This is where risk management is important, in that it can be used to protect against loss or danger arising from a risky activity. For proper control and management of risks, as insurers, we should always keep the following in mind with regard to any project or subject-matter of insurance Establishing the context includes planning the remainder of the process and mapping out the scope of the exercise, the identity and objectives of stakeholders, the basis upon which risks will be evaluated and defining a framework for the process, and agenda for identification and analysis At different levels of an organization, different levels of risks can be tolerated. For example, a project manager may not want to tolerate any delay in the schedule, while another member at the level of team leader might be more concerned with the reliability of the product. A project manager might not be able to tolerate the risk of running overbudget by more than 10% while a higher level manager who is more aware of the value of early entry into market may be more concerned with the time taken by the project and might be willing to overspend the budget by much more if the product can be produced sooner. Benchmarks can be run in almost all types of systems environments including batch and on-line jobs streams and with the users linked to the system directly or through other methods. Starting with the highest priority risk first, task your team with either solving or at least mitigating the risk so that it’s no longer a threat to the project. Effectively treating and mitigating the risk also means using your team's resources efficiently without derailing the project in the meantime. Identifying risks is a positive experience that your whole team can take part in and learn from.Leverage the collective knowledge and experience of your entire team. The risk management program must be periodically reviewed and evaluated to see whether the objectives are being attained or not. Especially, risk management costs, safety programs and loss preventive programs must be carefully monitored. Loss records must also be examined to detect any changes in frequency and severity. 9.6 KEYWORDS Periodic review: Periodic review is the university's mechanism for evaluating programmes and subjects holistically at least every five years, taking a view of the 151 CU IDOL SELF LEARNING MATERIAL (SLM)
quality and standards of the provision, allowing for external and independent confirmation. Evaluation: “The process of determining to what extent the educational objectives are actually being realized”. Evaluation is the collection of, analysis and interpretation of information about any aspect of a programme of education or training as part of a recognised process of judging its effectiveness, its efficiency and any other outcomes it may have. Dissemination of information: Information dissemination is to distribute or broadcast information. Learn more in: Intelligence and Security Informatics. This refers to as an active distribution and the spreading of information of all kinds to the users or those audiences that deserve it. Negotiation of terms: Haggling means to negotiate, argue, bargain or barter about the terms of a business transaction, usually focussing on the purchase or selling price of a product or service. Retention: Retention is the act or condition of keeping or containing something. Retention is the act or condition of keeping or containing something. An example of retention is a dam holding back a river. An example of retention is someone being held in a rehabilitation center 9.7 LEARNING ACTIVITY 1. Insurance policies are the most complex element in Risk Management, and consequently in our system. Give reasons to support your answer. ______________________________________________________________________________ ______________________________________________________________________________ Find out how the Responsibilities of risk managers in commissioning and supporting a risk assessment affects the organization. ______________________________________________________________________________ ______________________________________________________________________________ 9.8 UNIT END QUESTIONS 152 A. Descriptive Questions Short Questions CU IDOL SELF LEARNING MATERIAL (SLM)
1. What is the meaning and Definition of Risk Management Process? 2. What are the steps in Risk Management Process? 3. Explain Risk Identification 4. Define the following: i. Risk Measurement ii. Risk Implementation 5. What are the steps in identifying the Tools of Risk Management? Long Questions 1. Explain the steps in Personal Risk Management 2. What is the objective of risk management process? Define the meaning and scope of risk management process? 3. What are the steps in risk management process? 4. Define the term risk administration or implementation? 5. How is selection of risk tools an important decision for an organization? B. Multiple Choice Questions 1. As a tester which of the following will come under product risk if you are testing an e- commerce website? a. Shortage of testers b. Many changes in SRS that caused changes in test cases c. Delay in fixing defects by development team d. Failure to transfer a user to secure gateway while paying Which of the following technique will ensure that impact of risk will be less? a. Risk avoidance technique b. Risk Mitigation technique c. Risk contingency technique d. All of these What is associated with product risk? 153 a. Control of test item CU IDOL SELF LEARNING MATERIAL (SLM)
b. Negative consequences c. Non-availability of test environment d. Test object Risk management is responsibility of the a. Customer b. Investor c. Developer d. Project team The steps in Risk Management process are: a. Risk Identification, Risk Measurement b. Identifying the Tools of Risk Management c. Selection of Risk Tools d. All of these Answers 1-d, 2-c, 3-d, 4-d, 5-d 9.9 REFERENCES References Bhardwaj, H.P. Foreign Exchange Handbook. Bhardwaj Publishing Company,Murnbai. 2. Joel Bessis. (1 998). Risk Management in Banking, MIS John Willy Sons, New York,U.S.A. 3. Rajwade A.V. (2000). Foreign Exchange International Finance: Risk Management,Academy of Business Studies, Ansari Road, New Delhi. Textbooks Trivedi and Hassan. Tkeasury Operations and Risk Management, Genesis Publishers,Mumbai. Banking in New Millenium: Report on Conference of Chairman of Bank, NIBM,Pune (2000). Risk Management Systems in Banks, Guidelines by Reserve Bank of India (1999). 154 CU IDOL SELF LEARNING MATERIAL (SLM)
Websites https://www.lucidchart.com/blog/risk-management-process https://www.iedunote.com/risk-management https://www.lucidchart.com/blog/risk-management-process 155 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT – 10: RISK CONTROL AND RISK FINANCING STRUCTURE 10.0 Learning Objectives 10.1 Introduction 10.2 Risk Avoidance 10.3 Risk Reduction 10.4 Difference between Risk Avoidance and Risk Reduction 10.4 Summary 10.5 Keywords 10.6 Learning Activity 10.7 Unit End Questions 10.8 References 10.0 LEARNING OBJECTIVES After studying this unit, you will be able to: Explain how risk financing, basically, helps a business to align the risks it is ready to take with its ability to pay for those risks Illustrate that it is also important to examine if the right kind of risks is taken to reach these goals, and the cost of taking such risks are accounted for financially Examine the process of determining how an organization will pay for losses in an effective and least costly way is called risk financing. Explain how risk financing chooses the least-costly risk among them and ensures that the company has the required financial resources to recover and continue with the operations in the case of a loss event. Evaluate how efficiently a company manages events that call for risk financing indicates a company's potential for long-term growth and its competitiveness. 10.1 INTRODUCTION 156 CU IDOL SELF LEARNING MATERIAL (SLM)
The process of determining how an organization will pay for losses in an effective and least costly way is called risk financing. It identifies risks, determines the ways of financing, and monitors the effectiveness of the chosen financing method. Risk financing, basically, helps a business to align the risks it is ready to take with its ability to pay for those risks. The potential cost of their actions and the possibility of those actions leading them to reach their goal must be estimated. Businesses lay down their priorities to verify if they are taking the required risks to achieve their goals. It is also important to examine if the right kind of risks is taken to reach these goals, and the cost of taking such risks are accounted for financially. Risk financing is designed to help a business align its desire to take on new risks to grow, with its ability to pay for those risks. Businesses must weigh the potential costs of their actions and whether the action will help the business reach its objectives. The business will examine its priorities to determine whether it is taking on the appropriate amount of risk to achieve its objectives. It'll also examine whether it is taking the right types of risks and whether the costs of these risks are being accounted for financially. Companies have a variety of options when it comes to protecting themselves from risk. Commercial insurance policies, captive insurance, self-insurance, and other alternative risk transfer schemes are available, though the effectiveness of each depends on the size of the organization, the organization’s financial situation, the risks that the organization faces and the organization’s overall objectives. Risk financing seeks to choose the option that is the least costly, but it also must ensure the organization has the financial resources available to continue its objectives after a loss event occurs. The process for determining risk financing typically involves a company forecasting the losses that they expect to experience over a period and then determining the net present value of the costs associated with the different risk financing alternatives available to them. Each option is likely to have different costs, depending on the risks that need coverage, the loss development index that is most applicable to the company, the cost of maintaining a staff to monitor the program and any consulting, legal, or external experts that are needed. Protection Options from Risks There may be many options for the companies to protect themselves from risks, such as self- insurance, captive insurance, commercial insurance, and other risk transfer mechanisms. The effectiveness of these mechanisms vastly depends on the size of the company, its financial situation, the kind of risks the company has taken, and the company's overall objectives. 157 CU IDOL SELF LEARNING MATERIAL (SLM)
Whatever risks the company chooses to take, risk financing chooses the least-costly risk among them and ensures that the company has the required financial resources to recover and continue with the operations in the case of a loss event. The process of risk financing includes the company listing down and broadcasting the expected losses over a period. This event is followed by determining the net present value of each of the listed risks that need coverage. Indicator of Company's Financial Health How efficiently a company manages events that call for risk financing indicates a company's potential for long-term growth and its competitiveness. The way in which risk financing is handled brings out the financial health of an organization in the form of identifying and monitoring key metrics. 10.2 RISK AVOIDANCE Risk is avoided when the organization refuses to accept it. The exposure is not permitted to come into existence. This is accomplished by simply not engaging in the action that gives rise to risk. If you do not want to risk losing your savings in a hazardous venture, then pick one where there is less risk. If you want to avoid the risks associated with the ownership of property, the do not purchase property but lease or rent instead. If the use of a particular product is hazardous, then do not manufacture or sell it. This is a negative rather than a positive technique. It is sometimes an unsatisfactory approach to dealing with many risks. If risk avoidance were used extensively, the business would be deprived of many opportunities for profit and probably would not be able to achieve its objectives. Risk avoidance is not performing any activity that may carry risk. A risk avoidance methodology attempts to minimize vulnerabilities that can pose a threat. Risk avoidance and mitigation can be achieved through policy and procedure, training and education, and technology implementations. For example, suppose an investor wants to buy stock in an oil company, but oil prices have been falling significantly over the past few months. There is political risk associated with the production of oil and credit risk associated with the oil company. If an investor assesses the risks associated with the oil industry and decides to avoid taking a stake in the company, this is known as risk avoidance. 10.3 RISK REDUCTION Risk can be reduced in 2 ways—through loss prevention and control. Examples of risk reduction are medical care, fire departments, night security guards, sprinkler systems, burglar alarms— attempts to deal with risk by preventing the loss or reducing the chance that it will occur. Some techniques are used to prevent the occurrence of the loss, and other techniques like sprinkler 158 CU IDOL SELF LEARNING MATERIAL (SLM)
systems are intended to control the severity of the loss if it does happen. No matter how hard we try, it is impossible to prevent all losses. The loss prevention technique cannot cost more than the losses. On the other hand, risk reduction deals with mitigating potential losses through more of a staggered approach. For example, suppose an investor already owns oil stocks. The two factors discussed earlier are still relevant: there is political risk associated with the production of oil, and oil stocks often have a high level of unsystematic risk. As opposed to a risk avoidance strategy, this investor can reduce risk by diversifying their portfolio by keeping their oil stocks while at the same time buying stocks in other industries, especially those that tend to move in the opposite direction to oil equities. To engage in risk management, a person or organization must quantify and understand their liabilities. This evaluation of financial risks is one of the most important and most difficult aspects of a risk management plan. However, it is crucial for the well-being of your assets to ensure you understand the full scope of your risks. If you have several streams of income, for instance, losing one stream won't hurt as much if only 25% of a person's income comes from that stream. Financial diversification is one of the most reliable risk reduction strategies. When your financial risk is diversified, the adverse side effects are diluted. Suppose the investor diversifies his portfolio and invests in various sectors of the market. However, he currently faces systematic risk due to an economic downturn. The investor may reduce his risk through a hedge. For example, the investor can protect his long positions and reduce his risk by buying put options for his long positions. He is protected from a potential drop in his portfolio value because he can sell his stocks at a predetermined price within a specified period. The investor who avoids the risk forfeits any potential gains the oil stock may have. On the other hand, the investor who reduces his risk still has potential gains. If the stock market goes higher, his long positions will appreciate in value. However, if his positions decrease in value, he is protected by his put options. 10.4 DIFFERENCE BETWEEN RISK AVOIDANCE AND RISK REDUCTION Prevention vs. mitigation strategies when it comes to an investor who wants to avoid risk should be equally weighed. It may come down to just the level of risk involved, and how an investor ultimately diversifies his portfolio. Here are some pros and cons of risk avoidance vs. risk reduction: 159 CU IDOL SELF LEARNING MATERIAL (SLM)
Risk Avoidance Risk Reduction Safely guarantees that returns will not be lost Seeks a \"best of both worlds\" approach to or jeopardized mitigating risk, while exposing yourself to potentially high returns Closes the door on opportunities for future Can be riskier financially if risks come to gains, especially potentially higher returns on fruition investment Simple way to focus on steady streams of Requires a more complex approach to income investing, including full understanding of your liabilities Table 10.1: Difference between risk avoidance and risk reduction 10.4 SUMMARY Risk Management is one of the current trends when talking about ways of improving business performance in any marketplace. Risk is an unavoidable part of human activities, minimize its negative consequences. These approaches include several degrees of commitment with the risk management philosophy: from having little or none at all (risk assumption) to a “paranoid” attitude (risk avoidance), and including an optimal balance between transference and prevention. As much progress as we are making in introducing new technologies in almost every aspect of our lives and jobs, Risk Management is surprisingly lagging well behind in this endeavor. Apart from text processors, spreadsheets, and a few adhoc specific non- reusable solutions, there seems to be a disconcerting lack of generic, flexible, powerful tools in this field. This is clearly not due to an absence of need for them, to be sure. The task of a risk manager is so complex that benefiting from a really comprehensible analysis tool can only improve his/her function, enormously increasing his/her level of knowledge, and thus, the control and management experience and overall results. an increasing rate, the number of contracted policies is stable, reflecting that a better understanding of the exposures and improved overall risk management has been achieved. Procedures are powerful enough to overcome initial concerns. The key step in the way to applying new technologies in such scenarios is knowledge elicitation from the experts. Here we have shown how the available standard notational solutions and well-known 160 CU IDOL SELF LEARNING MATERIAL (SLM)
development life cycles perfectly apply and favor good results. A few ideas on this include additional customizable reports, for example, perhaps in the same way the system already deals with risk situations and hazards definition (through the use of meta- information). Another very interesting line of inquiry would be that of architectural and functional pattern detection for these sort of highly critical applications. The effort carried out to meticulously analyze the domain and extract the relevant information that was then written down as a model design, lead to the gathering of the kind of expert knowledge that would be needed for a task. Risk avoidance is not performing any activity that may carry risk. A risk avoidance methodology attempts to minimize vulnerabilities that can pose a threat. Risk avoidance and mitigation can be achieved through policy and procedure, training and education, and technology implementations. A company manages situations that call for risk financing is a good indicator of that organization's competitiveness and potential for long term success. That's because risk financing depends on the aptitude of business leaders to identify and monitor key metrics that provide insight into its financial health. One of the most widely accepted of those key metrics is Cost of Risk (COR), a quantitative measure of the total direct and indirect expenditures dedicated to mitigating the risk exposures. 10.5 KEYWORDS Jeopardized: put (someone or something) into a situation in which there is a danger of loss, harm, or failure. Mitigating risk: mitigation means reducing risk of loss from the occurrence of any undesirable event. ... They employ a variety of quantitative techniques in order to assess the risk associated with the insured and decide the appropriate premiums commensurate with the risk. Diversifying portfolio: Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited. This practice is designed to help reduce the volatility of your portfolio over time. Vulnerabilities: the quality or state of being exposed to the possibility of being attacked or harmed, either physically or emotionally. Diluted: When a company issues additional shares of stock, it can reduce the value of existing investors' shares and their proportional ownership of the company. This common problem is called dilution. 161 CU IDOL SELF LEARNING MATERIAL (SLM)
10.6 LEARNING ACTIVITY 1. Conduct a survey on a nearby market and find out how risk management is one of the current trends when talking about ways of improving business performance in any marketplace. ______________________________________________________________________________ ______________________________________________________________________________ Analyze and assess how financial diversification is one of the most reliable risk reduction strategies. ______________________________________________________________________________ ______________________________________________________________________________ 10.7 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What are the learning Objectives of risk control and risk financing? What is the meaning and definition of risk control? What is Risk Avoidance? What is Risk Reduction? Write down the differences between Risk Avoidance and Risk Reduction? Long Questions 1. Risk is an unavoidable part of human activities, minimize its negative consequences. What are your views on this statement? Explain meaning of risk control and risk financing. 2. Financial diversification is one of the most reliable risk reduction strategies. When your financial risk is diversified, the adverse side effects are diluted. Is this statement true or false according to you? Give reasons. 3. It is strongly believed that the risk identification, particularly, is an ongoing process, why is risk avoidance considered as an ongoing process? 4. Explain the term risk avoidance and risk reduction? Write down the differences between risk avoidance and risk reduction. 5. Write down the objectives, aims and procedures of risk control and risk financing? 162 CU IDOL SELF LEARNING MATERIAL (SLM)
