HOW TO MANAGE RISKS?

Capital Market Risk and Return

 Systematic Risk :-
o Averting Panics: The ideal regulatory approach would focus on eliminating the
risk of systemic collapse from the outset. This goal could be substantially achieved
by preventing financial panics, since they are often the triggers that commence a
chain of failures.
o Requiring Increased Disclosure: Disclosure works by reducing, if not
eliminating, asymmetric information among market players, making the risks
transparent to all. Individual market participants who fully understand that risk will
be motivated to protect themselves.
o Limiting Financial Institution Size: This is related to financial exposure limits,
but this approach also addresses potential moral-hazard from institutions who
believe they are “too big to fail.” There is, however, no clear evidence of such risky
behavior, and financial institutional losses in the recent financial crisis can be
explained by other reasons. Financial institution size should not be artificially
limited. Size should be governed by the economies of scale and scope needed for
institutions to successfully compete, domestically and abroad—so long as that size
is manageable.
o Ensuring Liquidity : Ensuring liquidity could facilitate stability in two ways: by
providing liquidity to financial institutions in order to prevent them from defaulting,
and by providing liquidity to financial markets as necessary to keep them
functioning. The Federal Bank has had the role of lender of last resort by providing
liquidity to banks and other financial institutions in order to prevent them from
defaulting.
o Reducing Complexity: Require investments and other financial products to be
more standardized, so market participants do not need to engage in as much due
diligence.
 Unsystematic Risk
o A company can reduce the unsystematic risk of its security issues, by doing any of
the things that typically strengthen and solidify a company's position in the
marketplace and its overall soundness as a business.
o Diversifying its product portfolio so it is not solely dependent on revenues from
just one or two products.
o Having a management team that is recognized as effective, such as managers with
recognized success in previous management positions. Anything a company can do
to strengthen its position in the marketplace against potential competitors, such as
producing a product that is recognized as superior or enhancing its brand name
recognition, can reduce the company's unsystematic risk.
o Taking steps to strengthen its financial soundness, such as reducing its debt level
or improving its credit rating.

 Credit Risk
o Strategies for credit risk management, including credit policy development and risk
monitoring, is the responsibility of business unit and senior management, and the
board of directors.
o Financial institutions should establish credit limits to control the risk in all credit-
related activity. Limits by industry sector, geographical region, product, customer,
and country should be specified, along with the approaches to be used for
calculating exposures against those limits, and made part of credit policy.
Consideration should also be given to the spread across industries or regions as the
default of one firm or industry may also affect others. Larger financial institutions
might also consider multiple limits for each borrower or borrower group, by
product, operational unit, and borrower member so that banking and trading
activities of those borrowers or borrower groups creating credit risk can be more
adequately monitored. While the trend has been that many financial institutions
monitor total exposures in those categories, most have not set maximum limits on
those exposures.
 Business Risk
o The best ways for a business to manage risk is to evaluate risk factors and make
contingency plans on how to deal with the risk when and if it presents itself.
o Write a business plan: The process of writing and putting together a business plan
is a vital step to assessing, evaluating and planning for the risks of running a
business from the various standpoints of the business. This includes operations,
finance and marketing.
o Determine insurance needs and obtain coverage: Most businesses carry liability
insurance or insure the building and contents where the business operates.
Depending on the business activities, you need to determine the other types of
insurance and obtain the correct coverage for your business.
o Write a risk management plan: Separate from your business plan, write a risk
management plan, which lists all of the possible risks that can affect the business.
The plan also lists the steps, procedures and ways in which the business intends on
dealing with the risk as it arises.
o Train employees: Avoiding risks and how to deal with the risk if it occurs can help
the business avoid further damage or exposing itself to risk in the first place.
o Update plans: Even the best of planning efforts may fall short, so when the
business is exposed to a risk, react accordingly and then put a formal plan and
procedure in place in case the same risk occurrence happens again.

