Financial Risk Management

Introduction: Due to liberalization and globalization the economic climate and markets can be affected very quickly by change in exchange rates, interest rates, and commodity prices. Counter parties can rapidly become problematic. As a result, it is important to ensure financial risks are identified and managed appropriately preparation is a key component of risk management. What is Risk? Risk provides the basis for opportunity. The terms risk and uncertainity/exposure have subtle differences in their meaning. Risk refer to the probability of loss, while exposure is the probability of loss, although they are often used interchangeably. Risk arises as a result of exposure. Exposure to financial market affects most organisations, either directly or indirectly. When an organization has financial market exposure, there is a possibility of loss bit also an opportunity for gain or profit. Risk is likelihood of losses resulting from events such as changes in market prices. Events with a low probability of occuring but that may result in high loss, are particularly troublesome because they are after not anticipated. Since it is not always possible ar desirable to eliminate risk, understanding it is an important step in determining how too manage it. How does financial Risk Arise? The three main sources of financial risk: 1. Financial risks arising from an organization s exposure to changes in market prices. Such as interest rates, exchange rates and commodity prices. 2. Financial risks arising from the actions of, and transactions with, other organizations such as vendors, customers, and counterparties in derivatives transactions. 3. Financial risks resulting from internal actions or failure of the organization particularly peopple, processes, and systems. What is Financial Risk Management?

Financial risk management is a process to deal with the uncertainties resulting from financial markets. It involves assessing the financial risks facing an organization and developing management strategies consistent with internal priorities and policies. Organizations manage financial risk using a variety of strategies and using a variety of strategies and products. It is important to understand how these products and strategies work to reduce risk within that context of the organization s risk tolerance and objectives. Strategies for risk management often involve derivatives. The process of financial risk management is an ongoing one strategies need to be implemented and refined as the market and requirements change. Refinements may reflects changing expectations about market rates, changes to the business environment, or changing international political conditions. In general the process can be summarized as follows: 1. 2. 3. 4. Identify and prioritize key financial risks. Determine an appropriate level of risk tolerancs. Implement risk management strategy in accordance with policy. Measure, report, monitor and rrefine as needed.

Type of Financial Risk: 1. Credit Risk: credit risk, also called default risk, is the risk associated with a borrower going into default (not making payments as promised). Investor losses include lost principal and interest, decreased cash flow, and increased collection costs. Credit risk orginates from the point where FI has completed its transaction and the obligation of counterparty starts. All types of banks and Fis face credit risk. Those banks which are exposed to longer term investment or loans are more exposed to this risk in comparision to the banks having shorter term assets. Credit risk could occur in case of loans, bonds, debentures, commercial papers, intercorporate deposites, debentures and debts of similar nature. To minimize the chances of default, Fis need to monitor and collect information about borrowers on a continued basis. Credit risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers ar counterparties. In a bank s portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financialtransactions. Alternatively losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality. Credit risk emanates from a bank s dealing with an individual, corporate, bank, financial institution or a sovereign.

2. Market Risk: Market risk is the risk to which banks/FIs are exposed while trading in financial assets and liabilities due to the movement in interest rates, exchange rates, security prices and market parameters which eventually lead to the changes in the prices of assets and liabilities. Market risk is the risk of losses due to the adverse movements in financial market variables. Market risk is the risk of fluctuations in portfolio value because of adverse moovement in such market variables. Definition: The risk that the value of on or off balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices . By Bank for International settlements (BIS) Price rice may be seen as an unfavourable movement in the price of a commodity, security or other obligations and result in the overall market risk. A very large exposure in one kind of security or in one kind of security or in a single market exposes the FIs to concentration risk. This also arises due to non-diversified portfolio of product or business line. Another type of risk which also is associated with market risk, is volatility risk. This risk results not from changes in levels of prices but their volatility. Volatility is measured in ters of degree of unpredictable changes in a financial variable over a period of time. 3. Interest Rate Risk: The assets and liabilities of banks and financial institution have different maturity and liquidity. This means that they create loan assets aand investments and at the same time create deposite or other borrowing liabilities. The investment and loan assets invested in by the bank earn at the same time, interest cost has to be paid to the lenders of deposit and other borrowings. The mismatches of the maturities of assets and liabilities expose the Fis to interest rate risk. The rate of interest on assets and liabilities are different and is higher on the assets. this difference is the net interest margin and changes several times in a year. It may happen that the assets in which the firm has invested its money could be of a relatively longer term when compared to the time to maturity of the liabilities. In such a situation, if the mivement of interest rate is upward, this will increase the cost of liability at the time of rollover and the same time net interest margin will also come down. On the other and, if the liabilities have a long term maturity and funds are deployed for shorter duration at higher rate and there is down trend of interest rate which may result ina decline. 4. Foreign Exchange Risk: The risk that exchange rate changes can effect the value of the assets and liabilities of an FI located abroad. It is the change in the domestic currency

