Risk Management OPTIONAL Notes and Questions CAIIB

RISK MANAGEMENT OPTIONAL CAIIB
Syllabus 2023
Risk Management subject has a total of 5 modules:
An Overview
Credit Risk Management
Market Risk
Operational Banking
Risk Organization and Policy
Module – A: Risk Management
An Overview of Risk Management:
Terms & policies in relation to Risk, Risk Process, Risk Organization, and Key risks
such as Credit risk, Market Risk, Operational Risk, Liquidity Risk, Legal Risk, Interest
Rate Risk Currency Risk, etc.
Asset Liability Management (ALM):
Concepts of ALM such as Asset Liability Management Organization, Asset-Liability

Committee (ALCO) techniques or tools, Simulation, Gap, Duration analysis, Linear
& other statistical methods of control.
Risk measurement & Control:
Calculation of Risk, Analysis of Risk Exposure, Risk management or mitigation

policy, Capital adequacy norms, Risk-Adjusted Return on Capital, Risk Immunization
strategy or policy or strategy for fixing exposure limits, Risk Management Policy &
Procedure, etc.
Risk Management Concepts:

Norms such as Capital adequacy, Exposure, Prudence; Concept of Mid-office,
Forwards, Futures and Options, Strategies and Arbitrage opportunities, and
Regulatory Prescriptions of Risk Management.
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Module – B: Credit Risk Management
Basel Norms, Three pillars of Basel and Capital requirements for Operational risk,
Methods for estimating capital requirements, Methods estimating capital
requirements, Risk rating and risk pricing, Framework for risk management, RBI
guidelines on risk management, Standardized approach for Credit risk, Advanced
Approach for Credit risk, Credit rating or credit scoring and rating system design,
Credit Bureaus, Stress Test and Sensitivity Analysis, Internal Capital Adequacy
Assessment Process i.e ICAAP & Introduction to structured products.
Module – C: Operational Risk
Basel Norms, RBI guidelines, Likely forms of operational risk and causes for a
significant increase in operational risk, Sound Principles of Operational Risk
Management – organizational setup and key responsibilities of ORM, SPOR – policy
requirements and strategic approach for ORM, SPOR identification, measurement,
control/ mitigation of operational risks, SPOR identification, measurement, how to
control/mitigation of operational risks, Capital allocation for operational risk,
methodology, qualifying criteria for banks for the adoption of the methods,
Computation of capital charge for operational risk, etc.
Module – D: Market risk
Definitions of different terms & the Prescriptions of Basel Norms, Liquidity &
Interest rate risk, Foreign Exchange & Price risk (Equity), Commodity risk, how to
treat market risk under Basel Standardized duration method & Internal
measurement approach – VaR, etc.
Module – E: Risk Organization and Policy
Risk Organization and Policies including Risk Management Policy, Credit,

Interlinkages to – Treasury, ALCO, etc.
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Module – A: Risk Management
Index
Chapter No Topics Covered
01 An Overview of Risk Management: Terms & policies in relation

to Risk, Risk Process, Risk Organization, and Key risks such as
Credit risk, Market Risk, Operational Risk, Liquidity Risk, Legal Risk,
Interest Rate Risk Currency Risk, etc.
02 Asset Liability Management (ALM) : Concepts of ALM such as

Asset Liability Management Organization, Asset-Liability
Committee (ALCO) techniques or tools, Simulation, Gap, Duration
analysis, Linear & other statistical methods of control.
03 Risk measurement & Control: Calculation of Risk, Analysis of Risk

Exposure, Risk management or mitigation policy, Capital
adequacy norms, Risk-Adjusted Return on Capital, Risk
Immunization strategy or policy or strategy for fixing exposure
limits, Risk Management Policy & Procedure, etc.
04 Risk Management Concepts: Norms such as Capital adequacy,

Exposure, Prudence; Concept of Mid-office, Forwards, Futuresand
Options, Strategies and Arbitrage opportunities, and Regulatory
prescriptions of risk management.
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Chapter 01 - An Overview of Risk Management
The following topics are covered in this Chapter:
Terms & policies in relation to Risk, Risk Process, Risk Organization, and Key risks
such as Credit risk, Market Risk, Operational Risk, Liquidity Risk, Legal Risk, Interest
Rate Risk Currency Risk, etc.
***
01. Risk can simply be considered to be ‘an unplanned event with unexpected
consequences.
02. Risk may have positive or negative outcomes or may simply result in
uncertainty.
03. Risks may be considered to be related to an opportunity or a loss or the

presence of uncertainty for an organization.
04. There are certain risk events that can only result in negative outcomes. These
risks are hazard risks or pure risks, and these may be thought of as operational or
insurable risks.
05. There are other risks that give rise to uncertainty about the outcome of a
situation. These can be described as control risks and are frequently associated with
project management.
06. The management of control risks will often be undertaken in order to ensure
that the outcome from the business activities falls within the desired range. The
purpose is to reduce the variance between anticipated outcomes and actualresults.
07. Organizations deliberately take risks, especially marketplace or commercial

risks, in order to achieve a positive return. These can be considered as opportunity
or speculative risks, and an organization will have a specific appetite for investment
in such risks.
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08. Opportunity risks relate to the relationship between risk and return. The
purpose is to take action that involves risk to achieve positive gains.
09. The focus of opportunity risks will be towards investments.
10. Control risks are associated with unknown and unexpected events.
11. Control Risks are sometimes referred to as uncertainty risks and they can be
extremely difficult to quantify.
12. Control risks are often associated with project management and the
implementation of tactics.
13. There are two main aspects associated with opportunity risks. There are risks/
dangers associated with taking an opportunity, but there are also risks associated
with not taking the opportunity.
14. Opportunity risks may not be visible or physically apparent, and they are
often financial in nature.
15. There is deviation in what we achieve from what we had planned or what we
had expected. This unpredictability of future is due to uncertainties associated
with the steps that we undertake in the process or various external factors that
influence the processes that are necessary to achieve our planned objective.
16. Risks are uncertainties resulting in adverse outcome, adverse in relation to

planned objective or expectations.
17. 'Financial Risks' are uncertainties resulting in adverse variation of profitability

or outright losses.
18. Uncertainties associated with risk elements impact the net cash flow of any
business or investment. Under the impact of uncertainties, variations in net cash
flow take place. This could be favourable as well as unfavourable. The possible
unfavourable impact is the 'RISK’ of the business.
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19. Lower risk implies lower variability in net cash flow with lower upside and
downside potential.
20. Higher risk implies higher upside and downside potential.
21. Lower risk implies lower variability in net cash flow with lower upside and
downside potential.
22. Higher risk would imply higher upside and downside potential.
23. Zero Risk would imply no variation in net cash flow.
24. Return on zero risk investment would be low as compared to other

opportunities available in the market.
25. Risk management is a process through which an organisation identifies,

assesses and controls threats, if any, to its earnings and capitals.
26. The source of threats could be due to a variety of causes like uncertainties in
finances, legal liabilities, errors in strategy by the management, accident or a natural
disaster.
27. For digitised organisations, protection of data and threats to their IT security
are of major concern.
28. The word, ‘Risk’ is derived from the early Italian language ‘Risicare’ which
means ‘to dare’, means to take on challenge.
29. Warren Buffet maintained, ‘Risk comes from not knowing what you aredoing’.
30. Uncertainty is imprecise (vague/unclear) knowledge about future events. On

the other hand, risk is that kind of uncertainty which can be systematically assessed
through reasonably reliable probability distribution of the outcomes andtherefore
measured and priced.
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31. Uncertainty is a clouded situation and from uncertainty, one has to travel to
the risk situation from where only he can start managing the risk.
32. Uncertainty is mother of risk.
33. Uncertainties associated with risk elements impact the net cashflow of any
business or investment.
34. Under the impact of uncertainties, variations in net cashflow take place. This
could be favourable as well as unfavourable. The possible unfavourable impact is
the ‘Risk’ of the business.
35. Risk, Capital and Return can be called as Trinities of Risk Management.
36. A business with wide variations in net cash flow would be a business with
higher risk. The profit potential and loss possibilities would be higher in such
businesses due to higher variability of net cash flow. . Capital requirements would
be higher because of possibilities of higher losses.
39. A business with lower variation in net cash flow would be a business with low
risk. The profit potential as well as loss possibilities would be lower in such
businesses due to low variability of net cash flow. Capital requirements would also
be lower because of possibilities of lower losses.
40. The returns expected from a business would be in relation to the risks
associated with the business.
41. Returns net of risk would be the proper basis of comparing investments.
42. Risk in a business or investment is netted against the return from it. This is
called Risk Adjusted Return on investment.
43. The Risk Adjusted Return happens to be the key factor for investment
decisions of investors.
44. The key driver in managing a business is seeking enhancement in Risk-

Adjusted Return on Capital (RAROC).
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45. Risk-Adjusted Return on Capital (RAROC) is a better performance measures
when compared to measures like Return on Assets (ROA) or Return on Equity (ROE)
46. The higher the RAROC, the higher is the reward to investors/shareholders
and more preferable such investment would be to the market.
47. Controlling the level of risk to an organisation’s capacity to bear the risk is
the essence of risk management and requires not only the identification of risks but
also their measurement, control, mitigation and estimating the costs of risk.
48. ALCO- Asset-Liability Committee
49. CRMC - Credit Risk Management Committee
50. ORMC - Operational Risk Management Committee
51. Aggregated risk determines capital needs.
52. Risk Identification consists of identifying various risks associated with the risk
taking at the transaction level and examining their impact on the portfolio and on
capital requirement.
53. Risk management relies on the quantitative measures of risk. T
54. The risk measures seek to capture variations in earnings, market value, losses
due to default, etc., (referred to as target variables), arising out of uncertainties
associated with various risk elements.
55. Quantitative measures of risks can be classified into three categories.
• Based on Sensitivity
• Based on Volatility
• Based on Downside Potential
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56. Sensitivity captures deviation of a target variable due to unit movement of a
single market parameter. Only those market parameters, which drive the value of
the target variable are relevant for the purpose.
57. The volatility characterises the stability or instability of any random variable.
It is a common statistical measure of dispersion around the average of anyrandom
variable such as earnings, mark-to-market values, market value, lossesdue to
default, etc.
58. Volatility is the standard deviation of the values of these variables. Standard
deviation is the square root of the variance of the random variable.
59. Downside Potential only captures possible losses ignoring the profit
potential.
60. The downside potential has two components - potential losses and
probability of occurrence.
61. Potential losses may be estimated but the difficulty lies in estimating the
probabilities.
62. Risk pricing implies factoring risks into pricing through capital charge and loss
probabilities.
63. Pricing is transaction-based.
64. Since risks arise from uncertainties associated with the risk elements, risk
reduction is achieved by adopting strategies that eliminate or reduce the
uncertainties associated with the risk elements.
65. Risk reduction is achieved by adopting strategies that eliminate or reduce the
uncertainties associated with the risk elements. This is called ‘Risk Mitigation’.
66. Risk mitigation measures aim to reduce downside variability in net cash flow
but these measures also reduce the upside potential simultaneously.
67. Risk mitigation measures reduce the variability in net cash flow.
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68. Risks can be mitigated through diversification.
69. Risk associated with a portfolio is always less than the weighted average of
risks of individual items in the portfolio.
70. Enterprise-Wide Risk Management (EWRM) is a continuous and structured

process of listing the objectives of the organisation; identifying all external and
internal risk-factors that could impact the achievement of the objectives and
organisation’s business and financial targets; prioritising the risk-factors; exploring
alternatives for mitigating the risks; and controlling and monitoring such risks.
71. Enterprise-Wide Risk Management (EWRM) encompasses the entire gamut of

the organisation’s operations and is not limited to a single event or circumstance
impacting the organisation’s functioning.
72. Enterprise-Wide Risk Management (EWRM) is a dynamic process involving

people at all levels, covers every aspect of the organisation’s resources and
operations and takes a holistic picture of the entire organisation for the purpose
of risk management.
73. Banks have identified and started adapting the Enterprise Risk Management
Framework released by COSO (Committee of Sponsoring Organizations of the
Treadway Commission) as a framework to drive their initiatives in risk management
beyond Basel norms and regulatory compliances.
74. Enterprise Risk Management (ERM) helps in identifying and selecting among
alternative risk responses -risk avoidance, reduction, transfer, and acceptance.
75. Enterprise Risk Management (ERM) helps to ensure effective reporting and
compliance with laws and regulations, and avoid damage to the entity’s reputation
and associated consequences. As the risks keep constantly changing and evolving
in a global economy, ERM is a never ending journey.
76. Liquidity Risk is the inability to obtain funds to meet cash flow obligations at
a reasonable rate.
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77. Funding Risk arises from the need to replace net outflows due to
unanticipated withdrawal/non-renewal of deposits (wholesale and
retail/premature closure of term deposits.
78. Time Risk arises from the need to compensate for non-receipt of expected
inflows of funds i.e. performing assets turning into non-performing assets; or
borrowers not repaying their instalments (EMIs) on due dates.
79. Call Risk arises due to crystallization of contingent liabilities since customers
are not meeting their commitments on due dates.
80. Call Risk may arise when a bank may not be able to undertake profitable
business opportunities when it arises.
81. Interest Rate Risk (IRR) is the exposure of a Bank’s revenue to adverse
movements in interest rates.
82. Interest Rate Risk (IRR) refers to potential adverse impact on Net Interest
Income or Net Interest Margin or Market Value of Equity (MVE), caused by changes
in market interest rates.
83. Interest Rate Risk (IRR) is the risk of changes in the financial value of assets or
liabilities (or inflows/outflows) because of fluctuations in interest rates.
84. Gap or Mismatch Risk arises from holding assets and liabilities and off-
balance sheet items with different principal amounts, maturity dates or repricing
dates, thereby creating exposure to unexpected changes in the level of market
interest rates.
85. The risk that the interest rate of different assets, liabilities and off-balance
sheet items may change in different magnitude is termed as Basis Risk.
86. Yield curve risk stems from the fact that bond prices and interest rates have an
inverse relationship to one another, as the price of bonds decreases when market
interest rates increase and vice versa.
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87. Yield Curve Risk is a type of basis risk and this arises with respect to different
maturity benchmarks to which liabilities and assets are linked.
88. Embedded options expose investors to reinvestment risk as well as the

propensity for limited price appreciation.
89. Reinvestment risk manifests if an investor or issuer exercises the embedded

option, where the recipient of the transactional proceeds is forbidden from
reinvesting them.
90. Reinvestment Risk is the chance that cash flows received from an investment
will earn less when put to use in a new investment.
91. Risk is a quantifiable uncertainty.
92. Market risk is the risk of adverse deviations of the mark-to-market value of the
trading portfolio, due to market movements, during the period of holding. This
results from adverse movements of the market prices of interest rate instruments,
equities, commodities and currencies.
93. Market Risk is also referred as Price Risk.
94. Price risk is the risk that the value of a security or investment will decrease.
95. Factors that affect price risk include earnings volatility, poor business
management, and price changes.
96. Diversification is the most common and effective tool to mitigate price risk.
97. Foreign exchange risk is the chance that a company will lose money on
international trade because of currency fluctuations.
98. Forex Risk is a also known as currency risk, FX risk and exchange rate risk.
99. Forex Risk describes the possibility that an investment's value may decrease
due to changes in the relative value of the involved currencies.
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100. Credit Risk is the potential of a borrower or counterparty fail to meet its
obligations in accordance with agreed terms.
101. Credit Risk is also known as Default Risk.
102. Counterparty' Risk is a variant of credit risk and is related to non- performance
of the trading partners due to counterparty’s refusal and or inability to perform.
103. The counter-party risk is generally viewed as a transient financial risk

associated with trading rather than standard credit risk.
104. Country Risk is a type of credit risk where non-performance by a borrower or

counter-party arises due to constraints or restrictions imposed by a country.
105. In case of Country Risk, the reasons for non-performance are external factors
on which the borrower or the counterparty has no control.
106. Operational Risk is the risk of loss resulting from inadequate or failed internal
processes, people and systems or from external events.
107. Strategic risk and reputation risk, though in the nature of Operational Risk, are
not covered under the definition of operational risk by BCBS.
108, Operational risk may loosely be comprehended as any risk, which is not
categorised as market or credit risk.
109. Transaction Risk is the risk arising from fraud, both internal and external, failed
business processes and the inability to maintain business continuity and manage
information.
110. Compliance risk is the risk of legal or regulatory sanction, financial loss or
reputation loss that a bank may suffer as a result of its failure to comply with any
or all of the applicable laws, regulations, codes of conduct and standards of good
practice.
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111. Compliance Risk is also called integrity risk since a bank’s reputation is
closely linked to its adherence to principles of integrity and fair dealing.
112. Strategic Risk is the risk arising from adverse business decisions, improper
implementation of decisions, or lack of responsiveness to industry changes.
113. Strategic Risk is a function of the compatibility of an organization’s strategic

goals, the business strategies developed to achieve those goals, the resources
deployed against these goals and the quality of implementation.
114. Strategic Risk calls for whether there is gap between the strategy aimed at and
implemented.
115. Reputational Risk is normally treated as an indirect risk.
116. Reputational Risk is the risk arising from negative public opinion.
117. Reputational Risk may expose the institution to litigation, financial loss, or a
decline in customer base.
118. Model risk is the gap between value predicted through model and the value
actually observed.
119. Climate-related risks refer to the potential risks that may arise from climate
change or from efforts to mitigate climate change, the irrelated impact, and the
economic and financial consequences.
120. Climate-related risks can impact on the financial sector through two broad
channels i.e., physical risks and transition risks.
121. Physical risks, which arise from the changes in weather and climate that impact
the economy.
122. Physical risks can be categorized as acute risks (such as floods, heatwaves,
landslides etc), which are related to extreme weather events, or chronic risks (such
as ocean acidification, rising sea levels, extreme weather variability etc.) which
associated with gradual shifts in climate.
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123. Transition risks arise from the process of adjustment towards a low-carbon
economy.
124. Settlement risk is the risk that a counterparty fails to deliver a security or its
value in cash as per agreement when the security was traded after the other
counterparty or counterparties have already delivered security or cash value asper
the trade agreement.
125. Settlement risk is the risk that arises when payments are not exchanged
simultaneously.
126. One form of settlement risk is foreign exchange settlement risk or cross-
currency settlement risk, sometimes called Herstatt risk.
127. BCBS - Basel Committee on Banking Supervision.
128. Translation risk is the exchange rate risk associated with companies that deal
in foreign currencies and list foreign assets on their balance sheets.
129. The basic linkage between Risk & Capital is high capital is required in case of
high risk and low capital is required in case of low risk.
130. In view of time value of money a plan with steady stream of cash flow will be
preferred to a plan with high risk with volatile income flow.
131. If the risk in a business or investment is netted against the return from it, then
it is called Adjusted Return on Investment.
132. The Risk adjusted return is key factor in investment decision.
133. Mismatch in maturities of assets and liabilities is known as Liquidity Risk.
134. Interest rate changes at maturity of assets and liabilities affects net interest
margin and it is called Interest Rate Risk.
135. Banking book is not exposed to Market Risk.
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136. Operational Risk arises due to human failures, omissions, commissions or
nonadherence of internal processes external events etc.
137. Banking book is mainly exposed to Liquidity Risk, Interest Rate Risk, Default
Risk or Credit Risk and Operational Risk.
138. Liquidity Risk arises from funding long term assets out of short term
liabilities.
139. Funding Liquidity Risk is inability to obtain funds to meet cash obligations.
140. Time Risk arises from non receipt of expected inflow of funds.
141. Call Risk arises due to crystallization of contingent liabilities.
142. Funding Risk, Time Risk and Call Risk are part of Liquidity Risk.
143. Internal Rate of Return (IRR) is the exposure of a bank’s financial condition to
adverse movements in interest rate.
144. IRR refers to potential impact on NII or NIM or Market value of equity caused
by unexpected changes in market interest rates.
145. Prepayment of loans, premature withdrawals of term deposits exercise of call