B. Multiple Choice Questions 1. Risk assessment policy setting is a risk management responsibility, which should be carried out in full collaboration with risk assessors, and which serves. a. To protect the scientific integrity of the risk assessment. b. To endanger the strategies of business prospects c. To accomplish long term goal d. To diversify capital Risk profiling is the process of describing and analyzing, to identify those elements of the hazard or risk which are. a. Irrelevant to various risk management decisions b. Exponential in companies growth c. Relevant to various risk management decisions d. None of these A typical risk profile might include the following: a. a brief description of the situation b. product or commodity involved c. the human health and economic consequences consumer perception of the risks; d. All of these Protection of human health should be the primary objective: a. In risk management decisions b. Of business planning meeting c. Of defence organisations d. None of these The elements of a structured approach to risk management are: a. Risk Evaluation and Risk Management Option Assessment, b. Implementation of Management Decision, and c. Monitoring and Review. d. All of these 163 CU IDOL SELF LEARNING MATERIAL (SLM)
Answers 1-a, 2-c, 3-d, 4-a, 5-d 10.8 REFERENCES References Ronald P. Higuera, Yacov Y. Haimes,“Software Risk Management”, Technical Report Linda westfall, “Software is a riskybusiness”, USA, 2009. Hooman Hoodat, Hassan rashidi,“Classification and Analysis of Risks in SoftwareEngineering”, Robert Armestrong, Gillian Adens,“Managing software project risks”, TASSC technicalpaper, 2008. 2009. Textbook J. Rothfeder, “It’s Late, Costly, and incomplete-But Try Firing a Computer System, “BusinessWeek, November 7, Barry W. Boehm, “software risk management: principles and practices” Basit Shahzad, Javed Iqbal, “”Software Risk Management – Prioritization of frequently occurring Risk in Software Development Phases. UsingRelative Impact Risk Model”, 2nd International Conference on Information and CommunicationTechnology (ICICT2007), December 16-17, 2007,IBA Karchi. Websites https://cleartax.in/g/terms/risk-financing https://www.sciencedirect.com/topics/computer-science/risk-avoidance https://www.investopedia.com/ask/answers/040315/what-difference-between-risk- avoidance-and-risk-reduction.asp 164 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT – 11: SOURCES AND MEASUREMENT OF RISK STRUCTURE 11.0 Learning Objectives 11.1 Introduction 11.2 Risk Evaluation 11.2.1 Consolidation of Risk Analysis Results 11.2.2 Evaluation of Risk Level 11.2.3 Risk Aggregation 11.2.4 Risk Grouping 11.2.5 Further Reading 11.3 Risk Prediction 11.4 Disaster Risk Management 11.5 Summary 11.6 Keywords 11.7 Learning Activity 11.8 Unit end Questions 11.9 References 11.0 LEARNING OBJECTIVES In the end on the unit, you will be able to: Examine that risk measures are statistical measures that are historical predictors of investment risk and volatility. Evaluate that risk measures are also major components in modern portfolio theory (MPT), a standard financial methodology for assessing investment performance. Evaluate about latest investment strategies and performance evaluation. Illustrate performance measurement measures. Evaluate portfolio performance,Examine the contrast between different investment strategies,Identify to understand Propose investment strategy solutions. 165 CU IDOL SELF LEARNING MATERIAL (SLM)
11.1 INTRODUCTION Risk in general is pervasive and complex, these affect the fluctuation the sources of risk and level of its severity can vary according to the farming systems, geographic location, weather conditions, supporting government policies and farm types. Risk is a major concerning developing countries where farmers have imperfect information to forecast things such as farm input prices, product prices, and weather conditions, that might impact the farms in the future. The types and severity of risks that farmers face differ from place to place. Incorporating and understanding the effects of risk at the farm level will benefit policy makers who develop appropriate strategies that can help farmers survive the numerous risks they confront. Sources of risk in agriculture are classified into business risk and financial risk. Business risks can be classified further into a) production or yield risk, b) marketing or price risk, c) institution, policy, and legal risk, d) human or personal risk, and e) technological risk. On the other hand, financial risk occurs when farmers borrow to finance farm activities as farmers often face variations in interest rates on borrowed funds, inadequacy of cash flow for debt payments and changes in credit terms and conditions. Risk measures are statistical measures that are historical predictors of investment risk and volatility. Risk measures are also major components in modern portfolio theory (MPT), a standard financial methodology for assessing investment performance. The five principal risk measures include the alpha, beta, R-squared, standard deviation, and Sharpe ratio. Risk measures are statistical measures that are historical predictors of investment risk and volatility, and they are also major components in modern portfolio theory (MPT). MPT is a standard financial and academic methodology for assessing the performance of a stock or a stock fund as compared to its benchmark index. For several decades, agricultural production in Thailand has faced many risks such as variability in yields, product-prices, and cost of inputs. Farmers typically grow their crops in rain-fed conditions due to poor irrigation systems. The annual rainfall fluctuates widely each year, and pests, diseases and poor soil fertility affect the yields of cash crops. 11.2 RISK EVALUATION 166 CU IDOL SELF LEARNING MATERIAL (SLM)
At this point we have identified the risks and analyzed their likelihood and consequence. From this we can establish the risk level and compare it to the risk evaluation criteria. We also need to consider whether some risks that we have regarded as separate are instances of the same risk and therefore should be aggregated and evaluated as one risk. Furthermore, as preparation for the risk treatment, we group risks according to relationships such as shared vulnerabilities or threats. However, as analysis of likelihood and consequence is notoriously difficult, we start by reviewing the results from the previous step to check whether any adjustments need to be made. Figure 11.1: Risk evaluation approaches 11.2.1 Consolidation of Risk Analysis Results The goal of the consolidation of risk analysis results is to make sure that the correct risk level is assigned to each risk. This is important because the risk levels direct the identification of treatments and provide essential decision support for the management. The central question is 167 CU IDOL SELF LEARNING MATERIAL (SLM)
not whether each likelihood and consequence estimate are correct, but rather whether the resulting risk level is correct. We also make sure to check whether there are any risks that are both malicious and non-malicious. This is typically the case if malicious and non-malicious three can result in the same incident. In our case in such cases, we need to check that the likelihood and consequence estimates are consistent, and that both the malicious and the non-malicious causes have been considered when estimating the likelihood. This can be easy to overlook since we are dealing with the malicious and non-malicious risks separately during much of the risk assessment. As part of the consolidation, we also revisit the risk evaluation criteria defined during the context establishment. Sometimes decision makers will want to adjust the criteria based on any new insights gained through the process so far, or on the results of the analysis. The results of the consolidation are documented in the same place as the risk analysis results simply by making the necessary corrections and updates, and adding references if new information sources have been used. 11.2.2 Evaluation of Risk Level Having consolidated the risk analysis results, we are ready to evaluate the risks. The risk level of each risk is determined by its likelihood and consequence according to the risk matrix. 11.2.3 Risk Aggregation During the evaluation we need to consider that some risks may “pull in the same direction” to the degree that they should be evaluated as a single risk. There are basically two cases where this may hold. Whatever the case and whatever the situation, we need not aggregate unless this can bring the aggregated risk to a new risk level. The risk level is, after all, what matters with respect to decision making. For a set of risks that are acceptable only if considered individually, deciding not to aggregate can give a false impression that no treatments are needed. Such decisions should therefore be taken with care. We now return to our assessment. They can therefore be viewed as special instances of a more enteric incident, which we can call Software on the. We therefore decide to perform the aggregation. This done by aggregating likelihood and consequence values. Separately, and then combining these to obtain the risk level in the usual way. As a starting point, we list the incidents, likelihoods, and consequences of the original risks, as shown in the upper rows of Table 9.1. First up are the likelihoods. Here we notice that the incidents of risks nos. 4 and 11 may overlap to some degree. For example, malware may compromise meter data that are already compromised by a software bug. Moreover, the likelihoods are given as intervals rather than exact values, which means that adding up likelihoods may yield a new interval that spans 168 CU IDOL SELF LEARNING MATERIAL (SLM)
more than one step of the likelihood scale defined in Table 6.3. This means that we cannot simply sum up the likelihoods of the contributing incidents but need to use our judgment. After careful considerations about the nature the incidents and the degree of overlap, we may for example arrive at likelihood Possible for the aggregated risk. Next up are the consequences. Since the aggregated incident represents a generalization of each of the original incidents, rather than a combined occurrence, it clearly would not make sense to add up their consequences. Unless we are considering instances where simultaneous occurrences of several incidents cause additional harm, the consequence of the aggregated incident should not be greater than the highest of the original consequences. A good rule of thumb is that if all the original incidents have the same consequence, then we use the same value for the aggregated incident. If they do not, we can either use average value, possibly weighted according to likelihoods, or resolve the issue by consulting representatives of the party of the asset. 11.2.4 Risk Grouping As preparation for the risk treatment, we also want to take into consideration the fact that treatments may influence several risks, thereby justifying higher cost than if we only consider individual risks. Therefore, be useful to group risks with this is in mind. The distinction between malicious and non-malicious risks earlier in the assessment has given us two groups. This is already useful, as some treatments will only influence one of these groups. For example, data encryption, firewalls, and intrusion detection systems will usually reduce the likelihood or consequence of (some) malicious risks, without having any effect on non-malicious risks. In addition to distinguishing between malicious and non-malicious risks, we may typically group risks according to shared vulnerabilities, threats, threat sources, or assets. The purpose of the grouping is to facilitate identification of the treatments that give the best effect for the least cost by placing together risks that may benefit from a common treatment. Do any of these risks have anything in common that indicates that they will benefit from the same treatment? Treatments that address both these risks are therefore quite likely to be worth the cost. By grouping such risks, we make it easier to take such considerations into account. Similarly, to the above case, we find that risks nos. 11.2.5 Further Reading For how to deal with risk which is dedicated to this problem. With respect to risk aggregation and grouping, we are not aware of any standards or similar sources that provide detailed guidelines. 11.3 RISK PREDICTION 169 CU IDOL SELF LEARNING MATERIAL (SLM)
