Financial Risk Management: BY S.Lingeswari

FINANCIAL RISK
MANAGEMENT
BY
S.LINGESWARI
FINANCIAL RISK
 Financial risk is an umbrella term for any risk

associated with any form of financing.
 In finance, risk is synonymous with downside risk

and is intimately related to the shortfall or the
difference between the actual return and the
expected return (when the actual return is less).
CONTD…
There are three main sources of financial risk:
1. Financial risks arising from an organization’s exposure to

changes in market prices, such as interest rates, exchange
rates, and commodity Prices.
2. Financial risks arising from the actions of, and transactions

with, other organizations such as vendors, customers, and
counterparties in derivatives transactions.
3. Financial risks resulting from internal actions or failures of

the organization, particularly people, processes, and systems.
FINANCIAL RISK MANAGEMENT
 It is the practice of creating economic value in a
firm by using financial instruments to manage
exposure to risk, particularly credit risk and market
risk.
 Other types include Foreign exchange, Shape,

Volatility, Sector, Liquidity, Inflation risks, etc.
 Financial risk management requires identifying its

sources, measuring it, and plans to address them.
TYPES OF FINANCIAL RISK
Equity Risk Trading Risk
Market Risk
Interest Rate Risk
Gap Risk
Currency Risk
Commodity Risk
Transaction Risk Counterparty Risk

Credit Risk
Financial Portfolio Issuer Risk
Concentration Risk
Risks Liquidity Risk
Operational Risk
Regulatory Risk
Human Factor
Risk
CREDIT RISK
 It is an investor's risk of loss arising from a borrower who does
not make payments as promised. Such an event is called a default.
 It include lost principal and interest, decreased cash flow, and

increased collection costs, which arise in a number of
circumstances:
 A consumer does not make a payment due on a mortgage loan, credit card, line
of credit, or other loan
 A business does not make a payment due on a mortgage, credit card, line of
credit, or other loan
 A business or consumer does not pay a trade invoice when due

CONTD…
 A business does not pay an employee's earned wages when due
 A business or government bond issuer does not make a payment

on a coupon or principal payment when due
 An insolvent insurance company does not pay a policy obligation
 An insolvent bank won't return funds to a depositor
 A government grants bankruptcy protection to an insolvent

consumer or business
CREDIT RISK MANAGEMENT
 To effectively identify , measure , manage and control
credit risk both at the portfolio and individual levels in
accordance with an organisation risk principles , risk
policies , risk process and risk appetite as a continuous
feature.
 It aims to strengthen and increase the efficiency of the

organisation while maintaining consistency and
transparency.
GOALS
 Maintaining risk-return discipline by keeping risk
exposure within acceptable parameters.
 Fixing proper exposure limits keeping in view the risk

philosophy and risk appetite of the organisation.
 Handling credit risk both on an ‘entire portfolio’ basis

and on an ‘individual credit’ basis.
 Maintaining an appropriate balance between credit risk

and risks,like market risk,operational risk etc
CONTD…
 Placing equal emphasis on ‘banking book credit risk’
and ‘off-balance sheet risk’.
 Impartial and value-added control input from credit

risk management to protect capital.
 Providing a timely response to business requirements

efficiently.
 Maintaining consistent quality and efficient credit

process.
TECHNIQUES
 The basic techniques of an credit risk management are:
 Certain risks are not to be taken at all even though there is

the likelihood of major gains or profits like speculative
activities.
 Transactions with a sizeable risk content should be

transferred to professional risk institutions.
 The other risks should be managed by the institution with a

proper risk management architecture.
MARKET RISK
 Market risk is the risk that the value of a portfolio,
either an investment portfolio or a trading portfolio,
will decrease due to the change in value of the market
risk factors.
 The four standard market risk factors are

i) Stock prices
ii)Interest rates
iii)Foreign exchange rates and
iv)Commodity prices.
 The associated market risk are:
• Equity risk, the risk that stock prices and/or the

implied volatility will change.
• Interest rate risk, the risk that interest rates and/or the
implied volatility will change.
• Currency risk, the risk that foreign exchange rates
and/or the implied volatility will change.
• Commodity risk, the risk that commodity prices (e.g.
corn, copper, crude oil) and/or implied volatility will
change.
MARKET RISK MANAGEMENT
 The Market Risk Management component (TR-MRM)
in the Treasury (TR) area helps treasurers to plan,
manage and control the market risks a company is
exposed to.
 The Market Risk Management component (TR-MRM)

builds on Cash Management (TR-CM),which contains
all the payment flows from other operating areas such
as Sales and Distribution.
FUNCTIONS
 Create and maintain the market data required to value
financial instruments.
 Select financial instruments, including transactions
from operating business, according to various criteria.
 Value the following transactions on the basis of real
and fictitious data:
 Forward exchange transactions
 Currency options
 Bonds
 Loans
 Money market transactions
 Forward rate agreements
 Interest rate guarantees
 Interest rate/cross-currency interest rate swaps
 Swaptions
 Futures
 Bond options
 Options on futures
 Calculate the following key figures:
 Market values and differences to market values

 Future values for any horizon
 Effective prices and effective interest rates
 Currency and interest exposures
 Sensitivities to changes in interest rates, exchange rates and
volatilities
 Value at risk
 Cash flows of variable and option instruments
LIQUIDITY RISK
 Liquidity risk is the risk that a given security or

asset cannot be traded quickly enough in the
market to prevent a loss.
TYPES
 Asset liquidity - An asset cannot be sold due to lack of
liquidity in the market - essentially a sub-set of market
risk.
• Widening bid/offer spread
• Making explicit liquidity reserves
• Lengthening holding period for VaR calculations
 Funding liquidity - Risk that liabilities:
• Cannot be met when they fall due
• Can only be met at an uneconomic price
• Can be name-specific or systemic
MANAGING LIQUIDITY RISK
 Liquidity-adjusted value at risk
 Liquidity-adjusted VAR incorporates exogenous liquidity risk into

Value at Risk. It can be defined at VAR + ELC (Exogenous Liquidity
Cost).
 Liquidity at risk
 A country's liquidity position under a range of possible outcomes for

relevant financial variables (exchange rates, commodity prices, credit
spreads, etc.) is considered.
 It might be possible to express a standard in terms of the probabilities of

different outcomes.
CONTD…
 Scenario analysis-based contingency plans
 "Contingency funding plans should incorporate events that

could rapidly affect an institution’s liquidity, including a
sudden inability to securitize assets, tightening of collateral
requirements or other restrictive terms associated with
secured borrowings, or the loss of a large depositor or
counterparty."
OPERATIONAL RISK
 Risk arising from execution of a company's business
functions.
 It focuses on the risks arising from the people, systems and

processes through which a company operates.
 It also includes other categories such as fraud risks, legal

risks, physical or environmental risks.
 The Basel Committee defines operational risk as:

"The risk of loss resulting from inadequate or failed
internal processes, people and systems or from external events."
OPERATIONAL RISK MANAGEMENT
 Operational Risk Management (ORM) is defined as

a continual cyclic process which includes risk
assessment, risk decision making, and implementation
of risk controls, which results in acceptance,
mitigation, or avoidance of risk.
 ORM is the oversight of operational risk, including the

risk of loss resulting from inadequate or failed internal
processes and systems; human factors; or external
events.
PRINCIPLES
 The principles of ORM as follows:
• Accept risk when benefits outweigh the cost.
• Accept no unnecessary risk.
• Anticipate and manage risk by planning.
• Make risk decisions at the right level.

LEVELS OF ORM
 In Depth
In depth risk management is used before a project is
implemented, when there is plenty of time to plan and
prepare.
 Deliberate
Deliberate risk management is used at routine periods
through the implementation of a project or process.
 Time Critical
Time critical risk management is used during
operational exercises or execution of tasks.
BENEFITS
 Reduction of operational loss.
 Lower compliance/auditing costs.
 Early detection of unlawful activities.
 Reduced exposure to future risks.

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FINANCIAL RISK

 Financial risk is an umbrella term for any risk

 In finance, risk is synonymous with downside risk

1. Financial risks arising from an organization’s exposure to

2. Financial risks arising from the actions of, and transactions

3. Financial risks resulting from internal actions or failures of

 Other types include Foreign exchange, Shape,

 Financial risk management requires identifying its

Transaction Risk Counterparty Risk

 It include lost principal and interest, decreased cash flow, and

 A business or consumer does not pay a trade invoice when due

 A business or government bond issuer does not make a payment

 An insolvent insurance company does not pay a policy obligation

 An insolvent bank won't return funds to a depositor

 A government grants bankruptcy protection to an insolvent

 It aims to strengthen and increase the efficiency of the

 Fixing proper exposure limits keeping in view the risk

 Handling credit risk both on an ‘entire portfolio’ basis

 Maintaining an appropriate balance between credit risk

 Impartial and value-added control input from credit

 Providing a timely response to business requirements

 Maintaining consistent quality and efficient credit

 Certain risks are not to be taken at all even though there is

 Transactions with a sizeable risk content should be

 The other risks should be managed by the institution with a

 The four standard market risk factors are

• Equity risk, the risk that stock prices and/or the

 The Market Risk Management component (TR-MRM)

 Calculate the following key figures:

 Market values and differences to market values

 Liquidity risk is the risk that a given security or

 Liquidity-adjusted value at risk

 Liquidity-adjusted VAR incorporates exogenous liquidity risk into

 A country's liquidity position under a range of possible outcomes for

 It might be possible to express a standard in terms of the probabilities of

 "Contingency funding plans should incorporate events that

 It focuses on the risks arising from the people, systems and

 It also includes other categories such as fraud risks, legal

 The Basel Committee defines operational risk as:

 Operational Risk Management (ORM) is defined as

 ORM is the oversight of operational risk, including the

• Accept risk when benefits outweigh the cost.

• Accept no unnecessary risk.

• Anticipate and manage risk by planning.

• Make risk decisions at the right level.

 Reduction of operational loss.

 Lower compliance/auditing costs.

 Early detection of unlawful activities.

 Reduced exposure to future risks.

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