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Risk concerns the deviation of results of one or more future events from their expected value.
Technically, the value of those results may be positive or negative. However, general usage
tends to focus only on potential harm that may arise from a future event, which may accrue
either from incurring a cost ("downside risk") or by failing to attain some benefit ("upside
risk").
Types of risks
Operational risk
An operational risk is, as the name suggests, a risk arising from execution of a company's business
functions. This refers to the losses arising out of inefficiency and inadequacy in the functioning
system. Operational risk is controllable through improvement in the functioning of the system.
Investment risk :-
Depending on the nature of the investment, the type of investment risk will vary. A concern with any
investment is that you may lose the money you invest - your capital. This risk is therefore often
referred to as "capital risk."
If the assets you invest in are held in another currency there is a risk that currency movements alone
may affect the value. This is referred to as "currency risk."
Many forms of investment may not be readily saleable on the open market (e.g. commercial property)
or the market has a small capacity and may therefore take time to sell. Assets that are easily sold are
termed liquid; therefore this type of risk is termed "liquidity risk."
The risk that there may be a disruption in the internal financial affairs of the investment, thereby
causing a loss of value, is called "financial risk."
a) Economic risk
Economic risks can be manifested in lower incomes or higher expenditures than expected. The causes
can be many, for instance, the hike in the price for raw materials, the lapsing of deadlines for
construction of a new operating facility, disruptions in a production process, emergence of a serious
competitor on the market, the loss of key personnel, the change of a political regime, or natural
disasters.
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt
contract, e.g. he/she has not made a scheduled payment, or has violated a loan covenant (condition) of
the debt contract. A default is the failure to pay back a loan.[1] Default may occur if the debtor is either
unwilling or unable to pay their debt. This can occur with all debt obligations including bonds,
mortgages, loans, and promissory notes.
c) risk exposure
Definition:
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The situation or set of circumstances where the probability of harm to an area or its population
increases beyond a normal level.
d) collateral risk :-
liquidity risk
In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the
market to prevent a loss (or make the required profit). Liquidity risk arises from situations in which a
party interested in trading an asset cannot do it because nobody in the market wants to trade that asset.
Liquidity risk becomes particularly important to parties who are about to hold or currently hold an
asset, since it affects their ability to trade
Interest rate risk is the risk (variability in value) borne by an interest-bearing asset, such as a loan or
a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will
fall, and vice versa. Interest rate risk is commonly measured by the bond's duration.
Derivatives
A financial derivative is a financial instrument whose value is derived from the price of an asset (or a
number of assets).
Forwards
Spot markets allow the purchase and sale of an asset today. By contract a forward contract specifies
the price at which an asset can be purchased or sold at some future date. A forward contract does not
require upfront payment. It is simply the purchase or sale of an asset at some future date at a fixed
price (the forward price). Therefore the assumption is that the forward price reflects the value of this
asset on this date. If this assumption is based on a market view, characterising a forward contract as a
derivative is misleading. In financial markets forwards can be determined through a no-arbitrage
argument
Futures
Futures contracts, like forward contracts, specify the delivery of an asset at some future date. Futures
contracts, unlike forward contracts,
1. Require the buyer or the seller of the futures contract to post margin.
2. Have minimum margin requirements; these requirements are achieved through a margin call.
3. Use the process of mark-to-market.
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There three requirements in practice are not unique to futures contracts. The best way to understand
them is by looking at a specific futures contract.
Options
• Call Option: Call option gives the buyer a right to purchase the given stock at the strike price.
Thus Call option is generally bought when the buyer is bullish about the underlying security.
• Put Option: Similarly buying a put option gives you the right to sell the underlying stock at
the strike price. Put option is bought when the buyer has bearish views about the underlying
security.
Swaps
A Swap is an agreement to exchange a sequence of cash flows over a period of time in the future in
same or different currencies. Mainly used for hedging various interest rate exposures, they are very
popular and highly liquid instruments. Some of the very popular swap types are
Risk management :-
Risks can come from uncertainty in financial markets, project failures, legal liabilities, credit risk,
accidents, natural causes and disasters as well as deliberate attacks from an adversary. The strategies to
manage risk include transferring the risk to another party, avoiding the risk, reducing the negative
effect of the risk, and accepting some or all of the consequences of a particular risk.