Predictive risk management is the process of performing risk management activities on hypothetical hazards, risk events, and/or consequences. Predictive risk management is an attempt to account for hazards and risks that can potentially occur in each situation. Predictive risk management is especially useful during safety actions like safety cases and change management. There are many misnomers about predictive risk management, namely that it is the most \"advanced\" form of risk management. Programs need to be clear about the different types of risk management activities and use them accordingly. Predictive activities for risk management are based on: Normal operational data, such as by understanding where in regular operations your organization is most exposed; and Potentialities that have not already occurred. Many large online resources discuss the need to “shift” from reactive to predictive risk management. This seems to imply a false notion that predictive is a “better” form of risk management than reactive or proactive. This is not true. \"Moving towards predictive risk management\" simply means adopting predictive activities as a part of your risk management repertoire. What are Predictive Risk Management Activities? As said, the two most common predictive activities for risk management are: Management of change; and Safety cases. Both activities are regularly used in well-developed safety programs and involve: Analyzing current operations; Identifying new hazards; Identifying new risks; Implementing controls to prevent these potentialities; and Analyzing controls for “substitute risk.” Some common tools for risk management that is predictive are: Bowtie analysis; Shortfall analysis; Inspections; and 170 CU IDOL SELF LEARNING MATERIAL (SLM)
Aviation safety audits. 11.4 DISASTER RISK MANAGEMENT Figure 11.2: Steps of disaster management Disaster risk management is the application of disaster risk reduction policies and strategies to prevent new disaster risk, reduce existing disaster risk and manage residual risk, contributing to the strengthening of resilience and reduction of disaster losses. Annotation: Disaster risk management actions can be distinguished between prospective disaster risk management, corrective disaster risk management and compensatory disaster risk management, also called residual risk management. 171 CU IDOL SELF LEARNING MATERIAL (SLM)
Prospective disaster risk management activities address and seek to avoid the development of new or increased disaster risks. They focus on addressing disaster risks that may develop in future if disaster risk reduction policies are not put in place. Examples are better land-use planning or disaster-resistant water supply systems. Corrective disaster risk management activities address and seek to remove or reduce disaster risks which are already present and which need to be managed and reduced now. Examples are the retrofitting of critical infrastructure or the relocation of exposed populations or assets. Compensatory disaster risk management activities strengthen the social and economic resilience of individuals and societies in the face of residual risk that cannot be effectively reduced. They include preparedness, response and recovery activities, but also a mix of different financing instruments, such as national contingency funds, contingent credit, insurance and reinsurance and social safety nets. Community-based disaster risk management promotes the involvement of potentially affected communities in disaster risk management at the local level. This includes community assessments of hazards, vulnerabilities and capacities, and their involvement in planning, implementation, monitoring and evaluation of local action for disaster risk reduction. Local and indigenous peoples’ approach to disaster risk management is the recognition and use of traditional, indigenous and local knowledge and practices to complement scientific knowledge in disaster risk assessments and for the planning and implementation of local disaster risk management. Disaster risk management plans set out the goals and specific objectives for reducing disaster risks together with related actions to accomplish these objectives. They should be guided by the Sendai Framework for Disaster Risk Reduction 2015-2030 and considered and coordinated within relevant development plans, resource allocations and programme activities. National-level plans need to be specific to each level of administrative responsibility and adapted to the different social and geographical circumstances that are present. The time frame and responsibilities for implementation and the sources of funding should be specified in the plan. Linkages to sustainable development and climate change adaptation plans should be made where possible. 11.5 SUMMARY 172 CU IDOL SELF LEARNING MATERIAL (SLM)
Risk taking is the core of any business activity. The risk assumption in manufacturing and financial situations is different from each other due to the very nature of these two sector The significance of risk and its management are comparatively more in financial sector in general and banks in particular because of the very nature of the industry. The risks banks face in their normal course of operations can be generic (those that are common to all banks more or less alike) or specific (others that are specific to a bank or transaction). Disaster risk management plans set out the goals and specific objectives for reducing disaster risks together with related actions to accomplish these objectives Risk in lending to a particular industry, say, in troubled times to textiles is a generic risk. Lending to particular chemical industry is again a generic risk. There may be risks that are specific to a particular unit. For example, pharmaceutical industry may be doing fine in majority of the accounts. However, a particular unit may not be performing or is not likely to perform well due to managerial deficiencies or similar reasons. Taking an exposure on such a unit is a specific risk. The location of units in a particular area or State can be a reason for increased risk. By the term risk we mean a situation in which the possible future outcome of a present decision is plural and in which the probabilities and dimensions of their outcomes are known in the form of a frequency distribution. Risk refers to variability. It is measured in financial analysis generally by standard deviation or by beta coefficient. Technically risk can be defined as a situation where the possible consequences of the decision that is to be taken are known. Risk is composed of the demands that bring in variations in return of income. The main forces contributing to risk are price and interest. Risk is also influenced by external and internal considerations. External risks are uncontrollable and broadly affect the investments. These external risks are called systematic risk. Risk due to internal environment of a firm or those affecting a particular industry are referred to as unsystematic risk. Unsystematic risk is unique to a firm or industry. It does not affect the investor. Unsystematic risk is caused by factors like labour strike, irregular disorganised management policies and consumer preferences. Predictive risk management is the process of performing risk management activities on hypothetical hazards, risk events, and/or consequences. Predictive risk management is an attempt to account for hazards and risks that can potentially occur in a given situation. 173 CU IDOL SELF LEARNING MATERIAL (SLM)
When a plant is located in a far- flung area, there is a possibility of the unit becoming bad as the provision of immediate rescue supports in terms of all inputs may not be feasible. The ownership pattern or type can be another reason for risk differential. Obviously, the capital- raising capacity of a public limited company would be more than a proprietary or partnership firm. A capital- intensive unit in the corporate sector would be less risky than one in partnership or proprietary category. 11.6 KEYWORDS Ssubstitute risk :Substitution, the second most effective hazard control, involves replacing something that produces a hazard with something that does not produce a hazard or produces a lesser hazard Proprietary: Proprietary trading refers to a financial firm or commercial bank that invests for direct market gain rather than earning commission dollars by trading on behalf of clients Potentialities Human: potential management is an integrative and continuous process of enhancing human capabilities and capacities by enhancing human beings existing potential and helping them to discover and tap their talent potential through micro level human development intervention Indigenous: indigenous management is the management that develops naturally in the organizations of a culture. It derives its principles, systems, and procedures by using the natural taxonomies Sustainable development: Sustainable development is an organizing principle for meeting human development goals while simultaneously sustaining the ability of natural systems to provide the natural resources and ecosystem services on which the economy and society depend. 11.7 LEARNING ACTIVITY 1. Conduct a survey on how community-based disaster risk management promotes the involvement of potentially affected communities in disaster risk management at the local level. ______________________________________________________________________________ ______________________________________________________________________________ 174 CU IDOL SELF LEARNING MATERIAL (SLM)
Why do you think the capital- raising capacity of a public limited company would be more than a proprietary or partnership firm? Give reasons. ______________________________________________________________________________ ______________________________________________________________________________ 11.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What is Risk Evaluation? 2. What do you mean by Consolidation of Risk Analysis Results? 3. Explain Evaluation of Risk Level? 4. Describe Risk Aggregation? 5. Explain Risk Grouping? Long Questions 1. What is the definition and Learning Objectives of sources and management of risk? 2. What is Risk Evaluation? Explain with the help of suitable examples. 3. What is risk Prediction? Explain in detail. 4. What is Disaster Risk Management? Use appropriate examples to support your answer. 5. What are risk evaluation approaches? B. Multiple Choice Questions 1. The risk assumption in manufacturing and financial situations is -----------------from each other due to the very nature of these two sectors. a. Different b. Similar c. Identical d. Unrelated \"Moving towards predictive risk management\" simply means ------------------predictive activities as a part of your risk management repertoire. a. Denying b. Recycling 175 CU IDOL SELF LEARNING MATERIAL (SLM)
