Banking and Financial Markets : A Risk Management Perspective

Prof. P C Naryan

Week 1

Overview of Risk Management

In this session, we will look at an overview of risk management. "No risk, no gain" goes a
famous saying in the English language. Nowhere is this more applicable than in the world of
banking and financial markets, manifested as risk-return relationship. Higher the risk, higher
the expected return; lower the risk, lower the expected return.

To illustrate, consider a financial assets company that has invested only in treasury bonds or
government securities. These investments are absolutely risk free. However, not surprisingly,
the returns would also be the lowest. On the other hand, another financial asset company that
has invested in high-yield bonds or junk bonds as they are referred to would obviously expect
a much higher return, however, it also carries a far higher risk since the issuer of such high
yield bonds might more easily go into liquidation or become insolvent and might therefore not
be in a position to repay even the periodic coupon payments and possibly the principal
repayment as well.

Given this understanding of risk-return relationships, let's try and further unravel the phrase
"risk". Let us say a decision maker has a view but he is not sure that his view will come true
going forward. Here's an example, the chief financial officer of a firm might, based on the
information at his command, believe i.e.; have a view that interest rates will fall going forward
and/or the domestic currency would appreciate with respect to other globally traded currencies.

In number of decisions that he takes would therefore be based on that view that going forward,
interest rates would fall and the domestic currency would appreciate. Should his view turn out
to be right, the profitability of his firm would be favorably impacted. On the other hand, if the
outcome turns out to be the converse i.e., opposite of the view he took, the company could
potentially book significant losses.

Risk management is about protecting the downside, that is, minimize the losses if the future
outcome turns out to be opposite of the view taken by the decision maker. As a case in point,
if the CFO expected the domestic currency to depreciate in the coming weeks, he would want
to manage the risk, i.e., hedge the risk of currency appreciating in the future. He would achieve
that using instruments such as currency options, currency futures, etc.

© All Rights Reserved. This document has been authored by P C Narayan and is permitted for use only within the course Banking and Financial
Markets : A Risk Management Perspective delivered in the online course format by IIM Bangalore. No part of this document, including any
logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.
 Banking and Financial Markets : A Risk Management Perspective

Prof. P C Naryan

Week 1

Let's look at how risk manifests itself in the context of firms managing financial assets. What
we would provide here is a thumbnail description of the type of risks and each of these risks
would be dealt with in much greater detail in the many sessions to follow.

First, credit risk. Credit risk is the failure of a borrower or an issuer of bonds to meet his
contracted cash out flow obligations arising from a loan he has taken or a bond he has issued.

Two, off-balance-sheet risk. This risk relates to the creation of contingent assets and liabilities
that are held outside or off the balance sheet of the firm. Here's an example, say a letter of credit
is issued by a bank on behalf of an importer. If the importer meets his obligation to effect
payment on the due date, then the bank will bear no risk at all.

On the other hand, the risk would devolve on the bank if the importer reneges on his obligation
to effect payment on the due date as per the terms of the letter of credit. Another example, say
a currency forward contract where one counter party does not have adequate funds to meet his
payment obligations on the maturity date.

Three, foreign exchange risk. Foreign exchange risk relates to the gain or loss that arises due
to fluctuations in the foreign exchange rate. All assets and liabilities denominated in foreign
currency as well as operating income that is dependent on sales revenue or costs incurred in a
foreign currency are subject to foreign exchange risk.

Four, interest rate risk. Interest rate risks reflect the sensitivity of capital and income to
volatilities in the interest rates. It is manifested distinctly when the maturities of assets and
liabilities are mismatched and therefore interest rate risk management is a key component of
asset liability management in any firm that deals in financial assets.

Five, market risk. While managing credit risk is endogenous to any financial assets company,
i.e., factors affecting credit risk are more often within the firm's control, both interest rate risk
and foreign exchange risks arise from factors that are completely exogenous to the firm, i.e.,
cost by factors outside the firm's control. Remember, changes in interest rates and foreign
exchange rates are largely a result of macroeconomic factors and equally impact all entities in
that financial market. Hence, these risks are also referred to as market risk. More importantly,
several financial asset companies run what is popularly referred to as a trading book, which is

© All Rights Reserved. This document has been authored by P C Narayan and is permitted for use only within the course Banking and Financial
Markets : A Risk Management Perspective delivered in the online course format by IIM Bangalore. No part of this document, including any
logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.
 Banking and Financial Markets : A Risk Management Perspective

Prof. P C Naryan

Week 1

they buy and sell government securities, corporate bonds, foreign currencies, etc., on their own
account with a view to generate additional profits. Often times, the risk on the trading book can
be significant manifested through market risk.

Six, operational risk. The risk of direct or indirect losses resulting from failed or inadequate
internal processes, people, break down of information technology, or other external events such
as terrorist attack, floods, typhoon, etc.

Seven, liquidity risk. Liquidity risk pertains to the potential inability of any financial asset
company to generate additional liabilities to cope with the decline in its liabilities or increase
in its assets. As a case in point, a sudden reduction in liabilities owing to excess withdrawal by
depositors may necessitate the financial asset company to perhaps liquidate its assets in a very
short time frame consequently at a huge discount to the price that the asset would otherwise
command.

Eight, solvency risk. The risk that a financial asset company may not have adequate capital or
net worth to cope with a sudden or steep decline in the mark to market value of its assets.

During the course of this week and the next week, we will look at each one of those risks in
great detail covering the causes, the consequences, measurement, and management of each of
those risks.

© All Rights Reserved. This document has been authored by P C Narayan and is permitted for use only within the course Banking and Financial
Markets : A Risk Management Perspective delivered in the online course format by IIM Bangalore. No part of this document, including any
logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.