Introduction to Market Risk

Topics Covered
• Liquidity Risk
• Interest Rate Risk
• Basel Norms
• Forex Risk
• Forwards and Futures
• Equity Price Risk
• Commodity Risk
• Market Beta
• SML
• CML
• Standardised duration method
• Internal measurement method
• VaR
Liquidity Risk
• Risk of not being able to convert an asset into cash quickly.
• Also, revenues and outlays are not synchronised
• Often, this friction ends up in a loss
• Two types:
• Funding Liquidity Risk: The inability to settle obligations with immediacy.
Possibility of a bank becoming unable to settle obligations with immediacy,
over a specific time horizon. This will lead into default
• Market Liquidity Risk: inability to sell an asset , before the price fall. Few
takers for an asset. Spread is very low
• For further reading - https://www.bis.org/publ/work316.pdf
Interest Rate Risk
• Risk of existing investments losing their market value, if new
investment with higher interest rates enter the market.
• Bonds are affected more, than equities.
• Also, can happen with fluctuating interest rates.
• Bond Theorems – quick recap
Foreign Exchange Risk
• Forex Risk or FX Risk or exchange rate risk or currency risk
• Occurs when we are valuing one currency (base currency) in terms of
another currency.
• Currency Pair
• Base currency - appreciation
• Quote currency - depreciation
Defining Exposure and Risk
• Increase in the foreign currency value increases the domestic
currency value of a firm’s foreign currency assets and liabilities:
foreign currency receivables and payables, bank deposits etc.,
• Increase in the interest rates reduces the market value of a portfolio
of fixed rate bonds and may increase the interest payouts
• Increase in the rate of inflation may increase the value of unsold
stocks, revenue from the future sales and future cost of production.

Thus, the firm is ‘exposed’ to unforeseen changes in the number of

variables in the environment – also called as “Risk Factors”
Exposure and Risk
Example:
Between April 1992 and to about Jul 1995, the exchange rate between
INR and USD were steady. A firm whose business involved both exports
and imports with US.
During this period, the firm’s operating cashflows were sensitive to the
INR-USD exchange rate (i.e., significant exposure to this risk)
At the same time, it would not have been perceived as a risk, given the
stability of exchange rate.
Measuring Exposure and Risk
Exposure of a firm to a risk factor is the sensitivity of the real value of a
firm’s assets, liabilities or operating income, expressed in functional
currency, to unanticipated changes in the risk factor.

• Value of the assets, liabilities or operating income to be in functional

currency of the firm – Primary currency of the firm in which the
financial statements are published (Domestic currency, in most of the
cases)
• Stresses on unanticipated changes in the relevant risk factors.
Because, the markets would have already made an allowance for
anticipated changes.
Exposure and Risk
How do we separate a given change in exchange rates/interest rates
into anticipated and unanticipated components?
Relevant forward rate as the expected value of the underlying risk
factor.
Example: Estimating the exchange rate 3 months from now. That will be 3
month forward rate (today’s).
If price of GBP to INR is Rs.68.00 (immediate delivery/Spot Price), and 1 month
forward rate is Rs.68.20, that means an anticipated depreciation of 20 paise per
GBP in one month.
If the price is Rs.68.30 after a month, there has been an unanticipated
depreciation of 10 paise per pound.
Why are they volatile?
• Inflation Rates: Countries having lower inflation will have higher
valued currencies, generally.
• Interest Rates: Often, higher interest rates translate to investors
getting better return in one country than the other. Sometimes, it
pushes the value of the currencies up vis-à-vis countries with low
interest rates.
• Current Account Deficits: It means that a country is spending more
on foreign trade (via imports) than it is earning (via exports). It would
need more borrowings from other countries to finance its deficit.
Generally, this would lead to decline in the value of its currency.
Why are they volatile?
• Level of public debt: If a country has a large budget deficits and
corresponding borrowings to cover the cost, the inflation will go up,
generally. In turn, the currency valued at lower level

• Terms of trade: Means the difference in the price of exports to the price of
imports. A positive term means a country would get more from exports
than its payments (towards imports). Generally, stronger the term of
trade; stronger the currency is

• Stability and economic growth: Political stability, growth rate of the

economy matter a lot to investors. Stable, growing countries are pegged at
lower risk, and thus, tend to have a stronger currency valuation
Classification of Currency Exposure
Foreign exchange exposure is said to exist when a firm’s value of its
future cash flows is dependent on value of foreign currencies.
Accounting
(Translation)
Contractual
Short Term
(Transactions)
Cash flow
Currency Exposure Anticipated
Operating
Long Term
Strategic Source:
International Finance – A Business
Perspective by Prakash Apte
Foreign Exchange Transaction?
• Any financial transaction that involves more than one currency is a
“Foreign Exchange Transaction”
• It involves Foreign Exchange Risk: Risk of investment’s value
decreasing due to changes in currency exchange rates
• FX trader can bet if one currency can get stronger or weaker relative
to another currency
• 1 EUR = 1.05 USD (can change any second)
• It is the banks adjusting continuously to the supply and demand of
currency that are responsible for this fluctuation
Example
• 1 EUR = 1.05 USD
• Let us go long – EUR/USD (expecting EUR gets stronger)
• Buy EUR/USD from the broker (place a bet for 10,000 EUR)
• In around 5 hours, if 1 EUR = 1.07 USD, what is the profit?
• 10,000 EUR would now fetch, 10,700 USD (instead of $10,500 earlier)
• Profit of $200 in couple of hours
• Pip: Is (1/100)% or 0.0001 – Smallest amount of currency used by
forex; Unit used to express the price change of an exchange rate
Forex Transaction
• Brokers can help to bet larger amounts (even without having money)
• That is called Leverage
• In the earlier example, if the trader is sure of EUR going stronger, he
can even bet larger amount, say 100,000 EUR, lent by brokers
• Interest charged at the current rate
• 1000 EUR as collateral deposit
• Borrowing can go up to 400 times of initial collateral deposit
• No Leverage / 1:1 Leverage Ratio: 1,000 : 1,000 (bet)
• 50,000 as Bet : 1,000 EUR (50:1 Leverage)
Forex Transaction
• Lot = size of the bet
• 1,000 EUR bet = micro Lot
• 10,000 EUR bet = mini lot
• 100,000 EUR bet = standard lot
• Going long on a mini lot on EUR/USD means we are betting 10,000
EUR
Movement of Exchange Rates
• Interest rates vary among different currencies
• Euros as bank deposits in Paris may fetch 3.5% as interest; GBP in UK
might fetch 5.5% as interest
• To take advantage of this, everyone starts selling EUR and buy GBP
• This would lead to a weaker EUR and a stronger GBP
• Selling leads to supply; Buying leads to demand
Managing a Forex Account
• Sell / Bid – This is the amount at which, the market would be one unit
of base currency, using the quote currency
• Buy / Ask – This is the amount at which, the market will sell one unit
of base currency, using the quote currency
• Bid < Ask – Always
• Ask – Bid = Spread
Bid and Ask
• Let us say a Bank quotes 1 USD = INR 59.60/60.50
• Rs.59.60 is the bid price
• Rs.60.50 is the ask price
• Bank is ready to buy 1 USD @ Rs.59.60
• Bank is ready to sell 1 USD @ Rs.60.50
• Bid – Ask: Spread is Rs.0.90 / 1USD

