Risk Classification

Prof.C.S.Balasubramaniam
Basic classification
 From Managerial perspective
Risks that need to be avoided
Risks that should be transferred
Risks to be actively managed
 From Functional perspective
Credit risk /counterparty risk
Market risk
Operational risk
Credit/Counterparty risk
 Risk related to investment/borrowings
are subject to financial soundness of the party
 also related to foreign exchange risk if
transacted in foreign currency
 Put thru organized exchanges where
performance is guaranteed
 In OTC transactions, no third party
guarantee ,entire risk borne by bank
Credit/counterparty risk
 In financial contracts ,it is default risk
 In derivative contracts, it is exposure risk
 In bonds/debentures ,it is issuer risk
 Generally this risk is related to financial
performance of the borrower/counterparty
 If earlier borrowings are retired/paid off
the risk would reduce to that extent
Pre-settlement risk
 Defined as the bankruptcy of the counterparty
which impairs the ability of the borrower to perform
obligation prior to settlement .In such a case, risk is
limited to replacement value of the original
contract .
 Replacement cost is a basic metric of credit
exposure due to pre settlement risk .
 It arises when the borrower arranges a second
counterparty to replace an original defaulted deal. If
the new transaction comes at a higher price to the
firm ,then replacement cost loss is higher
Settlement risk
 Involves two parties
 Subject to entire value of the counterparty’s
obligation.
 Greater in foreign exchange markets because each
currency must be delivered in its home country
 Basel Committee says , this risk arises when a
counterparty pays the currency sold .In other
words ,foreign exchange settlement risks have a
credit risk dimension inherent ,in addition to liquidity
risk .Therefore two dimensions need to be monitored
and managed .
Market risk
 Risk of losses due to movements in
financial market variables like interest
rates, foreign exchange rates, security
prices etc.
 Thus market risk is due to fluctuations in
portfolio value because of movements in
such variables
Price risk
 It is a market driven measure of value
 “ Unfavorable movement in the realized price
as against expected price “
 Significant for financial/ investment institutions
 Valuation of these institutions is dependent on
the net value of its assets which are affected
by price risk
Short/long positions
 Short position implies that the institution has
committed to sell the security without actually
holding it .
 Long position implies that the institution has
committed to pay the consideration
 In a long position ,any increase /potential
increase in price is favorable
 If it has lesser securities than promised, the
same price movements would affect .
Price risk classification
 Symmetrical versus unsymmetrical
symmetrical is even on both directions up
&down and can be measured /predictable
 Unsymmetrical is irregular / unequal and
not predictable
 Derivatives are subject to unsymmetrical
risks more and thus become attractive
Absolute versus relative risk
 Absolute risk measured with reference to
initial investment value
 Relative risk measured relative to the
benchmark indices like sensex or nifty
 Significant for blue chips traded on stock
exchanges
 Subject to volatility /severe fluctuations
Discontinuity and event risk
 Discontinuity implies a large movement
over a small time interval and potentially
create a large loss.
 Very difficult to establish the probability of
a discontinuity
 Due to sudden changes in govt. policy,
wars, devaluation which are events
Asset liquidity risk
 Many securities which are not traded
frequently are called “ illiquid stocks”
 Thus large transactions of these stocks are
not possible as they would be traded below
par
 If traded in large quantities, it would dampen
the price ,which is not in the seller’s interest.
Concentration risk
 It arises due to very large exposure to a
particular company ,industry, geographic
region , market. If anything goes wrong ,it
can affect the whole organization
 Lack of diversification results in
exposure/concentration risk
Credit spread risk
 It is difference between yield on corporate
bonds and treasury bonds
 It reflects the compensation that bond
holders should get for undertaking the extra
credit risk inherent in corporate bonds
 It is subject to duration of the bond and yield
on the bond
Volatility risk
 Price risk which is subject to
unpredictable/violent changes in market prices
of securities
 In short run, it can lead to
upheavals/meltdowns/crashes in stock
markets
 Necessitates intervention by stock market
authorities/SEBI
Systemic risk
 It can arise due to failure of a major market
system or institution ,also known as “Domino
effect “
 Affects the whole market /economy
 Failure of central clearing &payment systems
 Examples in 1992-93 (Harshad Mehta )