value of assets and liabilities to the changes in the exchange rates. This may be positive or negative. 1. The risk of an investment's value changing due to changes in currency exchange rates. 2. The risk that an investor will have to close out a long or short position in a foreign currency at a loss due to an adverse movement in exchange rates. Also known as "currency risk" or "exchange-rate risk". This risk usually affects businesses that export and/or import, but it can also affect investors making international investments. For example, if money must be converted to another currency to make a certain investment, then any changes in the currency exchange rate will cause that investment's value to either decrease or increase when the investment is sold and converted back into the original currency. In global market, currencies are like other commodities. It follows simple demandsupply theory, as due to the increase in the demand for a currency, the exchange rate tends to go up. On the other hand, if there is an excess supply in the globle financial market or demand for the particular currency is low, the exchange rate would tend to move down. The increase in demand due to capital flows arises when investors or lenders seek assets or funds denominated in that currency. The exchange rate fluctuations are not perfectly correlated across countries. This means the dollar-euro exchange rate may be appreciating and at the same time dollar-rupee exchange rate may be depreciating. Example: How Forerign exchange Risk ArisesA US FI gives a loan to an Indian company in rupee. If the INR depreciates in value relative to USD, the principal and interest payments to US FI would be devalues in dollar terms. If INR depreciates to such an extent that where over the investment period the overall return turn out to be negative, the US FI will get even lesser principal at the time maturity from the actual lent amount. The situatioon will get reverse if Indian company takes USD loan. In this case, Indian company will be ending up paying more interest and principal repayment in INR terms. In banks, foreign exchange risk can arise for a variety of reasons. Assets in the form of foreigh currency loans given to customers as well as investments denominates in foreign currency and give rise to this risk. Similarly, a bank s borrowing activities from the overseas market could als expose the bank to the foreign exchange risk. 5. Liquidity Risk: The risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss.

Types of Liquidity Risk Asset liquidity - An asset cannot be sold due to lack of liquidity in the market - essentially a sub-set of market risk. This can be accounted for by:
  

Widening bid/offer spread Making explicit liquidity reserves Lengthening holding period for VaR calculations

Funding liquidity - Risk that liabilities:

  

Cannot be met when they fall due Can only be met at an uneconomic price

Can be name-specific or systemic Causes of liquidity risk

Liquidity risk arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade. Manifestation of liquidity risk is very different from a drop of price to zero. In case of a drop of an asset's price to zero, the market is saying that the asset is worthless. However, if oneparty cannot find another party interested in trading the asset, this can potentially be only a problem of the market participants with finding each other. This is why liquidity risk is usually found to be higher in emerging markets or low-volume markets. Liquidity risk is financial risk due to uncertain liquidity. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity. Liquidity risk tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty that owes it a payment defaults, the firm will have to raise cash from other sources to make its payment. Should it be unable to do so, it too will default. Here, liquidity risk is compounding credit risk.

A position can be hedged against market risk but still entail liquidity risk. This is true in the above credit risk example the two payments are offsetting, so they entail credit risk but not market risk. Another example is the 1993 Metallgesellschaft debacle. Futures contracts were used to hedge an Over-the-counter finance OTC obligation. It is debatable whether the hedge was effective from a market risk standpoint, but it was the liquidity crisis caused by staggering margin calls on the futures that forced Metallgesellschaft to unwind the positions. Accordingly, liquidity risk has to be managed in addition to market, credit and other risks. Because of its tendency to compound other risks, it is difficult or impossible to isolate liquidity risk. In all but the most simple of circumstances, comprehensive metrics of liquidity risk do not exist. Certain techniques of asset-liability management can be applied to assessing liquidity risk. A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis. Any day that has a sizeable negative net cash flow is of concern. Such an analysis can be supplemented with stress testing. Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults. Analyses such as these cannot easily take into account contingent cash flows, such as cash flows from derivatives or mortgage-backed securities. If an organization's cash flows are largely contingent, liquidity risk may be assessed using some form of scenario analysis. A general approach using scenario analysis might entail the following high-level steps:


Construct multiple scenarios for market movements and defaults over a given period of time


Assess day-to-day cash flows under each scenario.