/ put options is called Embedded Option Risk.
146. Embedded Option Risk is experienced in volatility situations.
147. Uncertainty with regard to interest rate at which the future cash flow could
be reinvested is called Reinvestment Risk.
148. Where NIM gets reduced due to movements in interest rates it is called Net
Interest Position Risk.
149. The risk of adverse deviations of the market to market value of the trading
portfolio due to market movements during the period required to liquidate the
transaction is called Market Risk.
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150. Market liquidity risk arises when a bank is unable to conclude a large
transaction in a particular instrument near the market price.
151. Gap or Mismatch Risk, Yield Curve Risk, Basis Risk, Embedded Option Risk,
Investment Risk and Net Interest position Risk are Interest Rate Risks.
152. Forex Risk and Market liquidity risk are called Market Risk.
153. Counter party risk and Country risks are called Default Risk or Credit Risk.
154. Transaction Risk and Compliance Risk are called Operational Risk.
155. Aggregated Risk of the organization as a whole is called Portfolio Risk.
156. All the risks are concentrated at transaction level.
157. Certain risks such as liquidity risk and interest rate risk are managed at the
aggregate or portfolio level.
158. Credit risks, Operational risk & market risk arising from individual transactions
are taken cognizance of at transaction level as well as at portfolio level.
159. Guidelines from Corporate level help in standardizing risk content in the
business undertaken at the transaction level.
160. Reduction in PLR leads to Basis Risk.
161. In case of a loan funded with short term liability (Deposit) at the time of
maturity of deposit to fund the unpaid portion of loan, bank has to raise funds with
different interest rate, this is called Gap or Mismatch Risk.
162. Repayments received from an asset are to be redeployed with a different

interest rate which may not be equal to original ROI, this is called Reinvestment
Risk.
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163. Adopting strategies that eliminate or reduce the uncertainties associated
with the risk elements is called Risk Mitigation.
164. Risk based capital means bank’s capital in line with risks.
165. Failure of the whole banking system is Systemic Risk.
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Chapter 02 - Asset Liability Management (ALM)
Asset Liability Management Organization, Asset-Liability Committee (ALCO);

Techniques or tools, Simulation, Gap, Duration analysis, Linear & other statistical
methods of control.
***
01. Asset/Liability Management (ALM) is managing the volume and timing of cash
flows of assets and liabilities to increase profitability, manage risk, and maintain the
safety and soundness of the financial institution.
02. ALM is a delicate balancing act between maximizing profitability while

minimizing risk, between managing the needs of customers or members,
regulators, and shareholders all at the same time.
03. ALM is a decision-making tool that allows the institution to make decisions
about its assets and liabilities to generate sustainable earnings without
compromising the other interests of the institution.
04. ALM manages the balance sheet to maximize income without having that
income be too volatile (risky) in different market conditions.
05. Three key objectives of ALM are Meet financial goals; Manage risks and
Maintain safety and soundness.
06. Two Approaches to ALM function are Regulatory Approach and Management
approach.
07. Regulatory approach to ALM aims to “check the (regulatory) box.” It is called
the regulatory approach because there is regulatory expectation for the
measurement and management of risk on an institution’s balance sheet andincome
statement. This approach is geared toward meeting those expectations, at least
minimally.
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08. Management approach to ALM assess the risk/return trade-off in proposed
strategies and make decisions that benefit the institution both in the short term and
the long term.
09. Management approach leverages all the analyses typically performed in the
regulatory approach, and so meets examiner requirements. But it also considers
dynamic modelling of the balance sheet, which means that future growth plans and
strategies are analyzed as well, giving management a realistic look at the outlook
of the institution today and tomorrow.
10. Three pillars of asset liability management involve information systems, the
organisation and ALM processes.
11. The problem of ALM is addressed by analysing the behaviour of asset and
liability products in top branches accounting for significant businesses and then,
making calculated assumptions about the way in which assets and liabilities would
behave in other branches.
12. Asset-Liability Committee (ALCO) is a decision-making unit responsible for

balance sheet planning from risks - return perspective, including the strategic
management of interest rate and liquidity risks.
13. The business issues that an ALCO considers include product pricing for both
deposits and advances, desired maturity profile of the incremental assets and
liabilities.
14. ALCO is mandated to articulate the current interest rate view of the bank and
bases its decisions for future business strategy on this view.
15. In respect of the funding policy, ALCO’s responsibility would be to decide on

source and mix of liabilities or sale of assets.
16. ALCO will have to develop a view on future direction of interest rate
movements and decide on a funding mix between fixed versus floating rate funds,
wholesale versus retail deposits, money market versus capital market funding and
domestic versus foreign currency funding.
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17. ALM is a comprehensive and dynamic framework for measuring, monitoring
and managing the market risk of a bank.
18. ALM is concerned with risk management and provides a comprehensive and
dynamic framework for measuring, monitoring and managing liquidity, interest
rate, foreign exchange and equity and commodity price risks of a bank that needs
to be closely integrated with the banks’ business strategy.
19. ALM is the management of structure of balance sheet (liabilities and assets) in
such a way that the net earning from interest is maximised within the overall risk-
preference (present and future) of the institutions.
20. ALM manages liquidly risk management, management of market risk, trading
risk management, funding and capital planning and profit planning and growth
projection.
21. ALM is a tool that enables bank managements to take business decisions in a
more informed framework with an eye on the risks that bank is exposed to.
22. ALM is an integrated approach to financial management, requiring

simultaneous decisions about the types of amounts of financial assets and liabilities
– both mix and volume.
23. ALM is considered as an important tool for monitoring, measuring and

managing the market risk of a bank.
24. ALM has been introduced in Indian Banking industry w.e.f. 1st April, 1999.
25. ALM Information Systems -
(a) Management Information Systems

(b) Information availability, accuracy, adequacy and expediency
26. ALM Organisation
(a) Structure and responsibilities

(b) Level of top management involvement
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27. ALM Process
(a) Risk parameters
(b) Risk identification
(c) Risk measurement
(d) Risk management
(e) Risk policies and tolerance levels.
28. Asset-Liability Committee (ALCO) is the top most committee to oversee the
implementation of ALM system and it is to be headed by CMD or ED.
29. ALM process involve in identification , measurement and management of risk

Parameter.
30. Asset- Liability Management Techniques :
31. Gap Analysis is a technique of Asset – Liability management .
32. Gap Analysis is used to assess interest rate risk or liquidity risk.
33. Gap Analysis measures at a given point of time the gaps between RateSensitive
Liabilities (RSL) and Rate Sensitive Assets (RSA) (including off balance sheet
position) by grouping them into time buckets according to residual maturityor next
re-pricing period , whichever is earlier.
34. Rate Sensitive Assets (RSA) are bank assets, mainly bonds, loans and leases, and
the value of these assets is sensitive to changes in interest rates; these assets are
either repriced or revalued as interest rates change.
35. Rate Sensitive Liabilities (RSL) are bank liabilities, mainly interest-bearing
deposits and other liabilities, and the value of these liabilities is sensitive tochanges
in interest rates; these liabilities are either repriced or revalued as interest rates
change.
36. GAP=RSA-RSL
37. GAP Ratio=RSAs/RSL
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38. The asset-liability mismatch is of two types – Positive Mismatch and Negative
Mismatch.
40. When the Short Term Assets are more than Short Term Liabilities it is Positive
Mismatch.
41. When the Short Term Assets are less than Short Term Liabilities it is Negative
Mismatch.
42. In case of Positive mismatch, excess liquidity can be deployed in money

market instruments, creating new assets & investment swaps etc.
43. Negative mismatch can be financed from market borrowings (call/Term), Bills
rediscounting, repos & deployment of foreign currency converted into rupee.
44. Duration Gap Analysis is a method for measuring interest-rate risk.
45. Duration Gap Analysis examines the sensitivity of the market value of the
financial institution’s net worth to changes in interest rates.
46. Duration analysis is based on Macaulay’s concept of duration, which measures

the average lifetime of a security’s stream of payments.
47. Duration is an important measure of the interest rate sensitivity of assets and
liabilities as it takes into account the time of arrival of cash flows and the maturity
of assets and liabilities.
48. Duration is the weighted average time to maturity of all the preset values of
cash flows.
49. Duration basically refers to the average life of the asset or the liability.
50. The larger the value of the duration, the more sensitive is the price of that
asset or liability to changes in interest rates.
51. The bank will be immunized from interest rate risk if the duration gap between
assets and the liabilities is zero.
52. The duration model uses the market value of assets and liabilities.
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53. Duration analysis summarises with a single number exposure to parallel shifts
in the term structure of interest rates.
54. Both Gap and Duration approaches worked well if assets and liabilities
comprised fixed cash flows.
55. Options such as those embedded in mortgages or callable debt posed

problems that gap analysis could not address.
56. Under the scenario analysis of ALM several interest rate scenarios are created
for next 5 to 10 years . Such scenarios might specify declining interest rates, rising
interests rates, a gradual decrease in rates followed by sudden rise etc.
57. Different scenarios may specify the behavior of the entire yield curve, so there
could be scenarios with flattening yield curve, inverted yield curves etc.
58. Ten to twenty scenarios might be specified to have a holistic view of the
scenario analysis.
59. Assumptions would be made about the performances of assets and liabilities
under each scenario.
60. Assumptions might include prepayment rates on mortgages and surrender

rates on insurance products.
61. Assumptions may be made about the firms performance . Based upon these
assumptions the performance of the firm’s balance sheet could be projected under
each scenario.
62. If projected performance was poor under specific scenario the ALCO might
adjust assets or liabilities to address the indicated exposure .
63. A short coming of scenario analysis is the fact that it is highly dependent on the
choice of scenario. It also requires that many assumptions be made about how
specific assets or liabilities will perform under specific scenario.
64. Value at Risk ( VaR) refers to the maximum expected loss that a bank can uffer
over a target horizon, given a certain confidence interval.
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65. VaR enables the calculation of market risk of a portfolio for which no Historical
data exists.
66. VaR enables one to calculate the net worth of the organization at anyparticular
point of time so that it is possible to focus on long term risk implications of
decisions that have already been taken or that are going to be taken.
67. VaR is used extensively for measuring the market risk of a portfolio of assets
and/or liabilities.
68. A negative or liability sensitive gap occurs when liabilities exceed assets in a
given time bond.
69. A negative gap decreases the net interest income when there is increase in
market interest rate.
70 A positive or asset sensitive gap occurs when assets exceed liabilities in a given
time bond.
71. A positive gap mean an increase in market interest rates will increase the net
interest income.
72. The Gap Analysis does not take into account the variation in the characteristics
of different positions within a time band.
73. In Gap Analysis all positions within a given time band are assumed to mature
or re-price simultaneously.
74. Gap Analysis ignores differences in spreads between interest rates that could
arise as the level of market interest changes.
75. Gap Analysis does not take into account any changes in the timing topayments
that might occur as a result of changes in interest rate environment.
76. Gap Analysis provides only rough approximation of actual changes in Net
Interest Income (NII).
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77. Gap Analysis fails to capture variability in non-interest revenue & expenses.
78. Duration is a measure of the percentage change in the economic value of a

position that will occur given a small change in the level of interest rate.
79. Generally longer the maturity or next re-pricing date of instrument & smaller
the payments that occur before the maturity, then duration will be higher.
80. Higher duration implies that a given change in the level of interest rates will
have a larger impact on economic value.
81. In static simulations, the cash flow arising solely from the bank’s current on
and off Balance Sheet positions are assessed.
82. The Simulations entail relatively straight forward shifts or tilts of the yield
curve or changes of spreads between different interest rates.
83. One of the most difficult tasks in measuring interest rate risk is how to deal
with the positions where behavioural maturity differs from contractual maturity.
84. Prepayments create uncertainty about the timing of the cash flows.
85. Some prepayments arises due to demographic factors such as death, divorce or
job transfer.
86. The actual management of bank’s assets and liabilities focuses on controlling
the gap between rate sensitive assets and rate sensitive liabilities.
87. The NII can be insulated from the volatility of interest rate by matching
maturities of assets and liabilities closely.
88. In a dynamic Simulation approach, the Simulation builds in more detailed

assumptions about the future course of interest rates and expect changes in a
bank’s business activity over that time.
89. Simulation techniques typically involve detailed assessment of the potential

effects of the changes in interest rates on earnings and economic value by
simulating the future path of interest rates and their impact on cash flows
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90. Changes in interest rates affect underlying value of bank’s Assets & Liabilities.
91. Rise in interest rates decrease the market value of assets & liabilities,
conversely falling interest rates increase market value of assets & liabilities.
92. The Gap is the difference between the amount of assets and liabilities on
which the interest rates are reset during a given period.
93. Mismatch occurs when assets & liabilities fall due for re-pricing in different
periods.
94. The economic value of a bank can be viewed as the present value of the
bank’s expected net cash flow.
95. Estimates derived from a standard duration generally focus on just one form
of interest rate risk exposure i.e. re-pricing risk.
96. Interest rate risk can be managed by matching re-priceable assets with re-
priceable liabilities.
97. Proliferation of NPA results in increasing maturity mismatches.
98. The adverse impact on NII due to mismatches can be minimized by fixing
appropriate tolerance limit on interest rate sensitivity gaps.
99. Net Interest Income (NII) is the difference between revenues generated by
interest-bearing assets and the cost of servicing liabilities.
100. Net Interest Margin (NIM) is a profitability ratio that banks use to evaluate
their success in investing compared to the expenses of the same investments.
101. Net interest margin (NIM) reveals the amount of money that a bank is earning
in interest on loans compared to the amount it is paying in interest on deposits.
102. Yield refers to how much income an investment generates, separate from the
principal.
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103. Yield is commonly used to refer to interest payments an investor receives on
a bond or dividend payments on a stock.
104. Yield is often expressed as a percentage, based on either the investment's

market value or purchase price.
105. The Burden Ratio is the measure of the difference between Non-Interest
Income and Non-Interest Expenses expressed as a ratio to Average Assets.
106. Simulation models introduce a dynamic element while doing the analysis of
the interest rate risk.
107. Gap analysis and duration analysis as stand-alone tools for asset-liability
management suffer from their inability to move beyond the static analysis of current
interest rate risk exposures.
108. Simulation models utilize computer power to reconstruct the banking

portfolio and running what-if scenarios.
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Chapter 03 - Risk Measurement & Control
Calculation of Risk, Analysis of Risk Exposure, Risk management or mitigation

policy, Capital adequacy norms, Risk-Adjusted Return on Capital, Risk Immunization
strategy; Exposure limits, Risk Management Policy & Procedure, etc.
***
01. Risk management is defined as the process of identifying, monitoring and

managing potential risks in order to minimize the negative impact they may have
on an organization.
02. An effective risk management process will help identify which risks pose the
biggest threat to an organization and provide guidelines for handling them.
03. The risk management process consists of three parts: risk assessment and
analysis, risk evaluation and risk treatment.
04. The first step of the risk management process is called the Risk Assessment and
Analysis stage.
05. A risk assessment evaluates an organization’s exposure to uncertain events that

could impact its day-to-day operations and estimates the damage those events
could have on an organization’s revenue and reputation.
06. After the risk assessment/analysis has been completed, a risk evaluation should
take place.
07. A risk evaluation compares estimated risks against risk criteria that the
organization has already established.
08. Risk criteria can include associated costs and benefits, socio-economic factors,
legal requirements, and system malfunctions.
09. The last step in the risk management process is risk treatment and response.
10. Risk treatment is the implementation of policies and procedures that will help
avoid or minimize risks.
11. Risk treatment extends to risk transfer and risk financing.
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12. Risk management is an ongoing process and does not end once risks have been
identified and mitigated.
13. Risk management policies should be revisited every year to ensure policies are
up-to-date and relevant.
14. One of the earliest methods used to measure Risk is the simple Range Analysis.
15. In Range analysis, range of possible outcomes related to an asset is considered.

The highest point and the lowest point of the range are noted down and subtracted.
The end result is the width of the range.
16. Investments with the least width i.e. the least deviation from expected value are
considered to be least risky.
17. Expected Value Method uses the data of the recent past into account while
considering the riskiness of an asset. The Expected Value Method use recent data
as a benchmark to predict the possible future value.
18. One of the ways to manage risk is to maximize the expected value based on
past data.
19. Standard Deviation: The calculation of standard deviation is based on the

calculation of the mean. The standard deviation then studies the dispersion of
values from a mean (average).
20. The simple thumb rule is that a higher standard deviation denotes a higher
dispersion from the mean. Hence, the riskiness is higher.
21. Investors look for assets with a higher mean or average rate of return and lower
dispersion.
22. Coefficient of Variation: The coefficient of variation is a slightly more advanced

statistical measure when compared to standard deviation.
23. The problem with standard deviation is that the measure is relative and not
absolute. Hence, it starts giving misleading results.
24. In order to make the standard deviation comparable, it is then divided by the
mean value. The value derived after this calculation is called the Coefficient of
Variation and is more advanced as compared to standard deviation.
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25. Alpha and Beta are measures of external risk.
26. Alpha and Beta compare the variation in the value of an asset to an external
benchmark.
27. In the case of alpha, if the asset in question outperforms the benchmark, it is
said to have a positive alpha.
28. If the asset underperforms the external benchmark, then it is said to have a
negative alpha.
29. Beta compares the volatility of the asset as compared to the benchmark.
30. R-squared is a measure of the correlation between the asset and the underlying
benchmark.
31. An investment with an R-squared value of 80 is likely to mirror the movements

of the benchmark index more accurately as compared to another investment that
has a benchmark value of 60.
32. Sharpe Ratio is a complex indicator of the underlying risk.
33. The first step in calculating the Sharpe ratio is that the risk-free rate of return
needs to be subtracted from the total rate of return. The return leftover is then
divided by the standard deviation.
34. The Sharpe ratio helps the companies predict whether the excess return
generated in a period was due to smart investing or was it due to the assumption
of excessive risk, in which case, the returns could drastically vary in the forthcoming
periods.
34. a.) The Treynor Ratio calculates the excess return generated for each unit of risk
taken on by a portfolio. Excess return is the return generated above the risk- free
rate, while risk is measured by a portfolio's beta.
35. Risk exposure is the measurement of potential future loss due to a specific
event or business activity and is calculated as the probability of the event multiplied
by the expected loss due to the risk impact.
36. The calculation of probability related to a particular event resulting in loss to

the firm is an integral part of risk analysis.
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37. Risk exposure refers to the extent to which an organization or individual is
vulnerable to the potential negative impacts of risks.
38. Risk Exposure represents the level of risk they are exposed to based on their
activities, assets, and operations.
39. Risk exposure can be influenced by various factors, including the nature of the
risks, the organization’s industry, geographical location, financial position,
operational complexity, and external factors such as economic conditions or
regulatory changes.
40. Evaluating and understanding Risk Exposure is essential for effective risk
management.
41. Risk Exposure helps identify areas of high vulnerability, prioritize risk mitigation
efforts, allocate resources, and make informed decisions to minimize potential
losses.
42. Although specific risk involved in business cannot be predicted and controlled,
the risk which is predictable and can be managed are calculated with the following
formula:
Risk Exposure formula = Probability of Event * Loss Due to Risk (Impact)
43. There are four types of Risk Exposures:
Transaction Exposure
Operating Exposure
Translation Exposure
Economic Exposure
44. Transaction exposure is the extent of uncertainty related to business entities

