Financi

DR. ANURAG AGNIHOTRI

M.com, LLB, LLM, ACS,ACWA,
MBA(fin), MBA(HR), PGDIPR,
MIMA, M.Phil, UGC -Net,
PH.D (Risk Management
NISM certifications: VII,VIII. X-A, X-B, XIII,XV
Risk Financial Risk FRM

1. Personal Risk management

2. Farmer risk management
3. Institutional financial Risk Management
3. Industry risk management
• export
• import
• raw material
• sales
• BR RECOVERY
• Employee remuneration
4. Investor risk management
What it is Risk and Risk Mgt?
“art of approximations”

Sortino
 Magical triangle

Rate of return

Liquidity Risk
No Risk … No Gain!
We live in a risky world

1971 Collapse of Bretton EX rates became flexible

woods and volatile
1973 Oil price shocks Inflation
1987 Black Monday 1 trillion capital shaved
1989 Japanese stock market Nikkei declined from
deflated 39,000 to 17,000 in 3 yrs
1994 Fed increased rates 6 Bond market debacle
times consecutively
1997 Asian crisis Emerging markets
became pariahs
And the saga continues
 Risk and risk mgmt.

• Risk is defined as the uncertainty surrounding the outcome of

a future event

• Risk management is the process by which various risk

exposures are identified, measured and controlled.

Why Manage Financial Risks?
Firms can benefit from financial risk management to protect the firm’s
ability to attend to its core business and achieve its strategic objectives.
It helps to encourage equity investors, creditors, managers, workers,
suppliers, and customers to remain loyal to the business. In short, the
firm’s goodwill is strengthened . Its ancillary benefits:
• The firm’s reputation or ‘brand’ is enhanced, as firm is seen as
successful and its management is viewed as both competent and
credible.
• Risk management can reduce earnings volatility, which helps to make
financial statements and dividend announcements more relevant and
reliable.
• Greater earnings stability also tends to reduce average tax liabilities.
• Risk management can protect a firm’s cash flows.
• The risk management may reduce the cost of capital, therefore
raising the potential economic value added for a business.
• The firm is better placed to exploit through an improved credit rating
and more secure access to financing.
 financial risk management system
• Risk identification and assessment
• Development of a risk response
• Implementation of a risk control strategy and
the associated control mechanisms
• Review of risk exposures (via internal reports)
and repetition of the cycle
 What Did Businesses Do?
• Hire economists and financial economists to forecast
financial prices!
• How did the economists do?

Sample headlines in the financial press:

• The Forecastsers Flunk
• Why Did Economists Not Foresee the Crisis?
• The Perils of Prophecy
 Why Were Economists So Bad?
• Big Business Viewpoint:
• Economists rely too much on arcane theory.
• They don’t understand how the real world works.

• Economist’s Viewpoint:
• Markets are efficient!
• Prices, completely and instantaneously reflect all available
information…
• Therefore, prices are unpredictable.
 Risk Management - key drivers

• Deregulation
• Increased role of securities and derivatives
• Volatility
• Globalization
• Regulatory requirements
 Taxonomy of risks
• Market risk
• Credit risk •Cost Center
• Liquidity risk •Revenue center
• Operational risk •Profit center
• Legal risk
• Corporate Governance
 FINANCIAL RISKS

Financing/Liquid
Market Risks Credit Risks
ity Risks Financing
Equity risks Customer risks Market liquidity
Interest rates Supplier risks Cashflows
Exchange rates Partner risks
Commodity
prices
 Three ways to manage risk
The “ART” of Risk Management:

– Accept the risk (e.g., self-insure)

– Remove the risk (divest, diversify)

– Transfer the risk (hedging, insurance)

 Credit risks

• Settlement /delivery risk

Fundamental risks
• Sovereign risk
• Convertibility risk
• Collateral default risk
esoteric risks
• Cashflow mismatch risk
• Model risk
 Market risks
• Directional risk
• Curve risk
• Volatility risk Fundamental risks

• Basis risk
• Skew risk
• Volatility of volatility risk
• Cross volatility risk esoteric risks
 Risk quantification
• Risks discovered in the identification stage should be
decomposed into quantifiable terms; this allows exposures to
be constrained and monitored
• Models are based on assumptions that may or may not be
realistic; assumptions and the impact they can have on
valuation, must be well understood
• Models should not be used to the point of “blind faith” – they
are only ancillary tools intended to supplement the risk process
• “safe assets” can become risky in a crisis – quantifying the
downside of such exposures is useful
 Risk monitoring
• Monitoring involves internal scrutiny and tracking of exposures
in relation to limits/policies
• Reporting means communication of exposures internally and
externally
• It is more useful to have timely report of 90% of a firm’s risk
exposure than delayed reporting of 100%
• Information should not come from multiple sources – a single
independent source should be used a the kernel for all reports
and should be audited for accuracy on a regular basis
 Risk monitoring
• Profits must be reviewed with the same rigor as losses as they may
be indicative of large, or unknown risks
• Watch out your star traders
 Risk organization
• An independent ‘middle office’ responsible for compiling and
explicitly stating the firm’s approach to risk, defining trading
limits and the areas of the market the firm would like to have
exposures to
• Head of risk function reporting to an independent senior
manager who is a member of the Board
• Monitoring the separation of duties between front, middle and
back office
• Reporting to the senior management about the adherence of
the front office to the overall firm’s risk strategy
 Risk Management for different Cases
• Farmer
• Individual
• Institution Non corporate entity
• Companies (Industry)
• Banks and Financial Institution
• Portfolio Management
 Risk Management tools
Non Derivative Derivative
• Insurance • Forward
• Diversification • Futures
• Internal control • Options
• Shifting the manufacturing • Swap
• Natural hedging
• Risk sharing
• Long term fixed contracts
• Good corporate governance
 What is volatility?