• If a person X wants to sell USD 100,000, he will get Rs.5,96,000.00

• If a person Y wants to buy USD 100,000, he will give Rs.6,05,000.00
Arbitrage
• Defined as capitalizing on a discrepancy in quoted prices
• The funds invested are not tied up and no risk is involved
• In response to the imbalance in demand and supply resulting from
arbitrage activity, prices will realign very quickly, such that no further
risk-free profits can be made.
• One such variation is Locational Arbitrage.
• Process of buying a currency at a location where it is priced less and
immediately selling it at another location where it is priced high.
• This is possible when one bank’s bid is higher than another bank’s ask for the
same currency.
Locational Arbitrage – Example:
Bank C Bid Ask Bank D Bid Ask
NZ$ $0.635 $0.64 NZ$ $0.645 $0.65

• Buy NZD from Bank C at $0.640

• Sell it to Bank D $0.645
• Profit = $0.005/NZD
Cross Rates
• Suppose the exchange rates:
• $0.02339/1 Thai Baht
• INR costs $0.02538
How many Baht are for one unit of INR?

Solution:
$0.02538 / $0.02339 = 1.085
Cross Rates
• AUD = $0.62
• SF = $0.17
• How many units of SF per unit of AUD?
Triangular Arbitrage
• Currency transactions conducted in the spot market to capitalise on a
discrepancy in the cross-exchange rate between two currencies.
• This is possible, if quoted cross exchange rate differs from the
appropriate cross exchange rate.
• Example:
BID ASK
GBP $1.60 $1.61
MYR (Ringgit) $0.20 $0.202
GBP MYR8.1 MYR8.2
Triangular Arbitrage
• Steps:
• Buy GBP at $1.61
• Convert @ MYR 8.1/GBP
• Sell MYR @ $0.20
• Profit = $0.01/GBP

• When the exchange rates of the currencies are not in equilibrium,

triangular arbitrage will force them back to equilibrium.
Covered Interest Arbitrage
• The process of capitalizing on the interest rate differential between
two countries, while covering for exchange rate risk.
• Covered interest arbitrage tends to force a relationship between
forward rate premium and interest rate differentials.
Covered Interest Arbitrage
• Example:
• Funds available: $800,000
• GBP spot rate = 90 days forward rate = $1.60
• US 90-day interest rate = 2%
• UK 90-day interest rate = 4%
• Steps:
• Convert USD to GBP at $1.60/GBP and invest GBP at 4%
• Engage a 90-day forward contract
• Fulfil the forward contract on maturity and sell GBP at $1.60/GBP
• Determine the yield earned on arbitrage.
Covered Interest Arbitrage
• Since investors are trying to capitalise on covered interest arbitrage,
there is:
• Upward pressure on the spot rate and
• Downward pressure on 90-day forward rate.

