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NAGINDAS KHANDWALA COLLEGE

TOPIC NAME: TOOLS FOR RISK MANAGEMENT

SUBMITTED TO: ROHAN SIR

GROUP MEMBERS

KINJAL JOBIALIA BHAVEEN JOSHI URJA JOSHI ALTAF SHAH BHUMIKA SHAH KHUSHBOO SHAH

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Acknowledgement
We are very thankful to everyone who all supported us for completion of our project effectively and moreover on time. We are equally grateful to our teacher Prof. Rohan sir. He gave us moral support and guided us in different matters regarding the topic. He had been very kind and patient while suggesting us the outlines of this project and correcting our doubts. We thank her overall support.

Thanking you

What is Risk? Risk is when there's an uncertainty about whether an event will or will not occur. Thus, risk management is the process of identifying exposures to risk, choosing the best method for handling each exposure and implementing it. What is risk management? Risk management ensures that an organization identifies and understands the risks to which it is exposed. Risk management also guarantees that the organization creates and implements an effective plan to prevent losses or reduce the impact if a loss occurs. Benefits to managing risk Risk management provides a clear and structured approach to identifying risks. Having a clear understanding of all risks allows an organization to measure and prioritize them and take the appropriate actions to reduce losses. Risk management has other benefits for an organization, including:

Saving resources: Time, assets, income, property and people are all valuable resources that can be saved if fewer claims occur. Protecting the reputation and public image of the organization. Preventing or reducing legal liability and increasing the stability of operations. Protecting people from harm.

Protecting the environment. Enhancing the ability to prepare for various circumstances. Reducing liabilities. Assisting in clearly defining insurance needs.

An effective risk management practice does not eliminate risks. However, having an effective and operational risk management practice shows an insurer that your organization is committed to loss reduction or prevention. It makes your organization a better risk to insure.

TOOLS FOR RISK MANAGEMENT (1)INSURANCE:

Risk, in insurance terms, is the possibility of a loss or other adverse event that has the potential to interfere with an organizations ability to fulfill its mandate, and for which an insurance claim may be submitted. Insurance refers to a contract that reduces risk of loss and requires one party to pay a specified sum to another if a previously identified event occurs. Thus, insurance planning is the process of handling and safeguarding against future risk of loss and ensuring sufficient compensation is provided.

Role of insurance in risk management

Insurance is a valuable risk-financing tool. Few organizations have the reserves or funds necessary to take on the risk themselves and pay the total costs following a loss. Purchasing insurance, however, is not risk management. A thorough and thoughtful risk management plan is the commitment to prevent harm. Risk management also addresses many risks that are not insurable, including brand integrity, potential loss of tax-exempt status for volunteer groups, public goodwill and continuing donor support. Property and casualty, life, health, and other types of insurance all work on the same principle. The insurer agrees, in exchange for premium payments, to pay the insured a certain amount or up to a certain amount to compensate for a loss arising from a specific type of risk. The insurer creates a pool of insured people or entities that share the risk (the risk pool). The insurer determines the premiums based on the size and likelihood of the losses and the supply and demand for the insurance. The purpose of an insurance company is to determine the probabilities of risk and to design a premium structure ensuring that the company has a high chance of profiting in the future. The higher the risk, the larger the premium, and vice versa. In addition, insurance companies need to differentiate risks posed by different individuals, companies, asset classes, and other tasks. The more precise the risk model, the better an insurance company can serve its customers and derive profit. Insurance in India can be broadly categorized into two types: life and general. Life insurance can be further classified into term life insurance, whole life insurance, money back plan, endowment policy and pension plan. Health, home, accident, motor and travel insurances fall under the general insurance category. State-owned companies like Life Insurance Corporation of India, as well as private insurance providers,

like ICICI Prudential and Bajaj Allianz, provide life and general insurances in India. Insurance is all about planning for the unexpected. We have found that understanding the nuance of business insurance is probably one of the most complex parts of running your own business and the key to navigating this complex terrain is to find an agent that you trust. There are many types of insurance products that are available for you as a business owner knowing which ones are required, which ones are recommended, and which ones are simply a luxury is the best way for you to break it downwe hope the following will help you understand which are best for you.

