FINANCIAL RISK MANAGEMENT

It is the result of the general

tendency of the investors to move
with the market. So, it is
basically the tendency of
security prices to move
collectively. For instance, in a
falling market, the stock price
of even the best-performing
company drops. Usually,
market risk accounts for about two-
thirds of total systematic risk.
Market risk is the possibility that an individual or other entity will
experience losses due to factors that affect the overall performance of
investments in the financial markets.
Market risk may arise due to changes to interest rates, exchange rates,
geopolitical events, or recessions.
Systematic risk occurs due to macroeconomic factors. It is also called market risk or non-
diversifiable or volatility risk as it is beyond the control of a specific company or individual
and hence, can’t be diversified. All investments and securities suffer from such a type of risk.
One can’t eliminate such a risk by holding more number of shares.
This risk includes all the unforeseen events that happen in everyday life, thus, making it
beyond the control of the investors. Systematic risk impacts the entire industry rather than
a single company or security.
Systematic Risk Example
For example, inflation and interest rate changes affect the entire market. So, one can only
avoid it by not investing in any risky assets. More examples of systematic risk are changes to
laws, tax reforms, interest rate hikes, natural disasters, political instability, foreign policy
changes, currency value changes, failure of banks, and economic recessions.
Unsystematic or “Specific Risk” or “Diversifiable
Risk” or “Residual Risk” are primarily the industry or
firm-specific risks that are there in every investment.
Such risks are also unpredictable and can occur at
any time. Like, if workers of a manufacturing
company go on a strike resulting in a drop in
that company’s stock price.
 What Is a Recession?
A recession is a significant, widespread, and prolonged downturn in
economic activity. A common rule of thumb is that two consecutive quarters
of negative gross domestic product (GDP) growth mean recession, although
more complex formulas are also used.

What Is Gross Domestic Product (GDP)?

Gross domestic product (GDP) is the total monetary or market value of all the finished
goods and services produced within a country’s borders in a specific time period. As a
broad measure of overall domestic production, it functions as a comprehensive
scorecard of a given country’s economic health.

Real GDP takes into account the effects of inflation while nominal GDP does not.
Exchange Rate Risk
 This risk stems from the uncertainty in the changes in the value of the
currencies. So, it affects only the companies doing foreign exchange
transactions, like export and import companies
Political Risk
Political risk occurs primarily due to political instability in a country or a
region. For instance, if a country is at war, then the companies operating
there would be considered risky.
Opportunity Cost and Systematic Risk
Since systematic risk is non-diversifiable, investors demand a
premium to make up for this risk factor. For instance, if risk-free
government security is giving a 5% return, then an investor expects
to make more than that from the equity investment, like 8%. This
difference of 3% (or a premium of 3%) is for assuming the
systematic risk.
 So, systematic risk can also be viewed as the opportunity cost for
selecting one security over another. For instance, if an investor faces a
choice between two options – a 5% risk-free government and a stock with a
15% return, he will make a choice based on his financial goals. If he goes
for the first option, then the return is low, but no risk is involved, including
systematic risk. And, if he goes for the second option, then the additional
return is the opportunity cost of the risk taken by going for the risky asset
instead of the safer option.
Financial risk is an inherent part of the investment and
applies to businesses, government, individuals, and even
financial markets. It basically represents the chance that
the parties involved (shareholders, investors, or other
financial stakeholders) will lose money.

For example, for the government, it could mean a failure of

monetary policy and default on bonds or other debt. For the
companies, it could mean being unable to pay a debt and
losing value on investment. Similarly, individuals face such
risk if their financial decisions jeopardize their ability to pay
the debt. Financial markets face such risks due to
macroeconomic forces.
Settlement is the exchange of two payments or the exchange of an asset for payment.
Settlement risk is the risk that a counterparty will fail to deliver its obligation after the
party has made its delivery. Pre-settlement risk is lower than settlement risk because, with
this measure, payments will offset (i.e., are netted). On the other hand, settlement risk
exposure deals with the full value of each payment
 What are the 8 priority sectors?
The categories under priority
sector are as follows:
•Agriculture.
•Micro, Small and Medium
Enterprises.
•Export Credit.
•Education.
•Housing.
•Social Infrastructure.
•Renewable Energy.
•Others.