• Once the forward rate has a discount from the spot rate that is about
equal to the interest rate advantage, covered interest arbitrage will no
longer be feasible.
Equity Price Risk
• Risk arising out of fluctuations in equity prices
• High volatile stocks bear higher risk
• Less volatile ones bear less risk
• Impacts portfolio
Market Beta, CML and SML
• Beta coefficient is the measure of volatility of an individual stock in
comparison to the entire market.
• Capital Asset Pricing Model – CAPM – uses Beta to measure expected
returns/cost of equity of securities.
• Risk free rate
• Beta
• Market Return
Capital Market Line
• Represents portfolios that optimally combine
risk and return
• Risk and return trade off
• The Capital Market Line [CML] is a special case of the CAL –
the line which makes up the allocation between a risk-free
asset and a risky portfolio for an investor.
• In the case of CML, the risk portfolio is the market portfolio
–
• Where an investor has defined “the market” to be
their domestic stock market index,
• The expected return of the market is expressed as
the expected return of that index.
• The risk-return characteristics for the potential risk
asset portfolios can be plotted to generate Markowitz
efficient frontier
• Where the line from the risk-free asset touches the
Markowitz portfolio
• The line connecting the risk-free asset with he market
portfolio is the CML.
Commodity Price Risk
• Uncertainty in price that adversely impacts the profit margins of
producers. Also impacts users of those commodities.
• Examples:
• Steel prices - increases the cost of automobile production and impacts profit
margins
• Cotton, corn, wheat, oil, sugar, copper, aluminium etc.,
Forwards
• An agreement made directly between 2 parties to buy or sell an asset on a
specific future date, at a price decided today.
• Used mainly in commodities, equity, forex, interest rate markets.
Example:
Rohit identifies a requirement of wheat for his bread manufacturing unit by
27th Dec 2018 (one month from now). He approaches Amit, wheat grower,
for this. Both of them agree upon a price – Rs.30,000* per tonne of wheat.
On 27th Nov, both parties exchange wheat and money.
Rohit is long forward; Amit is short forward
Both are obligated to carry out this contract on 27th Dec at Rs.30k value
Essential Features of Forward:
• Contract between two parties
• All terms of contract like price, quantity and quality of underlying,
delivery terms like price, settlement procedure etc. are fixed on the
day of entering into the contract.
Major Limitations of Forwards
• Liquidity risk
• Counterparty risk
Features of Futures Contracts
• Contract between two parties through exchange
• Centralised trading platform, i.e., exchange
• Price discovery through free interactions of buyers and sellers
• Margins are payable by both parties.
• Quality and quantity are decided today (standardized)
Future Terminologies –with an example*
Instrument type Index Future
Underlying asset Nifty 50
Expiry date March 28th, 2018
Open Price (in Rs.) 10,200.00
High (in Rs.) 10,254.00
Low( in Rs.) 10,155.00
Close (in Rs.) 10,171.55
No. of contracts traded 1,98,900
Turnover in Lakhs (in Rs.) 15,21,894.99
Underlying value (in Rs.) 10,154.20
Future Terminologies
• Spot Price – the price at which an asset trades in the cash market. This is underlying
value of Nifty – 10154.20
• Futures Price – the price of the futures contract in the futures market. The closing price
of Nifty in futures trading is 10171.55.
• Contract cycle: Period over which the contract trades. On March 7th, the max number of
index futures contract is of 3 month contract cycle - Near month (March 2018) - Next
month (April 2018) - Far month (May 2018). Expires on last Thursday of the month and a
new one is introduced on next trading day for a near month contract.
• Expiration day: On which a derivative contract ceases to exist. Last trading day of the
contract – (last Thursday of the month).
• Tick Size: Minimum move allowed in the price quotations. Exchanges decide the tick
sizes on traded contracts as part of contract specification.
• Bid price is the price buyer is willing to pay
• Ask price is the price seller is willing to sell
Future Terminologies
• Cost of Carry: Relationship between futures prices and spot prices. It measures
the storage costs + the interest paid to finance or ‘carry’ the asset till delivery –
income earned on the asset during the holding period.
• Vishal wants to buy shares of ABC trading at Rs.100 in cash market. He borrows Rs.100 @6%
pa. Suppose he holds this share for 1 year and expects 200% dividend on FV (Re.1). His net
cost to carry = interest paid – dividend received = 6-2=4. Thus, break even futures prices for
him should be Rs.104.
• Margin Account: To protect itself, exchange charges various margins from
brokers, in turn is passed onto customers.
• Initial Margin: the amount deposited in the margin account at the time of
entering a futures contract.
Example of Initial Margin
• Example: On March 8, 2018 a person decided to enter into a futures contract;
expecting the market to go up. Thus he takes a long Nifty futures for March
expiry. On March 7th, 2018, Nifty March month futures contract closes at
10171.55.
• The contract value = Nifty futures price * lot size
• 10171.55 * 75 = Rs.7,62,866 (Contract value of one Nifty Future Contract expiring on March
28, 2018).
• If broker charges 10% of the contract value as initial margin, the person has to
pay Rs.76,287 as initial margin.
Mark to Market - Example
• Mark to Market (MTM): while contracts have maturity of several months, profits
and losses are settled on day-to-day basis. This is called MTM settlement. The
exchange collects these MTM margins from loss maker and pays to the gainer –
daily.
• Suppose Akash bought a futures contract on March 8th, 2018 when the Nifty
futures contact was trading at Rs.10,171.55. He paid an initial margin of
Rs.76,287. at the end of that day, Nifty futures closes at Rs.10,242.95, meaning
that he benefits due to the 71.4 points gain in Nifty futures contracts. His net gain
is 71.4 x lot size (say 75) = Rs.5355. This money will be credit to his account and
next day his position will start from 10242.95.
Pay off Charts for Futures Contracts
• Pay Off Charts: Pay off on a position is the likely profit/loss that would
accrue to a market participant with change in the price of the
underlying asset at expiry. The pay off diagram is graphical
representation showing the price of the underlying asset on X axis
and profits/loss on Y axis.
• Pay off charts for futures: in case of future contracts, long as well as
short has unlimited profit or loss potential. This results into linear pay
offs.
Pay off for Long futures: Buyer
• Ravi goes long in a futures contract at Rs.100, he has agreed to buy
the underlying asset at Rs.100 on expiry.
• If on expiry, the price of the underlying is Rs.150, he will make a profit
of Rs.50 (buy at 100 and sell immediately at 150)
• If on expiry, the price is Rs.70, he will lose Rs.30.
Pay Off Chart
• Potential profit/loss at expiry when expressed graphically, is pay off
chart Long futures at 100
Market Price at expiry Long futures pay off
50 -50
60 -40
70 -30
80 -20
90 -10
100 0
110 10
120 20
130 30
Pay Off Chart
Long Forward/Long Futures/Buyer
Market Price at expiry
40

30

20

10

0
50 60 70 80 90 100 110 120 130
-10

-20

-30

-40

-50

-60
Market Price at expiry
Short futures Pay off
Short futures at 100
Market price at expiry Short futures pay off
50 50
60 40
70 30
80 20
90 10
100 0
110 -10
120 -20
130 -30
Pay Off Chart
Short Forward/Short Futures/Seller
Short futures pay off
60

50

40

30

20

10

0
50 60 70 80 90 100 110 120 130
-10

-20

-30

-40
Short futures pay off
Futures Pricing
• Pricing depends on the characteristics of underlying asset (their
demand and supply patterns, cashflow patterns etc.)
• Popular models
• Cash and Carry Model
• Expectancy Model
Cash and Carry Model
• Also known as non-arbitrage model.
• This assumes that in an efficient market, arbitrage opportunities
cannot exist.
• The moment there is a mispricing of asset, arbitrageurs start trading
to profit and eliminate any such arbitrage opportunities. Equilibrium
price is hit.
Example
• Enter into a forward/futures contract, OR
• Create a synthetic forward/futures position by buying in the cash market
and carrying the asset to the future date.
• Bullion Market: Spot price of gold is Rs.15000 per 10 grams. The cost of
financing, storage and insurance for 3 months is Rs.100 per 10 gram. If you
buy 10 gram gold from the market at Rs.15000 and hold for 3 months, the
value of gold after 3 months is Rs.15100 per 10 grams.
• Assume a 3-month futures contract on gold trading at Rs.15150 per 10
gram.
• What is the arbitrage?
Arbitrage is…
• Buy the gold in cash market and sell 3month gold futures
simultaneously. We can borrow money to take delivery of gold in cash
market today, hold it for 3 months and deliver it in futures market on
expiry of future contract.
• Amount received from selling future contract will be used to repay
the loan borrowed.
• Rs.50 will be profit without taking any risk.
• (no transaction cost/brokerage considered).
Contd..
• Formula for futures fair price:
• Fair Price = Spot Price + Cost of carry – inflows
• F = S(1+r-q)t
• With continuous compounding

• F = Se(r-q)*t
Forward Pricing of Investment Assets
• Three situations are considered:
• Investment assets providing no income
• Investment assets providing known income
• Investment assets providing known dividend income
Investment assets providing no income
• Investments providing no income: Discount bonds, non dividend
paying equities etc.,
• F = SerT
• F is forward price of the stock
• S = Spot price of the stock
• T = maturity period (remained)
• r = risk free rate
• e = 2.71828183
Investment assets providing known income
• Coupon bearing bonds, treasury securities, known dividends etc.,
• F = (S-I)erT

• I = Known income
Investment assets providing known dividend
income/yield
• A known dividend yield means that when income expressed as a
percentage of the asset life is known.

• F = Se(r-q)t

• q = known yield
Hedging with Futures
• Reduce a particular risk faced – might relate to fluctuations in price of
oil, forex rates, index value etc.,
• A perfect hedge is one that completely eliminates the risk. Very rare!
• Consider a company that knows that it will gain $10,000 for each 1
cent increase in the price of a commodity over next 3 months and
lose $10,000 for each 1 cent decrease in the price during the same
period.
• How to hedge?
Hedging with Futures
• The company’s treasurer should take a short futures position that is
designed to offset this risk. The futures positions should lead to a loss
of $10,000 for each 1 cent increase in the price of the commodity
over the 3 months and a gain of $10,000 for each 1 cent decrease in
the price during this period.

• If the price of the commodity goes down, the gain on the futures
position offsets the loss on the rest of the company’s business. If the
price of commodity goes up, loss on the futures position is offset by
the gain on the rest of the company’s business.
Short Hedges
• This is a hedge that involves a short position in futures contracts.
• This is appropriate when the hedger already owns an asset and
expects to sell it at some time in the future.
• Farmer owning hogs and knows that these can be sold in 2 months
time. Short Hedge is a possibility.
Short Hedges
• When an asset is not owned right now but will be owned at some
time in future. US exporter knowing he will receive Euros in 3 months.
He will realise a gain if the euro increase in value relative to USD and
will sustain a loss if the euro decreases in value relative to USD. Short
futures position leads to loss if the euro increases value and gain if it
decrease in value. The effect of offsetting the exporter’s risk.
Long Hedges
• Involves taking a long position in futures contract.
• This is apt when a company knows it will have to buy a certain asset
in the future and want to lock in a price now.
• E.g.: Indian doctor buying that German manufactured CT scan machine.
• A copper fabricator knows it will need 100,000 pounds of copper on
May 15 to meet a certain contract. The spot price of copper is 340
cents per pound, the futures price of May delivery is 320 cents per
pound.
• How to hedge?
Long Hedges
• The fabricator can hedge by taking a long position in 4 futures
contracts closing its position on May 15. Each contract is for delivery
of 25000 pounds of copper. The strategy has the effect of locking in
the price of the required copper at close to 320 cents per pound.
• Suppose, that the spot price of copper on May 15 proves to be 325
cents per pound. Because May is the delivery month for the futures
contract, this should be very close to futures price. The fabricator
gains approximately $5,000 on the futures contracts.
• [$1,00,000 x (3.25-3.20)]
Long Hedges
• It pays $100,000 * 3.25 = $325,000 for the copper, making the net
cost approximately to $320,000 (325,000-5,000).
• Suppose the spot price is 305 cents per pound on May 15, then he
loses $15000 = 1000 x (3.20-3.05)
Some Challenges
• In practice, hedging is often not quite as straightforward as this. Some
of the reasons:
• The asset whose price is to be hedged may not be exactly the same as the
asset underlying the futures contract
• The hedger may be uncertain as to the exact date when the asset will be
bought or sold.
• The hedge may require the futures contract to be closed out before its
delivery month.
The Basis
• The Basis in a hedging is as follows:
• Basis = Spot price of asset to be hedged – Futures price of contract used.
• When the futures contract is on a financial asset, the alternative definition
is -
• Basis = futures price – Spot price.
• If the asset to be hedged and the asset underlying the futures contract are
the same, the basis should be zero at the expiration of the futures contract.
• As time passes, the spot price and the futures price for a particular month
do not necessarily change by the same amount. As a result, the basis
changes.
• An increase in the basis is referred to as a strengthening of the basis; a
decrease in the basis is referred to as a weakening of the basis.
The Basis
• Let us assume that a hedge is put
at t1 and closed out at t2.
• S1=$2.50; F1 = $2.20
• S2 =$2.00; F2= $1.90
• Basis1 = S1-F1 = 0.3
• Basis2 = S2-F2 = 0.10
Cross Hedging
• This occurs when the two assets are different.
• Consider an airline that is concerned about the future price of jet
fuel. Because, jet fuel futures are not actively traded, it might choose
to use heating oil futures contracts to hedge its exposure.
• Hedge Ratio: Ratio of the size of the position taken in futures
contracts to the size of the exposure.
Hedge Ratio
• When the asset underlying the futures contract is the same as the
asset being hedged, it is natural to use a hedge ratio of 1.0.
• When the cross hedging is used, setting the hedge ratio to 1 is not
optimal always. The hedger should choose a value for the hedge ratio
that minimizes the variance of the value of the hedged position.
Minimum Variance Hege Ratio
• Depends on the relationship between changes in the spot price and
changes in the futures price.
Capital Adequacy Norms for Banking Industry,
Prudential Norms, Exposure Norms, Risk
Adjusted Return on Capital
Capital Adequacy Norms for Banking Industry
• Capital Adequacy Ratio is the ratio of a bank’s capital in relation to its risk
weighted assets and current liabilities.
• Decided by Central Banks and Bank Regulators to prevent commercial
banks from taking excess leverage and becoming insolvent in the process.
• CAR = Tier I + Tier II + Tier III Capital funds / Risk Weighted Assets
• Aggregate of risk weighted assets and other exposures
• Assets of banks were classified and grouped in five categories to Credit Risk
Weights of zero ‘0’, 10, 20, 50 and up to 100%.
• Assets like cash and coins usually have ‘zero’ risk weight, while “unsecured
loans” might have a risk weight of 100%
Constituents of Capital
Tier I- Core Capital
• Equity Capital
• Disclosed Reserves
Tier II
Suppleme Tier II- Supplementary Capital
ntary • Undisclosed Reserves
Capital
• Revaluation Reserves –
(50%)
a) Formal revaluation
Tier I b) Latent Revaluation
• General Provisions
Core Capital • Hybrid Debt Capital Instruments
(50%) • Subordinated Term Debt (Limited to
50% of Tier I Capital)
NPAs & Income
Recognition
Some News