1998-99(Ketan Parekh )
Systematic risk
 Used in portfolio investment
 Also called un diversifiable risk since it is
inherent to any security in a particular market
 Due to financial performance /profitability of
a company
 Cannot be transferred /avoided
 Mitigated by portfolio diversification
Foreign exchange risk
 Each nation has a currency and trades
occur in multiple currencies .
 When trades/borrowings occur in different
currencies ,a market happens which
enables participants to buy and sell
currencies in such a way that they can
convert the inflow or outflow into the
currency of their choice = forex market
Forex market
 With advanced telecommunications ,a
virtual 24-hour market becomes possible
with different time zones .Before the Asian
markets close, the European exchanges
have already opened ,and before they can
close, the US markets are in full swing;
and it is time for Asia/Pacific markets to
open ,before the US markets to close.
Forex rates
 Currencies can be converted into another
currency at the current rate, which is
determined by a number of forces that are
constantly acting/interacting on these
prices. The forces are demand and supply,
expectations . Let me explain……
Demand and Supply
 Currencies are like commodities .With increase
in the demand for a currency, the price or
exchange rate goes up. On the other hand, if
there is more supply ,the exchange rate would
tend to move down. The spurt in demand could
happen either because of trade flows /capital
flows. A rise in trade demand occurs when large
imports denominated in that currency by the
buyer/importer.
Demand and supply
 Increase in demand due to capital flows arise
when investors/lenders seek assets
denominated in that currency or funds
denominated in that currency . Capital flights
from a geographical region can result in supply
of that currency in that market. The central
banks of various countries may intervene in the
foreign exchange markets to reduce the
pressures created by significant jump in
demand/supply created by trade /capital /money
flows.
Expectations
 Beliefs about emerging economic and
political situation in the home country of a
particular currency will have a bearing on
the exchange rate. The interest rate
scenario, exports & imports, government
borrowing programs, corporate debt
&equity programs – all these would affect
currency values.
Risks due to activities of Banks
 Banks undertake risk due to their own borrowing
programs as well as international asset
exposures. Foreign exchange exposures arise
due to income earning activities, costs, assets/
liabilities .When bank gives hedge to its
customers for their foreign exchange risk ,the
bank is in effect taking over the customer
exposure. Also, fluctuations in the currency
dealings during the day /overnight expose the
bank to foreign exchange risk.
 Foreign exchange risk of
corporates
 Transaction exposure due to cash outflow/inflow
on account of imports/exports
 Translation exposure due to activities of
subsidiaries being reflected in balance sheets
 Economic exposure is the threat to the core
business model on account of currency
exchange rate fluctuations .
 Country risk /sovereign risk
 Economic factors –foreign currency
reserves, current account deficit, size of
external currency borrowings,imports/
exports
 Political factors –stability of the party in
power, the policies of the govt. ,the bias
due to trade blocs
 Country risk
 Socio-economic factors –changes in
consumption patterns, income levels, inflation,
tastes and preferences,cultural factors
 Legal framework –FEMA, laws regarding
Imports/exports ,customs duties,
subsidies/drawbacks/incentives ,SEZ
concessions
 Political risk –stable government and financial
/fiscal policies /tax policies /trade policies /legal
and industrial policies
 Country risk
 Emerging market risk –the state of under
developed institutions ,market regulation,
handicaps of mature foreign players/
institutions
 Liquidity risk – availability ,demand and
supply factors
 Liquidity risk
 Due to low level of transactions /volume
 Due to lack of trading depth in a category of
securities /high in derivatives market
 Banks face it often due to meeting obligations of
cash outflows /inflows/ difficult to avoid
 Low liquidity leads to credit risk and low credit
rating
 Weak liquidity leads to volatility /sudden uptrend
 Liquidity risk
 Volatility means high discounts from par
value of security traded
 Availability of pool of securities stabilizes
price
 Sizeable net negative cash inflows
indicate need for liquidity management
 Tracking future cash inflows on daily basis
 Interest rate risk
 Interest is earned on borrowings and interest is
given on deposits of customers by banks
 Interest rate is a tool for central bank for
controlling inflation.
 Interest differential between borrowing rate and
lending rate is called spread and profitability of
banks is dependent on spread
 Technology risk
 Technology reduces effort and cost of
process
 Test of technology needs resources and
money
 Economies of scale and scope
 System updating increases efficiency
 Operational risk
 Due to ill defined procedures/weak control
 Due to improper documentation/processes
 Operational risks identified in advance and
control processes established
 Interlinked with action/result process
creates robustness
 Alerts top management on a regular basis
 Is fraud an operational risk ?

 Failed operational risk is fraud

 Fraud is due to failure of people
/process/systems
 External risk –legal ,money laundering
outsourcing,political,regulatory,supplier,tax
 Physical – fire, natural disaster, physical
security, terrorism ,threat ,burglary/theft
Techniques to avoid fraud
 Customer identity
 Review of customer activities
 Review of transaction /exposure
 Physical access control &security
 Reconciliation /review of suspense accounts
 Controls on document /stationery usage
 Regulatory risk
 Compliance with regulatory requirements
avoids loss of reputation /credit rating
 Avoids penalty/fines
 Avoids suspensions /cancellation of
licence
 Operating in multiple /international
locations increases exposure