 Foreign-Exchange Risk
o Firms with exposure to foreign exchange risk may use a number of foreign
exchange hedging strategies to reduce the exchange rate risk. Transaction exposure
can be reduced either with the use of the money markets, foreign exchange
derivatives such as forward contracts, futures contracts, options, and swaps, or with
operational techniques such as currency invoicing, leading and lagging of receipts
and payments, and exposure netting.
o Firms may adopt alternative strategies to financial hedging for managing their
economic or operating exposure, by carefully selecting production sites with a mind
for lowering costs, using a policy of flexible sourcing in its supply chain
 management, diversifying its export market across a greater number of countries,
or by implementing strong research and development activities and differentiating
its products in pursuit of greater inelasticity and less foreign exchange risk
exposure.
o 1. Analyze your business’ operating cycle to identify where FX risk exists. This
helps you determine the sensitivity of your profit margins to FX fluctuations and
the stages of your operating cycle where you need protection.
o 2. Calculate your exposure to FX risk. This covers both unconfirmed risk (the
risk that exists before a sales agreement is finalized) and confirmed risk (the risk
that exists after a firm sale is completed but you haven’t yet been paid). Once you
know your level of exposure, you can decide how much risk coverage (“hedging”)
you need.
o 3. Hedge your FX risk. Hedging simply means that you use specially designed
financial instruments to lock in the FX rate so that it remains the same over a
specified period of time. There are numerous ways to hedge, but as an exporter
you’re most likely to use an “FX facility,” which you’ll obtain from your bank. An
FX facility resembles an operating line and can support various types of financial
instruments (or “hedges”), all of which are designed to secure a specific exchange
rate for an export contract so you won’t get any surprises at payment time.
o 4. Create an FX policy and follow it. In this step you establish the FX risk criteria,
procedures and mechanisms that will support your FX risk management program,
and implement this policy across the company.
o 5. Don’t let hedges squeeze your working capital. The essential advantage of a
hedge is that it protects your profits from unfavourable movements in the FX rate.

 Interest Rate Risk

o Forwards - A forward contract is the most basic interest rate management product.
The idea is simple, and many other products discussed in this article are based on
this idea of an agreement today for an exchange of something at a specific future
date. A Forward Rate Agreements (FRAs) is based on the idea of a forward
contract, where the determinant of gain or loss is an interest rate. Under this
 agreement, one party pays a fixed interest rate and receives a floating interest rate
equal to a reference rate. The actual payments are calculated based on a notional
principal amount and paid at intervals determined by the parties. Only a net
payment is made - the loser pays the winner, so to speak. FRAs are always settled
in cash.
o Futures - A futures contract is similar to a forward, but it provides the
counterparties with less risk than a forward contract, namely a lessening of default
and liquidity risk due to the inclusion of an intermediary.
o Swaps - Just like it sounds, a swap is an exchange. More specifically, an interest
rate swap looks a lot like a combination of FRAs and involves an agreement
between counterparties to exchange sets of future cash flows. The most common
type of interest rate swap is a plain vanilla swap, which involves one party paying
a fixed interest rate and receiving a floating rate, and the other party paying a
floating rate and receiving a fixed rate.
o Options - Interest rate management options are option contracts for which
underlying security is a debt obligation. These instruments are useful in protecting
the parties involved in a floating-rate loan, such as adjustable-rate mortgages
(ARMs). A grouping of interest rate calls is referred to as an interest rate cap; a
combination of interest rate puts is referred to as an interest rate floor. In general, a
cap is like a call and a floor is like a put.
o Swaptions - A swaption, or swap option, is simply an option to enter into a swap.
o Embedded options - Many investors encounter interest management derivative
instruments via embedded options. If you have ever bought a bond with a call
provision, you too are in the club. The issuer of your callable bond is insuring that
if interest rates decline, they can call in your bond and issue new bonds with a lower
coupon.
o Caps - A cap, also called a ceiling, is a call option on an interest rate. An example
of its application would be a borrower going long, or paying a premium to buy a
cap and receiving cash payments from the cap seller (the short) when the reference
interest rate exceeds the cap's strike rate. The payments are designed to offset
interest rate increases on a floating-rate loan. If the actual interest rate exceeds the
 strike rate, the seller pays the difference between the strike and the interest rate
multiplied by the notional principal. This option will "cap," or place an upper limit,
on the holder's interest expense.
o Floors - Just as a put option is considered the mirror image of a call option, the
floor is the mirror image of the cap. The interest rate floor, like the cap, is actually
a series of component options, except that they are put options and the series
components are referred to as "floorlets." Whoever is long the floor is paid upon
maturity of the floorlets if the reference rate is below the floor's strike price. A
lender uses this to protect against falling rates on an outstanding floating-rate loan.
o Collars - A protective collar can also help manage interest rate risk. Collaring is
accomplished by simultaneously buying a cap and selling a floor (or vice versa),
just like a collar protects an investor who is long a stock. A zero-cost collar can also
be established to lower the cost of hedging, but this lessens the potential profit that
would be enjoyed by an interest rate movement in your favor, as you have placed a
ceiling on your potential profit.

