1. Portfolio Management Unit – IV Risk Management Unit – IV Risk Management

2. Unit Contents What is Risk Management? Risk Management Process Risk Governance and Steps Sources of Risk/ Classification of Risks Measuring Risk - Measuring Market Risk - VaR and Advantages and Limitations of VaR Managing Risk - 9 Principles. Summarizing and Q & A

3. Risk management is a process involving the identification of exposures to risk, the establishment of appropriate ranges for exposures (given a clear understanding of an entity’s objectives and constraints), the continuous measurement of these exposures (either present or contemplated), and the execution of appropriate adjustments whenever exposure levels fall outside of target ranges. The process is continuous and may require alterations in any of these activities to reflect new policies, preferences, and information. This definition highlights that risk management should be a process, not just an activity. A process is continuous and subject to evaluation and revision. Effective risk management requires the constant and consistent monitoring of exposures, with an eye toward making adjustments, whenever and wherever the situation calls for them Risk Management

6. First, it defines its risk tolerance - level of risk it is willing and able to bear. Identifies the risks from all sources of information, and Measure risks using information or data from all identified exposures. Adjustments of risk- the possible complete transfer of risk. The execution of risk management: Trade identification, pricing, and execution. Risk management is a general practice that involves risk modification (e.g., risk reduction or risk expansion) Risk Management

7. RISK GOVERNANCE The process of setting overall policies and standards in risk management is called risk governance. Risk governance involves choices of governance structure, infrastructure, reporting, and methodology. The quality of risk governance can be judged by its transparency, accountability, effectiveness (achieving objectives), and efficiency (economy in the use of resources to achieve objectives). Risk governance begins with choices concerning governance structure. Centralized risk management puts the responsibility on a level closer to senior management, where we have argued it belongs. It gives an overall picture of the company’s risk position, and ultimately, the overall picture is what counts. This centralized type of risk management is now called enterprise risk management (ERM) or sometimes firm wide risk management Risk Management

8. Risk governance is an element of corporate governance (the system of internal controls and procedures used to manage individual companies). An effective ERM system typically incorporates the following steps: 1. Identify each risk factor to which the company is exposed. 2. Quantify each exposure’s size in money terms. 3. Map these inputs into a risk estimation calculation. 4. Identify overall risk exposures as well as the contribution to overall risk deriving from each risk factor. 5. Set up a process to report on these risks periodically to senior management, who will set up a committee of division heads and executives to determine capital allocations, risk limits, and risk management policies. 6. Monitor compliance with policies and risk limits. Risk Management

9. IDENTIFYING RISKS Risk exposures take very different forms, each of which, to varying extents, may call for customized treatment. Effective risk management demands the separation of risk exposures into specific categories that reflect their distinguishing characteristics. Once a classification framework is in place, we can move on to the next steps in the risk management process: identification, classification, and measurement. Risk Management

10. Sources/Classification of Risks The list is far from exhaustive, many company (or portfolio) exposures fall into one of the following categories: Market risk (including interest rate risk, exchange rate risk, equity price risk, commodity price risk); credit risk; liquidity risk; operational risk; model risk; settlement risk; regulatory risk; legal/contract risk; tax risk; accounting risk; and sovereign/political risk. These risks may be grouped into financial risks and nonfinancial risks. Financial risk refers to all risks derived from events in the external financial markets; Nonfinancial risk refers to all other forms of risk. Risk Management

12. 1. Market Risk Market risk is the risk associated with interest rates, exchange rates, stock prices, and commodity prices. It is linked to supply and demand in various marketplaces. The possibility for an investor to experience losses due to factors that affect the overall performance of the financial markets. Market risk, also called "systematic risk," cannot be eliminated through diversification, though it can be hedged against.systematic risk The risk that a major natural disaster will cause a decline in the market as a whole is an example of market risk. Other sources of market risk include recessions, political turmoil, changes in interest rates and terrorist attacks. Risk Management

13. 2. Credit Risk Credit risk is the risk of loss caused by a counterparty or debtor’s failure to make a payment. The risk of loss of principal or loss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation. Credit risk is closely tied to the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk. Risk Management

14. 3. Liquidity risk This is the risk that a financial instrument cannot be purchased or sold without a significant concession in price because of the market’s potential inability to efficiently accommodate the desired trading size. 4. Operational risk sometimes called operations risk, is the risk of loss from failures in a company’s systems and procedures or from external events. These risks can arise from computer breakdowns (including bugs, viruses, and hardware problems), human error, and events completely outside of companies’ control, including ‘‘acts of God’’ and terrorist actions. Risk Management

15. 5. Model risk This is the risk that a model is incorrect or misapplied; in investments, it often refers to valuation models. Model risk exists to some extent in any model that attempts to identify the fair value of financial instruments, but it is most prevalent in models used in derivatives markets. 6. Settlement (Herstatt) Risk The payments associated with the purchase and sale of cash securities such as equities and bonds, along with cash transfers executed for swaps, forwards, options, and other types of derivatives, are referred to collectively as settlements. Risk Management

16. 7. Regulatory Risk Regulatory risk is the risk associated with the uncertainty of how a transaction will be regulated or with the potential for regulations to change. Equities (common and preferred stock), bonds, futures, and exchange-traded derivatives markets usually are regulated at the federal level, whereas OTC derivative markets and transactions in alternative investments (e.g., hedge funds and private equity partnerships) are much more loosely regulated. 8. Legal/Contract Risk Nearly every financial transaction is subject to some form of contract law. Any contract has two parties, each obligated to do something for the other. If one party fails to perform or believes that the other has engaged in a fraudulent practice, the contract can be abrogated. A dispute would then likely arise, which could involve litigation (Court Case), especially if large losses occur. Risk Management

17. 9. Tax Risk Tax risk arises because of the uncertainty associated with tax laws. Tax law covering the ownership and transaction of financial instruments can be extremely complex, and the taxation of derivatives transactions is an area of even more confusion and uncertainty. Tax rulings clarify these matters on occasion, but on other occasions, they confuse them further. In addition, tax policy often fails to keep pace with innovations in financial instruments. Risk Management

18. 10. Accounting Risk Accounting risk arises from uncertainty about how a transaction should be recorded and the potential for accounting rules and regulations to change. 11. Sovereign and Political Risks Sovereign risk is a form of credit risk in which the borrower is the government of a sovereign nation. The risk that a foreign central bank will alter its foreign-exchange regulations thereby significantly reducing or completely nulling the value of foreign- exchange contracts. Political risk is associated with changes in the political environment. Risk Management

19. 12. Other Risks ESG risk is the risk to a company’s market valuation resulting from environmental, social, and governance factors. Performance netting risk, which applies to entities that fund more than one strategy, is the potential for loss resulting from the failure of fees based on net performance to fully cover contractual payout obligations to individual portfolio managers. Settlement netting risk (or again, simply netting risk) refers to the risk that a liquidator of a counterparty in default could challenge a netting arrangement so that profitable transactions are realized for the benefit of creditors Risk Management