Risk Management

A business organization faces many types of risks. Important among them are discussed as below:

1.1 Strategic Risk: A successful business always needs a comprehensive and detailed business plan. Everyone knows that a successful business needs to keep pace with the latest trends. This is what is called as strategic risk. So, strategic risk is a risk in which a company’s strategy becomes less effective and it struggles to achieve its goal. It could be due to technological changes, a new competitor entering the market, shifts in customer demand, spikes in the costs of raw materials, or any other large-scale changes.

Real Corporate Case: We can take the example of Kodak which was able to develop a digital camera by 1975 but considers it a threat to its core business of film photography and fails to develop it. As a result, its competitors such as Sony, Canon, Nikon took the lead and Kodak was forced to declare bankruptcy in 2012. However, a positive example can be given in the case of Xerox which invented photocopy machine. When laser printing was introduced, Xerox had the foresight to invest in it and successfully defend its market position.

1.2 Compliance Risk: Every business needs to comply with rules and regulations. For example with the advent of Companies Act, 2013 and GST, businesses have to comply with many rules and regulations. However, when a company ventures into a new business line or a new geographical area, the real problem then occurs. For instance, in California, consumer privacy laws (CCPA) are stricter than in other states.

1.3 Operational Risk: This type of risk relates to internal risk. It also relates to failure on the part of the company to cope with day to day operational problems. This is a people as well as a process risk. An organization can employ another person to check the work of that person who has mistakenly paid ₹ 1,00,000 or it can install an electronic system that can flag off an unusual payment.

1.4 Financial Risk: Financial Risk is referred as unexpected changes in financial conditions such as prices, exchange rates, interest rates, credit rating etc. Broadly, Financial Risk can be divided into following categories:

• 1.4.1 Counterparty Risk: Occurs due to non-honoring of obligations by the counterparty, which can be failure to deliver goods after taking payment, or failure to make payment on receipt of goods.
• 1.4.2 Political Risk: Faced by overseas investors when adverse action by the host government causes loss:
  • Confiscation or destruction of overseas properties.
  • Rationing of remittance to home country.
  • Restriction on conversion of local currency into foreign currency.
  • Restriction as to borrowings.
  • Invalidation of Patents.
  • Price control of products.
• 1.4.3 Interest Rate Risk: Occurs due to change in interest rates resulting in change in assets and liabilities values. Affects organizations with fixed vs. floating rate mismatches.
• 1.4.4 Currency Risk: Affects organizations dealing in foreign exchange as cash flows change with exchange rate movements. If rupee depreciates vis-à-vis US$, exporters with receivables gain, whereas importers with payables suffer.
• 1.4.5 Liquidity Risk: Inability of organization to meet liabilities whenever they become due. Arises when organization cannot generate adequate cash or due to maturity mismatches between assets and liabilities (prominent in banking Asset-Liability Management - ALM).

Risk Taxonomy & Management Interface:

Frequently Asked Questions: "Explain the various types of financial risks faced by a multinational enterprise" or "Distinguish between Strategic Risk and Operational Risk with corporate examples."

The financial risk can be evaluated from different point of views as follows:

(a) From Stakeholder’s Point of View: Major stakeholders of a business are equity shareholders and they view financial risk as gearing or leverage. Higher the gearing, higher is the risk of variability of their earnings and dividend. Even for a lender, existing gearing is also a risk since a company having high gearing faces more risk of default in payment of interest and principal.

(b) From Company’s Point of View: From the company’s point of view, if a company borrows excessively or lends recklessly, it faces financial risk. If it borrows too much, fixed financing obligations increase bankruptcy probability. If it borrows too little, it fails to trade on equity and cannot optimize its weighted average cost of capital ($$WACC$$).

(c) From Government’s Point of View: From the Government’s point of view, financial risk can be viewed as failure of any major business unit having a domino effect on the entire economy. It leads to loss of employment, tax revenue loss, and wilful defaulters creating Non-Performing Assets (NPAs) in the banking sector. This can also extend to sovereign debt crisis.

1. Stakeholder Asymmetry: Equity shareholders carry residual risk; high financial leverage amplifies EPS volatility ($$DOL \times DFL = DCL$$). Debt providers, on the other hand, do not share in upside gains but face direct default loss when operating earnings drop below interest commitments.

2. Corporate Balance: Optimal capital structure balances tax shields against financial distress costs (Trade-Off Theory). Excessive debt creates under-investment problems and bankruptcy risk.

3. Sovereign & Systemic Risk: Large corporations (e.g. IL&FS, Lehman Brothers, Silicon Valley Bank) are "Too Big to Fail". Their collapse chokes credit markets, forces government bailouts, and risks sovereign credit rating downgrades.

