CHAPTER – 2

RISK
Meaning of risk – Risk refers to the probability of loss

In finance, risk refers to the degree of uncertainty and/or potential financial

loss inherent in an investment decision.

Exposure – Exposure is nothing but possibility of loss.

Financial Risk

Financial Risk: Financial Risk as the term suggests is the risk that involves
financial loss to firms. Financial risk generally arises due to instability and
losses in the financial market caused by movements in stock prices,
currencies, interest rates and more.

is one of the high-priority risk types for every business. Financial risk is caused
due to market movements and market movements can include a host of
factors. Based on this, financial risk can be classified into various types such
as Market Risk, Credit Risk, Liquidity Risk, Operational Risk, and Legal Risk.

SOURCES OF FINANCIAL RISK

1. Financial risk arising from an organization’s exposure to changes in

market prices, such as interest rates, exchange rates, and commodity
prices.
2. Financial risk arising from the actions of and the transactions with,
other organizations such as vendors, customers and counterparties in
the derivatives market.
3. Financial risks resulting from internal actions or failures of the
organization particularly people, processes, and system.

Increased financial risk causes losses to a profitable organization. This

underlines the importance of risk management to hedge against
uncertainty. Derivatives are risk management tools that help the
organization to effectively transfer the risk.
 MARKET RISK

Market risk is the risk that the value of an investment will decrease due to
changes in market factors. These factors will have an impact on the overall
performance on the financial markets and can only be reduced by
diversification into assets that are not correlated with the market – such as
certain alternative asset classes.

Market risk is sometimes called “systematic risk” because it relates to

factors, such as a recession, that impact the entire market.

Market risk is associated with other kinds of risks such as

a. Equity risk
b. Interest rate risk
c. Currency risk
d. Commodity risk

a. Equity risk

Equity risk is defined as the variance between the expected return and the
actual return provided by an investment. The greater the variance in returns
the greater the risk.

It is the risk that one’s investments will depreciate because of stock market
dynamics causing one to lose money.

b. Interest rate risk

Interest rate risk is the probability of a decline in the value of an asset resulting
from unexpected fluctuations in interest rates. Interest rate risk is mostly
associated with fixed-income assets (e.g., bonds) rather than with equity
investments. The interest rate is one of the primary drivers of a bond’s price.

In simple terms interest rate risk is the risk borne by an interest-bearing asset,
such as loan or a bond, due to variability of interest rates.

How to Mitigate Interest Rate Risk?

Similar to other types of risks, the interest rate risk can be mitigated. The most
common tools for interest rate mitigation include

1. Diversification - If a bondholder is afraid of interest rate risk that can

negatively affect the value of his portfolio, he can diversify his existing portfolio
by adding securities whose value is less prone to the interest rate fluctuations
(e.g., equity). If the investor has a “bonds only” portfolio, he can diversify the
portfolio by including a mix of short-term and long-term bonds.

2. Hedging

The interest rate risk can also be mitigated through various hedging strategies.
These strategies generally include the purchase of different types of derivatives.
The most common examples include interest rate swaps, options, futures, and
forward rate agreements (FRAs).

Techniques to measure the interest rate risk

a. Marking to market – calculating the net market value of the assets and
liabilities.
b. Stress testing – Shifting the market value and yield curve
c. Calculating the Value at Risk of the portfolio.
d. Calculating the multi period cash flow or financial accrual income and
expenses for periods which can be used for future yield cures.
e. Probability distribution of yield curve.

c. CURRENCY RISK

Currency risk, commonly referred to as exchange-rate risk, arises from the

change in price of one currency in relation to another. Investors or companies
that have assets or business operations across national borders are exposed to
currency risk that may create unpredictable profits and losses.

Transaction risk: is the risk that exchange rates will change unfavorably over
time. It can be hedged against using forward contract.

In other words

Transaction risk refers to the adverse effect that foreign exchange rate
fluctuations can have on a completed transaction prior to settlement. It is the
exchange rate risk associated with the time delay between entering into a
contract and settling it.

Translation risk (also known as translation exposure) is the risk that a

company's equities, assets, liabilities, or income will change in value as a result
of exchange rate changes. Translation risk occurs when a firm denominates a
portion of its equities, assets, liabilities, or income in a foreign currency.
 d. Commodity Risk

Commodity risk refers to the uncertainties of future market values and of the
size of the future income, caused by the fluctuation in the prices of
commodities.

In other words

Commodity risk is the threat of changes to a commodity price that may have a
negative effect on future market value and income.

Measurement of market risk

The standard method for evaluating market risk is value-at-risk.

Value at risk (VaR) is a measure of the risk of loss for investments. It estimates
how much a set of investments might lose (with a given probability), given
normal market conditions, in a set time period such as a day. VaR is typically
used by firms and regulators in the financial industry to gauge the amount of
assets needed to cover possible losses.

There are three approaches towards VaR

Three approaches

– Historical simulation

– Model-building approach

– Monte Carlo simulation

Prerequisites for effective market risk management:

1) Market to market – Measuring the fair value of the organization’s

portfolio should be done at least on an intra-day basis with an evolution
towards real-time mark to market data.
2) Stress testing/stimulation – Analysis should be performed which tests
the valuation effect of the derivatives portfolio under stress market
conditions.
3) Management reporting – There is a definite split between the tactical
information requirements of the trading room and the strategic level
information required by senior management.
4) Risk Limit structures – Risk limit structures using effective risk
measurement must be formally introduced and rigorously applied.
 They must be balanced, however, against business requirements and
appetite for risk among senior management and shareholders.
5) Risk capital and aggregation – Establishing a common risk and
performance measurement framework across product and functional
groups is increasingly recognized as being essential for the
comprehensive management of risk.

CREDIT RISK

Meaning - Credit risk is the possibility of a loss resulting from a borrower's

failure to repay a loan or meet contractual obligations. Traditionally, it refers to
the risk that a lender may not receive the owed principal and interest, which
results in an interruption of cash flows and increased costs for collection.

Excess cash flows may be written to provide additional cover for credit risk.
Although it's impossible to know exactly who will default on obligations,
properly assessing and managing credit risk can lessen the severity of a loss.
Interest payments from the borrower or issuer of a debt obligation are a
lender's or investor's reward for assuming credit risk.

In general, the credit risk may take the following forms:

• In case of direct lending the principal and or interest amount may not be
repaid.
• In case of guarantee or LOC, funds may not be forthcoming from the
constituents.
• In case of treasury operations, the payment or series of payments due
from the counterparties under the respective contact may not be effected.
• In case of securities trading business, funds, and securities settlement
may not be affected.
• In case of cross – border exposure the availability and free transfer of
foreign currency funds may either cease or restriction may be imposed by
the sovereign.

For risk-control purposes there are a variety of methods that an

organization can use to control credit risk, but most techniques can be
categorized as either counterparty as enhancements tools as part of the
ongoing process of credit analysis. Credit enhancement techniques include:

➢ Collateral agreements
➢ Netting agreements
➢ Credit guarantees
 ➢ Credit triggers
➢ Mutual termination Options.

Credit Risk Assessment

The following are the important three waves of credit risk assessment.

1) Traditional assessment – it is based on highly judgmental, emphasizing

on qualitative factors with a little bit analysis of a financial assessment.
2) Discriminate analysis – This assessment include quantitative measures
of a borrowers financial position into a statistical model.
3) Advance Technique – This assessment focuses on Option pricing Theory,
reflecting the fact that default is an option.

CREDIT RISK vs MARKET RISK

There is a difference between credit risk and market risk. Credit risk means the
chance that you won't get all your money back, market risk means the risk
that the value of your investment can fluctuate.

Credit risk Market Risk

Credit risk means the chance that you
won't get all your money back
It is relevant to interest-bearing
investments such as mortgage trusts
and bank deposits
Main source of credit risk is
borrower's failure to repay a loan or
meet contractual obligations.
Credit risk is related to a specific
lending
Market risk means the risk that the
value of your investment can
fluctuate.
It is relevant to property and shares.
Sources of market risk include
recessions, political turmoil, changes
in interest rates, natural disasters and
terrorist attacks.
Market risk tends to influence the
entire market at the same time.

Liquidity Risk

Liquidity risk is a financial risk that for a certain period of time a given
financial asset, security or commodity cannot be traded quickly enough in the
market without impacting the market price.

The liquidity risk embedded in derivative contracts requires careful analysis

because of the complex nature of payoffs and of cash flow profiles. For
derivative contracts to the general principle is that the value at inception
should be the present value of all future (expected) cash flows, and it should be
zero in order to be defined “fair”. All costs and remuneration for risks must be
included in the fair value to one of the parties involved,hence funding costs and
remuneration for liquidity risks have to be considered as well.

Operational risk

Operational risk summarizes the uncertainties and hazards a company faces

when it attempts to do its day-to-day business activities within a given field or
industry. Operational risk can also be classified as a variety of unsystematic
risk, which is unique to a specific company or industry.

Other Types of risks

Settlement risk

Settlement risk -- also often called delivery risk -- is the risk that one party will
fail to deliver the terms of a contract with another party at the time of
settlement. Settlement risk can also be the risk associated with default, along
with any timing differences in a settlement between the two parties. Default
risk can also be associated with principal risk.

Settlement risk is inherent in any transaction between two parties.

Legal Risk

Legal risk is the risk which arises when a contract is not legally enforceable

There are number of reasons which may result in the non-enforcement

including:

• Inadequate documentation
• The country party lacks the required authority to enter into the
transaction
• The underlying transaction is not permissible.
• Bankruptcy or insolvency of the counterparty changes contract
conditions.

Strategic Risk

A possible source of loss that might arise from the pursuit of an unsuccessful
business plan. For example, strategic risk might arise from making poor
business decisions, from the substandard execution of decisions, from
inadequate resource allocation, or from a failure to respond well to changes in
the business environment.

Purchasing Power Risk

Purchasing power is the value of a currency expressed in terms of the amount

of goods or services that one unit of money can buy.

Purchasing Power Risk is the chances of an adverse effect on the value of

money as a result of inflationary pressures within an economy. The purchasing
power risk of holding Cash rather than a physical asset like gold or real estate
tends to increase when inflation is high.

Systematic and Unsystematic risk

Systematic risk refers to the risk inherent to the entire market or market
segment. Systematic risk, also known as “undiversifiable risk,” “volatility” or
“market risk,” affects the overall market, not just a particular stock or
industry. This type of risk is both unpredictable and impossible to completely
avoid.

Unsystematic risk is the risk that is inherent in a specific company or industry.

By investing in a range of companies and industries, unsystematic risk can be
drastically reduced through diversification. Synoyms include diversifiable risk,
non-systematic risk, residual risk and specific risk.
Default Risk

Default risk is the chance that a company or individual will be unable to make
the required payments on their debt obligation. Lenders and investors are
exposed to default risk in virtually all forms of credit extensions. A higher level
of risk leads to a higher required return, and in turn, a higher interest rate.

Foreign Exchange risk

Foreign-exchange risk refers to the potential for loss from exposure to foreign
exchange rate fluctuations.

Foreign-exchange risk is the risk that an asset or investment denominated in a

foreign currency will lose value as a result of unfavorable exchange rate
fluctuations between the investment's foreign currency and the investment
holder's domestic currency.

Holders of foreign bonds face foreign-exchange risk, because those types of

bonds make interest and principal payments in a foreign currency.