c. Adopting d. Challenging During the evaluation we need to consider that some risks may “pull in the same direction” to the degree that they should be evaluated as a. Single risk. b. Double risk c. No risk d. Huge risk Normal operational data, such as by understanding where in regular operations your organization is most. a. Disposed b. Exposed c. Verified d. Disqualified Risk can be reduced in 2 ways— a. Through allocation of resources b. Through fund checking c. Through loss prevention and control d. All of these Answers 1-a, 2-c, 3-a, 4-b, 5-c 11.9 REFERENCES References Hardaker JB, Huirne RBM, Anderson JR, Lien G. Coping with risk in agriculture.Cambridge, MA: CABI Pub.; 2004. Hazell PBR, Norton RD. Mathematical programming for economic analysis inagriculture. New York: Macmillan; 1986. 176 CU IDOL SELF LEARNING MATERIAL (SLM)
Dunn JW. Farm level risk analysis for Kansas farmers [doctoral thesis]. Manhattan,Kansas: Kansas State University; 2002. Textbooks Hossain S, Mustapha NHN, Chen LT. A quadratic application in farm planning underuncertainty. International Journal of Social Economics. 2002;29(4):282-98. Nyikal RA, Kosura WO. Risk preference and optimal enterprise combinations in Kahuro division of Murang'a district, Kenya. Agricultural Economics. 2005;32(2):131-40. Pannell DJ, Malcolm B, Kingwell RS. Are we risking too much? Perspectives on risk in farm modeling. Agricultural Economics. 2000;23(1):69-78. Websites https://www.coursera.org/lecture/investment-strategies-portfolio-analysis/basic- measures-of-risk-0hoze https://www.researchgate.net/publication/300344571_Risk_Evaluation https://www.asms-pro.com/SMS/WhatisPredictiveRiskManagement.aspx https://www.undrr.org/terminology/disaster-risk-management 177 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT – 12: INSTRUMENTS OF EXTERNAL TECHNIQUES OF RISK MANAGEMENT- PART1 STRUCTURE 12.0 Learning Objectives 12.1 Introduction 12.2 Forwards 12.3 Futures 12.3.1 Strengths and Weaknesses of Futures Markets 12.3.2 Relationship of Futures Prices to Forward and Spot Prices 12.3.3 Hedging with Futures: The Perfect and Minimum-Variance Hedges 12.4 Swaps Options 12.4.1 Plain Vanilla Interest Rate Swaps 12.4.2 Currency Swaps 12.4.3 Pricing Swaps 12.5 Forward Rate Agreement 12.6 Summary 12.7 Keywords 12.8 Learning Activity 12.9 Unit End Questions 12.10 References 12.0 LEARNING OBJECTIVES After studying this unit, you will be able to: Comprehend the strengths and weaknesses of futures markets Explain the relationship of futures prices to forward and spot prices Identify hedging with futures: the perfect and minimum-variance hedges 178 CU IDOL SELF LEARNING MATERIAL (SLM)
Explain swaps options, plain vanilla interest rate swaps, currency swaps, pricing swaps forward rate agreement 12.1 INTRODUCTION With the fall of fixed exchange regime in 1973, exchange rates between currencies were determined by market forces of demand and supply leading to the advent of fluctuating exchange rate regime. This brought with it randomness and unpredictability in exchange rates. Exchange rates have become more volatile than they were expected. This random fluctuation in exchange rate has made cash flows and asset value of companies dealing in different currencies unpredictable cash flows and asset value of MNCs in their respective domestic currency are at stake of exchange rate between its domestic currency and foreign currency. Thus, Foreign Exchange Exposure is risk associated with unanticipated changes in exchange rate. With globalization and liberalization of Indian economy in nineties, scope of business for Indian companies with the rest of world has broadened and foreign corporations too have become much interested in India. In India, exchange rates were deregulated and were allowed to be determined by markets in 1993. This volatility in exchange rates can have detrimental effect on the firm’s financial position and negative effect on its competitive position in the market and value of firm, if ignored it can paralyze the company. Foreign exchange risk is managed through two means. i. Internal i.e., use of tools which are internal to the firm such as netting, matching, etc. and, ii. External techniques i.e., use of contractual means such as forward contracts, future, option, etc. to insure against potential exchange losses. The usage of internal techniques is also known as passive hedging, while the latter is known as active hedging. Usage of internal tools among the group companies may at times be difficult to practice owing to local exchange control regulations. Nevertheless, they are worth implementing for they do not involve extra pay-outs while being significantly effective in minimizing the forex exposure. It is essential to understand the difference between forex exposure and forex risk. Foreign exchange exposure is the sensitivity to changes in the real domestic currency value of assets, liabilities, or operating incomes to unanticipated change in exchange rates. Foreign exchange risk exposure is quite often used interchangeably with the term ‘foreign exchange risk’, although they 179 CU IDOL SELF LEARNING MATERIAL (SLM)
are conceptually quite different. Foreign exchange risk is defined in terms of variance of unanticipated changes in exchange rates. It is measured by the variance of the domestic currency value of an asset, liability or operating income that is attributable to unanticipated changes in exchange rates. 12.2 FORWARDS In 1992-93 Budget provided for partial convertibility of Indian Rupee in current accounts and, in March 1993, the Rupee was made fully convertible in current Account. Since then, there has been continuous increase in foreign investment in India. Multi-national corporations are entering the Indian market with their products and services either through subsidiaries or joint venture. Indian corporate houses are also involved in cross border transactions with different countries and in different products. Indian firms have also started raising funds from international financial sources. Rupee depreciated against dollar by about 24% between March 2008 and March 2009 from Rs. 39.80 to Rs. 52.20. And it depreciated against dollar by about 6.23% between June 2014 and June 2014. This impulsive and volatile change in exchange rate makes the environment unpredictable making the business decisions complicated and this volatility can negatively affect the firm's cash flows and value. The paper looks at the necessity of managing foreign exchange rate exposure and discusses the measures that can be taken to mitigate foreign exchange risk. It identifies various steps involved in foreign exchange risk management process. This paper attempts to evaluate the various alternatives available to the Indian corporates and foreign business houses operating in India for hedging exchange rate exposure. The financial stability report published by RBI in Dec 2012 mentions “excessive volatility in exchange rate makes it difficult for economic agents to make optimal intertemporal decisions. The economic agents, therefore, need to properly understand and measure the nature of currency risk embedded in their business and use appropriate derivative instruments to hedge their currency risk... 12.3 FUTURES This paper identifies various types of foreign exchange exposures in MNCs operating in India. The focal point of this paper is identification of various tools and techniques to mitigate foreign exchange exposure of companies operating in India. Objectives of the study have been to discuss foreign exchange risk management process and the steps involved in it and to examine the facilities available for managing foreign exchange exposure in Indi Bradford Cornell and Alan C. Shapiro (1983) described how foreign exchange risk can be managed. Ian H. Giddy and Gunter Duffey, in their article “The Management of Foreign Exchange risk”, identified that in many realistic situations, the economic effects of randomness of exchange rate are different from those predicted by the various measures of translation exposure. It emphasizes the distinctions between 180 CU IDOL SELF LEARNING MATERIAL (SLM)
the currency of location, the currency of denomination and the currency of determination of a business. They argued that a market-based approach be followed in international financial planning. Fook et al. (1997) have found that hedging not only reduces variability in earnings, but it also increases firm value. They found that hedging not only decreases the chances of financial distress but also the agency costs of debt and the costs of equity. Chowdhury and Howe (1999) argue that firms use financial instruments to hedge short term exposure and for managing long- run operating exposure, they use long-term strategy adjustments (i.e., operational hedges). Nicolas Hagel in and Bengt pramborg (2002) investigated the effectiveness of currency derivatives and foreign denominated debt in reducing foreign exchange exposure. The results were positive. Sathya Swaroop Debasish (2008) studied the foreign exchange risk management practices of 501 nonbanking Indian firms to identify the techniques which they use to hedge their foreign exchange risk. It was revealed that volatility and reduction in cash flows was the rationale behind hedging. The techniques used by Indian firms are forward contracts, swaps, and cross-currency options. Confused perception about derivative use, technical and administrative constraints and fear of high cost were found to the main reasons of not pursuing any foreign exchange risk management technique. The paper discusses the various foreign exchange risk management techniques. 12.3.1 Strengths and Weaknesses of Futures Markets Futures contracts in foreign exchange are different from currency forwards in quite a few ways. The first thing to realize is the future is completely different to a forward. A forward is mainly used for hedging currency exposure whereas a future (especially in foreign exchange) is used predominant (nowadays) for speculating. Here are the main advantages and disadvantages of future contracts versus forward contracts: Advantages of futures contracts Futures contracts have very low margin. Futures contracts are on exchange so somewhat reduce counter party risk. The cost for trading futures are very low compare to currency forwards. Disadvantages of futures contracts Some brokers may insist clients close positions before delivery. Trade in lots of preset amounts that are inflexible for exact accounting. Mainly traded on US based exchanges. Not as flexible for accounting purposes. 181 CU IDOL SELF LEARNING MATERIAL (SLM)
