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.
CHAPTER I
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models will also be discussed which would enable us to prescribe benchmarks for the
purpose of decision making in dispensing credit.
Any activity involves risk, touching all spheres of life, both personal
and business, Risk is pervasive condition of human existence. The term risk has a
variety of meaning in business and everyday life. Traveling in a car, crossing the
road, investing in financial instruments, launching a new product all involves risk. At
its most gnarl level, risk is used to describe any situation where there is uncertainty
about what outcome will occur. Although our instinctive understanding of concept of
risk is clear enough, terms that have a simple meaning in everyday usage sometimes
have a specialized connotation when used in particular field.
DEFINATION
There is no universal accepted definition of risk. The term risk is variously defined as
a) The chance of loss,
b) The possibility of loss,c) Uncertainty,
d) The dispersion of actual from expected results or
e) The probability of any outcome different from the on expected.
The Basel committee has defined risk as the probability of the unexpected
happening-the probability of suffering a loss.
Prof. John Geiger has defined risk as an expression of the danger that the
effective future outcome will deviate from the expected in a negative way.
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Vaughan & Vaughan defined risk as A condition in which there is a
possibility of an adverse deviation from desired outcome that is expected or hoped
for.
The four letters comprising the word R I S Kdefine its features.
R= Rare (unexpected).
I = incident (outcome).
S = selection (identification).
K= knocking (measuring, monitoring, controlling).
RISK, therefore, needs to b looked at from four fundamental aspects:
Identification
Measurement
Monitoring
Control (including risk audit)
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RISK VS UNCERTAINITY
Uncertainty must be taken in a sense radically distinct from the
familiar notion of Risk, from which it has never been properly separated, The term
risk, as loosely used in everyday speech and in economic discussion, really covers
two things which, functionally at least, in their causal; relations to be phenomena of
economic organization, are categorically different. The essential fact is that risk
means in some cases a quantity susceptible of measurement, while at other times it is
something distinctly not of this character; and there are far-reaching and crucial
differences in the bearings of phenomenon depending on which of which of the two is
really present and operating. It will appear that a measurable uncertainty, or risk
proper, as we shall use the term, is so far different from an immeasurable one that it is
not in effect an uncertainty at all. We accordingly restrict the term uncertainty to
cases of the non-quantities type.
TYPES OF RISKS
The risk profile of an organization may be reviewed from the following angles:
A. BUSINESS RISK:
I. capital risk.
ii. Credit risk.
iii. Market risk.
iv. Liquidity risk
V. business strategy and environment risk.
vi. Operational risk.
vii. Group risk.
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B. CONTROL RISK:
i. Internal controls.
ii. Organization.
iii. Management (including corporate governance).
iv. Compliance.
Both these types of risk, however, are linked to the three omnibus risk categories
listed below:
1. Credit risks.
2. Market risks.
3. Organizational risks.
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CLASSIFICATION OF RISK
Different risks require different methods and approaches to deal with them.
Pure Vs. Speculative Risk
As per the outcome of an event, a risk can either be pure or speculative. Pure
risk refers to those events whose effects cause either loss or no loss to the enterprise
in all circumstances but no gain. The chances of making any profit from such risk
occurrences are abysmally low. A few examples of pure risk are fire, theft,
earthquake, death, accident, etc. In case of speculative risk, the outcome may result in
either a loss or a profit to; the organization. Examples of speculative risk for an
organization include reduction in the selling price of its product, increasing number of
distribution outlets, merger with any other organization, etc. Thus most of the
speculative risks are from within the organization and are business-related. Some
speculative risks are optional. Investment in equity of another company is an option,
and not mandatory. Hence the risk arising out of such decision is optional and
avoidable if desired so. Usually an insurance company insures pure risks but not
speculative risks.
Classification of Pure Risks
There are four broad categories of pure risk. They are
Property risk
Personal risk
Liability risk
Loss of income risk.
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Property Risk
In this case there is a fear of loss of property because of some unforeseen
events. Property includes both movable and immovable assets. There are always
chances of loss of house because of earthquake, heavy storm and other natural
calamities. Similarly a severe damage to a personal computer may be caused because
of repetitive power failure or low voltage. Property risk is further divided into two
categories, namely direct loss and indirect loss.
The value of the property destroyed due to a given peril is a direct loss and the
additional expenses incurred due to the destruction of the property are the indirect
loss. Business establishment if there is loss to the stock because of fire, the company
not only loses the stock but also the time to make up the pending supply orders.
Chances are that it may lose some customers. This results in indirect loss to the
business.
Personal Risk
It refers to the possibility of loss of income or assets as a result of the loss of
the ability; to earn income. This may result from untimely death of the earning
member, dependent old age, prolonged illness, disability or unemployment.
Apart from individuals, organizations are also subject to personal loss
exposures. When employees meet with accidents, it may result in injuries or death.
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Liability Risk
Liability risk arises when there is a possibility of an unintentional damage to
other person or to his property because of negligence. However, the chances of
intentional harm are not ruled out in certain circumstances.
Legally speaking a person cannot be exonerated from his activities either
intentional or unintentional, if it he same result in loss to some other person or his
property. Thus there are always chances that liability risk is to be met because of
ones activities causing adversity to another person.
For example, construction of big dams results in dislocation of a number of villagers.
Loss of Income Risk
Loss of income risk is an indirect loss from a given risk. As discussed under
property risks, whenever there is a direct loss, it is followed by some consequencesthat result in indirect loss.
For example, if a textile companys premises were destroyed in an earthquake, the
production facilities and plant layout are also disturbed and it would take some time
to come back to the normal level of production. During this time the cost of
production will tend to be high and the production stoppage will lead to loss of
income.
Some times the direct loss will be minimum but the indirect losses will be
quite high. For instance, consider the plight of an Internet service provider where, an
electrical short circuit resulted in hard disk crash and loss of data.
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Dynamic vs. Static Risk
Static risk remains constant over an observed period of time. Risks remain static
because the environments in which they exist are static.Dynamic risks arise from the changes that occur in an environment, which may be
economic, social, technological, and political. Change in the environment creates risk
and uncertainty about the future.
Fundamental vs. Particular Risks
Those risks, which affect a larger group, such as a society or an industry, or a
particular segment of an industry, are termed as fundamental risks. For example,
natural calamities such as flood, earthquake, drought, epidemics, etc. affect the whole
mass in the same manner irrespective of caste, creed or religion or geographical
boundaries.
Attitude towards Risk
Attitude towards risk reflects the perception or a mental position with regard
to a fact or state, or it is a feeling or emotion towards a fact or a situation. Individuals
can be grouped into three different categories as per their attitude towards risk. They
are:
Those who are neutral/indifferent to risk,
Those who are willing to take up risks, and
Those who avoid risk.
Human Response to Risk
It is not possible for an individual or an organization to avoid risk. Every
organization is exposed to risks of various degrees in the course of business. It is the
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duty of the risk manager of a company to analyze the characteristics of risks to which
the organization is exposed and develop suitable strategies to minimize the same.
Mankind has developed various tools and techniques to safeguard itself
against the perceived risks and hazards since the dawn of civilization. Though the
procedures or methods adopted for the purpose might have undergone a sea change,
the objective remains the same. As the saying goes, Man proposes and God
disposes, the uncertainty of outcome of any future event adds to the severity of risk
in any situation.
OBJECTIVES OF THE STUDY
To study the methodology of risk analysis adopted by the company
To understand the various risks involved in setting up an industrial project
To study various measures for controlling the risk
METHODOLOGY
The format of the study was fixed after referring various books and reports
from libraries and internet.
