Post on 20-Jun-2015
RISKRisk is a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for
Risk may objective or subjective
Objective risk: relative variation of actual loss from expected loss.
Subjective risk: uncertainty based on a persons mental condition or state of mind.
In risk two elements are commonly found
The outcome is uncertain. There are at least two possible outcome
for given situation . Out of the possible outcome ,one is
unfavorable.
Risk v/s uncertainty
Uncertainty refers to a situation where the outcome is not certain or unknown.
Uncertainty refers to a state of mind characterised by doubt, based on the lack of knowledge about what will not happen in the future.
Risk refers to a situation where there is possibility of a loss
Loss means that portion of expired cost for which no compensating value has been received
Perils and hazards
Cause of loss or the contingency that may cause a loss.
Hazards are the condition that increase the severity of loss or the condition affecting peril.
Physical hazards: Property conditions.eg.stocking crackers
Intangible hazards: attitudes and culture-psychological nature.
Intanigible hazards
Moral hazard:Fraud eg.putting fire to a factory running in losses.
Moral hazard: indifference-it is the attitude of indifference to take care of the property on the premises that the loss will be indemnified by the insurance contract
Societal hazards: legal and cultural-these refer to the increase in the frequency and severity of loss arising from legal doctrines or social customs and structure.
Types of Risk
Financial and non-financial risk Individual and group risks Pure and speculative risk Static and dynamic risk Quantifiable and non-Quantifiable risk
Risk Management
Risk mean that some danger or loss may be involved in carrying out an activity and therefore,care has to be taken to avoid that loss.
definition
Risk management is an interated process of delineating specific areas or risk, developing a comprehensive plan, integrating the plan,and conducting ongoing evaluation.
The process
Defining the objectives of the risk management exercise.
Identifying the risk exposures Evaluating the exposures Critical analysis of risk management
alternative and selecting one of them Implementation and review
Risk mgmt. into three elements
Risk Analysis Risk control Risk financingRisk management process has a necessity
to be dynamic. Therefore continuous reassessment and monitoring of the results.
Prevention is better than cure
Risk identification: the first step in the process is to anlalyse the risk. Risk analysis has two prime elements-the identification of risk and its evaluation.
Risk identification requires knowledge of the org.,mkt. in which it operate,the legal,social,economic,political
Risk evaluation
The probability of loss occuring Its severity
Risk control
Risk control covers all those measures aimed at avoiding ,eliminating or reducing the chances of loss-producing events occurring or limiting the severity of losses that do happen.
Risk can be controlled either by avoidance or by controlling losses.
Before occurrence of losses
Reduction in worry and fear Economical ways of handing risk Overcome legal obligations
After occurrence of lossses
Survival Congruence with mission and objectives Optimising social effects
Risk financing
Risk exposure for an organisation exceeds the maximum limit that the org. can bear,it becomes necessary to either transfer or reduce risk
Cost involved in both Insurance is method adopted In long run an org. will have to pay for its
own losses
The primary objective of risk financing is to spread more evenly over time cost of risk in order to reduce the financial strain and possible insolvency.
It can finance in three ways Losses may be charge as they occur to
current operating cost Provision may be made through purchase
of insurance. Finaced through loans
Risk retention
It implies the losses arising due to a risk exposure shall be retained or assumed by the party or the org.
Self insurance Captive insurance
Risk transfer
Insurance Non-insurance
Risk management by individuals
A) Identification of potential losses: Personal risk Property risk liability risk
Evaluation of potential losses
Estimating the frequency and severity of losses
Eg. The chance that your home will be totally destroyed by certain natural calamity
Selecting the appropriate techniques for handling losses
Loss of control: it is method by which frequency and security of losses are controlled
Eg.locking of car ,wearing helmet2. avoidance:3. Retention: Active Risk Retention Passive risk retention4. Non insurance: Defective music System5.Insurance
Review the programe
To find out deviations,significant,modification
Factors affecting individual’s demand for insurance
Price for risk transformation Perception towards losses Income and wealth states Social insurance programs Nature of losses
Process of risk management by individual
1.Identifying potential losses.2. Evaluating Potential losses.3.Selecting the Appropriate Technique. a) Avoidance b) Risk control c) Risk Retention d) Non-insurance transfers e) Insurance4.Periodic Review
Personal Risk Management Strategies
Should ensure that assets are protected and debts are cleared in the event of the unforeseen death, major accident or major illness of a key financial members.
There are four key forms of personal protection insurances
Life term insurance
Known as Term Insurance It pays lump sum benefit to the policy
owner upon death of the life insured Is used to repay liabilities, such as
mortgage, credit cards etc.
Total & Permanent Disability (TPD) insurance
TDP insurance provides a lump sum upon medical confirmation that the insured person is totally and permanently disabled based on the definition provided in the policy document.
Usually sold as additional benefit
Trauma (Critical illness) Insurance
Trauma insurance pays you a lump sum in the event of a major trauma such as a major heart attact, cancer or stroke.
Income protection insurance Income protection cover is designed to
provide you with a regular monthly income while you cannot work due to sickness or accident.
Risk Management objective
Risk management is broader concept than insurance management and includes all techniques for treating loss exposure ,in addition to insurance.
It has impt. objectivea) Pre-loss objectiveb) Post loss objective
Pre loss objective
Reduction in worry and fear Economy Meeting legal obligation
Post loss objective
Survival Continued operation Stability of earning Continued growth Optimizing social effects
Levels of Risk management
Risk management operate at three levels1.Time-critical:time critical process of risk
management is employed by personnel to consider risk while making decisions in a time-compressed situation
Deliberate
Is application of the complete process. It uses experience and brainstorming to
identify risk. Planning of upcoming operations,review
of standard operating ,maintenance or training procedures and damage control or disaster response planning.
strategic
It is process with more through hazard identification and risk assessment involving research of available data, use of diagram and analysis tools,formal testing or long term tracking of the risks associated with the system or operation.
Risk management and Derivatives
The term derivative indicate that it has no independent
value Its value is entirely derived from the value of the
value of the underlying asset Securities, commodities, bullion, currency,live
stock. Derivative means a forward, future, option or any
other hybrid contract of pre determined fixed duration,linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities.
Derivative markets classified Commodity derivative market: wheat,
cotton,pepper,chana or precious metals like gold,silver.
Financial derivative: equity,interest rates and exchange rate.
Types/classification of Derivatives
Forwards Futures Options Swaps
Forward Contract
Two parties agree to do a trade at some future date, at a price and qty. agreed today.
No money changes hands at the time the deal is signed.
Agreed price is called forward price with a forward market the transfer of ownership occurs on the spot,but the delivery of the commodity or instrument does not occur until some future date
Features of forward contracts They are bilateral contracts and hence
exposed to counter-party risk. Each contract is custom designed, and hence
is unique in terms of contract size, expiration date and the asset type and quality.
The contract has to be settled by delivery of the asset on expiration date.
The party wishes to reverse the contract, it has to compulsorily go to the same counter party.
Future contract
Future contract means a legally binding agreement to buy or sell the underlying security on a future date.
Future contract are the organized/standardized contracts in terms of quantity,quality(in case of commodities), delivery time and place for settlement on any date in future.
The contract expires on a pre-specified date which is called the expiry date of the contract.
On expiry, future can be settled by delivery of the underlying asset or cash.
Cash settlement enables the settlement of obligations arising out of the the future/option contract in cash.
The agreed upon price is called the future price
Features of a futures contract Use of standard contracts:standardization
of the contracts fetches the potentials buyers and sellers and increases the marketability and liquidity of the contracts.
Clearing House: Future exchange will act as a clearing house. In future contract the obligation of the buyer and the seller is not to each other but to the clearing house in fulfilling the contract which eliminates default risk.
Margin requirements: 5% to 10% o face value Time spreads: relation between spot price
and future price of the contract. The relationship exists between prices of future contracts which are on same commodity or instrument but which has different expiry dates. The difference between the prices of two contracts is known as the time spread.
Simple pay off possitions in future: either positive or negative.
Options Contracts
Gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at end of a specified period.
The buyer of the option purchases the right from the seller/writer for a consideration which is called the premium.
European and American option
If an option that is exercisable on or before the expiry date is called American option.
The holder can exercise the right anytime between purchase date and expiration date.
European option An option that is exercisable only on
expiry date is called European option. The price at which the option is to be
exercised is called strike price or Exercise price.
Call and Put option
Call Option: A call option is the right (not the obligation) to buy the commodity or security at a specific price called the exercise price.
Call
Buyer Holder long
Seller Writer Short
Has the right but not the obligation to buy 100 shares of
the underlying stock at the strike price
Is obliged on demand, to sell 100 shares of the underlying stock at the strike price when
the holder exercises
Pays the total Premium
Receives the total premium
Expectations, rewards and risks of holder and writer of a call option
Call
Buyer Holder long
Seller Writer Short
Expectation: Wants the market price of the underlying stock to rise.Reward: Potentials unlimited gain when the price of the underlying stock appreciatesRisks: Losses only the total premium paid for the call when the market price of underlying stock declines.
Expectation: Wants the market price of the underlying stock to decline.Reward: gain limited to the total premium received when the option was writtenRisks: Losses only the total premium paid for the call when the market price of underlying stock rises.
Put
Buyer Holder long
Seller Writer Short
Has the right but not the obligation to sell100 shares of
the underlying stock at the strike price
Pays the total Premium
Receives the total premium
Is obliged on demand, to buy 100 shares of the underlying stock at the strike price when
the holder exercises
Expectations,rewards & risks of holder and writer of a put option
Call
Buyer Holder long
Seller Writer Short
Expectation: Wants the market price of the underlying stock to decline.Reward: Maximum profit when the price of the underlying stock declines to Zero.Risks: Losses only the total premium paid for the call when the market price of underlying stock rises.
Expectation: Wants the market price of the underlying stock to rise.Reward: Gain limited to the total premium received when the option was writtenRisks: Losses more and more as the stock price declines lower and lower.
Swap Contract
A swap is a derivative,where two counterparties exchange one stream of cash flows against another stream.
These streams are called the legs of the swap.
Used to hedge certain risks Swaps are OTC derivatiive
Commonly used swaps
Interest rate swaps: swapping only interest related cash flows between the parties in same currency
Currency swaps: swapping of both principal and interest between the parties.
Swaption: Swaption are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap.
Need
Transfer risk Reflects the perception Discovery of Prices
Risk involved in derivatives market Credit Risk Market Risk Liquidity Risk Legal Risk Operating Risk
Participants in the Derivative Markets
Hedgers: Speculators: Arbitrageurs: Day traders: Floor Trader: Market maker: