Risk Management: An
Overview
In this unit
• Types of Risk
• Risk Management Process
• Insurance Contracts: Benefits of Insurance, Principles of Insurance,
Types of Insurance
• Fundamentals of derivatives: Types, objectives, advantages of
financial derivatives.
• Participants in derivatives market
RISK MANAGEMENT
• Risk management is defined as the process of planning, organizing, directing
and controlling the resources and activities of an organization in order to
minimize the adverse effects of potential losses at the least possible cost.
• In other it is a process which identifies the loss expected to be faced by a trader
and selects suitable derivative techniques or strategics for eliminating or
minimizing such instances. The purpose of risk management is not to avoid the
risk altogether but at least to minimize it.
• It is important to understand here that the term 'risk' should not be confused with
the term ‘uncertainty'. An adverse deviation from an expected outcome is known
as risk, whereas lack of knowledge or information about the future is
uncertainty.
Types of Risk
On the basis of objectivity On the basis of Insurability Other types
Objective risk Pure risk Liquidity risk
Subjective risk
Speculative risk Counterparty risk
Interest rate risk
Exchange rate risk
Country risk
Default risk
Financial risk
Basis risk
Objective risk
The variation of actual loss from the estimated loss is known as objective risk. For instance, if an
insurance company has given insurance for 1000 cars and have forecast that 1% of the cars insured (i.e.,
10 cars) meet with accidents _in a year; it does not mean that only 10 cars exactly meet with accidents.
The actual number would be anything other than 10. If 15 cars met with accidents, the deviation is five
cars. This is considered as objective risk.
Subjective Risk
The level of uncertainty expected by an individual and that which varies from person to person is known
as subjective risk. For instance, a driver in a drunken situation is uncertain whether he will reach home
safely or would be caught by police. Two different individual in the similar situation may perceive the
same risk differently and respond differently. Such risk with differing perceptions is known as subjective
risk.
Pure Risk (Insurable Risk)
A category of risk wherein loss is the only possible outcome and no potential gain it known as insurable
risk or pure risk or non-speculative risk. Insurable risk is related to the events that are beyond the control
of risk takers such as accident, death, natural disasters, and hence can take insurance on such risk of loss.
For instance, loss of house due to natural disaster is a pure risk as there is no potential gain to the owner
on the occurrence of the event. The owner can, therefore, take the insurance. Pure risks can be divided
into three categories, viz., personal risk, property risk and liability risk.
Speculative Risk (or Non-Insurable Risk)
A category of risk wherein the possibility of either financial gain or loss exists, such as investing in
shares, and betting on horses, and which cannot be insured is known as non- insurable risk or speculative
risk. Although most investment activities involve speculative risks, some are more speculative than the
others. For instance, government securities such as bonds and treasury bills are less speculative than
shares.
Liquidity Risk
The risk of loss arising from the lack of immediate marketability of an investment is known as liquidity
risk. In other words, liquidity risk arises when the financial instruments such as shares and commodities
cannot be bought and sold quickly due to non-availability of investors. Generally, the financial
instruments or contracts which are traded in the exchanges such as futures and options are highly liquid
and free from liquidity risk while the contracts which are OTC-traded, such as, forward contracts face
liquidity risk. Liquidity risk is generally reflected in a wide bid-ask spread or large price movements.
Counterparty Risk
The risk of loss arising to each party of a contract on account of default from the other party is known as
counterparty risk or settlement risk. Such a risk arises in the contracts where performance bonds are not
given by the parties either by way of premium or margin money.
Interest Rate Risk
The risk of loss arising out of changes in the interest rate on bonds or debentures or loans is known as
interest rate risk. It is faced by the borrowers and lenders under fixed interest rate borrowings. When the
market rate of interest decreases, the borrowers lose and lenders gain and if market rate increases the
borrowers gain and lenders lose.
Exchange Rate Risk
The risk of loss arising out of fluctuations in the exchange value of a currency is known as exchange rate
risk or currency risk. It rate risk arises only when the investor or business firm has the assets or receivables
or business operations in foreign currency. For instance, assume that an Indian exporter is expected to
receive US$1,00,000 after three months of its exports. If the exchange value of US Dollar decreases from
Rs 67 to Rs 65, on the maturity the exporter will lose (Rs 67 – Rs 65) x 1,00,000 (i.e., 2,00,000)
Country Risk (Political Risk)
The risk of loss arising out of changes in the government policies of other countries is known as
country risk or political risk. It also arises when the government of the country fails to honour its
financial commitments. The country risk emerges only when the investor has investment or
business operations outside his/her own country.
Default Risk
The risk of loss faced by the lender due to non-payment of interest and/or repayment of principal
by the borrower is called default risk or credit risk. Such risk can be eliminated by providing loans
against collateral security and to the borrowers who are financially sound having no record of
default. The lenders are also suggested to diversify their lending among large number of
borrowers.
