ca final risk management book 2 mapping sheet

CA FINAL RISK MANAGEMENT

BOOK 2

MAPPING SHEET

Serial No. CHAPTER 1: INTRODUCTION TO RISK Book 2 Page No. ICAI Mat Page No.

1 Introduction to Risk 11.1 Risk Management- A Helicopter View 1

Definition of Risk 1 By Us 1 By ISO 31000 1Frequency Severity Matrix for Risk Prioritization 1Risk Response Strategies (RATA or MATA) 2Hierarchy of Objectives In Organization 3Types of Risk Stochastic Risk 4

CA FINAL RISK MANAGEMENTBOOK 2

MAPPING SHEET

Types of Risk Stochastic Risk 4 Variability Risk 4 Ambiguity Risk 5 Emergent Risk- Black Swan 5Risk Management Framework- 8 Questions Governance- Objective Setting & Risk Appetite 5Inherent Risk & Residual Risk 6Audit Risk, Detection Risk 8Difference between Threat, Vulnerability & Risk 10 Peril, Hazard & Risk 11 Pure( Hazard or Absolute) Risk & Speculative(Opportunity) Risk- Paul Hopkins 11 Fundamental Risk & Particular Risk 11 Static Risk & Dynamic Risk 12

1.2 Introduction to Risk 121.2.1 Introduction to Risk 15

Origin of word Risk & Risk 15 1.2Open Group Standard (Table) 15

Page 1 Sanjay Saraf Educational Institute Pvt. Ltd.

RBIA 16,17ICAI SA 315 16Risk in organizational Context 17Risk Breakdown Structure 18

1.2.2 Risk & Uncertainty 12Frank Knight 12Douglas Hubbard 12VUCA (Volatility,Uncertainty,Complex,Ambiguity) 12,13

1.2.3 Risk Classification- Paul Hopkins 11Hazard(Pure) Risks 11Control(Uncertainty) Risks 14Opportunity(Speculative) Risks 11

1.2.4 Dynamic Nature of Risk 15Static Risk & Dynamic Risk 12

1.3 FOD- Optimal level of Risk 191.3 FOD- Optimal level of Risk 191.4 MCQs 211.5 Risk Analysis in Capital Budgeting 37

1.5.1 Risk Analysis Techniques- Statistical 38 Probability (Expected Value) 38 Variance or Standard Deviation 40 Coefficient of Variation 41Application of Normal Distribution 46

1.5.2 Risk Analysis Techniques- Conventional 47 Certainty Equivalent Approach 47 Risk Adequate Discount Rate 49

1.5.3 Risk Analysis Techniques- Other 58Sensitivity Analysis 58Scenario Analysis 62


2 CHAPTER 2: SOURCE & EVALUATION OF RISKS Book 2 Page No. ICAI Mat Page No.

2.1 Lectures Notes/Summary 632.1.1 Identification & Sources of Risk 63

Meaning, Inclusion & Effectiveness 63 Participation in the Risk Identification Process 64 Business Functions Assessment from Risk Perspective 64 Strategic 64 Operational 64 Financial 64 Knowledge Management 64 Compliance Management 64

2.1.2 Quantification of Risk & Various Methodologies 65 Risk Assessment 65 Risk Measurement 65 Risk Quantification 65 Risk Quantification 65 Risk Impact Matrix 65Tools & Techniques for Risk Quantification 66 Judgement & Intuition 66 The Delphi Approach 66 Scoring 66 Quantitative Techniques 66 Qualitative Techniques 66 Expected Monetary Value 66 Simulation 66 Decision Tree 66 Expert Judgement 66 Frequency of Loss 66 Scenario Analysis 66Risk Identification & Assessment Approaches 66Brainstorming 66Questionnaires & Interviews 67Checklists 67


What-if Technique (WIFT) 67Scenario Analysis 67Fault Tree Analysis (FTA) 67Bow Tie Analysis 67Direct Observations 67Incident Analysis 67Surveys 67Workshops 67Stakeholder Analysis 67Working Groups 67Corporate Knowledge 68Risk Treatment Options 68

2.1.3 Impact of Business Risk 68Classification of Risks on basis of Impacts 69

2.3.2 Analyzing The Level of Risk 692.3.2 Analyzing The Level of Risk 69Likelihood Scale 69Consequences Scale 69Risk Rating Table 69

2.1.4 Identify & Assess the Impact upon the Stakeholders Involved in Business Risk 692.1.5 Principles for Effective Implementation of Risk Management Recommended by OECD 702.2 FOD 71

