Financial Derivatives &

Risk Management
 1-2

Objectives

 Understand the risk, its elements and

uncertainty
 To understand nature of risk
 To study different interpretation of risks
 To know about Risk management process &
methods
 To understand the overall objectives of risk
management is to minimize the cost of risk.
 1-3

Is
Risk is symbol of Danger
Or
Symbol of Opportunity ?

It is
symbol of both
Danger & Opportunity
 1-4

 The only one thing is certain about Stock

Market is…………..

………….. Uncertainty !
 1-5

 “Playing with F & O is injurious to Wealth”

 “ You will burn your money in Derivatives, if not

done in a systematic way”

 But at the same time ‘It is Money Vending Machine’.

 Learn to make money through……

Trade in Derivatives Systematically & Strategically
 1-6

Introduction: What is Risk???

 Risk is the possibility of an unfavorable deviation
from expectations; that is, the occurrence of an
undesirable contingency. It is the possibility that
something we do not want to happen will happen or
that something we want to happen will fail to do so.
 According to M.N.Mishra, “Risk is the uncertainly
of loss.”
 According to Prof. James Athearn; Risk may be
defined:-
 The possibility of loss or
 The possibility of unfavorable deviation from
expectations because any deviation from expectations
is a loss.
 1-7

Risk Management
Meaning:
“Risk can be defined as the possibility of loss
arising because of uncertainty of outcome of
particular transaction”.
“Risk refers to variability of the actual returns
from the expected returns in terms of cash
flows”.
“Risk management seeks to mitigate
variability and expected losses and increase
welfare”.
 1-8

Elements of Certainty and Risk

Certainty: Is the situation where it is

known what will happen and the
happening of an event carries a 100
percent probability.

Risk: Is the situation when there are a

number of specific, probable outcomes,
but it is not certain as to which one of
them will actually happen.
 1-9

Elements of Uncertainty and Risk….

Uncertainty: Is where even the probable

outcomes are unknown. It reflects a total lack
of knowledge of what may happen.

The Webster's Dictionary says that ‘ Risk’ is the

possibility of something unpleasant happening
or the chance of encountering loss or harm.
 1-10

Nature of risk
 Important nature of risk is uncertainty. One
cannot predict risk when it will occur. Its
period of occurrence is not known.
 It relates to theory of probability and it
standards more on guess work rather than
actual.
 Risk exists in any activities when the
decision maker is in a position to assign
probabilities to various outcomes.
 1-11

Different Interpretation of Risk

Risk can be divided into;

1. Pure Risk (PR) and Speculative Risk (SR):

PR are those in which the outcome tends to be a loss

with no possibility of gain.
Ex: the risk of fire in a godown
SR are those in which there is a possibility of gain
or loss.
Ex: Secondary market
While PR can be insured
SR cannot be insured
 1-12

Different Interpretation of Risk

Pure risk encompasses risk of loss from
(a) damage to and theft or expropriation of business
assets,
(b) legal liability for injuries to customers and other
parties,
(c) workplace injuries to employees, and
(d) obligations assumed by businesses under employee
benefit plans.
Pure risk frequently is managed in part by the purchase
of insurance to finance losses and reduce risk.
 1-13

Different Interpretation of Risk

2. Acceptable and Non-acceptable Risk:

While risks are unavoidable in any business the
potential loss may be so minimal. Ex: a loss of
few stationeries in a month is acceptable.
Certain risks are major and those are known as non-
acceptable. Ex. A major financial loss of Rs.50
crore is non-acceptable risk.
 1-14

Different Interpretation of Risk

3. Static Risks and Dynamic Risks:

Risks that do not depend on various scenarios

like pure risks are a type of static risks

Some risks depend on changes in the

economical, political, social and other
scenarios like speculative risks are a type
of dynamic risks.
 1-15

Risk Management

Risk management is a systematic approach in

identifying, analyzing and controlling areas or
events with the potentials for causing unwanted
change. It is through risk management that risks to
any specific programmed are assessed and
systematically managed to reduce risk to an
acceptable level.
 1-16

Types of Risk (Business & Individuals)

1. Business Risk : Is concerned with possible

reductions in business value from any
source. The business value include Price
risk, Credit risk and Pure risk.

