RISK MANAGEMENT

Risk
Risk is the potential that a chosen action or activity (including the choice of inaction) will lead to a loss (or an undesirable outcome). The notion implies that a choice having an influence on the outcome exists.
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RISK: types
There are many different types of risk Common risks include things like accidents in the workplace or fires, Tornadoes, earthquakes, and other natural disasters. It can also include legal risks like fraud, theft, and sexual harassment lawsuits. Risks can also relate to business practices, uncertainty in financial markets, failures in projects, credit risks, or the

Risk Management
Risk management is a process of identifying, assessing, and prioritizing risks of different kinds. Once the risks are identified, the risk manager will create a plan to minimize or eliminate the impact of negative events. The idea behind using risk management practices is to protect businesses from being vulnerable. Many business risk management plans may focus on keeping the company viable and reducing financial risks.
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Identification
Identify potential risks risks are events that, when triggered, cause problems. Risk identification can start with the source of problems or with the problem itself. Source: May be internal or external to the system that is target of risk management stakeholders of a project, employees of a company, or the weather over an airport Problem: risks are related to identified threats. For example: the threat of losing money (playing in a casino), the threat of abuse of confidential information (stolen information from clients account call centre) or the threat of accidents and casualties(Maruti strike).

Assessment
Once risks have been identified, they must be assessed as to their potential severity of impact ( such as damage or loss) and to the probability of occurrence. These quantities are either simple to measure, in the case of the value of a lost building, or impossible to know for sure in case of the probability of an unlikely event occurring. Therefore, in the assessment process it is critical to make the best educated decisions in order to properly prioritize the implementation of the risk management plan.
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Risk Prioritization
The number of risks can be vast. This means not all risks can be dealt with at the same time and priorities have to be set. Risks that have the highest impact on the project should get the highest priority. The risk class shows what these risks are. Risk classes may vary between catastrophic and minor for risk threats . Other criteria that influence prioritization are the times that a risk may occur, the type of effects it has, and the tools and resources available to management .cont.
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Risk Prioritization

(cont.)

Prioritizing the risk management processes too

highly could keep an organization from ever completing a project or even getting started. This is especially true if other work is suspended until the risk management process is considered complete.
If risks are improperly assessed and prioritized, time

can be wasted in dealing with risk of losses that are not likely to occur. Spending too much time assessing and managing unlikely risks can divert resources that could be used more profitably. Unlikely events do occur but if the risk is unlikely enough to occur it may be better to simply retain the risk and deal with the result if the loss does in fact occur.
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Method : Risk Management

The process for identifying and managing the risk consists of five basic steps. 1. Identify and assess threats. 2. Assess the vulnerability of critical assets to specific threats. 3. Determine the risk (i.e. the expected likelihood and consequences of specific types of attacks on specific assets). 4. Identify ways to reduce those risks. Insure , share. 5. Prioritize risk reduction measures based on a strategy.

1. Identify and assess threats.

Interest rates rising: Risk Threats Bond prices falling, loss on account of securities portfolio, increase in interest expenses on new , maturing and floating rate liabilities Disincentive for new business ventures Loss in consumer demand Lower employment Cost of goods and services going up making exports less competitive Weakening of currency rise in import costs; inflation Social unrest

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2. Vulnerability of critical assets to specific threats.

Asses:

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Specific threats to critical assets Floods lead to destruction of property, standing crops and infrastructure and loss of lives. A business may be affected by loss of plant & machinery , damage to buildings and raw and finished goods by floods Strike at Manesar plant of Maruti led to loss of life, injuries to people, damage to property and a loss of production in

3. Determine the risk

What is the probability of strike (violence)

happening again at Maruti Manesar plant and what will be damage to life, property and production? In the absence of sufficient rains , GDP will be affected by what percentage? How would stock market behave (% fall) in case the ruling party loses election 2014. How much the bond portfolio will fall given 1% rise in interest rate?
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4. Identify ways to reduce those risks.

In case of Maruti loss of life can be

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avoided by strengthening security and property damage by insurance. Production loss perhaps can not be avoided. So, budget for it. In case of rising interest rates, a positive gap (rate sensitive assets rate sensitive liabilities) would help. Buying FRA, selling IRFs is an example of protection against rising interest rates

5. Prioritize risk reduction measures based on strategy

Risk reduction measures may run into a long list,

hence they have to be prioritized given the limits on management time and resources. Subject to the strategy chosen, prioritization of risk reduction measures would be done. For example, in the Maruti case, prioritization could begin by efforts to improve relations between the management and the workers union, then beefing up security, buying insurance for expected damage to property and so on. The strategy is minimization of losses.
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Maruti : case study; risk management

Identification

Threat from the employees: Violence leading to fatal injuries, loss of production, destruction of property
Loss of life, property, financial loss on account of loss of production, loss of capitalization in 15 the stock market

assessmen t

Risk determination

Maruti : case study (cont.)