It helped in identifying the approach needed for project work, research
methods and report making.
Sources of these literatures are mentioned in references.
Data collection
For the preparation of any project report the collection of relevant data is
very much essential. There are basically two broad methods for collecting data,
which are followed in any report. These methods are:
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Primary data collection.
Secondary data collection.
The sources of secondary data are: Printed or published financial
statements of the corporation, Annual reports of the company.
Limitations of the study
The study is conducted for the purpose of fulfillment of the conditions
stipulated by the University for Completion of course, so the study may notfulfill all the requirements of a detailed investigation.
As I am learner, I may not be able to provide a proper findings and
suggestions.
Time was a major constraint for knowing the entire process in depth..
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CHAPTER II
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PROFILE OF THE COMPANY
Dr. Reddys Laboratories Ltd. Founded in 1984 by Dr. K. Anji Reddy,
has become Indias third biggest pharmaceutical company. Reddy had worked in the
publicly-owned Indian Drugs and Pharmaceuticals Ltd. Reddy's manufactures and
markets a wide range of pharmaceuticals in India and overseas. The company more
than 190 medications ready for patients to take, 60 active pharmaceutical ingredients,
for drug manufacture, diagnostic kits, critical care and biotechnology products.
Reddys began as a supplier to Indian drug manufacturers, but it soon started
exporting to other less-regulated markets that had the advantage of not spend time
and money on a manufacturing plant that that would gain approval from a drug
licensing body such as the USs Food and Drug Administration. Much of Reddys
early success came in those unregulated markets, where process patents not product
patents are recognized. With that money in the bank, the company could reverse-
engineer patented drugs from more developed countries and sells them royalty-free in
India and Russia. By the early 1990s, the expanded scale and profitability from these
unregulated markets enabled the company to begin focusing on getting approval from
drug regulators for their formulations and bulk drug manufacturing plants in more-
developed economies. This allowed their movement into regulated markets such as
the US andEurope.
By 2009, Reddys had six FDA-plants producing active pharmaceutical
ingredients in India and seven FDA-inspected and ISO 9001 (quality) and ISO 14001
(environmental management) certified plants making patient-ready medications five
of them in India and two in the UK.
By 2010 Dr. Reddys Q3 FY09 Revenue at Rs. 18,401 million,EBITDA at Rs. 3,453
million, PAT at Rs. 1,924 million
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By 2010 Dr. Reddys Q3 FY10 Financial Results: Revenues at Rs. 17,296 million;
EBITDA at Rs. 3,666 million, Profits after Tax adjusted for impairment at Rs. 2,307
million.
ABOUT DR.REDDYS
Established in 1984, Dr. Reddy's Laboratories (NYSE: RDY) is an emerging
global pharmaceutical company with proven research capabilities. The Company is
vertically integrated with a presence across the pharmaceutical value chain. It
produces finished dosage forms, active pharmaceutical ingredients and biotechnology
products and markets them globally, with focus on India, US, Europe and Russia. The
Company conducts research in the areas of diabetes, cardiovascular, anti-infectives,
inflammation and cancer.
KEY MILESTONES
1984
Dr Anji Reddy establishes Dr. Reddy's Laboratories with an initial capital outlay ofRs.25 lakhs
1986
Dr. Reddys goes public Dr. Reddys listed on Bombay Stock Exchange (BSE) Dr. Reddys enters international markets with exports of Methyldopa
1987
Obtains its first USFDA approval for Ibuprofen API Starts its formulations operations
1988
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Acquires Benzex Laboratories Pvt. Limited to expand its Bulk Activesbusiness.
1990
Dr. Reddys, for the first time in India, exports Norfloxacin and Ciprofloxacin toEurope and Far East.
1991
First formulation exports to Russia commence.
1993
Dr. Reddy's Research Foundation established. The company drug discoveryprogramme starts.
1994
Makes a GDR issue of USD 48 million Foundation stone laid for a finished dosages facility to cater to the highly
regulated markets such as the US.
1995
Sets up of a Joint Venture in Russia.
1997
Licenses anti-diabetic molecule, DRF 2593 (Balaglitazone), to Novo Nordisk.Becomes the first Indian pharmaceutical company to out-license an originalmolecule.
First ANDA filed with the United States Food and Drug Administration forRanitidine
1998
Licenses anti-diabetic molecule, DRF 2725 (Ragaglitazar), to Novo Nordisk
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1999
Acquisition of American Remedies Limited, a pharmaceutical company basedin India.
2000
Dr. Reddy's Laboratories becomes India's third largest pharmaceuticalcompany with the merger of Cheminor Drugs Limited, a group company
Reddy US Therapeutics, a wholly-owned subsidiary, is established at Atlanta,US to conduct target based drug discovery
2001
Becomes the first Asia Pacific pharmaceutical company, outside Japan, to liston the New York Stock Exchange. Listed with the symbol RDY on April 11,2001.
Out-licenses DRF 4158 to Novartis for up to US $55 million upfront payment Launches its first generic product, Ranitidine, in the US market Becomes the first Indian pharmaceutical company to obtain an 180-day
exclusive marketing rights for a generic drug in the US market with the launchof Fluoxetine 40 mg capsules on August 3, 2001
2002
Conducts its first overseas acquisition BMS Laboratories Limited and MeridianHealthcare in UK3
2003
Announces a 15-year exclusive product development and marketingagreement for OTC drugs with Leiner Health Products in the US
Launches Ibuprofen, first generic product to be marketed under the Dr.Reddys label in the US
2004
Acquires Trigenesis gives access to drug delivery technology platforms
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2006
Acquires Roche's API Business at the state-of-the-art manufacturing site in Mexico with a total investment of USD 59 million.
announces the formation of Perlecan Pharma: Indias First Integrated Drug
Development Company.Announces India's first major co-development and commercialization deal
for its molecule Balaglitazone (DRF 2593), with Rheoscience.announces a unique partnership for the commercialization of ANDAs with
ICICI Venture.
2009
Revenues touch USD 1 Billion in December 2009.Dr. Reddy's obtains its second 180-day marketing exclusivity for a generic
drug in the US market with the launch of Ondenesetron Hydrochloride
Tablets.becomes an Authorized Generic Partner for Mercks Proscar & Zocor
in the US market during 180 day exclusivity period.Acquires betapharm- the fourth-largest generics company in Germany for a
total enterprise value of 480 million.
2010
Becomes No.1 pharmaceutical company in India in turnover and profitability.
2010
Announces strategic alliance with GlaxoSmithKline plc to develop and marketselect products across emerging markets outside India.
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CORPORATE GOVERNANCE
Dr. Reddy's long-standing commitment to high standards of corporate
governance and ethical business practices is a fundamental shared value of its
Board of Directors, management and employees. The Company's philosophy
of corporate governance stems from its belief that timely disclosures,
transparent accounting policies, and a strong and independent Board go a long
way in preserving shareholder trust while maximizing long-term shareholder
value.
The company has identified and articulated its core purpose, mission and
values in keeping with its desire for achieving corporate excellence. Dr.
Reddy's believes in creating an environment where the parameters of conduct
and behavior of the company and its management is constantly aligned with
the business environment.
The mainstays of Dr. Reddy's Corporate Governance systems are an
independent Board of Directors following international practices, a committed
management team, rigorous internal control systems and the transparent
dissemination of information to stakeholders.
Committees of the Board
Committees appointed by the Board focus on specific areas and take informeddecisions within the framework of delegated authority, and make specificrecommendations to the board on matters in their areas or purview. All decisions andrecommendations of the committees are placed before the Board for information orfor approval.
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Dr. Reddy's has seven Board-level Committees, namely
The Audit Committee The Compensation Committee The Governance Committee The Shareholders' Grievance Committee The Investment Committee The Management Committee
The members of the Committees of Board are as under:
Audit Committee Management CommitteeDr. Omkar Goswami (Chairman)Kalpana Morparia
Ravi Bhoothalingam
Satish Reddy (Chairman)G V Prasad
P N Devarajan
Compensation Committee Investment CommitteeRavi Bhoothalingam (Chairman)Kalpana MorpariaP N DevarajanDr. JP Moreau
G V Prasad (Chairman)Satish ReddyP N Devarajan
Governance Committee Shareholders' Grievance CommitteeAnupam Puri (Chairman)
Prof. Krishna G PalepuDr. Omkar Goswami
P N Devarajan (Chairman)
G V PrasadSatish Reddy
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AWARDS AND ACCOLADE
The Appreciation Certificate of the District Collector for being the Best Clean
Production Industry for the year 2010 was awarded to API Unit V.
The CII Southern Region Leadership Excellence Award was awarded to
Dr. Reddy's for the year 2009.
The CII National Award for Excellence in Water Management for the year
2005 was awarded to both API Units II and VI.
The FTO III Unit of Dr. Reddy's achieved the ISO 14001:2004 standard on
June 9, 2005.
The Genentech Environmental Excellence Silver Award for the year
2004-05 was awarded to the API Global Business Unit.
KEY PERSONS
1. Mr.Dr.K.ANJI REDDY CHAIRMAN
2. Mr.G.V.PRASAD VICE CHAIRMAN & C.E.O
3. Mr.SATISH REDDY M.D & C.O.O
4. Mr.Dr.OMKAR GOUSWAMI
5. Mr.RAVI BHOOTHALINGAM
6. Mr Dr.KRISHNA PALEPU
7. Ms.KALPANA MORPARIA
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8. Mr.J.P.MORE
OTHER OBJECTS:
1. To carry on the business of Distributors, Dealers, Wholesalers, Retailers,
Commission Agents,
Manufacturers, Representatives for all types of products.
2. To carry on the business of professionals for all types of services.
3. To carry on the business of design, engineering and execution and
implementation of various
Types of projects on contract or turnkey basis and to acquire the designing or
technical know how.
4. To cultivate, grow, produce or deal in any vegetable products and to carry
on the business of
Farmers, dairy man, milk contractors, dairy farmers, millers, surveyors and
vendors of milk cream,
Cheese, butter and poultry and provision of all kinds, growers of and dealers
in corn, lay and
Straw, seeds men and nursery men and to buy, sell and trade in any goods
usually traded and of
The above business or other business associated with the farming interest
which may be
Advantageously carried on by the company.
5. To carry on the business of manufacturers, fabricators, erectors, dealers of
in all types of
Chemical equipment, pumps, valves, storage tanks etc. required by the
chemical and Pharmaceutical industry.
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6. To purchase plant, machinery, tools and implements from time to time and
he selling or disposing of the same.
7. To transact or carry on all kinds of agency business and in particular, in
relation to the investment of money, the sale of property and collection and
receipt of money, or otherwise of any assets, funds and business under any
agreement.
8. To carry on and undertake the business of investing its funds in equity and
preference shares, stocks, bonds, debentures (convertible and non-
convertible) of new projects and securities of all kinds and every description
of well established and sound companies, to subscribe to capital issues of
joint stock companies, ventures, industries, units, trading concerns whether
old or new as the company my think fit and to assist them by granting
financial accommodation by way of loans/advances to industrial concerns and
to assist industrial enterprises in creation , expansion and modernization upon
terms whatsoever and to act as finance brokers, merchants and commission
agents and to deal in Govt. Securities including Govt. bonds, loans, Nationalsavings
Certificates, post office saving schemes, units of investments etc., include
units of Unit Trust of India.
9. To promote industrial finance, deposit or lend money, securities and
properties to or with any company, body corporate, firm person or association
whether falling under the same management otherwise, in accordance with
and to the extent permissible under the provisionscontained in Section
370&372 of the, Companies Act, 1956, with or without security and on such
Terms as may be determined from time to time. However, the company shall
not carry on the business of Banking as defined under the Banking
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Regulation Act. 1949; and to carry on and undertake the business of finance,
investment and trading, hire purchase, leasing and to finance lease
operations of all kinds, purchasing, selling, hiring or letting on hire of all kinds
of plant and machinery and equipment that the Company may think fit and to
assist in financing operations of all and every kind of description of hire
purchase or deferred payment or similar transactions and to subsidies finance
or assist in subsidizing or financing the sale and maintenance of any goods,
articles or commodities of all and every kind of description upon any terms
whatsoever and to purchase or otherwise deal in all forms of immovable and
movable property, including lands and buildings, plant and machinery,
equipment, ships, aircraft, automobiles computers and all consumer,
commercial and industrial items and to lease or otherwise deal with them in
any manner whatsoever including release there of regardless of whether the
property purchased and leased be now and /or used.
10. To provide a package of investment/merchant banking services by acting
as manages to public issue securities, by underwriting securities, act as IssueHouse and to carry on the business of registrars to investment schemes,
Money managers to secure and extend market support by conducting
surveys, collecting data, information and reports and to act as general traders
and
Agents, to carry on the agency business and warehousing indenting and
dealership of business.
IV. The liability of the members of the company is limited.
V. a. The authorized share capital of the company is Rs.50,00,00,000/- (Rs.
Fifty Crores Only)divided into 10,00,00,000 equity shares of Rs.5/- (Rs. Five
only) each.
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b. The company has power from time to issue shares, Hybrids, Derivatives,
Options, Quasiequity Instruments, with differential rights, or to increase,
consolidate, sub-divide, exchange,reduce and also to purchase any of its
shares whether or not redeemable and to make payments out of its capital in
respect of such purchase or otherwise alter its share capital as equity or non
voting equity shares or preference shares and to attach to any classes of
such shares preferences, rights, privileges or priorities in payment of
dividends or distribution of assets or otherwise, over any other shares and to
subject the same to any restriction, limitation or condition and to vary the
regulation of the company, as for apportioning the right to participate in profits
in any manner subject to the provision of the Act and consent of the
appropriate authorities if required, being obtained before doing so. We the
several persons whose names, addresses and description are subscribed
hereto are desirous of being formed into a company in pursuance of the
Memorandum of Association and we respectively agree to take the number of
shares in the Capital of the Company set opposite to our respective names.
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CHAPTER III
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RISK MANAGEMENT:
Risk management is a scientific approach applied to the
problem of risk. Although the term risk management is a recent
phenomenon, the actual practice of risk management is as old as
civilization itself. Risk management allows financial institutions to
bring their risk leels to manageable proportions while not severely
reducing their income. Factors like increasing competition,
innovative products, technological revolution, and changing
external operating environment makes it necessary that proper risk
management systems b implemented, Risk management is thus a
functional necessity and adds to the strength and efficiency of an
organization on an ongoing basis.
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Risk Management Techniques:
Risk management is a structured approach to managing uncertainty through,
risk assessment, developing strategies to manage it, and mitigation of risk using
managerial resources.
The strategies include transferring the risk to another party, avoiding the
risk, reducing the negative effect of the risk, and accepting some or all of the
consequences of a particular risk.
