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DEFINITION of FRM The process of evaluating and managing current and possible financial risk at a firm as a method of decreasing

the firm's exposure to the risk. Financial risk managers must identify the risk, evaluate all possible remedies, and then implement the steps necessary to alleviate the risk. These risks are typically remedied by using certain financial instruments as a method of counteracting possible ramifications. Financial risk management cannot prevent a firm from all possible risks because some are unexpected and cannot be addressed quickly enough. What is Financial Risk Management As an important aspect of enterprise wide risk management, financial risk management is concern with the practice of creating more economic value in an organization and preserving shareholders value through the use of financial instruments to manage exposure to financial risks that may threaten the value of shareholders funds. The major financial risks are broadly classified as credit risk and market risk. Financial risk management focuses on risks that can be hedged using traded financial instruments. These risks are usually movements in commodity prices, interest rates, stock prices, foreign exchange rates. Derivatives are the instruments most commonly used in financial risk management. As unique derivative contracts tend to be costly to create and monitor, the most cost-effective financial risk management methods usually involve derivatives that trade on wellestablished financial markets or exchanges. These standard derivative instruments include options, futures contracts, forward contracts, and swaps. Transactions exposure, accounting exposure, and economic exposure in foreign exchange earnings can be managed by forex contracts. Other market sector risks include liquidity, inflation risks and other financial-related risks. The methodology and processes of financial risk management is similar to other areas of enterprise risk management, and therefore requires identifying its sources, measuring it, and plans to address them. Financial risk management can be qualitative and quantitative. As a major component of enterprise risk management, financial risk management focuses on when and how to hedge using financial instruments to manage costly exposures to different risks. Financial risk management also play an important role in cash management. +++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ Financial Risk Management

When companies make financial decisions, they always assume some degree of risk, especially when theyre making decisions about investments. Financial risk management is a set of practices that allow a company to optimize the way it takes financial risk. A financial risk management plan may include things like how the company monitors risky activities and applies the risk process. The companys board or senior management decides the plan to guide how financial decisions are made. Market Risks As with other types of risk management, in financial risk management there are a variety of different types of risks the risk managers must take into account and evaluate. Market risk, the exposure to financial loss because of the uncertain future value of stocks, is a key component of financial risk. This type of risk is managed by avoiding day-to-day losses on the stock market. Risk management procedures might impose a level of acceptable risk in investing to mitigate market risk. Credit Risks Credit risk is a type of risk that comes into play when a company is making loans, issuing credit cards, insuring, or investing in the debt of other companies. In these cases, the risk theyre assuming is that the other party will default, in which case theyll lose the investment. A risk management plan for credit risks would apply a procedure for determining how much of a risk a particular investment is. It would also detail how much risk is too much and how much is acceptable. Operational Risks An operation risk is slightly different from market risk and credit risk because it concerns the internal operation of a company, rather than an exterior source of risk. Operational risk is the risk of a loss because of the failure of internal systems or processes or the errors of people working for a company. These may include system errors like computer failures, or losses to physical assets like fire, floods, or earthquakes. It may also include employeecaused problems like errors, fraud, theft, or other criminal activities. Financial risk management involves protecting a company against financial loss due to a variety of factors. While this type of risk management only provides guidelines by which financial decisions should be made, it is still an important safeguard against loss. +++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ Differences Between Business Risk & Financial Risk Financial Risk Financial risk refers to the chance a business's cash flows are not enough to pay creditors and fulfill other financial responsibilities. The level of financial risk, therefore, relates less to the business's operations themselves and more to the amount of debt a business incurs to finance those operations. The more debt a business owes, the more likely it is to default on

its financial obligations. Taking on higher levels of debt or financial liability therefore increases a business's level of financial risk. Business Risk Business risk refers to the chance a business's cash flows are not enough to cover its operating expenses like cost of goods sold, rent and wages. Unlike financial risk, business risk is independent of the amount of debt a business owes. There are two types of business risk: systematic risk and unsystematic risk. Systematic Risk Systematic risk refers to the chance an entire market or economy will experience a downturn or even fail. Economic crashes, recessions, wars, interest rates and natural disasters are common sources of systematic risk. Any business operating in the market is exposed to this risk, and the amount of systematic risk does not vary between businesses in the same market. Therefore there is little small business owners can do to decrease their exposure to systematic risk. Unsystematic Risk Unsystematic risk describes the chance a specific company or line of business will experience a downturn or even fail. Unlike systematic risk, unsystematic risk can vary greatly from business to business. Sources of unsystematic risk include the strategic, management and investment decisions a small business owner faces every day. Investors decrease their exposure to unsystematic risk by diversifying their portfolio and holding ownership in a variety of companies operating in a variety of industries. +++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ Major market risks arise out of changes to financial market prices such as exchange rates, interest rates, and commodity prices.Major market risks are usually the most obvious type of financial risk that an organization faces. Major market risks include: Foreign exchange risk Interest rate risk Commodity price risk Equity price risk Other important related financial risks include: Credit risk Operational risk Liquidity risk Systemic risk The interactions of several risks can alter or magnify the potential impact to an organization. For example, an organization may have both commodity price risk and foreign exchange risk. If both markets move adversely, the organization may suffer significant losses as a result.There are two components to assessing financial risk. The first component is an understanding of potential loss as a result of a particular rate or price change. The second component is an estimate of the probability of such an event occurring.

Interest Rate Risk Interest rate risk arises from several sources, including: Changes in the level of interest rates (absolute interest rate risk) Changes in the shape of the yield curve (yield curve risk) Mismatches between exposure and the risk management strategies undertaken (basis risk) Interest rate risk is the probability of an adverse impact on profitability or asset value as a result of interest rate changes. Interest rate risk affects many organizations, both borrowers and investors, and it particularly affects capital-intensive industries and sectors. Changes affect borrowers through the cost of funds. For example, a corporate borrower that utilizes floating interest rate debt is exposed to rising interest rates that could increase the companys cost of funds. A portfolio of fixed income securities has exposure to interest rates through both changes in yield and gains or losses on assets held. Absolute Interest Rate Risk Absolute interest rate risk results from the possibility of a directional, or up or down, change in interest rates. Most organizations monitor absolute interest rate risk in their risk assessments, due to both its visibility and its potential for affecting profitability.From a borrowers perspective, rising interest rates might result in higher project costs and changes to financing or strategic plans. From an investor or lender perspective, a decline in interest rates results in lower interest income given the same investment, or alternatively, inadequate return on investments held. All else being equal, the greater the duration, the greater the impact of an interest rate change. The most common method of hedging absolute interest rate risk is to match the duration of assets and liabilities, or replace floating interest rate borrowing or investments with fixed interest rate debt or investments. Another alternative is to hedge the interest rate risk with tools such as forward rate agreements, swaps, and interest rate caps, floors, and collars. Yield Curve Risk Yield curve risk results from changes in the relationship between shortand long-term interest rates. In a normal interest rate environment, the yield curve has an upward-sloping shape to it. Longer-term interest rates are higher than shorter-term interest rates because of higher risk to the lender. The steepening or flattening of the yield curve changes the interest rate differential between maturities, which can impact borrowing and investment decisions and therefore profitability. In an inverted yield curve environment, demand for short-term funds pushes short-term rates above long-term rates. The yield curve may appear inverted or flat across most maturities, or alternatively only in certain maturity segments. In such an environment, rates of longer terms to maturity may be impacted less than shorter terms to maturity. When there is a mismatch between an organizations assets and liabilities, yield curve risk should be assessed as a component of the organizations interest rate risk.When the yield curve

steepens, interest rates for longer maturities increase more than interest rates for shorter terms as demand for longer-term financing increases. Alternatively, short-term rates may drop while long-term rates remain relatively unchanged. A steeper yield curve results in a greater interest rate differential between short-term and long-term interest rates, which makes rolling debt forward more expensive. If a borrower is faced with a steep yield curve, there is a much greater cost to lock in borrowing costs for a longer term compared with a shorter term. A flatter yield curve has a smaller gap between long- and short-term interest rates. This may occur as longer-term rates drop while short-term rates remain about the same. Alternatively, short-term demand for funds may ease,with little change to demand for longer-term funds. The flattening of the yield curve makes rolling debt forward cheaper because there is a smaller interest rate differential between maturity dates. Yield curve swaps and strategies using products such as interest rate futures and forward rate agreements along the yield curve can take advantage of changes in the shape of the yield curve. The yield curve is a consideration whenever there is a mismatch between assets and liabilities. Reinvestment or Refunding Risk Reinvestment or refunding risk arises when interest rates at investment maturities (or debt maturities) result in funds being reinvested (or refinanced) at current market rates that are worse than forecast or anticipated. The inability to forecast the rollover rate with certainty has the potential to impact overall profitability of the investment or project.For example, a short-term money market investor is exposed to the possibility of lower interest rates when current holdings mature. Investors who purchase callable bonds are also exposed to reinvestment risk. If callable bonds are called by the issuer because interest rates have fallen, the investor will have proceeds to reinvest at subsequently lower rates. Similarly, a borrower that issues commercial paper to finance longerterm projects is exposed to the potential for higher rates at the rollover or refinancing date. As a result, matching funding duration to that of the underlying project reduces exposure to refunding risk. Basis Risk Basis risk is the risk that a hedge, such as a derivatives contract, does not move with the direction or magnitude to offset the underlying exposure, and it is a concern whenever there is a mismatch. Basis risk may occur when one hedging product is used as a proxy hedge for the underlying exposure, possibly because an appropriate hedge is expensive or impossible to find. The basis may narrow or widen, with potential for gains or losses as a result. A narrower view of basis risk applies to futures prices, where basis is the difference between the cash and futures price.Over time, the relationship between the two prices may change, impacting the hedge. For example, if the price of a bond futures contract does not change in value in the same magnitude as the underlying interest rate exposure,