Financial Risk
The risk arising out of use of debt component in the capital structure is known as financial risk or financial
leverage. It arises on account of the burden of interest expense which has to be paid irrespective of whether
the business earns profit or suffers loss.
Basis Risk
Basis risk or spread risk is the risk associated with imperfect hedging. Lack of perfect correlation between
the two investments creates excess gains or loss causing increased amount of risk exposure. For instance, a
bank lending at prime rate and borrowing at LIBOR may face the basis risk if prime-LIBOR spread
narrows down. Basis risk may be classified as price basis risk, calendar basis risk and location basis risk.
Price basis risk arises due to mismatch between price of the asset to be hedged and price of the asset
serving as the hedge. The calendar basis risk arises due to mismatch between the expiration date of the
asset to be hedged and actual selling date of the asset, whereas location basis risk arises due to mismatch
between location of the asset to be hedged and asset serving as the hedge.
Risk Management Process
1. Risk Identification
The first and foremost step of risk management process is identification of the loss exposures
both the major and minor. Risk identification involves analysis of pure risk and business risk.
2. Risk Measurement and Evaluation
After identifying the loss exposures, the exposures are analyzed to ascertain the frequency (i.e.,
expected number of losses in a time period) and severity of losses (i.e., size of losses). The risk
measurement and evaluation is done for each type of the exposure. The risk measurement enables
to find out the techniques or strategies for handling the loss exposures.
3. Risk Control
Risk control involves avoiding losses before it occurs or reducing the severity of losses after it
occurs. Some risks can be completely eliminated or prevented before their occurrence, for
instance, avoiding construction of multi-storey apartments in earthquake zones. However, some
risks cannot be completely eliminated but reduced through loss preventive programme which is
known as loss reduction.
Risk Management Process
Risk Financing
Risk financing involves designing an appropriate financing strategy to fulfil risk management
objective. There are two different ways of risk financing: (a) Risk Retention (b) Risk Transfer
A business firm generally does not transfer all risks to the insurer as it is very expensive. The
insured incurs the cost for transferring the risk in the form of premium. A part of the losses is
retained by the firm which is known as risk retention and the rest is transferred to the insurer.
Risks can be hedged either by transferring to insurance companies (i.e., insurance contracts) or
by using derivative instruments (also known as contractual transfers) such as forwards, futures,
options etc-. which is known as risk transfer.
INSURANCE CONTRACTS
• Insurance is a contract between two parties (insured and insurer) wherein the
insurer makes the good for specified losses of insured in return for receiving
premium from the insured.
• Insurance contracts help the business firms to reduce the risk by way of
transferring some of the risk of loss to the insurer.
• The insurer, in turn, reduces the risk by applying principle of diversification (i.e.,
by selling insurance to large number of insured).
• The American Risk and Insurance Association has defined insurance as "It is the
pooling of fortuitous losses by transfer of such risks to insurers who agree
indemnify insured for such losses to provide other pecuniary benefits on their
occurrence or to render services connected with the risk"
Benefits of Insurance
• The insured will get huge amount of claim on the occurrence of the risk insured
thereby enabling the firm to keep the regular business unaffected and avoids
financial distress.
• The amount of claim received enables the firm to avoid raising costly external
funds
• Insurance contract reduces tax payments as the premium payments are tax
deductible.
Principles of Insurance
The insurance contracts are formed in line with the following principles.
(i) Principle of Utmost Good Faith: This principle implies that all material facts
relating to the subject matter of the insurance contract should be known to all
parties of the contract. None of the parties to the contract conceal or misrepresent
or commit mistake or fraud relating to the material facts. If this principle is not
followed, the contract becomes null and void and can be cancelled by any of the
parties. Hence, the insured shall disclose all material facts known to him but
unknown to the insurer and the insurer has to disclose scope of the insurance while
entering into the contract.
Principles of Insurance
(ii) Principle of Insurable Interest: The principle of insurable interest implies that
the insured should have insurable interest (i.e., pecuniary or monetary interest) in
the subject matter of the insurance contract. A person is said to have insurable
interest in the subject matter only when he/she has the benefit from its existence
and will be affected by its destruction. The insured should have insurable interest in
the subject matter of insurance at the time of entering into the contract (i.e., while
taking the policy) in case of life insurance and at the time of entering into contract
as well as at the time of occurrence of loss in case of fire and marine insurance.
Principles of Insurance
(iii) Principle of Indemnity: The principle of indemnity implies that the insured is
paid only the loss against which the policy is taken. Thus, the insured cannot make
profit out of the insurance contract.
(iv) Principle of Causa Proxima: The principle of causa proxima implies that
when loss occurs by more than one cause, the nearest (i.e., proximate) cause should
be considered while deciding liability of the insurer. Thus, the insurer is liable for
the loss caused by the immediate cause which is insured but not the remote cause.