Property and Casualty Insurance is a policy that is required to protect you and your business from personal injury to a customer or someone on your property, fire, or natural disaster. It is often required by your lenders and is considered a best business practice to protect your assets. Product Liability Insurance is required if you manufacture parts or products. It will protect you from faulty parts that cause damage or personal injury. Life Insurance will provide financial security for your survivors or business partners in the event of your death. This is a tool that can also protect you if your business partner or a key member of your management team dies unexpectedly. Proceeds in the event of a death can be used to pay off debt, train new staff to perform, and keep the business functioning through a traumatic time period. Disability Insurance will provide you the financial security if you are injured and cannot fulfill your mental or physical responsibilities in your company. This is a policy that can be purchased for any key staff member in your business and is

common in industries which are considered high risk. It is sometimes more important than life insurance. Business Interruption Insurance will pay you for any interruption in your business. An example would be if you had a fire in your business. If done correctly, the policy would help temporarily relocate your business or pay key employees during the time you are not operating to ensure that they stayed employed or to ensure that your business continues to operate during the time of rebuilding.

(2)ASSET LIABILITY MANAGEMENT Asset Liability Management (ALM) can be defined as a mechanism to address the risk faced by a bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates. Liquidity is an institutions ability to meet its liabilities either by borrowing or converting assets. Apart from liquidity, a bank may also have a mismatch due to changes in interest rates as banks typically tend to borrow short term (fixed or floating) and lend long term (fixed or floating). A comprehensive ALM policy framework focuses on bank profitability and long term viability by targeting the net interest margin (NIM) ratio and Net Economic Value (NEV), subject to balance sheet constraints. Significant among these constraints are maintaining credit quality, meeting liquidity needs and obtaining sufficient capital. An insightful view of ALM is that it simply combines portfolio management techniques (that is, asset, liability and spread management) into a coordinated process. Thus, the central theme of ALM is the coordinated and not piecemeal management of a banks entire balance sheet.

Although ALM is not a relatively new planning tool, it has evolved from the simple idea of maturity-matching of assets and liabilities across various time horizons into a framework that includes sophisticated concepts such as duration matching, variable rate pricing, and the use of static and dynamic simulation. Banks face several risks such as the liquidity risk, interest rate risk, credit risk and operational risk. Asset liability management (ALM) is a strategic management tool to manage interest rate risk and liquidity risk faced by banks, other financial services companies and corporations. Banks manage the risks of asset liability mismatch by matching the assets and liabilities according to the maturity pattern or the matching the duration, by hedging and by securitization. Measuring Risk The function of ALM is not just protection from risk. The safety achieved through ALM also opens up opportunities for enhancing net worth. Interest rate risk (IRR) largely poses a problem to a banks net interest income and hence profitability. Changes in interest rates can significantly alter a banks net interest income (NII), depending on the extent of mismatch between the asset and liability interest rate reset times. Changes in interest rates also affect the market value of a banks equity. Methods of managing IRR first require a bank to specify goals for either the book value or the market value of NII. In the former case, the focus will be on the current value of NII and in the latter, the focus will be on the market value of equity. In either case, though, the bank has to measure the risk exposure and formulate strategies to minimize or mitigate risk.

The immediate focus of ALM is interest-rate risk and return as measured by a banks net interest margin (NIM). NIM = (Interest income Interest expense) / Earning assets

The ALM process rests on three pillars: (1)ALM information systems => Management Information System => Information availability, accuracy, adequacy and expediency (2)ALM organization => Structure and responsibilities => Level of top management involvement (3)ALM process => Risk parameters => Risk identification => Risk measurement => Risk management => Risk policies and tolerance levels.

