financial risk analysis & mgt - copy

8/13/2019 Financial Risk Analysis & Mgt - Copy

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Concepts

Although the terms are used in various ways among the general public, manyspecialists indecision theory,statisticsand other quantitative fields have defineduncertainty, risk, and their measurement as:

1. Uncertainty: The lack of certainty. A state of having limited knowledge where itis impossible to exactly describe the existing state, a future outcome, or morethan one possible outcome.

2. Measurement of Uncertainty: A set of possible states or outcomes whereprobabilities are assigned to each possible state or outcome this also includesthe application of a probability density function to continuous variable

3. Risk: A state of uncertainty where some possible outcomes have an undesiredeffect or significant loss.

4. Measurement of Risk: A set of measured uncertainties where some possibleoutcomes are losses, and the magnitudes of those losses this also includes

loss functions over continuous variables.5. Uncertainty6.7. Uncertainty is a term used in subtly different ways in a number of fields,

includingphilosophy,physics,statistics,economics,finance,insurance,psychology,socio

logy,engineering,andinformation science.It applies to predictions of future events, to

physical measurements that are already made, or to the unknown. Uncertainty arises

inpartially observableand/orstochasticenvironments, as well as due

toignoranceand/orindolence.

Principles of Risk Management

Various organizations have laid down principles for risk management. There are risk managem

principles by International standardization Organization and by Project Management Body of

Knowledge.

The Project management body of knowledge (PMBOK) has laid down 12 principles. This article

an amalgamation of both PMBOK and ISO principles. The various principles are:

1. Organizational Context:Every organization is affected to varying degrees by various fa

its environment (Political, Social, Legal, and Technological, Societal etc). For example, a

organization may be immune to change in import duty whereas a different organization
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Speculation in commodities futures has been incorrectly referred to as gambling. Such activitiesmay appear to be similar based on making a margin deposit that is small in relation to the

notional value of the contract and attaining large rewards for making correct decisions.

Gambling is the action of creating a risk, when none exists, and seeking to take a profit. For

example, if blackjack is the game of choice and it is a game that is known to give the gambler thebest odds of winning, there is no risk prior to the time a bet is made and the cards are dealt. The

bet is the catalyst that created the risk.

Speculation is the action of seeking a profit based on analyzing the existing conditions and risks

associated with the proposed transaction. In the futures markets, hedgers have entered into this

market to transfer the risk they have in the commodities that they either produce or purchase.These markets allow the hedger to transfer the risk of buying/selling a commodity at an unknown

price in relation to the cost to produce or manufacture goods and deliver them to the market. The

speculator in these markets knows what the risks are prior to entering into a futures contract.

Price speculation is not limited to futures. Raw land, stocks, gold, or any other asset that storesvalue can be purchased on speculation. Generally the common element is that the only source of

return is the change in the price between purchase and sale. A home builder can developproperties on speculation. He commits funds to build homes in anticipation of fulfilling a market

need. If he correctly predicts the future demand and sells these homes faster, he will tend to

make a greater profit than the home builder that has negotiated a price in advance of constructionwith a buyer.

Speculators provide liquidity and stability to the economy. Without such individuals who arewilling to accept the risk of loss associated with the prospect of profit, the end consumers would

eventually be paying for this in terms of higher priced goods.

Trading futures and options involves substantial risk that can lead to loss of capital and is

unsuitable for many investors. Past performance is not indicative of future results. Speculate with

risk capital only, defined as funds you can afford to lose without adversely affecting yourlifestyle. These risks remain present irrespective of whether you hire an outside manager to trade

an account.

Types of Financial Risks:

Financial risk is one of the high-priority risk types for every business. Financial risk is caused

due to market movements and market movements can include host of factors. Based on this,

financial risk can be classified into various types such as Market Risk, Credit Risk, LiquidityRisk, Operational Risk and Legal Risk.


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Market Risk:

This type of risk arises due to movement in prices of financial instrument. Market risk can be

classified asDirectional Riskand Non - Directional Risk. Directional risk is caused due to

movement in stock price, interest rates and more. Non- Directional risk on the other hand can be

volatility risks.

Credit Risk:

This type of risk arises when one fails to fulfill their obligations towards their counter parties.

Credit risk can be classified into Sovereign Riskand Settlement Risk. Sovereign risk usually

arises due to difficult foreign exchange policies. Settlement risk on the other hand arises when

one party makes the payment while the other party fails to fulfill the obligations.

Liquidity Risk:

This type of risk arises out of inability to execute transactions. Liquidity risk can be classified

into Asset Liquidity Riskand Funding Liquidity Risk. Asset Liquidity risk arises either due to

insufficient buyers or insufficient sellers against sell orders and buy orders respectively.

Operational Risk:

This type of risk arises out of operational failures such as mismanagement or technical failures.

Operational risk can be classified into Fraud Riskand Model Risk. Fraud risk arises due to lack

of controls and Model risk arises due to incorrect model application.


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Legal Risk:

This type of financial risk arises out of legal constraints such as lawsuits. Whenever a company

needs to face financial loses out of legal proceedings, it is legal risk.

There are all sorts of financial and non-financial risks.

I define financial risk as all risks defined from events in the financial markets that affectall participants. Non-financial risks are all other forms of risk (including risks that aparticular firm may face).

Financial:

Market value risk (interest rate risk, exchange prices, equity prices, commodity

prices, etc.)

Credit risk (downgrade, default, credit spread risk)

Liquidity risk

Non-Financial:

Model Risk

Operational Risk (fraud, misconduct, failure of internal controls or audit systems,

natural disasters)

Settlement risk

Accounting risk (changes in GAAP/IFRS and comparability issues, managed

earnings, etc.)

Regulatory risk

Legal risk (counterparty does not honor a contract)

Tax risk

Sovereign risk (if you are trading EM debt for example) & Political risk

Performance netting risk

Key Man risk

Risk exposure

Definition

The quantified potential forloss that might occur as aresult of someactivity.Ananalysis of the

risk exposure for abusiness often ranksrisks according to theirprobability of occurring
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multiplied by the potential loss, and it might look at such things asliabilityissues,property loss

ordamage,andproductdemand shifts.

Risk ManagementDefinition:In the world of finance, risk management refers to the practice of identifying

potential risks in advance, analyzing them and taking precautionary steps to reduce/curb the risk.

Description:When an entity makes an investment decision, it exposes itself to a number of

financial risks. The quantum of such risks depends on the type of financial instrument. These

financial risks might be in the form of high inflation, volatility in capital markets, recession,bankruptcy, etc.

So, in order to minimize and control the exposure of investment to such risks, fund managers andinvestors practice risk management. Not giving due importance to risk management while

making investment decisions might wreak havoc on investment in times of financial turmoil in

an economy. Different levels of risk come attached with different categories of asset classes.

For example, a fixed deposit is considered a less risky investment. On the other hand, investment

in equity is considered a risky venture. While practicing risk management, equity investors and

fund managers tend to diversify their portfolio so as to minimize the exposure to risk.

Goals and Objectives
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(1) Design and execute a global business risk management process integrated with ourstrategic management process:

Integrate business risk management with our strategy formulation and businessplanning processes;

Articulate our strategies so that they are understood throughout our organization; Establish KPIs designed to drive behaviors consistent with our strategy; and Reward effective articulation and management of key risks.

(2) Ensure that process ownership questions are addressed with clarity so that roles,responsibilities and authorities are properly understood.

(3) Design and execute a global process to monitor and reassess the top quartile riskprofile and identify gaps in the management of those risks, based upon changes inbusiness objectives and in the external and internal operating environment.

(4) Define risk management strategies and clear accountabilities and action steps forbuilding and executing risk management capabilities and improving them continuously.

(5) Continuously monitor the information provided to decision-makers in order to assistthem as they manage key risks and protect the interests of shareholders.

The Risk Management Process


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1. Identify the Risks: as a group, list the things that might inhibit your ability to meet your

objectives. You can even look at the things that would actually enhance your ability to

meet those objectives eg. a fund-raising commercial opportunity. These are the risks

that you face eg. Loss of a key team member; prolonged IT network outage; delayed

provision of important information by another work unit/individual; failure to seize a

commercial opportunity etc.

2. Identify the Causes: try to identify what might cause these things to occur e.g. the key

team member might be disillusioned with his/her position, might be head hunted to go

elsewhere; the person upon whom you are relying for information might be very busy,

going on leave or notoriously slow in supplying such data; the supervisor required to

approve the commercial undertaking might be risk averse and need extra convincing

before taking the risk etc etc.

3. Identify the Controls: identify all the things (Controls) that you have in place that are

aimed at reducing the Likelihood of your risks from happening in the first place and, if

they do happen, what you have in place to reduce their impact (Consequence) eg.

providing a friendly work environment for your team; multi-skill across the team to

reduce the reliance on one person; stress the need for the required information to be

supplied in a timely manner; send a reminder before the deadline; provide additional

information to the supervisor before he/she asks for it etc.

4. Establish your Likelihood and Consequence Descriptors, remembering that these

depend upon the context of your analysis ie. if your analysis relates to your work unit,

any financial loss or loss of a key staff member, for example, will have a greater impact

on that work unit than it will have on the University as a whole so those descriptors used

for the whole-of-University (strategic) context will generally not be appropriate for the

Faculty, other work unit or the individual eg. a loss of $300000 might be considered

Insignificant to the University, but it could very well be Catastrophic to your work unit.

You will need to establish these parameters in consultation with the Head of the workunit.

5. Establish your Risk Rating Descriptors: ie. what is meant by a Low, Moderate, High

or Extreme Risk needs to be decided upon ahead of time. Because these are more

generic in terminology though, you might find that the University's Strategic Risk Rating

Descriptors are applicable.


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6. Add other Controls: generally speaking, any risk that is rated as High or Extreme

should have additional controls applied to it in order to reduce it to an acceptable level.

What the appropriate additional controls might be, whether they can be afforded, what

priority might be placed on them etc etc is something for the group to determine in

consultation with the Head of the work unit who, ideally, should be a member of the

group doing the analysis in the first place.

7. Make a Decision: once the above process is complete, if there are still some risks

that are rated as High or Extreme, a decision has to be made as to whether the activity

will go ahead. There will be occasions when the risks are higher than preferred but

there may be nothing more that can be done to mitigate that risk ie. they are out of the

control of the work unit but the activity must still be carried out. In such situations,

monitoring the circumstances and regular review is essential.

8. Monitor and Review: the monitoring of all risks and regular review of the unit's risk

profile is an essential element for a successful risk management program.

The four techniques of risk management

18 April 2013

Comprehensive business risk management is a multi-stage process that will vary

depending on the needs and requirements of each individual enterprise.

The first stage is to determine exactly what the risks facing your business are, in order

to assess the likely and potential impact of each incident occurring.

Once this process has been completed, you can get down to evaluating the technique

which will best suit your business and maximise your risk management moving forward.

Here are the four key potential risk treatments to consider.

Avoidance

Obviously one of the easiest ways to mitigate risk is to put a stop to any activities that

might put your business in jeopardy.

However it's important to remember that with nothing ventured comes nothing gained,

and therefore this is often not a realistic option for many businesses.


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Reduction

The second risk management technique is reduction - essentially, taking the steps

required to minimise the potential that an incident will occur.

Risk reduction strategies need to be weighed up in terms of their potential return on

investment. If the cost of risk reduction outweighs the potential cost of an incident

occurring, you will need to decide whether it is really worthwhile.

Transfer

One of the best methods of risk management is transferring that risk to another party.

An example of this would be purchasing comprehensivebusiness insurance.

Risk transfer is a realistic approach to risk management as it accepts that sometimes

incidents do occur, yet ensures that your business will be prepared to cope with the

impact of that eventuality.

Acceptance

Finally, risk acceptance involves 'taking it on the chin', so to speak, and weathering the

impact of an event. This option is often chosen by those who consider the cost of risk

transfer or reduction to be excessive or unnecessary.

Risk acceptance is a dangerous strategy as your business runs the risk of

underestimating potential losses, and therefore will be particularly vulnerable in the

event that an incident occurs.