concerned in multinational trade activity. Particularly, trade exposure is the risk,
which will affect the currency exchange rates cause fluctuations after an
organisation has taken up a fiscal commitment.
45. Operating Exposure refers to how exchange rate changes can impact on a firm's
future cash flows and consequently affect the firm's value. The cash flows may be
contractual or anticipated.
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46. Translation Exposure (also known as translation risk) is the risk that a
company's equities, assets, liabilities, or income will change in value as a result of
exchange rate changes.
47. Economic Exposure is a type of foreign exchange exposure caused by the effect
of unexpected currency fluctuations on a company's future cash flows, foreign
investments, and earnings.
48. Risk exposure is assessed through a combination of qualitative and

quantitative methods.
49. Qualitative assessment of Risk Exposure involves identifying and analyzing

potential risks and their potential impacts on the organization.
50. Quantitative assessment of Risk Exposure consists of quantifying risks’

economic or operational effects, determining the likelihood of their occurrence, and
calculating the likely exposure level.
51. Risk exposure cannot be eliminated, as every organization or individual faces

inherent risk in their activities or operations. However, risk exposure can be
minimized through effective risk management strategies, such as implementing
controls, diversifying risks, and transferring risk through insurance or contractual
arrangements.
52. Risk mitigation is a strategy to prepare for and lessen the effects of threats faced
by a business.
53. Compared to Risk Reduction, Risk Mitigation takes steps to reduce the negative
effects of threats and disasters on business continuity (BC).
54. Risk mitigation is the process of planning for disasters and having a way to
lessen negative impacts.
55. A proper risk mitigation plan will weigh the impact of each risk and prioritize
planning around that impact.
56. Risk mitigation focuses on the inevitability of some disasters and is used for
those situations where a threat cannot be avoided entirely.
57. Rather than planning to avoid a risk, mitigation deals with the aftermath of a
disaster and the steps that can be taken prior to the event occurring to reduce
adverse and, potentially, long-term effects.
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58. An organization would be prepared for all risks and threats and avoid them
entirely. However, having a risk mitigation plan can help an organization prepare
for the worst, acknowledging that some degree of damage will occur and having
systems in place to confront that.
59. There are five general steps in the design process of a risk mitigation plan:
Identify Risks; Perform a Risk Assessment; Prioritize Risks, Track Risks and and
Monitoring the Established Plan
60. A risk mitigation strategy takes into account not only the priorities but any risks
that might arise due to the nature of the business.
61. Risk assessment involves quantifying the level of risk in the events identified.
62. Risk assessments involve measures, processes and controls to reduce the
impact of risk.
63. Prioritize risks involves ranking quantified risk in terms of severity.
64. Tracking risks involves monitoring risks as they change in severity or relevance
to the organization.
65. Implement and monitor progress involves reevaluating the plan's effectiveness
in identifying risk and improving as needed.
66. In business continuity planning, testing a plan is vital.
67. Once a plan is in place, regular testing and analysis should occur to make sure
the plan is up to date and functioning well.
68. Risk avoidance is used when the consequences are deemed too high to justify
the cost of mitigating the problem.
69. Risk avoidance is a common business strategy and can range from something
as simple as limiting investments to something as severe as not building offices in
potential war zones.
70. Risk acceptance is accepting a risk for a given period of time to prioritize
mitigation effort on other risks.
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71. Risk transfer allocates risks between different parties, consistent with their
capacity to protect against or mitigate the risk.
72. Risk monitoring is the act of watching projects and the associated risks for
changes in the impact of the associated risks.
73. A Risk Assessment Framework (RAF) is commonly used risk mitigation tool.
74. An RAF provides an organization with an outline of which systems are at high
or low risk and presents information for both technical and nontechnical personnel.
75. An RAF can be used as a risk mitigation tool by presenting consistent risk
assessment and reporting methods.
76. The following are some of the best risk management tools and techniques that
professional project managers use to build risk management plans and guard
against inevitable risks, issues and changes.
77. The fundamental risk management tool is the risk register. Basically, what a
risk register does is identify and describe the risk. It then will provide space to
explain the potential impact on the project and what the planned response is for
dealing with the risk if it occurs.
78. The risk register is a strategic tool to control risk in a project. It works to
gather the data on what risks the team expects and then the way to respond
proactively if they do show up in the project. It has already mapped out a path
forward to keep the project from falling behind schedule or going over budget.
78. Root Cause Analysis is a process used to identify the fundamental risks that are
embedded in the project.
79. Root Cause is a tool that says good management is not only responsive but
preventative.
80. Often Root Cause analysis is used after a problem has already come up. It seeks
to address causes rather than symptoms.
81. SWOT, or strengths, weaknesses, opportunities, threats, is a tool to help with

identifying risks.
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82. Probability and Impact Matrix helps prioritize risk as we don’t want to waste
time chasing a small risk and exhaust your resources.
83. Probability and Impact Matrix technique combines the probability and impact
scores of individual risks and then ranks them in terms of their severity. This way
each risk is understood in context to the larger project, so if one does occur, there’s
a plan in place to respond or not.
84. With Risk Data Quality Assessment technique, project managers use data that
has been collated for the risks they’ve identified.
85. Risk Data Quality Assessment technique helps the project manager understand
the accuracy, reliability, quality and integrity of the risk as related to the collected
data about it.
86. Brainstorming starts with reviewing the project documentation, looking over
historic data and lessons learned from similar projects, and reading over articles
and organizational process assets.
87. A variant of Brainstorming is the Delphi technique, which is when a request is

sent to experts and they reply anonymously. Or the project manager can interview
experts, team members, stakeholders and others with experience in similar projects.
88. Variance and Trend Analysis helps when project managers look for variances
that exist between the schedule of the project and cost and compare them with the
actual results to see if they are aligned or not.
89. If the variances rise, uncertainty and risk also rise simultaneously. This is a good
way of monitoring risks while the project is underway.
90. Reserve Analysis - While planning the budget for the project, contingency
measures and some reserves should be in place as a part of the budget. This is to
keep a safeguard if risks occur while the project is ongoing. These financialreserves
are a backup that can be used to mitigate risks during the project.
91. Capital Adequacy Ratio (CAR) is the ratio of a bank's capital in relation to its risk
weighted assets and current liabilities.
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92. CAR is important to ensure that banks have enough room to bear a reasonable
number of losses before they become insolvent and lose depositors' funds.
93. Capital which is first readily available to protect the unexpected losses is called
as Tier-I Capital.
94. Tier – 1 Capital is also termed as Core Capital.
95. Tier-I Capital consists of Paid-Up Capital ; Statutory Reserves ; Other Disclosed
Free Reserves : Reserves which are not kept side for meeting any specific liability. ;
Capital Reserves : Surplus generated from sale of Capital Assets.
96. Capital which is second readily available to protect the unexpected losses is
called as Tier-II Capital.
97. Tier-II Capital consists of Undisclosed Reserves and Paid-Up Capital Perpetual
Preference Shares; Revaluation Reserves (at discount of 55%) ; Hybrid (Debt /
Equity) Capital ; Subordinated Debt ; General Provisions and Loss Reserves.
98. Tier II Capital cannot exceed 50% of Tier-I Capital for arriving at the prescribed
Capital Adequacy Ratio.
99. Risk Weighted Assets (RWA) are the loans and other assets of a bank, weighted
(that is, multiplied by a percentage factor) to reflect their respective level of risk of
loss to the bank.
100. Subordinated Debt are bonds issued by banks for raising Tier II Capital.
101. Subordinated Debt is any type of loan that's paid after all other corporate
debts and loans are repaid, in the case of borrower default.
102. Risk-adjusted return on capital (RAROC) is a risk-adjusted measure of the

return on investment.
103. RAROC is calculated by accounting for any expected losses and income
generated by capital, with the assumption that riskier projects should be
accompanied by higher expected returns.
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104. The risk-adjusted return on capital is calculated as follows:
Risk-adjusted return on capital = Net Income / Economic Capital
RAROC = (Revenues - costs - expected losses) / Economic capital.
105. The expected loss is the predicted loss of the business based on industry
averages.
106. Expected loss (EL) = Probability of default (PD) * Loss given default (LGD) *
Exposure at default (EAD)
107. Probability of default is the probability that the loan amount will not be
repaid.
108. Loss given default is the fractional loss due to default.
109. Exposure at default is the risk of exposure in the amount of money owed to
the bank at default.
110. A probability of default is calculated for each borrower, whether via internal
rating systems or external credit analyses.
111. A probability of default of 50% or higher is considered risky. So the higher

the probability of default, the higher the risk of the loan portfolio.
112. Loss given default is the displaced as a percentage. It is the part of the debt
that can be recovered divided by the loan amount. It can be calculated as one minus
the recovery rate percentage. The recovery rate percentage is the portion of the
debt that can be recovered.
113. Economic capital is the capital of the firm.
114. Economic capital is different from the regulatory capital required by

regulators.
115. Economic capital is the amount of risk capital a bank requires to cover its risk
exposure.
116. Banks calculate their economic capital.
117. Return on Assets (ROA) is a common profitability metric that’s useful in

comparing portfolios of different sizes, but this method doesn’t account for risk.
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118. Two portfolios or two different products can have the same ROA, but they may
not carry the same amount of risk.
119. A RAROC calculation takes into account the riskiness of the portfolio or
instrument when calculating profitability.
120. VaR is maximum loss over a target horizon such that there is a low, pre-
specified probability that the actual loss will be larger.
121. Economic Capital (EC) is the difference between some given percentile of a
loss distribution and the expected loss. It is sometimes referred to as the
unexpected loss at the confidence level. It is measured through the value at risk
metric.
122. Risk Immunization is a risk-mitigation strategy that matches asset and liability
duration so portfolio values are protected against interest rate changes.
123. Risk Immunization can be accomplished by cash flow matching, duration

matching, convexity matching, and trading forwards, futures, and options onbonds.
124. The downside to immunization of a portfolio is foregoing the opportunity cost

if the assets were to increase in value while the liabilities did not also rise in the
same manner.
125. Immunization is considered a "quasi-active" risk mitigation strategy because

it has the characteristics of both active and passive strategies.
126. Pure immunization implies that a portfolio is invested for a defined return for
a specific period of time regardless of any outside influences, such as changes in
interest rates.
127. The opportunity cost of using the immunization strategy is potentially giving
up the upside potential of an active strategy for the assurance that the portfolio will
achieve the intended desired return.
128. A Cash Flow Matching strategy is the identification and accumulation of

investments with payouts that will coincide with an individual or firm's liabilities.
129. Duration matching means to make the duration of assets and liabilities equal.
Then, the sensitivity to interest-rate changes is: ▪ Interest rate changes makes the
values of assets and liabilities change by (approximately) the same amount.
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130. Convexity is apparent in the relationship between bond prices and bond
yields.
131. Convexity is the curvature in the relationship between bond prices andinterest
rates.
132. Convexity reflects the rate at which the duration of a bond changes as interest
rates change.
133. Duration measures a bond's sensitivity to changes in interest rates. It

represents the expected percentage change in the price of a bond for a 1% change
in interest rates.
134. Credit exposure or Exposure Limit is a measurement of the maximum

potential loss to a lender if the borrower defaults on payment. It is a calculated
risk to doing business as a bank.
135. Credit exposure is one component of credit risk.
136. The credit rating system was created to help lenders control credit exposure.
137. Purchasing Credit Default Swaps is a method of limiting credit exposure.
138. A credit default swap is an investment that effectively transfers the credit risk
to a third party.
139. The swap buyer makes premium payments to the swap seller, who agrees to
assume the risk of the debt.
140. The swap seller compensates the buyer with interest payments, while also
returning the premiums if the borrower defaults.
141. A large exposure is defined as the sum of all exposure values of a bank to a
single counterparty or to a group of connected counterparties that are equal to or
above 10% of its Tier 1 capital.
142. Section 134 (3) (n) of the Companies Act, 2013 requires the Company to frame
Risk Management Policy to identify various elements of risk and steps taken to
mitigate the same.
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143. Risk management, by and large involves reviewing the operations of the
organization followed by identifying potential threats to the organization and the
likelihood of their occurrence, and then taking appropriate actions to address the
most likely threats.
144. The risk management process involves identifying the risks an organization is
subject to, deciding how to manage it, implementing the management technique,
measuring the ongoing effectiveness of management and taking appropriate
correction action.
145. The basic activities in any risk management system are - Risk identification;
Risk assessment and Risk control.
146. The Risk Monitoring Committee is chaired by an Independent Commissioner

and consists of Commissioners and independent parties with expertise in the area
of risk management and/or financial risk.
147. Risk Management Committee responsible for the implementation of the

overall risk management framework. This committee is chaired by the Director
responsible for the Risk Management Unit, consisting of a majority of the Board
of Directors and Executive Officers of the business units and/or support units, the
Compliance Director and the Risk Management Director.
148. Risk Management Unit coordinates and socializes the entire process of the
Bank's risk management to minimize the potential impact of various types of risks
faced by the Bank.
149. The Risk Management Unit develops a comprehensive process in identifying,

measuring, monitoring and controlling risks and reporting on the level of risk and
establishes a reliable system of internal control.
150. The Bank's risk management framework is implemented through policies,

procedures, transaction and authority limits, risk tolerance and management risk
methods. The Bank develops its risk management continuously in line with the
development and increase in complexity of business, strategy and management
information systems.
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151. Roles and Responsibilities of Risk Taking Unit have as follows:
a) Process of identifying, measuring, monitoring and controlling the risks

associated with its business activities.
b) Develop Standard Operating Procedure (SOP) and the limit for operational
activities, and conduct business activities in accordance with the SOP and
restrictions apply.
c) Informing the risk exposure related to the business activities on a regular basis
to Risk Management Unit
d) Raise awareness of the risks to any staff through effective communication
152. The application of risk management includes:
a) Active supervision by the Boards of Commissioners and Directors.
b) Adequacy of policies, procedures and establishing limits.
c) Adequacy of the process of identification, measurement, monitoring and

risk control as well as risk management information system.
d) Comprehensive internal control
153. Risk Management Policies are the written guidelines on managing risks.
154. Risk Management Policy is established to ensure the Bank's risk in

maintaining risk exposure is consistent with internal policies and procedures as well
as external laws and regulations.
155. Internal Control Systems Function Business Risk Management helps Risk
Taking Unit (RTU) in then enforcement of discipline of the daily operational risk
management practices.
156. Operational Risk Management (ORM) with the Compliance Unit defines,
refines and maintains the operational risk management methodology, ensures
adequate risk mitigation, policies and procedures and coordinates/facilitates the
overall operational risk management activities.
157. Internal Auditor will independently ensure that all residual risk has been
managed in accordance with the approved risk tolerance.
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158. Risk assurance is an important component of the overall risk management
process. The audit committee will seek assurance that all of the significant risks are
being adequately managed and that all of the critical controls are effectiveand
that they have been efficiently implemented.
159. Risk appetite is the level of risk that an organization is willing to accept while
pursuing its objectives, and before any action is determined to be necessary in order
to reduce the risk.
160. Risk Attitude” is an organization’s approach to assess and eventually pursue,

retain, take or turn away from risk.
161. Risk tolerance is when the investor or the organization would remain
comfortable despite taking losses or bearing uncertainties.
162. The endurance of risk depends upon many factors such as financial
expectation, strength, age, earning capacity, etc.
163. Risk aversion refers to a preference for avoiding or minimizing risks.
164. Risk appetite refers to the willingness to accept and embrace risks for
potential gains.
165. Risk-averse individuals or organizations tend to prioritize caution. They are

more conservative.
166. Those with a higher risk appetite are more comfortable with uncertainty and
potential losses.
167. Risk Reversal is a kind of derivative strategy that locks both downside risk
and upside potential of a stock by using derivative instruments. The main
components of risk reversal strategy call and put options.
@@@
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Chapter 04 - Risk Management Concepts
Concept of Prudence; Concept of Mid-office, Forwards, Futures and Options,

Strategies and Arbitrage opportunities, and Regulatory prescriptions of risk
management.
***
01. Prudence is the inclusion of a degree of caution in the exercise of the

judgements needed in making the estimates required under conditions of
uncertainty, such that income or assets are not overstated and expenses or liabilities
are not understated.
02. Prudent Risk Management refer to Legal obligation to act in a position of

responsibility with the degree of care, diligence, and skill that a person of ordinary
prudence would exercise in the same or similar circumstances.
03. Prudent risk taking requires the ability to make sound judgments or decisions
in times of uncertainty.
04. The Middle Office is the department in a financial services company,

investment bank, or hedge fund that sits in between the front and back office. It
typically manages risk and calculates profits and losses.
05. The Middle Office tracks and processes all of the deals made by the front office
before being reconciled by the back office.
06. The Middle Office is generally responsible for risk management and for a firm's
information technology.
07. The term ‘Derivative‗ stands for a contract whose price is derived from or is
dependent upon an underlying asset. The underlying asset could be a financial asset
such as currency, stock and market index, an interest bearing security or a physical
commodity.
08. Derivatives comprise four basic contracts namely - Forwards, Futures, Options
and Swaps.
09. A forward contract, often shortened to just forward, is a contract agreement to

buy or sell an asset at a specific price on a specified date in the future.
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10. To reduce this exchange risk for a transaction to be concluded at future date,
‘Forward Contracts’ are booked.
11. Forward Contract is a mechanism through which the rate is fixed in advance for
purchase or sale of foreign currency needed at that future date.
12. The Forward Contract is priced either at a ‘premium or discount’ over the spot
rate.
13. Types of Forward Contracts Forward Contracts can broadly be classified as -

Fixed Date Forward Contracts‘ and ‘Option Forward Contracts‘.
14. In Fixed Date Forward Contracts, the buying/selling of foreign exchange takes
place at a specified future date i.e. a fixed maturity date.
15. The Option Forward Contract is entered into in order that the customer gets the
flexibility to receive/deliver the foreign exchange on any day during a specified
period.
16. FEDAI rules require the option period of delivery to be specified as any period
not exceeding one month.
17. Forward contracts should be for definite amounts, without provisions for excess
or shortfall. Where partial shipments are permitted, separate forward contracts are
to be booked to cover each partial shipment. In such an event, each forward
contract will have different forward rate.
18. In case of an option forward contract, a contract can be booked for any option
period of delivery. However, the option period of the forward contract should not
exceed one month
19. Contracts permitting option delivery must state first and last dates of delivery.
20. If the delivery of foreign exchange falls in two or more separate calendar
months due to part shipments, it is advisable to book separate split contracts on
the basis of the same underlying transaction.
21. If the fixed date of delivery or last date of delivery option is a holiday/declared
a holiday, the delivery shall be effected/delivery option exercised on the preceding
working day.
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22. In case a holiday is declared without advance notice, delivery will take place on
the next working day.
23. Swap is the simultaneous buying and selling of identical amount of one
currency in terms of another currency for differing maturities.
24. The swap loss/gain is the difference between the rate at which currency is
purchased and sold.
25. If the Bank has to buy high and sell low, the difference is the swap cost (loss)
recoverable from the customer.
25. Swap gain would accrue when the Bank buys low and sells high.
26. The contingent liability in respect of Forward Contracts requires provision of

capital.
27. Forward Contracts cover foreign currency transactions against Indian rupees.
28. A Cross Currency Forward Contract provides forward cover for a foreign
currency transaction in terms of another foreign currency instead of Indian Rupees.
29. In a Cross Currency Transaction, the currency of the underlying contract is called
the commodity currency and the foreign currency to which the exposure is shifted
is called a settlement currency.
30. The settlement currency is then notionally converted into Indian Rupees at
interbank rate for the purpose of controlling the forward contract liability. This rate
is called Wash Rate.
31. Forward to Forward Contract is a swap transaction, which involves

simultaneous sale and purchase of one currency for another, where both
transactions are forward contracts, for e.g. a sale in three months against apurchase
in six months.
32. A forward to forward contract can be extended to a customer with a genuine

underlying transaction, who desires to lock in the forward premium without locking
in the spot rate. The locking in of the spot rate by the cancellation of a leg/both
legs of the contract has to be done before the start date of the forward to forward
contract.
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33. The forward to forward contract will be booked by customers who desire to
take advantage of opposite movements in the spot and forward rates.
34. In terms of prevailing exchange control guidelines, forward to forward

contracts are not allowed.
35. A forward contract can be used for hedging or speculation, although its non-
standardized nature makes it particularly apt for hedging.
36. Closed outright is the standard type of forward. Two parties agree to complete
a transaction at a set price on a specific date.
37. With a flexible forward, the two parties can settle the contract prior to the date
set in the contract. The settlement can happen in one transaction or over several
payments.
38. Long-dated Forward - Most forwards mature in a short amount of time, such as
three months. Long-date forwards can last much longer, sometimes a year or more.
39. Non-deliverable Forwards don‘t involve the physical exchange of funds.

Instead, the two parties simply exchange cash to settle the contract, with the
amount paid depending on the contracted price and the market price of the
underlying commodity or currency.
40. An outright is a spot transaction for a future date (past the spot date). It is a
derivative product consisting of a spot transaction combined with a forwardspread.
41. The spot portion of the transaction is more volatile than the forward portion, so
most of the price action will occur in that portion of the outright.
42. Definition of Derivative does not include Immovable Assets. It covers only
financial assets such as currency, stock and market index, an interest bearing
security or a physical commodity.
43. If price of underlying asset increases – the price of derivative will also increase.
44. If price of underlying asset decreases – the price of derivative will also decrease.
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45. A futures market is an auction market in which participants buy and sell
commodity and futures contracts for delivery on a specified future date.
46. Futures are exchange-traded derivatives contracts that lock in future delivery of
a commodity or security at a price set today.
47. Futures contracts are popular derivatives, used to exchange physical assets, as
well as speculate and hedge markets.
48. A futures contract is an agreement to buy or sell an asset at some point in the
future. These contracts will specify the price the asset will be exchanged for, the
exact time of expiry, and the quantity of goods.
49. Futures contracts can be used to speculate on commodities, currencies and

indices. They‘re often used to hedge against adverse price movements, as they
effectively enable the user to lock in a future price at which to execute their position.
50. Futures contracts are traded on exchanges, meaning they‘re subject to a lot
more regulations than over-the-counter contracts such as CFDs or forwards.
51. Futures contracts are referred to by their delivery month. depending on the type
of asset, delivery can be anywhere from a month to a few years.
52. Futures contract size is the amount of the underlying asset that will be
exchanged. These sizes are standardised by exchanges and will vary depending on
whether it‘s a physical commodity, like oil, or a financial product, like a currency.
53. One of the unique features of exchange-traded futures in India is that they are
standardized.
54. One of the methods of standardizing futures and options contracts is through
the prescription of minimum lot sizes.
55. A lot size in futures is a minimum ticket size of shares that you can trade in
futures. When trading futures and options, you can only buy and sell theseproducts
in a minimum of one lot or multiples of the lot size.
56. Futures lot size and options lot size is the same. When you talk of futures lot
size, the product of the lot size and the price is the notional value of the futures
contract.
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57. The payment and delivery of the asset is made on the future date termed as
delivery date.
58. The buyer in the futures contract is known as to hold a long position or simply
long.
59. The seller in the futures contracts is said to be having short position or simply
short.
60. The underlying asset in a futures contract could be commodities, stocks,

currencies, interest rates and bond.
61. The futures contract is held at a recognized stock exchange. The exchange acts
as mediator and facilitator between the parties. In the beginning both the parties
are required by the exchange to put beforehand a nominal account as part of
contract known as the margin.
62. Since the futures prices are bound to change every day, the differences in prices
are settled on daily basis from the margin. If the margin is used up, the contractee
has to replenish the margin back in the account. This process is called marking to
market. Thus, on the day of delivery it is only the spot price that isused to decide
the difference as all other differences had been previously settled.
63. Taking delivery of a futures contract refers to physical settlement, in which the
buyer receives the asset from the seller.
64. The alternative to delivery is cash settlement. This is where the buyer and seller
just exchange the monetary value of the asset, rather than the asset itself.
Speculative positions will always be settled in cash.
65. The concept across all the types of futures is the same. They are all a contract
between a buyer and seller for delivery at a future date.
66. Equity Futures Contract is a type of derivative whereby parties involved must
transact shares of a specific company at a predetermined future date and price. The
price of the contract is namely determined by the spot price of the underlyingstock.
67. Index futures are used to buy or sell a stock market index at a set price to be
settled at a date of expiry.
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68. Index futures are most commonly used for hedging, or to speculate on market
movements. As there are no physical asset to trade, index futures are always settled
in cash.
69. Commodity futures contracts are agreements to buy or sell a specific quantity
of a commodity at a specified price on a particular date in the future. Commodities
include metals, oil, grains and animal products, as well as financial instruments and
currencies.
70. Forex futures ( Currency Futures) specify the price you can buy one currency for
using another on a future date. They‘re exchange-traded, which makes it less
flexible than normal FX trading – which is over the counter – and a much smaller
market.
71. Interest Rate Future is a financial derivative that allows exposure to changes in
interest rates. Interest rate futures price moves inversely to interest rates. Investors
can speculate on the direction of interest rates with interest rate futures, or else use
the contracts to hedge against changes in rates.
72. Settlement of a futures contract: Majority of futures contracts in India are cash
settled before expiry. All futures contracts come with an expiry date. So, you have
to settle them. This means that if you bought a futures contract, you will have to
sell it before or on expiry. Similarly, if you sold a futures contract, you will have to
buy it back on expiry.
73. Prior to October 2019, futures in India were cash-settled. But since then, if you
do not settle your position before expiry, then you will have to settle your
transaction physically.
74. Open interest or OI, shows the number of open contracts or position on a given
date.
75. A high open interest shows high liquidity.
76. Open Interest increases when new contracts are added
77. Open Interest decreases when contracts are settled / squared-off.
78. A very high Open Interest may indicate an over-leveraged market.
79. Change in Open Interest shows the daily change that has taken place in the
futures contract.
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80. A positive change in OI along with increase in price shows that more contracts
have been added and that people are going long (buying) on the futures contract.
81. The futures market in India is highly regulated by Securities and Exchange
Board of India (SEBI).
82. Futures contracts are highly regulated and enjoy high liquidity.
83. The main benefit of a futures contract is it earn superior returns.
84. Leverage is one of the biggest advantages of a futures contract.
85. Contract for Difference (CFD) refers to a contract that enables two parties to
enter into an agreement to trade on financial instruments based on the price
difference between the entry prices and closing prices.
86. Futures contract have a maximum of 3-month trading cycle – the near month
contract (which is the 1st month ) the next month contract (which is the 2nd month
) and the far month contract (which is the 3rd month ).
87. The term option refers to a financial instrument that is based on the value of
underlying securities such as stocks.
88. An options contract offers the buyer the opportunity to buy or sell depending
on the type of contract they hold the underlying asset.
89. Unlike futures, the holder is not required to buy or sell the asset if they decide
against it.
90. Each contract will have a specific expiration date by which the holder must
exercise their option.
91. The stated price on an option is known as the strike price.
92. Options are typically bought and sold through online or retail brokers.
93. Options are financial derivatives that give buyers the right, but not the
obligation, to buy or sell an underlying asset at an agreed-upon price and date.
94. Option contracts involve a buyer and seller, where the buyer pays a premium
for the rights granted by the contract.
95. Call options allow the holder to buy the asset at a stated price within a specific
time frame.
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96. Put options, on the other hand, allow the holder to sell the asset at a stated
price within a specific timeframe.
97. Each call option has a bullish buyer and a bearish seller while put options have
a bearish buyer and a bullish seller.
98. Investors use options to hedge or reduce the risk exposure of their portfolios.
99. American options can be exercised any time before the expiration date of the
option.
100. European options can only be exercised on the expiration date or the exercise
date.
101. Exercising Option means utilizing the right to buy or sell the underlying
security.
102. Options Spreads are strategies that use various combinations of buying and
selling different options for the desired risk-return profile.
103. Spreads are constructed using vanilla options, and can take advantage of
various scenarios such as high- or low-volatility environments, up- or down-moves,
or anything in-between.
104. Options Risk Metrics: The Greeks
The options market uses the term Greeks to describe the different dimensions of
risk involved in taking an options position, either in a particular option or a portfolio.
These variables are called Greeks because they are typically associated with Greek
symbols. Each risk variable is a result of an imperfect assumption or relationship
of the option with another underlying variable.
105. Traders use different Greek values to assess options risk and manage option
portfolios.
106. Delta (Δ) represents the rate of change between the option's price and a $1
change in the underlying asset's price.
107. Delta of a call option has a range between zero and one, while the delta of a
put option has a range between zero and negative one.
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108. Delta also represents the hedge ratio for creating a delta-neutral position for
options traders.
109. Theta (Θ) represents the rate of change between the option price and time,
or time sensitivity - sometimes known as an option's time decay.
110. Theta indicates the amount an option's price would decrease as the time to
expiration decreases, all else equal.
111. Gamma (Γ) represents the rate of change between an option's delta and the
underlying asset's price. This is called second-order (second derivative) price
sensitivity. Gamma indicates the amount the delta would change given a $1 move
in the underlying security.
112. Vega (V) represents the rate of change between an option's value and the
underlying asset's implied volatility. This is the option's sensitivity to volatility. Vega
indicates the amount an option's price changes given a 1% change in implied
volatility.
113. Rho (p) represents the rate of change between an option's value and a 1%
change in the interest rate. This measures sensitivity to the interest rate.
114. Call options allow the holder to buy an underlying security at the stated strike
price by the expiration date called the expiry. The holder has no obligation to buy
the asset if they do not want to purchase the asset. The risk to the buyer is limited
to the premium paid. Fluctuations of the underlying stock have no impact.
115. Buyers are bullish on a stock and believe the share price will rise above the
strike price before the option expires. If the investor's bullish outlook is realized and
the price increases above the strike price, the investor can exercise the option, buy
the stock at the strike price, and immediately sell the stock at the current market
price for a profit.
116. If the underlying stock price does not move above the strike price by the
expiration date, the option expires worthlessly. The holder is not required to buy
the shares but will lose the premium paid for the call.
117. Selling call options is known as writing a contract. The writer receives the
premium fee. In other words, a buyer pays the premium to the writer (or seller) of
an option.
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118. The maximum profit is the premium received when selling the option. An
investor who sells a call option is bearish and believes the underlying stock's price
will fall or remain relatively close to the option's strike price during the life of the
option.
119. If the prevailing market share price is at or below the strike price by expiry, the
option expires worthlessly for the call buyer.
120. The option seller pockets the premium as their profit.
121. The option is not exercised because the buyer would not buy the stock at the
strike price higher than or equal to the prevailing market price.
122. If the market share price is more than the strike price at expiry, the seller of
the option must sell the shares to an option buyer at that lower strike price.
123. Put options are investments where the buyer believes the underlying stock's
market price will fall below the strike price on or before the expiration date of the
option. Once again, the holder can sell shares without the obligation to sell at the
stated strike per share price by the stated date.
124. Since buyers of put options want the stock price to decrease, the put option
is profitable when the underlying stock's price is below the strike price.
125. If the prevailing market price is less than the strike price at expiry, the investor
can exercise the put. They will sell shares at the option's higher strike price. Should
they wish to replace their holding of these shares they may buy them on the open
market.
126. The value of holding a put option will increase as the underlying stock price
decreases. Conversely, the value of the put option declines as the stock price
increases.
127. The risk of buying put options is limited to the loss of the premium if the
option expires worthlessly.
128. Selling put options is also known as writing a contract.
129. A put option writer believes the underlying stock's price will stay the same or
increase over the life of the option, making them bullish on the shares. Here, the
option buyer has the right to make the seller, buy shares of the underlying asset
at the strike price on expiry.
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130. If the underlying stock's price closes above the strike price by the expiration
date, the put option expires worthlessly. The writer's maximum profit is the
premium. The option isn't exercised because the option buyer would not sell the
stock at the lower strike share price when the market price is more.
131. If the stock's market value falls below the option strike price, the writer is
obligated to buy shares of the underlying stock at the strike price. In other words,
the put option will be exercised by the option buyer who sells their shares at the
strike price as it is higher than the stock's market value.
132. The risk for the put option writer happens when the market's price falls below
the strike price. The seller is forced to purchase shares at the strike price at
expiration. The writer's loss can be significant depending on how much the shares
depreciate.
133. The writer (or seller) can either hold on to the shares and hope the stock
price rises back above the purchase price or sell the shares and take the loss. Any
loss is offset by the premium received.
134. An investor may write put options at a strike price where they see the shares
being a good value and would be willing to buy at that price.
135. When the price falls and the buyer exercises their option, they get the stock
at the price they want with the added benefit of receiving the option premium.
136. A Vanilla Option is a financial instrument that gives the holder the right, but
not the obligation, to buy or sell an underlying asset at a predetermined price within
a given timeframe.
137. A vanilla option is a call option or put option that has no special or unusual
features.
138. Plain Vanilla is the most basic or standard version of a financial instrument,
usually options, bonds, futures, and swaps.
139. Plain Vanilla is the opposite of an exotic instrument,
140. Plain vanilla mean lacking special features or qualities.
141. Exotic options are options contracts that differ from traditional options in their
payment structures, expiration dates, and strike prices.
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142. Exotic options can be customized to meet the risk tolerance and desired profit
of the investor. Although exotic options provide flexibility, they do not guarantee
profits.
143. Strike price is a set price at which a derivative contract can be bought or sold
when it is exercised.
144. For call options, the strike price is where the security can be bought by the
option holder; for put options, the strike price is the price at which the security
can be sold.
145. An option can be In The Money (ITM) or Out of the Money (OTM) or At the
Money (ATM).
146. A call option is in the money (ITM) if the market price is above the strike price.
147. A put option is in the money if the market price is below the strike price.
148. In-the-money options contracts have higher premiums than other options
that are not ITM.
149. Out of the money is also known as OTM, meaning an option has no intrinsic
value, only extrinsic value.
150. A call option is OTM if the underlying price is trading below the strike price
of the call.
151. A put option is OTM if the underlying's price is above the put's strike price.
152. ATM Option A call option is said to be in ATM if the strike price is equal to the
current spot price of the security. I.e. Spot- Strike = 0.
153. A put option is said to be ATM if the strike price is equal to the current spot
price of the security.
154. A Covered Call is a two-part strategy in which stock is purchased or owned

and calls are sold on a share-for-share basis.
155. The term buy write describes the action of buying stock and selling calls at the
same time.
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156. The term overwrite describes the action of selling calls against stock that was
purchased previously.
157. Married put is the name given to an options trading strategy where an
investor, holding a long position in a stock, purchases an at the money put option
on the same stock to protect against depreciation in the stock's price.
158. The Married Call strategy is the reverse of a Married Put strategy. In a Married
Call strategy an investor will short (sell) shares of the underlying stock while
purchasing an equal number of call contracts to protect the short position.
159. Straddle Options Strategy is an options strategy involving the purchase of

both a put and call option for the same expiration date and strike price on the same
underlying security. The strategy is profitable only when the stock eitherrises or
falls from the strike price by more than the total premium paid.
160. Iron Condor is a non-directional option strategy, whereby an option trader

combines a Bull Put spread and Bear Call spread to generate profit. In thisstrategy,
there is a high probability of limited gain. An option trader resorts to thisstrategy if
he believes that the market is going to be range bound.
161. The term Butterfly Spread refers to an options strategy that combines bull and
bear spreads with a fixed risk and capped profit. These spreads are intended as a
market-neutral strategy and pay off the most if the underlying asset does notmove
prior to option expiration.
162. Long-Term Equity Anticipation Securities (LEAPS) are options contracts with
expiration dates that are longer than one year more.
163. Option on a Futures contract gives the holder the right, but not the obligation,
to buy or sell a s specific futures contract at a strike price on or before the option's
expiration date. These work similarly to stock options, but differ in that the
underlying security is a futures contract.
164. Most options on futures, such as index options, are cash settled. They also
tend to be European-style options, which means that these options cannot be
exercised early.
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165. Currency Option (also known as a Forex Option) is a contract that gives the
buyer the right, but not the obligation, to buy or sell a certain currency at a specified
exchange rate on or before a specified date. For this right, a premium is paid to the
seller.
166. Bond Option is an option contract with a bond as the underlying asset.
167. Outright Option is an option that is bought or sold individually and is not part
of a multi-leg options trade.
168. Synthetic Options is a way to recreate the payoff and risk profile of aparticular
option using combinations of the underlying instrument and different options.
169. A synthetic call is created by a long position in the underlying combined with
a long position in an at-the-money put option.
170. Volatility Skew describes the observation that not all options on the same
underlying and expiration have the same implied volatility assigned to them in the
market. For stock options, skew indicates that downside strikes have greaterimplied
volatility that upside strikes.
171. Derivatives contracts can be divided into two general families:
a) Contingent claims (e.g., options)
b) Forward claims, which include exchange-traded futures, forward contracts, and

swaps
172. A swap is an agreement between two parties to exchange sequences of cash

flows for a set period of time. Usually, at the time the contract is initiated, at least
one of these series of cash flows is determined by a random or uncertain variable,
such as an interest rate, foreign exchange rate, equity price, or commodity price.
173. A swap is a derivative contract in which one party exchanges or swaps the
values or cash flows of one asset for another. Of the two cash flows, one value is
fixed and one is variable and based on an index price, interest rate, or currency
exchange rate.
174. Swaps are customized contracts traded in the over-the-counter (OTC) market
privately.
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175. The plain vanilla interest rate and currency swaps are the two most common
and basic types of swaps.
176. Swaps are not exchange-traded instruments. Instead, swaps are customized
contracts that are traded in the over-the-counter (OTC) market between private
parties.
177. As swaps occur on the OTC market, there is always the risk of a counterparty
defaulting on the swap.
178. The most common and simplest swap is a Plain Vanilla Interest Rate Swap.
179. In Plain Vanilla Interest Rate Swap, Party A agrees to pay Party B a
predetermined, fixed rate of interest on a notional principal on specific dates for a
specified period of time. Concurrently, Party B agrees to make payments based on
a floating interest rate to Party A on that same notional principal on the same
specified dates for the same specified time period.
180. In a plain vanilla swap, the two cash flows are paid in the same currency.
181. In Plain Vanilla Interest Rate Swap the specified payment dates are called
settlement dates, and the times between are called settlement periods.
182. As Swaps are customized contracts, interest payments may be made annually,
quarterly, monthly, or at any other interval determined by the parties.
183. In a Plain Vanilla Interest Rate Swap, the floating rate is usually determined at
the beginning of the settlement period.
184. Normally, swap contracts allow for payments to be netted against each other
to avoid unnecessary payments.
185. In a Plain Vanilla Interest Rate Swap, at no point does the principal change
hands, which is why it is referred to as a "notional" amount.
186. Plain Vanilla Foreign Currency Swap involves exchanging principal and fixed
interest payments on a loan in one currency for principal and fixed interest
payments on a similar loan in another currency.
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187. Unlike an interest rate swap, the parties to a currency swap will exchange
principal amounts at the beginning and end of the swap. The two specifiedprincipal
amounts are set so as to be approximately equal to one another, given the
exchange rate at the time the swap is initiated.
188. The motivations for using swap contracts - Commercial needs and
Comparative advantage.
189. Swaption is an option on a swap.
190. Liability Swap is a financial derivative in which two parties exchange debt-
related interest rates, usually a fixed rate for a floating rate.
191. In a Currency Swap, the parties exchange interest and principal payments on
debt denominated in different currencies. Unlike an interest rate swap, the principal
is not a notional amount, but it is exchanged along with interest obligations.
192. Currency swaps can take place between countries.
193. Foreign Currency Swap an agreement to exchange currency between two

foreign parties, often employed to obtain loans at more favourable interest rates.
194. Zero Coupon Swaps involves the fixed side of the swap being paid in one lump
sum when the contract reaches maturity.
195. In Zero Coupon Swaps the variable side of the swap still makes regular
payments, as they would in a plain vanilla swap.
196. In a Fixed-to-Floating Zero Coupon Swap, the fixed rate cash flows are not
paid periodically, but just once at the end of the maturity of the swap contract.
The other party who pays floating rate keeps making regular periodic payments
following the standard swap payment schedule.
197. In a fixed-fixed zero coupon swap one party does not make any interim
payments, but the other party keeps paying fixed payments as per the schedule.
198. The zero coupon swap (ZCS) is primarily used by businesses to hedge a loan
in which interest is paid at maturity or by banks that issue bonds with end-of-
maturity interest payments.
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199. A zero-coupon inflation swap (ZCIS) is a type of derivative in which a fixed-
rate payment on a notional amount is exchanged for a payment at the rate of
inflation. It is an exchange of cash flows that allows investors to either reduce or
increase their exposure to the changes in the purchasing power of money.
200. A ZCIS is sometimes known as a breakeven inflation swap.
201. Debt-Equity Swaps involves the exchange of debt for equity—in the case of a
publicly-traded company, this would mean bonds for stocks. It is a way for
companies to refinance their debt or reallocate their capital structure.
202. In a Total Return Swap, the total return from an asset is exchanged for a fixed
interest rate. This gives the party paying the fixed-rate exposure to the underlying
asset—a stock or an index.
203. LIBOR, or London Interbank Offered Rate, is the interest rate offered by
London banks on deposits made by other banks in the Eurodollar markets. The
market for interest rate swaps frequently (but not always) used LIBOR as the base
for the floating rate until 2020. The transition from LIBOR to other benchmarks, such
as the secured overnight financing rate (SOFR), began in 2020.
204. Year-On-Year Inflation Swap - An inflation swap where the two

counterparties exchange an inflation rate against a fixed rate every year. This swap
is usually used to hedge issues of index-linked bonds. Put it another way, one
counterparty pays an index-linked coupon, which is a fixed rate leg plus the
annual rate of change in the underlying index, and receives Euribor/ LIBOR, plus a
specific spread, if any.
205. Year-On-Year Inflation Swap is also referred to as a pay-as-you-go swap or a

multipayment inflation swap
206. Yield-Yield Swap - A swap whose maturity matches that of another

instrument. This arises when an investor tries to synthetically hedge a bond/ note/
treasury security, etc.
207. A yield-yield swap is also referred to as a matched maturity swap.
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208. Swap Rate Lock is an agreement that in advance sets the absolute swap rate
level for a swap that starts on a future date. In other words, the buyer and seller
agree today to set the swap rate for a swap that will be entered into in the future.
This may help both parties to hedge future interest rate risk associated with interest
payments
209. The process of terminating a swap agreement by mutual consent of the parties
at an early date before maturity is known as Swap Buy-Back. The party requiring
buy-back has to pay the other party a lump-sum amount equal to the net present
value of the swap at the time of termination.
210. Swap Buy-Back usually involves the sale of the swap to the original
counterparty.
211. Swap Buy-Back is also known as a Cancellation of a Swap or a Swap Close- out.
212. A swap in which the payer of a given leg agrees to assign the other leg to a
third party is known as Swap Sale. As such, the payer of the other leg steps out of
the deal, receiving or paying the net amount of the new transaction.
213. Swap Sales are unwinds done with a third party (usually a bank or financial
institution) which steps into the shoes of one of the swap‘s counterparties.
214. Swap Sale is also called a Swap Assignment.
215. IAR Swap stands for Index Amortizing Rate swap; an interest rate swap (IRS)
that has an amortizing Notional Principal Amount (NPA) over time. Differently
stated, the swap‘s NPA decreases (may decrease) with the passage of time
depending on the path of future interest rates (the index).
216. An index amortizing rate swap is, by nature, an over-the-counter derivative

contract (OTC derivative) between two parties who agree to exchange (swap)
interest payment (measured at an amortizing notional) on two different legs: the
fixed rate leg and the floating rate leg.
217. MTM Swap stands for marked-to-market swap; any swap where settlement
takes place by periodically marking interest payments to market (marking to
market, MTM).
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218. Seasonal Swap is an interest rate swap (IRS) in which the notional principal
varies according to a specified schedule.
219. Floating Price is a leg of a swap contract that depends on a variable, including
an interest rate, currency exchange rate or price of an asset.
220. Accreting Principal Swap is an over-the-counter derivative contract that

features an increasing notional principal amount over time.
221. Secured Overnight Financing Rate (SOFR) is a benchmark interest rate for
dollar-denominated derivatives and loans that is replacing the London Interbank
Offered Rate (LIBOR).
222. Back to Back Swap is a combination of two swaps, namely two cross-currency
swaps or two interest rate swaps for the purpose of effectively extending the
maturity of a fixed-rate debt issued by a party into the swap.
223. Back to Back Swap reverses the terms of an existing swap such as the cash flow
pattern, where the fixed rate payer becomes the floating rate payer, and vice versa.
224. Back to Back Swap terminates the two opposing cash flow payments,
alleviating the need for the two counterparties to pay each other.
225. Back-to-back swap has the effect of cancelling a previously made swap.
However, the obligation of each counterparty doesn‘t terminate.
226. The back-to-back swap is also sometimes called a Reverse Swap.
227. Arbitrage is the simultaneous purchase and sale of the same or similar asset in
different markets in order to profit from tiny differences in the asset's listed price.
228. Arbitrage exploits short-lived variations in the price of identical or similar

financial instruments in different markets or in different forms.
229. Arbitrage takes advantage of the inevitable inefficiencies in markets.
230. An arbitrage trade is considered to be a relatively low-risk exercise.
231. Crypto arbitrage is a trading strategy that aims to capitalize on price

differences in cryptocurrencies.
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232. Basel Committee for Banking Supervision (the Basel Committee), which was
established in 1974 by the central bank governors of G-10 countries1, acts as the
primary global standard setter for banking prudential regulation.
233. The Basel Committee sets international standards and guidelines for national
regulators to assess and supervise their banking system.
234. Basel Accord largely affects the way banks manage their capital and risk as
well as the way they are monitored and supervised by the regulators.
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Module – B: Credit Risk Management
Chapter No Topics covered
05 Basel Norms, Three pillars of Basel
06 Methods for Estimating Capital Requirements
07 Risk Rating and Risk Pricing and Credit Bureaus
08 Framework for Risk Management & RBI guidelines on Risk

Management.
09 Stress Test and Sensitivity Analysis
10 ICAAP & Structured Products.
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05 Basel Norms
01. Regulations have a decisive impact on risk management.
02. The regulatory framework sets up the constraints and guidelines that inspire
risk management practices, and stimulates the development and enhancement of
the internal risk models and risk management processes of banks.
03. Regulations promote better definitions of risks, and create incentives for
developing better methodologies for measuring risks.
04. The Basel Committee on Banking Supervision (BCBS) issues Basel Norms for
international banking regulations.
05. The goal of these norms is to strengthen the international banking system by
coordinating banking regulations around the world.
06. The Basel Committee has currently issued three guidelines to achieve its goal:
Basel I, II, and III.
07. Basel is a city in Switzerland. It is the headquarters of the Bureau of

International Settlements (BIS), which promotes cooperation among central banks
with a common goal of financial stability and banking regulatory standards.
08. Every two months, the BIS hosts a meeting of the governors and senior officials
of member countries' central banks.
09. Basel norms are for individual banks and Systemically Important Financial
Institutions (SIFI).
10. In India, these norms are implemented by the Reserve Bank of India. As of now,
the committee has come up with Basel-I, Basel-II and Basel-III.
11. RBI began implementing Basel-I in 1992 and Basel-II in 2009. RBI also issued
guidelines on implementing Basel-III in a phased manner.
12. Basel -I Norms - It is also known as the Basel Capital Accord.
13. As per Basel-I, all banks were required to maintain a capital adequacy ratio
(CAR) of 8 %.
14. CAR is the minimum capital requirement of a bank and is defined as the ratio
of capital to risk-weighted assets (RWA).
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15. RWA is the assets weighted or classified according to the risk (default)profile.
16. Basel I Norms classified bank capital into Tier-I and Tier-2 Capital.
17. Tier 1 capital is the core capital of banks and is more permanent in nature (e.g.
equity capital, disclosed reserves, etc.).
18. Tier 2 capital is supplementary in nature and is fluctuating in nature (e.g.

undisclosed reserves, cumulative non-redeemable preference shares, etc.).
19. India adopted Basel -I guidelines in 1999.
20. Basel-II Norms is the revised capital framework of 1988. It comprises three
pillars - Minimum Capital Requirement, Supervisory Review, and Market Discipline.
21. Pillar 1: Minimum Capital Requirement (MCR) sets MCR for credit risk, market
risk and Operational risk.
22. As per Basel-II, the minimum capital requirement is 8% of the risk-weighted

assets. Risk-weighted assets means -Classification of assets based on their risk
profiles.
23. The capital ratio is calculated using the definition of regulatory capital and risk-
weighted assets.
24. As per Basel II framework, the total capital ratio must not be lower than 8%.
25. Tier-3 capital includes short-term subordinated loans (lower in ranking).
26. Tier 3 capital solely to support market risks.
27. For short-term subordinated debt to be eligible as Tier 3 capital, it needs to be

capable of becoming part of a bank’s permanent capital and thus be available to
absorb losses in the event of insolvency.
28. Pillar 2: Supervisory Review focuses on supervision of institution’s

implementing Pillar-1 guidelines.
29. Under Supervisory Review, Banks were required to develop and use better risk
management techniques.
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30. Pillar 3: Market Discipline is designed to promote greater stability in the
financial system.
31. Pillar 3 (Market Discipline) increased the disclosure requirements. Banks need
to mandatorily disclose their CAR, risk exposure, etc to the central bank.
32. The financial crisis of 2007-08 revealed shortcomings in the Basel norms.
Therefore, the previous accords were strengthened in Basel III.
33. The Basel III guidelines were published in 2010. These guidelines were put in
place in response to the 2008 financial crisis.
34. The Basel III norms aim to make most banking activities, such as trading books,
more capital-intensive.
35. The guidelines are intended to promote a more resilient banking system by
focusing on four critical banking parameters: capital, leverage, funding, and
liquidity.
36. Basel-Ill has tried to plug the loopholes of Basel-II guidelines in four different
ways.
37. In our country, the minimum CAR has been raised from 9% to 11.50% under
Basel III regime.
38. As per Basel III, the Capital Adequacy Ratio should be kept at 12.9 percent.
39. As per Basel III, the minimum Tier 1 and Tier 2 capital ratios must bemaintained
at 10.5 percent and 2 percent of risk-weighted assets, respectively.
40. As per Basel III, banks must maintain a capital conservation buffer of 2.5
percent.
41. As per Basel III, the counter-cyclical buffer should also be kept at 0-2.5percent.
42. As per Basel III, Banks are required to maintain more capital of higher quality to
cover unexpected losses.
43. As per Basel III, the minimum Tier 1 capital rises from 4% to 6%.
44. In our country, the minimum CAR has been raised from 9% to 11.50% under
Basel III regime.
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45. As per Basel III, the leverage rate must be at least 3%.
46. The leverage rate is the ratio of a bank's tier-1 capital to average of total
consolidated assets.
47. Basel-III established two liquidity ratios: LCR and NSFR.
48. Liquidity coverage ratio (LCR) will require banks to maintain a buffer of high-
quality liquid assets sufficient to deal with cash outflows encountered in an acute
short-term stress scenario as specified by regulators.
49. LCR introduced to avoid situations like the "Bank Run." The goal is to ensure
that banks have enough liquidity to weather a 30-day stress scenario if it occurs.
50. Net Stable Funds Rate (NSFR) mandates that banks maintain a consistent
funding profile in relation to their off-balance-sheet assets and activities.
51. The NSFR requires banks to fund their operations with stable sources of
funding (reliable over the one-year horizon).
52. The NSFR must be at least 100 percent.
53. High-quality Liquid assets are those that can be readily sold or used as collateral
to obtain funds in a range of stress scenarios. They should be unencumbered i.e.,
without legal, regulatory or operational impediments.
54. Assets are considered to be high quality liquid assets, if they can be easily and
immediately converted into cash at little or no loss of value.
55. There are two categories of assets which can be included in the stock of
HQLAs – Level 1 and Level 2
56. Level 1 includes Cash and near cash equivalents and hence no haircut applied
on these assets.
57. Level 2 assets are sub-divided into Level 2A (less liquid assets and hence a
haircut of 15% is applied for conversion of these assets into cash) and Level 2B
(Conversion of asset into cash is more difficult for these assets and hence a
haircut of 50% is applied) assets on the basis of their price-volatility.
58. Level 2B assets should comprise not more than 15% of the total stock of
HQLA.
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59. Facility to Avail Liquidity for Liquidity Coverage Ratio (FALLCR) shall mean
facility whereby banks will be permitted to reckon government securities held by
them up to a certain per cent of their NDTL (presently 5%) within the mandatory
SLR requirement as level 1 HQLA for the purpose of computing their Liquidity
Coverage Ratio.
60. This FALLCR can be availed/rolled over up to a maximum period of 90 days.
61. Liquidity against securities under FALLCR will be available after applying
haircuts as stipulated for MSF.
62. Rate of interest on the funds availed under FALLCR will be 200 bps above the
prevailing LAF repo rate, up to a period of 90 days, or as decided by the RBI from
time to time. This is known as Facility Rate.
63. Available Stable Funding (ASF) means the proportion of own and third-party
resources that are expected to be reliable over the one-year horizon (includes
customer deposits and long-term wholesale financing).
64. Required Stable Funding (RSF) is an input to the calculation of the net stable
funding ratio (NSFR) for bank prudential management purposes.
65. Systemic Risk is the risk of failure of the whole banking system.
66. Systemic risk is a major challenge for the regulator.
67. Systemic risk is the possibility that an event at the company level could trigger
severe instability or collapse an entire industry or economy.
68. Systemic risk was a major contributor to the financial crisis of 2008.
69. Companies considered to be a systemic risk are called "too big to fail."
70. Systemic Risk describes an event that can spark a major collapse in a specific
industry or the broader economy.
71. Systematic risk refers to the risk inherent to the entire market.
72. Systematic risk, also known as “undiversifiable risk,” “volatility” or “market risk,”
affects the overall market, not just a particular stock or industry.
73. Systematic risk is both unpredictable and impossible to completely avoid.
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74. Systematic Risk cannot be mitigated through diversification, only through
hedging or by using the correct asset allocation strategy.
75. Systematic risk is the pervasive, far-reaching, perpetual market risk that reflects
a variety of troubling factors.
76. In response to the 2008 global financial crisis, the Group of Twenty (G-20)
Finance Ministers and Central Bank Governors created the Financial Stability Board
(FSB) in 2009 as a successor to the Financial Stability Forum (FSF).
77. The FSB was created expressly to coordinate at the international level the work
of national financial authorities and international standard setting bodies and to
develop and promote the implementation of effective regulatory, supervisory and
other financial sector policies in the interest of financial stability.
78. The Cooke Ratio - Named for Peter Cooke of the Bank of England, the Cooke
ratio is the ratio of commitments (assets weighed by the risk of default) to total
assets.
79. Systemically Important Financial Institution (SIFI) - FIs/ Banks have been
characterised as systemically important if their distress or disorderly failure would
cause significant disruption to the financial system and economic activity due to
their size, complexity and systemic interconnectedness.
80. SIFI banks are interconnected entities whose failure could potentially impact the
entire financial system and cause instability. As a result, they are subject to closer
supervision and regulation by the RBI.
81. A SIFI is viewed as “too big to fail” and imposed with extra regulatory burdens
to prevent it from going under.
82. Securities Financing Transactions (SFTs) are transactions such as repurchase

agreements, reverse repurchase agreements, security lending and borrowing,
collateralised borrowing and lending (CBLO) and margin lending transactions,
where the value of the transactions depends on market valuations and the
transactions are often subject to margin agreements.
83. Haircut - In finance, a Haircut refers to the reduction applied to the value of an
asset for the purpose of calculating the capital requirement, margin, and collateral
level.
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84. Haircut is the difference between the amount of a loan given and the market
value of the asset to be used as collateral for the loan.
85. Available for Sale - The securities available for sale are those securities where
the intention of the bank is neither to trade nor to hold till maturity.
86. Available for Sale securities are valued at the fair value which is determined by
reference to the best available source of current market quotations or other data
relative to current value.
87. Long Position refers to a position where gains arise from a rise in the value of
the underlying.
88. Capital Conservation Buffer (CCB) is a concept introduced under the

international Basel III norms.
89. According to Basel III norms, during good times, banks must build up a capital
buffer that can be drawn from when there is stress. Individual countries areallowed
to take their own decision in this matter.
90. In India, to adhere to Basel norms, RBI wants all the commercial banks to
achieve minimum total capital of 9 per cent and a capital conservation buffer of
2.5 per cent, with the minimum total capital and CCB adding up to 11.5 per cent,
by April 1, 2022.
91. Countercyclical Capital Buffer (CCCB) - The concept of CCCB was first
introduced in Basel III as an extension of another buffer (called the capital
conservation buffer).
92. Basel III is a voluntary set of measures agreed upon by central banks all around
the world. These measures were drafted by the Bank of International Settlements’
Basel Committee on Banking Supervision in response to the financial crisis of 2007-
09, in order to strengthen regulation of banks and fight risks within the financial
system.
93. The countercyclical capital buffer (CCyB) is designed to counter procyclicality

in the financial system. When cyclical systemic risk is judged to be increasing,
institutions should accumulate capital to create buffers that strengthen the
resilience of the banking sector during periods of stress when losses materialise.
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94. The countercyclical capital buffer is intended to protect the banking sector
against losses that could be caused by cyclical systemic risks increasing in the
economy.
95. Countercyclical capital buffers require banks to hold capital at times when credit
is growing rapidly so that the buffer can be reduced if the financial cycle turns down
or the economic and financial environment becomes substantially worse.
96. Banks can use the capital buffers they have built up during the growth phase of
the financial cycle to cover losses that may arise during periods of stress and to
continue supplying credit to the real economy.
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06 Methods for Estimating Capital Requirements
01. Basel II introduces a requirement for holding capital to cover operational risk1
and prescribes three methods for calculating required levels, each progressing in
sophistication and risk sensitivity. These are:
a) The Basic Indicator Approach;
b) The Standardised Approach; and
c) The Advanced Measurement Approaches.
02. The basic approach or basic indicator approach is a set of operational risk
measurement techniques proposed under Basel II capital adequacy rules for
banking institutions. Basel II requires all banking institutions to set aside capitalfor
operational risk.
03. The Basic Indicator Approach is the most straightforward approach for
calculating the own funds’ requirement for operational risk. The own funds’
requirement is calculated as a fixed percentage (alpha-factor, 15 %) of a simple
indicator (gross income).
04. Gross income is defined as Interest earned – interest paid + non-interest

income.
05. The current Basic Indicator Approach (BIA) requires banks to keep aside 15%
of positive gross annual income over the preceding three years, excluding any year
where gross income is negative, as an operational risk capital charge.
06. Basel III sets a revised Standardised Approach (“SA”) framework to calculate
minimum Operational Risk Capital (“ORC”) requirements.
07. Standardised Approach replaces the three calculation methods part of Basel II
one of these being the Advanced Measurement Approach.
08. Standardised Approach allows banks to measure credit risk in a standardized

manner based on external credit assessments. Rating agencies try to capture risk
sensitivity using ratings.
09. The risk weights are inversely related to the rating of the counter party.
10. Under the standardised approach, banks apply standard risk weights to their
assets.
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11. Internal models allow banks to estimate the risk themselves. They are tailored
to individual banks and therefore allow risks to be measured more accurately.
12. Basic Indicator Approach help the banks calculate the amount of capital that
they need to set aside to meet operational risk requirements. This is done in three
steps.
13. As a part of Standardized Approach, the operations of a financial institution are

divided into eight separate lines of business viz. retail banking, corporate finance,
commercial banking, settlements and payments, trading, retail brokerage, asset
management, and agency services.
14. The Bank of International Settlement recommends that the average revenue for
three years be considered instead of single-year revenue. This is because the
average of three years is more reliable and may represent the business conditions
more accurately.
15. As a per Standardized Approach, The capital charge for all eight lines of
business is added together in order to obtain the capital that the organization
needs to set aside in order to meet operational risk requirements.
16. The Advanced Measurement Approaches (AMA) measurement model is tied

directly to the risks that are identified in the RCSA. It allows business management
to transparently see how the risk measure is affected by their decisions about the
business environments.
17. Under the Advanced Measurement Approaches (AMA), the regulatory capital
requirement will equal the risk measure generated by the bank’s internal
operational risk measurement system using the quantitative and qualitative criteria
for the AMA.
18. Under AMA the banks are allowed to develop their own empirical model to
quantify required capital for operational risk. Banks can use this approach only
subject to approval from their local regulators. Once a bank has been approved to
adopt AMA, it cannot revert to a simpler approach without supervisory approval.
19. According to the BCBS Supervisory Guidelines, an AMA framework mustinclude

the use of four data elements: (i) Internal loss data (ILD), (ii) External data (ED), (iii)
Scenario Based Analysis (SBA), and (iv) Business environment and internalcontrol
factors (BEICFs).
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20. LDA stands for Loss Distribution Approach (LDA) for computing the capital
charge of a bank for operational risk.
20 B) LDA refers to statistical/actuarial methods for modelling the lossdistribution.

In this framework, the capital charge is calculated using a Value-at- Risk measure.
21. With LDA, a bank first segments operational losses into homogeneous
segments, called units of measure (UoMs).
For each unit of measure, the bank then constructs a loss distribution that
represents its expectation of total losses that can materialize in a one-year horizon.
Bank will develop a frequency distribution that describes the number of loss events
in a given year, and a severity distribution that describes the loss amountof a
single loss event.
The frequency and severity distributions are assumed to be independent. The

convolution of these two distributions then give rise to the (annual) loss
distribution. (Convolution is a mathematical operation on two functions that
produces a third function that expresses how the shape of one is modified by the
other)
22. Internal losses arise from actual events, i.e. the materialization of operational
risks, and reflect the organisation's own experience. Therefore, internal loss events
(or Internal Loss Data – ILD) have the potential to be the most relevant basis for
analysis and management response.
23. External Data (ED) is information that originates outside the company and is
readily available to the public. External data is used to help a company develop a
better understanding of the world in which they are operating.
24. Scenario Based Analysis (SBA) is designed to derive reasoned assessments of

the likelihood and impact of plausible operational losses from business and risk
management experts. It is often used to identify and measure events with low
frequency but high severity losses, for example, natural disasters, terrorism, and
rogue traders.
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25. Scenario Based Analysis (SBA) is a method for predicting the possible
occurrence of an object or the consequences of a situation, assuming that a
phenomenon or a trend will be continued in the future.
26. Business Environment and Internal Control Factors (BEICFs) is a regulatory term
that denotes the set of tools and information generated internally be a regulated
firm to inform is management of Operational Risk.
27. BEICFs are defined as measures that track changes in the operational risk in
the business environment and changes in the effectiveness of a firm’s controls.
The environment is defined to include both the internal and external circumstances
of the firm’s businesses, and controls are defined as processes that the firm has in
place to reduce or eliminate its operational risks. The business environment is the
internal and external circumstances of a firm’s businesses that can materially affect
its operational risk profile.
28. Key Risk Indicators are metrics that can track the business environment and
internal control factors. They can help an organization keep track of a rapidly
changing internal and external environment.
29. Risk management is all about continuous scanning and monitoring of the
environment and key risk indicators are the best way to do so.
30. Key Risk Indicators can be understood to be predictors of adverse events which
are likely to impact organizations.
31. The main feature of the key risk indicator is that it should be expressed
numerically. There should be a predefined level for these numbers and then when
they vary from the predefined level, they should be immediately reported to the
risk management team.
32. Key Risk Indicators (KRI) can be considered to be the lens through which the
company views its internal and external environment.
33. Key Performance Indicators (KPIs) are tools that are used by organizations to
manage their day-to-day operations.
34. Key risk indicators can be thought of as being the precursor to the key
performance indicators.
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35. Key Control Indicators (KCI) help an organization determine the success of its
Key Risk Indicators.
36. Key control indicators help a company decide whether its risk indicators are
accurate or whether they need to be changed.
37. Key Risk Indicator approach is an integral part of the advanced measurement
approach suggested in the Basel norms.
38. Basel IV will be a game changer not only for banks but also for corporates when
it comes to access to financing.
39. Basel IV, a finalisation of Basel III, will overhaul global bank capital
requirements, changing the corporate lending landscape.
40. In 2017, the Basel Committee agreed on changes to the global capital
requirements as part of finalising Basel III. The changes are so comprehensive that
they are increasingly seen as an entirely new framework, commonly referred to as
“Basel IV,” set to take effect under transition rules from 2025.
41. An analysis by the Basel Committee highlighted a worrying degree of variability

in banks’ calculation of their risk-weighted assets. Basel IV reforms aim to restore
credibility in those calculations by constraining banks’ use of internal risk models.
42. Advanced internal risk models give banks the most freedom to estimate their
credit risk, often yielding a much lower risk than the regulator’s standard model.
43. Basel IV introduces a output floor, which prevents a bank’s own internal
measurement of its risk exposure from yielding less than 72.5% of the standardized
approach.
44. The purpose of Basel IV is to level the playing field and harmonize how banks
calculate risks, not to increase the level of capital in banks on a global level.
45. In December 2021, the EU Commission presented its proposal for

implementation of Basel IV in the EU, with transition rules set to take effect from
2025.
46. Regulation is needed to ensure banks have enough capital in place to absorb
potential losses in times of financial distress.
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47. The minimum reserve capital a bank needs under the Basel framework is 10.5%
of its risk-weighted assets plus the countercyclical capital buffer and leverage ratio
requirement.
48. Basel Committee on Banking Supervision is an international committee

formed in 1974 to develop global standards for banking regulation. Its 45 members
represent central banks and bank supervisors from 28 jurisdictions.
49. Basel I is a a set of international banking regulations adopted by the Basel

Committee in 1988, requiring banks to hold capital of at least 8% of their risk-
weighted assets.
50. Basel I and the subsequent II, III and “IV” comprise the Basel Accords.
51. Basel II is the second set of global banking regulations adopted by the Basel
Committee in 2004. They expanded the rules for minimum capital requirements
under Basel I, allowing banks to use their own internal models to assess credit risk
when determining capital requirements. Basel II also established a framework for
regulatory review and disclosure requirements.
52. Basel III is the third instalment of global banking regulations, adopted by the
Basel Committee in 2009 in response to the global financial crisis. The reforms
increased banks’ capital ratio to 2.5% and introduced a countercyclical capital
buffer, leverage ratio and liquidity requirements.
53. Basel IV - Changes to the global capital requirements the Basel Committee
agreed to in 2017 as part of the finalisation of Basel III, set to take effect under
transition rules from 2025.
54. Basel IV prevent banks from using internal risk models to assess the credit risk
of large corporates with a turnover of at least 500 million EUR.
55. Basel IV constrain banks’ use of internal models via an output floor and modify
the leverage ratio, credit valuation adjustment (CVA) and operational risk
frameworks.
56. Basel IV reforms aim to harmonise how banks calculate credit risk when
determining their capital requirements.
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57. Capital requirement - The amount of capital a bank has to hold, as required by
regulators. The Basel Accords are the main set of international rules governing
banks’ capital requirements, which are designed to shore up banks’ resiliency so
they can absorb losses in times of financial distress.
58. Capital ratio - A bank’s available capital expressed as a percentage of its risk-
weighted assets. That minimum ratio is 10.5% under the Basel framework.
59. Countercyclical capital buffer introduced under the Basel III reforms, designed
to be built up in times of economic expansion and released during recessions. The
buffer varies by country and is set by the national regulator anywhere between 0
and 2.5%.
60. Leverage ratio - A requirement added under Basel III as a backstop to the risk-
based capital measures. It requires a bank’s Tier 1 capital to be at least 3% of its
total exposure, which includes its equity, debt, derivative exposure and off- balance
sheet liabilities.
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07. Risk Rating; Risk Pricing and Credit Bureaus
01. Credit Rating of an account is done with the primary objective to determine
whether the account, after the expiry of a given period, would remain a performing
asset, i.e., it will continue to meet its obligation to its creditors, including Bank and
would not be in default.
02. Credit rating exercise seeks to predict whether the borrower would have the
capability to honour its financial commitment in future to the rest of the world.
03. A Credit Rating depicts the credit quality of the borrower and depicts his
default.
04. Active portfolio management is required to keep up with the dynamics of the
economy.
05. Credit risk control and monitoring is directed both at transaction level and
portfolio level.
06. An appropriate credit information system is the basic prerequisite for effective
control and monitoring.
07. A comprehensive and detailed MIS (Management Information System) and CIS
(Credit Information System) is the backbone for an effective CRM System.
08. Credit appraisal guidelines include borrower standards, procedures for

analyzing credit requirements and risk factors, policies on standards for
presentation of credit proposals, financial covenants, rating standards and
benchmarks, etc.
09. Credit appraisal guidelines may include risk monitoring and evaluation ofassets
at transaction level, pricing of loans, regulatory/legal compliance, etc.
10. Prudential limits serve the purpose of limiting credit risk.
11. Prudential limits may have flexibility for deviations. The conditions subject to
which deviations are permitted and the authority thereof should also be clearly
spelt out in the Loan Policy.
12. Risk Pricing - The pricing strategy for credit products should move towards
risk based pricing to generate adequate risk adjusted returns on capital.
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13. The Credit Spread should have a bearing on the expected loss rates and charges
on capital.
14. Credit Control and Monitoring at Portfolio Level deals with the risk of a given
portfolio, expected losses, requirement of risk capital, and impact of changing the
portfolio mix on risk, expected losses and capital.
15. Credit Control and Monitoring at Portfolio Level deals with the marginal and
absolute risk contribution of a new position and diversification benefits that come
out of changing the mix. It also analyses factors that affect the portfolio’s risk profile.
16. Loan Review Mechanism (LRM is also called as Credit Audit.
17. LRM an effective tool for constantly evaluating the quality of loan book and to
bring about qualitative improvements in credit administration.
18. Loan Review Mechanism is used for large value accounts with responsibilities
assigned in various areas such as, evaluating effectiveness of loan administration,
maintaining the integrity of credit grading process, assessing portfolio quality, etc.
19. The Loan Reviews are designed to provide feedback on effectiveness of credit
sanction and to identify incipient deterioration in portfolio quality. Reviews of
high value loans should be undertaken usually within three months of
sanction/renewal or more frequently when factors indicate a potential for
deterioration in the credit quality.
20. Credit risk mitigation is an essential part of credit risk management. This refers
to the process through which credit risk is reduced or it is transferred to
counterparty. Strategies for risk reduction at transaction level differ from that at
portfolio level.
21. Recent techniques include buying a credit derivative to offset credit risk at
transaction level.
22. Securitisation refers to a transaction where financial securities are issuedagainst

the cash flow generated from a pool of assets. Cash flows arising out of payment
of interest and repayment of principal are used to service interest and repayment
of financial securities. Usually an SPV – special purpose vehicle is created for the
purpose.
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23. Originating bank – that is the bank which has originated the assets —transfers
the ownership of such assets to the SPV. The SPV issues financial securities and
has the responsibility to service interest and repayments on such financial
instruments.
24. Credit Derivatives (CD) - A credit derivative is an over-the-counter bilateral

contract between two or more counterparties that provide for transfer of risks in a
credit asset or credit portfolio without necessarily transferring the underlyingasset
from the books of the originator.
25. Generally, credit derivatives transfer risks in a credit asset without transferring
the underlying asset themselves from the books of the originator. Hence, they are
off-balance sheet financial instruments. All credit assets (loans, bonds, account
receivable, financial leases, etc.) are bundles of risk and rewards.
26. Credit Default Swaps (CDS) is a transaction in which a credit hedger (PB) pays
a periodic premium to an investor (PS) in return for protection against a credit event
experienced on a reference obligation, (i.e., the underlying credit that is being
hedged).
27. Credit default swaps (CDS) are generally off-balance sheet items and are not
funded exposures.
28. Total return swap (TRS) is a swap agreement in which one party makes
payments based on a set rate, either fixed or variable, while the other party makes
payments based on the return of an underlying asset, which includes both the
income it generates and any capital gains.
29. In total return swaps, the underlying asset, referred to as the reference asset, is
usually an equity index, a basket of loans, or bonds. The asset is owned by the party
receiving the set rate payment.
30. A total return swap represents an off-balance sheet replication of a financial

asset such as a loan or bond, whereas credit default swaps capture only credit risk,
total return swaps involved the transfer of the total economic return of the asset
(i.e., both credit and market risks.)
31. Credit Linked Notes (CLN) are on-balance sheet which combine credit
derivatives with normal bond instruments and thus convert credit derivatives
(generally an OTC instrument) into capital market instruments.
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32 .Credit Spread Option (also known as a "credit spread") is an options contract
that includes the purchase of one option and the sale of a second similar option
with a different strike price.
33. A Credit Rating Agency (CRA) provides independent evidence and research-
based opinion on the ability and willingness of the issuer to meet debt service
obligations.
34. In India, CRAs are regulated by SEBI.
35. CRISIL (formerly Credit Rating Information Services of India Limited) is an Indian
analytical company providing ratings and is a subsidiary of American company S&P
Global.
36. CARE (Credit Analysis and Research Limited Ratings) commenced its
operations in the year 1993 and was promoted by major Banks/ FIs (financial
institutions) in India.
37. In the global arena CARE Ratings is a partner in ARC Ratings, an international
credit rating agency.
38. SMERA (Small and Medium Enterprises Rating Agency) is a joint enterprise by
SIDBI, Dun & Bradstreet Information Services India Private Limited (D&B), and some
chief banks in India.
39. ONICRA (Onida Individual Credit Rating Agency of India) has been promoted
by well known ‘ONIDA’ group. It is also known as Onicra Credit Rating Agency.
40. Fitch (India Ratings & Research) – Ind-Ra –(India Ratings and Research) is a
100% owned subsidiary of the Fitch Group.
41. Fitch Group is a global leader in financial information services with operations
in more than 30 countries.
42. Fitch Group is majority owned by New York based Hearst Corporation.
43. Fitch Ratings Inc. is an American credit rating agency and is one of the "Big
Three credit rating agencies", the other two being Moody's and Standard &Poor's.
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44. ICRA Limited (formerly Investment Information and Credit Rating Agency of
India Limited) was set up in 1991 by leading financial/investment institutions,
commercial banks and financial services companies.
45. The ultimate parent company of international Credit Rating Agency Moody’s
Investors Service is the indirect largest shareholder of ICRA.
46. BWR (Brickwork Ratings) was established in 2007 and is promoted by Canara
Bank.
47. IVRPL (Infomerics Valuation and Rating Private Limited) is a full-service rating
agency.
48. Acuite Ratings & Research Limited is an institutionally promoted organisation

with a unique combination of country's leading public & private sector banks along
with a global data & analytics company as its shareholders.
49. Globally The following 3 known as “The Big 3 Credt Rating Agencies”.
a) Moody’s (b) Fitch and ( c) S&P Global Ratings
50. Credit risk assessment is primarily through the internal rating process.
51. The risk rating of eligible borrowers is a pre sanction exercise.
52. Bank have developed their own Model of Risk Rating wherever RBI allows.
53. In many Banks for borrowers with exposure of Rs 2 lakh and above are rated
individually and under the appropriate risk rating models developed for the
purpose. The rating will be based on financial reports as well as recent information
available with the Bank.
54. The individual borrower ratings are subjected to annual review.
55. Banks are using internal risk rating model based on the exposure, wherever
freedom is given by RBI or Basel Norms.
56. Small Exposures and Retail Loans (up to some limit) are rated on the basis of
portfolio model.
57. Risk Rating function and Loan Approval functions are delinked and are handled
by separate entities to get fair analysis.
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58. Credit rating is not mandatory under Basel II, for exposures (FB+NFB) up to Rs
25 Crores. But banks are likely to save capital if they get their loan portfolios
rated.
59. If a bank chooses to keep some of its loans unrated, it may have to provide a
risk weight of 100% for credit risk on such unrated loans. Hence it is essential for
banks to get the loans rated.
60. Basel III norms emphasizes on banks to have a core capital ratio of 8% and a
total capital adequacy ratio of 11.5%.
61. Basel III norms concentrate on the capital adequacy framework of a bank and
the quality and quantity of capital held.
62. As Finance to Externally Rated Units saves pressure on Capital, Banks are going
for External Rating of Credit Proposals.
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08. Risk Management Framework (RMF) &
RBI Guidelines on Risk Management
01. The Risk Management Framework provides a process that integrates security,
privacy, and cyber supply chain risk management activities into the system
development life cycle.
02. The components of RMF are Risk Identification; Risk Measurement and
Assessment; Risk Mitigation; Risk Reporting and Monitoring; and Risk Governance.
03. Risk governance is the process that ensures all company employees perform
their duties in accordance with the risk management framework.
04. Risk governance involves defining the roles of all employees, segregating
duties, and assigning authority to individuals, committees, and the board for
approval of core risks, risk limits, exceptions to limits, and risk reports, and also for
general oversight.
05. From the risk management point of view, banking business lines may be
grouped broadly under the following major heads.- The Banking Book ; The Trading
Portfolio and Off-Balance Sheet Exposures
06. The Banking Book includes all advances, deposits and borrowings, whichusually
arise from commercial and retail banking operations.
07. All assets and liabilities in banking book have the following characteristics:
• They are normally held until maturity.
• Accrual system of accounting is applied.
• They are not subjected to MTM (mark to market) exercise.
• They attract capital charge on credit risk and not on market risk.
08. The Trading Book includes all the assets that are marketable, i.e., they can be
traded in the market.
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09. The trading book assets have the following characteristics:
a) They are normally not held until maturity and positions are liquidated in the
market after holding the assets for a certain period
b) Mark-to-Market system is followed and the difference between the market price
and the book value is taken to profit and loss account.
c) The trading book mostly comprises of fixed income securities, equities, foreign
exchange holdings, commodities, etc., held by the bank on its own account.
10. Off-Balance Sheet Exposures are contingent in nature.
11. Where banks issue guarantees, committed or backup credit lines, letters of
credit, etc., banks face payment obligations contingent upon some event. These
contingencies adversely affect the revenue generation of banks.
12. Banks may also have contingent assets (for example, a bank may have
purchased insurance to protect against certain negative events). Here banks are the
beneficiaries subject to certain contingencies.
13. Derivatives are off-balance sheet market exposures. They may be swaps,futures,
forward contracts, foreign currency contracts, options, etc.
14. Commitment Ratio tracks the total commitments given to corporates/banks

