Risk Management – CA Final SFM Study Material is designed strictly as per the latest syllabus and exam pattern.
Risk Management – CA Final SFM Study Material
Part 1 (Theory)
Question 1.
Discuss how the risk associated with securities is affected by Government policy. [May 2011] [4 Marks]
Answer:
The Government policy may change from time to time and thus influence various industries and their securities in a number of ways, thereby affecting the risks and returns associated with them. The risk from government policies may come due to following changes, having impact on securities:
- If there is change in Foreign Trade Policy (FTP), it will impact the Indian industries and securities issued by them.
- Restrictions on shareholding in different industry sectors.
- Licensing policy
- Changes in FDI and FII rules
- Restrictions on commodity and stock trading in exchanges.
- Changes in various corporate and other laws having direct and indirect impact on securities.
Question 2.
What are the Various types of risk faced by an organisation? [Practice Question]
Answer:
The various types of risk faced by an organization are :
1. Strategic Risk:-
A comprehensive, detailed and well thought out business plan is a pre-requisite for any successful business. These plans should be constantly updated. These strategic management decisions are pervasive in the whole organization and do not affect an isolated part. These plans and decisions are taken for the better future and success of organization. However, future being uncertain, the best laid out plans may even fail. This is known as strategic risk.
Strategic risk can be defined as the uncertainties and untapped opportunities embedded in strategic intent and how well the strategies are executed. If the organization responds well to the uncertainties and opportunities, the strategic risk is well managed. If strategic risk is to be managed, there should be a clear corporate strategy and complete understanding of risks associated with adopting and executing it.
2. Compliance Risk:
Every business needs to comply with rules and regulations. Many rules and regulations are imposed on organizations by the government and other regulatory authorities to ensure that organizations work ethically and fairly. They work for a better society, whether by sharing profits, or conserving the environment. These objectives can be achieved through rules and regulations.
- If the laws are not complied, there are heavy penalties. This could be in the form of payment for damages, fines, imprisonment and cancellation of contracts.
- An organization may face material loss if it does not adhere to the laws and regulations. This is called as compliance risk.
- In case some new product is launched or new territorial areas are explored, the compliance risks may increase as one is venturing into unknown and unforeseen territory.
- Further, with debacles and frauds in the organizations, the compliance laws increase in number as well as severity in consequences due to non-compliance. Compliance risk may cause severe damage to the reputation of an organization.
3. Operational Risk:
It is also called as internal risk. It is defined as a risk incurred by an or-ganizations internal activities.
The Basel II regulations defines operational risk as the risk of loss resulting from inadequate or failed internal process, people and systems, or from external events. It is the risk an organization undertakes when it attempts to operate within a given field or industry. This risk is not inherent in financial, systematic or market-wide risk. It is the risk remaining after determining financing and systematic risk, and includes risk resulting from break downs in internal procedures, people and systems. It includes internal frauds or external threats like theft, natural disasters etc. or poor management decisions.
4. Financial Risk:
The financial risk is the variability in earnings or cash flows and market values, caused by unpredictable changes in commodity prices, security prices, interest rates and exchange rates or it could be due to non fulfilment of obligations by counter parts in financial transactions. Though, political risk is not a financial risk in direct sense but same can be included, as any unexpected political change in any foreign country may lead to country risk which may ultimately result in financial loss.
The financial risk may be further divided into:
(a) Counterparty risk:- When the opposite party in a financial transac¬tions fails to honour their obligations, it is termed as counterparty risk. It is majorly default risk.
(b) Political Risk:- It is faced by those who have overseas financial transactions. If the government of another country makes some policy changes, it may cause huge loss. These policy changes could be
- Confiscation or destruction of properties
- Restrictions on borrowings
- Price control of products
- Invalidation of patents etc.
(c) Interest rate risk:-
This risk occurs due to change in interest rate resulting in change in assets and liabilities. This risk has more significance for banking companies and entities dealing in financial instruments.
(d) Currency Risk:
Also, known as exchange rate risk, it effects organizations dealing with foreign exchange. For example if an organization in India has debtors to the extent of $1,00,000 in its Balance sheet, the organiza¬tion will lose, if depreciates against Indian currency.
Question 3.
Discuss the evaluation of Financial risk from the perspective of
(a) Stakeholders
(b) Company
(c) Government [May 2019] [4 Marks]
Answer:
The financial risk can be evaluated from different point of views as follows:
(a) From stakeholder’s point of view:- The main stakeholder is any business is the equity shareholders or owners. For them, the financial risk can be evaluated by calculating the debt ratios or the total debt in its capital structure. Higher debt indicates more risk, as equity will always be paid after the payments are made to the lenders, while paying interest or at the time of repayment of loan.
A creditor or lender may evaluate his risk by finding the debt service coverage ratio and its debt ratio.
(b) From Company’s point of view:- A company may face financial risk if the company lends, or borrows excessively, especially, where there are chances of default in respect of payment of interest or principal.