Priority Sector refers to those sectors which the Government of India and
Reserve Bank of India consider as important for the development of the basic needs of the
country. They are assigned priority over other sectors. The banks are mandated to encourage
the growth of such sectors with adequate and timely credit.
 Absolute risks help put into perspective how much benefit an
individual is likely to have from a treatment or prevention.

 The relative risk can help us find disparities, like if one group is
having better outcomes than another. But be wary, relative risk
reductions are often used to exaggerate the effects of a treatment.

Relative risk is referred to as tracking error because it is usually measured

relative to a benchmark index or portfolio.
 Risk Terminology
Risk Profile: A composite view of the risk assumed at a particular level
of the entity, or aspect of the business that positions management to
consider the types, severity, and interdependencies of risks, and how they
may affect performance relative to the strategy and business objectives.

Risk appetite: It is the types and amount of risk; on a broad level a

company is willing to accept in its pursuit of value. Risk appetite guides
the practices an organization is encouraged to pursue or not pursue. It sets
the range of appropriate practices and guides risk ‐based decisions rather
than specifying a limit.
 Risk appetite is not static; it may change between products or business
units and over time in line with changing capabilities for managing risk.
The types and amount of risk that an organization might consider
acceptable can change.

Risk Capacity: The maximum level of risk at which a firm can operate
while remaining within constraints implied by capital and funding needs
and its obligations to stakeholders. No firm should want to operate at its
capacity since there would be a very real risk of a breach. Once the
capacity has been understood, a crucial task of risk management is to
understand how a firm‘s activities expose it to risks that use up that
capacity.
 The risk capacity is the maximum amount of risk the company can
assume and therefore represents the upper boundary for the risk
appetite. In the above-given case of an investment firm, the firm
may be able to trade $300 million of securities using leverage. In
that case, $300 million is its risk capacity.

To run a business each company has to take a minimum level of risk. If a company
does not make credit sales, the risk of bad debt expense can be brought to zero;
but cannot achieve its targeted business objective (revenue target). Hence, a floor
of 25% credit sales may be set up; which may adversely affect the targeted
revenue. Risk appetite below the floor will yield no business.
 Likewise, if the risk appetite is above the ceiling, the risk exposure will be
too high. In the case of credit sales beyond a threshold, there will be an
increased liquidity/solvency risk. A credit sale of 90% of total sales is
therefore not an acceptable risk level.
 Hence, it is important to keep the risk between a range [say between the
ceiling and flooring or within tolerance levels]. The upper and lower targets
are the risk tolerance or acceptable variation.
The British Bankers'
Association (BBA) fixing
of the London Interbank
Offered Rate ( LIBOR).
BBA LIBOR was used
as a benchmark or
reference rate for
calculating interest. It
was compiled by the
BBA and released to
the market at about
11.00 am each day.
MATA
Mitigate,
Avoid,
Transfer,
Accept
 1. Stop the production of the product if the product has no demand.
 Cancel the production of goods if there is a decline in the demand to completely avoid
future losses.
 2. ABC enterprise which manufactures air conditioner observes that there are many issues
with the circuits of the air conditioners so the management plan many visit to the
manufacturing unit and invest on repairs and maintenance TO MITIGATE potential losses.
 3. Alternative action – Associated risk – ABC enterprise based in India which
manufactures towel instead of purchasing cotton from china they prefer purchasing cotton
within India to avoid high exchange rate risk . They prefer purchasing cotton from within
the country
 4. Transferring risk to third parties like insurance companies.
 5. Natural disaster is one example which cannot be avoided and is accepted.
There are 8 components to ERP which work harmoniously to mitigate risk and seize
opportunity.