Mainly a speculative product. They trade in large amounts that cannot be partially closed. You need to be a professional trader to get the full benefits. 12.3.4 Relationship of Futures Prices to Forward and Spot Prices Spot and futures prices differ, because the financial markets are always looking forward, and adjusting expectations accordingly. The basis is the difference between the local spot price of a deliverable commodity and the price of the futures contract for the earliest available date. \"Local\" is relevant here because futures prices reflect global prices for any commodity and are therefore a benchmark for local prices. The basis can vary greatly from one region to another based primarily on the costs of transporting the commodity to its delivery point. As an example, for basis in futures contracts: Assume the spot price for crude oil is $50 per barrel. The futures price for crude oil deliverable in two months' time is $54. The basis is $4, or $54 - $50. Basis is a crucial concept for portfolio managers and traders because this relationship between cash and futures prices affects the value of the contracts used in hedging. Basis is used by commodities traders to determine the best time to buy or sell a commodity. Traders buy or sell based on whether the basis is strengthening or weakening. The basis, it must be noted, is not necessarily accurate. There are typically gaps between spot and relative price until the expiry of the nearest contract. Product quality also can vary, making basis an imperfect indicator. The futures market exists because producers want the safety that comes with locking in a reasonable price in advance, while futures buyers are hoping that the market value of their purchase rises during the interim before delivery. Commodity Spot Price vs. Futures Price FAQs What Is the Difference Between Spot Price and Futures Price? The spot price is the current price in the marketplace at which a given asset—such as a security, commodity, or currency—can be bought or sold for immediate delivery. The futures price is an agreed-upon price in a contract (called a futures contract) between two parties for the sale and delivery of the asset at a specified time later. How Do Futures Prices Affect Spot Prices? 182 CU IDOL SELF LEARNING MATERIAL (SLM)
It's actually more the other way round: Spot prices influence futures prices. A futures contract price is commonly determined using the spot price of a commodity—as the starting point, at least. Futures prices also reflect expected changes in supply and demand, the risk-free rate of return for the holder of the commodity, and the costs of storage and transportation (if the underlying asset is a commodity) until the futures contract matures and the transaction occurs. The futures market exists because producers want the safety that comes with locking in a reasonable price in advance, while futures buyers are hoping that the market value of their purchase rises during the interim before delivery. What Is a Spot Commodity? A spot commodity refers to a commodity that is being sold with the intention of being delivered to the buyer soon—either immediately or within a few days. A spot commodity contrasts with commodity futures, a contract in which the buyer receives delivery of the commodity at a forward point in time. How Are Commodities Priced? Commodities are priced in two basic ways: the spot price and the futures price. The spot price, aka the cash or market price, reflects what the commodity is trading in the current market or commodities exchange. It's what the commodity would cost you if you bought it today, for immediate delivery. In contrast, the futures price is delineated in a futures contract—an agreement between two parties to buy/sell the commodity at a predetermined price on a delivery date in the future. Supply and demand play a big role in the spot price of commodities. The spot price in turn acts as the basis for the futures price. The outlook for supply and demand of the commodity, along with cost of storing it until it's sold, also influence the futures price. 12.3.3 Hedging with Futures: the Perfect and Minimum-Variance Hedges One problem with using futures contracts to hedge a portfolio of spot assets, is that a perfect futures contract may not exist, that is, a perfect hedge cannot be achieved. For example, if an airline wishes to hedge its exposure to variation in jet fuel prices, it will find that there is no jet fuel futures market. A variation on the theme might go as follow. Although there exists a futures market for an underlying asset, that futures market is so illiquid that it is functionally useless. Thus, we need to find way to use sub-optimal contracts, contracts that are highly correlated with the underlying asset and who have a similar variance. This is achieved using the minimum variance hedge ratio. 183 CU IDOL SELF LEARNING MATERIAL (SLM)
The minimum variance hedge ratio (or optimal hedge ratio) is the ratio of futures position relative to the spot position that minimizes the variance of the position. The minimum variance hedge ratio is given as follows: Where, is the correlation and is the standard deviation. Let us take an example to understand this. An airlines company wishes to hedge their annual 2,000,000 gallons jet fuel requirement. In short, they fear that the price of jet fuel will rise. Unfortunately, there exists no jet fuel futures contract. However, a futures contract for heating oil trades at the NYMEX (New York Mercantile Exchange) and, it is known that jet fuel is a derivative of heating oil... The contract size of the NYMEX heating oil contract is 42,000 gallons. Thus, if heating oil were a perfect hedge, the Airline would purchase 2,000,000/42,000 contracts = 47.61 contract (either 46 or 47 contracts) Since heating oil is not a perfect hedge, they would use the minimum-variance hedge ratio to calculate the optimal number of contracts to purchase. i.e. The airlines company collects 15 months’ worth of data on spot jet fuel (S) and heating oil futures (F) prices. Month Δ in Future Price (ΔF) Δ in Spot Jet Fuel Price (ΔS) 1 0.021 0.029 2 0.035 0.020 3 -0.046 -0.044 184 CU IDOL SELF LEARNING MATERIAL (SLM)
4 0.001 0.008 5 0.044 0.026 6 – 0029 -0.019 7 -0.026 -0.010 8 -0.029 -0.007 9 0.048 0.043 10 -0.006 0.011 11 -0.036 -0.036 12 -0.011 -0.018 13 0.019 0.009 14 -0.027 -0.032 15 0.029 0.023 Table 12.1: Comparison of spot jet fuel and in future price We calculate the following: σF = 0.0313 σS = 0.0263 ρ = 0.928 So, the Optimal number of contracts is: = 37.14 Rounding, Airlines Company would buy: 37 heating oil futures contracts. If indeed jet fuel prices rose over the course of the year. The losses Airline would incur due to the higher spot jet fuel prices, would be offset by the gains they made from buying 37 contracts of heating oil futures. 185 CU IDOL SELF LEARNING MATERIAL (SLM)
12.4 SWAPS OPTIONS Contingent claims (e.g., options) Forward claims, which include exchange-traded futures, forward contracts, and swaps A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price, or commodity price. Conceptually, one may view a swap as either a portfolio of forward contracts or as a long position in one bond coupled with a short position in another bond. This article will discuss the two most common and most basic types of swaps: interest rate and currency swaps. Key Takeaways In finance, a swap is a derivative contract in which one party exchanges or swaps the values or cash flows of one asset for another. Of the two cash flows, one value is fixed and one is variable and based on an index price, interest rate, or currency exchange rate. Swaps are customized contracts traded in the over-the-counter (OTC) market privately, versus options and futures traded on a public exchange. The plain vanilla interest rate and currency swaps are the two most common and basic types of swaps. The Swaps Market Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments. Instead, swaps are customized contracts that are traded in the over the counter (OTC) market between private parties. Firms and financial institutions dominate the swaps market, with few (if any) individuals ever participating. Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap. Credit Default Swaps (CDS) The first interest rate swap occurred between IBM and the World Bank in 1981.1However, despite their relative youth, swaps have exploded in popularity. In 1987, the International Swaps and Derivatives Association reported that the swaps market had a total notional value of $865.6 billion.2 by mid-2006, this figure exceeded $250 trillion, according to the Bank for International Settlements.3. That’s more than 15 times the size of the U.S. public equities market. 12.4.1 Plain Vanilla Interest Rate Swap 186 CU IDOL SELF LEARNING MATERIAL (SLM)
The most common and simplest swap is a plain vanilla interest rate swap. In this swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period. Concurrently, Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the times between are called settlement periods. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties. For example, on Dec. 31, 2006, Company A and Company B enter a five-year swap with the following terms: Company A pays Company B an amount equal to 6% per annum on a notional principal of $20 million. Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of $20 million. LIBOR, or London Interbank Offered Rate, is the interest rate offered by London banks on deposits made by other banks in the Eurodollar markets. The market for interest rate swaps frequently (but not always) used LIBOR as the base for the floating rate until 2020. The transition from LIBOR to other benchmarks, such as the secured overnight financing rate (SOFR), began in 2020.4 For simplicity, let's assume the two parties exchange payments annually on December 31, beginning in 2007 and concluding in 2011. At the end of 2007, Company A will pay Company B $1,200,000 ($20,000,000 * 6%). On Dec. 31, 2006, one-year LIBOR was 5.33%; therefore, Company B will pay Company A $1,266,000 ($20,000,000 * (5.33% + 1%)). In a plain vanilla interest rate swap, the floating rate is usually determined at the beginning of the settlement period. Normally, swap contracts allow for payments to be netted against each other to avoid unnecessary payments. Here, Company B pays $66,000, and Company A pays nothing. At no point does the principal change hands, which is why it is referred to as a \"notional\" amount. Figure 1 shows the cash flows between the parties, which occur annually (in this example). Figure 12.1: Cash flows for a plain vanilla interest rate swap 187 12.4.2 Currency Swap CU IDOL SELF LEARNING MATERIAL (SLM)
A currency swap, sometimes referred to as a cross-currency swap, involves the exchange of interest—and sometimes of principal—in one currency for the same in another currency. Interest payments are exchanged at fixed dates through the life of the contract. It is considered to be a foreign exchange transaction and is not required by law to be shown on a company's balance sheet. Key Takeaways A currency swap involves the exchange of interest—and sometimes of principal—in one currency for the same in another currency. Companies doing business abroad often use currency swaps to get more favorable loan rates in the local currency than if they borrowed money from a local bank. Considered to be a foreign exchange transaction, currency swaps are not required by law to be shown on a company's balance sheet. Interest rate variations for currency swaps include fixed rate to fixed rate, floating rate to floating rate, or fixed rate to floating rate. The Basics of Currency Swaps Currency swaps were originally done to get around exchange controls, governmental limitations on the purchase and/or sale of currencies. Although nations with weak and/or developing economies generally use foreign exchange controls to limit speculation against their currencies, most developed economies have eliminated controls nowadays. So, swaps are now done most to hedge long-term investments and to change the interest rate exposure of the two parties. Companies doing business abroad often use currency swaps to get more favorable loan rates in the local currency than they could if they borrowed money from a bank in that country. Currency swaps are important financial instruments used by banks, investors, and multinational corporations. How a Currency Swap Works In a currency swap, the parties agree in advance whether or not they will exchange the principal amounts of the two currencies at the beginning of the transaction. The two principal amounts create an implied exchange rate. For example, if a swap involves exchanging €10 million versus $12.5 million, that creates an implied EUR/USD exchange rate of 1.25. At maturity, the same two principal amounts must be exchanged, which creates exchange rate risk as the market may have moved far from 1.25 in the intervening years. 188 CU IDOL SELF LEARNING MATERIAL (SLM)