Because balance sheets differ so significantly from one organization to the next, there is little standardization in how such analyses are implemented. Regulators are primarily concerned about systemic and implications of liquidity risk. Example: How Liquidity Risk arisesWhen liability holders of any FI immediately demands money, FI has to meet its obligation either by selling of assets or additional borrowing from the market. Thought, the daily movement of cash outflow is predictable from the past behaviour of withdrawals of fi but sudden demand due to some external factors beyond the FI s control may land the FI in liquidity crisis. Maintaining a high cash balance is not a profitable option to meet sudden demand of cash as cash does not earn any interest on it. When a liquidity crisis is being faced in the overall economy, FI either sell its assets at a

discounted price or raise money from market at higher rates to meet its sudden obligation. This in turn reduces Fis profitability and if the situation persists for a longer duration, Fis may be exposed to solvency risk. 6. Operational Risk: A form of risk that summarizes the risks a company or firm undertakes when it attempts to operate within a given field or industry. Operational risk is the risk that is not inherent in financial, systematic or market-wide risk. It is the risk remaining after determining financing and systematic risk, and includes risks resulting from breakdowns in internal procedures, people and systems. Operational risk can be summarized as human risk; it is the risk of business operations failing due to human error. Operational risk will change from industry to industry, and is an important consideration to make when looking at potential investment decisions. Industries with lower human interaction are likely to have lower operational risk. Banks and financial institutions have high magnitude of transactions and identification of operational risk in advance and control processes to mitigate these risks are very critical. Operational risk arises due to inappropriate systems (losses due to inadequate or wrong systems and procedures), settlements (consequences of failed settlements), model risk (losses due to error in model), fraud risk (damage due to internal/external frauds), errors and omissions, legal risk (inappropriate documentation), regulatory risk (non-compliance with regulations.) etc. The following list details some event types with some examples for each category: y Internal fraud misappropriation of asstes, tax evasion, intentional mismarking of positions, bribery, theft and embezzlement, payments without appropriate consideration, falsification of vouchers/records, misuse of vital stationery to create unauthorized documents, employee collusion and fraud. y External Fraud theft of information, hacking damage, third-party theft and forgery, disbursements against false a securities, unauthorized diversion of credits followed by withdrawals. y Employment Practices and Workplace Safety discrimination, workers compensation, employee health and safety, employment law, industrial action. y Damage to Physical Assets natural disasters, terrorism, vandalism, fire, theft. y Clients, Products, and Business Practice - market manipulation, antitrust, improper trade, product defects, fiduciary breaches, account churning. y Business Disruption & systems Failures utility disruptions, software failures, hardware failures, system capacity, system compatibility, security breach. y Execution, Delivery and process Management data entry errors, accounting errors, failed mandatory reporting, negligent loss of client asstes, reporting error, settlement/payment error, trasaction error, valuation error.

7. Sovereign Risk: When any FI holds assets in foreign countries or have exposure in corrency of a particular country, apart from traditional risk such as foreign exchange risk and foreign interest rate risk, FI is exposed to additional kind of risk called sovereign risk or country risk. Adomestic bank may transform itself into an international one when it starts lending across countries or invests in instruments issued by foreign institutions. When the bank starts doing so, th first risk that it encounters is sovereign risk, risk specific ot that country which is governed by a number of factors such as political, social and economic factors and the legal and regulatory framework. If a domestic company fails or is unwilling to pay the loan, lender usually has recourse the money through various means available. But if a foreign FI is even willing to repay the loan, may not do so due to the restriction imposed by its country, shortage of foreign currency or adverse political reasons. The economic position of a country has a significant role on its ability to service the loans availed by the govt. and its FIs/Banks. The parameters which decide countries position are foreign currency reserves, the current account deficit, the size of external commercial borrowings, FDI, equity exposure of FII in markets etc. The country s govt. And political stability are critical in assessing the country risk. If the govt. is run democratically with full majority, it indicates country s political maturity. If the country is globally accepted for trade and business, it shows that country will o by universally accepted laws. An established legal framework with suitable legislations is critical fo any country s economies forces FIs/Banks to move to emerging market for higher return and diversification. At the same time they are exposed to various kinds of risks of emerging markets such as banking supervision, market regulations legal systems not developed to the international standards, unstable democracies, the policies of the previous govt. be changed completely by the next govt, all resulting in an effect on the business model and assumptions of foreign investors. 8. Insolvency Risk: Insolvency risk is the risk that a FI may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilities. Insolvency is a consequence or outcome of one or more of the risk described as interest rat, market, credit, foreign exchange, liquidity and country risk. Technically, insolvency occurs when the capital or equity resources of an FI s owner are driven to or near to zero due to the losses incurred as the result of one or more of the risk. The recent development in US in 2007 sub prime loans is the example of insolvency risk where large no. Of borrowers of mortgage loans started defaulting repayments. At the same time due to default and recession in the US economy, there were no buyers of securitized assets when FIs wanted to sell to recover losses arising out of heavy provisions. Due to this situation, FI could not meet their obligations and the problem cumulated further when other players in the market refused to lend or roll over the funds to these FIs. To avoid such a

