risk mangaement final 2

8/7/2019 Risk Mangaement Final 2

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RISK MANAGEMENT


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RISK MANAGEMENTRISK MANAGEMENT

What is Risk Management?What is Risk Management?

Who uses Risk Management?Who uses Risk Management?

How is Risk Management used?How is Risk Management used? Risk Management in CustomsRisk Management in Customs

How do you use it in Customs?How do you use it in Customs?


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Process steps that enable improvement indecision making

A logical and systematic approach Identifying opportunities

Avoiding or minimising losses


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Risk Management is the name given to alogical and systematic method ofidentifying, analysing, treating andmonitoring the risks involved in anyactivity or process.


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Risk Management is a methodology thathelps managers make best use of theiravailable resources


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Risk Management practices are widely used in public andthe private sectors, covering a wide range of activitiesor operations.

Finance andInvestment

Insurance

Health Care

PublicInstitutions

Gover

nments

Finance andInvestment

Insurance

Health Care

PublicInstitutions

Gover

nments


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Risk Management isnow an integral part of business planning.


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Risk Managementis

now an integralpart of business

planning.

There are

77 stepsin the RMprocess


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THE BASIC PROCESS STEPS ARE:

Establish the context

Identify the risks

Analyse the risks

Evaluate the risks

Treat the risks


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Risk is dynamic and subject to constant change, sothe process includes continuing:

Monitoring and review

and

Communication & consultation


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CALCULATING INTEREST RATE RISK

Marking to market

Stress testing this market value

Calculating the Value at Risk of the portfolio

Calculating the multiperiod cash flow Doing step 4 with random yield curve

Measuring the mismatch of the interest sensitivity gapof assets and liabilities.


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BANKS AND INTEREST RATE RISK

Basis risk

Yield curve risk

Repricing risk

Option risk


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EFFECTS OF INTEREST RATE RISK

Changes in interest rates can have adverse effects bothon a banks earnings and its economic value. This hasgiven rise to two separate, but complementary,perspective for assessing a banks interest rate riskexposure.

Earnings perspective

Economic perspective

Embedded losses


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EARNINGS PERSPECTIVE

In the earnings perspective, the focus of analysis is the impact ofchanges in interest rates on accrual orreported earnings. This isthe traditional approach to interest rate risk assessment taken bymany banks.

Variation in earnings is an important focal point for interest raterisk analysis because reduced earnings or outsight losses canthreaten the financial stability of an institution by undermining itscapital adequacy and by reducing market confidence.


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EARNINGS PERSPECTIVE (CONTI.)

In this regard, the component of earnings that has traditionallyreceived the most attention is net interest income, this focusreflects both the importance of net interest income in banks overallearnings and its direct and easily understood link to changes in

inter

estr

ates.

However, as banks have expanded increasingly into activities thatgenerate fee-based and other non-interest income, a broader focuson overall net income incorporating both interest and non-interestincome and expenses has become more common.


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EARNINGS PERSPECTIVE (CONTI.)

By extension, the economic value of a bank can be viewed as the presentvalue of the banks expected bet cash flows, defined as the expected cashflows on assets minus the expected cash flows on liabilities plus theexpected net cash flows on OBS positions.

In this sense, the economic value perspective reflects one view of thesensitivity of the net worth of the bank to fluctuations in interest rates.


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EMBEDDED LOSSES

The earnings and economic value perspective discussed thusfar focus on how future changes in interest rates may affecta banks financial performance.

When evaluating the level of interest rate risk it is willing andable to assume, a bank should also consider the impact thatpast interest rates may have on future performance.

In particular, instruments that are not marked to market mayalready contain embedded gains or losses due to past rate

movements. These gains or

losses may bereflected ove

rtimein the banks earnings.

For example, a long-term, fixed-rate loan entered into wheninterest rates were low and refunded more recently withliabilities bearing a higherrate of interest will, over its

remaining life, represent a drain on the banks resources


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MEASUREMENT OF INTEREST RATERISK

Before risk can be managed they must be identified andquantified. Unless the quantum of risk inherent in a banksbalance sheet is measured, it is impossible to measure thedegree of risk to which bank is exposed.

It is also equally impossible be develop effective riskmanagement strategies/techniques without being able tounderstand the correct risk position of the bank.


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MEASUREMENT OF INTEREST RATERISK

o Utilise generally accepted financial concepts and risk measurementtechniques;

o Have well-documented assumptions and parameters.

A number of techniques are available for measuring the interestrate risk exposure of both earnings and economic value.

Their complexity ranges from simple calculations to static

simulations using current holdings to highly sophisticated dynamicmodeling techniques based on potential future business activities.


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INTEREST RATE RISK MEASUREMENTTECHNIQUES

Banks use various techniques to measure the exposure of earningsand of economic value to changes in interest rates.

The general approaches can be used to measure interest rate riskexposure from both an earnings and an economic value perspective.

The methods vary in their ability to capture the different forms of

interest rate exposure: the simplest methods are intended primarilyto capture the risks arising from maturity and repricing mismatches.


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REPRICING SCHEDULES

The simplest techniques for measuring a banks interestrate risk exposure begin with repricing schedule.

That distributes interest-sensitive assets and liability

into a cer

tain number

of pr

edefined time bands accor

dingto their maturity or time remaining to their next repricing.

Those assets and liabilities lacking definitive repricingintervals or actual maturities that could vary fromcontractual maturities are assigned to repricing timebands according to the judgment and past experience ofthe bank.


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GAP ANALYSIS

Gap analysis was one of the first methods developed tomeasure a banks interest rate risk exposure and continues tobe widely used by banks.

To evaluate earnings exposure, interest rate-sensitiveliabilities in each time band are subtracted from thecorresponding interest rate-sensitive assets to produce arepricing gap for that time band.

This gap can be multiplied by an assumed change in interestrates to yield an approximation of the change in net interestincome that would result from such an interest ratemovement.


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A negative or liability sensitive gap occurs when liabilitiesexceed assets in a given time band that is more liabilitiesreprice than assets

A positive or asset-sensitive gap occurs when interest-earningassets exceed interest-bearing liabilities for a specific orcumulative maturity period, that is, more assets reprice than

liabilities.

GAP ANALYSIS


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DURATION

Duration is the time-weighted average maturity of thepresent value of the cash flows from assets, liabilities andoff-balance sheet items.

It measures the relative sensitivity of the value of theseinstruments to changing interest rates .

Duration measures how price-sensitive an asset, liability oroff-balance sheet item is to small changes in interest rates byusing a single number to index the institutions interest raterisk.


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This index represents the average term to maturity of thecash flows.

Moreover, traditional duration analysis assumes that the cashflows of assets and liabilities are known, which may not alwaysbe the case.

Limitations in using duration analysis arise from the fact thatmatching the average term or duration of asset and liabilitycash flows does not eliminate all interest rate risk.

DURATION


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SIMULATION APPROACHES

Simulation models are a valuable complement to gap andduration analysis.

These analysis evaluate interest rate risk arising from bothcurrent and future business and provide a way to evaluate theeffects of strategies to increase earnings orreduce interestrate risk.

Simulation models can also be used to calculate the presentvalue and durations of assets and liabilities.


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STRATEGIES FOR CONTROLLING INTERESTRATE RISK

The actual management of banks assets and liabilities focuseson controlling the gap between Rate Sensitive Assets andRate Sensitive Liabilities.

Some banks pursue a strategy of matching assets andliabilities maturities as closely as possible to reduce the gapto zero and insulate the NII from the volatility of interestrate.

Reduce Asset Sensitivity

Extend investment portfolio maturities


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Increase short-term borrowings

Reduce Liability Sensitivity

Increase long-term deposits

Increase short-term deposits

STRATEGIES FOR CONTROLLING INTERESTRATE RISK


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PRODUCTS OF

INTERESTRATE RISK


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FORWARD RATE AGREEMENT

This is a contract and a financial instrument that is used hashedge against interest rate adverse fluctuations on deposit orloans starting in near future.

This resembles to forward exchange rate agreements to fixthe exchange rates.


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FEATURES OF FORWARD RATEAGREEMENT

It is between a bank and a client for fixingfuture interest rate on notional amount of loan or deposit.

The loan or deposit is for a stated period starting on aspecified time in future.

The size of the notional loan or deposit is agreed between thebank and the client.


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FEATURES OF FORWARD RATEAGREEMENT (CONTI.)

At settlement date buyer and seller must settle the contract.

The buyer of a FRA agrees to pay fixed interest rate onnotional loan/deposit. At the same buyer willreceive interest on notional loan/deposit at benchmark rateof interest.


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INTEREST OPTION

CALL OPTIONA call option gives the buyer the right to buy the underlyingvalue at the end of a specified period at a fixed price (strike).The buyer pays a premium for this right. The buyer is not

obliged to exercise this right. The maximum loss is thereforelimited to the price of the premium.

PUT OPTIONAn put option gives the buyer the right on sell the underlying

value at the end of a specified period at a fixed price. Thebuyer pays a premium for this right. The buyer is not obligedto exercise this right. The maximum loss is therefore limitedto the price of the premium.


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INTEREST RATE SWAP

An interest rate swap is also known as an IRS or simply as aswap. An interest rate swap is, in fact, an exchange. In aninterest rate swap two parties agree to swap their interestobligations.

FIXED INTERESTDuring the term of the swap one party pays a fixed interestto the other party. The level of the fixed interest is agreedat the start of the term.

VARIABLE INTERESTIn return, the counter-party pays the variable interest. Thevariable interest depends on changes in the money market

interest

rate.


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CUSTOMIZATION

A swap is a private agreement between two parties.

This makes customization possible.

The bank can match the specifications of a swap precisely toneeds. Once a swap has been agreed it is easy to unwind orclose. When a swap is unwound, the parties settle the cashvalue.

These possibilities increase the opportunity to activelymanage the interest risk.


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CONCLUSION

The deregulation of the financial system in India has put inplace a lot of operational freedom to the financial institutionsand the pricing of various assets and liabilities has been leftto their commercial judgment.

Thus, interest rate risk, a term totally unknown to thebanking industry in India has suddenly becomes relevant.


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risk mangaement final 2

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