Some traditional risk managements are focused on risks stemming from
physical or legal causes (e.g. natural disasters or fires, accidents, death and lawsuits).
Financial risk management, on the other hand, focuses on risks that can be managed
using traded financial instruments. Objective of risk management is to reduce
different risks related to a preselected domain to the level accepted by society. On the
other hand it involves all means available for humans, or in particular, for a risk
management entity (person, staff)
Steps in the risk management process
Establish the context
Establishing the context involves
1. Identification of risk in a selected domain of interest
2. Planning the remainder of the process.
3. Mapping out the following:
o the social scope of risk management
o the identity and objectives of stakeholders
o The basis upon which risks will be evaluated, constraints.
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4. Defining a frameworkfor the activity and an agenda for identification.
5. Developing an analysis of risks involved in the process.
6. Mitigation of risks using available technological, human and organizational
resources.
Identification
After establishing the context, the next step in the process of managing riskis
to identify potential risks. Risks are about events that, when triggered, cause
problems. Hence, risk identification can start with the source of problems, or with the
problem itself.
Source analysis Risk sources may be internal or external to the system that
is the target of risk management. Examples of risk sources are: stakeholders of
a project, employees of a company or the weather over an airport.
Problem analysis Risks are related to identify threats. For example: the
threat of losing money, the threat of abuse of privacy information or the threat
of accidents and casualties. The threats may exist with various entities, most
important with shareholders, customers and legislative bodies such as the
government.
Resources and consider the threats they are exposed to and the consequences
of each. Alternatively one can start with the threats and examine which
resources they would affect, or one can begin with the consequences and
determine which combination of threats and resources would be involved to
bring them about.
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Assessment
Once risks have been identified, they must then be assessed as to their
potential severity of loss and to the probability of occurrence. These quantities
can be either simple to measure, in the case of the value of a lost building, or
impossible to know for sure in the case of the probability of an unlikely event
occurring. Therefore, in the assessment process it is critical to make the best
educated guesses possible in order to properly prioritize the implementation of the
risk management plan.
The fundamental difficulty in risk assessmentis determining the rate of
occurrence since statistical information is not available on all kinds of past
incidents. Furthermore, evaluating the severity of the consequences (impact) is
often quite difficult for immaterial assets. Asset valuation is another question that
needs to be addressed. Thus, best educated opinions and available statistics are the
primary sources of information. Nevertheless, risk assessment should produce
such information for the management of the organization.
That the primary risks are easy to understand and that the risk managementdecisions may be prioritized. Thus, there have been several theories and attempts to
quantify risks.
Numerous different risk formulae exist, but perhaps the most widely
accepted formula forriskquantification is:
Rate of occurrence multiplied by the impact of the event equals risk
Later research has shown that the financial benefits of risk management are
less dependent on the formula used but are more dependent on the frequency and how
risk assessmentis performed.
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In business it is imperative to be able to present the findings of risk
assessments in financial terms. Robert Courtney Jr. (IBM, 1970) proposed a formula
for presenting risks in financial terms. The Courtney formula was accepted as the
official risk analysismethod for the US governmental agencies. The formula proposes
calculation of ALE (annualized loss expectancy) and compares the expected loss
value to the security control implementation costs (cost-benefit analysis).
The Effect of Risk
As mentioned earlier risk results in gains or losses. If we invest in an equality
share we may gain or lose when we sell it at a later date. If a fire accident occurs in a
warehouse it will result in losses only. We are very much concerned with negative
impact of risk when we attempt to manage it. Loss is a state wherein someone is
deprived of something he/she had. When we attempt to assess the risk, it is important
to know from whose point of view the risk is being assessed. It can be perceived from
the point of view of the insurer or the insured from the point of view of an insurance
agency risk may be perceived fro thepurpose of assessing the degree of vulnerability
of a particular object to a particular event.
Potential risk treatments
Once risks have been identified and assessed, all techniques to manage the
risk fall into one or more of these four major categories: (Dorfman, 1997)
Avoidance (elimination)
Reduction (mitigation)
Retention
Transfer ( buying insurance)
Risk avoidance:
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Includes not performing an activity that could carry risk. An example would
be not buying apropertyor business in order to not take on the liabilitythat comes
with it. Another would be not flying in order to not take the risk that the airplane were
to be hijacked. Avoidance may seem the answer to all risks, but avoiding risks also
means losing out on the potential gain that accepting (retaining) the risk may have
allowed. Not entering a business to avoid the risk of loss also avoids the possibility of
earning profits. Risk Reduction.
Involves methods that reduce the severity of the loss or the risk of the loss
from occurring. Examples include sprinklers designed to put out a fireto reduce the
risk of loss by fire. This method may cause a greater loss by water damage and
therefore may not be suitable. Halon fire suppression systems may mitigate that risk,
but the cost may be prohibitive as a strategy.
Modern software development methodologies reduce risk by developing and
delivering software incrementally. Early methodologies suffered from the fact that
they only delivered software in the final phase of development; any problems
encountered in earlier phases meant costly rework and often jeopardized the whole
project. By developing in iterations, software projects can limit effort wasted to asingle iteration.
Outsourcing could be an example of risk reduction if the outsource can
demonstrate higher capability at managing or reducing risks. In this case companies
outsource only some of their departmental needs. For example, a company may
outsource only its software development, the manufacturing of hard goods, or
customer support needs to another company, while handling the business
management itself. This way, the company can concentrate more on business
development without having to worry as much about the manufacturing process,
managing the development team, or finding a physical location for a call center.
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Risk retention:
Involves accepting the loss when it occurs. True self insurance falls in this
category. Risk retention is a viable strategy for small risks where the cost of insuring
against the risk would be greater over time than the total losses sustained. All risks
that are not avoided or transferred are retained by default. This includes risks that are
so large or catastrophic that they either cannot be insured against or the premiums
would be infeasible. Waris an example since most property and risks are not insured
against war, so the loss attributed by war is retained by the insured. Also any amounts
of potential loss (risk) over the amount insured are retained risk. This may also be
acceptable if the chance of a very large loss is small or if the cost to insure for greatercoverage amounts is so great it would hinder the goals of the organization too much.
Risk transfer:
Means causing another party to accept the risk, typically by contract or by
hedging. Insurance is one type of risk transfer that uses contracts. Other times it may
involve contract language that transfers a risk to another party without the payment of
aninsurance premium. Liability among construction or other contractors is very often
transferred this way. On the other hand, taking offsetting positions in derivatives is
typically how firms use hedging to financially manage risk.
Some ways of managing risk fall into multiple categories. Risk retention
pools are technically retaining the risk for the group, but spreading it over the whole
group involves transfer among individual members of the group.
This is different from traditional insurance, in that no premium is exchangedbetween members of the group up front, but instead losses are assessed to all
members of the group.
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RISK MANAGEMENT ESSENTIALS
After reading this chapter, you will be conversant with
The nature of risk management
The evolution of risk management
Risk in personal life
Corporate/organizational risks
The process of risk management
Nature of Risk Management
Risk management aims to at controlling the risk exposure of a firm. It is a
rational approach towards controlling the risk to which an organization or an
individual is exposed to; risk management function can be grouped with other
management functions such as financial management, human resources management,
etc. An over view of different risks will help us to understand the nature of risk
management organizations and individuals are exposed to a wide arrays of risk in
their day-to-day operations, such as
1 Fire risk
2 Risk of theft
3 Loss of customers
4 Delay in delivery of raw materials
5 Break down of machinery
6 Accidents
7 Bad debts
8 Changes in industrial policy whenever the government changes
9 Changes in financial markets
10 Changes in taxation etc.
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The perspective of risks management varies from one individual.