(c) From Government’s point of view:- When a government is unable to honour its bonds or bills (i.e. sovereign debt crisis) or the leading financial institutions in the country (non-sovereign debt) defaulting in repayment, it leads to spread of distrust among the society.
Question 4.
What is Value at Risk (VAR) ? What are its features and applications [May 2019] (Modified) [4 Marks]
Answer:
Value at Risk is a measure of risk of investment. Barry Schachter de-scribes value at Risk as “an estimate of the level of loss, which is expected to be equaled or exceeded with a given small probability.” It is a statistical measure calculated over a specific investment horizon and measures the expected loss arising due to normal market movements in variables which are responsible for risk.
VAR answers two basic questions:
- What is worst case Scenario?
- What will be the loss?
It was first applied in 1922 in New York Stock Exchange, entered the financial world in 1990’s and became world’s most widely used measure of financial risk.
Features of VAR:
The following are the features of VAR
- The calculation of VAR is based on three components:
(a) Standard deviation, or % loss or loss in amount
(b) Time period
(c) Confidence level which is generally taken as 95% or 99%. - It is a statistical tool based on standard deviation.
- It is possible to apply VAR for different time horizons from 1 day and upwards.
- It is assumed that the values are normally distributed and this helps in calculating the maximum loss.
- It helps in controlling risk by setting limits for maximum loss.
- Z score is calculated while calculating VAR i.e. it indicates how much standard deviation is the value away from mean value. When Z score is multiplied by standard deviation, it gives VAR.
- It is different from other measures of risk as it distinguishes between downside movements and upside movements and focuses only on down side movement.
Applications of VAR
The concept of VAR is used to quantify the risk arising out of individual assets and liabilities. This can help in laying down the policy of managing risk. Thus, VAR can be applied :
(a) to measure maximum possible loss on a portfolio for a period and for a trading position.
(h) to enable the management to decide and formulate strategies.
(c) to fix limits for individuals dealing in front office of a treasury department.
(d) as a tool for Assets and liabilities management, especially in banks.
(e) as a benchmark for performance measurement of any operation or trading.
Part – 2 (Numerical Problems)
Question 1.
Neel holds Rs. 1 crore shares of XY Ltd. whose market price standard deviation is 2% per day. Assuming 252 trading days in a year, determine maximum loss level over the period of 1 trading day and 10 trading days with 99% confidence level. Assuming share prices are normally distributed and for level 99%, the equivalent Z score from Normal table of Cumulative area shall be 2.33. [May 2018][4 Marks]
Answer:
Value of the Shares = Rs. 1,00,00,000
Standard deviation per day = 2% of Rs. 1,00,00,000 = Rs. 2 lakhs
(i) Therefore, Standard deviation in 1 day = 2 × √1 = Rs. 2 lakhs.
At 99% confidence level the value of one tailed (as cumulative area is given) Z table is 2.33.
So, the value at risk = 2.33 × 2 = Rs. 4.66 lakhs.
(ii) Standard deviation in 10 days = 2 × √10
= Rs. 2 lakhs × 3.162 = 6.324 lakhs
So, the value at risk = 2.33 × 6.324 = Rs. 14.735 lakhs.
Question 2.
Following is the information about Mr. J’s portfolio :
| Investment in shares of ABC Ltd. | Rs. 200 lakhs |
| Investment in shares of XYZ Ltd. | Rs. 200 lakhs |
| Daily standard deviation of both shares | 1% |
| Co-efficient of correlation between both shares | 0.3 |
Required:
Determine the 10 days 99% Value at Risk (VAR) for Mr. J’s portfolio. Given: The Z score from the Normal Table at 99% confidence level is 2.33. (Show your calculations up to four decimal points) [Nov. 2019] [8 Marks]
Answer:
The standard deviation ol both the shares is tv and the investment in both the shares is Rs. 2,00,00,000. Therefore, the daily change in the value of investment of each share will be 1% of Rs. 2,00,00,000 i.e. Rs. 2,00,000. The correlation coefficient between the two securities is 0.3. The daily change in the value of the portfolio will be: Portfolio Variance (σxA2)
σ = Wxσx2 + WAσA2 + 2WxWAσxσAr
= (0.50)2 (1) + (0.50)2 (1) + 2(0.50) (0.50) (1)(1) (0.3)
= 0.65%
σxy = \(\sqrt{0.65}\) = 0.80623%
Value of the portfolio = Rs. 4,00,00,000
Standard deviation per day = 0.80623% of Rs. 4,00,00,000 = Rs. 3.22490 lakhs
Therefore, Standard deviation in 10 days = 3.22490 × \(\sqrt{10}\) = Rs. 10.198 lakhs.
At 99% confidence level the value of one tailed Z table is 2.33.
So, the Value at Risk = 2.33 × 10.198 =Rs. 23.76 lakhs.