Non Marketable Financial Assets

 Bank Deposit - Although bank deposits are most safety than other type of investment, but
no one can make sure the bank or financial organization will shut down or not.
 Post Office Deposits - However,post office deposit do not have inflation protected, which
means their is no real returns basis on the scheme earns, if the inflation is above the
guaranteed interest rate.
 Public Provident Fund - By contrast, the public provident fund is also may bring the default
risk to the investors,the risk of default is the risk of government default,because the
government is unable to pay back investors' money.
 Company Deposits - The company deposits may be a risky investment when the company
defaults, like it will make the investor difficult to recover his capital. The company defaults
happen may because of many reason,like recession or the business are not running very
well during that time.
 Financial Derivatives

 they are not usually intended to result in the delivery of a commodity or currency;
 they are usually offset: e.g., a purchase offset by a sale, or vice versa, before delivery;
 the clearing house requires both parties to deposit cash against the transaction and this is
known as the ‘initial margin’;
 If the contract involves a party making a loss that is greater than the initial margin, further
deposits are required on a daily basis from the losing party.
 In the case of forward contracts two parties agree to exchange a real or financial asset on a
pre-arranged date in the future for a specified price are non-standard contracts traded OTC
(over-the-counter) entered bilaterally by two negotiating partners such as two banks;
 imply private agreements between two parties so they are customized to the specific needs
of the parties;
 are highly illiquid: not negotiable, there is no secondary market;
 are such that if one party cannot deliver from stock, then it must buy the commodity or
currency on the spot market in order to fulfil the forward contract; and
 The clearing house does not guarantee the operation so there is a risk of default by the
counterparty.
 Below are some of the motives for someone to use derivatives:

(1) To reduce (or hedge) exposure to risk. For example, a wheat farmer and a wheat miller
could enter into a futures contract to exchange cash for wheat in the future. Both parties
have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the
wheat miller, the availability of wheat.

(2) To speculate expected changes in future prices with the hope of making profit. In this
case, speculation increases the exposure to risk. The potential gain or loss can be leveraged
(i.e. magnified) relative to the initial investment.

(3) To reduce transaction costs, such as commissions and other trading costs.

(4) To maximize return on investments through asset management activities, tax loopholes,
and regulatory restrictions. For example, a company can use derivatives to produce
temporary losses to lower its taxes.
The primary risks associated with trading derivatives are market, counterparty, liquidity and
interconnection risks. Among the most common derivatives traded are futures, options, contracts
for difference, or CFDs, and swaps.

Market Risk

Market risk refers to the general risk in any investment. Investors make decisions and take
positions based on assumptions, technical analysis or other factors that lead them to certain
conclusions about how an investment is likely to perform. An important part of investment analysis
is determining the probability of an investment being profitable and assessing the risk/reward ratio
of potential losses against potential gains.

Counterparty Risk

Counterparty risk, or counterparty credit risk, arises if one of the parties involved in a derivatives
trade, such as the buyer, seller or dealer, defaults on the contract. This risk is higher in over-the-
counter, or OTC, markets, which are much less regulated than ordinary trading exchanges. A
regular trading exchange helps facilitate contract performance by requiring margin deposits that
are adjusted daily through the mark-to-market process. The mark-to-market process makes pricing
derivatives more likely to accurately reflect current value. Traders can manage counterparty risk
by only using dealers they know and consider trustworthy.

Liquidity Risk

Liquidity risk applies to investors who plan to close out a derivative trade prior to maturity. Such
investors need to consider if it is difficult to close out the trade or if existing bid-ask spreads are
so large as to represent a significant cost.

Interconnection Risk

Interconnection risk refers to how the interconnections between various derivative instruments and
dealers might affect an investor's particular derivative trade. Some analysts express concern over
the possibility that problems with just one party in the derivatives market, such as a major bank
that acts as a dealer, might lead to a chain reaction or snowball effect that threatens the stability of
financial markets overall.