Organizations have their own views on risk. Many scholars and practitioners
Agree that risk management is an evolving science while a distinct minority
feels that it is going to disappear in the years to come. In between there are many
views on the nature of risk management.
The traditional view of risk management, believes that risk management is
an interdisciplinary science that manages that pure risk of an organization. According
to this view risk management is not changing radically but moving in increments,
there fore it is an evolving science. This view recommends insurance purchase as a
risk management solution.
1 Hardware
2 Software failure
3 Organization failure
4 Human failure
Development of Risk Management
Risk management as discussed earlier is Avery old method through which the
organization aims to cover the perils to which the organization is exposed. The most
popular method advocated by traditional view was buying insurance. In 1929, the
corporate insurance buyers met and started discussing various problems of mutual
interest. Though the meeting was not a formal one, it was a precursor to orient
corporate thinking and deal with risk in a more systematic way. In 1931, the
American management association established an insurance division. The primary
objective of the division was to provide a platform for discussing about risk
management and publish news and views of the members. This helped in creating
awareness among the various risk managers about the existence of a systematic wing
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for managing the risk. National insurance buyers association was started in America,
which was later renamed as risk insurance management society (RIMS).
Though risk management penetrated deep in the world business as a form of
insurance, it had yet to carve a niche in the world of personal insurance, as the
individual risk management awareness arrived at a later stage of the growth of the
risk management. It is difficult to say whether the growth in risk management can be
attributed to the growth in business practices. But it can be said that the development
of present day risk management activities stem from the development which took
place during early 1950s. Risk management practices were in vogue prior to this
period, but they were not universally popular. In other ways the different countries
were having different sets of underlying principles, philosophy and strategies to
manage the risk management.
1 Maturity of the risk management.
2 Ability and knowledge of risk manager.
3 Types of organization.
During the earlier period, management was developed as an independent
function of management, as most of the organization perceived it as an offshoot of
financial management. This may be because of the conversion and measurement of
risk, which in turn resulted in underwriting of insurance policies in financial terms, as
was the case of the hierarchy of the risk manager in the organization. Previously, risk
managers were either working under the finance department of purchase department.
1 Reliability movement of the 1950s
2 System safety movement of the 1960s and the 1970s
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He illustrated how the concepts of safety management were well adopted in
risk management. He implied this way of risk management to be more inclined
towards the financial side of risk management.
The practice of risk management in Indians public sector is ever three decades
old. The reasons for late recognition of the importance of risk management are many.
In India government organization are immune to different types of legal liability and
the effect of any other exposures can be passed on to the government. Thus, the risk
management principles were not much popular in government organizations. But as
the completive forces of the market forced the government to shed the primitive
practices and rules, they have become more conscious and started to imbibe risk
management practice. There are various constraints in the implementation of risk
management function. Some of them are.
A. Size of the organization
B. Decentralization of authority
C. Democratization of decision making
D. Multiple objectives
E. Administration complexities, etc.
Corporate Risk Management
Private corporate sector adopted active risk management for a variety of
reasons. The risk management program of a corporate entity aims at logical way to
solve problems it perceives. These problems if not managed properly, can result in
heavy losses. The loss may be in term of money, material, opportunities or human
life.
1. The risk manager of a company develops plans for protecting against any
unfavorable events. He undertakes the risk management process, whish starts
from information, supervising the initiation and progress plans of loss control
measures, which are critical for the organization. He also undertakes
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negotiation for the terms and conditions to cover the losses and takes adequate
steps for amicably setting them against the insurers. There are few activities
involving risks, which still remain with in the organization even when no
insurance has been undertaken. What are the various activities or
circumstances, which can cause loss to the organization?
2. What are the alternatives available to the organization to protect it self against
these activities and circumstances?
TYPES OF RISK
BUSINESS RISKS
By definition, business risks includes all risk factors, whether it affects a
business directly (loss affecting capital etc.) or indirectly (continued loss affecting
business strategy). Business risk can be divided into following:
i. Capital risk:
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The size of the owners stake (like capital) in the organization
determines the strength of its operation. The composition of its capital- Tier-I (paid-
up capital + reserves) and Tier-II (bonds, hybrid instruments etc.)-depends on its
resource mobilization capacity. If an organization can access capital from only
limited sources like directors (their friends and relatives) rather than from the public,
then this may act as a constraint on capital. In contemporary financial management,
capital has a number of components. These include:
Accounting capital: funds belonging to the promoters/owners.
Regulatory capital: the minimum amount of capital necessary to take care of
asset value as per regulatory requirements
Economic capital: the amount of amounts of funds set aside to absorb any
violent unexpected loss.
According to the Basel committee, capital base is one of the three pillars of
risk assessment (the other two being supervisory role and market discipline).
ii. Credit risk:
While we will discuss comprehensively on this category of risk in subsequent
chapters, it may be sufficient at this stage to indicate its components:
Credit growth in the organization and composition of the credit folio in terms
of sectors, centers and size of borrowing activities
So as to assess the extent of credit concentration.
Credit quality in terms of standard, sub-standards, doubtful and loss-making
assets.
Extent of the provisions made towards poor quality credits.
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Volume of off-balance-sheet exposures having a bearing on the credit
portfolio.
iii. Market risk:
The components of this risk type are:
Composition of the investment portfolio.
Quality of the investment portfolio (i.e., investment in rated and unrated
instruments).
Interest rate volatility and sensibility.
Where in a business the foreign exchange aspect is also vital (i.e.,
banking/export oriented units).
Equity/commodity risk (i.e., hedged/unhedged component).
iv. Earnings risk:
This covers a host of items such as:
Budget and profit planning function in the organization.
Analysis of income/expenses (with a focus on interest and non-interest income
in case of banks/financial institutions).
Earnings quality and stability.
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v. Liquidity risk:
Covers areas such as:
Composition (wholesale/retail deposits in the case of banks with geographical
and classification of depositors etc.).
Liquidity profile (mismatch between term and non-term liabilities, behavioral
maturity profile, diversification of funding sources etc.)
vi. Business strategy and environment risk:
Covers the following areas:
External environment and macro-economic factors.
Strategy with regards to market share, geographical spread, compatibility ofstrategy with in-house experience and expertise.
Business profile analysis using SWOT (strength, weaknesses, Opportunities
and threats), strength of competitors, scope and diversification, extent of
customer loyalty etc.
Strategy business initiatives on the institution and streamlining of business
development and proactive measures taken.
Experience and skills of key personnel in the organization and success in
planning.
Adequacy and compatibility of IT system and business needs.
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vii. Operational risk:
This really is an omnibus type of risk as it covers the entire gamut of activities in an
organization. The main components of operational risk are:
People risk: the capabilities, competence and motives of the people in the
organization.
Technology risk: system failure, system security, back-up and disaster
recovery plans, IT- related frauds etc.
Legal risk: documentation for transactions, security, compliance with
customer confidentiality etc.
Reputation risk: perception of customers and stakeholders of the
organization, regulatory perception process, strength for transaction delivery
etc.
Operating environment: abrupt non-macro economic changes in the
organization.
viii. Group risk factors:
These include
Capital concentration of the parent/group, gearing of capital, return on capital,
investment, relationship with subsidiaries, commonality of interest.
Operating and financial performance of the subsidiaries, shares of business
and competition faced by subsidiaries.
Contagious problems overlooked by the parent organization.
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Risks arising from connected lending and intra-group exposures, risks from
joint ventures, etc.
Compliance by subsidiaries with regulatory guidelines in the area of
operation.
CONTROL RISKS
In the entire risk measurement process, control of activities finds a
prominent place. A control mechanism is a must for any organizations well-being.
Control risks can be divided into:
I. internal control risk:
Lack of a clear line of responsibility and authority. In-house lack of control
may lead to housekeeping and other problems, which may affect the
organizations well-being.
Poor system for monitoring and reporting suspicious transactions that have a
noticeable impact on the organization.
No regular surveillance of the control mechanism by the top management.
ii. Organizational risk:
Vague and overlapping organizational structure with unclear legal
implications.
Absence of a structured assessment mechanism to leverage external and
internal relationship.
Absence of a cordial industrial relationship.
Lack of an adequate support system to evaluate major customer relationships.
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iii. Management (including corporate governance) risk:
Composition, cohesiveness, competence and leadership attributes of the board
of directors. The match between the board and the organizations risk
philosophy and risk appetite.
Non-assessment of the effectiveness of control functions of senior
management.
Absence of a clear succession planning mechanism.
Undefined responsibility and accountability.
Whether it follow contemporary corporate governance practices, especially
with regards to strategy formulation and problem-solving.
iv. Risk from the compliance angle:
Necessary emphasis not accorded to compliance with guidelines laid down by
the regulatory authorities.
Deviations not reported to the competent authorities when they arise.
Non-adherence to a monitorable action plan (MAP), if any, prescribed by a
competent authority.
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avoidance of risk is a method of dealing with risk, which is a negative rather than a
positive technique. Personal advancement of the individual and progress in the
economy both require risk taking. If risk avoidance were utilized extensively, both the
individual and society would suffer. For this reason, avoidance is an unsatisfactory
approach to dealing with risks.
Retention:
Riskretention is perhaps themost common method of dealing with risk. An
individual faces an almost unlimited array of risks; in most cases nothing is done
about them. When an individual does not take positive action to avoid, reduce, and
transfer the risk, the possibility of loss involved in that risk is retained. As a general
rule, risks that should be retained are those that lead to relatively small losses.
Transfer:
Risk may be transferred from one individual to another who is more willing to
bear the risk. An example is the process of hedging, where an individual guards
against the risk of price changes in one asset by buying or selling another asset whose
price changes in an offsetting direction. For example, futures markets have been
created to allow farmers to protect themselves against changes in the price of their
crop between planting and harvesting. A farmer sells a futures contract, which is
actually a promise to deliver at a fixed price in the future. If the value of the farmers
crop declines, the value of the farmers future position goes up to offset the loss.
Insurance is also a means of shifting or transferring risk. In consideration of a
specific payment (the premium) by one party, the second party contracts to indemnifythe first party unto a certain limit for the specified loss that may or may not occur.
Sharing:
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Risk is shared when there is some type of arrangement to share losses. Risks
are shared in a number of ways in our society. Under the corporation form of
business, the investments of a large number of persons are pooled. A large number of
investors may pool their capital, each bearing only a portion of the risk that the
enterprise may fail. Insurance is another device designed to deal with risk through
sharing, (Sharing is a form of transfer, in which the risk of the individual is
transferred to a group. In addition, it may be viewed as a form of retention. In which
the risks of a number of individuals are retained collectively).
Reduction:
Risk may be reduced in two ways i.e., through loss prevention and control.
There is almost no source of loss where some efforts are not made to avert the loss.
Safety programs and loss prevention measures, such as Medicare, fire departments,
security guards, burglar alarms are examples of attempts to deal with risk by
preventing the loss or reducing the chance that it will occur.
RISK MANAGEMENT PROCESS
Risk management activities occur before, during, and after losses. Most
planning is done before losses occur. Losses involving natural disasters and other
emergencies also require action while losses are happening. After the loss, the risk
manager must file insurance claims and analyze loss patterns.
Establishing risk management objectives, tolerances and limits for all of
the enterprise's significant risks
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Assessing risks within the context of established tolerances
Developing cost-effective risk management strategies and processes
consistent with the overall goals and objectives
Implementin g risk management processes
Monitoring and reporting upon the performance of risk management
processes
Improving risk management processes continuously
Ensuring adequate communication and information for decision making
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SOURCES OF RISK
Source of risk can b classified in several ways. Source of risk that arises from
the ownership of property: physical (e.g., fire), social (riot), and economic (inflation).
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Changing morals and values, human behavior, social structures, and
institutions are a second source of risk. Many American business executives become
frustrated when thy move into the international domain. For example, differing social
values and norms in Japan have proven to be a particular source of uncertainly for
American and European business managers. Within the underscores the important of
this source of risk. Changing culture values also create opportunities, as when new
attitudes regarding women in the workforce open a door to a significant talent pool.
POLITICAL ENVIRONMENT:
Within a single country, the political environment cans b an important source
of risk. A new president can move the nation into a policy direction that might have
dramatic effects on particular organizations (cuts in aid to local governments, new
stringent regulation on toxic waste disposal). In the international realm, the political
environment is even more complex. Not all nations are democratic in their form of
government, and politics towards business. Foreign assts might b confiscated by a
host government o tax policies might change dramatically. The political environment
also can promote positive opportunities though fiscal and monetary policy,
enforcement of laws.
LEGAL ENVIRONMENT:
Within the United States today, a gat deal of uncertainty and risk arises from
the legal system. Not only are standards of conduct upheld and punishments enforced,
but as the system itself evolves new standards arise may that not b fully anticipated.
In the international domain, complexity increases because legal standards can vary
from country to country. The legal environment also produces positive outcomes in
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the sense that rights are protected and that the legal system provides a stabilizing
influences on society.
OPRATIONAL ENVIRONEMNT:
Processes and procedures of an organization generate risk and uncertainty. A
formal procedure for promoting, hiring, or firing employees may generate a legal
liability. The manufacturing process may put employees at risk of physical harm.
Activities of an organization may result in ham to the environment. International
business may suffer from risk or uncertainty due to unreliable transportation systems.
The operational environment also provides gains, as it is the ultimate source of the
goods and service by which an organization succeeds or fails.
ECONOMIC ENVIRONMENT:
Although the economic environment often flows directly from the political
realm, the dramatic expansion of the global market place has created an environmentthat is greater than any single government. Although a markets is beyond the reach
of a single nation. Inflation, recession and depression are now elements of
interdependent economic systems. On a local level, interest rates and credit policies
can impose significant risk on an organization.
COGNITIVE ENVIRONMENT:
An important source of risk for organization is the difference between perception andreality. The cognitive environment is a challenging source of risk to identify and
analyze. The analyst must contemplate such questions as How do we understand the
effect of uncertainty on the organization? and How do we know whether perceived
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risk is real? An evaluation of the cognitive environment partly addresses the
distinction between risk and uncertainty.
CHAPTER IV
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WHAT IS VAR?
Value-at-risk (VaR) is a quintile based method of risk assessment of a
portfolio. Value-at risk is widely used by banks, securities firms, commodity
merchants, energy merchants, and other trading organizations. Such firms could track
their portfolios' market risk by using historical volatility as a risk metric. They might
do so by calculating the historical volatility of their portfolio's market value over a
rolling 100 trading days. However, the problem with doing this is that it would
provide a retrospective indication of risk. The historical volatility would illustrate
how risky the portfolio had been over the previous 100 days. It would say nothingabout how much market risk the portfolio was taking today. For institutions to
manage risk, they must know about risks while they are being taken. If a trader
mishedges a portfolio, his employer needs to find out before a loss is incurred. Value
at-risk gives institutions the ability to do so. Unlike retrospective risk metrics, such as
historical volatility, value-at-risk is prospective. It quantifies market risk while it is
being taken. Another reason for popularity of VaR estimates is that it summarizes in a
single, easy to understand number the downside risk of an institution due to financial
market variables.