RBI's norms to give more headroom to lenders to resolve big ticket

NPAs: Report
Definition –
Non-Performing Assets
• As asset, including a leased asset, becomes an NPA when it ceases to
generate income for the bank.
• An NPA is a loan or an advance where;
• The interest and/or instalment of principal remain overdue for a period of
more than 90 days in respect of a term loan,
• An account remains ‘out of order’* in respect of an overdraft/cash credit
• A bill remains overdue** for a period of more than 90 days, in the case of bills
purchased and discounted
Definition –
Non-Performing Assets
• Out Of Order:
• An account is treated out of order, if the outstanding balance remains
continuously in excess of the sanctioned limit/drawing power. In cases, where
the outstanding balance in the operating account is less than the sanctioned
limit/drawing power, but there are not credits continuously for 90 days as on
the date of balance sheet or credits are not enough to cover the interest
debited during the same period, these accounts should be treated as “out of
order”.

• Overdue:
• Any amount due to the bank under any credit facility is ‘overdue’ if it is not
paid on the due date fixed by the bank.
Definition…Continued
• An installment of the principal or the interest thereon remains overdue for
one crop season for short duration crops,
• An installment of the principal or the interest thereon remains overdue for one crop
season for long duration crops
• in respect of derivative transactions, the overdue receivables representing positive mark-
to-market value of a derivative contract, if these remain unpaid for a period of 90 days
from the specified due date of payment
• Banks should classify an account as an NPA only if the interest
charged during any quarter is not serviced fully within 90 days from
the end of the quarter.
Exceptions
• Gold loans for non-agricultural purposes will have the same
treatment as any other loans. In case of a Board approved policy &
subject to adequate margin, gold loan up to Rs.1 lakh would be NPA
with bullet repayment option (not exceeding 12 months). It will be
NPA only after it is overdue from the date of bullet repayment
• Advances against TDs, NSCs eligible for surrender, IVPs, KVPs and life
policies need not be treated as NPA, provided adequate margin is
available
• Staff housing loan: As per the due date fixed by the bank, where
interest is payable after recovery of principal
Cash Credit as NPA
No monthly stock statement is submitted by the borrower for last 6
months (3 months + 90 days)
OR
The cash credit account hasn’t been reviewed/renewed for more than
90 days
OR
Where there is a solitary/a few credit entries before the balance sheet
date, but the account goes ‘out of order’ thereafter.
Prudential Norms on Income Recognition
Prudential norms on Income Recognition, Asset Classification and
Provisioning pertaining to Advances
Income Recognition
• The policy of income recognition has to be objective and based on the record of
recovery
• Internationally, income is not recognized from an NPA on an accrual basis, but is
booked as income only when it is received
• Interest on advances against term deposits, NSCs, IVPs, KVPs and Life policies are
taken to the income account on the due date, provided adequate margin is
available
• Fees and commission earned by banks out of renegotiations or rescheduling of
outstanding debt should be recognized on an accrual basis over the period
covered by the renegotiated or reschedule extension of credit
• If Government guaranteed advances become NPAs, the interest on such advances
should not be taken to income account unless the interest has been realised
Reporting of NPAs
• Banks are required to furnish a report on NPAs as on 31st March each
year.
• NPAs would relate to the banks’ global portfolio, including the
advances at the foreign branches.
 Computation
• Gross advances = Standard Asset Plus Gross NPA
• Gross NPA as % of gross Advances
• Net Advances = Gross Advances – Deductions
• Net NPA = Gross NPA – Deductions
• Net NPAs as % of Net Advances
Asset Classification
Banks have to classify NPAs based on the period for which they have
been NPAs:
• Substandard Assets: An asset which has remained NPA for a period <=
12 months (w.e.f. 31/03/2005)
• Doubtful Assets: An asset which has remained in substandard
category for a period of 12 months (w.e.f. 31/03/2005)
• Loss Assets: such an asset is considered uncollectible. An asset which
bank/internal/external auditor/RBI has identified as loss, salvage
value of security is negligible & the entire asset is proposed to be
written off after necessary approvals.
Provisioning Norms
• Loss Assets: Should be written off. If loss assets are permitted to
remain in the books for any reason, 100% of the outstanding should
be provided for.
• Doubtful Assets:
• 100% of the extent to which the advance is not covered by the realizable
value of the security to which the bank has a valid alternative.
• In regard to secured portion, provision may be made at the rates ranging from
25% to 100% depending upon the period for which the asset has remained
doubtful. Period for which the asset has been doubtful Provision requirement (%)

Up to One year 25%

One to three years 40%

More than three years 100%

Provisioning
• Substandard Assets:
• 10% on total outstanding irrespective of available security.
• However, if there is an erosion in the value of security* or a fraud is
committed by the borrower, the account will be classified as ‘doubtful’ and
provisioned accordingly
• Further, if the erosion in the value of security is to the extent that the
realizable value of security depletes to less than 10% of the outstanding loan,
the account can be classified as “Loss asset” and provisioned accordingly
Provisioning
Standard Assets:
• Banks should make general provisions for standard assets at the
following rates:
• Direct advances to agriculture and SME sector – 0.25%
• Advance to specific sectors* – 01%
• All other advances in under above 2 points – 0.40%
Robust Internal System
• Banks should establish appropriate internal system to eliminate the
tendency to postpone the identification of NPAs, especially in respect
of high value accounts.
• Responsibility and validation levels for ensuring asset classification
may be fixed by the bank
• RBI would continue to identify the divergences arising due to non-
compliance, for fixing responsibility.
Know Your Customer
• Key Elements of KYC Policy:
• Customer Acceptance Policy
• Customer Identification Procedures
• Monitoring of Transaction
Customer Acceptance Policy
• The Bank will:
• Classify customers into various risk categories and based
on risk perception
• Decide on acceptance criteria for each category of
customers
• Accept customers after verifying of anonymous/benami
persons
• Strive not to cause inconvenience to general public who
desire to transact banking business
Customer Identification Process
• Process of identifying the customer and verifying his/her identity
by using reliable, independent source documents, information
• Not only at the time of banking relationship, but also at the time
of transactions
• Typically, info like – nature of business, location, mode of
payments, volume of turnover, social and financial status etc.,
will be collected for customer profile building
• 3 risk categories – High, Medium and Low – based on risk
perceptions
Customer Identification Process
• Risk Categories:
• Low: Individuals (other than HNIs) and entities whose identities, source of
income/wealth can be easily identified. Transactions conform to the known profile
• Customers likely to pose a higher than average risk are categorized as medium or
high
• Minimum of once in six months, risk categorization exercise is carried out
by banks
• Fully KYC exercise is carried out at least -
• Once in two years for high risk profiles
• Once in eight years for medium risk profiles
• Once in ten years for low risk profiles
Monitoring of Transactions
• Monitoring happens considering the risk profile of the customers
• Special attention paid to complex, high value transactions, unusual
patterns
• Scrutiny done for – inconsistent activities, large amounts of cash etc.,
• Prescribed under Rule 3 of PML (Prevention of Money Laundering)Rules,
2005:
• All cash transactions more than Rs.10 lakhs in foreign currencies
• Transactions integrally connected; less than Rs.10 lakhs or equivalent in foreign
currency happened within a month
• All receipts by non-profit organisation more than Rs.10 lakhs or equivalent foreign
currency
• All suspicious transactions (cash or otherwise)
 Managing Credit Risk
Managing Interest-Rate Risk
Managing Credit Risk
▪ A major part of the business of financial institutions is making loans,
and the major risk with loans is that the borrow will
not repay.

▪ Credit risk is the risk that a borrower will not repay a loan according
to the terms of the loan, either defaulting entirely or making late
payments of interest or principal.
Managing Credit Risk
▪ The concepts of adverse selection and moral hazard will provide a framework to
understand the principles financial managers must follow to minimize credit risk
yet make successful loans.

▪ Adverse Selection is a concept in economics, insurance, and risk management,

which describes a situation where market participation is affected by asymmetric
information.

▪ Moral Hazard occurs when one person takes more risks because someone else
bears the cost of those risks. Moral hazard also arises in a principal-agent
problem, where one party, called an agent, acts on behalf of another party, called
the principal. The agent usually has more information about his or her actions or
intentions than the principal does, because the principal usually cannot
completely monitor the agent
Managing Credit Risk
Solving Asymmetric Information Problems:
1. Screening and Monitoring:
• collecting reliable information about prospective borrowers.
This has also led some institutions to specialize in regions or
industries, gaining expertise in evaluating firms
• also involves requiring certain actions, or prohibiting others,
and then periodically verifying that the borrower is
complying with the terms of the loan contract
Managing Credit Risk
▪ Specialization in Lending helps in screening. It is easier to collect data
on local firms and firms in specific industries. It allows them to better
predict problems by having better industry and location knowledge.
Managing Credit Risk
▪ Monitoring and Enforcement also helps. Financial institutions write
protective covenants into loans contracts and actively manage them
to ensure that borrowers are not taking risks at their expense.
Managing Credit Risk
2. Long-term Customer Relationships: past information contained in
current accounts, savings accounts, and previous loans provides
valuable information to more easily determine credit worthiness.
Managing Credit Risk
3. Loan Commitments: arrangements where the bank agrees to
provide a loan up to a fixed amount, whenever the firm requests
the loan.
4. Collateral: a pledge of property or other assets that must be
surrendered if the terms of the loan are not met ( the loans are
called secured loans).
Managing Credit Risk
5. Compensating Balances: reserves that a borrower must
maintain in an account that act as collateral should the
borrower default.
6. Credit Rationing:
▪ lenders will refuse to lend to some borrowers, regardless of
how much interest they are willing to pay, or
▪ lenders will only finance part of a project, requiring that the
remaining part come from equity financing.
Managing Interest-Rate Risk
▪ Financial institutions, banks in particular, specialize in earning a
higher rate of return on their assets relative to the interest paid on
their liabilities.
▪ As interest rate volatility increased in the last 20 years, interest-rate
risk exposure has become a concern for financial institutions.
Managing Interest-Rate Risk
▪ To see how financial institutions can measure and manage interest-
rate risk exposure, we will examine the balance sheet for First
National Bank
▪ We will develop two tools, (1) Income Gap Analysis and (2) Duration
Gap Analysis, to assist the financial manager in this effort.
Managing Interest-Rate Risk

Risk Management Association home page http://www.rmahq.org

Managing Interest-Rate Risk
• Income Gap Analysis: measures the sensitivity of a bank’s
current year net income to changes in interest rate.

