Introduction

Krupa Desai
Objective

At the end of the session, you will be able to :

Interpret Risk
Describe Type of Risk
Introduce various types of risk
Define Risk management
State objectives of risk management
Describe the tools of risk management
Risk
Risk is the effect of uncertainty on objective
Risk can be defined as the combination of the
probability and event in its consequences
In all types of undertaking, there is a potential for
events and consequences that constitutes opportunities
for upside and downside
Risk is multidimensional

Market Risk
Credit Risk
Financial
Risks Operational Risk

Reputational Risk
Business and strategic risks
 Introduction
One can slice and dice these multiple
dimensions of risk* Specific
Risk
Equity Risk Trading Risk
`Market Risk General
Interest Rate Risk
Market
Gap Risk Risk
Currency Risk
Credit Risk
Commodity Risk
Counterparty
Operational Risk
Risk
Financial Transaction Risk
Risks Reputational Issuer Risk
Risk Portfolio
Concentration
Business and Risk Issue Risk
strategic risks
External sources

Economic
Political
Competitive environment, social and market forces
Technological
Shocks and natural events
External stakeholders and third parties
Internal Sources

Strategic
Operational
Financial
Terminology

Risk culture
Risk appetite
Inherent risk
Residual risk
Risk profile
Risk mitigation
Broad classification of the
risk The risk inherent tothe entire
market or entire market segment.
Systematic Alsoknown as "un-diversifiablerisk"
risk or "market risk.

Company or industryspecific risk that is

inherent in each investment.The amount of
unsystematic risk can be reduced through
Unsystemati appropriate diversification.

c risk Also known as "specific risk," "diversifiable

risk" or "residual risk.
Factors boosting risks
Increased
Risk

linked
systematically
exposure to
global
macroeconomic
firms are more factors
competitive

increasing
competition

lower entry
barriers
Introduction to RM

Risk managementis the identification, assessment, and

prioritization ofrisks

Process of risk management

Identify, characterize, and assessthreats
Assess thevulnerabilityof critical assets to specific threats
Determine therisk(i.e. the expected likelihood and
consequences of specific types of attacks on specific
assets)
Identify ways to reduce those risks
Prioritizerisk reduction measures based on a strategy
Need of Risk Management

The only alternative to risk management is crisis

management --- and crisis management is much more
expensive, time consuming and embarrassing.
JAMES LAM, Enterprise Risk Management, Wiley Finance 2003

Without good risk management practices, government

cannot manage its resources effectively. Risk management
means more than preparing for the worst; it also means
taking advantage of opportunities to improve services or
lower costs.
Sheila Fraser, Auditor General of Canada
Growth of RM industry

Following global events contributed to the growth of risk

management industry
Japanese stock market collapse of 1989 and further (from
39,000 to 17,000)
Asian Currency crisis of 1997
Russian default and subsequent failure of LTCM in 1998
Dot com bust of 2000
Sub prime crisis and subsequent failures of Bear Stern, Lehman
and other financial institutions in 2008-2009
Euro zone crisis
Greece fall out
The great fall of China
Japanese asset price bubble
Highlights
The price of real estate and stock price were
inflated
Uncontrolled money supply and credit expansion
Inflating Bubble
Tokyo Stock Exchange (Nikkei stock
index/Nikkei 225) hits record high 38,957.44
in fourth quarter 1989
Opportunity fuels real estate bubble in late
1980s
Monetary policy responses to the
bubble

BOJ raised the official discount rate sharply from May

1989 until August 1990 to preemptively prevent
inflation.
BOJ did not mention to land prices as a reason for
policy changes. Nonetheless, after Yasushi Mieno
became Governor in December 1989, general public
seemed to think that Governor Mieno intended to crash
the bubble.
Stock prices turned to decline at the beginning of 1990,
while land prices continued to increase until the end of
1990.
Effects

The Japanese stock market index

Peaked at 40,000 in 1989
Dropped to below 15,000 in 1992

There were periods in the 1990s when it rose in

anticipation that the market would bounce back, but the
harsh reality is that the Nikkei 225 has been in steady
decline even to this day.

Real estate
From 1991 1998 property lost 80% of its value
Nikkei 225
Balance sheet adjustment by firms

Non-manufacturing firms raised the debt-to-asset ratio

in the bubble period, and it took a decade to return the
leverage ratio to the pre-bubble period.
The debt-to-asset ratio of manufacturing firms
increased after the collapse of the bubble, as the value
of assets declined.
Return on assets (ROA) declined in the 1990s. Because
non-manufacturing firms had made overinvestment in
the bubble period.
 NPA at the banks
Fall in land price did harm to bank balance sheets through the decline in
collateral value.

In addition, banks continued to lend to some failing firms ,including real

estate firms, to cover up the loss from non-performing loans.

Non-performing loan problems led to the financial crisis in 1998,

continued for a decade and ended in 2005.
Results

Real GDP (RGDP) would flounder throughout the 1990s

1990 - 428,826 billion (USD 1 trillion)
2000 - 469,480 billion (USD 4.66 trillion)

Unemployment
Rose from 2.1 % in 1991 to 4.7 % by year end 2000
When comparing unemployment to other countries it may
seem low, however, 4.7 % is unheard of in Japan
Decade earlier unemployment never passed 2.8 %
Nikkei vs DJI

Nikkei
225

Dow Jones
Industrial
 Asian Currency crisis of 1997

Countries most affected

Indonesia
South Korea
Thailand
Hong Kong
Malaysia
Lao
Philippines
Thailand

May 1997: Thailand spends billions of its foreign reserves to defend the Thai
baht against speculative attacks

In case of Thailand:
Allowing too many short-term capital flows to accumulate with a high degree
of currency speculation,
Sustaining a fixed exchange rate when it was no longer suitable,
Lack of sufficient risk management system at the national level as well as
regional level.
concerns of large current account deficits
weakness in the Thai financial system
culminating with the failure of a major finance company, Finance One

Speculative attacks brings down investor confidence causing- capital flight

Crisis in Thailand turned out to be a contagion
 July 1997
Thailand is forced to devalue the baht, which drops
the value of the baht by as much as 20%-- a record
(had actually attempted a 15% controlled
devaluation)
Malaysias central bank intervenes to defend the
ringgit.
The Philippine peso is devalued. Indonesia widens its
trading band for the rupiah in a move to discourage
speculators
The Singapore dollar starts a gradual decline.
The currency exchange rate per USD
June 1997 compare to July 1998

Thai baht: 24.5 to 41

Indonesian rupiah: 2,380 to 14,150
Philippine peso: 26.3 to 42
Malaysian ringgit: 2.5 to 4.1
South Korean won: 850 to 1,290
Why it happened
Artificially
high Interest rate to attract
investors
Large
quantities of available credit
Highly-Leveraged economic climate

Asset prices pushed up to unsustainable level, and

eventually collapse
Default on Debt obligation

Panic among Lenders

Large withdrawal of credit

Credit crunch and further bankruptcies

Depreciative pressure on credit rates

Potential Collapse of the market Government enters..

 Government is forced to raise Domestic interest

rate to exceedingly high
Government buys excess domestic currency at
fixed exchange rate
Foreign currency-denominated liabilities grew
substantially (in domestic currency terms)
Bail out

IMF unveiled a $17 billion rescue package, and another

bailout package of $3.9 billion
subject to conditionality for reorganizing and
restructuring, establishing strong regulatory
frameworks
Tax revenue balanced the budget in 2004, 4 years ahead
of schedule
Baht reached 31/US$ by 2013
Russian default and subsequent
failure of LTCM in 1998

Highlights
LTCM, a hedge fund found in 1994 with $ 1.01 billion in
capital
The company used complex mathematical models to take
advantage offixed income arbitragedeals usually with
U.S., Japanese, Europeangovernment bonds with a high
leverage
By 1998, LTCM had extremely large positions in areas such
asmerger arbitrageandS&P 500options
Strategy

convergence trades
These trades involved finding securities that were
mispriced relative to one another, taking long positions in
the cheap ones and short positions in the rich ones.
Types
Convergence among U.S., Japan, and European sovereign
bonds
Convergence among European sovereign bonds
Convergence between on-the-run and off-the-run U.S.
government bonds
Long positions in emerging markets sovereigns, hedged back
to dollars.
Fall out

On Monday, October 27,1997the DOW dropped 554

points. This 7% market share loss was termed as Black
Monday and the New York Stock Exchange shut down
TWICE in an attempt to calm the market.
The Russian Financial Crisis of August and September
1998 which was caused due to the default of the
Russian Government bonds further contributed to these
losses. This was called the Ruble crisis
The firm had investments in Japanese and European
bonds and knowing that the Russian Crisis would affect
the value of these bonds, the panicked investors sold
their holdings and purchased US Government Bonds
 LTCM had to liquidate a number of positions at a highly
unfavourable moment and suffer further losses. The
company which was proving almost 40 percent returns
up to this point experienced a flight to liquidity.

The equity value of the firm tumbled from $2.3 billion

at the start of the month to just $400 million by
September 25, 1998. With liabilities still over $100
billion this translated to a leverage ratio of more than
250 to 1.
Major loss
Dotcom burst

The dot.com bubble (1995-2001) was a period when the

Western world saw technology stocks soared to
unbelievable new heights
Historical NASDAQ prices

low 1100
Peak at 5100
 First example of speculative
growth.
Nortel Network (NT on NYSE&TSX)
Known as Nortel telecom in the 1800s. Four years after the telephone was
invented.
The first Canadian company to be listed on the NYSE
From 1995-2000, Nortel saw spectacular growth. It added 20 000 new jobs
Stock grew from merely 100 (adjusted scale) to 1200 (peaked at August
2000)
Ended up facing 950 million dollar of charges on bed debts (could not keep
up payments)
Write-down of 12.3 Billion on technology related investments
Had a operating loss of 1.5 Billion dollars.
Accounting fraud was found about Nortels financial statements. They
were hiding almost millions of dollars for debts.
Stock hit a 10 year low in 2008 with stock price of 12.78 CAD on the TSX
Chart
Second Example

Cisco Systems Inc

In 1995, they started making a new device called the router to link
networks It became well-know for their networking products. (new
devices)
Revenue raised from 1995-2000
At the height of the dot.com bubble, CSCO was at 80 dollar/share
with a market cap of 580 Billion (Thats big as a stock exchange)
Cisco could not give up the 60% growth rate even though they saw
high risks
Management team was too mercenary and promoted downfall.
(ordering numerous equipments)
After the burst of dot.com bubble, they could not sell the extra
inventory. Wrote down 2.5 Billion
Stocks dropped to a low of 14 dollars in 2002.
Causes

Belief that internet would become the only means of

commerce (internet replacing retail)
Get Big Fast
Business leaders did not understand direct marketing
Technology was misunderstood by investors
Marketers overestimated the willingness of consumers
to pay online
Series of events

Technology became a new venture for new entrepreneurs. New companies

and IPO came into the market
The NASDAQs trading volume exceed that of the NYSE. This showed
popularity among trading dot.com stocks
As 2000 came near, people realized a fatal error in technology machines. It
was the Y2K bug
Y2K bug meant that there was no date on the calendar (for tech machines)
for the year 2000.
Economic activities speeded up, spending increased, technology firms
worked to fix the problem
Federal Reserve (central bank of US) raised interest rates 7 times in 1999.
Economy was out of control and inflation risks were high.
More interest rates=less margin on stocks which led to sell off on Wall
Street.
Y2k problem was over when 2000 begin. Economic activities cooled down.
Effects

Massive sell off on March 10, 2000. (NASDAQ reached a

high of 5100.
Analyst did not like the earning reports that showed
slowdown in the tech companies (expectation was very
high)
Downgraded many stocks, investors followed the
institution firms and dumped shares.
NASDAQ dropped from 5100 to 1100 in two years. 80% in
loss. Trillions of dollars was lost in terms of market cap.
Only 50% companies survived. Many were brought by
bigger ones.
Sub prime crisis
Eurozone crisis
Scope for RM

To identify and prioritize potential risk events

Help develop risk management strategies and risk
management plans
Use established risk management methods, tools and
techniques to assist in the analysis and reporting of
identified risk events
Find ways to identify and evaluate risks
Develop strategies and plans for lasting risk
management strategies
Process
1. Identify and Analyze Exposure

2. Examine risk management

techniques

3. Select risk management

technique

4. Implement technique

5. Monitor result
Tools of RM

Derivatives is the most popular tool used by Risk

Managers for RM
RM tools include
Stop-loss limit: Limit on the amount of losses in a position
Notional Limit: Maximum amount to be invested in a asset
Exposure limit: Exposure to risk factors like duration for
debt instruments and Beta for Equity Investments
VaR: maximum loss at given confidence level
Risk Management principles
TheInternational Organization for Standardization(ISO)
identifies the following principles of risk management
createvalue resources expended to mitigate risk should be less than
the consequence of inaction, or (as invalue engineering), the gain
should exceed the pain
be an integral part of organizational processes
be part of decision making
explicitly address uncertainty and assumptions
be systematic and structured
be based on the best available information
be tailor able
take human factors into account
be transparent and inclusive
be dynamic, iterative and responsive to change
be capable of continual improvement and enhancement
be continually or periodically re-assessed
49
Recap

At the end of the session, you learned to :

Interpret Risk
Describe Type of Risk
Introduce various types of risk
Define Risk management
State objectives of risk management
Describe the tools of risk management
Questions
Thank you