Risk

February 2011

Risk

Any event or possibility of an event which can impair corporate earnings or cash flow over short/medium/long term horizon Corporate earnings or cash flows have a bearing on the wealth of shareholders through valuation of a corporation Potential for future returns to vary from the expected returns is RISK

Some factors that expose a corporate to risk

Economic policies of government Consumptions and savings propensities and preference of individual consumers which results in certain patterns of international trade Political, social, racial and ethnic issues that impact the availability or demand for a particular commodity Technological factors that bring in new products Governance of corporations and their financial performance

Sources of risk

Prices Market Share Productivity Competition Technology

Risk Classification

From a managerial perspective

Risks that need to be avoided Risks that should be transferred Risks to be actively managed Credit/counterparty risk Market risk Operational risk

From a function perspective

Counterparty/Credit Risk

This is also known as the default risk It is the risk to each party of a contract that the other will not live p to its contractual obligation In the case of a pure lending transaction this takes the form of Credit risk When bank has invested in a security the performance of this instrument is dependent on the financial solvency of the issuer Issuer risk could arise on default in payment of interest or in repayment of principal by the issuer

(contd) Counterparty/Credit Risk

Pre-settlement Risk: It is the bankruptcy of the counterparty which impairs its ability to perform its obligation prior to settlement. In such a case the risk of the organization is not 100% but the replacement value of the original contract Example: APPLE enters into contract to buy Govt bonds for INR 2 from ORANGE on 10th January but ORANGE goes bankrupt on 9th January, the risk of APPLE is not INR 2, but the price over and above it that they have to pay to buy the same bonds from another party REPLACEMENTCOST

(contd) Counterparty/Credit Risk

Settlement Risk: Exposure here is the entire value of the counter-partys obligation In the earlier example, if ORANGE goes bankrupt on 10th January after APPLE has paid the entire amount but before they have received the bonds, their risk extends to the whole amount of the contract. In addition they still have to incur the replacement cost (if any)

Market Risk

The risk of losses due to movement in financial market variables

Interest rates Forex rates Security prices

Price Risk

Price is market-driven measure of value The possibility of not realizing a expected price in the future is called Price risk

Symmetrical vs unsymmetrical Holding equity Vs holding an option Absolute vs relative Initial investment Vs Benchmark index Directional vs non-directional Discontinuity & event large movement that occurs over a small time interval.Very difficult to establish the probability of discontinuity 9/11 Asset liquidity risk irregular traded assets Concentration risk

(..contd) Price Risk

Credit spread risk difference between yield on corporate bonds and treasury bonds Volatility risk degree of unpredictable change in a financial variable over a period of time Systemic risk failures of a major market institution or system Systematic risk also called un-diversifiable risk since it is inherent to any security in a particular market

Forex Risk

Demand & Supply Expectations From a corporate point of view

Transaction exposure: Movement of rates between the date of txn to the date of cash flow Translation exposure: investments in subsidiaries or branches overseas date of investment & date of consolidation Economic exposure threat to the business model from the exchange rates

Country Risk

Economic factors Political factors Socio-community factors Legal framework Emerging markets risk

Liquidity Risk

Funding risk inability to raise funds at normal cost Asset liquidity risk lack of trading depth in the market for a security class or class of assets Liquidity risk tends to aggravate other risk eg if a securities trading company has a position in an illiquid asset (eg z category stocks) it will find it difficult or liquidate that position at short notice. This will compound its market risk. Another example default on payments might trigger a domino effect aggravating credit risk

Interest Rate Risk

Example: fixed and floating interest rate

Technology Risk

Example: fixed and floating interest rate

Operational Risk

Ill defined procedures and a weak control environment Human intervention in technology Risk arising out of failed internal processes, people and systems or from external events

Other Risks

Off-Balance Sheet Risk: In addition to recognized assets and liabilities on a firms balance sheet there are transactions that do not give rise to any asset or liability at present but could do so in the future eg. Letter of credit issued on behalf of a customer. Underwriting facilities offered by banks Regulatory risk

Lack of proper compliance organization Compliance interpretation Absence of compliance reviews

Measuring Risk

Measurement of Credit Risk

Amount of credit risk depends upon the structure of the agreement between bank and its customers. Eg loan vs line of credit

Risk measurement for a single credit facility Risk measurement for a credit portfolio

Risk Measurement of a Single Facility

Probability of Default (PD) Exposure at Default (EAD) outstanding amount at time of default Loss given Default (LGD) fraction of exposure that can be recovered through bankruptcy proceedings or other form of settlement Expected loss = PD*EAD*(1-LGD)

Risk Measurement of a Credit Portfolio

Co-relations comes into play for a portfolio Macro-economic factors like recession or interrelationships between various credit assets (parent company and subsidiaries)

Co-variance model Actuarial model Merton-based simulation model Marco-economic default model

Measurement of Market Risk

Sensitivity Analysis What if Scenario Analysis all risk factors are considered in one shot Stress Testing impact of extreme events Value At Risk (VAR) at 99% confidence level this is the loss