Identification of ways for reduction of risks

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Negotiate , insurance of personnel and property, better security Lock out to avoid further loss of personnel and property Negotiate for things to return to normal Look for alternatives. (Gujrat) Media explain the case for a positive public opinion. Seek Govt. help, arbitration

Prioritization of risk reduction methods

Potential risk treatments

Once risks have been identified and assessed, all techniques to manage the risk fall into one or more of these four categories: 1. Avoidance (eliminate, withdraw from or not become involved) 2. Reduction (medical care, fire
departments, night security guards, sprinkler systems, and burglary alarm)
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3. Sharing (corporation, insurance)

Strategic Risk
Exposure to loss resulting from a

strategy that turns out to be defective or inappropriate.

Strategic risk is the current and

prospective impact on earnings or capital arising from adverse business decisions, improper implementation of decisions, or lack of responsiveness to industry changes.
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Risk Organization
Board of Directors

Chairman &CEO

Senior management. Chief Risk Officer Risk Officers at functional divisions like Credit, Technology and Treasury Functional Heads like Treasury, Credit, Technology, Internal Audit

Operational managemen t

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Asset Liability Management

An attempt to match : Assets

and Liabilities In terms of : Maturities and interest rate sensitivities To Minimize : Interest rate risk and Liquidity risk
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Asset Liability management (ALM): Structure

Board

ALCO

Risk Management Department CEO

ALCO Secretariat
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Research & Analysis Unit

Assets Liabilities = Liquidity Gap

Next 2-7 day days Assets liabilities Gap (AL) Assets Liabilitie s Assets Liabilitie s
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8 days1 month

1-3 months

3-6 months

6-12 month s

1-3 3-5 > Y Y 5Y

Tota l

x =

y
positive

z Positive Gap

negative

Negative Gap

Rate sensitive Assets(RSA)- Rate sensitive Liabilities(RSL) = Rate Sensitive Gap

1-28 days
A. Liabilities B.Assets C. Gap (B-A)

29 D-3 month s

3-6 M

6-12 M

1Y 3 Yrs.

3-5 Yrs.

Over 5 Yrs.

NonSensitiv e

total

D.
Other interest product: (FRA, Swaps, Futures, Options)

E. Net Gap (C-D) RSA-RSL

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x =

y positive

c interest

d rates rise

(+)
Gap

+ ve. when

Duration
Interest rate risk on bonds:

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(1) reinvestment risk, (2) capital gain/ loss on liquidation When interest rate rises, there is gain on reinvestments and loss on liquidation. Converse is true when interest rate falls For any bond there is a holding period for which these two effects exactly balance each other. The loss on reinvestment is exactly compensated by capital gain on liquidation and vice versa. For this holding period there is no interest risk. The holding period for which the interest rate risk is immunized is called duration.

Duration

(cont.)

Consider a 12.5% bond with annual coupons, maturing on

1.09.2017, with 5% premium. Today is 1.09.2012 and prevailing interest rate is 15%. What is the price of the bond today?
Date 1.09.2013 1.09.2014 1.09.2015 1.09.2016 1.09.2017

Year no.
Cash flow PV of cash flows @15%

1
12.50 10.87

2
12.50 9.45

3
12.50 8.22

4
12.50 7.15

5
117.50 58.40 94.10

PV* Year No.

Weighted avg. of 25 time with PV cash flows

10.87*1 10.87

9.45*2 18.90

8.22*3 24.66

7.15*4 28.60

58.40*5 292 375.0 3

Duration
Date 1.09.201 3

(cont.)

5- year, 12.5% Bond ( 5% prem.) maturing 1.09.2017, Face value 100. Duration : 4 years
1.09.201 4 1.09.201 5 1.09.201 6 1.09.2016 (2017 cash flow 117.50 discounted) 102.17 102.17 164.59 Bond price after 4 years.

@15%
Cash flow Terminal Value @16% Cash flow Terminal Value @14% 26 Cash flow 12.50 12.50 12.50 12.5 103.07 12.50 19.51 12.50 16.82 12.50 14.50 12.50 12.50 101.29 101.29 164.62 12.50 19.01 12.50 16.53 12.50 14.38 12.50 12.50

VAR: Value at Risk

A VAR statistic has 3 components: 1. A time period ( a day, a month or a year) 2. A confidence level ( 95% or 99%) 3. A loss ( amount or % terms)

VAR answers the following questions: What is the most (amount) one can with a 95% or 99% level of confidence-expect to lose over the next month? What is the maximum % one can with 95% or 99% confidence expect to lose over the next year?
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VAR as a Risk measure

VAR (cont.)
Data set of almost 1400 points The histogram compares the frequency of return buckets The highest bar shows that there were more than 250 days

when the daily return was between 0 % and 1 % Red bars are the lowest 5% of daily returns. The red bars run from daily losses of 4% to 8%. With 95% confidence, we expect that our worst daily loss will not exceed 4%. That is if we invest Rs. 100, we are 95% confident that our worst daily loss will not exceed Rs. 4. Further left, the first 2 red bars, at -8% and -7%, represent the worst 1% of daily returns. With 99% confidence, we expect daily losses will not exceed 7% or if we invest Rs. 100, we are 99% confident that our daily worst loss will not exceed Rs.7.
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