the hedger may suffer a loss as a result. Basis risk can also arise if prices are prevented from fully reflecting underlying market changes. This could potentially occur with some futures contracts, for example, where daily maximum price fluctuations are permitted. In the case of a significant intra-day market move, some futures prices may reach their limits and be prevented from moving the full intra-day price change. Foreign Exchange Risk Foreign exchange risk arises through transaction, translation, and economic exposures. It may also arise from commodity-based transactions where commodity prices are determined and traded in another currency. Transaction Exposure Transaction risk impacts an organizations profitability through the income statement. It arises from the ordinary transactions of an organization, including purchases from suppliers and vendors, contractual payments in other currencies, royalties or license fees, and sales to customers in currencies other than the domestic one. Organizations that buy or sell products and services denominated in a foreign currency typically have transaction exposure.Management of transaction risk can be an important determinant of competitiveness in a global economy.There are few corporations whose business is not affected, either directly or indirectly, by transaction risk. Translation Exposure Translation risk traditionally referred to fluctuations that result from the accounting translation of financial statements, particularly assets and liabilities on the balance sheet. Translation exposure results wherever assets, liabilities, or profits are translated from the operating currency into a reporting currencyfor example, the reporting currency of the parent company. From another perspective, translation exposure affects an organization by affecting the value of foreign currency balance sheet items such as accounts payable and receivable, foreign currency cash and deposits, and foreign currency debt. Longer-term assets and liabilities, such as those associated with foreign operations, are likely to be particularly impacted. Foreign currency debt can also be considered a source of translation exposure. If an organization borrows in a foreign currency but has no offsetting currency assets or cash flows, increases in the value of the foreign currency vis--vis the domestic currency mean an increase in the translated market value of the foreign currency liability.

Foreign Exchange Exposure from Commodity Prices

Since many commodities are priced and traded internationally in U.S. dollars, exposure to commodities prices may indirectly result in foreign exchange exposure for non-U.S. organizations. Even when purchases or sales are made in the domestic currency, exchange rates may be embedded in, and a component of, the commodity price.In most cases, suppliers of commodities, like any other business, are forced to pass along changes in the exchange rate to their customers or suffer losses themselves.
By splitting the risk into currency and commodity components, an organization can assess both risks independently, determine an appropriate strategy for dealing with price and rate uncertainties, and obtain the most efficient pricing. Protection through fixed rate contracts that provide exchange rate protection is beneficial if the exchange rate moves adversely. However, if the exchange rate moves favorably, the buyer might be better off without a fixed exchange rate.Without the benefit of hindsight, the hedger should understand both the exposure and the market to hedge when exposure involves combined commodity and currency rates.

Commodity Risk Exposure to absolute price changes is the risk of commodity prices rising or falling. Organizations that produce or purchase commodities, or whose livelihood is otherwise related to commodity prices, have exposure to commodity price risk. Some commodities cannot be hedged because there is no effective forward market for the product. Generally, if a forward market exists, an options market may develop, either on an exchange or among institutions in the over-the-counter market.In lieu of exchange-traded commodities markets, many commodity suppliers offer forward or fixed-price contracts to their clients. Financial institutions may offer similar products to clients, provided that a market exists for the product to permit the financial institution to hedge its own exposure. Financial institutions in some markets are limited by regulation to the types of commodity transactions they can undertake, though commodity derivatives may be permitted. Commodity Price Risk Commodity price risk occurs when there is potential for changes in the price of a commodity that must be purchased or sold. Commodity exposure can also arise from noncommodity business if inputs or products and services have a commodity component. Commodity price risk affects consumers and end-users such as manufacturers , governments, processors, and wholesalers. If commodity prices rise, the cost of commodity purchases increases, reducing profit from transactions.Price risk also affects commodity producers. If commodity prices decline, the revenues from production also fall, reducing business income. Price risk is generally the greatest risk affecting the livelihood of commodity producers and should be managed accordingly. Commodity prices may be set by local buyers and sellers in the domestic currency in order to facilitate local customer business. However, when transactions are conducted in the domestic currency for a commodity that is normally traded in another currency, such as U.S. dollars, the exchange rate will be a component of the total price for the commodity,

and the currency exposure continues to be a consideration. Some companies help their clients manage risk by offering domestic commodity prices. The company may fix the commodity price for a period of time or, alternatively,may pass along commodity price changes but allow customers to use a fixed exchange rate for calculating the domestic price. In the latter case, the supplier is effectively assuming the currency risk. Either scenario may be useful for small organizations or those that are only occasional buyers of a commodity and do not wish to manage the risk themselves. Commodity Quantity Risk Organizations have exposure to quantity risk through the demand for commodity assets. Although quantity is closely tied to price, quantity risk remains a risk with commodities since supply and demand are critical with physical commodities. For example, if a farmer expects demand for product to be high and plans the season accordingly, there is a risk that the quantity the market demands will be less than has been produced. Demand may be less for a number of reasons, all of which are out of the control of the farmer. If so, the farmer may suffer a loss by being unable to sell all the product, even if prices do not change dramatically. This might be managed using a fixed price contract covering a minimum quantity of commodity as a hedge. Special Risks Commodities differ from financial contracts in several significant ways, primarily due to the fact that most have the potential to involve physical delivery.With notable exceptions such as electricity, commodities involve issues such as quality, delivery location, transportation, spoilage, shortages, and storability, and these issues affect price and trading activity. In addition, market demand and the availability of substitutes may be important considerations. If prices of potential substitutes become attractive because a commodity is expensive or there are delivery difficulties, demand may shift, temporarily or in some cases, permanently. Credit Risk Credit risk is one of the most prevalent risks of finance and business. In general, credit risk is a concern when an organization is owed money or must rely on another organization to make a payment to it or on its behalf. The failure of a counterparty is less of an issue when the organization is not owed money on a net basis, although it depends to a certain degree on the legal environment and whether funds are owed on a net or aggregate basis on individual contracts. The deterioration of credit quality, such as that of a securities issuer, is also a source of risk through the reduced market value of securities that an organization might own. Credit risk increases as time to expiry, time to settlement, or time to maturity increase. The move by international regulators to shorten settlement time for certain types of securities trades is an effort to reduce systemic risk, which in turn is based on the risk of individual market participants. It also increases in an environment of rising interest rates or poor economic fundamentals. Organizations are exposed to credit risk through all business and financial transactions that depend on the payment or fulfillment of obligations of others. Credit risk that arises from exposure to a counterparty, such as in a derivatives transaction, is often known as counterparty risk.

Default Risk Default risk arises from money owed, either through lending or investment, that the borrower is unable or unwilling to repay. The amount at risk is the defaulted amount, less any amount that can be recovered from the borrower. In many cases, the default amount is most or all of the advanced funds. Counterparty Pre-Settlement Risk Aside from settlement, counterparty exposure arises from the fact that if the counterparty defaults or otherwise does not fulfill its obligations under the terms of a contractual agreement, it might be necessary to enter into a replacement contract at far less favorable prices. The amount at risk is the net present value of future cash flows owed to the organization, presuming that no gross settlements would be required. Potential future counterparty exposure is a probability estimate of potential future replacement cost if market rates move favorably for the hedger, which would result in a larger unrealized gain for the hedger and larger loss in the event of default. The amount at risk is the potential net present value of future cash flows owed to the organization. Counterparty Settlement Risk Settlement risk arises at the time that payments associated with a contract occur, particularly cross payments between counterparties. It has the potential to result in large losses because the entire amount of the payment between counterparties may be at risk if a counterparty fails during the settlement process. As a result, depending on the nature of the payment, the amount at risk may be significant because the notional amount could potentially be at risk. Because of the potential for loss, settlement risk is one of the key market risks that market participants and regulators have worked to reduce. Settlement risk also exists with exchange-traded contracts.However, with exchange-traded contracts the counterparty is usually a clearinghouse or clearing corporation, rather than an individual institution. Sovereign or Country Risk Sovereign risk encompasses the legal, regulatory, and political exposures that affect international transactions and the movement of funds across borders. It arises through the actions of foreign governments and countries and can often result in significant financial volatility. Exposure to any nondomestic organization involves an analysis of the sovereign risk involved. In areas with political instability, sovereign risk is particularly important. Concentration Risk Concentration is a source of credit risk that applies to organizations with credit exposure in concentrated sectors. An organization that is poorly diversified, due to its industry or regional influences, has concentration risk. Concentration risk is most effectively managed with the addition of diversification, where possible.

Legal Risk

The risk that a counterparty is not legally permitted or able to enter into transactions, particularly derivatives transactions, is known as legal risk.The issue of legal risk has, in the past, arisen when a counterparty has suffered losses on outstanding derivatives contracts.A related issue is the legal structure of the counterparty, since many derivatives counterparties, for example, are wholly owned special-purpose subsidiaries. The risk that an individual employed by an entity has sufficient authority to enter into a transaction, but that the entity itself does not have sufficient authority, has also caused losses in derivatives transactions. As a result, organizations should ensure that counterparties are legally authorized to enter into transactions. Operational Risk Operational risk arises from human error and fraud, processes and procedures, and technology and systems. Operational risk is one of the most significant risks facing an organization because of the varied opportunities for losses to occur and the fact that losses may be substantial when they occur. Human Error and Fraud Most business transactions involve human decision making and relationships.The size and volume of financial transactions makes the potential damage as a result of a large error or fraud quite significant. Processes and Procedural Risk Processes and procedural risk includes the risk of adverse consequences as the result of missing or ineffective processes, procedures, controls, or checks and balances. The use of inadequate controls is an example of a procedural risk. Technology and Systems Risk Technology and systems risk incorporates the operational risks arising from technology and systems that support the processes and transactions of an organization. Other Types of Risk Other types of risk include equity price risk, liquidity risk, and systemic risk, which are also of interest to financial market participants. Risks arising from embedded options are also a consideration. Equity Price Risk Equity price risk affects corporate investors with equities or other assets the performance of which is tied to equity prices. Firms may have equity exposure through pension fund investments, for example, where the return depends on a stream of dividends and favorable equity price movements to provide capital gains. The exposure may be to one stock, several stocks, or an industry or the market as a whole.Equity price risk also affects companies

ability to fund operations through the sale of equity and equity-related securities. Equity risk is thus related to the ability of a firm to obtain sufficient capital or liquidity. Liquidity Risk Liquidity impacts all markets. It affects the ability to purchase or sell a security or obligation, either for hedging purposes or trading purposes, or alternatively to close out an existing position. Liquidity can also refer to an organization having the financial capacity to meet its short-term obligations. Assessing liquidity is often subjective and involves qualitative assessments, but indicators of liquidity include number of financial institutions active in the market, average bid/ask spreads, trading volumes, and sometimes price volatility. Although liquidity risk is difficult to measure or forecast, an organization can try to reduce transactions that are highly customized or unusual, or where liquidity depends on a small number of players and therefore is likely to be poor.Another form of liquidity risk is the risk that an organization has insufficient liquidity to maintain its day-to-day operations.While revenues and sales may be sufficient for long-term growth, if short-term cash is insufficient, liquidity issues may require decisions that are detrimental to long-term growth. +++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ Sources of Financial Risk There are three main sources of financial risk Financial risks arising from an organizations exposure to changes in market prices, such as interest rates, exchange rates, and commodity prices Financial risks arising from the actions of, and transactions with,other organizations such as vendors, customers, and counterparties in derivatives transactions Financial risks resulting from internal actions or failures of the organization,particularly people, processes, and systems +++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ Tools for FRM