Once risks have been identified and assessed, all techniques to manage the risk fall into one or more of
these four major categories:
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Risk avoidance
This includes not performing an activity that could carry risk. An example would be not buying a
property or business in order to not take on the legal liability that comes with it. Another would be not
be flying in order to not take the risk that the airplane were to be hijacked.
Risk reduction
Risk reduction or "optimisation" involves reducing the severity of the loss or the likelihood of the loss
from occurring. For example, sprinklers are designed to put out a fire to reduce the risk of loss by fire.
This method may cause a greater loss by water damage and therefore may not be suitable. Halon fire
suppression systems may mitigate that risk, but the cost may be prohibitive as a strategy.
Risk sharing
Briefly defined as "sharing with another party the burden of loss or the benefit of gain, from a risk, and
the measures to reduce a risk."
The term of 'risk transfer' is often used in place of risk sharing in the mistaken belief that you can
transfer a risk to a third party through insurance or outsourcing. In practice if the insurance company
or contractor go bankrupt or end up in court, the original risk is likely to still revert to the first party.
As such in the terminology of practitioners and scholars alike, the purchase of an insurance contract is
often described as a "transfer of risk." However, technically speaking, the buyer of the contract
generally retains legal responsibility for the losses "transferred", meaning that insurance may be
described more accurately as a post-event compensatory mechanism. For example, a personal injuries
insurance policy does not transfer the risk of a car accident to the insurance company. The risk still lies
with the policy holder namely the person who has been in the accident. The insurance policy simply
provides that if an accident (the event) occurs involving the policy holder then some compensation
may be payable to the policy holder.
Risk retention
Involves accepting the loss, or benefit of gain, from a risk when it occurs. True self insurance falls in
this category. Risk retention is a viable strategy for small risks where the cost of insuring against the
risk would be greater over time than the total losses sustained
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the
risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss,
from one entity to another, in exchange for payment. An insurer is a company selling the insurance;
an insured or policyholder is the person or entity buying the insurance policy. The insurance rate is
a factor used to determine the amount to be charged for a certain amount of insurance coverage, called
the premium.
Types of insurance
1) Auto insurance:- Vehicle insurance (also known as auto insurance, car insurance, or motor
insurance) is insurance purchased for cars, trucks, and other vehicles. Its primary use is to provide
protection against losses incurred as a result of traffic accidents and against liability that could be
incurred in an accident.
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2) Home insurance :-Home insurance, also commonly called hazard insurance or homeowners
insurance (often abbreviated in the real estate industry as HOI), is the type of property insurance that
covers private homes. It is an insurance policy that combines various personal insurance protections,
which can include losses occurring to one's home, its contents, loss of its use (additional living
expenses), or loss of other personal possessions of the homeowner, as well as liability insurance for
accidents that may happen at the home or at the hands of the homeowner within the policy territory.
Property insurance provides protection against risks to property, such as fire, theft or weather damage.
This includes specialized forms of insurance such as fire insurance, flood insurance, earthquake
insurance, home insurance, inland marine insurance or boiler insurance
3) Health insurance:- Health insurance policies by the National Health Service in the United
Kingdom (NHS) or other publicly-funded health programs will cover the cost of medical treatments.
Disability insurance policies provide financial support in the event the policyholder is unable to work
because of disabling illness or injury. It provides monthly support to help pay such obligations as
mortgage loans and credit cards. Short-term and long-term disability policies are available to
individuals, but considering the expense, long-term policies are generally obtained only by those with
at least six-figure incomes, such as doctors, lawyers, etc. Short-term disability insurance covers a
person for a period generally up to six months, paying a stipend each month to cover medical bills and
other necessities.
5) Casuality insurance :-
Casualty insurance is a problematically defined term loosely used to describe an area of insurance
not particularly or directly concerned with life insurance, health insurance, or property insurance. It is
sometimes equated to liability insurance, and is mainly used to describe the liability coverage of an
individual or organization's for negligent acts or omissions.crime insurance and political risk
insurance are forms of casuality insurance.