and other financial institutions to limit the off-balance sheet exposure
15. Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreigncurrency
sources.
16. Fund Transfer Pricing (FTP) is a process designed to assess the financial impact
of different sources of funds that will be helpful in evaluating profitability.
17. FTP analyses the cost of various funds available in the market and helps in
ascertaining of profits which shall help in reducing risk of unfavourable returns or
even losses.
18. FTP works by assigning various assets and liabilities to the functional units. As
each unit attracts a source of fund, this helps in evaluating the cost of each source
of fund and the return each funding source shall provide.
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19. The guidelines as provided by the RBI for Risk Management are discussed
below.
a) Credit Risk Management
The banks must articulate the management of credit risk in their Loan Policy. The
guidelines in order to deal with the credit risk are:
Measurement of risk through credit rating/scoring.
Quantifying the risk through estimating expected losses, i.e., the amount of loss a
bank shall endure in a specific time period.
Risk pricing on a specific basis.
Controlling the risk through effective Loan Review Mechanism (LRM).
Portfolio Management is a technique that enables us to gauge asset quality. It is

very helpful in determining the non- performing loans and much efficient than the
older system of checking the same through balance sheet.
Inter-Bank Exposure
Cash Reserve Requirements – CRR, SLR
20. Prudential Limits
There are certain prudential limits that the banks must place in order to avoid
liquidity crisis. Some of the limits are:
a) Cap on inter-bank borrowings, especially call borrowings
b) Purchased funds vis-à-vis liquid assets
c) Core deposits vis-à-vis Core Assets
d) Duration of liabilities and investment portfolio
e) Maximum Cumulative Outflows.
21. Operational Risk Management - In order to escape from the risk associated with
the operations of the bank, the banks must regularly conduct internal control
(segregation of duties, clear management reporting lines and adequate operating
procedures) and internal audit.
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22. The banks can utilize contingent processing capabilities to reduce the impact
of operational risk.
23. Capital Adequacy - In order to maintain long term soundness of the banks, the
banks must evaluate their capital adequacy based on the economic risk that
surrounds the bank.
24. While considering the economic risk, the banks must take account of both the
qualitative and quantitative factors. They must take care of internal as well as future
capital needs apart from established minimum capital requirements.
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09. Stress Test and Sensitivity Analysis
01. Stress testing, also known as scenario testing, is an analysis or simulation
designed to measure the effect on the plans of various projected, generallyadverse,
investment and actuarial events.
02. Sensitivity testing examines the effect on the plan of different actuarial
assumptions and methods.
03. Stress testing is a risk management technique utilized in the evaluation of the
potential effects on an institution’s financial condition, of a set of specified changes
in risk factors, corresponding to exceptional but plausible events.
04. Stress testing attempts to determine the impact of situations where the
assumptions underlying established models used in managing a business break
down.
05. Stress testing can also be used to assess the impacts of customer behaviour
arising from options embedded in certain products – particularly where the impact
is not easily modelled under extreme events.
06. Stress testing includes scenario testing and sensitivity testing.
07. Scenario testing adopts a hypothetical future state of the world or nature to
define changes in risk factors that would affect an institution’s operations.
08. Scenario testing is conducted over the time horizon appropriate for the
business and risks being tested.
09. Sensitivity testing typically involves an incremental change in a risk factor (or a
limited number of risk factors) which have to deal with providing answers to what
if questions.
10. Sensitivity Testing is conducted over a shorter time horizon.
11. Sensitivity testing requires fewer resources than scenario testing and can be
used as a simpler technique for assessing the impact of a change in risks when a
quick response or when more frequent results are needed.
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12. A reverse stress test starts with a specified outcome that challenges theviability
of the firm. The analysis would then work backward (reverse engineered) to identify
a scenario or combination of scenarios that could bring about such a specified
outcome.
13. The reverse stress test induces institutions to consider scenarios beyond normal
business settings that would include events with contagion and systemic
implications.
14. Stress testing explores the impact of a single factor or risk by itself. In contrast,
scenarios analysis is about understanding the impact of multiple factors, or risks,
occurring within a short time.
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10. ICAAP & Introduction to Structured Products
01. ICAAP stands for Internal Capital Adequacy Assessment Process
02. The Internal Capital Adequacy Assessment Process (ICAAP) notifies the Board
of the current assessment of the bank's risks, how the bank plans to alleviate
those risks, and the quantity of current and future capital is needed. It does so after
having considered other mitigating factors.
03. Internal capital adequacy assessment process gives input for the assessment
of risks to capital as a part of the annual Supervisory Review and Evaluation Process
(SREP).
04. ICAAP has six main components:
Senior Management Oversight.
Sound Capital Assessment and Planning.
Comprehensive Assessment of Risks.
Stress Testing.
Monitoring and Reporting.
Internal Control Review.
05. ICAAP provides additional information that can aid in assessing inherent risk
and may point to the need for additional supervisory work as part of the normal
course Supervisory Review Process.
06. Senior management is responsible for overseeing the design and

implementation of the institution’s ICAAP. In order to perform an effective
assessment of its capital adequacy, an institution should have in place a sound
risk management process.
07. ICAAP should address all material risks faced by the institution as they relate
to the adequacy of capital, including all risks explicitly captured in minimum
regulatory capital requirements as well as risks that are not fully captured under
minimum regulatory capital requirements.
08. The impact of risk concentrations should be reflected in an institution’s ICAAP.
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09. Wrong Way Risk (WWR) occurs when credit exposure to a counterparty is
negatively correlated with the credit quality of that counterparty. In other words,
the more a party gains on a trade, the more likely it is for the counterparty to
default.
10. Institutions that engage in cross border lending are subject to increased risk
including country risk, concentration risk, foreign currency risk (market risk) as well
as regulatory, legal, compliance and operational risks, all of which should be
reflected in the ICAAP.
11. Stress testing is a risk management technique used to evaluate the potential
effects on an institution’s financial condition, of a set of specified changes in risk
factors, corresponding to exceptional but plausible events
12. In their ICAAPs, institutions should examine future capital resources and capital
requirements under adverse scenarios.
13. An institution must have sufficient capital to meet its target regulatory
requirements (regulatory capital), as well as sufficient capital to support its risk
profile, (i.e., its Inherent Risks and Overall Net Risk (ONR))
14. Risk concentration refers to an exposure with the potential to produce losses
large enough to threaten a financial institution’s health or ability to maintain its
core operations.
15, Concentration risk is a banking term describing the level of risk in a bank's
portfolio arising from concentration to a single counterparty, sector or country.
16. Concentration risk is the risk of over-reliance on, or excessive exposure to, a
type of risk, counterparty, asset class, industry or region as a result of credit, balance
sheet and market, reserving, insurance, reinsurance, operational and group risks.
17. The Internal Capital Adequacy Assessment Process (ICAAP) allows firms to
assess their capital adequacy and requires them to have appropriate risk
management techniques in place. This process is summarised in the ICAAP
document which should be completed by firms on a regular basis.
18. The ICAAP document sets out the framework for the bank’s internal
governance, and the operation of the risk and capital management arrangements.
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19. The ICAAP document has to be produced on a proportionate basis, taking into
account the size, nature and complexity of the bank’s activities.
20. ICAAP document should set out the approach taken by the bank to identifying
material risks, the impact of such risks and the capital required over a three/five
year forward-looking horizon.
21. The ICAAP document is one of the key inputs used by the regulators in the
Capital Supervisory Review and Evaluation Process (C-SREP).
22. The Supervisory Review and Evaluation Process (SREP) is a set of procedures
carried out on an annual basis by the supervisory authorities to ensure each credit
institution has in place the strategies, processes, capital and liquidity that are
appropriate to the risks to which it is or might be exposed to.
23. The SREP assesses the way a bank deals with its risks and the elements that
could adversely affect its capital or liquidity, now or in the future. This process
determines where a bank stands in terms of capital and liquidity requirements, as
well as the adequacy of its internal arrangements and risk controls.
24. The Pillar 2 requirement (P2R) is a bank-specific capital requirement which

applies in addition to the minimum capital requirement (known as Pillar 1) to cover
certain risks.
25. A bank's P2R is determined as part of the Supervisory Review and Evaluation
Process (SREP).
26. Structured products include bonds, equities, and derivatives as the principal
assets.
27. Bonds and equities together generate returns which makes structured
products great investment options.
28. Structured products offer retail investors easy access to derivatives.
29. Structured products are pre-packaged investments that normally include

assets linked to interest plus one or more derivatives.
30. Structured products may take traditional securities such as an investment-

grade bond and replace the usual payment features with non-traditional payoffs.
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31. Structured products can be principal-guaranteed that issue returns on the
maturity date.
32. One of the principal attractions of structured products for retail investors is the
ability to customize a variety of assumptions into one instrument.
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Module – C: Operational Risk
Basel Norms, RBI guidelines, Likely forms of operational risk and causes for a
significant increase in operational risk, Sound Principles of Operational Risk
Management – organizational setup and key responsibilities of ORM, SPOR – policy
requirements and strategic approach for ORM, SPOR identification, measurement,
control/ mitigation of operational risks, SPOR identification, measurement, how to
control/mitigation of operational risks, Capital allocation for operational risk,
methodology, qualifying criteria for banks for the adoption of the methods,
Computation of capital charge for operational risk, etc.
The above is the Syllabus. As many points are already covered in earlier Modules, I
want to cover only those points which are not covered in earlier Modules, to save
time and to avoid duplications. As such I am covering points related to only the
Operational Risk Management.
***
11. Operational Risk Management (ORM)

01. Operational Risk would arise due to deviations from normal & Planned
functioning of systems, procedures, technology and human failures of omissions
and commissions.
02. Operational Risk may also arise due to inherent defaults in systems, procedures
and technology which also impacts revenues of an organization adversely.
03. Operational Risk is the risk of loss resulting from inadequate or failed internal
processes people and systems or from external events.
04. Classification of Operational Risk based on causes are:
a) People oriented causes – Negligence
b) Process oriented causes – Business volume
c) Technology oriented causes – Poor technology
d) External causes – Natural disasters.
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05. Classification of Operational Risk based effects:
A) Legal liability
B) Loss of damage
C) Regulator, compliance and taxation penalties
D) Restitution
E) Loss of resources
F) Write downs.
06. Role of Board: The Board of Directors takes overall responsibility to manage and
implement the Operational Risk framework. BOD should approve bank’s
Operational Risk Management framework and review it periodically.
07. Role of Operational Risk Management Committee: The ORM committee should
identify the Operational Risk to which the banks is exposed, to formulate policies
and procedures for ORM set clear guidelines on Risk Management
/Management and ensure adequacy of risk mitigating controls.
08. Role of Operational Risk Management Department: The ORMD is the nodal
department for identifying, managing and quantifying Operational Risk. ORMD in
conjunction with groups lays down procedures for management of Operational
Risk.
09. The monitoring and control practices encompasses:
a) Collection of Operational Risk data
b) Regular monitoring and feed back mechanism
3) Collection of incidental reporting data to asses frequency and profitability of

occurrences or Operational Risk events
c) Monitoring and control of management of large exposures.
10. The options of measurement of Operational Risk as per Basel – II are The Basic
Indicator Approach (BIA); Standardized Approach (SA); Advanced Management
Approach (AMA)
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11. Operational risk management (ORM) is a set of processes that encompass risk
assessment, decision making, and implementation of risk control, to reduce such
threats to acceptable levels.
12. Operational Risk Management (ORM) is a process designed to detect, assess

and control risk, and at the same time, enhance mission performance.
13. There are five categories of operational risk: people risk, process risk, systems
risk, external events risk, and legal and compliance risk.
14. Three pillars of operational risk management: capital allocation, transfer of

operational risk through insurance, and proactive mitigation of operational risk
through product inspection and quality control. Thorough operational risk
management will generally involve all three pillars.
15. Operational risk management (ORM) is defined as a continual recurring process

that includes risk assessment, risk decision making, and the implementation of risk
controls, resulting in the acceptance, mitigation, or avoidance of risk.
16. ORM is the oversight of operational risk, including the risk of loss resulting from
inadequate or failed internal processes and systems; human factors; or external
events.
17. Unlike other type of risks (market risk, credit risk, etc.) operational risk had rarely
been considered strategically significant by senior management.
18. The principles of ORM –
Accept risk when benefits outweigh the cost
Accept no unnecessary risk
Anticipate and manage risk by planning
Make risk decisions in the right time at the right level
19. Operational risk management (ORM) is the effective identification,

measurement, and monitoring of operational risks.
20. ORM is the most comprehensive form of risk management and involves an
assessment of all risks faced by an organization.
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21. The main objective of ORM is to protect existing businesses and ensure value
creation while realizing opportunities created by business activities.
22. Operational risks may vary in their consequences, but they are all related to
the way an organization conducts its business activities. Everything ranging from
natural calamities to employee attrition is a risk to business operations.
23. ORM leverages a set of processes for identifying and mitigating risks related
to an organization’s business operations.
24. ORM is focused on the operational element of independent, non-operational

risks identified by regulators as having a significant financial impact on an
organization's ability to manage its business effectively if not managed properly.
25. The primary objective of ORM is to protect value creation and

shareholder/stakeholder confidence by managing operational risks arising from
business activities while seizing opportunities that they create.
26. ORM is critical to maintaining smooth operations within the organization and
preventing any detriment, reduction in efficiency, reduction in productivity, or halt
in consistent business activity.
27. People risk is the risk associated with the human resource employed at an
organization and originates out of any actions or omissions committed by the
workforce. The acts or omissions can be an individual or a collective effort.
28. People risk seeks to understand the effects of the decisions taken by
employees within the organization and their impact on the operations.
29. Process risk is the risk associated with several processes deployed by the
organization. The risk originates from inefficiencies within the process that have the
potential to cause detriment to operations and revenues of the organization.
30. Process risk involves understanding the changes in processes, changes in the
market concerning the processes, and changes in organizational culture with
respect to the processes that can cause damage.
31. Systems Risk is the risk associated with organizational systems that has the
potential to create damage, extend unauthorized access, or delete critical business
data.
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32. External Events Risk encompasses all risks that originate and exist outside of the
organization, but can have a direct or indirect impact on its operations.
33. External events may originate from third parties, customers, competitors, and
partnerships – bringing the risks associated with each of these entities to the
organization’s operations.
34. Legal and Compliance Risks are risks associated with regulatory authorities,
jurisdictions, and geopolitics of a particular market. These risks differ depending on
the operating region and affect the organization differently in different areas. The
risks typically involve the risk of changing regulations, policies, and new tax regimes.
35. A Risk Appetite Statement documents an organization's risk appetite, clearly

defining what the organization considers as threats and what the likely responses
will be.
36. ORM Challenges -- the most prominent challenges to ORM are
a) Failure to Detect New Risks
b) Lack of a Common Understanding of Operational Risk
c) Lack of Resources
d) Difficulty in Representing the Impact in Monetary or Business Terms
e) Data Inconsistency
37. Four Steps for Effective Operational Risk Management
a) Risk Identification
b) Risk Assessment
c) Risk Mitigation
d) Risk Reporting
38. Integrating Operational Risk Management with Governance, Risk and

Compliance (GRC) frameworks provide a structured approach to managing risks
and ensuring compliance with relevant regulations and standards.
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Principles for the Principles of Sound Management of Operational Risk
In the Syllabus it is mentioned as SPOR - Sound Principles of Risk Management.

However, I am of the opinion it is Principles of Sound Management of Operational
Risk (PSMOR)
39. Sound operational risk management reflects the effectiveness of the board and
senior management in the administration of portfolio products, activities,
processes, and systems.
40. Firms often employ 3 lines of defense to be able to control operational risks:
Business Line Management
Independent Corporate Operational Risk Management Function
Independent Review/Audit
41. Business Line Management - In modern banking, banks have established

several business lines that work with some level of independence, but they all work
towards the attainment of a set of institution-wide goals. Each business line is faced
with its own set of operational risks and is responsible and accountable for
assessing, controlling, and mitigating these risks.
42. An Independent Corporate Operational Risk Management Function - This is a

functionally independent corporate operational risk function (CORF) involved in
policy setting and provides assurance over first-line activities.
43. The CORF generally complements the operational risk management activities
of individual business lines.
44. The third line of defense consists of the bank’s audit function, which performs
independent oversight of the first two lines. Everyone involved in the auditing
process must not be a participant in the process under review.
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45. The Fundamental Principles of Operational Risk Management as
Suggested by the Basel Committee
The Basel Committee has suggested 11 fundamental principles that should form
the bedrock of operational risk management across banks:
Principle 1 – The bank should maintain a strong risk management culture

spearheaded by the bank’s board of directors and senior managers. The bank
should strive to propagate a culture of operational risk resilience where every
individual understands the need to manage risk.
Principle 2 – The operational risk framework must be developed and fully integrated
into the overall risk management processes of the bank.
Principle 3 – The board of directors has the mandate to establish, approve, and
periodically review the operational risk management framework. The board should
oversee senior management to ensure that the policies, processes, and systems are
implemented effectively at all decision levels
Principle 4 – The board must identify the types and levels of operational risks the
bank is willing to assume as well as approve risk appetite and risk tolerance
statements. These statements should be worded in a clear manner to ensure fast
and efficient implementation
Principle 5 – Consistent with the bank’s risk appetite and risk tolerance, senior
management must develop a well-defined governance structure within the bank.
The governance structure is subject to approval by the board of directors.
Principle 6 – Senior management must understand the risks inherent in the bank’s
business lines and processes. They must also understand the incentives associated
with those risks so as to be able to put in place effective counter measures
comparative analysis
Principle 7 – New lines of business, products, processes, and systems should require
an approval process that assesses the potential operational risks
Principle 8 – A process for monitoring operational risks and material exposures to

losses should be put in place by senior management with support from the board
of directors and business line employees
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Principle 9 – The bank must come up with strong internal controls, risk mitigation,
and risk transfer strategies in place to manage operational risks.
Principle 10 – The bank must have plans that guarantee survival and continuity in
the event of a major business disruption. All business operations must be resilient.
Principle 11 – The bank should make disclosures that are clear enough to ensure
that all stakeholders can conduct their own assessment of the bank’s approach to
operational risk management.
46. There are five Key Components Of Internal Control:
Control Environment: This refers to a set of standards, structures, and processes

that provide the bedrock for performing internal control within the entity.
Risk Assessment: Risk assessment is a process used to identify, assess, andmanage

risks the bank is faced with as it works toward the achievement of its objectives.
Control Activities: These are actions taken to mitigate the risks to the achievement
of the entity’s objectives. These actions are subject to management approval. The
approval process looks at the bank’s policies and procedures.
Information and communication: Information and communication is the

distribution of information needed to perform control activities and to understand
internal control responsibilities to personnel internal and external to the entity.
Monitoring: Monitoring has much to do with continuous evaluations of the

implementation and operation of operational risk policies.
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Module – D: Market risk
Definitions of different terms & the Prescriptions of Basel Norms, Liquidity &
Interest rate risk, Foreign Exchange & Price risk (Equity), Commodity risk, how to
treat market risk under Basel Standardized duration method & Internal
measurement approach – VaR, etc.
Market Risk Management.
Chapter 12. Market Risk