(3)BASEL 2 NORMS BASEL ACCORDS refers to banking supervision Accords (recommendations on banking laws and regulations), Basel I and Basel II issued by the Basel Committee on Banking Supervision (BCBS).Called the Basel Accords as the BCBS maintains its secretariat at the Bank of International Settlements in Basel, Switzerland Background under capital requirements rules, credit institutions like banks must at all times maintain minimum financial capital, to cover the risks Aim - to ensure financial soundness of such institutions, maintain customer confidence in the solvency of the institutions, ensure stability of financial system at large, and protect depositors against losses. Basel Committee on Banking Supervision established in 1974 to provide a forum for banking supervisory matters. Members are from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, UK and USA. Background Basel Committee not a formal regulatory authority, but has great influence over supervising authorities in many countries. Committee hopes to achieve common approaches and common standards across member countries, without detailed harmonization of each member country's supervisory techniques. In 1988, recognizing the emergence of larger more global financial

services companies, the Committee introduced Basel Capital Accord (Basel I) to strengthen soundness and stability of international banking system by requiring higher capital ratios. Background since 1988, the framework of Basel I progressively introduced not only in member countries but also in virtually all other countries with active international banks. In June 1999, proposal issued for a new Capital Adequacy framework to replace Basel I. After extensive communication with banks and industry groups, the revised framework, Basel II issued in 2004. Basel II has been or will be implemented by regulators in most jurisdictions but with varying timelines and may be restricted methodologies. BASEL II The second of the Basel Accords. Purpose is to create an international standard that banking regulators can use when creating regulations about capital banks to be put aside to guard against financial and operational risks. An international standard can help protect the international financial system from possible problems should a major bank or a series of banks collapse. Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through lending and investment practices. Greater the risk greater the amount of capital bank needs to hold to safeguard its solvency and overall economic stability. FINAL OBJECTIVE Ensuring that capital allocation is more risk sensitive Separating operational risk from credit risk, and quantifying both Attempting to align economic and regulatory capital more closely to reduce scope for regulatory arbitrage

Why BASEL IIBasel I Accord succeeded in raising total level of equity capital in the system. However, it also pushed unintended consequences. Since it does not differentiate risks very well, it perversely encouraged risk seeking. All loans given to corporate borrowers were subject to the same capital requirement, without taking into account ability of the counterparties to repay. It ignored credit rating, credit history, risk management and corporate governance structure of all corporate borrowers. All were treated as private corporations. It also promoted loan securitization that led to the unwinding in the subprime market. BASEL II much more risk sensitive, as it is aligning capital requirements to risks of loss. Better risk management in a bank means bank may be able to allocate less regulatory capital. The objective of Basel II is to modernize existing capital requirements framework to make it more comprehensive and risk sensitive. The Basel II framework therefore designed to be more sensitive to the real risks that firms face than Basel I. Apart from looking at financial figures, it also considers operational risks, such as risk of systems breaking down or people doing the wrong things, and also market risk. Three Pillars of Basel II Framework Pillar 1 set out the minimum capital requirements firms will be required to meet to cover credit, market and operational risk. Pillar 2 sets out a new supervisory review process. Requires financial institutions to have their own internal processes to assess their overall capital adequacy in relation to their risk profile.

Pillar 3 cements Pillars 1 and 2 and is designed to improve market discipline by requiring firms to publish certain details of their risks, capital and risk management as to how senior management and the Board assess and will manage the institution's risks.

CONCLUSION Basel II Framework lays down a more comprehensive measure and minimum standard for capital adequacy Seeks to improve on existing rules by aligning regulatory capital requirements more closely to underlying risks that banks face. In addition, it intends to promote a more forward-looking approach to capital supervision that encourages banks to identify the present and future risks, and develop or improve their ability to manage them. Hence intended to be more flexible and better able to evolve with advances in markets and risk management practices. Basel II Accord attempts to fix glaring problems with the original accord. It does this by more accurately defining risk, but at the cost of considerable rule complexity

(4) Forward Contracts In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today.[1] This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time and date of trade is not the same as the value date where the securities themselves are exchanged. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the

forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party. Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive. A closely related contract is a futures contract; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets.[2] Forwards also typically have no interim partial settlements or "trueups" in margin requirements like futures such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. However, being traded OTC; forward contracts specification can be customized and may include mark-to-market and daily margining. Hence, a forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain How a forward contract works Suppose that Bob wants to buy a house a year from now. At the same time, suppose that Andy currently owns a $100,000 house that he wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $104,000 (more below on why the sale price should be this amount). Andy and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Andy will have the short forward contract. At the end of one year, suppose that the current market valuation of Andy's house is $110,000. Then, because Andy is obliged to sell to Bob

