Risk Management

What is risk
Risk is the downside potential of the actual
results being adverse compared to the
expected results
Certainty where it is known what will
happen and the happening or non
happening carries a 100% probability
Uncertainty is where even the probable
outcomes are unknown. Reflects a total
lack of knowledge of what may happen

Risk is a variable which can be calibrated,
measured and compared
Risk is a function of not only the probability of an
outcome being different from the outcome but
also its potential intensity, if it occurs.
The magnitude of the outcome and the
probability of their occurrence together
determine the riskiness of the event.
Risk is generally measured using the concept of
standard deviation.
Risk is the possibility of a loss and peril is
a cause of the loss
Hazard is a factor that may create or
increase the possibility of a loss in the face
of an undesired event.
The degree of information available
determines the entitys perception of the
expected value and the probability
distribution
Definition of risk
Risk is the possibility of something
unpleasant happening or the chance of
encountering loss or harm. Webster
Risk in the present context means the
uncertainty of future cash flows.
Risk Managers job involves identification
of
The nature of risk
Remedial measures available for managing
the risk
Cost of managing the risk
Pure Risks and Speculative risks
Acceptable risks and Non Acceptable risks
Static and Dynamic Risks
Pure Risks
Property Exposure
Liability Exposure
Life and Health Exposure
Financial Exposure can be either a pure
risk or a speculative risk

Types of risk
Business Event Risk
Collapse of markets
Currency convertibility
risk
Disaster risk
Legal risk
Regulatory risk
Reputation risk
Shift in credit rating
Taxation risk
War risk
Inflation risk
Investment risk
Liquidity risk
Market risk
Political risk
Reinvestment risk
Replacement risk
Sovereign risk
Systemic risk



Types of risk
Operational Control
risk
Exceeding Limits
Fraud
Key Personnel risk
Money Laundering
Processing risk
Rogue Trading
Security risk
Transaction risk
Booking error
Commodity delivery
Contract/
documentation risk
Execution Error
Product Complexity
Settlement Error

Types of Risk
Systems Risk
IT Systems Failure
Mark to market Error
Model Error
Programming error
Telecom Failure

Types of Risk
Interest rate risk
Exchange risk
Liquidity risk
Default risk
Internal Business risk
External Business risk
Financial risk
Events of GOD
Market risk
Marketability risk
Credit risk
Personnel risk
Environmental risk
Production risk


Managing the Risk
Avoidance
Loss control
Separation
Combination
Transfer
Retention
Risk sharing
Costs of Risk
Risk Identifying costs
Risk handling costs
Actual Losses
Social costs
Loss financing costs
Loss control costs
Residual uncertainty costs
Risk Management Process
Determining Objectives
Identifying risks
Risk evaluation
Development of policy
Development of strategy
Implementation
Review
How are exposures created
Purchase Managers
Sales Managers
Engineers
HR Managers
Logistics Managers
Divisional Presidents
Risk Management Techniques
Internal
External
Internal Techniques of hedging
Netting
Matching
Leading and Lagging
Price variation
Invoicing in a foreign currency
Short term overdraft
ALM

External Techniques of hedging
Forwards
Futures
Options
Swaps

Guidelines for Risk Management
Common goal of risk management and
financial management
Proper mix of risk management
techniques
Proactive risk management
Flexibility
Bringing risk to the optimum level
Risk substitution

Banking Risks
Asset Liability Management
Practices
Credit Risk Management
Business Related
Risks :

Credit Risks

Market Risks

Country Risks

Business
environment
Risks

Operational Risks

Group Risks


















Control
Related
Risks












ALM
Information
System
ALM
Organization


ALM Process :

Liquidity Risks

Currency Risks

Interest Rate Risks




Policies
&
Procedures
Organizational
Structure

Credit Rating
Framework :

RBI Guidelines

Scoring & Rating
Model




Country Risk
Management

Risk Management in Banks
The correct answer is:
Open the refrigerator, put in the giraffe
and close the door.
This question tests whether or not you
are doing simple things in a
complicated way.
How do you put an elephant into a refrigerator?
Incorrect answer:
Open the refrigerator, put in the elephant and shut
the refrigerator.