01. Market risk is the risk of adverse deviations of the mark-to-market value of the
trading portfolio, due to market movements, during the period of holding.
02. Market Risk results from adverse movements of the market prices of interest
rate instruments, equities, commodities and currencies. Market Risk is also referred
as Price Risk.
03. Price risk occurs when assets are sold before their stated maturities.
04. In the financial market, bond prices and yields are inversely related. The price
risk is closely associated with the trading book, which is created for making profit
out of short-term movements in interest rates.
05. Market liquidity risk arises when a bank is unable to conclude a large
transaction in a particular instrument near the current market price.
06. Forex risk, also termed as Exchange Risk, is the risk that a bank may suffer losses
as a result of adverse exchange rate movements during a period in which it has an
open position, either spot or forward, or a combination of the two, in an individual
foreign currency.
07. Since our (Indian) inflation rate is always more than US, our rupee is subjected
to depreciation on long term basis in the $/rupee parity.
08. Interest Rate Risk (IRR) is the exposure of a Bank’s revenue to adverse
movements in interest rates.
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09. Interest Rate Risk (IRR) refers to potential adverse impact on Net Interest
Income or Net Interest Margin or Market Value of Equity (MVE), caused by changes
in market interest rates.
10. Interest Rate Risk is the risk of changes in the financial value of assets or
liabilities (or inflows/outflows) because of fluctuations in interest rates.
11. Commodity risk is the threat of price fluctuations of a raw material. For
commodity producers, a decrease in raw material prices is going to hurt, because
they're going to receive less money for the raw material that they're providing.
12. Value at Risk (VaR) has been called the "new science of risk management," and
is a statistic that is used to predict the greatest possible losses over a specific time
frame.
13. Commonly used by financial firms and commercial banks in investment

analysis, VaR can determine the extent and probabilities of potential losses in
portfolios.
14. Risk managers use VaR to measure and control the level of risk exposure.
15. The calculation of market risk capital charge using the standardised method
consists of determining a capital charge per risk class using the Sensitivities Based
Approach (SBA) and aggregating them to determine the overall capital charge for
market risk.
16. The most common types of market risk include Interest Rate Risk, Equity Risk,
Commodity Risk and Currency Risk.
17. The Banking Book includes all advances, deposits and borrowings, whichusually
arise from commercial and retail banking operations.
18. The banking book is mainly exposed to liquidity risk, interest rate risk, default
or credit risk and operational risks.
19. The Trading Book includes all the assets that are marketable, i.e., they can be
traded in the market.
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20. Currency risk refers to the uncertainty and change in wealth (losses or profits)
that can come from fluctuations in the value of various foreign currencies. For
investors, currency risk commonly arises from the ownership of foreign stocks in
one's portfolio.
21. Total Risk = Market Risk + Diversifiable Risk.
22. Market risk, or systematic risk, affects the performance of the entire market
simultaneously.
23. Market risk cannot be eliminated through diversification.
24. Specific risk, or unsystematic risk, involves the performance of a particular

security and can be mitigated through diversification.
25. Market risk may arise due to changes to interest rates, exchange rates,
geopolitical events, or recessions.
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Module – E: Risk Organization and Policy
Risk Organization and Policies including Risk Management Policy, Credit,

Interlinkages to – Treasury, ALCO, etc.
Market Risk Management.
Chapter 13 – Interlinkages of Risks

01. Liquidity risk has been a major factor in many crises impacting both credit risk
and market risk.
02. Funding liquidity risk arises from the liability side, for both on-balance sheet
and off-balance sheet items.
03. Liabilities can be classified as core or volatile, where each term refers to the
predictability of cash flows.
04. Generally, banks often face or take distinct risks, such as credit and/or liquidity
risks. Despite that each of these risks may exist independently, they are often
dependent and reciprocal in reality.
05. Liquidity is considered as a fundamental part of banking operations andcredits

are one of the main assets generating profit for the bank. According to themodern
theory of financial intermediation, banks exist because they ensure two crucial roles.
First, they are considered as liquidity provider and second theytransform risk.
06. Liquidity and credit risks are closely linked as Banks act as Financial
Intermediation.
The Reciprocal Relationship Between Credit and Liquidity Risks
07. Credit risk is related to liquidity risk through borrower defaults and fund
withdrawals. Banks’ mix of illiquid (long maturity) assets and liquid (short-term)
liabilities may lead to panic among depositors which may be displayed through
borrower defaults and fund withdrawals. Banks’ asset and liability structures are
closely connected, especially in terms of borrower defaults and deposit outflows.
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08. There is a positive relationship between liquidity risk and credit risk.
09. Increase in credit risk (bad loan), the loan (asset) portfolio of such a bank is
negatively affected causing an increase in bank illiquidity.
10. Liquidity risk and credit risk jointly contribute to bank default risk.
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Chapter 14. Risk Related Terms
Artificial Intelligence Risk
AI Risk is the possibility that something that uses AI will be programmed to do

something devastating.
Audit Risk
Audit risk is defined as 'the risk that the auditor expresses an inappropriate audit
opinion when the financial statements are materially misstated. Audit risk is a
function of the risks of material misstatement and detection risk'.
Brand Risk
Brand risk refers to the potential harm that a company's reputation and financial
performance may face as a result of negative public opinion, regulatory actions, or
other external factors.
Business Continuity Risk
Business continuity risk refers to threats or risks that disrupt the functioning of a
business. These threats maybe any untoward incidents or disasters that negatively
impact an organization.
Business Risk
Business risk refers to anything that could impact your company's finances. In many
cases, these financial risks could destroy your company. While there are many
factors that can create a business risk, some include: Fire damage. Flooding.
Commodity Price Risk
Commodity price risk is the financial risk on an entity's financial performance/

profitability upon fluctuations in the prices of commodities that are out of the
control of the entity since they are primarily driven by external market forces.
Competitive Risk
Competitive risk is the potential for a business's competitors to prevent its growth
and success. Since many companies compete for the same target customers and
distributors, they may take measures that prevent similar enterprises from entering
new markets and reaching customers.
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Compliance Risk
Compliance risk is the threat posed to a company's financial, organizational, or

reputational standing resulting from violations of laws, regulations, codes of
conduct, or organizational standards of practice.
Conduct Risk
Conduct risk is the risk to customers that arises from Banks/ intermediaries
conducting their business in a way that does not ensure fair treatment of customers.
Conduct Risk is now also recognized as a major risk that arises due to people or
Personnel risk.
Country Risk
Country risk refers to the economic, social, and political conditions and events in a
foreign country that may adversely affect a financial institution's operations.
Credit Risk
Credit risk is the probability of a financial loss resulting from a borrower's failure
to repay a loan. Essentially, credit risk 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.
Cyber Security Risk
Cyber security risks relate to the loss of confidentiality, integrity, or availability of

information, data, or information (or control) systems and reflect the potential
adverse impacts to organizational operations (i.e., mission, functions, image, or
reputation) and assets, individuals, other organizations, and the Nation.
Data Risk
Data risk is the potential for business loss due to: Poor data governance: The
inability for an organisation to ensure their data is high quality throughout the
lifecycle of the data. Data mismanagement: Weak processes for acquiring,
validating, storing, protecting, and processing data for its users.
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Default Risk
Default risk is the risk a lender takes that a borrower will not make the required
payments on a debt obligation, such as a loan, a bond, or a credit card. Lenders and
investors are exposed to default risk in virtually all forms of credit offerings.
Exposure Risk
Risk exposure refers to the extent to which an organization or individual is

vulnerable to the potential negative impacts of risks. It represents the level of risk
they are exposed to based on their activities, assets, and operations.
Economic Risk
Economic risk refers to the potential for adverse changes in economic conditions
that can negatively impact businesses, industries, and economies.
Environment Risk
Environmental Risk a risk that can have a material environmental or

environmentally-driven impact on the business associated with the current or
planned use of commercial real estate.
Expropriation Risk
Expropriation is the risk that a government forcibly takes over the ownership of
privately owned property without proper compensation.
External Risk
Risks outside the project control or global risks inherent in any project are called
External Risks.
Financial Risk
Financial risk is the possibility of losing money on an investment or business

venture.
Foreign Exchange Risk
Foreign exchange risk refers to the losses that an international financial transaction
may incur due to currency fluctuations.
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Fraud Risk
Fraud risk is the chance that an internal or external person will commit actions that
will result in the financial, material, or reputational loss of your organization.
Fraud Triangle
Fraud Triangle is one where an employee, often under financial pressure and
using their knowledge of the organization's control systems, has sufficient incentive
and opportunity to redirect funds for their own use. The employee would then
rationalise the action to themselves as e.g, " I am due the money because the firm
does not appreciate all the hard work I have put in”.
Governance Risk
Governance risk includes the risks related to an organization’s ethical and legal
management, the transparency and accuracy of company performance, and
involvement in other ESG initiatives important to stakeholders.
Hazard
A hazard is a source or a situation with the potential for harm in terms of human
injury or ill-health, damage to property, damage to the environment, or a
combination of these.
Human Resource Risk
HR risk management focuses on analyzing the risks that employees of an

organization pose to the business. HR risk management addresses risks related to
inadequate employee management, employees' behavior, or risks related to the
certain ways that human resources use to hire and sack employees.
Industry Risk
Industry risk refers to factors that can positively or negatively impact a specific
industry and, by association, the companies in it. Most significantly, your industry's
risk factors can affect your business's growth, profitability, and volatility.
Information Risk
Information risk is a calculation based on the likelihood that an unauthorized user

will negatively impact the confidentiality, integrity, and availability of data that you
collect, transmit, or store.
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Inherent Risk
Inherent risk is the risk present in any scenario where no attempts at mitigation
have been made and no controls or other measures have been applied to reduce
the risk from initial levels to levels more acceptable to the organization.
Interest Rate Risk
Interest rate risk is the potential for investment losses that can be triggered by a
move upward in the prevailing rates for new debt instruments.
Jurisdiction Risk
Jurisdiction risk is any additional risk that arises from borrowing and lending or
doing business in a foreign country. This risk can also refer to times when laws
unexpectedly change in an area in which an investor has exposure. This type of
jurisdiction risk can often lead to added price volatility.
Legal Risk
Legal risk is when a business fails to comply with regulations or contractual terms.
It is caused by internal errors, flawed processes, and deliberate infractions.
Liquidity Risk
Liquidity risk is the risk of loss resulting from the inability to meet payment
obligations in full and on time when they become due. Liquidity risk is inherent to
the Bank's business and results from the mismatch in maturities between assets and
liabilities.
Loss Given Default (LGD)
Loss Given Default (LGD) captures the uncertainty about the actual loss that will
be realized given a Credit Event. It is calculated as the ratio of the loss on an
exposure due to the default of a counterparty to the amount outstanding at default.
LGD is complementary to Recovery Risk, the possibility that in case of default the
recovered amount may be less than expected.
Management Risk
Management risk is the risk—financial, ethical, or otherwise—associated with

ineffective, destructive, or underperforming management. Management risk can
also refer to the risks associated with the management of an investment fund.
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Market Risk
Market risk is the chance of incurring losses due to factors that affect the overall
performance of financial markets, such as changes in interest rates, geopolitical
events, or recessions. It is referred to as systematic risk since it cannot be eliminated
through diversification.
Natural Hazardous Risk
Natural Disaster (Hazardous) risk is expressed as the likelihood of loss of life, injury
or destruction and damage from a disaster in a given period of time. Disaster risk
is widely recognized as the consequence of the interaction between a hazard and
the characteristics that make people and places vulnerable and exposed.
Operational Risk
Operational risk is the risk of loss as a result of ineffective or failed internal

processes, people, systems, or external events which can disrupt the flow ofbusiness
operations. These operational losses can be directly or indirectly financial.
Payment Risk
Payment risk refers to the potential of losses due to a contract default or other
payment event such as fraud, security breaches or chargebacks. Companies
regularly handling a high volume of online payments are subject to such risks.
People Risk
People Risk' in the context of Operational Risk is referenced by the Basel Committee
as one of the key Operational Risk category of events being 'the riskof loss
resulting from inadequate or failed internal processes, people and systems or from
external events'.
Political Risk
Political risk is the risk an investment's returns could suffer as a result of political
changes or instability in a country.
Price Risk
Price risk is the risk that the value of a security or investment will decrease.
Page 117 of 125

Probability of Default (PD)
The probability of default (PD) is the probability of a borrower or debtor defaulting

on loan repayments. Within financial markets, an asset’s probability of default is the
probability that the asset yields no return to its holder over its lifetime and the asset
price goes to zero. Investors use the probability of defaultto calculate the expected
loss from an investment.
Process Risk
Process risk is a loss in revenue as a result of ineffective and/or inefficient processes.

Ineffective processes hamper the achievement of the organization's objectives,
whereas the processes that are inefficient, may be successful in achieving objectives,
yet fail to consider high costs incurred.
Product Risk
Product development risk refers to all the uncertainties and risks that can cause a
product development effort to be unsuccessful.
Project Risk
Project risk refers to uncertainties and risks encountered in the execution of a

specific project.
Recovery Risk
Recovery Risk denotes the risk that following a Default Event, contracts of the
defaulting entity cannot be honoured in full, thereby leading to financial loss to the
lender or other counterparty. Recovery risk is the complement of LGD Risk.
Refinancing Risk
Refinancing risk refers to the possibility that an individual or company won't be able
to replace a debt obligation with suitable new debt at a critical point. Factors that
are beyond the borrower's control—such as rising interest rates or a shrinking
credit market—often play a role in their ability to refinance.
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Residual Risk
Residual risk is the risk that remains after your organization has implemented all
the security controls, policies, and procedures you believe are appropriate to take.
Residual risk is risk that can affect your business even after taking all appropriate
security measures.
Regulatory Risk
Regulatory risk is the risk that a change in laws and regulations will materially
impact a security, business, sector, or market.
Reputation Risk
Reputational risk is the damage that can occur to a business when it fails to meet
the expectations of its stakeholders and is thus negatively perceived. It can affect
any business, regardless of size or industry.
Risk
A risk is the chance of something happening that will have a negative effect.
Social Risk
Social risk is the exposure to adverse consequences stemming from population-

based activities and negative public perception. In other words, social risk is a
manifestation of what goes on around us and is driven by influences inside every
one of us—beliefs, emotions, mental health, fears and anxieties.
Strategic Risk
Strategic risk refers to the internal and external events that may make it difficult,
or even impossible, for an organisation to achieve their objectives and strategic
goals. These risks can have severe consequences that impact organisations in the
long term.
Systemic Risk
Systemic risk is the possibility that an event at the company level could trigger
severe instability or collapse an entire industry or economy.
Systematic Risk
Systematic risk refers to the risk inherent to the entire market.

Page 119 of 125
Systemic Risk vs. Systematic Risk
Systemic risk means the risk of sink whole financial system due to weakness of a
single unit of the system.
Systematic Risk is the risk of whole market due to weakness of market structure.
Technological Risk
Technology risk is the potential for any technology failure to disrupt a business.
Volatility Risk
Volatility often refers to the amount of uncertainty or risk related to the size of
changes in a security's value. A higher volatility means that a security's value can
potentially be spread out over a larger range of values.
Voluntary Prepayment Risk
Voluntary Prepayment Risk (some loans carry prohibitions or penalties covering

voluntary prepayment) is the risk that the borrower will repay ahead of schedule,
forcing the lender to take Reinvestment Risk (the risk of earning less on reinvested
funds)
-x-x-x-x-x-x-x-x—x-x-x-x-x-x-x-x-x-

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RISK MANAGEMENT OPTIONAL CAIIB

Risk Management subject has a total of 5 modules:

Module – A: Risk Management

An Overview of Risk Management:

Asset Liability Management (ALM):

Concepts of ALM such as Asset Liability Management Organization, Asset-Liability

Risk measurement & Control:

Calculation of Risk, Analysis of Risk Exposure, Risk management or mitigation

Risk Management Concepts:

Module – C: Operational Risk

Module – D: Market risk

Module – E: Risk Organization and Policy

Risk Organization and Policies including Risk Management Policy, Credit,

01 An Overview of Risk Management: Terms & policies in relation

02 Asset Liability Management (ALM) : Concepts of ALM such as

03 Risk measurement & Control: Calculation of Risk, Analysis of Risk

04 Risk Management Concepts: Norms such as Capital adequacy,

The following topics are covered in this Chapter:

03. Risks may be considered to be related to an opportunity or a loss or the

07. Organizations deliberately take risks, especially marketplace or commercial

09. The focus of opportunity risks will be towards investments.

16. Risks are uncertainties resulting in adverse outcome, adverse in relation to

17. 'Financial Risks' are uncertainties resulting in adverse variation of profitability

20. Higher risk implies higher upside and downside potential.

23. Zero Risk would imply no variation in net cash flow.

24. Return on zero risk investment would be low as compared to other

25. Risk management is a process through which an organisation identifies,

30. Uncertainty is imprecise (vague/unclear) knowledge about future events. On

32. Uncertainty is mother of risk.

44. The key driver in managing a business is seeking enhancement in Risk-

48. ALCO- Asset-Liability Committee

49. CRMC - Credit Risk Management Committee

50. ORMC - Operational Risk Management Committee

51. Aggregated risk determines capital needs.

53. Risk management relies on the quantitative measures of risk. T

55. Quantitative measures of risks can be classified into three categories.

63. Pricing is transaction-based.

70. Enterprise-Wide Risk Management (EWRM) is a continuous and structured

71. Enterprise-Wide Risk Management (EWRM) encompasses the entire gamut of

72. Enterprise-Wide Risk Management (EWRM) is a dynamic process involving

88. Embedded options expose investors to reinvestment risk as well as the

89. Reinvestment risk manifests if an investor or issuer exercises the embedded

91. Risk is a quantifiable uncertainty.

93. Market Risk is also referred as Price Risk.

101. Credit Risk is also known as Default Risk.

103. The counter-party risk is generally viewed as a transient financial risk

104. Country Risk is a type of credit risk where non-performance by a borrower or

113. Strategic Risk is a function of the compatibility of an organization’s strategic

115. Reputational Risk is normally treated as an indirect risk.

127. BCBS - Basel Committee on Banking Supervision.

132. The Risk adjusted return is key factor in investment decision.

133. Mismatch in maturities of assets and liabilities is known as Liquidity Risk.

135. Banking book is not exposed to Market Risk.

141. Call Risk arises due to crystallization of contingent liabilities.

145. Prepayment of loans, premature withdrawals of term deposits exercise of call

146. Embedded Option Risk is experienced in volatility situations.

155. Aggregated Risk of the organization as a whole is called Portfolio Risk.

156. All the risks are concentrated at transaction level.

160. Reduction in PLR leads to Basis Risk.