6) Life insurance:- Life insurance or life assurance is a contract between the policy owner and the
insurer, where the insurer agrees to pay a designated beneficiary a sum of money upon the occurrence
of the insured individual's or individuals' death or other event, such as terminal illness or critical
illness. In return, the policy owner agrees to pay a stipulated amount at regular intervals or in lump
sums. There may be designs in some countries where bills and death expenses plus catering for after
funeral expenses should be included in Policy Premium
7) Liability insurance :- It is a policy to protect the purchaser (the "insured") from the risks of
liabilities imposed by lawsuits and similar claims. It protects the insured in the event he or she is sued
for claims that come within the coverage of the insurance policy
8) Credit insurance:- Credit insurance repays some or all of a loan when certain things happen to the
borrower such as unemployment, disability, or death.
Functions of insurance
The function of insurance companies is to pay out if you are in an accident or require reimbursement
after an accident caused by yourself or another person.
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Mitigation of losses :- Loss mitigation is used to describe a third party helping a homeowner, a
division within a bank that mitigates the loss of the bank, or a firm that handles the process of
negotiation between a homeowner and the homeowner's lender. Loss mitigation works to negotiate
mortgage terms for the homeowner that will prevent foreclosure.
Subrogation in its most common usage refers to circumstances in which an insurance company tries
to recover expenses for a claim it paid out when another party should have been responsible for paying
at least a portion of that claim. More specifically, subrogation is the legal technique under common
law by which one party, commonly an insurer (I-X) of another party (X), steps into X's shoes, so as to
have the benefit of X's rights and remedies against a third party such as a defendant (D).
For example, assume an insurer sells one thousand policies, each with a $1 million policy limit.
Theoretically, the insurer could lose $1 million on each policy – totaling to $1 billion. It may be better
to pass some potential risk to a reinsurance company (reinsurer) as this will minimize the insurer's
risk.
Double indemnity is a clause or provision in a life insurance or accident policy whereby the company
agrees to pay the stated multiple (i.e. double) of the face amount in the contract in cases of accidental
death. An accidental death is a death that is neither intentionally caused by a human being, such as
murder or suicide, nor from natural causes, such as cancer or heart disease.
As for the nature of the subject matter of the insurance contract the “product” is an intangible one.
Again the circumstances surrounding the subject matter are known mainly to the proposer therefore
utmost good faith is important.
The proposer thus has a duty of disclosure to disclose to the insurer all material facts. Material Facts –
Facts that can affect the judgment of an underwriter. For e.g. nature of packing in case of marine
insurance.
The International Organization for Standardization (ISO) identifies the following principles of risk
management:
• create value
• be an integral part of organizational processes
• be part of decision making
• explicitly address uncertainty
• be systematic and structured
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• be based on the best available information
• be tailored
• take into account human factors
• be transparent and inclusive
• be dynamic, iterative and responsive to change
• be capable of continual improvement and enhancement.
Transaction risk:-
Probability of loss associated with a business transaction denominated in a foreign currency, due to
changes in the exchange rate. Also called transaction exposure.
Position risk:- Probability of loss associated with a particular trading (long or short) position due to
price changes.
Mismatch risk:- The risk that an investor has chosen investments that are not suitable for his or
her circumstances.Mismatch risk is the risk that you are investing in something that is inappropriate
for your investment needs. Keeping you clear of this risk is one of the major tasks of a financial
planner when discussing investments.A category of risk that refers to the possibility that a swap dealer
will be unable to find a suitable counterparty for a swap transaction for which it is acting as an
intermediary
Presettlment risk:- The risk that one party of a contract will fail to meet the terms of the contract and
default before the contract's settlement date, prematurely ending the contract.
This type of risk can lead to replacement-cost risk
Settlement risk :- The risk that one party will fail to deliver the terms of a contract with another party
at the time of settlement. Settlement risk can be the risk associated with default at settlement and any
timing differences in settlement between the two parties. This type of risk can lead to principal risk.
Settlement risk is a form of credit risk that arises at the settlement of a transaction. Settlement often
entails two parties both performing on respective obligations—say one party paying for a bond, and
the other party delivering the bond. The risk is that one party may perform on its obligation but the
other might not.
Country risk:- A collection of risks associated with investing in a foreign country. These risks
include political risk, exchange rate risk, economic risk, sovereign risk and transfer risk, which is the
risk of capital being locked up or frozen by government action. Country risk varies from one country
to the next. Some countries have high enough risk to discourage much foreign investment. Country
risk refers to the risk of investing in a country, dependent on changes in the business environment that
may adversely affect operating profits or the value of assets in a specific country.
Political risk:- The risk that an investment's returns could suffer as a result of political changes or
instability in a country. Instability affecting investment returns could stem from a change in
government, legislative bodies, other foreign policy makers, or military control.
Political risk is also known as "geopolitical risk", and becomes more of a factor as the time horizon of
an investment gets longer.
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Currency futures:-
A transferable futures contract that specifies the price at which a currency can be bought or sold at a
future date. Currency future contracts allow investors to hedge against foreign exchange risk
Currency option:- A contract that grants the holder the right, but not the obligation, to buy or sell
currency at a specified exchange rate during a specified period of time. For this right, a premium is
paid to the broker, which will vary depending on the number of contracts purchased. Currency options
are one of the best ways for corporations or individuals to hedge against adverse movements in
exchange rates.
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move.
6 With the Forwards contract, the profit or The profit or loss on a Futures position is
loss is realized only at the time of exchanged in cash every day.
settlement so the credit exposure can
keep increasing.
7 In a Forwards contract it is clearly The Futures contract does not specify to
specified who receives the delivery. whom the delivery of a physical asset must be
made
8 No brokerage Brokerage fees is paid
9 It is not regulated Regulated by RBI & SEBI
10 Negotiated directly by the buyer and Quoted and traded on the Exchange
seller
11 Institutional guarantee :-The Institutional guarantee :-Clearing House.
contracting parties
Payoff profile
The slope of a line graphed according to the value of an underlying asset on the x-axis and the value of
a position taken to hedge against risk exposure on the y-axis. Also used with changes in value. See:
Risk profile.
Definition
It is an Option contract with an intrinsic value. A call option is in the money when its exercise price is
below the current price of the underlying asset. A put-option is in the money when its exercise price is
above the underlying asset's market price.
Examples: If December crude oil futures are trading at 75.50, then any December crude oil call option
with a strike price of less than 75.50 is considered to be in the money. A put option with a strike price
greater than 75.50 is considered to be in the money.
Out-of-the-money option
A call option is "out of the money" if the strike price is greater than the market price of the underlying
security. That is, you have the right to purchase a security at a price higher than the market price,
which is not valuable. A put option is out of the money if the strike price is lower than the market
price of the underlying security.
1. A call option with a strike price more than the value of the underlying asset.
2. A put option with a strike price less than the value of the underlying asset.
In both these situations, the option contract has no intrinsic value. If an option is deep out of the
money, it is unlikely that the option will be in-the money by the expiration date. If possible, out-of-
the-money options are sold; if not, they expire worthless and the option holder loses the premium.
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At the money option :-
at the money option – it is an option purchased by an investor to buy or sell, with a strike price equal
to the current market price of the underlying cash or futures contract. In this instance, the intrinsic
value of the option is zero. Its value reflects the premium paid for the additional time the holder has to
decide whether or not to exercise the option, in especially in times of price volatility.
Futures Options
1 Price Protection Establishes fixed price Establishes floor or
ceiling price protection
2 Margin Required on long or short Futures style margins for
positions sellers, margin contained
in the cost of premium for
buyers
3 Hedging Long, short, spread Multiple hedging
strategies
4 Gains gains on futures are With an option, a gain can
decided by the price of the be obtained by exercising
future at the end of the the option, by taking the
trading day. However, like opposite position in
an option, an investor can market, or by allowing the
realize the gains on a option to expire without
future by taking the taking action.
opposite position in the
market.
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7 Risk futures are characterized . On the other hand,
as having unlimited risk options are characterized
on long and short as limiting risk on
positions, establishing a positions, establishing
fixed price and requiring a floor or ceiling price
margin on long or short protection, and not
positions always requiring a margin
on long or short positions.
8 Types There are no any such Call option
types.future contract are Put options
nokt divided further in any
types.
9 Definition
The first thing to understand in risk management is that it's an on-going activity. It's not about
identifying risks upfront and then forging ahead regardless. It's too easy to forget the risks once the
project is started and fail to recognize and raise new risks when the project is underway.
• Risk Assessment
• Risk Monitoring
• Risk Reporting
• Risk Evaluation.
Risk Assessment
The goal of risk assessment is to identify the risk factors that are a part of the activity being
undertaken. Basically, it's about working out what could go wrong. For example, the task could be
attending a client meeting. The possible risk factors would include
• Availability of cabs
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• Availability of public transport
The more risk factors there are with a given task, the more that can go wrong.
Risk Evaluation
Once you have identified the risk factors, then you have to work out what impact they can have on the
task. Following the previous example, what would be the impact of arriving at the meeting late?
Risk Reduction
Risk reduction can also be considering risk containment or minimization. What term you use doesn't
matter as long as you are consistent. The are two parts to risk reduction:-
In getting to our client meeting on time we could take the following actions.
The idea is to avoid the risk altogether but if that's not possible, have plans in place that can minimize
the impact.
Risk Monitoring
Risk monitoring has two dimensions to it. Firstly it's about keeping an eye on the risks that you've
already identified to see if anything has changed, if the impact has increased or decrease, which could
require action. And secondly, to see if there are any new risks that have arisen during the project.
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For example, while we're on our way to the client meeting, we could be keeping an eye on the time
while listening to traffic reports for any potential traffic delays. The most important thing to remember
is that just because we have identified risks upfront, that doesn't mean new ones won't emerge.
Risk Reporting
Risk reporting is about ongoing awareness and the effectiveness of any actions or strategies taken to
reduce risk. For example calling your colleagues about traffic delays or train cancellations. The goal of
risk reporting is to keep an eye on the existing risks to help any new ones arising.
• Risk Identification- Risk management outlines various categories of risks faced by new
business including operational, financial, strategic, compliance related and environmental, political,
safety and health risks.
• Risk Management- Clarifies the importance and events for tackling the risks that your new
business establishments may face. This includes the information about the evaluation of various risks
and four options for managing each risk. This also helps in outlining some preventive ideas to
decrease the likely hood of risks immobilizing your business.
• Business recovery planning- Outlines disaster planning and also minimizes the impact of the
disaster on your business and this includes aspects such as data security, employees, insurance
policies and equipment.
• Prevention of crime- This outlines crimes disturbing small businesses and derives some
simple steps to tackle it.
• Scams-Risk management discusses scams and how they could hamper your business. It also
lists the methods that could help to avoid scams such as investigating the source of the scam, keeping
and maintaining proceedings and filtering the scam.
• Shop Theft- Risk management discusses theft problems in a business and the areas to protect,
such as adopting simple safety measures and by keeping track of the staff and inventory.
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• Data Security- This offers a variety of information, which protects the businesses and also
secures data. Includes disaster recovery, risk assessment, backups and policies regarding data
security.
An organization that wants to survive all odds and risks, must focus on employment of risk
management services. It is imperative to learn about various ways to reduce potential risks to your
business to ensure its smooth running.
3 Defination
4 In the money option
5 Out of the money option
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Questions bank :
1. What is risk management and imp of risk management?
2. What is CALL OPTION and PUT OPTION & SHOW THE
DIFFERENT PAYOFF Diagram?
3. Explain :
4. In the money options
5. Out of the money options
6. At the money options.
8. Show the payoff profile for long futures and short futures?
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14. What are derivatives and what are the different types of
derivatives product?
15. What is a forward contract and limitation of a forward contract?
16. Define Risk? Explain different steps in risk mgmt? Importance of
risk mgmt in modern business environment?
17. What are the 2 classification of Risk? Distinguish between them.
Which risk can b diversified and passed on to another person?
18. Explain risk mgmt system in banking companies? What are Basel
1, 2 &3 norms?
19. Define Insurance? What is /’
20. Q qqqqq? Distinguish Life and General insurance? Explain re-
insurance. What is subrogation?
21. Define derivatives, define and distinguish forwards and futures
contract, futures and options, call and put option.
22. What is pay-off? Draw pay off diagram for call and put option,
buyer and writer. Explain.
23. What is the value of futures contract? Draw a payoff diagram for
the buyer and seller of futures contract. Problem.
24. Explain :
a. In the money options
b. Out of the money options
c. At the money options.
1. Discuss any 3 methods of valuation of options and
why options are to be valued?
25. Discuss the effect of foreign exchange inflow to Indian market?
What are tariff and non-tariff barriers to control the inflows? In your
opinion, what is the correct amount of foreign exchange inflows?
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26. Discuss
the effect of P/E ratio, Price Book Value Ratio and Dividend
Yield Ratio of share purchase decisions.
27. What are Swaps? Explain 2 methods of Swapping. What is
arbitrage?
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