Correct answer:
Open the refrigerator, take out the giraffe, put in the
elephant and close the door.

This question tests your foresight
The Lion King is hosting an animal
conference.
All the animals attend except one.
Which animal does not attend?
Correct answer: The elephant. The elephant is in the
refrigerator!


This tests if you are capable of comprehensive thinking.
There is a river filled with crocodiles.
How do you cross it?

Correct Answer:
Simply swim through it. All the crocodiles
are attending the animal meeting!


This question tests your reasoning ability.

Risk and Return Calculation

Defining an Investment
A current commitment of Rs for a
period of time in order to derive future
payments that will compensate for:
Time value of money
Expected rate of inflation
Risk involved
How Do We Measure The Rate
Of Return On An Investment ?
The pure rate of interest is the exchange
rate between future consumption and
present consumption. Market forces
determine this rate.
Rs. 1.00 + 4% = Rs. 1.04
Peoples willingness to pay the
difference for borrowing today and
their desire to receive a surplus on
their savings give rise to an interest
rate referred to as the pure time
value of money.
Measuring the Rate Of
Return On An Investment ?

If the future payment will be
diminished in value because of
inflation, then the investor will demand
an interest rate higher than the pure
time value of money to also cover the
expected inflation expense.
Measuring The Rate Of
Return On An Investment ?
If the future payment from the
investment is not certain, the
investor will demand an interest rate
that exceeds the pure time value of
money plus the inflation rate to
provide a risk premium to cover the
investment risk.
Measuring The Rate Of
Return On An Investment ?
Measures of Historical Rates
of Return- Holding Period
Return
Holding Period Yield
HPY = HPR - 1
1.10 - 1 = 0.10 = 10%
HPR = Ending value of investment
Beginning Value of the investment
220 / 200 = 1.10
Annual Holding Period Return
Annual HPR = HPR
1/n
where n = number of years investment is
held
Annual Holding Period Yield
Annual HPY = Annual HPR -
1
Measures of Historical
Rates of Return
Measures of Historical
Rates of Return
Arithmetic Mean
yields period holding
annual of sum the HPY
: where
HPY/ AM

=
= n
Measures of Historical
Rates of Return
Geometric Mean

44
| |
( ) ( ) ( )
n
n
HPR HPR HPR
: follows as returns period holding
annual the of product the
: where
1 HPR GM
2 1
1

=
=
t
t
A Portfolio of Investments
The mean historical rate of return
for a portfolio of investments is
measured as the weighted average
of the HPYs for the individual
investments in the portfolio.
Computation of Holding
Period Yield for a Portfolio
# Begin Beginning Ending Ending Market Wtd.
Stock Shares Price Mkt. Value Price Mkt. Value HPR HPY Wt. HPY
A 100,000 10 1000000.00 12 1200000 1.20 20% 0.05 0.010
B 200,000 20 4000000.00 21 4200000 1.05 5% 0.20 0.010
C 500,000 30 15000000.00 33 16500000 1.10 10% 0.75 0.075
Total 20000000.00 21900000 0.095
21900000
20000000
HPY = 1.095 - 1 = 0.095
= 9.5%
HPR = = 1.095
Expected Rates of Return
Risk is uncertainty that an investment
will earn its expected rate of return
Probability is the likelihood of an
outcome
Expected Rates of Return

=

=
n
i 1
i
Return) (Possible Return) of y Probabilit (
) E(R Return Expected
) R (P .... ) )(R (P ) )(R [(P
n n 2 2 1 1
+ + +
) )(R P (
1
i i
n
i

=
Measuring the Risk of
Expected Rates of Return
2
n
1 i
Return) Expected - Return (Possible y) Probabilit (
) ( Variance

=
= o
2
i i i
1
)] E(R )[R P (

=
n
i
Expected Return and Risk
Economic Condit ions Probabilit yRat e of PixRi
Condit ions (Pi) Ret urn (Ri)
St rong - No inf lat ion 0.15 0.20 0.03
Weak - above-average inf lat ion 0.15 -0.20 -0.03
No Major Change in economy 0.70 0.10 0.07
Expect ed Ret urn E(Ri) 0.07
St andard Deviat ion 0.05
Risk Aversion
The assumption that most investors
will choose the least risky alternative,
all else being equal and that they will
not accept additional risk unless they
are compensated in the form of
higher return
Measuring the Risk of
Expected Rates of Return
Coefficient of variation (CV) a measure of
relative variability that indicates risk per unit
of return
Standard Deviation of Returns
Expected Rate of Returns
E(R)
i
o
=
Measuring the Risk of
Historical Rates of Return
variance of the series
holding period yield during period i
expected value of the HPY that is equal
to the arithmetic mean of the series
the number of observations
n / HPY)] ( E HPY [
2 n
1 i
i
2

=
= o
=
=
=
=
n
E(HPY)
HPY

i
2
o
The Real Risk Free Rate
(RRFR)

Assumes no inflation.
Assumes no uncertainty about
future cash flows.
Influenced by time preference for
consumption of income and
investment opportunities in the
economy
Nominal and Real RFR
Real RFR =

Nominal RFR = (1+Real RFR) x
(1+Expected Rate of Inflation) - 1
1
Inflation) of Rate (1
RFR) Nominal 1 (

+
+
Business Risk
Uncertainty of income flows caused by
the nature of a firms business
Sales volatility and operating leverage
determine the level of business risk.
Financial Risk
Uncertainty caused by the use of debt financing.
Borrowing requires fixed payments which must
be paid ahead of payments to stockholders.
The use of debt increases uncertainty of
stockholder income and causes an increase in the
stocks risk premium.
Liquidity Risk
Uncertainty is introduced by the secondary
market for an investment.
How long will it take to convert an investment
into cash?
How certain is the price that will be received?

Exchange Rate Risk
Uncertainty of return is introduced by
acquiring securities denominated in a
currency different from that of the investor.
Changes in exchange rates affect the
investors return when converting an
investment back into the home currency.
Country Risk
Political risk is the uncertainty of returns caused
by the possibility of a major change in the
political or economic environment in a country.
Individuals who invest in countries that have
unstable political-economic systems must
include a country risk-premium when
determining their required rate of return
Risk Premium
f (Business Risk, Financial Risk,
Liquidity Risk, Exchange Rate
Risk, Country Risk)
or
f (Systematic Market Risk)

Risk Premium
and Portfolio Theory
The relevant risk measure for an individual
asset is its co-movement with the market
portfolio
Systematic risk relates the variance of the
investment to the variance of the market
Beta measures this systematic risk of an
asset
Fundamental Risk
versus Systematic Risk
Fundamental risk comprises business risk,
financial risk, liquidity risk, exchange rate
risk, and country risk
Systematic risk refers to the portion of an
individual assets total variance attributable
to the variability of the total market portfolio
Relationship Between
Risk and Return
Rateof Return
Risk
(business risk, etc., or systematic risk-beta)
RFR
Security
Market Line
Low
Risk
Average
Risk
High
Risk
The slope indicates the
required return per unit of risk
(Expected)
Changes in the Required Rate of
Return Due to Movements Along the
SML
Rate
Risk
(business risk, etc., or systematic risk-beta)
RFR
Security
Market Line
Expected
Movements along the curve
that reflect changes in the
risk of the asset
Changes in the Slope of the
SML
RP
i
= E(R
i
)- NRFR
where:
RP
i
= risk premium for asset i
E(R
i
) = the expected return for asset i
NRFR = the nominal return on a risk-free asset
Market Portfolio Risk
The market risk premium for the market
portfolio (contains all the risky assets in the
market) can be computed:
RP
m
= E(R
m
)- NRFR where:
RP
m
= risk premium on the market portfolio
E(R
m
) = expected return on the market portfolio
NRFR = expected return on a risk-free asset
Change in Market Risk
Premium
Risk
RFR
Original SML
New SML
Rm
Rm'
E(R)
NRFR
Expected Return
R
m

R
m

Capital Market Conditions,
Expected Inflation, and the
SML
Risk
RFR
Original SML
New SML
Rate of Return
RFR'
NRFR
NRFR
Expected Return