26507765 Financial Risk Management

Financial Risk Management

Risk is the chance of encountering loss

Risk is the possibility of something unpleasant happening

Risk means uncertainty of future cash flows.

Risk Manager’s job involves in ensuring that RISK is maintained at the desired level.

In all cases where risk is imperative, increasing the predictive ability also forms part of risk management

Different meanings of risk

Pure risk and Speculative risk

Pure risks are those in which the outcome tends to be a loss with no possibility of gain.

Speculative risks are those in which there is a possibility of loss or profit.

Ex: Risk of fire in a warehouse results in a pure risk while the risk involved in dealing in the stock market is a speculative risk, because one may either gain or lose.

While it is possible to insure pure risk, speculative risks can’t be insured.

Acceptable Risks and Non-Acceptable Risks

Certain risks are acceptable without any prevention being taken since the potential loss may be minimal.

Certain risks are major and non – acceptable too. The mgmt. Must find ways to reduce, avoid or transfer the risk.

Eg: A major financial loss of Rs.1 crore due to fire in the warehouse is a non-acceptable risk.

Static risks and Dynamic risks:

There are various risks that depend on changes in the economic, political, social and other scenarios. Such risks are known as dynamic risks.

Eg: Speculative risks, Business risks.

Risks that do not depend on various scenarios are known as static risks. Pure risk is a type of static risk.

Types of risk

Interest rate risk

Interest rate risk is the risk of an adverse effect of interest rate movements on a firm’s profit.

Exchange Risk

Volatility in the exchange rates will have a direct impact on the values of assets and liabilities, which are denominated in foreign currencies.

Default Risk

Default risk is the risk of non – recovery of sums due from outsiders. This risk has to be considered when credit is extended to any party.

Types of risk

Liquidity risk

Liquidity risk refers to the risk of a possible bankruptcy arising due to the inability of the firm to meet its financial obligations.

A firm may be having huge profits but may have a severe liquidity crunch because it has blocked its money in illiquid assets.

Types of risk

Market Risk

Market risk is the risk of the value of a firm’s investments going down as a result of market movements.

Market risk can’t be separated from other risks, as it results from presence of other risks.

Interest rate risk and exchange rate risk contribute the most to the presence of market risk.

Types of risk

Types of risk

Financial risk

Financial risk refers to the risk of bankruptcy arising from the possibility of a firm not being to repay its debts on time.

Higher the debt-equity ratio of a firm, higher the financial risk faced by a firm.

Types of risk

Types of risk

Operational control risk Key personnel risk Frauds committed by staffelectronic transactions risk.

Other risks

Legal risks

Economic environment risk

Political risks

Managing the Risk

1)Avoidance

Avoidance refers to not holding such an asset/liability which is exposed to risk.

2)Loss control

3)Transfer of risk through hedging (Forwards, futures,options, swaps )

Risk management Process

Risk management needs to be looked at as an organisational approach, as management of risks independently can’t have the desired effect over the long term.

Risks result from various activities in the firm and the personnel responsible for these activities do not always understand the risk attached to them.


Risk management process involves a logical sequence of following steps.

1)Determining Objectives

The objectives of risk management needs to be decided by the management of an enterprise.

The objective may be to protect profits or to develop competitive advantage.


2) Identifying sources of Risks

Each company faces different risks, based on its nature of business – like

Degree of competition

Availability of Raw material

Dependence on foreign markets for sales or finances


3) Risk evaluation

Once the risks are identified, they need to be evaluated to know their significance and classified as

Critical risks – leads to bankruptcy Important risks – financial distress

Acceptable risks – Min. potential loss


4) Development of policy

Policy takes the form of a declaration stating How much risk should be covered ? How much risk the firm is ready to bear ?

Policy may specify that not more than a specific sum can be at risk at any point of time.


Interdependence for managing risk


5) Development of strategy

Specifies the nature of risk to be managed, tools, techniques and instruments that can be used to manage these risks.

Specify whether it would be more beneficial for a subsidiary to manage its own risk or to shift it to the parent company.

Specify whether the company would try to make profits out of risk management ( from active trading in derivatives market ) or stick to cover existing risks.


6) Strategy implementation & Review

Includes finding best deal in case of risk transfer,

providing for contingencies in case of risk retention

Taking care of details in operations, like back office work.

Periodic review of risk management function, depending on costs involved.

Cost of Risks

Risk identifying costs

Costs which an enterprise incurs to identify and analyse the risks, like consultant fee.

Risk Handling costs

Certain expenses of handling risks, like insurance premium, loss prevention devices.

Cost of Risks

Social costs

Costs that an enterprise may have to incur to compensate the society for damages caused by its actions.

Ex: Union carbide had to pay millions of dollars as compensation to the victims ofBhopal Gas tragedy

Limitations of Risk management

Risk management although essential to control risks and avoid losses cannot guarantee full success.

No money manager can guarantee a foolproof system against risks because many risks are unexpected.

Managing risk tools may prove to be very costly and investment in such tools may not justify the returns.