ICAI Question: "The Financial Risk can be viewed from different perspectives. Explain." (TYK Theoretical Question 2)

Value at Risk (VAR) is a measure of risk of investment. Given normal market conditions in a set period (say 1 day, 10 days, 1 month) and a specified confidence level (say 95% or 99%), VAR answers two fundamental questions:

1. What is the worst-case scenario?
2. What will be the loss?

It was first applied in 1922 in the New York Stock Exchange, entered the financial world in the 1990s, and became the world’s most widely used measure of financial risk.

3.1 Features of VAR:

1. Components of Calculations: VAR calculation is based on three components:
   • (a) Time Period (Time Horizon)
   • (b) Confidence Level – Generally 95% and 99%
   • (c) Loss in percentage or in amount
2. Statistical Method: It is a statistical tool based on Standard Deviation ($\sigma$).
3. Time Horizon: VAR can be applied for different time horizons say 1 day, 1 week, 1 month, etc.
4. Probability: Assuming asset returns are normally distributed, probability of maximum loss can be predicted.
5. Risk Control: Risk can be controlled by setting limits for maximum loss.
6. Z Score: Z score indicates how many standard deviations an observation lies away from the Mean of a normal distribution:
   • For 95% Confidence Level (5% tail): $$Z = 1.645 \approx 1.65$$
   • For 99% Confidence Level (1% tail): $$Z = 2.33$$

3.2 Applications of VAR:

• (a) To measure maximum possible loss on any portfolio or trading position.
• (b) As a benchmark for performance measurement of any operation or trading (e.g. RAROC).
• (c) To fix limits for individuals dealing in the front office of a treasury department.
• (d) To enable management to decide trading strategies.
• (e) As a tool for Asset and Liability Management (ALM) especially in banks.

1. Understanding the VaR Statement:

If a bank states that its "1-day 99% VaR is ₹10 Crores", it means:

2. The Time-Scaling Rule (Square Root of Time Rule):

Assuming daily returns are independently and identically distributed (i.i.d.), the volatility scales with the square root of time:

3. Standard Normal Critical Z-Values:

ICAI Question: "Explain the significance and main applications of VAR." (TYK Theoretical Question 1)

Example (Para 3.3):

Suppose you hold worth ₹ 2 crore shares of X Ltd. whose market price standard deviation is 2% per day. Assuming 252 trading days a year, determine the maximum possible loss for 1 day and for 10 trading days at 99% confidence level.

Answer (Official ICAI Solution):

Assuming share prices are normally distributed, for a confidence level of 99%, the equivalent Z score from the Normal table of Cumulative Probabilities is 2.33.

Volatility in terms of rupees shall be:

The maximum loss for 1 day at 99% Confidence Level shall be:

And expected maximum loss for 10 trading days shall be:

The Generalized VaR Formula:

Exam Nuance: If the question specifies a 95% Confidence Level, replace $$Z = 2.33$$ with $$Z = 1.645$$:

4.1 Counterparty Risk:

Hints providing identification of counterparty risk:

1. Failure to obtain necessary resources to complete the project or transaction undertaken.
2. Any regulatory restrictions from the Government.
3. Hostile action of foreign government.
4. Let down by third party.
5. Have become insolvent.

Techniques to manage counterparty risk:

1. Carrying out Due Diligence before dealing with any third party.
2. Do not over commit to a single entity or group or connected entities.
3. Know your exposure limits.
4. Review the limits and procedure for credit approval regularly.
5. Rapid action in the event of any likelihood of defaults.
6. Use of performance guarantee, insurance or other instruments.

4.2 Political Risk:

Identification actions by host country government:

1. Insistence on resident investors or labour.
2. Restriction on conversion of currency.
3. Expropriation of foreign assets by the local government.
4. Price fixation of the products.

Assessment of country risk:

• (1) By referring political ranking published by business magazines.
• (2) By evaluating country’s macro-economic conditions.
• (3) By analysing the popularity of current government and assessing their stability.
• (4) By taking advice from the embassies of home country in host countries.

Techniques to mitigate political risk:

• (i) Local sourcing of raw materials and labour.
• (ii) Entering into joint ventures with local partners.
• (iii) Local financing (raising debt in host currency).
• (iv) Prior negotiations (concession agreements).

4.3 Interest Rate Risk:

Identification signals: Monetary Policy of Government/Central Bank, government moves (e.g. demonetization), Economic Growth rates, Industrial Data releases (IIP/CPI), FII capital inflows, Stock market movements.

