Professional Documents
Culture Documents
A
PROJECT REPORT
ON
RISK MANAGEMENT
SUMMITED TO :
SUMMITED BY:
Mr. Vinay Kandpal Vivek
Singh Mewar
STUDENT DECLERATION
This Project has Been Undertaken for Partial Full Fillment of The Requirement for The Award
of Degree of Master of Business Administration of Uttarakhand Technical University (UTU)
Dehradun .
This Project was Executed in III Semester Under The Guidance of Mr. Vinay Kandpal
Faculty (Management Department ) Further We Declare That This Project is Our Original
work and not Submitted for The Award of Any Another Degree or Diploma.
I express my deep sense of gratitude to our internal guide Mr. Vinay Kandpal (Lecturer of
management Dept.) for his valuable support and guidance given to me through out the project.
I consider myself lucky to have worked under his.
This project provided me a platform to increase my knowledge and empowered me with a better
understanding of concepts in the financial world scenario and the most special the Mr. Vinay
Kandpal who accepted me in spite of my inexperience in the field and gave me the opportunity
to work and learn with them.
Last but not the least I would like to thank my God and my ever loving and caring parents for
their ever encouraging words during my days of distress.
The shift to flexible exchange rates in the late 1960s has led to more volatility in exchange rates.
As volatility increased, financial markets began to offer a new breed of securities, that is,
derivatives such as futures and options, to allow institutions to hedge their exposures to currency
fluctuations.
The increase in inflation in the early 1970s and the advent of floating exchange rates soon began
to generate interest rate instability. Again, the market responded by offering new derivative
products to hedge and manage these new risks. Banks found themselves increasingly engaged
in risk intermediation and less in traditional maturity intermediation. Banks also started to
innovate and off new customized derivative instruments, known as over-the-counter (OTC)
products, that both compete with and complement traded derivatives.
CONTENTS
CHAPTER I
The Need for Risk Management Systems
1.1Introduction
1.2Historical Evolution
CHAPTER II
The New Regulatory and Corporate Environment
2.1 Introduction
CHAPTER III
Structuring and Managing the Risk Management Function in a Bank
3.1Introduction
Framework
CHAPTER IV
Model Risk
4.1 Introduction
CHAPTER V
Risk Management in the Future
5.3 Process for Reviewing Risk in Extreme Markets Will Become Standardized
CHAPTER VI
6.1 Summary & conclusion
6.2 References
Chapter I
The Need for Risk Management Systems
1.1Introduction
The Financial Services Act of 1999 will lead to further far-reaching changes in the U.S. financial
system. It will repeal key provisions of the Glass–Steagall Act, passed during the Great
Depression, which prohibits commercial banks from underwriting insurance and most kinds of
securities. Most significantly, brokerage firms, banks, and insurers will be able to merge with
each other; this sort of alliance was prohibited by the Bank Holdings Act of 1956. The proposed
reform is intended to allow bank holding companies to expand their range of financial services
and to take advantage of new financial technologies such as web-based e-commerce.
The new legislation will also put brokerage firms and insurers on a par with banks by allowing
them to enter into the full range of financial activities and compete globally.
The expansion of the activities of bank holding companies will incur new market, credit and
operational risks. The consolidations will also precipitate a thorough revision of capital adequacy
requirements, which are currently tailored to the needs of traditional bank holding companies.
1.2Historical Evolution
Regulation strongly affects the attitude of financial institutions to risk taking, and often dictates
how they accommodate risk. Around the world, the banking industry is regulated in a variety of
ways, and through a multitude of governing bodies, laws, and bylaws. Two related observations
can be made: nowadays there is a world-wide recognition of the need to measure and control
risks in global and local banking activities, and regulation is converging and becoming more
consistent across countries.
But before we look at how this is happening, we need to understand some of the historical
foundations of the banking industry.
The crash of 1929 and the economic crisis that followed led to major changes in bank regulation
in the United States. The regulators focused on what is termed today "systemic risk," i.e., the risk
of a collapse of the banking industry at a regional, national, or international level. In particular,
regulators were concerned to prevent the "domino effect": the chance that a failure by one bank
might lead to failure in another, and then another. In a series of acts and laws, the government
tried to increase the stability of the banking system in order to avoid this and other types of
economic crisis. At the same time, the safety of bank deposits was enhanced by the
establishment in 1933 of the Federal Deposit
Insurance Corporation (FDIC). A third set of legislation defined the playing field for commercial
banks: crucially, they were barred from dealing in equity and from underwriting securities. The
famous Glass–Steagall Act of 1933 effectively separated commercial banking and investment
banking activities.
In 1980 the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) marked
a major change in regulatory philosophy in the United States. This act was an important step in
the deregulation of the banking system, and the liberalization of the economic environment in
which banks operate. The act initiated a six-year phase-out period for Regulation Q, which had
placed a ceiling on the interest rates that banks could offer deposit accounts with check facilities
and savings deposits. The act allowed commercial banks to pay interest on accounts with
withdrawal rights (the so-called "NOW" accounts).
This trend continued with the 1982 Garn–St. Germain Depository Institution Act (DIA), which
allowed banks to offer money market deposit accounts, and the so-called "super-NOW" accounts
(i.e., accounts that paid interest but offered limited check-writing privileges). These regulatory
moves opened up the banking industry to further competition from federally chartered thrift
institutions, but they also allowed commercial banks to expand by buying failed savings banks.
By the late 1970s and early 1980s, the numbers of such failed institutions had increased
substantially. The main reason was an economic squeeze on banks that held sizable fixed-rate
loan portfolios and which had financed these portfolios by means of short-term instruments. The
inflationary environment of the 1970s left such institutions exposed to rising interest rates.
Chapter II
The New Regulatory and Corporate Environment
2.1Introduction
We discussed the importance of the regulatory environment to the development of risk
management in financial institutions. In this chapter, we take the story one step further by
explaining how sophisticated methodologies in risk management are starting to become part of
the new regulatory and corporate risk environment. First, though, we need to ask a fundamental
question. Regulators impose a unique set of minimum required regulatory capital rules on
commercial banks. Why do they do so? Prior to the implementation in 1992 of the 1988 Basle
Accord, bank capital was regulated by imposing uniform minimum capital standards. These were
applied to banks regardless of the individual risk profiles, and the off-balance-sheet positions and
commitments of each bank were simply ignored. The increased international competition among
banks during the 1980s emphasized how inconsistently banks were regulated with regard to
capital. Japanese bank regulations contained no formal capital adequacy requirements, while in
the United States and the United Kingdom banks were required to finance more than 5 percent of
their risky assets by means of equity.
The major increase in off-balance-sheet activity by banks that took place in the 1980s altered the
risk profile of banks, while the regulatory requirements concerning equity ratios remained the
same. The 1988 Basle Accord (known also as the 1988 BIS Accord, or the "Accord") established
international minimum capital guidelines that linked banks' capital requirements to their credit.
It defined two minimum standards for meeting acceptable capital adequacy requirements: an
assets-to-capital multiple and a risk-based capital ratio. The first standard is an overall measure
of the bank's capital adequacy. The second measure focuses on the credit risk associated with
specific on- and off- balance-sheet asset categories. It takes the form of a solvency ratio, known
as the Cooke ratio, and is defined as the ratio of capital to risk-weighted on-balance-sheet assets
plus off-balance-sheet exposures, where the weights are assigned on the basis of counterparty
credit risk.
Chapter III
Structuring and Managing the Risk Management Function
in a Bank
3.1Introduction
If they are to measure, price, and control risk in a comprehensive manner, financial institutions
must establish appropriate firm-wide policies, and develop relevant firm-wide risk
methodologies that are coupled to a firm-wide risk management infrastructure. This chapter
provides an integrated framework for just such an approach to risk management, in the context of
best-practice risk management.
The independent first-class active management of risk, as shown in the center of Figure 3.2,
includes the capability to attribute capital, to appropriately price risk, and to actively manage the
portfolio of residual risks.
3.2.1Best-Practice Policies
Risk tolerance must be expressed in terms that are consistent with the bank's business strategy
(Figure 3.3). The business strategy should express the objectives of the financial institution in
terms of risk/ return targets. This should lead to setting risk limits, or tolerances, for the
organization as a whole, and for its major activities.
