “ how much
could I lose in a really bad month”?

VAR has three components:

1. time period : ( a day , a month, a year)

2. confidence level:
90% confidence
95% confidence
99% confidence
3. loss amount or loss % ( expressed in dollar)

Keep these three parts in mind as we give some examples of variations of the
question that VAR answers:

1. What is the most I can – expect to lose amount over the next month? with
95% or 99% confidence level
2. What is the maximum % I can expect to lose over the next year? with 95%
or 99% confidence level

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Risk Management

Advantages of VAR

1. It measures the financial risk

2. It controls the risk
3. It helps banks in setting capital requirements
4. It easy to understand and explain
5. it describes the total risk of investment
6. it is a measure of risk of loss

Disadvantages

1. it is unable to prevent heavy losses

2. value at risk is very difficult to calculate with large portfolio
3. different value at risk methods leads to different results
4. multivariate factors affect VAR

who does use VAR what for

1. bank risk manager measure operational risk

2. bank executives set limits of capital requirements
3. exchanges compute margins
4. regulators fore cast systematic risk

Important questions from V chapter

2 marks

1. Hedging 2. VAR 3. Objectives Of Hedging or features of hedging

6 marks/ 14 marks

1. Fundamental concept of hedging and options

2. Fundamental concept of currency swap and interest rate swap
3. Value at risk (VAR)

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