2.2.1 SWOT 712.2.2 Fishbone 722.2.3 Bowtie 762.3 MCQs 81


3 CHAPTER 3: RISK MANAGEMENT Book 2 Page No. ICAI Mat Page No.

3.1.1 Concept of Risk Management- Views by 98Warren Buffet 98Theodore Roosevelt 98The Risk Management Standard, The Institute of Risk Management 98Thomas S. Coleman, Practical Guide Risk Management, CFA Institute 98

3.1.2 Risk Attitude, Appetite & Tolerance 993.1.3 Risks Appetite- Principles & Approach 993.2 Objectives of Risk Management 99

Process of Risk Management 993.3 Risk Management Techniques 100

Tolerate 100Transfer 100Terminate 100Treat 100Terminate 100Treat 100

3.4 FOD 101Risk Process 101Risk Awareness 101Risk Measurement 103Risk Control 105Risk is a Bell Curve 109

3.5 MCQs 112


4 CHAPTER 4: EVALUATION OF RISK MANAGEMENT STRATEGIES Book 2 Page No. ICAI Mat Page No.

4.1 Risk Management Strategy Alignment with Business Strategy 1234.2 Internal Control Environment & Linkages with Risk Management 1244.3 Risk Culture & Attitudes to Risk Management 1244.4 Integrated Risk Reporting & Stakeholders Responsibility 124

4.4.1 Organizational Overview & External Environment 1244.4.2 Governance 1254.4.3 Business Model 1254.5 IT Risk Management- Disaster Recovery Plan 1274.6 FOD- Risk Culture 1284.7 MCQs 130

5 CHAPTER 5: RISK MODEL Book 2 Page No. ICAI Mat Page No.

5.1 Risk Measures 147

5 CHAPTER 5: RISK MODEL Book 2 Page No. ICAI Mat Page No.

5.1 Risk Measures 147At trader level 147At Top level - VaR 147

5.2 Interpretation of VaR 1485.3 VaR Parameters 148

Confidence Level 148Time period 148Example 149

5.4 VaR Methods 1505.5 Delta Normal Method/Linear/Variance-Covariance Method 150

Question 150Theory of Delta Normal Approach 151Z- Values at Different Confidence Levels 151Table C 152Example 153Example 154

5.6 Full Revaluation 155Method:1 Historical Stimulation 155


Method:2 Bootstrap Simulation 156Method: 3 Monte Carlo Simulation 157 Drawbacks of MCS 157

5.7 Coherent Risk Measures 157Sub-Additivity 157Homogeneity 158Monotonicity 158Risk Free Condition 158

5.8 Expected Shortfall or Conditional VaR 158Limitations of VaR 158

5.9 Chapter Summary 160Stress Testing 160Scenario Analysis 161Country Risk Analysis- Types of Country risk 162 Political Risk 162 Political Risk 162 Financial & Economic Risk 162Country Risk Management Process 163Country Risk Assessment Tools 163

5.10 FOD 164Risk Control Analytics 164 Scenario Analysis 164 Economic Capital 165 Risk Indicators 166Country Risk 167Stress Testing 167

5.11 MCQs 169


6 CHAPTER 6: CREDIT RISK MEASUREMENT & MANAGEMENT Book 2 Page No. ICAI Mat Page No.

6.1 Basics 2096.1.1 Understanding Credit risk 209

i.Definition: Counterparty Failure 209ii.Two-way risks 209iii.Risk-return trade-off 209iv. Crédit risk in Capital markets 209

6.1.2 Components of Credit Risk 2106.1.2.1 Default Risk(PD)/Default Intensity/Hazard Rate-Method of calculating 210

Method 1: Pooling 210Method 2: Statistical 210 Case:1 credit scoring models for consumer credit (retail lending) 210 Case:2 Altman Z Score 211 Discriminant Analysis 211 Discriminant Analysis 211 Range 212Method:3 Structural (MERTON Model) 212 Example 2122 Types of PD 213 Worst Case PD 213 Expected PD 213

6.1.2.2 Loss Given Default(LGD)/recovery Risk 213 a.Collateral 213 b.Third party guarantee 214Types of LGD 214a.Cyclical 214b.Long run 214c.Downturn 214