situation, regulators of various countries and Bank for International Settlement (BIS) in BASEL II document empasises on the need of adequate capital to cater to the insolvency risk. 9. Technology Risk: Technology and operational risks are closely related and is an area of major concern fr every FI in techno era. Technology is the backbone of the business of banks and financial institutions. The major objectives of technological expansion are to lower operation cost and increasing operational efficiency of the system in order to capture new market and cutomer. Technology needs a lot of money, time and effort in order to be implemented. Technology risk occurs when investment in some type of technology does not give desired results for good services and cost effective due to redundant technology or organisational and bureaucratic inefficiencies, it brings diseconomies of scale. Diseconomies of scope arise when banks faol to achieve synergy or cost savings through new technology investment. In extreme cases, it could result in major losses in competitive efficiency and in longer run, it may have a very negative impact on the survival and growth of the organisation. 10. Off-Balance Sheet Risk: Due to many financial innovaions such as derivatives and guarantee products, many FI s off balance sheet activities has been growing tremendously in recent years and accordingly there has been an increase in their off balance sheet risk. In addition to assets and liabilities on a bank s balance sheet, there are various transactions that do not increase the size of asset or liability at present, but could do so in the future. These can be off-balance sheet items. Oof balance sheet includes letter of credit, loan commitment by bank and positions in forwards, futures, swaps and other derivatives securities.

Questions to be Review: 1. How does a change in interest rates affect the valuation of assets and liabilities? 2. How does credit risk come into play when a bank invests in bonds or debentures issued by a corporate? 3. Is the product diversification a right strategy for credit risk exposure os an FI? Explain. 4. If the bank funds short-term assets and long-term liabilities, what would be the impact of interest fluctuation on its profitability? 5. What are the various key factors that derive foreig exchange rates? 6. How liquidity risk trigger other risks? 7. One type is often linked to another. Explain with an example.

Measurement of Interest Rate Risk

The FI s strength is measured in term of Net Interest Income (NII) earned which is the difference between interest income and interest expenditures. The interest rate fluctuations have direct impact on NII and market value of equity (MVE) which is the net worth. The RBI s manetory policy to the extent decides the movement of interest rates in economy that affects the cost of borrowings and return on assets of an FI. The RBI through its daily open market operations (OMO) such as buying and selling of treasurt bills and treasury bonds controls money supply, inflation and short-term inerest rates. Changes in interest rates also set pace of the economy of the country. These days, it is quite visible that changes in bank repo/reverse repo rates and CRR aare the measure tools with RBI to set the pace of the economy of the country. To measure interest rate volatility or risk, various models/methos have been evolved which mainly includeI. II. III. I. The repricing gap model or interest rate sensitivity madel, The maturity model and The duration model. Repricing Gap Model The repricing ga model is the cash flow analysis of the repricing gap between the interest revenue earned on assets of bank and the interest paid on its liabilities over a period of time. The different time buckets have been set for repricing gaps for asstes and liabilities. These time buckets or maturities range from 1 to 10 years and above. The different buckets are as under. y 1 month y Above 1 month to 3 months y Above 3 months to 6 months and so on. Buckets 1 month Above 1 month to 3 month Above 3 to 6 month ........ ....... ...so on

Rate Sensitive Assets (A) Rate Sensitive Liabilities (B)

GAP (A-B) Cummulative Gap (CGAP)

Under the repricing gap model, banks calculate gaps in eah maturity bucket for al its Rate Sensitive Assets (RSAs) and Rate Sensitive Liabilities (RSLs). Rate Sensitive Assets and Liabilities means, assets and liabilities that are repriced at prevailing market interest rate within the maturity bucket. The GAP points out bank s net interest income exposure to interest rate fluctuation in different buckets. If for a bank Rate Sensitive Assets (RSAs) are greater than Rate Sensitive Liabilities (RSLs) (RSA > RSL), the gap is positive and if RSLs are greater than RSAs (RSA < RSL) then the gap is called negative gap. A bank that has a positive gap will see its interest income rise if market interest rates rise, since more assets than liabilities will give this increase. A bank with a negative gap will be hurt by rising rates and benefit from falling rates. For example, an FI that issues a one year certificate of deposit (CD), and invested that fund in a three year AAA bond, will see its net interest income eroded if interest ratesrise the first year, because it will have to roll over the CD at a higher rate, while the rate on the AAA bond will remain the same. Limitations of the Repricing Gap Modely Not taking into account the market value of assets and liabilities due to change in interest rate,. y Only book value of assets and liabilities while change in interest rates also affects the market value of assets and liabilities. y In the buckets where range of period is more say 3-5 years, it may happen that a liability is maturing in the beginning of the bucket and assets is maturing at the end of the bucket. In such a situation, hedging strategies for interest rate risk will go wrong and the change in net interest income cannot be measured correctly. II. The Maturity ModelThe maturity model originated due to the limitations of repricing gap model which takes only book value of assets and liabilities into account. The market value approach gives real value of assets and liabilities of an FI at which these may be liquidated not at the price these were actually acquires. This method of valuing the securities of an FI at their market value is known as marking to market (MTM) method. The maturity model takes into account the effects of interest rate changes on the market values of assets and liabilities of an FI. If the tenure of bond is more than 1 year the value of bond will fall more for any

increase to current yield to maturity. Thus maturity of asset has inverse relationship with rise in market yield on asset for value of asset, i.e., if the longer the maturity and an upward change in market yeild will result in greater fall in the value of asset in comparison to the assets of shorter maturities. The same relationship is also true for portfolio of assets and liabilities of an FI. The net effect of rising and falling of interest rates on an FI s portfolio depends on the size and nature of mismatches (+ve or -ve) of maturities of its assets and liablilities. The outcome depends on wether maturities gap (MA - ML), is greater than, equals to or is less than zero. To nullify the effect of maturity mismatches, the best way is to achieve a (MA - ML) = 0. By minimising the gap between weighted average maturity of assets and liabilities, the effects of interest rate risk may be minimised but may not be eliminated. While a strategy of matching of assets and liabilities maturities may provide hedging to the some extent against interest rate risk to some extent but does not always eliminate all interest rate risk of an FI. III. The Duration ModelDuration is one of the most effective measures of asset or liability interest rate sensitivity when compared to maturity because duration taken into account the cash flow of asset and liability along with maturity. Duration is weighted average time to maturity on an investment. The concept of duration was develope dby Macaulay in 1938, so it is also called Macaulay Duration. Duration represents an account s weighted average time to repricing, where the weights are discounted cash flows. The duration gap is the difference between the duration of assets and the duration of liabilities. The large the duration gap, the more sensitive the FI is to the market interest rate. However, duration gap is an accurate measure of the interest rate risk only if the term structure of interest rates shifts in parallel, or if any departures from parallel shifts are known in advance. In time value of money concept, the duration is the measurement of the period of the required to recover initial investment on the loan. Any cash flow received by FI on loan is treated as repayment of principal till the time it is fully paid and thereafter cash flows are profit or return earned by FI till the maturity. To understand how an fI is exposed to interest rate risk where maturity of deposit and investment is equal, we have to calculate the duration. In this case duration of deposit is one year and duration of investment is 0.7326. the duration gap is 0.2674. now it is very clear that maturity gap is not a correct method to measure and hedge interest rate risk and FIs need to rely on duration gap method duration equals to maturity where there is on interim payment and the payment is limited to one at the end of maturity.

Formula for Duration for n cash flows:  

Where, D = duratin measured in years PVt = Present value of cash flow at the end of the period t N = Last period in which cash flow is received t = Time of cashh flow. FIs may adopt strategy on the basis of duration gap analysis to hedge interest rate risk. Instead of matching maturities of asstes and liabilities, the emphasis should be on matching of duration of assets and liabilities. For this purpose, duration of all assets and liabilities should be calculated maturing in different buckets and duration gap should be calculated. The duration of the asset or liability portfolio may be calculated by multiplying duration of individual asset and its proportion i total market value of assets or liability.