Meaning and definition of currency risk

Currency riskrefers to a risk form arising from the changes price of one currency as

compared to another currency. Whenever companies or investors possess assets orbusiness operations across national boundaries, they experience currency risk if their

positions are not prevaricated. Currency risk is also referred as exchange rate risk.

Putting it simple, currency risk can be defined as the possibility that

currencydepreciationwill show negative effect on the value of assets, investments, and

their related interest and dividend payment streams, specifically those securities

denominated in foreign currency.
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As illustrated by Investopedia through an example, if a US investor has stock in

Canada, the return realized by you will be affected by the change in [price of stock as

well as the change in value of Canadian dollar against the US dollar. Therefore, if a

15% return is realized on the Canadian stock but the Canadian dollar deflates 15%

against the US dollar, this will generate no profit at all. Moreover, as per the academicstudies of currency risk, although without complete certainty, that investors facing

currency risk are not rewarded with greater potential returns, implying that it is

essentially an unnecessary risk to bear.

Types of currency risk

Generally, there are two basic types of currency risk:

Transaction risk

This type of risk is the one related to an unfavorable change in the exchange rate over a

certain time period.

Translation risk

This risk type is an accounting concept. It is relative to the amount of assets held in

foreign currencies. Alterations in exchange rate over a certain period will provide an

inaccurate report, and thus the assets are generally balanced by borrowings in the

specific currency.

Global Environmental Modeling and Analysis

TP&D Global Environmental Analysis capability focuses on the relationship betweentechnology adoption and climate changes. TP&D has been developing and using a setof integrated assessment models to analyze the role that technology plays indetermining future emissions of greenhouse gases (GHGs) and the economicimplications of reducing these emissions. Global environment models examine thecompetition among technologies in a variety of markets, and explore conditions underwhich new markets could emerge.

TP&D provide the appropriate framework and analyses to assist the evaluation ofpossible social and economic impacts of present and future global environmentalchanges on life. TP&D Staff implemented large number of studies on the economic,environmental, social, regional and private cost of greenhouse gases emissions. TheTP&D staff published a large number of studies related to the structure of emissiontrading systems, and emissions mitigation and sequestration.


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Tools include PNNL's GCAM model. GCAM is an integrated assessment model of

global change with a focus on the world's energy and agriculture systems. GCAMincorporates carbon capture and sequestration technology options, a hydrogen fueloption, a global market for biomass energy, and agriculture and land use.

Another example of tools used at the TP&D group is the System Assessment Capability(SAC) used for the Groundwater/Vadose Zone (GW/VZ) Integration Project at theHanford Site in Washington State is currently developing the tools and supporting datato assess the cumulative impact to human and ecological health and the region'seconomy and cultures from waste that will remain at the Hanford Site after the sitecloses. This integrated system of new and legacy models and data is known as theSystem Assessment Capability (SAC). The environmental transport modules of the SAC

modeling system provide estimates of contaminant concentrations from Hanford Sitesources in a time-dependent manner in the Vadose zone, groundwater, and theColumbia River and its associated sediments. The Risk/Impact Module uses theseestimates of media- and time-specific concentrations to estimate potential impacts onthe ecology of the Columbia River corridor, the health of persons who might live in oruse the corridor or the upland Hanford environment, the local economy, and the culturalresources. The Monte Carlo realizations from the SAC modeling system demonstratethe feasibility of large-scale uncertainty analysis of the complex relationships inenvironmental transport on the one hand and ecological, human, cultural, and economicrisk on the other.

TP&D Staff are involve in number of projects at the national, regional, state and locallevels and they apply the appropriate tools to study the climate change impacts onspecific industries including energy, agriculture, forestry, fisheries, and transportation.

For further information on Global Environmental Modeling and Analysis, contactMichaelJ. Scott,Pacific Northwest National Laboratory (PNNL), at (509) 372-4273.
mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]


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Mark-to-market

Mark-to-market is an accounting practice by which companies value and report theirassets, especially financial instruments, atmarketprice. Market price basically refers tothe price at which the asset, or a similar asset, is trading at in a public exchange. Theconcept is derived from the accountingprinciple of prudence.

This is different frommark-to-modelwhere the asset value is based on management'sassumptions.

Mark-to-market accounting is typically used forLevel 1andLevel 2assets. In the caseof Level 1 assets there is typically an actively traded exchange for that asset, e.g. formoststocks,a market price can be found easily. Level 2 assets are not traded actively,but it is possible to determine their prices based on prices of other similar assets;

e.g.bondsof comparable quality. On the other hand, mark-to-market accounting is notused forLevel 3assets since they cannot be reasonably compared to any market price.

Mark-to-market accounting is always used in valuingfuturescontracts. The final valueof a contract is not known till its expiration, but at the end of each day the value of thecontract is adjusted to reflect the closing price for that date.

The mark-to-market principle73) the crisis has brought into relief the difficulty to apply the

mark-to-market principle in certain market conditions as well as the strong pro-cyclical impact

that this principle can have. The Group considers that a wide reflection is needed on the mark-to-

market principle. Whilst in general this principle makes sense, there may be specific conditions

where this principle should not apply because it can mislead investors and distort managers'

policies.

74) It is particularly important that banks can retain the possibility to keep assets, accounted for

amortized cost at historical or original fair value (corrected, of course, for future impairments),

over a long period in the banking book - which does not mean that banks should have the

discretion to switch assets at will from the banking to the trading book. The swift October 2008

decision by the EU to modify IAS-39, thereby introducing more flexibility as well as

convergence with US GAAP, is to be commended. It is irrelevant to mark-to-market, on a daily

basis, assets that are intended to be held and managed on a long-term horizon provided that they

are reasonably matched by financing.
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75) Differences between business models must also be taken into account. For example,

intermediation of credit and liquidity requires disclosure and transparency but not necessarily

mark-to-market rules which, while being appropriate for investment banks and trading activities,

are not consistent with the traditional loan activity and the policy of holding long term

investments. Long-term economic value should be central to any valuation method: it may be

based, for instance, on an assessment of the future cash flows deriving from the security as long

as there is an explicit minimum holding period and as long as the cash flows can be considered

as sustainable over a long period.

76) Another matter to be addressed relates to situations where assets can no longer be marked to

market because there is no active market for the assets concerned. Financial institutions in such

circumstances have no other solution than to use internal modeling processes. The quality and

adequacy of these processes should of course be assessed by auditors. The methodologies used

should be transparent. Furthermore internal modeling processes should also be overseen by the

level 3 committees, in order to ensure consistency and avoid competitive distortions.

77) To ensure convergence of accounting practices and a level playing-field at the global level, it

should be the role of the International Accounting Standard Board (IASB) to foster the

emergence of a consensus as to where and how the mark-to-market principle should applyand

where it should not. The IASB must, to this end, open itself up more to the views of the

regulatory, supervisory and business communities. This should be coupled with developing a far

more responsive, open, accountable and balanced governance structure. If such a consensus does

not emerge, it should be the role of the international community to set limits to the application of

the mark-to-market principle.

78) The valuation of impaired assets is now at the centre of the political debate. It is of crucial

importance that valuation of these assets is carried-out on the basis of common methodologies at

international level. The Group encourages all parties to arrive at a solution which will minimise

competition distortions and costs for taxpayers. If there are widely variant solutionsmarket

uncertainty will not be improved.


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79) Regarding the issue of pro-cyclicality, as a matter of principle, the accounting system should

be neutral and not be allowed to change business modelswhich it has been doing in the past by

'incentivising' banks to act short term. The public good of financial stability must be embedded

in accounting standard setting. This would be facilitated if the regulatory community would have

a permanent seat in the IASB (see chapter on global repair).

International Financial System

The International Financial System application (IFS) is a standalone application, whichtakes care of the electronic transfer of international money orders. IFS uses electronicdata interchange (EDI) to send international money order data electronically, usingsophisticated data encryption techniques to ensure the integrity of the data sent over

the postal network. IFS also helps Posts provide electronic domestic money orderservices.

IFS is a complete management tool that responds perfectly to the needs of Posts in theelectronic transfer of money orders especially at a time when the money transfer marketis becoming increasingly competitive.

Its Gross National Index (GNI) based costing structure and low transaction-tax enablesa very fast return on investment. The goal of the IFS system is to provide postalenterprises with reliable, secure, and timely electronic financial services, which in turnallows Posts to be more competitive in the global marketplace. The IFS system not only

handles all phases of international and domestic money processing but also providesadvanced features that facilitate cash management and accounting.

IFS has a wide range of functions, including:

Money order data collection, such as registration of any processing up to the finalpayment, reimbursement or cancellation of the transactionTracking and tracing of individual transactions or groups of transactionsMoney order service monitoring and production of statistics

Quality control measurementsBi-lateral agreement definition and automatic validation of transactions against theagreementsProduction of UPU standard international accounting documents

IFS also supports a variety of money order and fund transfer services, from ordinarycash-to-cash orders to urgent wired transfers. On the IFS network, any transfer of datais protected by strong software encryption techniques. Network members are part of aPublic Key Infrastructure (PKI) operated by the PTC.


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The IFS operational front-end is run as a Web application. This is specifically adaptedfor easy deployment over an Intranet or even over the Internet. It is possible to securethe protocol between the Web browser and the Application server.

IFS can easily be interfaced with an existing application, such as a counter operationssystem. In addition, the system user interface can be localised into any language.

The advantages of the International Financial System include:

IFS can be used as a simple gateway for accessing the postal network or as acomplete money order management toolIFS complies with all UPU regulationsIFS is easy to deploy and staff training can be provided during the installationphase. In most cases, no additional hardware is requiredIFS is an end-to-end solution and can be used from the point of sale (at the origin)to the point of final payment (at the destination)

IFS supports multiple international and domestic services and service definitions arefree. Each network member is free to negotiate and configure the serviceconditions, rules and prices bilaterally with each of its partnersIFS is scalable ensuring that the same software supports from very low to very highvolumes of transactionsIFS functions are constantly enhanced, based on requests from all networkmembersIFS offers various options for connecting to the postal network, including leased lineor dial-up over the Internet or using SITA lines

Currency Rate risk

Foreign exchange risk(also known as exchange rate riskor currency risk) is

afinancial riskposed by an exposure to unanticipated changes in theexchange

ratebetween twocurrencies.[1][2]Investors and multinational businesses exporting or

importing goods and services or making foreign investments throughout the global

economy are faced with an exchange rate risk which can have severe financial

consequences if not managed appropriately

Managing your exchange rate risk

Fluctuations in exchange rate can majorly affect the growth of your businessin the international market.

So understanding the effects of these fluctuations and learning to manageyour exchange rate risk should be a top priority.
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What is exchange rate risk?

When you trade internationally, your business is open to exchange rate risk.This means a world currency's ups and downs in value could affect your

profits when money is converted back to your home currency. Exchange raterisk is simply the risk of making a loss (or gain) during the conversion

process.

Why is it so important to manage?Exchange rate fluctuations can have a significant effect on the earnings andcashflow of your business. Without proper management, major exchangerate movements can leave you vulnerable to greatly reduced profits and

asset values when you convert foreign currencies into sterling.

A few ways to manage exchange rate risk

Be aware of the volatility of the currency you're trading in

Keep a close eye on the currency pairs you're trading in and consider

setting up exchange rate alerts withBarclays Business Abroad you can

get alerted of fluctuations to your chosen currency pairs for free withiAlert

Manage all your transactions in sterling effectively transferring theexchange rate risk to your foreign associates

Interest Rate Risk (IRR) Management

What is Interest Rate Risk :Interest rate risk is the risk where changes in market interest rates might adversely affect a banks

financial condition. The management of Interest Rate Risk should be one of the criticalcomponents of market risk management in banks. The regulatory restrictions in the past had

greatly reduced many of the risks in the banking system. Deregulation of interest rates has,however, exposed them to the adverse impacts of interest rate risk. T

What is the Impact of IRR:The immediate impact of changes in interest rates is on the Net Interest Income (NII). A long

term impact of changing interest rates is on the banks networth since the economic value of a

banks assets, liabilities and off-balance sheet positions get affected due to variation in market

interest rates.The Net Interest Income (NII) or Net Interest Margin (NIM) of banks is dependent on the

movements of interest rates. Any mismatches in the cash flows (fixed assets or liabilities) orrepricing dates (floating assets or liabilities), expose banks NII or NIM to variations. Theearning of assets and the cost of liabilities are closely related to market interest rate volatility.The interest rate risk when viewed from these two perspectives is known as earnings

perspective and economic value perspective, respectively.Management of interest rate risk aims at capturing the risks arising from the maturity and

repricing mismatches and is measured both from the earnings and economic value perspective.
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(a) Earnings perspectiveinvolves analysing the impact of changes in interest rates on

accrual or reported earnings in the near term. This is measured by measuring the changes

in the Net Interest Income (NII) or Net Interest Margin (NIM) i.e. the difference between

the total interest income and the total interest expense.

(b) Economic Value perspectiveinvolves analysing the changes of impact og interest on

the expected cash flows on assets minus the expected cash flows on liabilities plus the net

cash flows on off-balance sheet items. It focuses on the risk to networth arising from all

repricing mismatches and other interest rate sensitive positions. The economic value

perspective identifies risk arising from long-term interest rate gaps.

BCBS Principles for Interest Rate Risk Management

Board and senior management oversight of interest rate risk

Principle 1: In order to carry out its responsibilities, the board of directors in a bank should

approve strategies and policies with respect to interest rate risk management and ensure thatsenior management takes the steps necessary to monitor and control these risks. The board of

directors should be informed regularly of the interest rate risk exposure of the bank in order to

assess the monitoring and controlling of such risk.

Principle 2: Senior management must ensure that the structure of the bank's business and the

level of interest rate risk it assumes are effectively managed, that appropriate policies and

procedures are established to control and limit these risks, and that resources are available for

evaluating and controlling interest raterisk.

Principle 3: Banks should clearly define the individuals and/or committees responsible for

managing interest rate risk and should ensure that there is adequate separation of duties in key

elements of the risk management process to avoid potential conflicts of interest. Banks shouldhave risk measurement, monitoring and control functions with clearly defined duties that are

sufficiently independent from position-taking functions of the bank and which report risk

exposures directly to senior management and the board of directors. Larger or more complex

banks should have a designated independent unit responsible for the design and administration of

the bank's interest rate risk measurement, monitoring and control functions.


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TOOLS AND TECHNIQUES FOR THE MANAGEMENT OF FOREIGN EXCHANGE

RISK

In this article we consider the relative merits of several different tools for hedging exchange risk,

including forwards, futures, debt, swapsand options. We will use the following criteria for

contrasting the tools.

First, there are different tools that serve effectively the same purpose. Most currency

management instruments enable the firm to take a long or a short position to hedge an oppositeshort or long position. Thus one can hedge a Euro payment using a forward exchange contract, or

debt in Euro, or futures or perhaps a currency swap. In equilibrium the cost of all will be the

same, according to the fundamental relationships of the international money market. They differin details like default risk or transactions costs, or if there is some fundamental market

imperfection. indeed in an efficient market one would expect the anticipatedcost of hedging to

be zero. This follows from the unbiased forward rate theory.

Second, tools differ in that they hedge different risks. In particular, symmetric hedging tools likefutures cannot easily hedge contingent cash flows: options may be better suited to the latter.

Tools and techniques: foreign exchange forwards

Foreign exchange is, of course, the exchange of one currency for another. Trading or "dealing" in

each pair of currencies consists of two parts, the spot market, where payment (delivery) is made

right away (in practice this means usually the second business day), and the forward market.The rate in the forward market is a price for foreign currency set at the time the transaction is

agreed to but with the actual exchange, or delivery, taking place at a specified time in the future.

While the amount of the transaction, the value date, the payments procedure, and the exchange

rate are all determined in advance, no exchange of money takes place until the actual settlementdate. This commitment to exchange currencies at a previously agreed exchange rate is usually

referred to as a forward contract.

Forward contracts are the most common means of hedging transactions in foreign currencies.

The trouble with forward contracts, however, is that they require future performance, and

sometimes one party is unable to perform on the contract. When that happens, the hedgedisappears, sometimes at great cost to the hedger. This default risk also means that many

companies do not have access to the forward market in sufficient quantity to fully hedge their

exchange exposure. For such situations, futures may be more suitable.

Currency futures

Outside of the interbank forward market, the best-developed market for hedging exchange rate

risk is the currency futuresmarket. In principle, currency futures are similar to foreign

exchange forwards in that they are contracts for delivery of a certain amount of a foreigncurrency at some future date and at a known price. In practice, they differ from forward contracts

in important ways.


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One difference between forwards and futures is standardization. Forwards are for any amount, as

long as it's big enough to be worth the dealer's time, while futures are for standard amounts, each

contract being far smaller that the average forward transaction. Futures are also standardized interms of delivery date. The normal currency futures delivery dates are March, June, September

and December, while forwards are private agreements that can specify any delivery date that the

parties choose. Both of these features allow the futures contract to be tradable.

Another difference is that forwards are traded by phone and telex and are completely

independent of location or time. Futures, on the other hand, are traded in organized exchangessuch the LIFFE in London, SIMEX in Singapore and the IMM in Chicago.

But the most important feature of the futures contract is not its standardization or tradingorganization but in the time pattern of the cash flowsbetween parties to the transaction. In a

forward contract, whether it involves full delivery of the two currencies or just compensation of

the net value, the transfer of funds takes place once: at maturity. With futures, cash changes

hands every day during the life of the contract, or at least every day that has seen a change in the

price of the contract. This daily cash compensation feature largely eliminates default risk.

Thus forwards and futures serve similar purposes, and tend to have identical rates, but differ intheir applicability. Most big companies use forwards; futures tend to be used whenever credit

risk may be a problem.

Debt instead of forwards or futures

Debt -- borrowing in the currency to which the firm is exposed or investing in interest-bearing

assets to offset a foreign currency payment -- is a widely used hedging tool that serves much the

same purpose as forward contracts. Consider an example.