3.2.2Market Risk Policy
Business and risk managers should establish a policy that explicitly states their risk policy in
terms of a statistically defined potential or "worst case" loss: dealers and loan officers require a
policy that states how much money can be put at risk. To this end, most major financial
institutions are moving toward a value-at-risk (VaR) framework, which calculates risk in terms
of a probabilistic worst-case loss.
A best-practice market risk policy should state the statistically defined worst-case loss in a way
that considers the probability of both parallel and nonparallel shifts in the yield
curve.
The policy should also define the worst-case loss in terms of a sufficiently low level of
probability, say, 1 percent. Management should decide how to allocate capital and risk units
across activities and divisions in the institution in order to achieve their goals, while controlling
exposure to market risk. The greater the market risk, the higher the expected rate of return that
the bank can expect. The question is, how much risk exposure can the bank afford? Management
should also set the authorities for assuming market risks, and specify the nature of the market
risks to which the institution should be exposed.
For example, a local or regional bank might decide to limit its exposure mainly to interest rate
and local credit risks, while minimizing its exposure to currency risks.
Chapter IV
Model Risk
At times we can lose sight of the ultimate purpose of the models when their
mathematics become too interesting. The mathematics of financial models can be
applied precisely, but the models are not at all precise in their application to the
complex real world. Their accuracy as a useful approximation to that world varies
significantly across time and place.
The models should be applied in practice only tentatively, with careful assessment
of their limitations in each application.
4.1Introduction
The special risk that arises when an institution uses mathematical models to value and hedge
securities has come to be known as ''model risk." For simple instruments, such as stocks and
straight bonds, model risk is relatively insignificant. It becomes a compelling issue, however, for
institutions that trade over-the-counter (OTC) derivative products and for institutions that
execute complex arbitrage strategies.
In relatively efficient and liquid securities markets, the market price is, on average, the best
indicator of the value of an asset. In the absence of liquid markets and price discovery
mechanisms, theoretical valuation models have to be used to mark-to-model the bank's position,
to assess the risk exposure in terms of the various risk factors, and to derive the appropriate
hedging strategy.
The key principles for the valuation of fundamental securities are well known and are generally
accepted: investors prefer high returns and dislike risk. Even so, the models are expected to
produce guidelines rather than very precise valuations. For example, a risky security should offer
a higher expected return than a risk-free security. But how much higher? Pricing theory cannot
give a specific value unless it is fed with "perfect" information. The dependence of models on
unobservable market factors—investor expectations and risk aversion—makes precise valuation
difficult, therefore, even in the case of fundamental securities. It also means that market
participants do not rely extensively on theoretical models when trading in these markets.
Pricing models for derivatives, on the other hand, value a derivative instrument relative to the
price of its underlying asset. A swaption, for example, is an option on an underlying swap.
The values of the derivative and the underlying are perfectly correlated over short time intervals.
It is not necessary that the underlying asset is priced correctly in the market in order to produce
the equilibrium value of the derivative. This is because the pricing model for the derivative
depends simply on considerations of no arbitrage between the derivative and its underlying asset.
If the derivatives market price differs from the value predicted by the model, then an arbitrage
strategy can be implemented that will earn a risk-adjusted return that is above normal. This is
true whether or not the underlying is accurately priced vis--vis other securities in the market.
At the risk of oversimplifying, we can classify all the models that prevail in finance into three
categories: structural models, statistical models, and models that are a mixture of structural and
statistical models. It is worth reviewing these different types of models before looking in more
detail at the kind of model risks that can occur.
(i) Structural models are based on a system of premises concerning how markets operate under
the assumption of rational behavior. They employ assumptions about the underlying asset price
process and market equilibrium conditions to allow the modeler to draw inferences about the
equilibrium prices. The celebrated Black-Schooles (1973) formula is the best-known example of
a structural model in the derivatives markets. It is derived from an arbitrage-based trading
strategy that combines the option and its underlying to create a delta-neutral portfolio which is
therefore unaffected by small changes in the underlying price over a short interval of time.