However, life insurance is exceptional to this principle. Hence, insurer has to pay
the claim irrespective of reason of death (whether natural or an unnatural).
Principles of Insurance
(v) Principle of Mitigation of Loss: The principle of mitigation of loss implies
that in the event of some mishap to the insured property, the insured has to take
necessary efforts to safeguard the remaining property and minimize the loss as
much as possible. If the insured is proved to be negligent in preserving the
property, the insurer may compensate only to the extent of loss suffered.
(vi) Principle of Subrogation: The principle of subrogation implies that all the
rights and remedies available with the insured with respect to the subject matter are
transferred to the insurer after the loss is compensated. It implies substitution of the
insurer in place of the insured in respect of the latter's rights and remedies.
Types of Insurance
The insurance contracts are broadly classified into two categories: Life Insurance
and General Insurance
Life insurance: Life Insurance a contract between Insured and insurer wherein the
insurer pays a sum assured at the time of death or at the expiry of certain period
whichever is earlier in turn for payment of premium by the insured. Thus the
subject matter of life insurance is life of human beings and it provides protection to
the family on premature death or gives adequate amount at the old age or upon
retirement when the earning capacity is reduced.
Types of Insurance
General insurance: General Insurance is a contract between insured and insurer
wherein the subject matter of insurance is property of the insured. The property of
a person or business is insured against a certain specified risk such as fire.
Other forms of Insurance: The other forms of insurance contracts are: Social
insurance (pension plans, disability benefits, widow pension, unemployment
benefits, sickness insurance), liability insurance, flood insurance etc.
What is Derivatives?
• A derivative is a financial instrument (Contract) whose value is
derived from the value of another asset, which is known as the
underlying.
• A underlying assets could be financial assets such as index, stocks,
currency, bonds, commodities etc.
• When the price of the underlying changes, the value of the
derivatives so changes.
• A Derivative is not a product. It is a contract.
• It is contract between two or more parties
Factors Causing Growth of financial Derivatives
• Wide fluctuations in the asset prices
• Integration of domestic market with international market
• Introduction of advanced information technology and communication facilities in
financial market
• Development of innovative and advanced risk management tools.
• The cost effectiveness of derivative tools
Functions of Derivative Markets
The derivatives market performs a number of economic
functions. They help in :
• Transferring risks
• Catalysing entrepreneurial activity
• Price discovery
• Leveraging
Criticism for Derivatives
• Increased Volatility
• Increased Bankruptcies
• Burden of Increased Regulations
Who are the participants?
• Hedgers use futures or options markets to reduce or eliminate
the risk associated with price of an asset.
• Speculators use derivatives contracts to get extra leverage in
betting on future movements in the price of an asset. For
example, if a speculator thinks that a stock is overpriced, they
may sell the stock and wait for the price to decline
• Arbitrageurs are in business to take advantage of a discrepancy
between prices in two different markets.
Hedging
• Hedgers are essentially spot market players.
• Hedgers are interested in reducing price risk (that they already face
the spot market) with derivative contracts and options.
• Forward contracts are designed to neutralize risk by fixing the price
that hedger will pay or receive for the underlying asset.
• Future contracts can be used to undertake minimum variation
hedging.
• Option strategy enables the hedger to insure itself against adverse
exchange rate movements while still benefiting from favorable
movements.
Speculation
• Speculators wish to take a position in the market either by betting
that the price will go up or down.
• Futures and options can be used for speculation
• When a speculator uses futures then the potential gain or loss is high.
• When a speculator uses options, speculator’s loss is limited to the
amount paid for the option.
Arbitrageurs
• Arbitrage means making a riskless profit by entering into transactions
in two or more markets simultaneously.
• The purpose of an arbitrage is to even out the price of assets in the
markets in which they are traded. If assets are not correctly priced
relative to each other, arbitragers can make riskless profits by buying
underpriced assets and selling overpriced ones. However, such
arbitrage opportunity cannot exist for long, because the arbitragers’
actions will bring asset prices in line in all the markets.
Classification of derivatives
Classification based Classification based Classification based
on Instruments on Underlying Assets on Trading
Forward Equity Over the Counter (OTC)
Futures Commodity Exchange Traded
Options Currency
Swaps Interest Rate
Indices
Weather
Comparison between the Exchange traded and OTC
Exchange-Traded Derivative Over-the-counter Derivative
Markets: Market:
Clearing and settlement process Informal network of market participants
All contract terms standardized except Dealer market
price Less liquid
More liquid Less transparent
More transparent Customized
Basic Terminologies
Spot date: The
Spot Contract: An Spot Price: The
normal settlement
agreement to buy price at which the
day for a
or sell an asset asset changes hands
transaction done
today. on the spot date.
today.
Long position: The
Short position: The Delivery Price: The
party agreeing to
party agreeing to price agreed upon
buy the underlying
sell the asset in the at the time the
asset in the future
future assumes a contract is entered
assumes a long
short position into.
position.
