Chapter 3

RISK
MANAGEMENT
CA Mayank Kothari

1
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- सी . ए . म यं क को ठा री

2
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 Chapter 3

RISK
MANAGEMENT
CA Mayank Kothari

6
 Organisations
exist for a
purpose.

!7
 Achievement of
that purpose is
clouded by
uncertainties
that both poses
threats to and
offers
opportunity for
increasing
success.

!8
 Businesses
operate in
dynamic
90
environment
72
where change is
55
50 48
58
a constant.

26
15

Region 1 Region 2

!9
Risks are those uncertainties
of outcome, whether an
opportunity or threat, arising
out of actions and events.

!10
Risks are those uncertainties
which impede the
achievement of the objective.

!11
Integral part of syllabus

A corporate launching a new product or service in the

market place may result in failure thereby leading to
financial and reputational losses..
!12
 Risk Management

01 03
Introduction Value At
Risk

02 04
Types of Revision
Risk

!13
 Types of Risk

Strategic Risk Compliance Risk

Operational Risk Financial Risk

!14
 A possible source of loss that might arise
from the pursuit of an unsuccessful
01 business plan.

For example, strategic risk might arise

from

Strategic Risk from the

making poor
substandard
business
execution of
decisions,
decisions,

from a failure to
from inadequate respond well to
resource changes in the
allocation business
environment

!15
Example 01 01. Strategic Risk
When apple introduced its Iphone Nokia's phones became
obsolete overnight. Samsung quickly entered the market with
many models and Nokia was losing market share to both
Samsung and Apple

As touchscreens evolved Nokia was reluctant to take the step of

using touch screens on its phones. Shortly touch screens became
the new standard and the Late Nokia moves didn't help it regain
the market share it lost.

The Symbian Os which Nokia used successfully for years was

inferior to both IOS and Andriod. While those two OS's resulted in
a significant leap in the user interface Nokia's Symbian almost
remained where it was

While both Samsung and Apple focused on innovating and

producing new features Nokia lagged behind and didn't make any
break through changes to its phone or OS.

As Nokia Os remained obsolete customers started embracing the

App store concept and started moving away from phones that
didn't allow them to add new apps easily

!16
 Example 02 01. Strategic Risk
Kodak is synonymous with photography. Their
print processing methods were global and
technologies ahead of the competition.

However, the company ultimately came crashing

down because it didn’t change their strategy with
the market.

1975 Kodak invented the digital camera in 1975. Even

though they produced a report on predicted
future trends in the market, management
decided that the technology wouldn’t disrupt the
market so strategic change was unnecessary.

2012 They had 10 years to act, but didn’t. The

company lost 75% of its value before filing for
bankruptcy in 2012.

!17
 01. Strategic Risk
Example 03
eBay – Misguided Merger
Although 70-90% of mergers fail, on the 10th birthday of her online auction
site, eBay, Meg Whitman spent USD $3.1 billion on Skype, which was
then, only two years old. Whitman believed that Skype would boost its e-
commerce strategy, along with eBay’s auctions and PayPal’s online
payment system.
Skype’s value soon dropped to USD $1.4 billion. Whitman resigned and
was replaced by former business consultant John Donahoe, who sold 65%
of Skype, arguing that it was a strong standalone business. To cope with
losses, eBay cut 10% of its workforce in 2008. Donahoe also moved away
from eBay’s flea market auction style towards more set prices from larger
retailers, a strategy which angered many sellers. Today Skype is worth USD
$8.5 billion under Microsoft.

Example 04
Iridium – Gambling on Technology
Iridium was a company that produced global satellite phones. Backed by Motorola,
it spent $5 billion to expand and launch its wireless satellite phone range. To work,
the system relied on 66 satellites, which were not yet in place. In an effort to make
this happen, the company put itself in $1.5 billion of debt.
Further, each handset was priced at $3000 and cost $5 a minute per call, on top of
other significant monthly charges. Customers rejected this and in 1999 the company
filed for bankruptcy, less than a year after launching.

!18
Example 05
Ten years after it was launched, Tata Motors’s Nano is dead, waiting to be formally buried.
In June 2018, only one Nano was produced and the company admitted two weeks ago that the car cannot continue in its present
form after 2019.
What went wrong and what lessons can be learnt?
1. First, several Nano cars caught fire in the first two years. Tata
Motors rectified the glitches and offered an extended warranty for
both new and existing cars but the reputational damage was done.
2. Second, there was a production delay (having to shift from Singur,
West Bengal to Sanand, Gujarat) of 18 months which was acutely
felt because of high expectations created by the hype over the car.
3. Third, it was low on riding comfort, lacking the stability that
greater weight gives.
4. Fourth, the biggest initial selling point – the cheapest car you can
get – boomeranged. Value-conscious Indians, particularly those
who would like to switch from a scooter to a car, should have
embraced it with open arms but didn’t.