(ii) Statistical models rely on empirical observations that are formulated in terms of correlation
rather than causation. A classic example is the market model, which specifies the return
generating process for a stock
As:
(iii)Mixture of structural and statistical models. For example, the GARCH option pricing model
combines features of both types of model.In the case of the GARCH option pricing model,
volatility is assumed to follow a GARCH process, calibrated on historical data, but the
equilibrium price of the option is based on a no-arbitrage argument that is conditional on
GARCH volatility.
Since most financial models rely on mathematical formulations, often using complex statistical
tools, there is always the danger of reaching the wrong solution. This problem is especially
serious when pricing new complex derivatives with special features that make them path
dependent, or dependent on more than one source of risk.
Chapter V
Risk Management in the Future
To manage conflicting objectives, it will need to determine a number of policy variables such as
a target risk-adjusted rate of return (RAROC), target regulatory return, target tier 1 ratio, target
liquidity, and so on in turn, this will mean transforming the risk management function. Risk
management will need to encompass limit management, risk analysis, RAROC, and active
portfolio management of risk (APMR).
In the first part of this chapter, we look at how these changes in risk management will be induced
— and facilitated—by advances in technology, the introduction of more sophisticated regulatory
measures, rapidly accelerating market forces, and an increasingly complex legal environment.
As with any step-change in how an industry is structured, banks may need to act quickly. ''The
easiest way is to be first: Yahoo was first, eBay was first, Amazon was first, etc. Being first helps
immensely to get that critical number of users necessary for the business to take on a life of its
own: critical mass."
For example, over the last year banks have asked how they can avoid significant losses in market
conditions such as those of August–October 1998. Some market commentators have called
market conditions during these three months a "Series of Firsts." There is no easy answer to
this. Banks n to review continually their risk management performance, and ask themselves a
series of tough questions in terms of each element of the risk management framework introduced
earlier.
They also need to ask how they can improve their risk management policies. It is not enough to
measure risks; banks need to ensure continually that in the future the risks in extreme markets
will properly disclosed, made transparent, and—most difficult of all—understood. of course, the
methodological perspective is vital too, and ever changing. Banks will need to ask themselves a
series of questions. How well will the bank's risk measurement models serve the organization in
the future? Will risk measurement models appropriately capture all the risk of future business
lines? How advanced is the bank's measurement of risk in comparison to its competitors?
Finally, a series of questions concerning infrastructure should be asked. Will the bank's risk
management infrastructure—staff, as well as its systems—serve it well in extreme markets? Let's
first analyze the policy component of the risk management framework. The tolerance for risk
should follow directly from the bank's business strategy. For example, the strategic plan at the
beginning of the year may call for the daily value at risk for credit spread risk to be set at a
certain level which is in excess of current trading limits in order to earn the income projected for
credit- intensive business, e.g., a high-yield business.
Chapter VI
Conclusion
Risk analysis and management is most effective when deployed early. A properly structured risk
identification, analysis, and mitigation process can moderate the risks associated with
international construction projects.
An organisation’s risk management policy should set out its approach and appetite for risk and
its approach to risk management. The policy should also set out responsibilities for risk
management throughout the organisation. Furthermore, it should refer to any legal requirements
for policy statements.
Different stake-holding body for the project play important role in successful management of
risk in organization. Bodies like project management unit and different business units when
proactive can do a great deal to identify risk and propose a mitigation plan. Project managers
today has to accept the fact that risk assessment and management is not a substitute for adequate
pre-project planning, project controls, or other management and technical requirements. The
most effective risk management process is coordinated with all aspects of project development
and management.
Project managers have to become more dynamic in terms of project management. They have to
have some idea about project portfolio management and program management. Because small
negligible risk in the project if not managed can cost very big deal in the program.
Project risk management is still a practice in present world. There is no set rule for the risk
management yet. Often organization manages their own risk in their own set way. And when
there is a change in the business rule or the project itself, it becomes really tough for the project
managers track the previous risk of the project. For this reason I believe there should be set
standards for project risk management as it is there for project management itself. Institutions
like PMI, RMI and AIRMIC should come forward to address the problem.
References
1) www.google.com
2) www.powermin.nic.in
3) www.scripbd.org
4) www.wikipedia.com
5) Economic Times
6) Financial Express