A German company has shipped equipment to a company in Calgary, Canada. The exporter's

treasurer has sold Canadian dollars forward to protect against a fall in the Canadian currency.Alternatively she could have used the borrowing market to achieve the same objective. She

would borrow Canadian dollars, which she would then change into Euros in the spot market, and

hold them in a Euro deposit for two months. When payment in Canadian dollars was received

from the customer, she would use the proceeds to pay down the Canadian dollar debt. Such atransaction is termed a money market hedge.

The cost of this money market hedge is the difference between the Canadian dollar interest ratepaid and the Euro interest rate earned. According to the interest rate parity theorem, the

interest differential equals the forward exchange premium, the percentage by which the forward

rate differs from the spot exchange rate. So the cost of the money market hedge should be the

same as the forward or futures market hedge, unless the firm has some advantage in one marketor the other.

The money market hedge suits many companies because they have to borrow anyway, so it

simply is a matter of denominating the company's debt in the currency to which it is exposed.

that is logical. but if a money market hedge is to be done for its own sake, as in the example just


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given, the firm ends up borrowing from one bank and lending to another, thus losing on the

spread. This is costly, so the forward hedge would probably be more advantageous except where

the firm had to borrow for ongoing purposes anyway.

Currency options

Many companies, banks and governments have extensive experience in the use of forward

exchange contracts. With a forward contract one can lock in an exchange rate for the future.

There are a number of circumstances, however, where it may be desirable to have moreflexibility than a forward provides. For example a computer manufacturer in California may have

sales priced in U.S. dollars as well as in Euros in Europe. Depending on the relative strength of

the two currencies, revenues may be realized in either Euros or dollars. In such a situation theuse of forward or futures would be inappropriate: there's no point in hedging something you

might not have. What is called for is a foreign exchange option: the right, but not the obligation,

to exchange currency at a predetermined rate.

A foreign exchange option is a contract for future delivery of a currency in exchange for another,where the holder of the option has the right to buy (or sell) the currency at an agreed price,

thestrikeor exercise price, but is not required to do so. The right to buy is a call; the right to sell,aput. For such a right he pays a price called the option premium. The option seller receives the

premium and is obliged to make (or take) delivery at the agreed-upon price if the buyer exercises

his option. In some options, the instrument being delivered is the currency itself; in others, afutures contract on the currency. Americanoptions permit the holder to exercise at any time

before the expiration date; Europeanoptions, only on the expiration date.

Hedging TechniquesInternalSometimes known as commercial or natural, these techniques are within the internalmanagement control of the company.

Pricing:

In the currency in which the majority of the costs are incurred.

In thedomestic currency of the main competitors, so that comparative prices are lessaffected by exchange rate variations.

Inserting an exchange rate variation clause (always difficult commercially) to protectmargins.

Matching:

Setting up an equal and opposite commercial transaction when the original exposure iscreatedfor example, using the currency receivable to buy a commodity used by thebusiness.
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Borrow in the same currency as that needed to complete the asset purchase.

Netting:

A partial alternative to matchinga net amount is still left exposed, but the overall risk is

reduced.Leading and lagging:

Simply, either delaying payment, or settling early, in anticipation of falling or risingexchange rates. Safe, and simple to manage, but there is a reliance on the accuracy ofa forecast.

Intercompany payment discipline:

Intercompany payables and receivables are real exposure and should be rankedequally for settlement with external liabilities.

There is no canceling gain or loss situation within a group. When the transactioninteracts with the market there will be a gain or a lossand it will be real.

ExternalWhen the use of internal techniques has been exhausted, external ones should beused. There are four main instruments:

Forward contracts;

Lending and borrowing;

Options;

Swaps.

Forward Contracts

Aforward contract is an agreement to exchange a fixed amount of one currency for afixed amount of another currency at an agreed date in the future. Theeffectiveexchange rate is derived from the comparativeinterest rates of the two currencies beingexchanged. Its suitability depends on being able to forecast the currency flowsconfidently. If the forecast proves not to be accurate, the business has in reality createdan exposure rather than protected an existing one, because theforward contract is abinding agreement to deliver a quantity of one currency and receive a quantity ofanother. The key features of aforward contract are:

Certainty and simplicityenabling goodcash management;

Off balance sheetit does not count as borrowings that affect gearing;

Normally sourced from a bank.
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Lending and Borrowing

As an alternative to aforward contract,the currency could be exchanged immediately inthespot market,i.e. where the transaction is agreed on the spot and takes placeimmediately. The exchange rate is known as fixed, the transaction immediate (two days

delivery normally), and the administration and monitoring offorward contracts areavoided. The currency is normally deposited in an interest-bearing currency accountuntil needed.

Illustration: Aforward transaction to buy yen for acapital equipment purchase has beenmade. Delivery will be late. A way around this problem would be to take delivery of theyen as agreed and put the amount on deposit until needed. As yen interest rates arelower than for sterling, there will be an effective interest cost. If delivery was availableearlier and agreed to by the company, yen could be borrowed short term and repaidwhen theforward contract matured.

Options

An option is the right, but not the obligation, to exchange a fixed amount of one currencyfor a fixed amount of another within, or at the end of, a predetermined period. In effect, itis aforward contract that can be walked away from, where you lose only the cost of theoption, which could be 35% of the contract value. It therefore has the advantage oflimiting the downside, as the maximum cost is known at the beginning, while leavingunlimited profit potential. These options are ideally suited to translations, where the sizeor existence of the exposure is uncertain, for example tender-to-contract or price listexposures.

Illustration: A quantity of a commodity (or currency to pay for it) is needed in threemonths time. A dealer is willing to accept US$100 per ton to supply a predeterminedquantity at US$2,000 per ton. If the price of this commodity in three months time isUS$1,700 per ton, then the option would be thrown away, the product bought in the spotmarket,and the cost to the company would be US$1,800 per ton. The tender-to-contract or price list item would have been safeguarded, and the price could even bereduced by US$200 per ton if competitive conditions demanded. If the price of thecommodity rose, the cost to the company would be contained. The option could be soldat a profit if the product was not needed, or the loss would in any event be limited toUS$100 per ton.