This reaffirmed the widely-held notion that a car does more than
taking you from point A to point B. It is an aspirational symbol.
Prospective buyers felt that to be seen owning the “cheapest” was to
acquire a lowly social status. Instead of being a people’s car it actually
had a niche appeal among the trendy for being cute and almost funky,
like the now-dead Matiz of Daewoo.
Finally, Nano was never the “one lakh” car, as was originally
indicated by Ratan Tata whose brainchild it was. Over time the gap
between the Nano and the cheapest car in the market narrowed. Right
now, the lowest on-the-road price of a Nano in Delhi is quoted at Rs
2.59 lakh, compared to the cheapest Alto 800 going at Rs 2.88 lakh.

!19
 02
Compliance risk is exposure
to legal penalties, financial
Compliance Risk forfeiture and material loss an
organization faces when it
fails to act in accordance with
industry laws and regulations,
internal policies or prescribed
best practices. 

!20
Example 01 02. Compliance Risk

Environmental Risk

Potential for damage to living organisms or the environment arising out of an

organization's activities.

!21
Example 02 02. Compliance Risk

Workplace Health & Safety

Risks related to all aspects of health and safety in the workplace such as
accidents or repetitive strain injuries.

!22
Example 03 02. Compliance Risk

Corrupt Practices

The potential for corrupt

practices such as bribery or
fraud. Organizations are
generally responsible for the
actions of their employees and
agents in this regard.

!23
Example 04 02. Compliance Risk

Quality

Releasing a low quality product or service that fails to

meet the expected level of due diligence in your industry
or that violates laws and regulations.
!24
 03 Operational risk is the
prospect of loss resulting
from inadequate or failed
Operational Risk procedures, systems or
policies. 

Operational risk relates to

‘people’ as well as
‘process’

!25
Example 01 03. Operational Risk
Human Error
A mechanic leaves a tool inside an jet engine resulting in the blowout of the
engine during flight. The aircraft is able to return to the airport but the
passengers are shaken, the airline's reputation is damaged, they face a
government investigation and the engine must be completely replaced.

!26
 Example 01 03. Operational Risk
Insufficient Processes

The settlement process for an investment bank is only designed for regular market
volume. One day there is a market crash and volume on the stock exchanges
spikes to 50x normal. The settlement process fails because it involves manual
steps and the bank doesn't have enough trained staff to complete the processes in
a timely fashion. Customers are impacted as their orders don't show as settled
within the regular time. The bank suffers a loss of reputation with its customers
and trading counterparties.

!27
 04 Financial Risk is referred as the
unexpected changes in
financial conditions such as
Financial Risk prices, exchange rate, Credit
rating, and interest rate etc.

Though political risk is not a financial risk in direct sense but same
can be included as any unexpected political change in any foreign
country may lead to country risk which may ultimately result in
financial loss.

!28
Example 01 04. Financial Risk

!29
Example 02 04. Financial Risk

!30
Example 03 04. Financial Risk

!31
Example 04 04. Financial Risk

89% 93%

1 2 3 4 5 6 7 8
!32
 Risk Management

01 03
Introduction Value At
Risk

02 04
Types of Revision
Risk

!33
 RISK

TYPES VAR

STRATEGIC COMPLIANCE OPERATIONAL FINANCIAL

TYPES EVALUATION

COUNTERPARTY POLITICAL INTEREST RATE CURRENCY

!34
 Counterparty
Risk
Meaning

This risk occurs due to non-honoring of obligations by the counter party which can be
failure to deliver the goods for the payment already made or vice-versa or repayment of
borrowings and interest etc. Thus, this risk also covers the credit risk i.e. default by the
counter party.

!35
Counterparty Example 02

Risk

!36
Counterparty Example 02

Risk

!37
 Counterparty
Risk
Identifying Counterparty Risk Manging Counterparty Risk
1. Necessary Resources
1. Due Diligence

2. Government Restrictions
2. Do not over commit

3. Hostile action of foreign

3. Limits and Procedures
government

4. Rapid Action
4. Let down by third party.

5. Guarantee
5. Insolvent

!38
 RISK

TYPES VAR

STRATEGIC COMPLIANCE OPERATIONAL FINANCIAL

TYPES EVALUATION

COUNTERPARTY POLITICAL INTEREST RATE CURRENCY

!39
 Political
Risk
Meaning

Political risk is a type of risk faced by investors, corporations, and governments that
political decisions, events, or conditions will significantly affect the profitability of a
business actor or the expected value of a given economic action.

Political decisions by governmental leaders about taxes, currency valuation, trade tariffs or barriers,
investment, wage levels, labor laws, environmental regulations  and development priorities, can
affect the business conditions and profitability.  Similarly, non-economic factors can affect a
business.  For example, political disruptions such as terrorism, riots, coups, civil wars, international
wars, and even political elections that may change the ruling government, can dramatically affect
businesses’ ability to operate.

!40
 Examples
Political
Risk

!41
 Examples
Political
Risk

!42
 Examples
Political
Risk

!43
 Political
Risk
Identifying Political Risk Manging Political Risk

1. Confiscation of Overseas property 1. Local sourcing of raw materials and labour.

2. Rationing of Remittance
2. Entering into joint ventures

3. Restriction on conversion of local currency

3. Local financing

4. Restriction as borrowings.
4. Prior negotiations
5. Invalidation of Patents

6. Price control of products

!44
 RISK

TYPES VAR

STRATEGIC COMPLIANCE OPERATIONAL FINANCIAL

TYPES EVALUATION

COUNTERPARTY POLITICAL INTEREST RATE CURRENCY

!45
 Interest Rate
Risk
Meaning

Interest rate risk exposure arises when a change in interest rates has the potential to
affect the value of a company’s assets and liabilities. As a consequence, interest rate
risk could result in higher costs, a loss of earnings and diminished profits. Changing
interest rates can impact companies in different ways and all companies are sensitive to
interest rate movements in one form or another.

!46
 Interest Rate
Risk
Example 01

!47
 Interest Rate
Risk
Identifying Interest Rate Risk Manging Interest Rate Risk
1. Monetary Policy of the Government.

2. Any action by Government such as

1. Using Forward Rate Agreement
demonetization etc.

2. Using Swaps
3. Economic Growth

3. Using Interest Rate Futures

4. Release of Industrial Data

4. Using Caps, Collars, & Floors

5. Investment by foreign investors

6. Stock market changes

!48
 RISK

TYPES VAR

STRATEGIC COMPLIANCE OPERATIONAL FINANCIAL

TYPES EVALUATION

COUNTERPARTY POLITICAL INTEREST RATE CURRENCY

!49
 Currency
Risk
Meaning

Currency risk is the potential risk of loss from fluctuating foreign exchange rates when
an investor has exposure to foreign currency or in foreign-currency-traded investments.

!50
 Currency
Risk
Example

For example, if rupee depreciates vis-à-vis US$ receivables will stand to gain vis-à-vis

to the importer who has the liability to pay bill in US$. The best case we can quote

Infosys (Exporter) and Indian Oil Corporation Ltd. (Importer).

!51
 Currency
Risk
Identifying Currency Risk Manging Currency Risk
1. Government Action

1. Using Forward & Swaps

2. Nominal Interest Rate Contract

3. Inflation Rate
2. Using Futures & Options
Contract
4. Natural Calamities

5. War, Coup, Rebellion etc

3. Leading or Lagging,

6. Change of Government 4. Home Currency Invoicing

!52
 RISK

TYPES VAR

STRATEGIC COMPLIANCE OPERATIONAL FINANCIAL

TYPES EVALUATION

COUNTERPARTY POLITICAL INTEREST RATE CURRENCY

!53
EVALUATION OF FINANCIAL RISK

FROM STAKEHOLDER’S POINT OF VIEW

FROM COMPANY’S POINT OF VIEW

FROM GOVERNMENT’S POINT OF VIEW

!54
FROM STAKEHOLDER’S
POINT OF VIEW Major stakeholders of a business are
equity shareholders and they view
financial gearing i.e. ratio of debt in
capital structure of company as risk
since in event of winding up of a
company they will be least prioritized.

Even for a lender, existing gearing is

also a risk since company having high
gearing faces more risk in default of
payment of interest and principal
repayment.

!55
FROM COMPANY’S POINT
OF VIEW From company’s point of view
if a company borrows
excessively or lend to
someone who defaults, then it
can be forced to go into
liquidation.

!56
FROM GOVERNMENT’S
POINT OF VIEW
From Government’s point of view,
the financial risk can be viewed as
failure of any bank or (like Lehman
Brothers) down grading of any
financial institution leading to spread
of distrust among society at large.
Even this risk also includes willful
defaulters. This can also be extended
to sovereign debt crisis.

!57
FROM GOVERNMENT’S
POINT OF VIEW

!58
 RISK

TYPES VAR

STRATEGIC COMPLIANCE OPERATIONAL FINANCIAL

TYPES EVALUATION

COUNTERPARTY POLITICAL INTEREST RATE CURRENCY

!59
 Value at Risk VaR

!60
 Value at Risk VaR

What is more
00
3 6,5 important before the
₹4,
Risk Management is
the Risk Measurement

!61
 Value at Risk VaR

The most popular and

traditional measure of risk is
Volatility.

!62
 Value at Risk VaR

The main problem with volatility,

Loss however, is that it does not care
Profit about the direction of an
investment's movement: a stock
can be volatile because it
suddenly jumps higher.

!63
 Value at Risk VaR

Of course, investors are not

distressed by gains For Loss

investors, risk is about the

odds of losing money, and
VAR is based on that
common-sense fact.
!64
 Value at Risk VaR

VAR answers the question,

"What is my worst-case scenario?" or
"How much could I lose in a really bad month?"

!65
 Value at Risk VaR

Case Study 1 – Analytical VaR of a single asset

Suppose an investor invests ₹20 lakh in a single asset over
a time horizon of 1 day and the VaR for this portfolio is
found to be ₹1,72,400 at 99% confidence interval.

This means that there is a 1% chance that this asset may

lose at least ₹1,72,400 at the end of the next trading day
under normal market conditions.

172400
50000 120000 250000 300000

!66
 Value at Risk VaR

Case Study 2 – Analytical VaR of a portfolio of two

assets
Suppose another investor invests ₹1 crore in a portfolio
diversified across two asset classes. The VaR at a 95%
confidence level over a one-day horizon is calculated to
be ₹4,98,900.

This means that there is a 5% chance that this asset may

lose at least ₹4,98,900 at the end of the next trading day
under normal market conditions.

498900
20000 400000 650000 850000

!67
 Value at Risk VaR

Case Study 3 - VaR of a portfolio of five equally

weighted schemes
We considered a portfolio consisting five equally-
weighted schemes which belonged to equity, debt, gilt,
balanced and liquid funds respectively. We calculated
VaR for three different periods – 2006-07, 2007-08 and
2010-11. The VaR for the portfolio is listed as follows:

Market Portfolio
Period VaR
Condition Value

Mar 2016 - Feb 2017 Normal ₹ 1,00,000 ₹ 20210

Mar 2017 - Feb 2018 Turbulent ₹ 1,00,000 ₹ 78930

Mar 2018 - Feb 2019 Emerging ₹ 1,00,000 ₹ 52039

!68
 Value at Risk VaR

The Value at Risk (VaR) framework is now an industry standard to measure the risk
associated with a given portfolio of financial instruments. VaR finds favor because it is
easy to understand. It is simply one number which gives you a rough idea about the
extent of risk in the portfolio. It is measured in terms of price units (dollars, euro) or as
a percent of the portfolio value. Value at Risk is applicable to stocks, bonds,
currencies, derivatives, or any other assets with price. This is why banks and financial
institutions like it so much – they can compare profitability and risk of different
units and allocate risk based on VaR (this approach is called risk budgeting).

!69
 Features of VaR VaR

!70
 Features of VaR VaR

01 Components of Calculation
02 Statistical Method
03 Time Horizon
04 Probability
05 Control Risk
06 Z Score

!71
 Use or applications of VaR VaR

1. To measure the maximum possible loss on any portfolio or a trading position.

2. As a benchmark for performance measurement of any operation or trading.

3. To fix limits for individuals dealing in front office of a treasury department.

4. To enable the management to decide the trading strategies.

5. As a tool for Asset and Liability Management especially in banks.

!72
Use or applications of VaR VaR

1. Maximum Possible Loss

2. Benchmark for Performance Measurement

3. To Fix Limits

4. Trading Strategies.

5. Asset and Liability Management

!73
 Formula of VaR VaR

Variance = (SDa)2+ (SDb)2 + 2r(SDa)(SDb)

SD1Day = Variance1Day

VaR1Day = Z Score x SD1Day

SDt days = SD1Day X t

!74
 Z Score

Z Score

90% 1.28

95% 1.65

99% 2.33

75
 RISK

TYPES VAR

STRATEGIC COMPLIANCE OPERATIONAL FINANCIAL

TYPES EVALUATION

COUNTERPARTY POLITICAL INTEREST RATE CURRENCY

!76
Confidence Interval

77
 MALE

FEMALE

Population

6 5.9 6.2 5.7 6.1 5.8

5.6 5.6
5.3
4.5

78
 Confidence Level 90%

Level of Significance 10%

Confidence Interval 5.3 - 6.2

79
 Confidence level refers to the possibility of a parameter that lies within a
specified range of values, which is denoted as c. Moreover, the confidence level is
connected with the level of significance.