Measure of the amount and intensity of price

fluctuation
The more volatile a stock’s price, the more often
and intensely it fluctuates

FRMM 26
 Causes of volatility
• Information release
• Trading

FRMM 27
 Types of volatility
• Historical volatility
• Forecasted volatility
• Implied volatility
• Actual volatility

FRMM 28
• Risk Mgt of portfolio using
Futures and Option
 Fair Value of A Futures Contract

The futures price should equal the index plus a differential based on the

short-term interest rate minus the dividend yield:

( R  D )T
F  Se

Financial Derivatives 31
 Fair value of an SIF: Example
Assume the following information on a
hypothetical index futures contract:

• Current level of the spot index (S) = 1,484.43

• Interest rate = 6.07%
• Dividend yield (D) = 1.10%
• Days until December settlement (T) = 100 = 0.274 years
( R  D )T
F  Se
(.0607.0110 )(100 / 365)
 1,484.4e  1,504.75

Financial Derivatives 32
 When will you sell SIFs?
• .. feel some stocks no longer offer adequate returns
for the risks the stocks possess;
• .. have turned bearish (or less bullish) on the overall
market, or;
• .. have to sell in order to provide cash for the clients.

Stock index futures provide an efficient means to achieve

the objectives

Financial Derivatives 33
 When will you buy SIFs?

• receive an inflow of cash but has not decided

which stocks or market sectors in which to invest.
• growing bullishness about the market.
• wants to get market exposure in advance of a
near-term expected cash inflow.
• wants an investment that can be quickly
liquidated to raise cash, if needed

Financial Derivatives 34
 Hedging

• The primary purpose of index futures is to

facilitate risk transfer from one who bears
undesired risk to someone else willing to bear
the risk
• Index futures are used by many institutional
investors to hedge

Financial Derivatives 35
 Hedging with SIFs
• To construct a proper hedge, one must
consider that portfolios are of
– Different sizes
– Different risk levels
• The hedge ratio incorporates the relative value
of the stock and futures, and accounts for the
relative riskiness of the two portfolios

Financial Derivatives 36
 Hedge ratio
• To determine the hedge ratio, you need:

– The monetary value of the chosen futures contract

– The monetary value of the portfolio to be hedged
– The beta of the portfolio

Monetary value of the portfolio

HR   beta
Monetary value of the SIF contract

Financial Derivatives 37
 Changing the Beta of a Portfolio
Capital Market Theory predicts that rational investors will only
hold combinations of two assets:
– The market portfolio of all assets, (by definition, has a beta of 1.0)
– A risk-less asset, (by definition, has a beta of 0.0)
If investors are relatively more risk averse or are bearish about
the prospects for the stock market, investors will lower the
beta of their portfolio by shifting a portion of their assets
into risk-less securities.
If investors are not very risk averse or if they are bullish about
the market, investors will raise their portfolio's beta by
borrowing additional capital and investing the borrowed
funds in risky securities.
Financial Derivatives 38
 Adjusting beta
Futures can be used to adjust the level of market risk in a portfolio:
Portfolio value  βdesired  βcurrent 
N
futures level Contract Multiplier

• N = no. of futures contracts required to change beta from ß p to ßd

• A negative number indicates that futures should be sold in order to lower the
portfolio beta. A positive number means that futures should be bought.

Financial Derivatives 39
 Ex: Adjusting beta
A fund manager owns a portfolio of Rs 2 million in stocks with a portfolio
beta of 1.20 is concerned that the stock market will temporarily decline
in the next few days.
The manager decides to use futures contracts to hedge against the expected
market decline.
Suppose, the spot Nifty is at 1275 and the observed futures price is 1280.
How many contracts should he trade?

Financial Derivatives 40
 Ex: Adjusting beta
• Set the target portfolio beta, d, equal to 0.0.
Then, using the earlier equation, we conclude
that the manager should sell
2,000,000   0  1.20 
# contracts   37.5 ~ 38
1280  50

• Suppose the manager was right about the

market's movement, and the index declines to
1224, which is a 4% decline in the market.
Financial Derivatives 41
 Ex: Adjusting beta
The value of the manager’s equity portfolio should
decline by 4.8% (1.20 times 4%). This results in a loss
in the capital value of the portfolio of Rs 96,000
Now the futures price also declines by 4%, to 1228.80.
A futures price decline of 51.2 points results in a profit
of 2,560 on one futures contract. On a position of
38 short futures contracts, the profit would be Rs
97,280
Here, the hedge eliminated the effects of the market
decline

Financial Derivatives 42
Factors affecting an Option’s Value
Factor Call Owner Put Owner

Current Price (S) + -

Strike Price (X) - +

Time to Expiry (T) - -

Volatility (s) + +

Risk-free rate (rf) + -

43
 Any Questions PL

• Thanks and Regards