2. Personal Risk: The risks faced by

individuals and families viz., earnings risk,
medical expense risk, liability risk,
physical asset risk, financial asset risk.
 1-17

Risk Management Process

Risk Mgmt. process involves:
1. Identify all significant risks.
2. Evaluate all potential frequency and
severity of losses.
3. Develop and select methods for managing
risk.
4. Implement the risk management methods
chosen.
5. Monitor the performance and suitability
of the risk management methods and
strategies on an ongoing basis.
1-18
 1-19

Risk Management Methods:

Major risk management methods include:
1. Loss control
2. Loss financing
3. Internal risk reduction
Loss control & Internal risk reduction are
commonly involve decisions to invest
resources to reduce expected losses.
Loss financing decisions refer to decisions
about how to pay for losses if they do
occur.
 1-20

Risk Management methods contd…..

Loss Control Loss Financing Internal risk reduction

Reduced level of Retention and Diversification

risky activity self-insurance

Increased
Insurance
precautions

Hedging

Other contractual
risk transfers
 1-21

Objectives
The overall objectives of risk management is
to minimize the cost of risk.
Risk mgmt. seeks to mitigate variability and
expected losses and increase welfare.

Cost of risk:
Components of the cost of risk include;
1. the expected cost of loss,

2. the cost of loss control,

3. the cost of loss financing,

 1-22

Cost of risk contd…..

4. the cost internal risk reduction, and
5. the cost of any residual uncertainty that
remains after loss control, loss financing,
and internal risk reduction methods have
been implemented.
In the context of business risk management,
maximizing firm value is equivalent to
minimizing the cost of risk.
 1-23

THE RULES OF RISK MANAGEMENT

 These rules are simply commonsense
principles applied to risk situations:

1. Don’t risk more than you can afford to

loose.
2. Consider the odds
3. Don’t risk a lot for little
 1-24

RISK MANAGEMENT MATRIX

High Low Frequency

Frequency
High Risk Risk Transfer i.e,
Severity Avoidance & Insurance
Reduction

Low Risk Risk Retention

Severity Reduction &
Retention
 1-25

Risk Management
 Derivatives allow firms to:
 Separate out the financial risks that they face.
 Remove or neutralize the risk exposures they do
not want.
 Retain or possibly increase the risk exposures
they want.

 Using derivatives, firms can transfer, for a

price, any undesirable risk to other parties
who either have risks that offset or want to
assume that risk.
 1-26

Risk Management
 The proliferation of derivatives
allows firms to:
 Efficiently manage a great variety of
risks.
 To manage those risks in a variety
of different ways.
 1-27

Example
 Consider a Indian fund manager with a
portfolio of U.S. equities.

 If he buys IBM shares, he is exposed

to three risks:
 Prices in the U.S. equity market
generally.
 The price of IBM stock specifically.
 The dollar/rupee exchange rate.
 1-28

Example

 He is bearish about:
 The dollar’s medium-term
prospects.
 The overall U.S. stock market.
 1-29

Example
 To hedge the currency risk, he could
sell dollars under the terms of a
forward contract.
 To hedge the market risk, he could
short futures contracts on the S&P 500
index.
 He would be left with exposure to
IBM’s share price only.
 1-30

Example

 But the same result could be achieved in

another way: an equity swap denominated
in sterling.

Price performance of IBM shares in

sterling
Fund Swap
manager dealer
Interest in sterling
 1-31

Preferred derivatives

Type of Risk Preferred Derivative

Foreign exchange risk Forward contracts

Interest rate risk Swaps

Commodity price risk Futures contracts

Stock market risk Options

 1-32

Lessons in risk management

 Barings Bank
 Long-Term Capital Management

 Amaranth Advisors LLC

 Bank of Montreal
 1-33

Barings Bank
 British investment bank, founded in 1763.
 1803: Negotiated the purchase of Louisiana by
the U.S. from Napoleon.
 Queen of England was a client.

 1995: was wiped out when a trader (Nick

Leeson) ran up losses of close to $1 billion
trading derivatives.

 Lesson: Monitor employees/traders closely.

 1-34

Long-Term Capital Management

 A hedge fund that sought very high returns by
undertaking investments that were often highly
risky.
 Bet: yield spreads would narrow

( y I  yG )
( y D  yG )

High yield Low yield

Lower quality Higher quality
 1-35

Long-Term Capital Management

 August 1998: Russian government default

 Flight to quality and spreads widened
 Highly leveraged positions lead to large losses,
about $4 billion
 Bail out
 Lessons:
 Do not ignore liquidity risk.
 Beware when everyone else is following the same
trading strategy.
 Carry out scenario analysis and stress tests.
 1-36

National Post, March 1, 2006

 “U.S. central bankers are again getting nervous
about the huge US$300-trillion global
derivatives markets”.
 Until recently, derivatives held mainly by banks.
 Hedge funds becoming major players.
 Trade in the OTC market.
 Trades are largely unregulated.
 Concerns:
 Closing out positions when markets are under stress.
 Potential damage to banking system.
 1-37

Amaranth Advisors LLC

 September 2006: The Connecticut-based hedge

fund lost about $6.5 billion trading natural gas
derivatives.
 In 2005, the fund had made considerable money
on natural gas “spread trades”:
 A cold winter in 2004.
 An active hurricane season in 2005.
 Political instability in oil-producing countries.
 In 2006, a similar scenario did not materialize.
 Fuelled concern about “regulatory black hole”.
 1-38

Bank of Montreal
 May 2007: Reported losses of $680 million
betting on the natural gas market.
 BMO reported:
 Its commodity trading team “did not operate
according to standard BMO business practices”.
 “In the future in the (commodity) portfolio we will
only engage in the amount of market-making
activity required to support the hedging needs of our
oil and gas producing clients.”
 “the bank has revised its risk management
procedures.”
 1-39

Hedging Currency Risk

&
Hedging Risk through
Forward Contracts
 1-40

Basic principles
 The object of the exercise to to take a
position that neutralizes risk as far as
possible.
 1-41

Long & Short Hedges

 A long futures hedge is appropriate when

you know you will purchase an asset in
the future and want to lock in the price

 A short futures hedge is appropriate when

you know you will sell an asset in the
future & want to lock in the price
 1-42

Hedging
 Two counterparties with offsetting
risks can eliminate risk.
 For example, if a wheat farmer and a flour mill
enter into a forward contract, they can
eliminate the risk each other faces regarding
the future price of wheat.
 Hedgers can also transfer price risk to
speculators and speculators absorb
price risk from hedgers.
 1-43

Hedging: How many contacts?

You are a farmer and you will harvest 50,000 bushels
of corn in 3 months. You want to hedge against a
price decrease. Corn is quoted in cents per bushel at
5,000 bushels per contract. It is currently at $2.30
cents for a contract 3 months out and the spot price
is $2.05.
To hedge you will sell 10 corn futures contracts:
50,000 bushels
 10 contracts
5,000 bushels per contract
Now you can quit worrying about the price of corn
and get back to worrying about the weather.
 1-44

Forward Market Hedge

 If you are going to owe foreign currency
in the future, agree to buy the foreign
currency now by entering into long
position in a forward contract.

 If you are going to receive foreign

currency in the future, agree to sell the
foreign currency now by entering into
short position in a forward contract.
 1-45

Forward Market Hedge: an Example

You are a U.S. importer of British woolens and

have just ordered next year’s inventory.
Payment of £100M is due in one year.

Question: How can you fix the cash outflow in

dollars?

Answer: One way is to put yourself in a position

that delivers £100M in one year—a long
forward contract on the pound.
 1-46

Arguments for and against hedging

 The arguments in favor of hedging are

readily apparent.

 The arguments against hedging are

somewhat more subtle.
 1-47

Arguments in Favor of Hedging

 Companies should focus on the main

business they are in and take steps to
minimize risks arising from interest rates,
exchange rates, and other market variables
 1-48

Arguments against Hedging

 Shareholders are usually well
diversified and can make their own
hedging decisions

 It may increase risk to hedge when

competitors do not.

 Explaining a situation where there is a

loss on the hedge and a gain on the
underlying can be difficult
 1-49

How hedging could increase risk.

 Consider single competitor in a
commodity industry dominated by
competitors who do not hedge.

 If the competitor hedges the raw

materials and then prices of raw
materials fall, the price of the finished
product will fall as well—this could
decrease profit margins.
 1-50

Should the Firm Hedge?

 Not everyone agrees that a firm should
hedge:
 Hedging by the firm may not add to
shareholder wealth if the shareholders can
manage exposure themselves.
 Hedging may not reduce the non-diversifiable
risk of the firm. Therefore shareholders who
hold a diversified portfolio are not helped
when management hedges.
 1-51

Should the Firm Hedge?

 In the presence of market imperfections,
the firm should hedge.
 Information Asymmetry
 The managers may have better information than
the shareholders.
 Differential Transactions Costs
 The firm may be able to hedge at better prices
than the shareholders.
 Default Costs
 Hedging may reduce the firms cost of capital if it
reduces the probability of default.
 1-52

Should the Firm Hedge?

 Taxes can be a large market imperfection.
 Corporations that face progressive tax rates
may find that they pay less in taxes if they
can manage earnings by hedging than if they
have “boom and bust” cycles in their
earnings stream.
 1-53

What Risk Management Products do Firms Use?

 Most U.S. firms meet their exchange risk

management needs with forward, swap,
and options contracts.

 The greater the degree of international

involvement, the greater the firm’s use of
foreign exchange risk management.
 1-54

Basis risk
 It may be difficult to find a forward
contract on the asset that you are trying to
hedge.

 There may be uncertainty regarding the

maturity date.

 These problems give rise to basis risk.

 1-55

Basis Risk

 Basis is the difference between spot &

futures:

Basis = Spot price of asset to be hedged – Futures price of

contract used

 Basis risk arises because of the

uncertainty about the basis when the
hedge is closed out
 1-56

Variation of basis over time

Futures
Price Spot Price

Spot Price Futures

Price

Time Time

(a) (b)
 1-57

Long Hedge

 Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
 You hedge the future purchase of an asset
by entering into a long futures contract
 Cost of Asset=S2 –(F2 – F1) = F1 + Basis
 1-58

Short Hedge
 Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
 You hedge the future sale of an asset
by entering into a short futures
contract
 Price Realized=S2+ (F1 –F2) = F1 +
Basis
 1-59

Choice of Contract
 Choose a delivery month that is as close
as possible to, but later than, the end of
the life of the hedge

 When there is no futures contract on the

asset being hedged, choose the contract
whose futures price is most highly
correlated with the asset price. There are
then 2 components to basis
 1-60

Cross-Hedging: Minor Currency Exposure

 The major currencies are the: U.S. dollar,
Canadian dollar, British pound, Swiss
franc, Mexican peso, Japanese yen, and
now the euro.

 Everything else is a minor currency, like

the Polish zloty.

 It is difficult, expensive, or impossible to

use financial contracts to hedge exposure
to minor currencies.
 1-61

Cross-Hedging: Minor Currency Exposure

 Cross-Hedging involves hedging a position in
one asset by taking a position in another asset.
 The effectiveness of cross-hedging depends
upon how well the assets are correlated.
 An example would be a U.S. importer with liabilities
in Czech koruna hedging with long or short forward
contracts on the euro. If the koruna is expensive
when the euro is expensive, or even if the koruna is
cheap when the euro is expensive it can be a good
hedge. But they need to co-vary in a predictable way.
 1-62

Hedging Contingent Exposure

 If only certain contingencies give rise to
exposure, then options can be effective
insurance.

 For example, if your firm is bidding on a

hydroelectric dam project in Canada, you
will need to hedge the Canadian-U.S.
dollar exchange rate only if your bid wins
the contract. Your firm can hedge this
contingent risk with options.
 1-63

4.4 Minimum variance hedge ratio

Size of the
exposure
 The hedge ratio is
Size of the
position taken in
the futures
contracts

• If the objective of the hedger is to minimize

risk, setting the hedge ratio equal to one is
not necessarily optimal.
 1-64

Notation

dS Change in the spot price, S, during the life of the

hedge
dF Change in the futures price, F, during the life of
the hedge
sS is the standard deviation of dS
sF is the standard deviation of dF
r is the coefficient of correlation between dS and dF.
 1-65

Optimal Hedge Ratio

Proportion of the exposure that should optimally be

hedged is
sS
h r
*
sF
where
sS is the standard deviation of dS, the change in the spot
price during the hedging period,
sF is the standard deviation of dF, the change in the
futures price during the hedging period
r is the coefficient of correlation between dS and dF.
 1-66

Optimal Number of Contracts

The number of futures contracts required is

 NA
N h 
QF
where
NA size of the position being hedged (units),
QF size of one futures contract (units),
N* Optimal number of futures contracts
 1-67

Creating Value with

Risk Management
 1-68

What is it?

 A potential gain or loss that occurs as a

result of an exchange rate change.
 1-69

Should Firms Manage Risk?

 They consider any use of risk management

tools, such as forwards, futures and options,
as speculative. Or they argue that such
financial manipulations lie outside the firm's
field of expertise.

 They claim that exposure cannot be

measured. They are right -- currency
exposure is complex and can seldom be
gauged with precision.
 1-70

Managing Firm’s Economic Value

 Reduces volatility of firm’s value by

reducing volatility of income and return on
assets without altering firm’s expected value

 Creates value because firm’s expected value

is higher in the presence of a risk
management strategy
 1-71

Financial Distress
 Risk worth managing is that which may
have material impact on the value of the
firm’s periodic cash flows

 Large, highly diversified firms may not be at

much risk from risk exposure

 Small, poorly diversified firms are at greater

risk because more transactions are large
 1-72

Financial Distress
Risk Aversion Loss Aversion
 Requires corporations  Recognizes risk is
give up the chance for concern because of
upside foreign the downside losses
exchange gains to rather than the
protect themselves upside gains
from possible
downside foreign
exchange losses

 Fear of Bankruptcy
 Hedging with options
 1-73

Three Preliminary Questions

 What exchange risk does the firm face, and
what methods are available to measure
currency exposure?

 What hedging or exchange risk management

strategy should the firm employ?

 Which of the various tools and techniques of

the foreign exchange market should be
employed: debt and assets; forwards and
futures; and options
 1-74

Last Thought
 Risk management adds value because
it helps ensure that a corporation has
sufficient internal funds available to
take advantage of profitable
investment opportunities. Risk
management helps the firm avoid
short-run and intermediate-run capital
constraints to survive in the long run
 1-75

Ex. 1: Hedging practice at GE

 Use a portfolio approach (50%: forward,

25%: option, and 25%: spot)

 Keep its individual business units well-

educated about risk management

 Encourage them to bill in premium

currencies like Japanese yen and receive
invoices in discount currencies such as
Italian lira
 1-76

Ex. 2: Hedging practice at Baxter Int.

 Educate a wide range of people within the

company in the proper use of risk
management tools

 Make many of its risk-management decisions

by consensus (as an effective check-and-
balance system)

 Try to interact and share information with

several investment banks correctly
 1-77

Elimination of downside losses

Managers and shareholders

→ Not worried about impacts of foreign exchange
gain, but exchange losses
↓
Options are best justified as hedging tools.
 Because of asymmetric pay-off structure
 Because of no possibility for loss beyond the
amount of the premium paid
 Because of costs to symmetric hedges like
forwards, money markets, and futures
 1-78

Does risk management create value ?

 If marketing resources are allocated where
currencies are overvalued and are taken away
from locations where currencies are
undervalued…

 If production is increased where currencies are

undervalued and is decreased where currencies are
overvalued…
↓
The firm as a whole is more profitable.
↓
Risk management may indeed create value as
well as reduce the variability of firm value.
 1-79

Foreign Exchange Risk

 Foreign exchange risk is the risk that
the value of an asset or liability will
change because of a change in
exchange rates.
 Because these international obligations
span time, foreign exchange risk can
arise.
 1-80

Sources of Risk
 Transaction Exposure: The risk that the
domestic cost or proceeds of a transaction
may change.
 Translation Exposure: The risk that the
translation of value of foreign-currency-
denominated assets is affect by exchange
rate changes.
 Economic Exposure: The risk that exchange
rate changes may affect the present value of
future income streams.
 1-81

Country and Political Risk

Importance of country risk
 Has adverse impact on cash flow.

 Monitor countries for doing business

 Major decision like divesting or

franchising can be taken easily
 Helps in revising financing and
investing decision.
 1-82

Political Risk Factors

 Attitudes of consumers in host country
 Local preference by consumers
 Countries exert pressure on consumers(
Walmart )
 Joint venture better if loyal consumers
 Host Govt. Actions
 Additional corporate taxes
 Fund transfer restrictions
 High Import duties
 Extra taxes, subsidize competitors
 Lack of restrictions
 1-83

Political Risk Factors contd….

 Fund transfers blockage
 Some countries block fund transfer to parent
company
 Lower return for subsidiaries
 Currency Inconvertibility
 Countries block currency conversion
 Parent company exchanges currency for goods
 War
 Has an impact on the business
 High cost due to safety of employees
 Eg . French tourism affected by differences with US
on IRAQ war.
 1-84

Political Risk Factors contd….

 Bureaucracy
 High govt. bureaucracy deterrent
 Slow decision making
 Eg . India, Eastern Europe
 Corruption
 Increases the cost of conducting business
 Loss in revenue
 Double standards exist in major
countries(U.S)
 1-85

Financial Risk Factors

 Current & Potential state of Economy
 Subsidiary is affected by the demand of its
product
 Recession reduces demand
 Economic growth Indicators
 Interest rates: High interest rates reduces
demand and vice versa.
 Exchange rates: Strong currency reduces
demand for country exports, increases imports.
 Inflation: Affect consumers purchasing power
and therefore demand
 1-86

Type of Country Risk Assessment

 Macro-assessment of Country risk
 Consideration of all risk factors at macro level
 Remains same for the country irrespective of
industry
 Political factors
 Relationship between both the govt.
 Stability of the govt.
 Attitude of people towards MNC
 Financial Factors
 GDP growth
 Inflation
 Interest Rates etc.
 1-87

Type of Country Risk Assessment contd…

 Micro-assessment of Country Risk

 Specific to the Industry
 Risk varies with firm, industry and
project of concern
 Sensitivity of the firm’s business to real
GDP growth, inflation needs
 Overall assessment
 Macropolitical risk
 Macrofinancial risk
 Micropolitical risk
 Macropolitical risk
 1-88

Country Risk Rating

 Different country risk assessors have their
own individual procedures for quantifying
country risk.
 Although most procedures involve rating
and weighting individual risk factors, the
number, type, rating, and weighting of the
factors will vary with the country being
assessed, as well as the type of corporate
operations being planned.
 One can also use risk ratings provided at
certain reliable websites.
 1-89

Country Risk Measurement

 Firms may use country risk ratings
when screening potential projects, or
when monitoring existing projects.
 For example, decisions regarding
subsidiary expansion, fund transfers to
the parent, and sources of financing,
can all be affected by changes in the
country risk rating .
 1-90

Comparing Risk Rating among Countries

 One approach to comparing political and

financial ratings among countries is the
foreign investment risk matrix (FIRM ).
 The matrix measures financial (or
economic) risk on one axis and political
risk on the other axis.
 Each country can be positioned on the
matrix based on its political and
financial ratings.
 1-91

The Foreign Investment Risk Matrix (FIRM)

 1-92

What is Financial Risk?

 Risk is the probability that the realized return would

be different from the anticipated/expected return on
investment.

 Risk is a measure of likelihood of a bad financial

outcome.

 All other things being equal risk will be avoided.

 All other things are however not equal and that a

reduction in risk is accompanied by a reduction in
expected return.
 1-93

Some major financial

risks
Credit

Interest Rate

Market

Financial Liquidity
Risks
Operational

Foreign Exchange
Other Risks, Country Risk,
Settlement risk,
performance risk
Business Poles Business Lines

Commercial
Retail Financial Services
Lending & Collecting Deposits and

Banking Corporate-Middle from/to Individuals, small businesses

Management
Identified borrowers & relationship
Large Corporates banking

Advisory Services
Mergers & Acquisition
LBO
Investment Banks & Financial Firms ‘Structured Finance’
Banking Asset Financing
Commodities
Securitisation

Derivatives
Trading Equity Traded Instruments
Fixed Income

Others Custody

sartaj.hussain
 Schematic classification of some major Financial
1-95

Risks

Financial Risks

Credit Risk Liquidity Risk Interest Rate Risk Market Risk Forex Operational
Risk

Mismatch Risk People oriented

Optionality Processes
Default Risk Procedural
Decline in credit standing Technology
External events

Funding Risk
Market Liquidity Risk
Asset Liquidity Risk
 1-96

Credit Risk: Composition

 Default Risk.

 Risk of decline in credit standing of an

obligor.

 Market value loss due to change in credit

standing of issuer.

 Difficulty in measurement on ex ante basis.

 1-97

Credit risk in banking portfolio:

 Prolonged Delinquency.
 Deterioration in the credit standing of
borrower
 Restructuring of debt obligations.
 Bankruptcies.
 1-98

Credit risk in Trading portfolio

 Deterioration in the rating of a debt.

 Credit risk valued in market prices.
 Pre & post default comparison.
 Upward movement in the required
yield.
 Highly customised derivative.
 1-99

Liquidity Risk: Composition

 Funding Risk.

 Market Liquidity Risk.

 Asset Liquidity Risk.

 1-100

Funding Risk
 Inability to raise funds at normal cost.

 Market perception about a borrowing

entity

 Linkages of credit standing and cost of

funds
 1-101

Market Liquidity Risk

 Liquidity crunches due to lack of
volume.

 Funding risk due to market weakness.

 Distress on asset prices.

 1-102

Asset Liquidity Risk

 Asset specific rather than market
created.

 More prevalent in long term assets.

 Exotic products.
 1-103

Consequence of liquidity risk

 Sale of asset on distressed prices.

 Borrowing extremely high rates.

 Depositors runs.

 Refusal of Lenders to further funding.

 Massive withdrawal of funds by financial

institutions.

 Brutal liquidity crisis leading to bankruptcy

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