There are two types of option:

Callsgiving the right to buy a currency;

Putsgiving the right to sell a currency.

Currency Options
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The exchange rate (known as thestrike price)and theexpiry date of the option arechosen by the customer at the outset. The cost (known as the premium) of the option iscalculated based on these decisions and the volatility of the currency involved. Optionscan be exchange-traded where they exist in standardized form, or bought over thecounter, where they are written to fit a customers particular circumstances.

There are two styles of option:

American option.The buyer can exercise the option (make the exchange ofcurrencies) at any time up to theexpiry date.

European option.This can be exercised on theexpiry date only, and is slightlycheaper because of its lack of flexibility.

Options may have a resale value, determined by the same criteria as theoriginal cost.When theexercise price of an option is better than the currentspot exchange rate,it iscalled in the money; when it is the other way round, it is out of the money.

Swaps

Swaps are like long-datedforward contracts.They involve the exchange of a liabilitynow, with the exchange back at a predetermined future time, and the compensation ofthe other party for costs in the intervening period. Swaps are used primarily to protectan investment or portfolio of borrowings. They involve aback-to-back loan betweencompanies with a matching but opposite need. What is swapped is essentially a seriesof cash flows.

Illustration: A UK company wishes to raise cash to invest in developing its business inthe United States. It is quoted in the United Kingdom only, which means it does nothave access to UScapital markets and it does not have a rating, so it would beextremely difficult to borrow in the United States.

What sources of funds are available?

Raise equity via a UKrights issue;

Borrow sterling from a UK bank;

Borrow in US dollars.

The first two of these options will appear on a balance sheet as sterling liabilities, butthe asset will appear as a dollar asset, creating atranslation exposure.The returns fromthe investment will be in dollars, which will create atranslation exposure when they areconverted to sterling income in the profit statement, and a transaction exposure whenthey need to be converted to pay interest or dividends in sterling.
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A solution is to swap the currency flows for the duration of a loan, paying or receiving asum of money from the other party, leaving both sides in an equivalent cash flowposition but having avoided specific payments in another currency. The loan wouldrevert to the borrowing currency on maturity.

Categories of hedgeable risk

There are varying types of risk that can be protected against with a hedge. Those typesof risks include:

Commodity risk:the risk that arises from potential movements in the value ofcommodity contracts, which include agricultural products, metals, and energyproducts.

Credit risk:the risk that money owing will not be paid by anobligor.Since credit riskis the natural business of banks, but an unwanted risk for commercial traders, anearly market developed between banks and traders that involved selling obligations

at adiscountedrate. Currency risk(also known as Foreign Exchange Risk hedging) is used both by

financial investors to deflect the risks they encounter when investing abroad and bynon-financial actors in the global economy for whom multi-currency activities are anecessary evil rather than a desired state of exposure.

Interest rate risk:the risk that the relative value of an interest-bearing liability, suchas a loan or abond,will worsen due to aninterest rateincrease. Interest rate riskscan be hedged using fixed-income instruments orinterest rate swaps.

Equity risk:the risk that one's investments will depreciate because of stock marketdynamics causing one to lose money.

Volatility risk:is the threat that an exchange rate movement poses to an investor'sportfolio in a foreign currency.

Volumetric risk:the risk that a customer demands more or less of a product thanexpected.

Derivatives

What are derivatives?Derivatives are financial contracts, which derive their value off a spot price time-series,which is called "the underlying". The underlying asset can be equity, index, commodityor any other asset. Some common examples of derivatives are Forwards, Futures,

Options and Swaps.

Derivatives help to improve market efficiencies because risks can be isolated and soldto those who are willing to accept them at the least cost. Using derivatives breaks riskinto pieces that can be managed independently. From a market-oriented perspective,derivatives offer the free trading of financial risks.
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What is the importance of derivatives?There are several risks inherent in financial transactions. Derivatives are used toseparate risks from traditional instruments and transfer these risks to parties willing tobear these risks. The fundamental risks involved in derivative business includes:

Credit Risk

This is the risk of failure of a counterparty to perform its obligation as per the contract.Also known as default or counterparty risk, it differs with different instruments.

Market Risk

Market risk is a risk of financial loss as a result of adverse movements of prices of theunderlying asset/instrument.

Liquidity Risk

The inability of a firm to arrange a transaction at prevailing market prices is termed asliquidity risk. A firm faces two types of liquidity risks

1. Related to liquidity of separate products2. Related to the funding of activities of the firm including derivatives.

Legal Risk

Derivatives cut across judicial boundaries, therefore the legal aspects associated withthe deal should be looked into carefully.

What are the various types of derivatives?Derivatives can be classified into four types:

Forwards Futures Options Swaps

Who are the operators in the derivatives market?

Hedgers - Operators, who want to transfer a risk component of their portfolio. Speculators - Operators, who intentionally take the risk from hedgers in pursuit of

profit. Arbitrageurs - Operators who operate in the different markets simultaneously, in

pursuit of profit and eliminate mis-pricing.

FINANCE 353 - Derivatives


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Course Objectives

Derivatives such as futures, forwards, swaps and options are financial contracts thatderive their value from some basic underlying events, for example, the value of anasset, the price of a commodity, or the performance of a company, etc.

Derivatives have become a popular investment tool over the last three decades. Thenotional amount of derivative contracts traded on the OTC market alone has exceeded$284 trillion in the year 2005. Many companies routinely use derivatives to hedge risksand to compensate employees. Moreover, since many financial transactions andinvestment decisions today contain some derivative-like features, the materials coveredin this course should be useful to students planning a career in asset management,corporate finance, investment banking, sales and trading, financial consulting or anyother fields that involve financial decision making.

This course is designed to achieve two main objectives. The first objective is to provide

students with a framework to understand the fundamental concepts and to develop thenecessary skills used in valuing derivative contracts. This will include emphasis on thekey concept of No Arbitrage Principle, and on the two work horses of the binomialmodel and the Black-Sholes-Merton model. The second objective is to apply theframework to understand a wide variety of issues related to risk management andinvestment decisions.