• Requires determining which assets and liabilities will have their

interest rate change as market interest rates change.

• Let’s see how that works for First National Bank.

Income Gap Analysis: Determining Rate Sensitive Items for First
National Bank

▪ Assets
• assets with maturity less than one
year
• variable-rate mortgages
• short-term commercial loans
• portion of fixed-rate mortgages (say
20%)
▪ Liabilities
• money market deposits
• variable-rate CDs
• short-term CDs
• federal funds
• short-term borrowings
• portion of checkable deposits (10%)
• portion of savings (20%)
Income Gap Analysis: Determining Rate Sensitive Items for First
National Bank
Rate-Sensitive Assets = $5m + $ 10m + $15m + 20%  $10m
RSA = $32m
Rate-Sensitive Liabs = $5m + $25m + $5m + $10m + 10%  $15m
+ 20%  $15m
RSL = $49.5m
Estimate of % of checkable
if i  5%  deposits and savings
Asset Income = +5%  $32.0m = +$ 1.6m accounts that will
Liability Costs = +5%  $49.5m = +$ 2.5m experience rate change
Income = $1.6m − $ 2.5 = −$ 0.9m
Income Gap Analysis
If RSL > RSA, i  results in: Net Interest Margin , Income 
GAP = RSA − RSL
= $32.0m − $49.5m = −$17.5m
Income = GAP  i
= −$17.5m  5% = −$0.9m
This is essentially a short-term focus on interest-rate risk exposure. A longer-term
focus uses duration gap analysis.
Duration Gap Analysis
▪ Owners and managers do care about the impact of interest rate
exposure on current net income.
▪ They are also interested in the impact of interest rate changes on the
market value of balance sheet items and on net worth.
▪ The concept of duration, plays a role here.
Duration Gap Analysis
• Duration Gap Analysis: measures the sensitivity of a
bank’s current year net income to changes in interest
rate.
• Requires determining the duration for assets and
liabilities, items whose market value will change as
interest rates change. Let’s see how this looks for First
National Bank.
Duration of First
National Bank's
Assets and
Liabilities
Duration Gap Analysis
▪The basic equation for determining the change in
market value for assets or liabilities is:

or:
Duration Gap Analysis
▪ Consider a change in rates from 10% to 11%. Using the
value from Table -
we see:
▪ Assets:
Duration Gap Analysis
▪ Liabilities:

▪ Net Worth:
Duration Gap Analysis
• For a rate change from 10% to 11%, the net worth of First National
Bank will fall, changing by −$1.6m.
• Recall from the balance sheet that First National Bank has “Bank
capital” totaling $5m. Following such a dramatic change in rate, the
capital would fall to $3.4m.
Managing Interest-Rate Risk
▪ Strategies for Managing Interest-Rate Risk
─In example above, shorten duration of bank assets or lengthen duration of
bank liabilities
─To completely immunize net worth from interest-rate risk, set DURgap = 0
Credit Risk Modelling
• Altman’s Z Score Model
• Credit Metrics Model
• Value at Risk Model
• Merton Model
Altman’s Z Score Model
• Altman’s Z Score variables developed to measure the financial strength of a firm
Ratios Weights
Working Capital to Total Assets 1.2
Retained Earnings to Total Assets 1.4
EBIT to Total Assets 3.3
Market Value of Equity to Book Value of Total Liabilities 0.6
Sales to Total Assets 1.0

• <1.81 = Distress Zone

• Between 1.81 and 2.99 = Grey Zone
• > 2.99 = Safe Zone
Credit Metrics Model
• Assessment of portfolio risk due to changes in debt value caused by changes in
credit quality.
• This methodology is used to quantify the credit risk across a broad range of
instruments.
• Applications
• Reduces portfolio risk
• Sets exposure limits
• Identify correlations across portfolio
• Reduce potential risk concentration
• Results in diversified portfolio
• Reduction of total risk
• Videos:
• Credit Metrics - Part 1
• Credit Metrics - Part 2
Value at Risk Model
• Estimate of potential loss in loan portfolio over a given holding period
at a given level of confidence
• Probability distribution of a loan portfolio value reducing by an
estimated amount over a given time horizon.
• Time horizon estimate is over a daily, weekly or monthly basis.
Merton Model
• Banks would default only if its asset value falls below a certain level
(default point), which is a function of its liability.
• Estimates the asset value of the banks and its assets volatility from
the market value and the debt structure in the option theoretic
framework.
• A measurement that represents the number of standard deviation
that the bank’s asset value would be away from the default point.
Merton Model
• Historical default experience to compute Expected Default Frequency (EDF)
• Distance from Default (DFD) is the estimation of asset value and asset
volatility and volatility of equity return
• DFD = (Expected asset value – Default point) / (Asset Value x Asset
Volatility)
• Expected default frequency (EDF) is arrived at from the historical data in
terms of number of banks that have DFD values similar to the bank’s DFD in
relation to the total number of banks considered for evaluation.

