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Financial
Risk Management
By Dr. Manoj Vaish
Four
Steps in Risk Management
1. Understand
the nature of various risks.
2. Define
a risk management policy for the organization and quantifying maximum risk that
organization is willing to take if quantifiable.
3. Measure
the risks if quantifiable and enumerate otherwise.
4. Build
internal control mechanism to control and monitor all the risks.
Step
1 - Understand Risks
Risks can
be classified into three categories.
Price
Risks
This
is the risk of loss due to change in market prices.
Price risk can increase further due to Market Liquidity Risk, which
arises when large positions in individual instruments or exposures reach more
than a certain percentage of the market, instrument or issue. Such a large
position could be potentially illiquid and not be capable of being replaced
or hedged out at the current market value and as a result may be assumed to
carry extra risk.
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Counterparty
Risks
This is
the risk of loss due to a default of the Counterparty in honouring its commitment
in a transaction (Credit Risk). If the Counterparty is situated in
another country, this also involves Country Risk, which is the risk
of the Counterparty not honouring its commitment because of the restrictions
imposed by the government though counterparty itself is capable to do so.
Dealing Risk
Dealing
Risk is the sum total of all unsettled transactions due for all dates
in future. If the Counterparty goes bankrupt on any day, all unsettled transactions
would have to be redone in the market at the current rates. The loss would
be the difference between the original contract rate and the current rates.
Dealing risk is therefore limited to only the movement in the prices and
is measured as a percentage of the total exposure.
Settlement Risk
Settlement
risk is the risk of Counterparty defaulting on
the day of the settlement. The risk in this case would be 100% of the exposure
if the corporate gives value before receiving value from the Counterparty.
In addition the transaction would have to be redone at the current market
rates.
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Operating
Risks
Operational
risk is the risk that the organization may be exposed to financial loss either
through human error, mis-judgement, negligence and malfeasance, or through
uncertainty, misunderstanding and confusion as to responsibility and authority.
Following are the different kinds of of operating risks:
- Legal
- Regulatory
- Errors
& Omissions
- Frauds
- Custodial
- Systems
Legal
Legal
risk is the risk that the organisation
will suffer financial loss either because contracts or individual provisions
thereof are unenforceable or inadequately documented, or because the precise
relationship with the counterparty is unclear.
Regulatory
Regulatory
risk is the risk of doing a transaction which is not as per the prevailing
rules and laws of the country.
Errors
& Omissions
Errors
and omissions are not uncommon in financial operations. These may relate
to price, amount, value date, currency, buy/sell side or settlement instructions.
Frauds
Some
examples of frauds are :
- Front
running
- Circular
trading
- Undisclosed
Personal trading
- Insider
trading
- Routing
deals to select brokers
Custodial
Custodial
risk is the loss of prime documents due to theft, fire, water, termites
etc.
This
risk is enhanced when the documents are in transit.
Systems
Systems
risk is due to significant deficiencies in the design or operation of supporting
systems; or inability of systems to develop quickly enough to meet rapidly
evolving user requirements; or establishment of a great many diverse, incompatible
system configurations, which cannot be effectively linked by the automated
transmission of data and which require considerable manual intervention.
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