Although the course will be quantitative in nature, anybody who has taken Decision 311(Probability and Statistics) and Finance 350 (Global Financial Management) shouldhave enough preparation to succeed in this course. The emphasis of Finance 353 willbe on economic intuitions, problem solving skills, and real world applications.

Types of Derivative Instruments:Derivative contracts are of several types. The most common types are forwards,futures, options and swap.Forward Contracts

A forward contract is an agreement between two parties a buyer and a seller topurchase or sell something at a later date at a price agreed upon today. Forwardcontracts, sometimes called forward commitments , are very common in everyone life.

Any type of contractual agreement that calls for the future purchase of a good or


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service at a price agreed upon today and without the right of cancellation is a forwardcontract.Future Contracts

A futures contract is an agreement between two parties a buyer and a seller to buyor sell something at a future date. The contact trades on a futures exchange and is

subject to a daily settlement procedure. Future contracts evolved out of forwardcontracts and possess many of the same characteristics. Unlike forward contracts,futures contracts trade on organized exchanges, called future markets. Future contactsalso differ from forward contacts in that they are subject to a daily settlementprocedure. In the daily settlement, investors who incur losses pay them every day toinvestors who make profits.Options ContractsOptions are of two types calls and puts. Calls give the buyer the right but not theobligation to buy a given quantity of the underlying asset, at a given price on or beforea given future date. Puts give the buyer the right, but not the obligation to sell a givenquantity of the underlying asset at a given price on or before a given date.SwapsSwaps are private agreements between two parties to exchange cash flows in thefuture according to a prearranged formula. They can be regarded as portfolios offorward contracts. The two commonly used swaps are interest rate swaps and currencyswaps.

1. Interest rate swaps:These involve swapping only the interest related cash flowsbetween the parties in the same currency.

2. Currency swaps:These entail swapping both principal and interest between theparties, with the cash flows in one direction being in a different currency than those inthe opposite direction.

Options Pricing: Introduction

Optionsarederivativecontracts that give the holder the right, but not the

obligation, to buy or sell theunderlyinginstrument at a specified price on or

before a specified future date. Although the holder (also called the buyer) of

the option is not obligated to exercise the option, the optionwriter(known as

the seller) has an obligation to buy or sell the underlying instrument if the

option is exercised.

Depending on the strategy, option trading can provide a variety of benefits

including the security of limited risk and the advantage ofleverage.Options

canprotect or enhance an investor's portfolioin rising, falling and neutral

markets. Regardless of the reasons for trading options or the strategy

employed, it is important to understand the factors that determine the value

of an option. This tutorial will explore the factors that influence option
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pricing, as well as several popular option pricing models that are used to

determine the theoretical value of options.

Options PayoffsThe optionality characteristic of options results in a non-linear payoff for options. In simple

words, it means that the losses for the buyer of an option are limited, however the profits are

potentially unlimited. For a writer (seller), the payoff is exactly the opposite. His profits are

limited to the option premium, however his losses are potentially unlimited. These nonlinear

payoffs are fascinating as they lend themselves to be used to generate various payoffs by using

combinations of options and the underlying. We look here at the six basic payoffs (pay close

attention to these pay-offs, since all the strategies in the book are

derived out of these basic payoffs).

Payoff profile of buyer of asset: Long asset

In this basic position, an investor buys the underlying asset, ABC Ltd. shares for instance, for Rs.

2220, and sells it at a future date at an unknown price, St. Once it is purchased, the investor is

said to be "long" the asset.

Payoff profile for seller of asset: Short asset

In this basic position, an investor shorts the underlying asset, ABC Ltd. shares for instance, for

Rs. 2220, and buys it back at a future date at an unknown price, St. Once it is sold, the investor is

said to be "short" the asset.

Payoff profile for buyer of call options: Long call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in

the option. The profit/loss that the buyer makes on the option depends on the spot price of the

underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher

the spot price, more is the profit he makes. If the spot price of the underlying is less than the

strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid

for buying the option.

Payoff profile for writer (seller) of call options: Short call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in

the option. For selling the option, the writer of the option charges a premium. The profit/loss that

the buyer makes on the option depends on the spot price of the underlying. Whatever is the

buyer's profit is the seller's loss. If upon expiration, the spot price exceeds the strike price, the

buyer will exercise the option on the writer. Hence as the spot price increases the writer of the

option starts making losses. Higher the spot price, more is the loss he makes. If upon expiration


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the spot price of the underlying is less than the strike price, the buyer lets his option expire un-

exercised and the writer gets to keep the premium.

Payoff profile for buyer of put options: Long put

A put option gives the buyer the right to sell the underlying asset at the strike price specified inthe option. The profit/loss that the buyer makes on the option depends on the spot price of the

underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower

the spot price, more is the profit he makes. If the spot price of the underlying is higher than the

strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid

for buying the option.

Payoff profile for writer (seller) of put options: Short put

A put option gives the buyer the right to sell the underlying asset at the strike price specified in

the option. For selling the option, the writer of the option charges a premium. The profit/loss thatthe buyer makes on the option depends on the spot price of the underlying. Whatever is the

buyer's profit is the seller's loss. If upon expiration, the spot price happens to be below the strike

price, the buyer will exercise the option on the writer. If upon expiration the spot price of the

underlying is more than the strike price, the buyer lets his option un-exercised and the writer gets

to keep the premium.

Factors influencing Currency Options Prices

Parameter Call Premium Put Premium

Exchange Rate As exchange rate increases

call premium also increases

As exchange rate increases put

premium decreases.Strike Price As strike rate increases call

premium decreasesAs strike rate increases put premiumalso increases

Risk Free InterestRate

As the interest rate in theeconomy increases, valueof call option increases

As the interest rate in the economyincreases, value of Put optiondecreases

Time to maturity Call & Put options become more valuable as time to maturityincreases, it is because of Risk as the time increases.

Volatility As volatility increases there is high degree of uncertainty about therate of the currency and hence on the option. The owner of the callbenefits from the rate increase and that of the put benefits from the

rate decreases.

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