Pricing is usually expressed as London Interbank Offered Rate (LIBOR), plus or minus a certain number of points, based on interest rate curves at inception and the credit risk of the two parties. Due to recent scandals and questions around its validity as a benchmark rate, LIBOR is being phased out. According to the Federal Reserve and regulators in the UK, LIBOR will be phased out by June 30, 2023, and will be replaced by the Secured Overnight Financing Rate (SOFR). As part of this phase-out, LIBOR one-week and two-month USD LIBOR rates will no longer be published after December 31, 2021.1. A currency swap can be done in several ways. Many swaps use simply notional principal amounts, which means that the principal amounts are used to calculate the interest due and payable each period but is not exchanged. If there is a full exchange of principal when the deal is initiated, the exchange is reversed at the maturity date. Currency swap maturities are negotiable for at least 10 years, making them a very flexible method of foreign exchange. Interest rates can be fixed or floating. 12.4.3 Pricing Swap A price swap derivative is a derivative transaction where one entity guarantees a fixed value for the total asset holdings of another entity over a specified period. Under this type of agreement, whenever the value of the secured assets declines, the counterparty must deliver securities or other collateral to offset that loss and bring the asset back to its original value. Key Takeaways A price swap derivative is a derivative transaction where one entity guarantees a fixed value for the total asset holdings of another entity over a specified period. Under this type of agreement, whenever the value of the secured assets declines, the counterparty must deliver securities or other collateral to offset that loss and bring the asset back to its original value. A price swap derivative can effectively hide the fact that the receiving company’s financial position is weakening over time. Understanding a Price Swap Derivative Price swap derivatives enable the value of one company’s assets to stay constant over a set period through the help of another company’s distributing shares. In this sense, the price swap derivative can effectively hide the fact that the receiving company’s financial position is weakening over time. However, when the counterparty issues new shares to fill the gap created by the lowered asset, it results in dilution of value for existing shareholders. This combination of 189 CU IDOL SELF LEARNING MATERIAL (SLM)
a misleading valuation on one side and increasingly diluted stock on the other can destabilize the financial standing of both parties in the agreement. Today, price swap derivatives are relatively unusual transactions. Their rareness is due to changes in accounting rules and the availability of more common methods to insure against declines in asset values. A more common derivative is known as a futures contract. With a futures contract, one party agrees to sell an asset to another party at a preset price on a predetermined future date. An additional type of derivative that can be used to insure against declines in asset values is called an option. Options are a derivative like futures; the chief difference is that the buyer is not required to purchase assets when the future date arrives. Example of a Price Swap Derivative Price swap derivatives were made famous because of the Enron financial scandal. Enron used price swap derivatives to guarantee the value of one of its subsidiaries, a limited partnership named Raptor. Under the derivative transaction, whenever Raptor’s assets fell below $1.2 billion, Enron promised to give enough stock to the subsidiary to make up the difference and keep Raptor assets at a constant. As this repeatedly happened over time, Enron stock made up an increasing portion of Raptor’s total assets. This practice only increased the need to trigger transactions, since whenever Enron’s stock fell, it would also bring Raptor assets below the $1.2 billion threshold. This downward spiral continued to force Enron to issue additional shares to the subsidiary. While the accelerating derivative transactions diluted stock values for Enron shareholders, they also prevented the company from having to record the plummeting value of the subsidiary, resulting in helping to inflate its bottom line on regular financial statements. 12.5 FORWARD RATE AGREEMENT Forward rate agreements (FRA) are over-the-counter contracts between parties that determine the rate of interest to be paid on an agreed-upon date in the future. In other words, an FRA is an agreement to exchange an interest rate commitment on a notional amount. The FRA determines the rates to be used along with the termination date and notional value. FRAs are cash-settled. The payment is based on the net difference between the interest rate of the contract and the floating rate in the market—the reference rate. The notional amount is not exchanged. It is a cash amount based on the rate differentials and the notional value of the contract. Key Takeaways 190 CU IDOL SELF LEARNING MATERIAL (SLM)
Forward rate agreements (FRA) are over-the-counter contracts between parties that determine the rate of interest to be paid on an agreed-upon date in the future. The notional amount is not exchanged, but rather a cash amount based on the rate differentials and the notional value of the contract. A borrower might want to fix their borrowing costs today by entering into an FRA. Formula and Calculation for a Forward Rate Agreement FRAP=(Y(R−FRA) ×NP×P) ×(1+R×(YP)1 Where: FRAP=FRA paymentFRA=Forward rate agreement rate, or fixed interestrate that will be paidR= Reference, or floating interest rate used inthe contractNP=Notional principal, or amount of the lo an thatinterest is applied toP=Period, or number of days in the contract periodY=Number of days in the year based on the correctday-count convention for the contract Calculate the difference between the forward rate and the floating rate or reference rate. Multiply the rate differential by the notional amount of the contract and by the number of days in the contract. Divide the result by 360 (days). In the second part of the formula, divide the number of days in the contract by 360 and multiply the result by 1 + the reference rate. Then divide the value into 1. Multiply the result from the right side of the formula by the left side of the formula. Forward rate agreements typically involve two parties exchanging a fixed interest rate for a variable one. The party paying the fixed rate is referred to as the borrower, while the party paying the variable rate is referred to as the lender. The forward rate agreement could have the maturity if five years. A borrower might enter into a forward rate agreement with the goal of locking in an interest rate if the borrower believes rates might rise in the future. In other words, a borrower might want to fix their borrowing costs today by entering an FRA. The cash difference between the FRA and the reference rate or floating rate is settled on the value date or settlement date. For example, if the Federal Reserve Bank is in the process of hiking U.S. interest rates, called a monetary tightening cycle, corporations would likely want to fix their borrowing costs before rates rise too dramatically. Also, FRAs are very flexible, and the settlement dates can be tailored to the needs of those involved in the transaction. Forward Rate Agreements (FRA) vs. Forward Contracts (FWD) 191 CU IDOL SELF LEARNING MATERIAL (SLM)
A forward rate agreement is different than a forward contract. A currency forward is a binding contract in the foreign exchange market that locks in the exchange rate for the purchase or sale of a currency on a future date. A currency forward is a hedging tool that does not involve any upfront payment. The other major benefit of a currency forward is that it can be tailored to a particular amount and delivery period, unlike standardized currency futures. The FWD can result in the currency exchange being settled, which would include a wire transfer or a settling of the funds into an account. There are times when an offsetting contract is entered, which would be at the prevailing exchange rate. However, offsetting the forward contract results in settling the net difference between the two exchange rates of the contracts. An FRA results in settling the cash difference between the interest rate differentials of the two contracts. A currency forward settlement can either be on a cash or a delivery basis, provided that the option is mutually acceptable and has been specified beforehand in the contract. Limitations of Forward Rate Agreements There is a risk to the borrower if they had to unwind the FRA and the rate in the market had moved adversely so that the borrower would take a loss on the cash settlement. FRAs are very liquid and can be unwound in the market, but there will be a cash difference settled between the FRA rate and the prevailing rate in the market. 12.6 SUMMARY Market analysis brought with randomness and unpredictability in exchange rates. Exchange rates have become more volatile than they were expected. This random fluctuation in exchange rate has made cash flows and asset value of companies dealing in different currencies unpredictable, that is to say, cash flows and asset value of MNCs in their respective domestic currency are at stake of exchange rate between its domestic currency and foreign currency. Leading means paying an obligation in advance of the due date and lagging means delaying payment of an obligation beyond its due date. It basically refers to credit terms and payment between associate companies within a group. In forex market where exchange rates are constantly fluctuating, the leading and lagging tactics come handy to take advantage of expected rise / fall in exchange rates. Exporters and importers of goods always face a dilemma in deciding the currency in which the goods are to be involved. It is obvious that sellers always prefer to invoice in their domestic currency or the currency in which they incur cost, so that it avoids foreign 192 CU IDOL SELF LEARNING MATERIAL (SLM)
exchange exposure. On the other hand, buyers will have their own preferences for a particular currency Foreign Exchange Exposure is risk associated with unanticipated changes in exchange rate. With globalization and liberalization of Indian economy in nineties, scope of business for Indian companies with the rest of world has broadened and foreign corporations too have become much interested in India. In India, exchange rates were deregulated and were allowed to be determined by markets in 1993. This volatility in exchange rates can have detrimental effect on the firm’s financial position and negative effect on its competitive position in the market and value of firm, if ignored it can paralyze the company. Currency swaps were originally done to get around exchange controls, governmental limitations on the purchase and/or sale of currencies. Although nations with weak and/or developing economies generally use foreign exchange controls to limit speculation against their currencies, most developed economies have eliminated controls nowadays. The basis is the difference between the local spot price of a deliverable commodity and the price of the futures contract for the earliest available date. \"Local\" is relevant here because futures prices reflect global prices for any commodity and are therefore a benchmark for local prices. The basis can vary greatly from one region to another based primarily on the costs of transporting the commodity to its delivery point. A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price, or commodity price. 12.7 KEYWORDS Foreign Exchange Exposure: Foreign exchange exposure refers to the risk a company undertakes when making financial transactions in foreign currencies. All currencies can experience periods of high volatility which can adversely affect profit margins if suitable strategies are not in place to protect cash flow from sudden currency fluctuations. Equity price risk: Equity price risk is the risk that arises from security price volatility – the risk of a decline in the value of a security or a portfolio. ... In a global economic crisis, equity price risk is systematic because it affects multiple asset classes. A portfolio can only be hedged against this risk. 193 CU IDOL SELF LEARNING MATERIAL (SLM)
Commodity price risk: Commodity price risk is the financial risk on an entity's financial performance/ profitability upon fluctuations in the prices of commodities that are out of the control of the entity since they are primarily driven by external market forces. Termination date: A termination date is a day on which a contract ends. It is the natural ending of any financial contract such as a swap, rental lease, or loan agreement. ... Termination dates are also found in employment contracts, which indicate the last day of an individual's employment with a company. Notional value: Notional value is a term often used to value the underlying asset in a derivatives trade. It can be the total value of a position, how much value a position controls, or an agreed-upon amount in a contract. This term is used when describing derivative contracts in the options, futures, and currency markets. Deliverable commodity: Deliverable Commodity risk is the risk a business faces due to change in the price and other terms of a commodity with a change in time and management of such risk is termed as commodity risk management which involves various strategies like hedging on the commodity through forwarding contract, futures contract etc. 12.8 LEARNING ACTIVITY 1. With globalization and liberalization of Indian economy in nineties, scope of business for Indian companies with the rest of world has broadened and foreign corporations too have become much interested in India. Study about the Globalization and Liberalization trends in India and prepare a report. ______________________________________________________________________________ ______________________________________________________________________________ 2. Study in detail about the Enron financial scandal and analyze how it brought changes to price swap derivative. ______________________________________________________________________________ ______________________________________________________________________________ 12.9 UNIT END QUESTIONS 194 A. Descriptive Questions Short Questions CU IDOL SELF LEARNING MATERIAL (SLM)
1. What are the Strengths and Weaknesses of Futures Markets? 2. Explain the Relationship of Futures Prices to Forward and Spot Prices? 3. What do you mean by Hedging with Futures? 4. What is the meaning of Plain Vanilla Interest Rate Swaps? 5. Explain Currency Swaps? Long Questions 1. Explain Swaps Options? What is the meaning of the term Pricing Swaps? 2. What do you mean by Forward Rate Agreement? Write about the Relationship of Futures Prices to Forward and Spot Prices? 3. What are the objectives of instruments of external techniques of risk management? 4. Explain Futures? Hedging with Futures: The Perfect and Minimum-Variance Hedges. 5. What is the meaning of the term Swaps Options and explain Plain Vanilla Interest Rate Swaps, Currency Swaps and Pricing Swaps.? B. Multiple Choice Questions 1. A currency forward is a binding contract in the foreign exchange market that locks in the exchange rate for the purchase or sale of a currency on a a. Current date b. Past date c. future date d. all of these 2. Commodity price risk is the financial risk on an entity's financial performance/ profitability upon fluctuations in the prices of commodities that are out of the control of the entity since they are primarily driven by. a. external market forces b. Internal market forces c. Both external and internal market d. Economy of the country 3. A price swap derivative is a derivative transaction where one entity guarantees a fixed value for the total asset holdings of another entity over a. 195 CU IDOL SELF LEARNING MATERIAL (SLM)
a. Unlimited period b. specified period c. market price d. business prospect 4. A futures contract price is commonly determined using the --------------------of a commodity. a. Interest rate b. Exchange price c. Market rate d. spot price 5. Foreign exchange exposure refers to the risk a company undertakes when making financial transactions in a. Foreign currencies. b. Indian currency c. Gold rate d. Per capita income Answers 1-c, 2-a, 3-b, 4-d, 5-a 12.10 REFERENCES References Pellegrino JM. Risk management in agriculture: Argentine evidence of perceived sources of risk, risk management strategies and risk efficiency in rice farming [masterthesis]. Lincoln, New Zealand: Lincoln University; 1999. Katikarn K. Risk and uncertainty of farmers in the central plain of Thailand [doctoral thesis]. Lexington, Kentucky: University of Kentucky; 1981 Gamma E., Helm R., Johnson R., Vlissides J., Design Patterns: Elements of Reusable Object-Oriented Software, Addison Wesley, 1996. Textbook 196 CU IDOL SELF LEARNING MATERIAL (SLM)
Harwood J, Heifner R, Coble K, Perry J, Somwaru A. Managing risk in farming:concepts, research, and analysis. [report]. In press 1999. Shadbolt NM, Martin SK. Farm management in New Zealand. Auckland: Oxford University Press; 2005. Patamakitsakul S. Thailand agriculture in the 10th National Economic and SocialDevelopment Plan (2007-2011) (in Thai)2006. Websites http://www.raijmr.com/ijrhs/wp- content/uploads/2017/11/IJRHS_2016_vol04_issue_05_09.pdf https://goodmoneyguide.com/advantages-and-disadvantages-of-future-contracts/ https://www.investopedia.com/ask/answers/062315/how-are-commodity-spot-prices- different-futures-prices.asp 197 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT – 13: INSTRUMENTS OF EXTERNAL 198 TECHNIQUES OF RISK MANAGEMENT-PART 2 STRUCTURE 13.0 Learning Objectives 13.1 Introduction 13.2 Caps 13.3 Collars 13.4 Pricing Techniques 13.4.1 Price Skimming 13.4.2 Market Penetration Pricing 13.4.3 Premium Pricing 13.4.4 Economy Pricing 13.4.5 Bundle Pricing 13.5 Operational Aspects 13.6 Summary 13.7 Keywords 13.8 Learning Activity 13.9 Unit End Questions 13.10 References 13.0 LEARNING OBJECTIVES After completing this unit, you will be able to: Explain about Caps, Collars and pricing Techniques Examine about Price Skimming Evaluate the Market Penetration Pricing Illustrate the concept of Premium Pricing Examine the different concepts of Economy Pricing CU IDOL SELF LEARNING MATERIAL (SLM)
Evaluate and access about Bundle Pricing, and Operational Aspects 13.1 INTRODUCTION Foreign exchange risk is managed through two means (a) internal i.e., use of tools which are internal to the firm such as netting, matching, etc. and (b) external techniques i.e., use of contractual means such as forward contracts, future, option, etc. to insure against potential exchange losses. The usage of internal techniques is also known as passive hedging, while the latter is known as active hedging. Usage of internal tools among the group companies may at times be difficult to practice owing to local exchange control regulations. Nevertheless, they are worth implementing for they do not involve extra payouts while being significantly effective in minimizing the forex exposure. It is essential to understand the difference between forex exposure and forex risk. Foreign exchange exposure is the sensitivity to changes in the real domestic currency value of assets, liabilities, or operating incomes to unanticipated change in exchange rates. Foreign exchange risk exposure is quite often used interchangeably with the term ‘foreign exchange risk’, although they are conceptually quite different. Foreign exchange risk is defined in terms of variance of unanticipated changes in exchange rates. It is measured by the variance of the domestic currency value of an asset, liability or operating income that is attributable to unanticipated changes in exchange rates. Management of Foreign Exchange Risk Internal (Passive hedging) Netting, Matching, etc. External (Active hedging) e.g. Forward contract, future contract, etc. Figure 13.1 Management of Foreign Exchange Risk 13.2 CAPS An interest rate cap structure refers to the provisions governing interest rate increases on variable-rate credit products. An interest rate cap is a limit on how high an interest rate can 199 CU IDOL SELF LEARNING MATERIAL (SLM)
rise on variable-rate debt. Interest rate caps can be instituted across all types of variable rate products. However, interest rate caps are commonly used in variable-rate mortgages and specifically adjustable-rate mortgage (ARM) loans. Key Takeaways An interest rate cap is a limit on how high an interest rate can rise on variable rate debt. Interest rate caps are commonly used in variable-rate mortgages and specifically adjustable-rate mortgage (ARM) loans. Interest rate caps can have an overall limit on the interest for the loan and also be structured to limit incremental increases in the rate of a loan. Interest rate caps can give borrowers protection against dramatic rate increases and also provide a ceiling for maximum interest rate costs. How Interest Rate Caps Work Interest rate cap structures serve to benefit the borrower in a rising interest rate environment. The caps can also make variable rate interest products more attractive and financially viable for customers. Variable Rate Interest Lenders can offer a wide range of variable rate interest products. These products are most profitable for lenders when rates are rising and most attractive for borrowers when rates are falling. Variable-rate interest products are designed to fluctuate with the changing market environment. Investors in a variable rate interest product will pay an interest rate that is based on an underlying indexed rate plus a margin added to the index rate. The combination of these two components results in the borrower’s fully indexed rate. Lenders can index the underlying indexed rate to various benchmarks with the most common being their prime rate or a U.S. Treasury rate. Lenders also set a margin in the underwriting process based on the borrower’s credit profile. A borrower’s fully indexed interest rate will change as the underlying indexed rate fluctuates. How Interest Rate Caps can be Structured Interest rate caps can take various forms. Lenders have some flexibility in customizing how an interest rate cap might be structured. There can be an overall limit on the interest for the loan. The limit is an interest rate that your loan can never exceed meaning that no matter how much 200 CU IDOL SELF LEARNING MATERIAL (SLM)
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