for only $104,000, Bob will make a profit of $6,000. To see why this is so, one need only to recognize that Bob can buy from Andy for $104,000 and immediately sells to the market for $110,000. Bob has made the difference in profit. In contrast, Andy has made a potential loss of $6,000, and an actual profit of $4,000. The similar situation works among currency forwards, where one party opens a forward contract to buy or sell a currency (ex. a contract to buy Canadian dollars) to expire/settle at a future date, as they do not wish to be exposed to exchange rate/currency risk over a period of time. As the exchange rate between U.S. dollars and Canadian dollars fluctuates between the trade date and the earlier of the date at which the contract is closed or the expiration date, one party gains and the counterparty loses as one currency strengthens against the other. Sometimes, the buy forward is opened because the investor will actually need Canadian dollars at a future date such as to pay a debt owed that is denominated in Canadian dollars. Other times, the party opening a forward does so, not because they need Canadian dollars nor because they are hedging currency risk, but because they are speculating on the currency, expecting the exchange rate to move favorably to generate a gain on closing the contract.

(5)Futures Contract In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today (the futures price or the strike price) with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange. The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be "short". The terminology reflects the expectations of the parties -- the buyer hopes or expects that the asset price is going to increase, while the seller hopes or expects that it will decrease. Note that the contract itself costs nothing to enter; the buy/sell terminology is a linguistic convenience reflecting the position each party is taking (long or short). In many cases, the underlying asset to a futures contract may not be traditional commodities at all that is, for financial futures the underlying asset or item can be currencies, securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates. While the futures contract specifies a trade taking place in the future, the purpose of the futures exchange institution is to act as intermediary and minimize the risk of default by either party. Thus the exchange requires both parties to put up an initial amount of cash, the margin. Additionally, since the futures price will generally change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily also. The exchange will draw money out of one party's margin account and put it into the others so that each party has the appropriate daily loss or profit. If the margin account goes below a certain value, then a margin call is made and the account owner must replenish the margin account. This process is known as marking to market. Thus on the delivery date, the amount exchanged is not the

specified price on the contract but the spot value (since any gain or loss has already been previously settled by marking to market). A closely related contract is a forward contract. A forward is like futures in that it specifies the exchange of goods for a specified price at a specified future date. However, a forward is not traded on an exchange and thus does not have the interim partial payments due to marking to market. Nor is the contract standardized, as on the exchange. Unlike an option, both parties of a futures contract must fulfill the contract on the delivery date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position can close out its contract obligations by taking the opposite position on another futures contract on the same asset and settlement date. The difference in futures prices is then a profit or loss Who trades futures? Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying asset (which could include an intangible such as an index or interest rate) and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and opening a derivative contract related to the asset "on paper", while they have no practical use for or intent to actually take or make delivery of the underlying asset. In other words, the investor is seeking exposure to the asset in a long futures or the opposite effect via a short futures contract.

Hedgers Hedgers typically include producers and consumers of a commodity or the owner of an asset or assets subject to certain influences such as an interest rate. For example, in traditional commodity markets, farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern (financial) markets, "producers" of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap. Those that buy or sell commodity futures need to be careful. If a company buys contracts hedging against price increases, but in fact the market price of the commodity is substantially lower at time of delivery, they could find themselves disastrously non-competitive. Speculators Speculators typically fall into three categories: position traders, day traders, and swing traders (swing trading), though many hybrid types and unique styles exist. With many investors pouring into the futures markets in recent years controversy has risen about whether speculators are responsible for increased volatility in commodities like oil, and experts are divided on the matter. An example that has both hedge and speculative notions involves a mutual fund or separately managed account whose investment objective is to track the performance of a stock index such as the S&P 500 stock index. The Portfolio manager often "equities" cash inflows in an easy and cost effective manner by investing in (opening long) S&P

500 stock index futures. This gains the portfolio exposure to the index which is consistent with the fund or account investment objective without having to buy an appropriate proportion of each of the individual 500 stocks just yet. This also preserves balanced diversification, maintains a higher degree of the percent of assets invested in the market and helps reduce tracking error in the performance of the fund/account. When it is economically feasible (an efficient amount of shares of every individual position within the fund or account can be purchased), the portfolio manager can close the contract and make purchases of each individual stock. The social utility of futures markets is considered to be mainly in the transfer of risk, and increased liquidity between traders with different risk and time preferences, from a hedger to a speculator, for example.