Model Efficiency
• Difference between the estimated default values and actual default rate
Merton Model (Example)
• Expected asset value (1 year hence) = 200 Billion
• Default Point (DP) = 140 Billion
• Volatility of asset value = 12%
• Asset value = 250 Billion

• If from historical observation the number of banks among 80 banks

that have a default point of 2.00 are 12, then EDF = 12/80 = 15%
Merton Model (Example)
• Relationship between DFD and EDF
Risk Adjusted Rate of Capital for Banks
• Mark-to-Market Concept

• Allocates capital to a transaction at an amount equal to the maximum

expected loss (at a 99 percent confidence level)

• Basic risk categories

• Interest rate risk
• Credit risk
• Operational risk
• Foreign exchange risk
Risk Adjusted Return on Capital
• Quantify the risk in each category
• Risk factor = 2.33 x weekly volatility x square root of 52 x (1-tax rate)
• 2.33 gives the volatility at 99% confidence level
• 52 weekly price movement is annualized
• (1-tax rate) converts this to an after-tax basis
• Capital required for each category
• Multiplying the risk factor by he size of the position
Risk Adjusted Return on Capital
• Risk adjusted return on capital is an adjustment to the return on
investment that accounts for the element of risk.
• It gives the decision maker the ability to compare the returns on several
different projects with varying risk levels.
• This was popularised as an adjustment to simple return on capital.
• In financial analysis, riskier projects and investments must be evaluated
differently from their risk less counterparts by discounting risky cash flows
against less risky cash flows.
• RAROC accounts for the changes in the profile of the investment
• In general, the higher the risk, the higher the return. Thus, when
companies need to compare two different projects/investments, it is
important to take into account these possibilities
Credit Risk Mitigation
• Credit risk mitigation reduces exposure of credit risk
• Safety net of tangible assets
• Safety from realizable (marketable) securities
• Reduces exposure of risk from counterparty dealings in guarantees and
insurance
• Risk mitigation measures
• Collateral securities
• Guarantees
• Credit derivatives
• Balance sheet netting
Risk Mitigation
• Needed procedures
• Documentation made for all credit related transactions
• Collateralized transactions monitored regularly
• Legally binding terms of the credit transaction
• Review of borrower performance profile
• Alternate options in terms of loan structure to changed scenarios
Credit Audit
• Compliance with pre sanction and post-sanction processes set by the
external and internal audit committee

• Special compliance requirement by the credit risk management

committee of the Board of Directors of the Bank
Credit Audit
• Bank credit audit
• Quality of credit portfolio
• Review of loan processes
• Compliance status of large loans
• Report on regulatory compliance
• Independent audit of credit risk management
• Identification of loan distress signals
• Review of loan structuring decisions in terms of distress loans
• Review of credit quality
• Review of credit administration
• Review of employee credit skills
RBI Guidelines on Credit Exposure and
Management
• Bank cannot grant loans against security of its own shares
• Prohibition on remission of debts of UCBs without prior approval of
RBI
• Restrictions on loans and advances to Directors and their relatives
• Ceiling on advances to nominal members – with deposits up to Rs.50
Crore (Rs.50k per borrower) and Rs.100000 for above Rs.50 crore.
• Prohibition on UCBs for bridge loans including that against
capital/debenture issues
RBI Guidelines on Credit Exposure and
Management
• Loans and advances against shares, debentures
• UCBs are prohibited to extend any facilities to stock brokers
• Margin of 40% to be maintained on all such advances

• Restrictions on advances to real estate sector

• Genuine construction and not for speculative purposes
Stress Testing and Sensitivity Analysis
• Measures the vulnerability of an institution or an entire system under
different hypothetical scenarios
• Help to find proactive measures – absorbers of future shocks
• Regulatory requirements

• Solvency Test – looks for sufficient solvency (+ve equity capital)

• Capital Adequacy Ratio
• Debt-Equity
• Capital Shortfall
• Liquidity Test – looks out for liquidity levels.
Methods of Stress Testing
• Scenario Analysis
• Portfolio-driven approach
• Event-driven approach

Portfolio Driven Event Driven

Risk drivers of a given portfolio are identified and then This approach is based on plausible events and how
plausible scenarios are designed under which those these events might affect the relevant risk factors for a
factors are stressed bank or a given portfolio

• Under each approach, scenarios can be developed either based on

historical events or hypothetically.
Types of Stress Testing Depending on the
Objective
Type Internal Risk Crisis Management Macro Prudential Micro Prudential
Management
Objective Financial institutions After the financial Ensues system wide This entails
use stress testing to crisis, supervisory monitoring and supervisory
measure and authorities use analyse the system assessment of the
manage risk with stress testing to wide risk financial health of
their investments. It check whether the individual
serves as an input key institutions institutions
for business need to be
planning recapitalised
Approaches for translating macro scenarios
into Balance Sheets
Approach Description Advantage
Bottom up Granular borrower level analysis Granular risk factor driven
approach leads to more
precise results
Uses advanced internal model
Provides detailed risk analysis
and risk management capacity
of an institution
Top down This impact is estimated using Ensures uniformity in
aggregated data methodology and consistency
of assumptions across all the
institutions.
An effective tool for validating
bottom up approach
Disadvantage
The result it provides is
institution specific. Hence,
comparison across similar
institutions can be a
challenge.
Implementing this approach
is resource intensive
Applying the tests only to
aggregate data can disguise
concertation of exposures to
risk at the level of individual
institutions.
Risk estimates may not be
precise to limited data
coverage
Different Types of Sensitivity Analysis
Method Procedure Advantages Disadvantages
One factor Repeatedly varying one It is the most simple and They examine only small
at a time parameter at a time while holding common approach. perturbations and don’t
(OFAT) the other inputs fixed and then Best suited for linear models explore full input space.
monitoring changes in the output. Its does not work well
with non linear models.
Ignores interactions with
other inputs
Multi Examine the relationship The outputs can be presented as Typically limited to two
factor at a between two or more factors scatterplots. Such things help inputs since it is difficult
time changing simultaneously. The assess the rank order of key to assess the impact for
variation could be: inputs or key drivers. three ore more inputs
% change Considers aggregate impact of
Std Deviation multiple inputs.
Best or Worst Possible value of More accurate.
inputs
 Method Procedure Advantages Disadvantages
Regression Analysis Fitting a relationship It allows evaluation of Possible lack of
between inputs and sensitivity of individual robustness, if key
outputs. The effect can model inputs considering assumptions of regression
be studied using the simultaneous impact are not met
regression coefficients of other model inputs on
and the level of the result
significance of the
regression coefficient
Difference in Log Odds The odds ratio of an event It can be used when the It cannot be used for non
Ratio (DLOR) is a ratio of the output is a probability linear models
probability that the event
occurs to the probability
that the event does not
occur. DLOR is used to
examine the difference
between in the outputs
when the input changes
and when it is at its
baseline value.