Derivatives
1. Rise of Derivatives The global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates. The system of fixed prices came under stress from the 1970s onwards. High inflation and

unemployment rates made interest rates more volatile. The Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Less developed countries like India began opening up their economies and allowing prices to vary with market conditions. Price fluctuations make it hard for businesses to estimate their future production costs and revenues. Derivative securities provide them a valuable set of tools for managing this risk. This article describes the evolution of Indian derivatives markets, the popular derivatives instruments, and the main users of derivatives in India. I conclude by assessing the outlook for Indian derivatives markets in the near and medium term. 2. Definition and Uses of Derivatives A derivative security is a financial contract whose value is derived from the value of something else, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices. Derivatives may be traded for a variety of reasons. A derivative enables a trader to hedge some preexisting risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market. In India, most derivatives users describe themselves as hedgers and Indian laws generally require that derivatives be used for hedging purposes only. Another motive for derivatives trading is speculation (i.e. taking positions to profit from anticipated price movements). In practice, it may be difficult to distinguish whether a particular trade was for hedging or speculation, and active markets require the participation of both hedgers and speculators. A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of spot and derivatives prices, and thereby help to keep markets efficient.

1.4 Types of Financial Derivatives In the past section, it is observed that financial derivatives are those assets whose value are determined by the value of some other assets, called as the underlying. Presently, there are bewilderingly complex varieties of derivatives already in existence, and the markets are innovating newer and newer ones continuously. For example, various types of financial derivatives based on their different properties like, plain, simple or straightforward, composite, joint or hybrid, synthetic, leveraged, mildly leveraged, customized or OTC traded, standardized or organized exchange traded, etc. are available in the market. Due to complexity in nature, it is very difficult to classify the financial derivatives, so in the present context, the basic financial derivatives which are popular in the market have been described in brief. The details of their operations, mechanism and trading, will be discussed in the forthcoming respective chapters. In simple form, the derivatives can be classified into different categories which are shown in the Fig

One form of classification of derivative instruments is between commodity derivatives and financial derivatives. The basic difference between these is the nature of the underlying instrument or asset. In a commodity derivatives, the underlying instrument is a commodity which may be wheat, cotton, pepper, sugar, jute, turmeric, corn, soyabeans, crude oil, natural gas, gold, silver, copper and so on. In a financial derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign exchange, stock index, gilt-edged securities, cost of living index, etc. It is to be noted that financial derivative is fairly standard and there are no quality issues whereas in commodity derivative, the quality may be the underlying manners. However, the distinction between these two from structure and functioning point of view, both are similar in nature. Another way of classifying the financial derivatives is into basic and complex derivatives. In this, :r d conk-acts, futures contracts and option contracts have been included in the basic derivatives whereas swaps and other complex derivatives are taken into complex category because they are built up tram either forwards/futures or options contracts, or both. In fact, such derivatives are effectively derivates of derivatives. 1.5 Basic Financial Derivatives

1.5.1 Forward contracts A forward contract is a simple customized contract between two parties to buy or sell an asset at a certain time in the future for a certain price. Unlike future contracts, they are not traded on an exchange, rather traded in the over-the-counter market, usually between two financial institutions or between a financial institution and one of its client. Example: An Indian company buys Automobile parts from USA with payment of one million dollar clue in 90 days. The importer, thus, is short of dollar that is, it owes dollars for future delivery. Suppose present price of dollar is Rs 48. Over the next 90 days, however, dollar might rise against Rs 48. The importer can hedge this exchange risk by negotiating a 90 days forward contract with a bank at a price Rs 50. According to forward contract in 90 days the bank will give importer one million dollar and importer will give the bank 50 million rupees hedging a future payment with forward contract. On the due date importer will make a payment of Rs 50 million to bank and the bank will pay one

million dollar to importer, whatever rate of the dollar is after 90 days. So this is a typical example of forward contract on currency. The basic features of a forward contract are given in brief here as under: 1. Forward contracts are bilateral contracts, and hence, they are exposed to counter-party risk. There is risk of non-performance of obligation either of the parties, so these are riskier than to futures contracts. 2 Each contract is custom designed, and hence, is unique in terms of contract size, expiration date, the asset type, quality, etc. 3 In forward contract, one of the parties takes a long position by agreeing to buy the asset at a certain specified future date. The other party assumes a short position by agreeing to sell the same asset at the same date for the same specified price. A party with no obligation offsetting the forward contract is said to have an open position. A party with a closed position is, sometimes, called a hedger. 4. The specified price in a forward contract is referred to as the delivery price. The forward price for a particular forward contract at a particular time is the delivery price that would apply if they were entered into at that time. It is important to differentiate between the forward price and the delivery price. Both are equal at the time the contract is entered into. However, as time passes the forward price is likely to change whereas the delivery price remains the same. 5.In the forward contract the derivative assets can often be contracted from the combination of the underlying assets .Such assets are often known as synthetic assets in the forward market. 6. In the forward market, the contract has to be settled by delivery of the asset on expiration date. In case the party wishes to reverse the contract, it has to compulsory go to the same counter party, which may dominate and command the p1-ice it wants as being in a monopoly situation. 7. In the forward contract, covered parity or cost-of-carry relations are relation between the prices of forward and underlying assets. Such relations further assist in determining the arbitrage-based forward asset prices. 8. Forward contracts are very popular in foreign exchange market as well as interest rate bearing instruments. Most of the large and international banks quote the forward rate through their forward desk lying within their foreign exchange trading room. Forward foreign exchange quotes by these banks are displayed with the spot rates. 9. As per the Indian Forward Contract Act-1952, different kinds of forward contracts can be done like hedge contracts, transferable specific delivery (TSD) contracts and nontransferable specify delivery (NTSD) contracts. Hedge contracts are freely transferable and do not specific, any particular lot, consignment or variety for delivery. Transferable specific delivery contracts are though freely transferable from one party to another, but are concerned with a specific and predetermined consignment. Delivery is mandatory. Nontransferable specific delivery contracts, as the name indicates, are not transferable at all, and as such, they are highly specific. In brief, a forward contract is an agreement between the counter parties to buy or sell a specified quantity of an asset at a specified price, with delivery at a specified time (future)

and place. These contracts are not standardized, each one is usually being customized to its owners specifications. 1.5.2 Futures contracts Like a forward contract, a futures contract is an agreement between two parties to buy or sell a specified quantity of an asset at a specified price and at a specified time and place. Futures contracts are normally traded on an exchange which sets the certain standardized norms for trading in the futures contracts . Example: A silver manufacturer is concerned about the price of silver since be will not be able to plan for profitability. Given the current level of production, he expects to have about 20.000 ounces of silver ready in next two months. The current price of silver on may 10 is Rs.1052.5 per ounce, and July futures price at FMC is Rs 1068 per ounce, which he belives to be a satisfactory price. But he fears that prices in future may go down. So he will enter into a futures Contract. He will sell four contracts at MCX where each contract is of 5000 ounces at Rs 1069 for delivery in July.

In the above example trader has hedged his risk of prices fall and the trading is done through standardized exchange which has standardized contract of 5000 ounce silver. The futures contracts have following features in brief: Standardization: One of the most important features of futures contract is that the contract has certain standardized specification, i.e., quantity of the asset, quality of the asset, the date and month of delivery, the units of price quotation, location of settlement, etc. For example, the largest exchange on which futures contracts are traded are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME). They specify about each terjn of the futures contract. Clearing house: In the futures contract, the exchange clearing house is an adjunct of the exchange and acts as an intermediary or middleman in futures. It gives the guarantee for the performance of the parties to each transaction. The clearing house has a number of members all of which have offices near to the clearing house. Thus, the clearing house is the counter party to every contract.

Settlement price: Since the futures contracts are performed through a particular exchange, so at the close of the day of trading, each contract is marked-to-market. For this the exchange establishes a settlement price. This settlement price is used to compute the profit or loss on each contract for that day. Accordingly, the members accounts are credited or debited. Daily settlement and margin: Another feature of a futures contract is that when a person enters into a contract, he is required to deposit funds with the broker, which is called as margin. The exchange usually sets the minimum margin required for different assets, but the broker can set higher margin limits for his clients which depend upon the creditworthiness of the clients. The basic objective of the margin account is to act as collateral security in order to minimize the risk of failure by either party in the futures contract. Tick size: The futures prices are expressed in currency units, with a minimum price movement called a tick size. This means that the futures prices must be rounded to the nearest tick. The difference between a futures price and the cash price of that asset is known as the basis. Cash settlement: Most of the futures contracts are settled in cash by having the short or long to make a cash payment on the difference between the futures price at which the contract was entered and the cash price at expiration date. This is done because it is inconvenient or impossible to deliver somet2rnes. the underlying asset. This type of settlement is very much popular in stock indices futures contracts Delivery: The futures contracts are executed on the expiry date. The counter parties with a short are obligated to make delivery to the exchange, whereas the exchange is obligated to make to the longs. The period during which the delivery will be made is set by the exchange which which varies from contract to contract. Reagulation: The important difference between futures and forward markets is that the futures through a exchange, but the forward contracts are self regulated by the counter parties themselves.The various countries have established Commissions in their country to regulate future markets in stocks and commodities. Any such new futures contracts and changes to 1.5.3 Options contracts Options are the most important group of derivative securities. Option may be defined as a contract, between two parties whereby one party obtains the right, but not the obligation, to buy or sell a particular asset, at a specified price, on or before a specified date. The person who acquires the right is known as the option buyer or option holder, while the other person (who confers the right) is known as option seller or option writer. The seller of the option for giving such option to the buyer charges an amount which is known as the option premium.