6.1.2.3 Exposure Risk (EAD) Exposure at default 214Examples 214Expected Loss-Formula 214

6.1.3 Factors affecting Credit Risk 215a.Internal Factors 215


b.External factors 2156.1.4 Types of Credit Facilities(Sources) 215

6.1.4.1 Retail- 215 Personal loan 215 Mortgage/Home loan 215 Credit Card 215

6.1.4.2 Wholesale- 215 Term Loan 215 Agri Loan 215 Demand Loan 215 Working Capital Loan- 215 i.Theme 215 ii.TAndon Committee Norms on MPBF-3 methods 215 iii.Forms/Types 215 a.BAnk Overdraft 215 a.BAnk Overdraft 215 b.CAsh Credit 215 c.Bill discounting 215 d.Pre-Sipment Credit 215 e.Post-Shipment Credit 215 f.FActoring 215

2166.2 Day to Day Operations 217

6.2.1 Qualitative techniques for evaluation and credit risk management 217Credit appraisal matrix-5 C's 2171. Characters 2172. Capital 2173. Capacity 2174. Collateral 2175. Conditions 217CAPACITY 217 i. Financial statement analysis (ratio analysis) 217 Category 1: Profitability Ratios 217 Margin Type 217


Gross Profit Margin 217 Operational Profit Margin 217 Net Profit Margin 217 Return Type 217 ROCE 217 ROE 217 ROA 218Category 2: Performance-turnover-efficiency-activity ratios 218 Sales Growth Rate 218 Net fixed asset turnover ratio 218 Inventory turnover ratio 218 Debtors turnover ratio 218Category 3: Long term solvency ratio (leverage ratio) 218 Coverage Ratio (higher the better) 218 Interest coverage ratio 218 Interest coverage ratio 218 Debt service ratio 218 Capital Structure ratio (lower the better) 218 Category 4: Liquidity Ratio- Short term solvency ratio(Higher- better liquidity) 218ii.CAsh Flow Analysis 218CFO 218CFI 218CFF 219iii. Working Capital Analysis 219Accounts receivable days 219Inventory days 219Payable days 219

6.2.2 Credit risk rating-Process &Scales 2191.Internal rating 219 PD- Pooling 219 Statistical 219 Structural 219 LGD-Cyclical(PIT) 219 Long Run(TTC) 219


Downturn(LGD) 2192.External rating-leading agencies in India 219 CRISIL 219 ICRA 219 CARE 219 Fitch 219 Equifax 219 CIBIL 219 SMERA 219 Brickwork 219Rating Scale for long term instruments 219AAA highest safety 219AA high safety 220A adequate safety 220BBB Moderate safety 220BBB Moderate safety 220BB moderator risk 220B high risk 220C very high risk 220D default 221

6.2.3 CREDIT RISK MITIGATION 2211.Control credit risk- 221Diversification 221credit standardization 221Netting 221collateral 221Covenants 221margin required 221 tightening 221loan pricing 221 credit insurance 221Credit derivative 2212.Three parties in CDS 221Protection buyer 221


Protection Seller 221Reference Entity 2223.Credit Event 2224.Settlement of CDS 222 Physical 222 Cash 222 Auction 223Example 2245.Difference b/w CDS & Credit insurance 2246.Guidelines of RBI on CDS 226

6.3 Top-Down View 2266.3.1 Economic Capital & Regulatory Capital as per Basel II- Capital charge for Credit Risk 226

a.Credit Risk 226Unexpected Risk 226Expected risk 227Expected risk 227 Loan Pricing 227 Provisioning- Special Mention Account Classification (SMA Accounts) 227 Standard Assets 227 Sub-standard Assets 227 Doubtful Assets 227 Loss Assets 228b.Types of Capital 228 Regulatory Capital 228 Economic Capital 228Methods for calculating Capital Change for credit risk 228Method I: Standardized Approach 228Method II: Internal Rating based foundation Approach 229Method III: IRR Advance Approach 230

6.3.2 Credit Risk Governance 2301.Qualitative Techniques for credit risk Management 230 Transaction risk Management 230 Portfolio Risk Management 230 Policies/Processes 230


2. Capital Allocation & Performance Appraisal 230 Risk adjusted performance appraisal measures- 230 Sharpe Ratio 230 Alpha 231 Beta 231 R-Squared 231Advanced Risk adjusted performance appraisal measures- 231a.Return on Risk Adjusted Capital (RORAC) 231 Formula 231 Icai's Example 232 Better Example 232b.Risk-adjusted Return on capital (RAROC) 232 Formula 232 Example 232FOD 234FOD 234Risk-Adjusted Return on Capital (RAROC) 234The Credit Risk Management Process 234 Policy & Infrastructures 234 Credit Granting 235 Monitoring & Exposure Management 237 Portfolio Management 241MCQs 243