VaR can be intuitively defined as the worst loss over a target horizon with a
given confidence level. It can be defined either as an absolute number or as a
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percentage of the portfolio value .Crucial for the determination of the extreme future
market value, and hence for the VaR, is the distribution function of the return on
market value. The portfolio value as of today is a known parameter. However, its
future value in a given time horizon is unknown and is a random variable. It will have
a probability distribution based on historical data or expected value of different
market variables like interest rate, Forex, etc. One such distribution is as shown in
Exhibit 3, where the present portfolio value is shown to be P0. With VaR, we
summarize the portfolios market risk by reporting some parameter of this
distribution. For Ex, if the above distribution is for daily portfolio value, then the VaR
value in the above figure depicts the 95% quintile of the portfolios daily loss. By this
we mean that, the maximum loss in a single period cant exceed this value with a
confidence level of 95% i.e. the expected loss would not be more than this value in 19
out of 20 days. Or in other words, the portfolio is expected to lose more than this
value in 1 out of 20 days.
Exhibit 3:The distribution function of the return on market value usually a
normal or lognormal distribution is assumed for the market return. However, a normal
distribution is claimed to underestimate the probability in the tail and hence the VaR,
as VaR deals with extreme market situations. Popular alternatives include GARCH-
type of models to allow for time-varying volatility and the Student-t distribution,
since it allows for more probability mass in the tail than the normal distribution.
Equally important for VaR estimation is uncertainty in parameter values. Parameter
uncertainty leads to uncertainty in the VaR estimates. And this uncertainty increases
with models that try to incorporate complex tail behaviors. Hence there is a trade off
between more complex tail behavior and uncertainty in the VaR estimate.
There are different methods for VaR calculation. One thing to keep in mind is
that the choice of methodology used to estimate VaR gives rise to very different
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results of the VaR and hence it is more important to identify which method is best
suited for a given portfolio and the intended use. The different methods are:
1. Variance-Covariance method
2. Historical simulation
3. Constant maturity model
4. Monte Carlo simulation
VaR
Variance-Covariance Method
In this method, the portfolio return is assumed to have normal probability
distribution. The advantage of this assumption is that the model can be defined in its
entirety in terms of only 2 parameters Mean and Standard deviation of the portfolio
return. In this way, this method is parametric in nature. The expected value of the
portfolio is calculated as: Where 0E (1P) is the expected portfolio value in period 1
based on information in period 0.B is a column vector giving the weightage ofdifferent variables in the portfolio.is the mean vector of the variables in the portfolio.
Similarly, standard deviation of the portfolio is defined as: Where: is the standard
deviation for the portfolio. Is the covariance matrix of the portfolio, 1|0 indicating that
the parameter is for period 1, and conditional on information available in period 0? B`
is the transpose of vectorb. One advantage of normal assumption is that quintiles of a
normal distribution occur a fixed number (z) of standard deviations from the
distributions mean which can be determined from standard normal distribution table.
Since the computations are so modest, implementation of Variance-Covariance
method runs in real time.
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However, it has the disadvantages associated with the normal distribution
function. It ignores the distribution with fat tails and since VaR is more of a measure
of tail distribution, normal assumption can lead to problem of overestimation or
underestimation of VaR, thereby defeating the purpose of VaR estimation
Historical Simulation
This method is the simplest and most transparent method of calculation. This
involves evaluating the current portfolio across a set of historical changes in the
underlying variables to yield a distribution of changes in portfolio value, and
computing VaR. The benefits of the method are its simplicity to implement, and the
fact that it does not assume a normal distribution of asset returns. However, it requires
a large database of historical values to be effective. Moreover, it assumes that the
historical values are a good estimate for future values, which may not be always true.
Constant Maturity Model
In the Variance-Covariance method, the interaction between different
variables underlying the portfolio has to be taken into account. This leads to
multivariate models that include many parameters that are all estimated with
uncertainty. This suggests that VaR-estimates for portfolios of securities are more
uncertain. To avoid multivariate models, constant maturity value of the portfolio is
determined at all times in history. The resulting time series of constant maturity
values may be modeled in a univariate time series framework, which can be used to
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determine the VaR estimate for the constant maturity value of the portfolio. There is
difference in the actual value and constant maturity value of a portfolio, however,
over short forecasting horizons, this difference is negligible. An advantage of this
approach is that it focuses on the portfolio return directly and not on
Individual variable. Moreover, we can restrict ourselves to univariate models, which
have the advantage of less parameter uncertainty than multivariate models, as the
number of parameters to be estimated is less.
Monte Carlo Simulation
It is conceptually simple, but is generally computationally more intensive
than the methods described above. In this method, some market model is used to
generate random scenario of market variables for the pre-decided number of
iterations. For each set, portfolio is revaluated and profit (loss) is calculated under the
simulated scenario. These profits/losses are sorted in an order to give the simulated
distribution and then this distribution is used to determine VaR at a particular
confidence level. It is possible to compute an error term associated with the VaR
estimate thus obtained and this error will reduce as the number of simulationsincreases. Monte Carlo Simulation is generally used to compute VaR for portfolios
containing securities with non-linear returns. However, for a portfolio without these
complex instruments, variance-covariance method is perfectly suitable and should be
used. One thing should be kept in mind that Monte Carlo method is subjected to
model risk if the model used is not very suitable.
To determine which method is best suited for a given portfolio, the validity of the
VaR
Estimate should be carried out. This is generally done by back-testing. This is done
through comparison of predicted and actual loss levels. This testing can also help in
checking the assumptions, parameters and accuracy of the model. Another important
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aspect of VaR estimation is determination of time horizon and confidence level the
popular values for time horizon are 1 day and 10 days. And for confidence level are
95% and 99%. We recommend the use of 1 day VaR with a confidence level of 99%.
Time horizon of 1 day will help in monitoring daily mark-to-market changes in
portfolio value and 99% confidence level would reduce the frequency of loss
exceeding the VaR estimate.
ILLUSTRATION
In this section, the actual portfolio for the company taken as on 17 th of May, 2010 is
taken and then this portfolio is evaluated using market data since Apr 99 to
determine VaR estimates with time horizon ranging from 1 day to 1 month and a
confidence level of 95% and 99%. Valuation of Assets and Liabilities
Below shows the exposure of the Company to various risk elements because of its
Operation as well as treasury activities.
Particulars Amount Exposure to Forex Exposure to Interest Rate
Receivables USD 100 Millions
Payables USD 10 Millions
Loan EUR 400 Millions
PCFC USD 154.5 Millions
Adv (Falcon) USD 39 Millions
Adv (Betapharma) EUR 26 Millions
Exhibit 4:
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Risk elements because of the company operation and treasury activities. Net
Receivables Because of the predominantly export oriented business of the company,
its Receivables in USD is greater than its Payables in USD and hence the difference is
net receivables2. As explained earlier, because of a possible adverse forex market
movement, the Company stands the risk of incurring a loss. Loan On 16th of
February, 2009, the Company made the historic acquisition of Betapharma, 4th
largest generic pharma company of Germany, for a huge sum of EUR 480,000,000.