Options can be divided into two types: calls and puts. A call option gives the holder the right to buy an asset at a specified date for a specified price whereas in put option, the holder gets the right to sell an asset at the specified price and time. The specified price in such contract is known as the exercise price or the strike price and the date in the contract is known as the expiration date or the exercise date or the maturity date. The asset or security instrument or commodity covered under the contract is called as the underlying asset. They include shares, stocks, stock indices, foreign currencies, bonds, commodities, futures contracts, etc. Further options can be American or European. A European option can be exercised on the expiration date only whereas an American option can be exercised at any time before the maturity date. Example: Suppose the current price of CIPLA share is Rs 750 per share. X owns 1000 shares of CIPLA Ltd. and apprehends in the decline in price of share. The option (put) contract available at BSE is of Rs 800, in next two-month delivery. Premium cost is Rs 10 per share. X will buy a put option at 10 per share at a strike price of Rs 800. In this way X has hedged his risk of price fall of stock. X will exercise the put option if the price of stock goes down below Rs 790 and will not exercise the option if price is more than Rs 800, on the exercise date. In case of options, buyer has a limited loss and unlimited profit potential unlike in case of forward and futures. In April 1973, the options on stocks were first traded on an organized exchange. ie, Chicago Board Options Exchange. Since then, there has been a dramatic growth in options markets. Options are now traded on various exchanges in various countries all over the world. Options are now traded both on organized exchanges and over-the-counter (OTD). The option trading mechanism on both are quite different and which leads to important differences uin market conventions. Recently, options contracts on OTC are getting popular because they more liquid. Further most of the banks and other financial institutions now prefer the OTC options market because of the ease and customized nature of contract. It should be emphasized that the options contract gives the holder the right to do something. The holder may exercise his option or not. The holder can make a reassessment of the situation and seek either the execution of the contracts or ono execution as be profitable to him. He is not under obligation to exercise the option. So this fact distinguishes options from forward contracts and futures contracts, where the brokes is under obligation to buy or sell the underlying asset. Recently in India, the banks are allowed ot write cross currency options after obtaining the permission from the Reserve Bank of India 1.5.4 Warrants and convertibles Warrants and convertibles are another important categories of financial derivatives, which are frequently traded in the market. Warrant is just like an option contract where the holder has the right to buy shares of a specified company at a certain price during the given time period. In other words, the holder of a warrant instrument has the right to purchase a specific number of shares at a fixed price in a fixed period from a issuing company. If the holder exercised the right, it increases the number of shares of the issuing company, and thus, dilutes the equities of its shareholders. Warrants are usually issued as sweeteners attached to senior securities like bonds and debentures so that they are successful in their

equity issues in terms of volume and price. Warrants can be detached and traded separately. Warrants are highly speculative and leverage instruments, so trading in them must be done cautiously. Convertibles are hybrid securities which combine the basic attributes of fixed interest and variable return securities. Most popular among these are convertible bonds, convertible debentures and convertible preference shares. These are also called equity derivative securities. They can be fully or partially converted into the equity shares of the issuing company at the predetermined specified terms with regards to the conversion period, conversion ratio and conversion price. These terms may be different from company to company, as per nature of the instrument and particular equity issue of the company. 1.5.5 Swap contracts Swaps have become popular derivative instruments in recent years all over the world. A swap is an agreement between two counter parties to exchange cash flows in the future. Under the swap agreement, various terms like the dates when the cash flows are to be paid, the currency in which to be paid and the mode of payment are determined and finalized by the parties. Usually the calculation of cash flows involves the future values of one or more market variables. There are two most popular forms of swap contracts, i.e., interest rate swaps and currency swaps. In the interest rate swap one party agrees to pay the other party interest at a fixed rate on a notional principal amount, and in return, it receives interest at a floating rate on the same principal notional amount for a specified period. The currencies of the two sets of cash flows arc the same. In case of currency swap, it involves in exchanging of interest flows, in one currency for interest flows in other currency. In other words, it requires the exchange of cash flows in two currencies. There are various forms of swaps based upon these two, but having different features in general. 1.5.6 Other derivatives As discussed earlier, forwards, futures, options, swaps, etc. are described usually as standard or plain vanilla derivatives. In the early 1980s, some banks and other financial institutions have been very imaginative and designed some new derivatives to meet the specific needs of their clients. These derivatives have been described as non-standard derivatives. The basis of the structure of these derivatives was not unique, for example, some non-standard derivatives were formed by combining two or more plain vanilla call and put options whereas some others were far more complex. In fact, there is no boundary for designing the non-standard financial derivatives, and hence, they are sometimes termed as exotic options or just exotics. There are various examples of such non-standard derivatives such as packages, forward start options, compound options, choose options, barrier options, binary options, look back options, shout options, Asian options, basket options, Standard Oils Bond Issue, Index Currency option Notes, range forward contracts or flexible forwards and so on.

2.2 Financial & Futures Contracts A futures contract is an agreement between a buyer and a seller where the seller agrees to deliver a specified quantity and grade of a particular asset at a predetermined time in futures at an agreed upon price through a designated market (exchange) under stringent financial safeguards. A futures contract, in other words, is an agreement to buy or sell a particular asset between the two parties in a specified future period at an agreed price through specified exchange. For example, the S&P CNX NIFTY futures are traded on National Stock Exchange (NSE). This provides them transparency, liquidity, anonymity of trades, and also eliminates the counter party risks due to the guarantee provided by National Securities Clearing Corporation Limited (NSCCL). Bombay Stock Exchange (BSE) website defines futures contract: Futures are exchange traded contracts to sell or buy financial instruments or physical commodities for future delivery at an agreed price. There is an agreement to buy or sell a specified quantity of financial instrument/commodity :n a designated future month at a price agreed upon by the buyer and the seller. The contracts have certain standardized specifications. The standardized items in any futures contract are: Quantity of the underlying asset Quality of the underlying asset (not required in financial futures) The date and month of delivery The units of price quotation (not the price itself) and minimum change in price (tick-size) From the above, it is evident that a financial futures termed as a notional commitment to buy or sell standard quantity of a financial instrument at a specified (predetermined) price on a specified future date. It means this market is rarely used for the exchange of financial instruments. In fact, financial futures markets are independent of the underlying assets. For example, currency futures contracts are different from the currencies themselves. No doubt, currency futures prices normally move in the direction of the related underlying currency prices changes, but sometimes this relationship may not exist. For example, contract traded on Chicago Mercantile Exchange of wheat for the fine grade delivery months in March, May, July, September and December are available for up to 18 months into the future. Eh contract size is 5000 bushels. Contracts traded on National Stock Exchange of equity share for delivery period of one, two, six and twelve months named as NIFTY futures, Each contract size is of 50 shares comprising different companies from different sector of Economy. In general, financial futures are not different from commodity futures except of the underlying asset, for example, in commodity futures, a particular commodity like food grains, metals, vegetables, etc. are traded whereas in financial futures, various particular financial instruments like equity shares, debentures, bond, treasury securities, currencies, etc. are traded. There are now a large variety of financial futures contracts available at the various markets (centres) like Chicago, London, Tokyo and so on.

2.3 Types of Financial Futures Contracts These are different types of contracts in financial futures which are traded in the various futures financial markets of the world. These contracts can be classified into various categories which are as under 2.3.1 Interest rate futures It one of the important financial futures instruments in the world. Futures trading on interest bearing securities started only in 1975, but the growth in this market has been tremendous. Important interest- bearing securities are like treasury bills, notes, bonds, debentures, euro-dollar deposits and municipal bonds. In this market, almost entire range of maturities bearing securities are traded. For example, three- month maturity instruments like treasury bills and euro-dollar time deposits, including foreign debt instruments at Chicago Mercantile Exchange (CME), British Government Bonds at London International Financial Futures Exchange (LIFFE), Japanese Government Bonds at CBOT, etc. are traded. This market is also further categorized into short-term and long-term interest bearing instruments. A few important interest rate futures traded on various exchanges are: notional gilt-contracts, short-term deposit futures, treasury bill futures, euro-dollar futures, treasury bond futures and treasury notes futures. 2.3.2 Foreign currencies futures These financial futures, as the name indicates, trade in the foreign currencies, thus, also known as exchange rate futures. Active futures trading in certain foreign currencies started in the early 1970s. Important currencies in which these futures contracts are made such as US-dollar, Pound Sterling, Yen, French Francs, Marks, Canadian dollar, etc. These contracts have a directly corresponding to spor market, known as inter bank foreign exchange market, and also have a parallel inter bank forward market Normally futures currency contracts are used for hedging purposes by the exporters, importers, bankers, financial institutions and large companies. 2.3.3 Stock index futures These are another major group of futures contracts all over the world. These contracts are based on stock market indices. For example, in the US markets, there exist various such futures contracts based on different indices like Dow Jones Industrial Average, Standard and Poors 500, New York Stock Exchange Index, Value Line Index, etc. Other important futures contracts in different countries are like in London market, based on the Financial TimesStock Exchange 100 share Index, Japanese Nikkei Index on the Tokyo Futures Exchange and on the Singapore International Monetary Exchange (SIMEX) as well. Similarly, in Septembet, 1990, Chicago Mercantile Exchange began trading based on Nikkei 225 Stock Index and Chicago Board of Trade launched futures contracts based on the TOPIX index of major firms traded on the Tokyo Stock Exchange. One of the most striking features of these contracts is that they do not insist upon the actual delivery, only traders obligation must be fulfilled by a reversing trade or settlement by cash payment at the end of trading. Stock Index futures contracts are mainly used for hedging and speculation purposes. These are commonly traded by mutual funds, pension funds, investment trusts, insurance companies, speculators, arbitrageurs and hedgers.

2.3.4 Bond index futures Like stock index futures, these futures contracts are also based on particular bond indices, i.e., indices of toad prices. As we know that prices of debt instruments are inversely related to interest rates, so the bond index is also related inversely to them. The important example of such futures contracts based on bond index is the Municipal Bond Index futures based on US Municipal Bonds which is trac cur Chicago Board of Trade (CBOT). 2.3.5 Cost of living index futures This is also known as inflation futures. These futures contracts are based on a specified cost of living index, for example, consumer price index, wholesale price index, etc. At International Monetary Market (1MM) in Chicago, such futures contracts based on American Consumer Price Index are traded. Since in USA, the inflation rates in 1980s and 1990s were very low, hence, such contracts could not be popular in the futures market. Cost of living index futures can be used to hedge against unanticipated inflation which cannot be avoided. Hence, such futures contracts can be very useful to certain investors like provident funds, pension funds, mutual funds, large companies and governments. 2.5 Operators/Traders in Futures Market Futures contracts are bought and sold by a large number of individuals, business organizations, governments and others for a variety of purposes. The traders in the futures market can be categorized on the basis of the purposes for which they deal in this market. Usually financial derivatives attract following types of traders which are discussed here as under: Hedgers: In simple term, a hedge is a position taken in futures or other markets for the purpose of reducing exposure to one or more types of risk. A person who undertakes such position is called as hedger. In other words, a hedger uses futures markets to reduce risk caused by the movements in prices of securities, commodities, exchange rates, interest rates, indices, etc. As such, a hedger will take a position in futures market that is opposite a risk to which he or she is exposed. By taking an opposite position to a perceived risk is called hedging strategy in futures markets. The essence of hedging strategy is the adoption of a futures position that, on average, generates profits when the market value of the commitment is higher than the expected value. For example, a treasurer of a company knows the foreign currency amounts to be received at certain futures time may hedge the foreign exchange risk by taking a short position (selling the foreign currency at a particular rate) in the futures markets. Similarly, he can take a long position (buying the foreign currency at a particular rate) in case of futures foreign exchange payments at a specified futures date. The hedging strategy can be undertaken in all the markets like futures, forwards, options, swap, etc. but their modus operandi will be different. Forward agreements are designed to offset risk by fixing the price that the hedger will pay or receive for the underlying asset. In case of option strategy, it provides insurance and protects the investor against adverse price movements. Similarly, in the futures market, the investors may be benefited from favourable price movements.

Speculators: A speculator may be defined as an investor who is willing to take a risk by taking futures position with the expectation to earn profits. The speculator forecasts the future economic conditions and decides which position (long or short) to be taken that will yield a profit if the forecast is realized. For example, suppose a speculator has forecasted that price of gold would be Rs 5500 per 10 grams after one month. If the current gold price is Rs 5400 per 10 grams, he can take a long position in gold and expects to make a profit of Rs 100 per 10 grams. This expected profit is associated with risk because the gold price after one month may decrease to Rs 5300 per 10 grams, and may loseRs 100 per 10 grams. Speculators usually trade in the futures markets to earn profit on the basis of difference in spot and futures prices of the underlying assets. Hedgers use the futures markets for avoiding exposure to adverse movements in the price of an asset whereas the speculators wish to take position in the market based upon such movements in the price of that asset. It is pertinent to mention here that there is difference in speculating trading between spot market and forward market. In spot market a speculator has to make an initial cash payment equal to the total value of the asset purchased whereas no initial cash payment except the margin money, if any, to enter into forward market. Therefore, speculative trading provide the investor with a much higher level of leverage than speculating using spot markets. That is why, futures markets being highly leveraged market, minimums are set to ensure that the speculator can afford any potential losses. Speculators can be classified into different categories. For example, a speculator who uses fundamental analysis of economic conditions of the market is known as fundamental analyst whereas the one who uses to predict futures prices on the basis of past movements in the prices of the asset is known as technical analyst. A speculator who owns a seat on a particular exchange and trades in his own name is called a local speculator. These, local speculators can further be classified into three categories, namely, scalpers, pit traders and floor traders. Scalpers usually try to make profits from holding positions for short period of time. They bridge the gap between outside orders by filling orders that come into the brokers in return for slight price concessions. Pit speculators like scalpers take bigger positions and hold them longer. They usually do not move quickly by changing positions overnights. They most likely use outside news. Floor traders usually consider inter commodity price relationship. They are full members and often watch outside news carefully and can hold positions both short and long. Arbitrageurs: Arbitrageurs are another important group of participants in futures markets. An arbitrageur is a trader who attempts to make profits by locking in a riskless trading by simultaneously entering into transactions in two or more markets. In other words, an arbitrageur tries to earn riskiess profits from discrepancies between futures and spot prices and among different futures prices. For example, suppose that at the expiration of the gold futures contract, the futures price is Rs 5500 per 10 grams, but the spot price is Rs 5480 per 10 grams. In this situation, an arbitrageur could purchase the gold for Rs 5480 and go short a futures contract that expires immediately, and in this way making a profit of Rs 20 per 10 grams by delivering the gold for Rs 5500 in the absence of transaction costs. The arbitrage opportunities available in the different markets usually do not last long because of heavy transactions by the arbitrageurs where such opportunity arises. Thus, arbitrage keeps the futures and cash prices in line with one another. This relationship is also expressed by the simple cost of carry pricing which shows that fair futures prices, is the set

of buying the cash asset now and financing the same till delivery in futures market. It is generalized that the active trading of arbitrageurs will leave small arbitrage opportunities in the financial markets. In brief, arbitrage trading helps to make market liquid, ensure accurate pricing and enhance price stability. It involves making profits from relative mispricing. Spreaders: Spreading is a specific trading activity in which offsetting futures position is involved y creating almost net position. So the spreaders believe in lower expected return but at the less risk. For a sucessful trading in spreading, the spreaders must forecast the relevant factors which affect the changes in the spreads. Interest rate behaviour is an important factor which causes changes in the spreads. In a profitable spread position, normally, there is large gain on one side of the spread in comparison to the loss on the other side of the spread. In this way, a spread reduces the risk even if the forecast is incorrect. On the other hand, the pure speculators would make money by taking only the profitable side of the market but at very high risk. 13.2 SWAP Concept and Nature The meanings of word Swap or Swop as per the Chambers Dictionary are to barter or to give in exchange or to exchange one for another. So, in business world, swaps have been termed as private agreements between the two parties to exchange cash flows in the future according to a prearranged formula.. In simple words, a swap is an agreement to exchange payments of two different kinds in the future. Since it involves exchange of cash flows or payments, hence, it is also called financial swap in global financial markets. In the context of financial markets, the term swap has two meanings. First, it is a purchase and simultaneous forward sale or vice versa. Second, it is defined as the agreed exchange of future cash flows, possibly, but not necessarily with a spot exchange of cash flows. The second definition of swap is most commonly used stating as an agreement to the future exchange of cash flows. These can be regarded as series or portfolios of forward contracts. Such a currency swap is similar to a succession of forward foreign exchange contracts with relatively more distant maturity basis. The study of swap is, thus a natural extension of the study of forward and futures contracts. Financial swap is a specific funding technique which permits a borrower to access one market and then exchange the liability for another type of liability. In other words, swaps can be helpful to change the nature of liability accrued on a particular instrument with the others. It means that swaps are not a funding instrument, rather just like a device to obtain the desired form of financing indirectly which otherwise might be inaccessible or too expensive. Since, the swaps involve the exchange of cash flows, there are a wide variety of basis of cash flows in a business firm. For example, in case of interest payments, the typical exchange may be of cash flows arising from a fixed rate of interest to cash flows arising from floating rate of interest. Foreign currency transactions can be exchanged with the different cash flows arising out in different currencies. Equity swaps tend to involve cash

flows based on the returns from a stock index portfolio being exchanged for the cash flows based on an interest rate. Basically, swaps involve the exchange of interest or currency exposures or a combination of both by two or more borrowers. They may not necessarily involve legal swapping of actual debts but an agreement is executed to meet certain cash flows under loan lease agreements. Swaps markets exist because different companies and institutions have specific access to various financial markets, and further they have different needs. For example, some of the firms may have better access in Japanese markets than others, whereas some others may have good reputation in US markets, Further, some firms need floating rate payments. It is often a more advantageous to swap payments with another party, thus, transforming ones liability, rather than borrowing directly in the desired mark. In brief, it is observed that the swap is private agreement between the two parties to exchange predetermined amount of cash flows in future as per desired predetermined formula along with terms and conditions. 13.4 Features of Swaps Important features of a swap agreement, in common, are stated as follows: counter parties: All swaps involve the exchange of a series of periodic payments between atleast two parties. For example. a firm having a loan of ten million dollar payable at ten percent fixed rate for five years wants to exchange for a floating interest rate with that party who is also interested to exchange its liability from floating to fixed. It means, for a swap agreement, there must be two parties who are ready to exchange their liabilities with each other. Facilitators: Swap agreements are arranged mostly, (known as swap facilitators), through an intermediary which is usually a large international financial institution/bank having network of its in major countries. This institution is normally having contracts with major international business 1minm who have direct link with other firms. These intermediaries play a significant role in bringing close various parties for such deals. They will note down the requirements of the parties and try to match and fulfil these with other parties. Swap facilitators can be classified into two categories: Brokers. They function as agents that identify and bring the counter parties on the table for deal. The brokers basic objective is to initiate the counter parties to finalize the swap deal x according to their respective requirements. Swap dealers. They themselves become counter-parties and takeover the risk. Since the swap dealers are the part of the swap deals, therefore, they face two important problems. First, how to price swap amd provide for his service. Second, the swap dealer creates a portfolio, therefore, the second problem is to manage this portfolio. Cash flows: In the swap deal, two different payment streams in terms of cash flows are estimated to have identical present values at the outset when discounted at the respective cost of funds in relevant primary markets. As described earlier, swap deal is an exchange of