Lecture Notes 2597.1 Evaluation of Risk Associated with Corporate Governance 259

Governance Risk 259Sound Governance Practices Recommended by Financial Stability Board in 2013 260a)Board of Directors 260b)Risk Committee 261c)Audit Committee 261d)CRO 261Risk Management Function 262Entity's Risk Assessment Process with Financial Reporting 262Risk Based Internal Auditing(RBIA) 264Audit Risk & Sampling 264Risk Management Disclosures in India 264

Book 2 Page No. ICAI Mat Page No.CHAPTER 7: RISK ASSOCIATED WITH CORPORATE GOVERNANCE7

Risk Management Disclosures in India 264a)Companies Act,2013 264b)SEBI LODR Regulations 2015 264Risk Management Disclosures -Global Scenario 265Integrated Reporting Key 266 7.13Risk & Opportunity Reporting(ROR) 266 7.14a) In India 266b) Global Case Study 267

7.2 Description & Evaluation of Framework for Board Level Consideration of Risk 266Corporate Risk Management 267Risk Management Frameworks, Approaches & Techniques 268

7.3 OECD Guidelines (Principles) for Corporate Governance 2697.4 FOD 271

7.4.1 Governance Risk & Compliance 271GRC Systems- SOX 271

7.4.2 Corporate Governance & Risk Governance 272Code of Conduct 274Best Practices 275 Stakeholder Communication 275


Board Independence 275 Board Performance Assessment 277 Executive & Board Compensation 278 Linking Corporate Governance & ERM 279 Risk Appetite & Policy 280 Organizational Structure 281 Risk Culture & Corporate Values 282

7.5 MCQs 284

Lecture Notes 2978.1 Definition & Scope of ERM by 297

a) CIMA Official Terminology,2005 298b) Webster's New World Law Dictionary 298

Book 2 Page No. ICAI Mat Page No.8 CHAPTER 8: ENTERPRISE RISK Management

b) Webster's New World Law Dictionary 298ERM can help organization 298ISO 31000 Risk Management Standard 298COSO ERM Framework 298Implementing ERM 298Risk Appetite 299Processes of ERM 299 Risk Assessment 299 Risk Management 299 Risk Communication 299Risk Register 299

8.2 Techniques of ERM suggested by ISO 31000 300Risk Maturity of Organization 301Different Levels of Risk Maturity 301Process of ERM & Internal Audit 301Stakeholder Value Creation by ERM 302

8.3 FOD 303All About ERM 303 Definitions 304


Benefits 305 Chief Risk Officer (CRO) 308 Components of ERM 312 i)Corporate Governance 312 ii)Line Management 313 iii)Portfolio Management 314 iv)Risk Transfer 314 v) Risk Analytics 315 vi) Data & Technology Resources 315 vii) Stakeholder Management 315

8.4 MCQs 317

Lecuture Notes 324

ICAI Mat Page No.9 CHAPTER 9: OPERATIONAL RISK Management Book 2 Page No.

Lecuture Notes 324Nick Leeson-Barings Bank 324Runaway Algorithms- Knight Trading 328

9.1 Introduction, Relevance & Governance of "Operating risk" 328Definition & Scope of ERM byRelevance of Operating Risk Companies Act 329 SA 315 329 ICAI Guidance Notes 330 SOX Compliance 330Operational Risk Management Policy 332Lines of Defense 326Effective Policy Framework 333

9.2 Business Process Management 333Process Notes/ Standard Operating Procedures(SOP) 333Risk Identification & Risk Types 333 RCM- Risk & Control Matrix 333 RCSA- Risk & Control Self-Assessment 333 Inherent Risk 333


Risk Type 333 1.Regulatory Risk 333 2.Financial Risk 333 3.Financial Reporting 333 4. Legal Risk 333 5. Reputation risk 333 6.Fraud Risk 334 7. External Risk 334Risk Grading/ Rating 335Understanding of Controls 335 Other Classification 336Risk Control Self-Assessment (RCSA) 339Key Risk Indicators & Scenario Analysis 326Operational Loss Data Management 335

9.3 System 3389.3 System 338Technology Risk 340Cyber Risk & Information Security Controls 340Business Analytics & Artificial Intelligence 340Machine Learning 327Distributed Ledger Technology

9.4 External EventsMan Made-Fraud 341Natural Disasters 336Insurance 337Business Continuity Plan 337Business Impact Analysis(BIA) 327Functional Recovery Plan (FRP) 337

9.5 Residual TopicsOutsourcing Risk 337

9.6 FOD 342Operational Risk Analytics 342Emerging IT Risk 343

9.7 MCQs 348


10 IN HOUSE CASE STUDIES Book 2 Page No. ICAI Mat Page No.10.1 Fraud Reporting 37010.2 Risk Report 37510.3 Responding to Risk 37910.4 Controls by Auditor-Cash & Inventory 38210.5 Internal Controls 38610.6 Types of risk 39310.7 VaR 40210.8 Sensitivity Analysis 40610.9 VaR-Risk Models 408

10.10 Ratio analysis 41310.11 Ratio analysis 41910.12 Ratio analysis 42410.13 Ratio analysis 43110.14 Ratio analysis 43610.14 Ratio analysis 43610.15 Rogue trading (Barings Bank) Operational Risk Management 44210.16 LTCM 44810.17 Operational Risk Management 45410.18 Cyber Risk 45910.19 VaR 46310.20 ERM 46810.21 Credit Risk 47210.22 Operational Risk Management 47610.23 Chapter 2 Source & evaluation of risk 48410.24 48810.25 Risk Models-VaR 49410.26 Credit Risk 49810.27 Risk Models-VaR 50210.28 Operational Risk Management 50810.29 Hedging, Risk-Uncertainty/Opportunity 51110.30 ERM, Operational risk 51610.31 Risk Models-VaR, Stress testing 52110.32 Forex-Purchase Power Parity, Hedging 525


10.33 Forex 53410.34 CRO & ERM 54210.35 VaR, Portfolio Management 54610.36 ERM 55010.37 Risk Scenarios 55510.38 Credit Risk-Governance 56210.39 Types of Risks 56810.40 Corporate Governance Risk 57710.41 Operational Risk Management 58410.42 Cyber Risk 58810.43 Risk Models-VaR 59210.44 Risk Models-VaR 59810.45 Corporate Governance Risk 602

11 Risk management failures and lessons learned Book 2 Page No. ICAI Mat Page No.11.1 Cautionary tales 608

Bausch & Lomb, consumer product company 608Kidde, Peabody, An investment bank 610Metallgesellschaft, an energy company 611Morgan Grenfell, an asset management company 612Societe Generale, a global bank 613MF Global, a commodity trading firm 615

11.2 Reinsurance 622Currency Hedging 623

11.3 Enron 62611.4 the BP Oil Spill 629

12 Real Life Risk Management Practices Book 2 Page No. ICAI Mat Page No.Canadian Imperial Bank of Commerce 633Microsoft 638Ford 640Airbus & Boeing 641


Everlast Financial 642JP Morgan Chase 646Duke Energy 648

13 Deep Dive Analysis on a Handful Crisis Book 2 Page No. ICAI Mat Page No.13.1 The 2008 Global Finance Crisis 650

Causes of Crisis- 650 The Role of China 650The role of Housing Markets 650The role of Regulation 650The role of incentives 651The role of Models 652Organizational Issues 652Evolution Of crisis 652Lessons from crisis- 653Lessons from crisis- 653Organizational structure 654capital structure 654Bank Bonuses 654Models 654

13.2 Barings Bank 655Background 655Development of the Collapse 655Reasons for the Collapse 656Lessons from the Collapse 657

13.3 Equitable Life 658Background 658Development of the Collapse 659Reasons for the Collapse 660Consequences of Collapse 660

13.4 Korean Air 661Korean Air Flight 801 661Reasons for Accident 661Lessons from accident 661


Implications for Financial Organization 66213.5 Long Term Capital Management 663

Background 663Market events 663Lessons from LTCM 664

13.6 Bernard Madoff 665Background 665How fraud Happened 665

13.7 Robert Maxwell 667Background 667How fraud Happened 667Consequences of Fraud 667

13.8 Space Shuttle Challenger 668Background 668Organizational Failure 668Organizational Failure 668Implications for financial Organizations 669

13.9 Heartland Payment Systems 670Background 670Details of Data Breach 670Heartland's Response 670Lessons to be learned 670Recent Developments 671

13.10 Kim Philby 67213.11 HoneyWell 67313.12 Conclusion 674

14 Risk Management FAQs 675


ca final risk management book 2 mapping sheet

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