This acquisition has strategic importance because this will help the Company to get a
strong 2 For the sake of simplicity; it is assumed that all the receivables and payables
are only in USD. Although there are sales and purchases in other currencies as well,
these are minor compared to USD transaction and hence this assumption is justified.
14 footholds in European market. However, for the acquisition, the Company had the
take a massive long term loan ofEUR 400,000,000 that is linked to the volatile 6 M
EUR Libor rate. This loan is to be repaid within 5 years such that the average
duration does not exceed 4 years. Because of this linkage and since the repayment of
loan is to be made in EUR, the company is subjected to both interest rate and Forex
risk. The terms of the loan are stated in Exhibit 5below:
Bank Amount (EUR) Resettlement Freq Interest Rate Duration
Citibank 400,000,000 3 months 6 M EUR Libor rate + 150 basis points 5 Years
Exhibit 5:
Terms of the loan of EUR 400,000,000 for Betapharma acquisition since the
interest rate is reset every 3 months, the market value of the loan amount is same as
the book value on the date of reset. Hence, the valuation of the loan on any date is
done as follows:
Where:
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P = Book value of the loan
CP = Interest rate (Reset every 3 months, 6 M EUR Libor rate + 150 basis points)
DR = Discount rate (6 M EUR spot Libor rate + 150 basis points)
D = Number of days from valuation date to next resettlement
Z = Number of days between resettlements
B = Interest basis (Taken 365 days)
The Market value obtained is in EUR and to convert it to INR, it has to be multiplied
with the EUR/INR exchange rate on the valuation date.
PCFC
Packing Credit Foreign Currency (PCFC) are short term loans taken by the Company
for
Meeting its working capital requirement. Exhibit 6below shows the terms and details
of the various PCFC loans taken by the Company.
P*(1+CP/4) (ZD)*CP
(1+DR/4) D/Z B Market Value =15
Bank Amount (USD) Start Date End Date Basis points Resettlement Freq
StanC 5,000,000 5/6/2009 5/31/2010173.60 1 Month
StanC 10,000,000 12/29/2009 6/27/2010 60.00 1 Month
StanC 20,000,000 2/16/2009 8/15/2010 50.00 1 Month
StanC 10,000,000 3/17/2009 9/13/2010 51.00 1 Month
HSBC 10,000,000 2/16/2009 8/17/2010 68.00 1 Month
HSBC 4,500,000 3/21/2009 6/19/2010 60.00 1 Month
Bank Am 15,000,000 3/3/2009 6/2/2010 59.00 1 MonthSBI 25,000,000 4/28/2009 5/28/2010 51.00 1 Month
CITI 20,000,000 4/3/2009 9/3/2010 -10.30 1 Month
CITI 10,000,000 3/17/2009 9/13/2010 75.00 1 Month
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CITI 20,000,000 2/16/2009 8/15/2010 82.00 1 Month
CITI 5,000,000 3/17/2009 9/13/2010 40.00 1 Month
Exhibit 6:
Terms and details of the PCFC loan taken by the Company Interest rate is
reset every 1 month and it is linked to the 6 M USD Libor rate plus the basis point as
indicated against each of the PCFC. The valuation of a PCFC loan is done as follows:
Where all the symbols have the same meaning as described above the market value
obtained is in USD and to obtain the corresponding INR value, the USD value is to be
multiplied with the spot USD/INR exchange rate. Because of the dependence of INR
value on interest rate and exchange rate, the value of a PCFC is subjected to both
interest rate and forex risk.
Advances
The Company has given advances to its subsidiaries for their operation. The
details of the advances are shown in Exhibit 7below3.
3 Advances have been given to subsidiaries other than Falcon and Betapharma as
well. However, they are not considered here for 2 reasons:
1. They are insignificant compared to advances to Falcon and Betapharma2. The notional currency for them is INR; hence there is no forex risk for those
subsidiaries
P*(1+CP/12) (ZD)*CP
(1+DR/12) D/Z B Market Value =16
Subsidiary Amount Start Date Basis points Resettlement Freq
Falcon USD 39,000,000 1/1/2010 150.00 3 Months. Betapharma EUR 26,000,000
2/16/2010 175.00 3 Months.
Exhibit 7:
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Details of the advances to Falcon and Betapharma the market value of the advances is
calculated in the same way as that for the loan above. It is copied below for
convenience. The symbols have same meaning described earlier. The value obtained
will be in respective currencies and hence need to be multiplied with appropriate spot
exchange rate to determine the value in INR. Because of the dependence on both
interest rate and exchange rate, advances are subjected to both interest rate and Forex
risk.
Calculation
The calculations shown below are the snapshot of VaR estimate for the
portfolio of Dr.Reddys as on a particular day. Hence the estimates shown below
should not be taken to be conclusive. It would change with the changes in the
portfolio. Moreover, these calculations are done for determining the method that
gives a better estimate of VaR. Variance-Covariance method is not taken for the
calculation purpose because of the complexity involved in assigning weightage to
each of the market variable manually.
Parameters Method Overall Risk Interest Rate Forex Risk
Historical Simulation Rs. 20.7 Crores Rs. 0.11 Crores Rs. 20.6 Crores
Constant Maturity Rs. 24.2 Crores Rs. 0.14 Crores Rs. 24.0 Crores TH 1 day
and CL 95%
Monte Carlo Simulation Rs. 16.0 Crores NA NA
Historical Simulation Rs. 38.6 Crores Rs. 0.23 Crores Rs. 38.4 Crores
Constant Maturity Rs. 34.1 Crores Rs. 0.197 Crores Rs. 33.9 Crores TH 1 dayAnd CL 99%
Monte Carlo Simulation Rs. 24.7 Crores NA NA
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Historical Simulation Rs. 98.5 Crores Rs. 0.68 Crores Rs. 97.8 Crores TH 1
Month
And CL 95% Constant Maturity Rs. 91.5 Crores Rs. 0.73 Crores Rs. 90.7 Crores
Historical Simulation Rs. 111.3 Crores Rs. 1.16 Crores Rs. 110.1 Crores TH 1
Month and CL 99% Constant Maturity Rs. 127.2 Crores Rs. 1.03 Crores Rs.
126.2 Crores
P*(1+CP/4) (ZD)*CP
(1+DR/4) D/Z B Market Value =17
Back-testing of various models has not been considered in the absence of more
sophisticated techniques. Hence, another criterion for comparison can be the
conservative nature of the estimate. We can see thatHistorical Simulation Method
gives the most conservative estimate for a time horizon of 1 day and 99% confidence
level. Hence it can be used for the VaR estimation in case a conservative estimate is
desired. However, Variance-Covariance method can also be looked at before making
any decision.
The calculations are shown in the attached files:
E:\Summers\FinalPresentation\VaREstimation\HistoricalReturnDaily.xls
E:\Summers\FinalPresentation\VaREstimation\HistoricalReturnMonthly.xls
H OW TO U SE V A R?
Because of the variability in the market condition, businesses run the risk of
losing because of possible adverse market movement. However, with the advent of
derivative products and various other hedging mechanisms, it is possible for treasury
department to hedge the cash flows such that irrespective of the market movement,
the company has a risk-free cash flow. But it has a downside to it. While the
Company stands to lose from adverse market movement, at the same time it can gain
substantially if the market moves favorably for the Companys portfolio. So, if
treasury hedges the entire portfolio, the Company will miss out the opportunity to
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LIMITATIONS OF VAR
Although VaR is the most used method of risk assessment, it is not panacea
of risk measurement methodologies. According to theory of coherent risk measur