Introduction to Futures & Options AsDerivative Instruments

Derivative instruments are financial instruments whose value is derived from the value of an underlying asset

An underlying asset can be a commodity, Bond, foreign exchange, equity shares or share indices.

Introduction to Futures & Options AsDerivative Instruments

The main instruments clubbed under the general term derivatives are

Forwards

Futures

Options

Option on futures

Forward rate agreements(FRAs) Swaps

Types of Derivative instruments

Derivative instruments are of two types

1) Those that are traded in an exchange, such as futures and options

2) Those that are traded over the counter(OTC), such as forwards, FRAs, swaps.

An important difference between these two types of instrument is in counter party risk and liquidity.

Forward contracts

Forward contracts are the oldest and simplest form of derivative contracts.

A forward contract is an agreement between two persons for the purchase and sale of a commodity or financial asset at a specified price to be delivered at a specified future date

Positive aspects of Forward contracts

A firm can use the forward market to hedge or lock in the price of purchase or sale of the commodity/financial asset on a future date.

Margins are not generally paid on forward contracts and there is also no up-front premium, hence these contracts do not have an initial cost.

As forward contracts are tailor-made, the price risk exposure can be hedged upto 100%

Negative aspects of Forward contracts

• There is no performance guarantee in a forward contract – always counter party risk

• Forward contracts do not allow an investor to gain from favourable price movements or cancel transactions once the contract is made.

• It is difficult to get a counterparty that agrees completely to one’s terms

• No ready liquidity since forward contract is not traded on exchange

Futures contracts

A futures contract is an agreement between a buyer and a seller that requires delivery of a specified quantity of a security, commodity or forex at a fixed time in the future at a price agreed to at the time of entering into the contract.

Features of futures contracts

Futures are highly standardised contracts that provide for their performance either through deferred delivery of the asset or cash settlement

Future contracts trade on organised exchanges with a clearing association that acts as a middleman between the contracting parties.

Both the seller and the buyer of a futures contract pay an initial margin amount to the clearing house, which is used as a performance bond by the contracting parties.

Features of futures contracts

Apart from the initial margin, the buyers and sellers of futures contracts also have to pay a daily mark to market margin(MTM margin) to the clearing house through their respective brokers.

Individual stocks and stock index derivatives have a maturity date of the last Thursday of the contract month. If the last Thursday happens to be a holiday, the previous day will be the maturity day.

Every futures contract represents a specific quantity known as Lot size.

Distinction between forward and futures contracts

Forwards Futures

Size of contracts Decided b/w buyer & Standardised by exchangeseller for each lot

Price of contract Remains fixed till maturity Changes everyday

Marking to market Not done Marked to market daily

Margin No margin is required To be paid by both parties

Counter party risk Present Not present

No. of contracts in a year Any no. of contracts Fixed by the exchange

Hedging Tailor made for specific Done by using nearestdates & quantity. month and fixed lots

Liquidity No liquidity Highly liquid

Mode of delivery Specifically decided. Standardised. Most

Some result in delivery. contracts do not result in

Players/participants in the derivatives market

1) Hedgers

Hedgers are attracted to derivatives market to reduce a risk that they already face.

In the commodity market, hedging may be done by a producer or a miller or a stockist of goods.

2) Speculators

Speculators have a view on the future price of a commodity, shares, stock index, interest rates or currency.

In contrast to hedgers who want to reduce their risk, speculators take a position in the market.

Speculators provide hedgers an opportunity to manage their risk by assuming their risk.


3) Arbitrageur

An arbitrageur is risk averse and enters into those contracts where he can earn riskless profits.

In imperfect markets, it is possible to make risk less profits by buying at a lower price in one market and selling at a higher price in another market or vice versa.

Eg: Spot price of HDFC Bank is Rs.1000/- and its 3-month futures are at Rs.1040/-.

Cost of carry (C) = F – S * 365 * 100

S Days to maturity


Intermediary participants 4) Brokers

Brokers perform the important function of bringing buyers and sellers together.

As a member of a Derivatives exchange, a broker need not be a speculator, arbitrageur or hedger.

Membership in the exchange confers on the broker the right to conduct transactions with other members


Institutional framework 5)Exchange

An exchange acts a guarantor for the performance of the contract entered by a seller and a buyer, through its member broker.

In an online trading system, the exchange provides its members with real time access to information and allows them to execute their orders.


6) Clearing house

The National Securities Clearing Corporation Ltd( NSCCL) is the clearing and settlement agency for all deals executed onNSE’s F&O segment.

NSCCL acts as a counter party to all deals on NSE’s F&O segment

NSCCL performs clearing, settlement and risk management functions.


7) Bank for fund management

Futures and options contracts are settled daily and this requires transfer of funds from members to clearing house.

A bank can make the daily accounting entries in the accounts of the members of the exchange, clearing house and facilitate daily payments.

8) Regulatory framework

A regulator creates confidence in the market besides providing a level playing field to all the concerned participants.

Documents

26507765 Financial Risk Management