4.4 Currency Risk:

Identification factors:

1. Government Action (e.g., UK Brexit referendum impact on GBP).
2. Nominal Interest Rates (Interest Rate Parity - IRP).
3. Inflation Rates (Purchasing Power Parity - PPP).
4. Natural Calamities.
5. War, Coup, Rebellion.
6. Change of Government and attitude towards foreign investment.

Strategic Mechanics of Political Risk Mitigation:

• Local Sourcing: By hiring local staff and purchasing from local vendors, any expropriation by the host government causes severe local unemployment and domestic supplier backlash, disincentivizing government seizure.
• Local Financing: If a firm finances its overseas plant via loans from host-country domestic banks, the host government cannot nationalize the plant without causing massive loan defaults to its own local banking system.
• Joint Ventures: Partnering with politically influential domestic entities creates a powerful domestic lobby against adverse regulatory actions.

Frequently Tested Theory: "Discuss the techniques an MNC can adopt to manage Political Risk" or "Explain the techniques for mitigating Counterparty Risk."

Question: Explain the significance of VAR.

Answer:

Value at Risk (VAR) is the world’s most widely used statistical measure for quantifying market risk. It indicates the maximum expected loss of a portfolio over a specified time horizon at a given confidence level under normal market conditions.

The significance and primary applications of VAR are:

1. Portfolio Risk Quantification: Provides senior management with a single, intuitive, consolidated monetary figure representing portfolio risk across diverse asset classes (equities, bonds, currencies, derivatives).
2. Trading Limits (Front-Office Control): Used by corporate treasuries and investment banks to set daily stop-loss and maximum allowable exposure limits for individual traders and desks.
3. Performance Measurement (Risk-Adjusted Performance): Serves as a benchmark for evaluating trading performance on a risk-adjusted basis (e.g. RAROC — Risk-Adjusted Return on Capital).
4. Formulating Trading Strategies: Guides portfolio managers on rebalancing, diversification, and hedging strategies.
5. Asset and Liability Management (ALM) & Capital Adequacy: Central banks and Basel regulatory frameworks require commercial banks to maintain regulatory capital based on 10-day 99% VaR.

Question: The Financial Risk can be viewed from different perspective. Explain.

Answer:

Financial risk is not perceived identically across economic agents. It is evaluated from three distinct viewpoints:

1. From Stakeholder’s Point of View:
   • Equity Shareholders: View financial risk as gearing or financial leverage ($$DFL$$). Higher debt increases fixed interest charges, creating high variability in earnings per share (EPS) and dividend stability.
   • Lenders (Debt Providers): View high gearing as elevated credit risk and probability of default in timely servicing of interest and principal.
2. From Company’s Point of View:
   • Excessive borrowing threatens corporate solvency and increases bankruptcy probability.
   • Under-borrowing deprives equity shareholders of the benefits of trading on equity, raising the firm's overall weighted average cost of capital ($$WACC$$).
3. From Government’s Point of View:
   • Large corporate insolvencies produce contagion effects across supply chains, causing job losses and tax revenue depletion.
   • Wilful defaulters generate Non-Performing Assets (NPAs), choking bank credit flow and potentially precipitating a systemic sovereign financial crisis.

Question: Consider a portfolio consisting of a ₹ 200,00,000 (₹ 2 Crore) investment in share XYZ and a ₹ 200,00,000 (₹ 2 Crore) investment in share ABC. The daily standard deviation of both shares is 1% and the coefficient of correlation between them is 0.30.

Determine the 10-day 99% Value at Risk (VaR) for the portfolio.

Solution:

Given Parameters:

• Investment in Share XYZ ($$X_1$$) = ₹ 200 Lakhs
• Investment in Share ABC ($$X_2$$) = ₹ 200 Lakhs
• Total Portfolio Value ($$V_0$$) = ₹ 400 Lakhs
• Portfolio Weights: $$w_1 = \frac{200}{400} = 0.50$$,\quad $$w_2 = \frac{200}{400} = 0.50$$
• Daily Standard Deviation of XYZ ($$\sigma_1$$) = 1%
• Daily Standard Deviation of ABC ($$\sigma_2$$) = 1%
• Correlation Coefficient ($$r_{12}$$) = 0.30
• Holding Period ($$T$$) = 10 Days
• Confidence Level = 99% ($$Z = 2.33$$)

Method 1: Direct Monetary Variance Approach (ICAI Primary Method)

The standard deviation of daily change in each asset in amount is:

The variance of daily change in portfolio value ($$V$$) is:

Method 2: Percentage Variance Approach (ICAI Alternative Method)

Step 2: Scale Volatility to 10 Days ($$\sqrt{T}$$ Rule)

Step 3: Compute 10-Day 99% Value at Risk (VaR)

From the Normal Table, for 99% confidence level (1% lower tail), $$Z = 2.33$$: