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: