risk management

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Presentation at FICCI Conference on ”Global Banking Paradigm Shift” On Sept 14, 2003, Bangalore RISK MANAGEMENT ROHIT GARG

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2 What is Risk? Risk, in traditional terms, is viewed as a ‘negative’. Webster’s dictionary, for instance, defines risk as “exposing to danger or hazard”. The Chinese give a much better description of risk >The first is the symbol for “danger”, while >the second is the symbol for “opportunity”, making risk a mix of danger and opportunity.

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3 Risk Management Risk management is present in all aspects of life; It is about the everyday trade-off between an expected reward an a potential danger. We, in the business world, often associate risk with some variability in financial outcomes. However, the notion of risk is much larger. It is universal, in the sense that it refers to human behaviour in the decision making process. Risk management is an attempt to identify, to measure, to monitor and to manage uncertainty.

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4 Types of financial risk

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5 Understanding Market Risk It is the risk that the value of on and off-balance sheet positions of a financial institution will be adversely affected by movements in market rates or prices such as interest rates, foreign exchange rates, equity prices, credit spreads and/or commodity prices resulting in a loss to earnings and capital.

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6 Convergence of Economies Easy and faster flow of information Skill Enhancement Increasing Market activity Why the focus on Market Risk Management ? Leading to Increased Volatility Need for measuring and managing Market Risks Regulatory focus Profiting from Risk

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7 Best Practices in Market Risk Management

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8 Increased reliance on objective risk assessment Align “Risk strategy” & “Business Strategy” Investment process differentiated on the basis of risk, not size Investment in workflow automation / back-end processes Active Portfolio Management

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9 Board and senior Management Oversight Delineate banks overall risk tolerance in relation to market risk Ensure that bank’s overall market risk exposure is maintained at prudent levels and consistent with the available capital Ensure that top management as well as individuals responsible for market risk management possess sound expertise and knowledge to accomplish the risk management function. Ensure that the bank implements sound fundamental principles that facilitate the identification, measurement, monitoring and control of market risk. Ensure that adequate resources (technical as well as human) are devoted to market risk management.

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10 Investment & Market Risk Policies should be comprehensive Set exposure Limits On Different Parameters – dealer wise, transaction, instruments, broker, & other counter parties Investment organisation - Independent set of people for front, mid & back offices Implement straight - through processing Operationalise stop-loss limits

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11 Organization Structure The structure should conform to the overall strategy and risk policy set by the BOD Those who take risk (front office) must know the organization’s risk profile, products that they are allowed to trade, and the approved limits. Apart from BOD responsibility to be assumed by forming following The risk management function should be independent, reporting directly to senior management or BOD. The Risk Management Committee The Asset-Liability Management Committee (ALCO) The Middle Office.

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12 Risk Management Business Process Management Improved Control Enhanced Reporting Improved Integration Enhanced Productivity Straight -through Processing

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13 Interest Rate Swaps Forward Rate Agreements Forward Contracts Currency Options Equity Derivatives Equity Options

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14 The need arises due to structured products and lack of liquidity results in the absence of traded prices CRISIL is the official provider of valuation services and appointed by SEBI / AMFI for the Mutual Fund industry segment In case of non-traded securities, marking to market is critical for valuation & risk management In case of active investment management and for risk management, the periodicity of daily valuation is required

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15 sound treasury control liquidity management position keeping limit management risk management settlement management treasury accounting middle office back office front office Complete integration Align Business strategy and treasury process

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16 Value-at-Risk Value-at-Risk is a measure of Market Risk, which measures the maximum loss in the market value of a portfolio with a given confidence VaR is denominated in units of a currency or as a percentage of portfolio holdings For e.g.., a set of portfolio having a current value of say Rs.100,000- can be described to have a daily value at risk of Rs. 5000- at a 99% confidence level, which means there is a 1/100 chance of the loss exceeding Rs. 5000/- considering no great paradigm shifts in the underlying factors. It is a probability of occurrence and hence is a statistical measure of risk exposure

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17 Variance- covariance Matrix Multiple Portfolios Yields Duration Incremental VaR Stop Loss Portfolio Optimization VaR Features of CRISIL VaR Model Facility of multiple methods and portfolios in single model Return Analysis for aiding in trade-off For Identifying and isolating Risky and safe securities For picking up securities which gel well in the portfolio For aiding in cutting losses during volatile periods Helps in optimizing portfolio in the given set of constraints

Managing Market Risk : 

18 Managing Market Risk

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19 Crisil’s Corporate predictor Model (CCOP) is a quantitative model to predict default risk dynamically Model is constructed by using the hybrid approach of combining Factor model & Structural model (market based measure) The inputs used include: Financial ratios, default statistics, Capital Structure & Equity Prices. The present coverage include listed & Crisil rated companies The product development work related to private firm model & portfolio management model is in process The model is validated internally CCoP is one of the most complicated product developed and with the help of in-house technology. Derivation of Asset value & volatility Calculated from Equity Value , volatility for each company-year Solving for firm Asset Value & Asset Volatility simultaneously from 2 eqns. relating it to equity value and volatility Calculate Distance to Default Calculate default point (Debt liabilities for given horizon value) Simulate the asset value and Volatility at horizon Calculate Default probability (EDF) Relating distance to default to actual default experience Use QRM & Transition Matrix Calculate Default probability based on Financials Arrive at a combined measure of Default using both

Effective Management of Market Risk benefits the bank.. : 

20 Effective Management of Market Risk benefits the bank.. Efficient allocation of capital to exploit different risk / reward pattern across business Better Product Pricing Early warning signals on potential events impacting business Reduced earnings Volatility Increased Shareholder Value To Summarise….

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21 for further details contact, . . . Rohit garg PGDM-IB (IITTM) Email : rohitgarg_1987@yahoo.co.in Ph.no: 5653 7531