 Internal environment

 Objective setting

 Issue identification

 Risk assessment

 Risk response

 Control objectives

 Information and communication

 Monitoring
 Enterprise Risk Management (ERM) Components
( Risk Planning Components by Board of Directors)
1. Internal Environment: The internal environment encompasses the tone of
an organization, and sets the basis for how risk is viewed and addressed
by an entity’s people, including risk management philosophy and risk
appetite, integrity and ethical values, and the environment in which they
operate.
2. Objective Setting: Objectives must exist before management can identify
potential events affecting their achievement. Enterprise risk management
ensures that management has in place a process to set objectives and that
the chosen objectives support and align with the entity’s mission and are
consistent with its risk appetite.
 ( Risk Response Components by Risk Team)

3. Event Identification: Internal and external events affecting achievement of an

entity’s objectives must be identified, distinguishing between risks and opportunities.
Opportunities are channelled back to management’s strategy or objective-setting
processes.

4. Risk Assessment: Risks are analysed, considering likelihood and impact, as a basis
for determining how they should be managed. Risks are assessed on an inherent and a
residual basis.

5. Risk Response: Management selects risk responses – avoiding, accepting, reducing,

or sharing risk – developing a set of actions to align risks with the entity’s risk
tolerances and risk appetite.
6. Control Activities: Policies and procedures are established and implemented to help
ensure the risk responses are effectively carried out.
( Risk Monitoring Components by management Information system)
7. Information and Communication: Relevant information is identified,
captured, and communicated in a form and timeframe that enable people to
carry out their responsibilities. Effective communication also occurs in a
broader sense, flowing down, across, and up the entity.

8. Monitoring: The entirety of enterprise risk management is monitored and

modifications made as necessary. Monitoring is accomplished through
ongoing management activities, separate evaluations, or both.
 In the year 1996 there was dot.com boom is US wherein the technology industry was doing well. However the stock prices
started falling between the year 2000-2002 as the dot.com boom busted and the prices of the started falling and hence people
started withdrawing their money from the stock market.

In the year 2001, the interest rates in US was close to 1% and the stock market was also down so investors were neither
interested in the stock market nor wanted to park their money in bank as the interest rate was low.

The investors were looking for a good investment opportunity.

 The real estate industry was doing good during
2001-2002. The US government was promoting
people to buy house. The interest rate was low
and people preferred taking loan and investing
in real estate. This increased the demand for
houses in the US and also the prices of the real
What Is an Investment Bank? estate was increasing. This shifted the attention
An investment bank is a financial services company that
of the investors towards real estate and started
acts as an intermediary in large and complex financial
transactions. An investment bank is usually involved investing in the real estate and anticipated that
when a startup company prepares for its launch of an the prices of the houses will continue to increase
initial public offering (IPO) and when a corporation in the years to come and they wil be able to
merges with a competitor. It also has a role as a broker or make good profit.
financial adviser for large institutional clients such as
pension funds.1 The investment banks also wanted to take the
Global investment banks include advantage of the rising prices in the real estate
JPMorgan Chase, Goldman Sachs, Morgan Stanley,
Citigroup, Bank of America, Credit Suisse, and Deutsche
Bank.
Investment banks started buying the loans from the banks and combined many loans
and created a bundle and created a complex derivative product and named them as
collateral debt obligation . The investment banks later got the credit rating for these
CDOs from the credit raters.

The credit rating agencies used to evaluate the loans and give the CDOs a rating. The
Investment banks now sold these CDOs to the investors.

Ideally the banks evaluate the borrowers credit worthiness before issuing loans to the
customers (verifying their income ) here the banks were transferring the risk to the
investment bankers and the investment bankers were inturn transferring the risk to the
potential invetors.

The housing loan usually have longer repayment period.

 Some of the Top Credit Rating Agencies in India
are:
 Credit Rating Information Services of India
Limited (CRISIL) ...
 ICRA Limited. ...
 Credit Analysis and Research limited (CARE) ...
 Brickwork Ratings (BWR) ...
 India Rating and Research Pvt. ...
 Acuite Ratings & Research Limited. ...
 Infomerics Valuation and Rating Private Limited.
 The credit rating agencies gave most of the CDOs AAA ratings . AAA rating is the
most highest rating and means it is a safe investment and there are very little chances
of default. The investors were wooed by the rating the raising demand for the real
estate and started investing in the CDOs
 With the increase in demand for the CDOs the investment banks wanted to buy more
loans from the banks, however the banks had already given loans to the credit worthy
customers and now banks started giving housing loans to less credit worthy customers
who did not have a steady income source and there was no guarantee that they would
repay the loans. The low quality loans are called sub prime loans

 With the greed to get more commission from the investment banks the banks now
started giving housing loans to low credit worthy customers without verifying their
income source
 The banks sold these loans to the Investment Bankers and the Investment bankers in turn complied
many loans together and made a bundle of these loans and called them as CDOs.
 The investor bankers also got a AAA rating to almost 70% of these CDOs .
 The AAA rating created good demand for the subprime loan as well. The investors sold these CDOs to the
investors and the investors had no idea what was happening in the backdrop
 Countrywide Financial Corp and Amerequest Mortage company had given close to $177 Bn subprime loans
Between 2000- 2007 the investment banks made huge profits. Along with the banks and
investment banks even the credit rating agencies made huge profits
 Since the CDOs had AAA rating the AIG
which was the largest Insurance company in
the world gave insurance to the CDOs
thinking there was very little chance of
these CDOs defaulting .
The insurance called it as Credit Default
Swaps.
The CDOs investors bought insurance in
order to get protection against the losses
 The investors did not know that the interest
rate on the sub prime loans were adjustable
rate loan which is usually low in the initial
years and later increases.
 The banks had not informed the borrowers
about the adjustable rate loan and as the
interest rate increased the the sub prime
borrowers were unable to pay the interest and
the banks recovered the loan amount by
auctioning the houses .

 This happened because the banks had lent

loan to the customers without verifying their
income source or repayment capacity

 Also the home buyers had bought the home

entirely on borrowings and did not have any
make any payment out of their savings which
is ideally not the right way.

 With the increasing number of defaulters the banks were auctioning all the houses
however they were not able to find any prospective buyers for the homes which
resulted in the falling prices of the real estate
 Example : When Mr. Alex bought the home , the value
of the house was 50 lakh , however because of the
decline in the demand for home the value of the house
reduced to 35 lakh and the borrowers were defaulting as
they did not want pay higher price.

Because of the defaults the banks stopped receiving

money and the activities came to an halt . The value of
the CDOs also became zero.

Those investors who knew the reality of the CDOS had

bought insurance , when the CDOs failed they made
profit.

AIG which is the largest insurance company incurred

around $99 billion losses
 Since AIG was a big company the
government bailed out AIG and rescued
the company by investing around $ 85
billion to prevent the crisis from further
getting worst and also to save the
employees of AIG

Additionally there were no demand for the

CDOs because of the latest development,
however the Investment bankers had many
CDOs with them and did not have anyone
to buy these CDOs and hence they became
bankrupt
 CORPORATE GOVERNANCE
Corporate governance is the combination of rules, processes or laws by which

businesses are operated, regulated or controlled. The term encompasses the

internal and external factors that affect the interests of a company's stakeholders,

including shareholders, customers, suppliers, government regulators and management.

The purpose of corporate governance is to help build an environment of trust,

transparency and accountability necessary for fostering long-term investment,

financial stability and business integrity, thereby supporting stronger growth and

more inclusive societies.

What is Corporate Governance?
Corporate governance is a system by which corporates are directed and controlled. The
Board of Directors have a fiduciary duty to the shareholders, and thereby are responsible for
overseeing the operations and activities of the company. Corporate governance also provides
the framework for the attainment of a company’s objectives. The main focus is to make
the business function in a highly effective manner so as to achieve positive results and
thereby maximize the returns of the stakeholders.
 Advantages of Corporate Governance
• Compliance with laws: With corporate governance in place, compliance with various laws is taken care of easily, as
corporate governance includes the rules, regulations and policies that enable a business to stay compliant throughout and function
without any hassle or legal inconveniences whatsoever.

• Lesser fines and penalties: Since the legal compliance aspect is taken care of credit to the corporate governance practices,
companies are able to save a fortune on unnecessary fines and compliances and possibly redirect those funds towards business
objectives to achieve greater heights.

• Better management: Since there is a structure in place with regard to how the entity operates, its day-to-day functioning,
managing the activities and achieving targets becomes a whole lot easier. The work atmosphere also takes care of itself under good
principles of corporate governance fostering teamwork, unity, efficiency and a drive for success.

• Reputation and relationships: Companies with good corporate governance are able to attract investors and external
financiers with relative ease, going by their sterling reputation and brand image. One of the pillars of corporate governance is
transparency, which is the practice of sharing key internal information with the stakeholders. This improves the relationship of the entity
with its stakeholders and sows the seeds of trust between the company and society at large.

• Lesser conflicts and frauds: The rules instilled in the workplace encourage the employees to be morally conscious in
every situation that they encounter, thus eliminating the possibility of fraud and conflict between employees.
 THE CODE OF CONDUCT

 The GARP Code of Conduct contains a set of key principles designed to

support financial risk management practices. The Code was developed
for the Financial Risk Manager (FRM) program as well as other
certification programs administered by the Global Association of Risk
Professionals (GARP).
 All GARP Members (including FRM candidates) are expected to abide by
the principles outlined in the Code and are subject to consequences, such
as suspensions, for violating any parts of the Code.
A GARP Member should understand that high ethical behaviour
goes beyond the principles addressed in this topic. When
encountering a situation not specifically outlined in the Code,
Members are always expected to act in an ethical fashion.
Acting with prudence in all situations related to the profession will
uphold the integrity of the risk management field as well as risk
management practitioners
 The Code of Conduct Stresses ethical behaviour in two areas:
 (I) Principles:
The principles section addresses:
(1) professional integrity and ethical conduct,
(2) conflicts of interest, and
(3) confidentiality.
Professional Standards. The Professional Standards section addresses:
(1) fundamental responsibilities and
(2) adherence to generally accepted practices in risk management.
1. Professional Integrity and Ethical Conduct
GARP Members:
1.1. Shall act professionally, ethically and with integrity in all dealings with
employers, existing or potential clients, the public, and other practitioners in the
financial services industry.

1.2. Shall exercise reasonable judgment in the provision of risk services while
maintaining independence of thought and direction. GARP Members must
not offer, solicit, or accept any gift, benefit, compensation, or consideration
that could be reasonably expected to compromise their own or another‘s
independence and objectivity.
 1.3. Must take reasonable precautions to ensure that the Member‘s services are not
used for improper, fraudulent or illegal purposes. EX insider trading, market
manipulation.

 1.4. Shall not knowingly misrepresent details relating to analysis, recommendations,

actions or other professional activities.

 1.5. Shall not engage in any professional conduct involving dishonesty or deception or
engage in any act that reflects negatively on their integrity, character, trustworthiness,
 1.6. Shall not engage in any conduct or commit any act that
compromises the integrity of GARP, the FRM designation, or the
integrity or validity of the examinations leading to the award of the
right to use the FRM designation or any other credentials that may be
offered by GARP. Ex do not leak the papers, no cheating in the exam

 1.7. Shall be mindful of cultural differences regarding ethical

behaviour and customs, and avoid any actions that are, or may
have the appearance of being unethical according to local customs.
If there appears to be a conflict or overlap of standards, the GARP
Member should always seek to apply the highest standard.
 2. Conflict of Interest
 GARP Members shall:
 2.1. Act fairly in all situations and must fully disclose any actual or potential conflict
to all affected parties.
 2.2. Make full and fair disclosure of all matters that could reasonably be
expected to impair independence and objectivity or interfere with
respective duties to their employer, clients, and prospective clients.
 3. Confidentiality
 GARP Members:
 3.l Shall not make use of confidential information for
inappropriate purposes and unless having received prior
consent shall maintain the confidentiality of their work, their
employer or client.
 3.2 Must not use confidential information for personal benefit.
 GARP Members shall:
4. FUNDAMENTAL RESPONSIBILITIES

 4.1 comply with all the applicable laws, rules and regulations (including this Code)
governing the GARP members‘ professional activities and shall not knowingly participate
or assist in any violation of such laws, rules, or regulations.
 4.2 Have ethical responsibilities and cannot outsource or delegate those responsibilities
to others.
 4.3 Understand the needs and complexity of their employer or client, and should
provide appropriate and suitable risk management services and advice.
 4.4 Be diligent about not overstating the accuracy or certainty of results or
conclusions
 4.5 Clearly disclose the relevant limits of their specific knowledge and expertise
concerning risk assessment, industry practices, and applicable laws and regulations.