two financial obligations in future obviously, both the parties would desire to have same financial liabilities as before the swap deal.so in a swap deal, the present value of future cash streams are examined, and then appropriate decision. Documentations: Swap transactions may be set up with great speed since their documentations and formalities are generally much less in comparable to loan deals. Basically, in swap deals evaluation of various futures cash streams arisen out in various contracts done in past. If the terms of different contracts suit the interested firms requirements, the deal will be enacted. Thus, such deals are less complicated, less time consuming and simpler in terms of documentations and other formulation. Transaction costs: It has been also observed that transaction costs are relatively low in such transactions in comparison to loan agreements. They are unlikely to exceed half percent of the total sum involved in the swap agreement. Benefit to parties: Swap deals are needed as long as it is profitable to transform them.In other words, swap agreements will be done only when the parties will be benefited by such agreements. otherwise such deals will not be excepted. This will be discussed further in the economics of Termination: Since swap is an agreement between two parties, therefore, it cannot be terminated at ones instance. The termination also requires to be accepted by counter parties. Default risk: Since most of the swap deals are bilateral agreements, therefore, the problem of potential default by either of the counter party exist, hence, making them more risky products in comparison to futures and options. 13.5 Major Types of Financial Swaps As observed earlier, the basic objective of a swap deal is to hedge the risk as desired by the counter parties. The major risks, which can be changed with the swap transactions relating to interest rate, currency commodity, equity, credit, climate and so on. Hence, in this section only important financial are popular in financial markets, have been discussed. Interest Rate Swaps Currency Swaps Equity swaps 13.6 Interest Rate Swaps An interest rate swap is a financial agreement between the two parties who wish to change the interest payments or receipts in the same currency on assets or liabilities to a different basis. There is no exchange of principal amount in this swap. In other words, it is an exchange of interest payment for a specific maturity on a agreed upon notional amount. The term notional refers to the theoretical principal underlying the swap. The principal amount applies only for the purpose of calculating the interest to be exchanged under an

interest rate swap. Maturities range from a year to over 15 years, however, most transactions fall within two years to ten years period. The simplest example of interest rate swap is to exchange of fixed for floating rate interest payments between the parties in the same currency. This is also known in the market as plain vanilla swap, exchange of borrowings or coupon swap. it involves credit differentials between two borrowers in the fixed and floating debt markets which generate substantial cost savings for both the counter parties. 13.6.3 Types of interest rate swaps Plain vanila swap: It is also known as fixed-for-floating swap. In this swap, one party with floating interest rate liability is exchanged with fixed rate liability. Usually swap period ranges from 2 years to over 15 years for a pre-determined notional principal amount. Most of deals occur within four year period. Zero coupon to floating: The holders of zero-coupon bonds get the full amount of loan and interest accrued at the maturity of the bond. Hence, in this swap, the fixed rate player makes a bullet payment at the end and floating rate player makes the periodic payment throughout the swap period. Alternative floating rate: In this type of swap, the floating reference can be switched to other as per the requirement of the counter party. These alternatives include three-month LIBOR commercial paper (which refers to the Federal Reserve release), T-Bill rate, etc. In other words. floating interest rates are charged in order to meet the exposure of other party. Floating to floating: In this swap, one counter party pays one floating rate say. LIBOR while the other counter party pays another, say, prime for a specified time period. These swap deals are mainly used by non-US banks to manage their dollar exposure. Forward swap: This swap involves an exchange of interest rate payment that does not begin until a specifed future point in time. It is also kind of swap involving fixed for floating interest rate. Ratecapped swap: In this type of swap, there is exchange of fixed rate payments for floating rate payments, whereby the floating rate payments are capped. An upfront fee is paid by floating rate party to the fixed rate party for the cap. Swaptions: Swaptions are combination of the features of two derivative instruments, i.e., option and swap. Option interest rate swaps are referred as swaptions. The buyer of the swaption has the right to enter into an interest rate swap agreement by some specified date in the future. The swaption agreement will specify whether the buyer of the swaption will be a fixed rate receiver or a fixed rate payer. If the buyer exerrcises the option then the writer of the option will become the counter party. Extendable swap: Extendable swap contains an extendable feature, which allows fixed for floating counter party to extend the swap period.

Equity swap: The equity swap involves the exchange of interest payment linked to the change iii the stock index. For example, an equity swap agreement may allow a company to swap a fixed interest of 6 percent in exchange for the rate of appreciation on a particular index, say, BSE or NSE Index, each year over the next four years. 13.7 Currency Swap A swap deal can also be arranged across currencies. It is an oldest technique in swap market, in this swap, the two payment streams being exchanged are denominated in two different currencies. Fc example, a firm which has borrowed Japanese yen at a fixed interest rate can swap away the exchang4 rate risk by setting up a contract whereby it receives yen at a fixed rate in return for dollars at either a fixed or a floating interest rate. The currency swap is, like interest rate swap, also two party transaction, involving two counter parties with different but complimentary needs being bought by a bank. In this swap, normally three basic steps are involved which are as under: 1. Initial exchange of principal amount 2. Ongoing exchange of interest 3. Re-exchange of principal amounts on maturity The first step in this swap is the initial exchange of the principal amounts at an agreed rate of exchange. This rate is usually based on the spot exchange rate. This initial exchange can be on a notional basis, i.e., no physical exchange of principal amounts. The counter parties simply convert principal amounts into the required currency-via-the spot market. The second step is related with ongoing exchange of interest. After establishing the principal amounts, the counter parties exchange interest payment on agreed date based on the outstanding principal amounts at the fixed interest rates agreed at the outset of the transaction. The third step is the re-exchange of principal to principal amounts. Agreement on this enables the counter parties to re-exchange the principal sums at the maturity date. These three steps have been shown through an example. 13.7.1 Types of currency swaps The structure of currency swaps differs from interest rate swaps in a variety of ways. The major difference is that in a currency swap, there is always an exchange of principal amounts at maturity at a predetermined exchange rate. Thus, the swap contract, behaves like a long dated forward, is foreign exchange contract, where the forward is the current spot rate. The currency swaps can be of different types based on their term structure such as fixed-to-fixed currency swap, floating-to-floating currency swap, fixed-to-floating currency swap and so on. These have been discussed in brief. Fixed-to-fixed currency swap: In this category, the currencies are exchanged at fixed rate. This swap works like this. One firm raises a fixed rate liability in currency X, say US dollar ($) while the other firm raises fixed rate funding in currency Y, say, Pound (i). The principal amounts are equivalent at the current market rate of exchange. In swap deal, first party will get pound whereas the second party gets dollars. Subsequently, the first party will make periodic get (pound) payments to the second, in turn gets dollars computed at

interest at a fixed rate on the respective principal amount of both currencies. At maturity, the dollar and pound principal are re-exchanged. Floating to floating swap: In this category, the counter parties will have payments at floating rate in different currencies. Fixed-to-floating currency swap: This swap is a combination of a fixed-to-fixed currency Swap and floating swap. In this, one party makes the payment at a fixed rate in currency, say, X while the ng rate in currency, say, Y. Contracts without the exchange and reexchange of principal do exist. In most cases a financial intermediary (a swap bank) structures the swap deal and remits the payment from one party to the other. 13.8 Debt-equity Swap There can be different structure of swap contracts but the basics are fairly simple. In debtequity swap a firm buys a countrys debt on the secondary loan market at a discount and swaps it into local equity. In other words, the debts are exchanged for equity by one firm with the other. Recently, a market for less-developed countries (LDC) debt-equity swap has developed that enables the investors to purchase the external debts of such underdeveloped countries to acquire equity or domestic currency in those same countries. Earlier, six major debt notionsChile, Brazil, Mexico, Venezuela, Argentina and the Philippines have initiated such debt-equity swap programmes. This market was developed in 1985, and by the 1988, the same was reached to $15 billion in size, and further it is rising trend. In this typical swap deal, for example, a multinational firm wants to invest in, say, Brazil, hires an intermediary (normally a bank) to buy Brazil loans in the secondary market. The MNC (again through a middleman) presents the loans, denominated in dollar as, to the Brazil Central Bank, which redeems them for Brazil currency. The Central Bank, which redeems them at face value but more than the loans trade in the secondary markets. For example, Mexico pays 88 percent and Chile 92 percent for such swaps. Further, in such deal, if an MNC wants to develop in Chile can pick up $100 million of loans in secondary market for $70 million and swap them for $92 million in pesos. Chile gets $100 million of debt its books and does not have to part with precious currency dollars. The MNC gets $92 million investment for $70 million, which amounts to a 24 percent app.(22/92)as subsidy. 14.2 The Concept of Options An option is a particular type of a contract between two parties where one person gives the other persen the right to buy or sell a specific asset at a specified price within a specific time period. In other words. option is a specific derivative instrument under which one party gets the right, but no obligation, to buy or sell a specific quantity of an asset at an agreed price, on or before a particular date. For example, person buys an option contract to purchase 100 shares of State Bank of India at Rs 300 per share for a period of 3 months. It means that the said person has the right to purchase the share of State Bank d india at Rs 300 per share within 3 months from the date of the contract. If the price of State Bank of

India increases, he will exercise the option, and if the price falls below Rs 300 then he will not exercise the option. It is evident from the above that an option is the right, but not the obligation to buy or sell something at a specified date at a stated price. It means the option buyer will exercise the optionally when he is in profit. In case of loss, he will not exercise the option. Today, options are traded on a variety of instruments like commodities, financial assets as diverse as foreign exchange, bank time deposits, treasury securities, stocks, stock indexes, petroleum products, food grains, metals, etc. 14.4 Options Terminology Following are the important terms which are frequently used in option trading: Parties of the option contract: There are two parties to an option contract: the buyer (the holder) and the writer (the seller). The writer grants the buyer a right to buy or sell a particular asset exchange for a certain sum of money for the obligation taken by him in the option contract. Exercise price: The price at which the underlying asset may be sold or purchased by the option buyer from the option writer is called as exercise or strike price. At this price the buyer can exercise his option. Expiration date and exercise date: The date on which an option contract expires is called as expiration date or maturity date. The option holder has the right to exercise his option on any date before the expiration date. In other words, the date after which an option is void is called the expiration date. Exercise date is the date upon which the option is actually exercised whereas the expiration date the last day upon which the option may be exercised. Option premium: The price at which option holder buys the right from the option writer is called option premium or option price. This is the consideration paid by the buyer to the seller and it remained with the seller whether the option is exercised or not. In other words, the price or premium is paid by the holder to the writer of the option against the obligation undertaken. This is fixed and paid at the time of the formation or writing an option deal. Option In, OutandAt-the-money: An option contract at a particular time, can be inthemoney, out-of-the money and at-the-money. When the underlying futures price/stock price is greater than the strike or exercise price, the call option will be in-the-money, and if the futures price is lesser ti the strike price, it will be called out-of-the money call option. Further, if the futures price is equal to strike price, it is said that call option is at-the-money. The reverse is the position in case of put options. This has been shown in Table

It should be noted that some financial experts have considered the market price of the stock ops instead of futures price to determine the option as in-the-money or out-of-the money. Since the options are listed with the exchanges and the market price changes as per chances in the price of underlying asset, so it can also be used to see whether the option is profitable or not. The break even price: It is that price of the stock where the gain on the option is just equal to option premium. The break-even-price level is determined by adding the strike price and the premium paid together. In other words, the option is sufficiently deep in-the-money to cover the option premium l yields a potentially unlimited net profit. Since there is zerosum-game, the profit from selling a call is mirror image of the profit from buying the call. 14.4.1 Types of options Options can be classified into different categories: I. Call and Put options 2 American and European options 3. Exchange-traded and OTC-traded options CalI and put options: When an option grants the buyer (holder) the right to purchase the wm1erIying asset/stock from the writer (seller) a particular quantity at a specified price within a specified expiration date, it is called call option or simply a call. It is an option to purchase; its holder has the pivilege of purchasing or calling from a second party (i.e. writer) to buy an asset. The call option holder pays the premium to the writer for the right taken in the option. A put option, on the other hand, is an option contract where the option buyer has the right to sell the underlying asset to the writer, at a specified price at or prior to the options maturity date. It is also called, simply a put. Thus, if you buy a put option on State Bank of India stock, you have gained the right to sell the shares of SBI to the writer at a specified price on or before the expiration date. American and European options: On the basis of the timing of the possible exercise, the option contracts can also be classified into two categories: American options and European options. A European option can be exercised only at the expiration date whereas the American option can be exercised at any time up to and including the expiration date.

Thus, the definitions given above relating to call and put options apply to the American style options. Most of the options traded in the world today are American style options. There is nothing particularly geographical about the names, it is just an convention. Exchange-traded and OTC-traded options: The options can be traded like other financial assets either on an organized exchange or on the over-the-counter (OTC) market. Exchange traded option contracts, like futures contracts are standardized and are traded on the recognized exchanges. On the other hand, over-the-counter (OTC) options are customertailored agreements sold directly by the dealer rather than through an organized exchange. The terms and conditions of these contracts are negotiated by the parties to the contract. Both the options have different mechanism of functioning. +++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ Integrated Risk Management Integrated Risk Management is an explicit and systematic approach to managing strategic, operational and project risk to organizational objectives, from an organization-wide perspective. Integrated Risk Management involves the culture, structures and processes for a proactive, systematic and explicit organization-wide discipline that identifies, assesses, manages and communicates all risks that can have a meaningful impact on the achievement of important objectives. In doing so, it fulfills key management accountability and governance expectations set down by the Organization. 2. Definition and process of integrated risk management 2.1 Definition Irrespective of the numerous existing definitions of the terms 'risk' and 'risk management', this paper takes a broader base as its point of departure and regards integrated risk management as a technique whereby all the risks of an open system, such as an organization, are taken into account and, furthermore, an attempt is made to optimize them as part of an all-encompassing approach. Consequently, integrated risk management as it is understood here is highly procedural by nature. In relation to the insurance industry, this means that integrated risk management is geared to the simultaneous recording and managing of as far as possible all the risks at a company, irrespective of whether these were previously classed as uninsurable or indeed even belong to the non-underwriting sector, and irrespective of the type of risk-policy instruments to be used. Ultimately, the goal is to hedge both sides of the balance sheet simultaneously as part of an integrated risk management approach. The main arguments in favour of such an approach are efficiency criteria (cost efficiency); whilst compensating for various risks by separate means generally also results in an enhancement of the overall risk situation, it can entail 'overhedging' effects and bring about ineffective or overly expensive risk management. The holistic approach to risks facilitates more cost-effective and hence more efficient risk management on an overall basis.

2.2 Process The process of integrated risk management spans several phases, which are illustrated in Figure 1; they constitute the basis for the design of an integrated risk management concept.

Risk Stripping In the first phase of integrated risk management a disaggregation of the overall risk situation is carried out on the basis of the Initial Risk Cost Position in order to arrive at an (isolated) detailed view of all risk situations (Isolated Risk View). Quantification of the individual risks constitutes a further part of risk stripping, and this is shown in the illustration by the division into the individual pieces of the puzzle. In the subsequent phases this disaggregation forms the basis for a reaggregation of selected risks and hence also the basis for greater risk spreading within the company.6 Risk Mapping During the second phase which builds upon the comprehensive description of all corporate risks in phase I the prevailing dependencies between various risk categories are analysed (e.g. correlation analysis). A holistic description of an organization's risk situation can only be arrived at through a detailed analysis of the relations between all risk positions. This step makes it possible to determine the way in which various risks behave in relation to one another (effects of amplification or diversification). The purpose of this sometimes highly extensive and complex Risk Mapping is to identify possible diversification effects within an organization's individual risk positions. For example, consideration is to be given to the structure of the correlation between various risks the simultaneous occurrence of which can be regarded as unlikely in order to be able to realize risk diversification effects. Consequently, not only the analysis of dependency structures but also the identification of non-correlated risks provides valuable information

for the further process of integrated risk management. The product of this subprocess is a picture (risk map, risk profile, risk spectrum, ...)7, which reveals the interdependent relations between all the risks of an organization and forms the basis for structuring an allencompassing integrated risk management solution. Risk Packing and Risk Hedging The purpose of the sometimes very extensive and complex process of Risk Mapping is to identify and exploit all possible diversification effects (related to the risk costs) within an organization's overall risk situation. Thus, on cost grounds it may be considered expedient to bundle certain ideally non-correlated or negatively correlated risks into risk packages (Risk Packing) and to hedge these packages in the light of already existing diversification effects within the portfolio as a totality by using appropriate means (Risk Hedging). Even though the simultaneous consideration of various risk categories and the packing of certain risks into risk packages can be misinterpreted as an undifferentiated approach, it is the idea in itself trivial that an organization's most widely differing risks in the final analysis have the same implication and in some way or other impact upon the financial situation of the company which renders an integrated approach expedient. In conjunction with the risk analysis set out above, the risk synthesis explained here in the context of Risk Packing makes up the process of risk engineering, which is of decisive importance to the attainment of an improved risk cost situation. The risk-policy measures which are to be applied in the Risk Hedging phase ultimately lead to a compared to the Initial Risk Cost Position leftward displaced and compressed risk cost distribution (Final Risk Cost Position, see figure 1). However, the individual distributions within the pieces of the puzzle remain unchanged. In business terms, such a scenario means quite simply reduced and stabilized risk costs (risk premium) something which should be of considerable interest to the insurance industry in particular. The precise effect of integrated risk management can be analysed and quantified by way of Risk Cost Controlling. Integrated Risk Management The evident disconnect which often occurs between strategic vision and tactical project deliverables typically arises from poorly defined project objectives and an inadequate attention to the proactive management of risks that could affect those objectives. On the risk management side, one of the main failings in the traditional approach arises from a narrow focus on tactical threats. This can be overcome by widening the scope of risk management to encompass both strategic risks and upside opportunities, creating an integrated approach which can bridge the gap between strategy and tactics. Integrated risk management addresses risks across a variety of levels in the organisation, including strategy and tactics, and covering both opportunity and threat. Effective implementation of integrated risk management can produce a number of benefits to the organisation which are not available from the typical limited-scope risk process. These include :

Bridging the strategy/tactics gap to ensure that project delivery is tied to organisational needs and vision. Focusing projects on the benefits they exist to support, rather than simply on producing a set of deliverables. Identifying risks at the strategic level which could have a significant effect on the overall organisation, and enabling these to be managed proactively. Enabling opportunities to be managed proactively as an inbuilt part of business processes at both strategic and tactical levels, rather than reacting too little and too late as often happens. Providing useful information to decision-makers when the environment is uncertain, to support the best possible decisions at all levels. Creating space to manage uncertainty in advance, with planned responses to known risks, increasing both efficiency and effectiveness, and reducing waste and stress. Minimising threats and maximising opportunities, and so increasing the likelihood of achieving both strategic and tactical objectives. Allowing an appropriate level of risk to be taken intelligently by the organisation and its projects, with full awareness of the degree of uncertainty and its potential effects on objectives, opening the way to achieving the increased rewards which are associated with safe risk-taking. Development of a risk-mature culture within the organisation, recognising that risk exists in all levels of the enterprise, but that risk can and should be managed proactively in order to deliver benefits. Strategy and tactics are connected through project objectives, which are both affected by uncertainty, leading to risk at both strategic and tactical levels. An integrated approach to risk management can create significant strategic advantage by bridging the strategy/tactics gap, and dealing with both threats and opportunities, to enable both successful project delivery and increased realisation of business benefits. +++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ The Chief Risk Officer: The new questions about the CRO for leading companies, then, are: What should the CRO do? What should the CRO look like? Where, exactly, does the CRO fit in the organization? And the question for risk management practitioners is: How do I become a chief risk officer? Duties and Responsibilities As a strategic function, the CRO and his or her team play a critical part in the organizations winning strategy. While just a few years ago that part may have been largely operational to provide technical input to the decisions of the organizations policy-makers,

today the CRO in leading companies participates in policy making and decision making. In particular, the CRO is becoming instrumental in two policy-making areas. The first is assuring that the organization has processes in place so that it complies with the very much heightened risk management expectations of shareholders, regulators, and even elected officials and attorneys general. The second is developing and introducing an integrative risk management framework. The purpose of the framework should be twofold: to help the organization mitigate risks, and to help it allocate capital to build shareholder value with a full understanding of both the positive and negative potential of the risks involved. In playing these broad, policy-level roles, the CRO helps senior managers understand the interrelationships of various types of risk. With that understanding, management can maximize value by relating its decisions on the risks it takes to its decisions on the capital used to finance its business. By managing a well-considered RM strategy, CROs can balance the enterprises portfolio of identified and quantified risks with a portfolio of capital resources to derive real value to the organization. CROs generally have a set of specific responsibilities that amount to creating a risk-aware culture in the organization. These include central oversight of the organizations risk assessment and risk appetite; familiarizing the organization, its shareholders, regulators and rating agencies with the RM program; implementing a consistent, integrated risk management framework throughout the company; managing that program with a particular emphasis on operational risks; and developing ways to mitigate and finance risk within the organizations larger business strategies. Obviously, the CRO cannot carry out these responsibilities alone. The CRO works with, and through, the other risk managers in the organization. But given how comprehensive the role is, the CRO also works with every part of the organization: senior management, operating groups, finance, legal, human resources and the like. We are also finding that most successful CROs tap into two valuable resource groups: internal audit and strategic planning. The audit function provides important lessons from its hindsight/compliance views. The planning function offers the opportunity to include a risk assessment and management aspect to all future strategies the organization intends to pursue. Competencies of the CRO Clearly, the role of the CRO is far different from the often-misunderstood function of risk manager. As the catalog of responsibilities above suggests, the work of the CRO in managing the companys ERM program touches all aspects of the organization and requires input from several disciplines, some of which are very complex and detailed. Does that mean the CRO needs to be the analysts analyst, the master of a wide variety of technical disciplines? When we began tracking RM, that seemed to be the assumption for companies considering a CRO. The CRO, in those relatively early days, was, in fact, viewed as the master technician of an arcane craft. But as the role has developed and companies have gained greater experience with it, the profile of the ideal CRO has shifted. Leading-edge companies agree that the CRO should be analytical and bright. He or she must, after all, assimilate and understand a mass of information from a variety of sources in the organization. And the CRO in many companies both guides the usage and understands the output of highly sophisticated

modeling tools. Nonetheless, those are not actually the critical competencies of the effective CRO. The CRO, above all else, is a leader, project manager, synthesizer and communicator. From the moment that the CRO and his or her team embark upon the formal risk assessment process, all the way through risk measurement, mitigation, optimization and monitoring, the effectiveness of communication will dictate how successful the overall process will be. But in addition to that, the CRO must be an integrative thinker with a thorough knowledge of all aspects of the business. He or she must be able to build strong partnerships with business and corporate staffs, communicate to a wide variety of audiences in clear, understandable language, and be a skilled facilitator of group action more than simply a technical manager of risk. Structure and Relationships While companies are reaching a consensus on the need for a CRO, including the positions responsibilities and many of the necessary competencies, there seems to be less of a consensus on the place of the CRO in the structure of the organization. The CRO may report to the CEO (as do about 49% of those managers primarily responsible for risk) or the CRO may report to the CFO (as do about 28% of those managers primarily responsible for risk, according to our recent survey) or the CRO may report directly to the board, or even the chief operating officer. Ultimately, the question of reporting relationship actually may be less important than three other attributes or critical success factors for the position: unfettered access to the CEO and board of directors; leadership of an enterprisewide risk management committee; and a mutually supportive working relationship with the chief financial officer and the chief administrative executive (CAE) of the organization. One of the leading barriers to the successful implementation of RM is the seemingly inevitable upper-level turf war it generates. Often the turf being fought over has belonged to either the CFO or the CAE. The CRO position breaks new ground in organizations, some of which may have been the responsibility of these two other senior positions. A CRO may be tempted to stake out that ground for himself or herself and battle to keep the claim. But that kind of belligerent, elbows-out-and-ready stance will more than likely doom RM and the CRO in the organization. Successful CROs acknowledge the possible tension with their new peers and look for opportunities to show that their position can complement what the CFO and CAE already do, take some of the load off their already full plates, and create synergies that benefit the organization and the CFO and CAE. What does the new CRO get from taking this cooperative and conciliatory approach? The CRO gains two strong allies and proponents for RM and support for creating a risk aware culture, as well as the insights he or she will need to do the job most effectively. Becoming the CRO As the CRO position has begun to take shape, traditional property and casualty risk managers have to be wondering if it is reasonable for them to aspire to the CRO position. Current practice suggests that senior managers do not automatically conclude that the CRO

must come from the ranks of existing risk managers. In fact, management looks for a CRO from a wide variety of disciplines: internal audit, strategic planning, finance, actuarial and risk management. In principle, risk managers should possess many of the skills that go into making a good CRO. As much as anyone in the organization, effective risk managers understand all the important aspects of the business. To recommend the best risk management and financing approaches, they must have a strong working knowledge of the businesss operations, finances, legal issues, buyers, suppliers, raw material inputs, finished productsin short, the value chain of the entire organization. They also need this comprehensive understanding to deal with all the organizations internal and external constituents, including underwriters, claimants, contract holders and many, many more. Moreover, risk managers have always had the difficult tasks of assimilating, analyzing and communicating sometimes complex concepts to leaders and managers whowhile generally well-informed on financial and technical issuesoften do not possess a strong risk management foundation. Nonetheless, at present risk managers are not necessarily the first choice for chief risk officer. Despite their breadth of experience, risk managers often tend to present themselves as technical experts rather than as communicators, facilitators and leaders. If risk managers are to rise to this new position, those are the skills and attributes they need to develop and demonstrate. That is the clearest path to becoming the chief risk officer. 1)Main Roles of a CRO: CRO is NOT the Risk Manager of the Risk Managers! Leader, facilitator, integrator, coordinator of risk rather than a manager of risk. Create a culture risk awareness within the organization. Formally bring consideration of risk into the strategic decision making. Develop a center of excellence for managing risk using the skills sets of individual risk managers. Communicate to all stakeholders internal and external about risk. Bring the BIG PICTURE PERSPECTIVE! Develop, maintain, and update risk governance framework: Risk policies, risk appetite and risk limits. Risk infrastructure, process and reporting. Risk integration and links between risks. Coordinate with business line: Risk training Risk assessment and action plans Incorporate risk elements in performance metrics Ensure lines of business have risk capacity both in personnel and risk systems.

Senior management: Advice on risk issues in strategic decision making Provide aggregated and detailed reports on risk in line with risk appetite and limits Keep management appraised of industry standards Committees: ALM, Credit, Operational, IT, Security External Party liaison New regulatory risk initiatives: Ex. NAIC Corporate Governance for Risk Management Act. Skills Required for a CRO : Some quantitative skills but not be a polymath: analytical, understands the models and bright! Excellent understanding of the supply value chains of your organization: See the links between risks that the risk silos dont see! Strategic and tactical thinker. Ability to understand business issues. Ability to compare risk and reward. Leader/ educator in terms of promoting a risk culture. Project manager of risk initiatives. Ability to synthesize a lot of data and see trends and potential impact on company. Communication skills are a priority because a CRO is a C-level Executive: written and oral.

++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ Double-Trigger Integrated Risk Management Plan Risk management is a critical and essential measure in the world of business. Small and large companies alike face many liabilities ranging from product damage and employer safety to consumer health and natural disasters. Mitigating these risks requires a clearly

outlined and comprehensive risk management plan. Plans may cover countless areas of individual risks and double-trigger possibilities. Double-trigger risks are when two risks actualize simultaneously. Implementing a double-trigger integrated risk management plan should be a consideration for any serious business policy How to implement a double trigger option 1. Outline the objective. Officially document the goals of the plan in clear and concise language. A central goal of a double-trigger risk management plan is to prevent the company from paying out excessive amounts of compensation when two or more risks occur at the same time. A subsidiary goal may entail developing a policy -- in conjunction with insurance, financial and legal partners -- to pay out a predetermined percentage on two simultaneous, actualized risks. 2 Assess and categorize all risks. Define the terms of high, moderate and low grade risks. Determine acceptable cost percentage losses should any of these risks occur. An acceptable low to moderate grade risk may be an occurrence where a setback results in a modified schedule and delayed delivery of a product, but costs the company no more than 5% in losses on that particular activity or job. Compare the likelihood of the occurrence against the consequences of its actualization. Use graphs and charts to help illustrate these assessments as needed. 3 Detail techniques for handling a double-trigger crisis and assess your resources for successfully carrying out these techniques and reducing risks. Plan what departments, staff and resources will be set aside to immediately handle double-trigger risk emergencies. Outline coordination protocols between departments and clarify a chain of command. Additionally, cost-benefit analysis, morale boosting, prototyping and reworking instruction manuals are examples of implementation methods to correct mistakes and lessen risks. 4 Note how to communicate and send feedback. Detail procedures and guidelines for making management aware of how the policy works, where it is strong and how it can be improved. Establish methods of feedback -- from email to monthly meetings -- where employees and department leaders can share information and discuss the strength and reliability of the plan. Keep the plan open to change and update as needed.

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