(6)Option Contract An option contract is defined as "a promise which meets the requirements for the formation of a contract and limits the promises power to revoke an offer." Restatement (Second) of Contracts 25 (1981). Quite simply, an option contract is a type of contract that protects an offeree from an offeror's ability to revoke the contract. Consideration for the option contract is still required as it is still a form of contract. Typically, an offeree can provide consideration for the option contract by paying money for the contract or by providing value in some other form such as by rendering other performance What is an Option? An option is a contract to buy or sell a specific financial product officially known as the option's underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange-traded fund (ETF), or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted on. And it has an expiration date. When an option expires, it no longer has value and no longer exists. Options come in two varieties, calls and puts, and you can buy or sell either type. You make those choices - whether to buy or sell and whether to choose a call or a put - based on what you want to achieve as an options investor.

Buying and Selling If you buy a call, you have the right to buy the underlying instrument at the strike price on or before the expiration date. If you buy a put, you have the right to sell the underlying instrument on or before expiration. In either case, as the option holder, you also have the right to sell the option to another buyer during its term or to let it expire worthless. The situation is different if you write, or "sell to open", an option. Selling to open a short option position obligates you, the writer, to fulfill your side of the contract if the holder wishes to exercise. When you sell a call as an opening transaction, you're obligated to sell the underlying interest at the strike price, if you're assigned. When you sell a put as an opening transaction, you're obligated to buy the underlying interest, if assigned. As a writer, you have no control over whether or not a contract is exercised, and you need to recognize that exercise is always possible at any time until the expiration date. But just as the buyer can sell an option back into the market rather than exercising it, as a writer you can purchase an offsetting contract, provided you have not been assigned, and end your obligation to meet the terms of the contract. When offsetting a short option position, you would enter a "buy to close" transaction. At a Premium When you buy an option, the purchase price is called the premium. If you sell, the premium is the amount you receive. The premium isn't fixed and changes constantly - so the premium you pay today is likely to be higher or lower than the premium yesterday or tomorrow. What those changing prices reflect is the give and take between what buyers are willing to pay and what sellers are willing to accept for the option. The point at which there's agreement becomes the price for that transaction, and then the process begins again.

If you buy options, you start out with what's known as a net debit. That means you've spent money you might never recover if you don't sell your option at a profit or exercise it. And if you do make money on a transaction, you must subtract the cost of the premium from any income you realize to find your net profit. As a seller, on the other hand, you begin with a net credit because you collect the premium. If the option is never exercised, you keep the money. If the option is exercised, you still get to keep the premium, but are obligated to buy or sell the underlying stock if you're assigned. The Value of Options What a particular options contract is worth to a buyer or seller is measured by how likely it is to meet their expectations. In the language of options, that's determined by whether or not the option is, or is likely to be, in-the-money or out-of-the-money at expiration. A call option is in-the-money if the current market value of the underlying stock is above the exercise price of the option, and out-of-the-money if the stock is below the exercise price. A put option is in-the-money if the current market value of the underlying stock is below the exercise price and out-of-the-money if it is above it. If an option is not in-the-money at expiration, the option is assumed to be worthless. An option's premium has two parts: an intrinsic value and a time value. Intrinsic value is the amount by which the option is in-the-money. Time value is the difference between whatever the intrinsic value is and what the premium is. The longer the amount of time for market conditions to work to your benefit, the greater the time value.

Options Prices Several factors, including supply and demand in the market where the option is traded, affect the price of an option, as is the case with an individual stock. What's happening in the overall investment markets and the economy at large are two of the broad influences. The identity of the underlying instrument, how it traditionally behaves, and what it is doing at the moment are more specific ones. Its volatility is also an important factor, as investors attempt to gauge how likely it is that an option will move in-the-money.

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