The level of significance is defined as the probability of rejecting a null

hypothesis by the test when it is really true, which is denoted as α.

The relationship between level of significance and the confidence level is c=1−α.

80
Normal Probability Distribution

Bell shape curve

81
 Normal Probability Distribution

Take some sand in your hand.Drop it slowly to ground. What do you see?? A small
hill like structure which resembles the graph of normal distribution.Most of the
sand tend to be in the middle and the their are two extremities too.This tendency
to be in middle is central tendency.

82
 Normal Probability Distribution

Garbage

83
 Normal Probability Distribution

So the only thing you have to keep in mind is as the size of

sample increases everything tends to normal

Normal distribution is the tendency of things to average out,

if 100 students write a test, very few of them do very badly,
very few of them do very well and most of them sit around
the average

84
 Normal Probability Distribution

50% to 50% to
the left the right

Mean

85
Normal curves that have smaller standard deviation are sharper compared to the curves that have
higher standard deviation for a given mean. For example, in the below curves, the one with
standard deviation of 5 is sharper compared to the one with std deviation of 10 (Both curves have
same mean of 100)

!86
!87
 Z Score

Z Score

90% 1.28

95% 1.65

99% 2.33

88
!89
 Formula of VaR VaR

VaR = Z Score x SD

!90
 Formula of VaR VaR

Variance = (SDa)2+ (SDb)2 + 2r(SDa)(SDb)

SD1Day = Variance1Day

VaR1Day = Z Score x SD1Day

SDt days = SD1Day X t

!91
Question 1
The VAR on a portfolio using a one day horizon is USD 100 million. What is the
VAR using a 10 day horizon?

!92
Question 2
If the daily VAR is $12,500, calculate the weekly, monthly, semi-annual and annual
VAR. Assume 250 days and 50 weeks per year.

!93
Question 3
Consider a portfolio of $5 million on AT & T shares with a daily volatility of 1%.
Calculate the 99% VAR for 10 day horizon

!94
Question 4
Suppose we have a portfolio of $10 million in shares of Microsoft. We want to calculate
VAR at 99% confidence interval over a 10 day horizon. The volatility of Microsoft is
2% per day. Calculate VAR.

!95
Question 5
Suppose Mr. A holds Rs.2crore shares of X Ltd. whose market price standard deviation
is 2% per day. Assuming 252 trading days a year, determine maximum loss level over
the period of 1 trading day and 10 trading days with 99% confidence level.

!96
Question 6
A trader has an allocation equal to 8% of the firm’s capital. The returns of this unit have a
beta with respect to overall returns of 0.9. The firm’s daily VAR is $120 million. What
should be the VAR allocated to the trader’s unit?

!97
Question 7
James has estimated an annual standard deviation of $750,000 on one of its projects, based
on a normal distribution of returns. The average annual return is $2,400,000. Estimate the
value at risk (VAR) at a 95% confidence level for one year and over the project’s life of six
years

!98
Question 8
Consider a portfolio consisting of a Rs.200,00,000 investment in share XYZ and a Rs.
200,00,000 investment in share ABC. The daily standard deviation of both shares is 1%
and that the coefficient of correlation between them is 0.3. You are required to determine
the 10-day 99% value at risk for the portfolio.

!99
Question 9
Consider a position consisting of a $100,000 investment in asset A and a $100,000
investment in asset B. Assume that the daily volatilities of both assets are 1% and that
the coefficient of correlation between their returns is 0.3. What is the 5-day 99% value
at risk for the portfolio?

!100
Question 10
The Westover Fund is a portfolio consisting of 42% fixed-income investments and 58%
equity investments. The manager of the Westover Fund recently estimated that the annual
VAR (5%), assuming a 250-day year, for the entire portfolio was $1,367,000 based on the
portfolio’s market value of $12,428,000 and a co-relation coefficient between stocks and
bonds of zero. If the annual loss in the equity position is only expected to exceed
$1,153,000; 5% of the time, then the daily expected loss in the bond position that will be
exceeded 5% of the time will be closest to which number?

!101
Question 11
Consider a portfolio with two foreign currencies, Canadian dollar and euro. These two
currencies are uncorrelated and have volatility against the dollar of 5% and 12%
respectively. The portfolio has $2 million invested in CAD and $1 million in Euro. What is
the portfolio VAR at 95% confidence level? What is the impact of diversification? Suppose
we increase the Canadian dollar position by $10,000. What is the marginal VAR?

!102
THANK
YOU