Risk Management in Investment Banking

Learning Objectives What is Investment Banking? Activities and Units of Investment Banking? Risk Risk Management Portfolio Diversification Case Study Fall of Barings Bank Plc
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Risk Management in Investment Banking

What is Investment Banking?

- Mathew S

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Investment Banking ?
Investment banking, or I-banking, as it is often called, is the term used to describe the business of raising capital for companies and advising them on financing and merger alternatives.
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Role of I-Banking
Raising Capital Mergers and Acquisitions Sales and Trading General Advisory Services

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Difference : I-Bank and Commercial Bank

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Global Investment Bankers

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Indian Investment Bankers

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Risk Management in Investment Banking

Activities and Units of Investment Banking

- Meghana Pawar

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Units of Investment Banker

Front Office Middle Office Back Office

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Activities of Front Office

Investment Management Structuring Merchant Banking Research Strategy

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Activities of Middle Office

Risk Management Finance Compliance

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Activities of Back Office

Operations Technology

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Risk Management in Investment Banking

Risk - Shantilal Khabiya

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What is Risk?
Risk - a dictionary meaning is the possibility of the actual outcome being different from the expected outcome. From a conventional finance viewpoint, it refers to the uncertainties associated with returns from an investment. These uncertainties would translate into volatility or the fluctuation of the expected returns from an investment

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Certainty, Risks, Uncertainty

Certainty it is known what will happen and happening or non-happening of an event carries a 100% probability Risk a situation where there are a number of specific, probable outcomes, but it is not certain as to which one of them will actually happen. Uncertainty is where even the probable outcomes are unknown. It reflects a total lack of knowledge of what may happen.

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Risks in Financial Markets

Market Risk - refers to changes in returns caused by changes in market prices of the asset Interest Rate Risk - can be either in the form of a change in asset prices arising from interest rate changes or as a change in the cost of funds/ capital Foreign Exchange Risk - refers to the potential losses that can result when the exchange rate of a currency to be received falls in value against home currency or a foreign currency in which a payment is to be made appreciates against home currency.

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Risks in Financial Markets

Underwriting Risk - In this a company which issues the debt or equity instruments has an immediate need for cash, and has no interest in waiting to locate buyers for the instruments at an indeterminate or specified date. Now the investment bank may take an underwriting to buy all the instruments on its books and pay the money to the company even if it is not able to find a buyer. Regulatory Risk - The investment bank has to ensure adherence to all the rules governing the country including proper due-diligence of the company the violation of which may lead to cancellation of its license

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Risks in Financial Markets

Default / credit risk - arises when a debtor is unable to meet its obligations. Liquidity risk - arises from infrequent or thin trading of an asset. Bond price risk A risk that the bond issuer will default on payments to bondholders. Inflation risk - refers to the erosion in purchasing power. Operational risks - e.g. unauthorized trading or system failure.

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Risk Management in Investment Banking

Risk Management
- Shailesh Moghe

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Risk Management- Ideology

Aims at desired and acceptable level of risk Risk is dynamic, therefore evaluation necessary continuously to bring it to targeted level. Traditional theories quote, profit is the reward for taking risk.

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Risk Management - Approach

Risk avoidance
Extreme way to avoid it altogether Results in no activity. More of an exception than a rule

Risk transfer
Firm transfers the risk to another party. Can be done 3 ways
Transfer of asset Transfer the risk w/o transferring asset or liability. Done by hedging or various derivative options Arranging for 3rd party to pay for losses. Also known as risk financing

Loss control
Attempts to reduce either possibility or quantum of loss E.g. Raw material purchases

Combination
Combining more than one business Aggregation or Diversification

Risk retention
Risk is retained when other techniques are too costly or not feasible

Separation
Reducing risk by separating biz, assets & liabilities

Risk sharing
Combination of Risk retention and Risk transfer

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Risk Management - Process

Determining Objectives
e.g. Protect profits,
competitive advantage

Development Strategy
Strategy for managing risk Shorter period than policy Frequently changing variables needs to be included

Identifying risks
Identify possible source of risks e.g. Competition, Social & Political, Foreign markets

Risk evaluation
Significance of risk & its classification Critical, Important, not-soimportant

Implementation
Operational part of RM

Review
Periodic review, depending on the costs involved RM decisions keep changing, necessitating need to effectively monitor

Development of policy
Policy generally talks about how much risk can be borne
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Risk Management - Tools

Hedging
Identifying 2 exactly correlated assets for returns One can hedge the risk by buying & selling others simultaneously

Options
Means choice Gives holder the right (no obligation) to enter into a deal at or before a specified date Call options (for purchase), Put options (for sell)

Forwards
Forward contract to buy or sell an asset at a predetermined future date for a current price.

Swaps
Exchange of one set of financial obligation for another Normally dealt with interest rate swaps & currency swaps

Futures
A standardized Forward contract, traded in future exchange
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Hybrid Debit Securities

These securities have feature of both equity and debt. E.g. Convertible Bonds

Risk Management in Investment Banking

Portfolio Diversification
- Pritesh Keniya
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Equity Risk Management

Basic form of Equity Risk Management Diversification Diversification Expansion of portfolio across different assets/stocks reducing risk (portfolio standard deviation)

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Portfolio Selection
Efficient Portfolios provide the largest possible expected return for given levels of risk Optimal portfolio the most suitable for the investor

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Optimum Portfolio Preparation

Steps: Finding expected risk and return of each securities and market Index Beta, correlation, covariance of securities to the market. Systematic and unsystematic risk of each securities. Finding cutoff rate for selection of securities and on that basis finding weights of securities for investment in portfolio for optimization.

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Simple SHARPE Portfolio Optimization

Evaluates size of the portfolio as well as weight of investment for particular securities

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Risk Management in Investment Banking

CASE STUDY Fall of Barings Bank Plc.

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- Jigar Kamdar

Barings Bank Plc - Risk Management Disaster

Barings Plc, one of the oldest Investment Bank of UK, also known as Queens Bank Nick Leeson, a rogue trader, joined as a trader in Banks Singapore office in 1992 Used to Arbitrage between Japan and Singapore Future Contracts In year 1993, he made profit of 10 million pound from trading in different stock exchanges Became Star Trader of Bank Incharge of Front-office and Back-office

Barings Bank Plc - Risk Management Disaster

In January 1995, Nick Leeson had losses of $320 million
Made huge bets on the direction of movements in the Nikkei index using futures contracts. No oversight or controls to prevent this Nobody even knew (hed set up dummy accounts to hide losses)

Used Straddles to bet Nikkei wouldnt move much

Kobe earthquake hit on January 17, 1995 Leesons losses were $1.4 billion by February 23, 1995 BARINGS Plc - No more bank Filed for bankruptcy on February 26, 1995 Share holders lost $1 billion

Conclusion
Risk Management should be given paramount Importance Risk Management should be analyzed on daily basis Independent Risk Management team for effective Risk Management

THANK YOU !!!