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CHAPTER I

RISK MANAGEMENT Page 1


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models will also be discussed which would enable us to prescribe benchmarks for the

purpose of decision making in dispensing credit.

Any activity involves risk, touching all spheres of life, both personal

and business, Risk is pervasive condition of human existence. The term risk has a

variety of meaning in business and everyday life. Traveling in a car, crossing the

road, investing in financial instruments, launching a new product all involves risk. At

its most gnarl level, risk is used to describe any situation where there is uncertainty

about what outcome will occur. Although our instinctive understanding of concept of

risk is clear enough, terms that have a simple meaning in everyday usage sometimes

have a specialized connotation when used in particular field.

DEFINATION

There is no universal accepted definition of risk. The term risk is variously defined as

a) The chance of loss,

b) The possibility of loss,c) Uncertainty,

d) The dispersion of actual from expected results or

e) The probability of any outcome different from the on expected.

The Basel committee has defined risk as the probability of the unexpected

happening-the probability of suffering a loss.

Prof. John Geiger has defined risk as an expression of the danger that the

effective future outcome will deviate from the expected in a negative way.



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Vaughan & Vaughan defined risk as A condition in which there is a

possibility of an adverse deviation from desired outcome that is expected or hoped

for.

The four letters comprising the word R I S Kdefine its features.

R= Rare (unexpected).

I = incident (outcome).

S = selection (identification).

K= knocking (measuring, monitoring, controlling).

RISK, therefore, needs to b looked at from four fundamental aspects:

Identification

Measurement

Monitoring

Control (including risk audit)



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RISK VS UNCERTAINITY

Uncertainty must be taken in a sense radically distinct from the

familiar notion of Risk, from which it has never been properly separated, The term

risk, as loosely used in everyday speech and in economic discussion, really covers

two things which, functionally at least, in their causal; relations to be phenomena of

economic organization, are categorically different. The essential fact is that risk

means in some cases a quantity susceptible of measurement, while at other times it is

something distinctly not of this character; and there are far-reaching and crucial

differences in the bearings of phenomenon depending on which of which of the two is

really present and operating. It will appear that a measurable uncertainty, or risk

proper, as we shall use the term, is so far different from an immeasurable one that it is

not in effect an uncertainty at all. We accordingly restrict the term uncertainty to

cases of the non-quantities type.

TYPES OF RISKS

The risk profile of an organization may be reviewed from the following angles:

A. BUSINESS RISK:

I. capital risk.

ii. Credit risk.

iii. Market risk.

iv. Liquidity risk

V. business strategy and environment risk.

vi. Operational risk.

vii. Group risk.



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B. CONTROL RISK:

i. Internal controls.

ii. Organization.

iii. Management (including corporate governance).

iv. Compliance.

Both these types of risk, however, are linked to the three omnibus risk categories

listed below:

1. Credit risks.

2. Market risks.

3. Organizational risks.



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CLASSIFICATION OF RISK

Different risks require different methods and approaches to deal with them.

Pure Vs. Speculative Risk

As per the outcome of an event, a risk can either be pure or speculative. Pure

risk refers to those events whose effects cause either loss or no loss to the enterprise

in all circumstances but no gain. The chances of making any profit from such risk

occurrences are abysmally low. A few examples of pure risk are fire, theft,

earthquake, death, accident, etc. In case of speculative risk, the outcome may result in

either a loss or a profit to; the organization. Examples of speculative risk for an

organization include reduction in the selling price of its product, increasing number of

distribution outlets, merger with any other organization, etc. Thus most of the

speculative risks are from within the organization and are business-related. Some

speculative risks are optional. Investment in equity of another company is an option,

and not mandatory. Hence the risk arising out of such decision is optional and

avoidable if desired so. Usually an insurance company insures pure risks but not

speculative risks.

Classification of Pure Risks

There are four broad categories of pure risk. They are

Property risk

Personal risk

Liability risk

Loss of income risk.



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Property Risk

In this case there is a fear of loss of property because of some unforeseen

events. Property includes both movable and immovable assets. There are always

chances of loss of house because of earthquake, heavy storm and other natural

calamities. Similarly a severe damage to a personal computer may be caused because

of repetitive power failure or low voltage. Property risk is further divided into two

categories, namely direct loss and indirect loss.

The value of the property destroyed due to a given peril is a direct loss and the

additional expenses incurred due to the destruction of the property are the indirect

loss. Business establishment if there is loss to the stock because of fire, the company

not only loses the stock but also the time to make up the pending supply orders.

Chances are that it may lose some customers. This results in indirect loss to the

business.

Personal Risk

It refers to the possibility of loss of income or assets as a result of the loss of

the ability; to earn income. This may result from untimely death of the earning

member, dependent old age, prolonged illness, disability or unemployment.

Apart from individuals, organizations are also subject to personal loss

exposures. When employees meet with accidents, it may result in injuries or death.



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Liability Risk

Liability risk arises when there is a possibility of an unintentional damage to

other person or to his property because of negligence. However, the chances of

intentional harm are not ruled out in certain circumstances.

Legally speaking a person cannot be exonerated from his activities either

intentional or unintentional, if it he same result in loss to some other person or his

property. Thus there are always chances that liability risk is to be met because of

ones activities causing adversity to another person.

For example, construction of big dams results in dislocation of a number of villagers.

Loss of Income Risk

Loss of income risk is an indirect loss from a given risk. As discussed under

property risks, whenever there is a direct loss, it is followed by some consequencesthat result in indirect loss.

For example, if a textile companys premises were destroyed in an earthquake, the

production facilities and plant layout are also disturbed and it would take some time

to come back to the normal level of production. During this time the cost of

production will tend to be high and the production stoppage will lead to loss of

income.

Some times the direct loss will be minimum but the indirect losses will be

quite high. For instance, consider the plight of an Internet service provider where, an

electrical short circuit resulted in hard disk crash and loss of data.



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Dynamic vs. Static Risk

Static risk remains constant over an observed period of time. Risks remain static

because the environments in which they exist are static.Dynamic risks arise from the changes that occur in an environment, which may be

economic, social, technological, and political. Change in the environment creates risk

and uncertainty about the future.

Fundamental vs. Particular Risks

Those risks, which affect a larger group, such as a society or an industry, or a

particular segment of an industry, are termed as fundamental risks. For example,

natural calamities such as flood, earthquake, drought, epidemics, etc. affect the whole

mass in the same manner irrespective of caste, creed or religion or geographical

boundaries.

Attitude towards Risk

Attitude towards risk reflects the perception or a mental position with regard

to a fact or state, or it is a feeling or emotion towards a fact or a situation. Individuals

can be grouped into three different categories as per their attitude towards risk. They

are:

Those who are neutral/indifferent to risk,

Those who are willing to take up risks, and

Those who avoid risk.

Human Response to Risk

It is not possible for an individual or an organization to avoid risk. Every

organization is exposed to risks of various degrees in the course of business. It is the



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duty of the risk manager of a company to analyze the characteristics of risks to which

the organization is exposed and develop suitable strategies to minimize the same.

Mankind has developed various tools and techniques to safeguard itself

against the perceived risks and hazards since the dawn of civilization. Though the

procedures or methods adopted for the purpose might have undergone a sea change,

the objective remains the same. As the saying goes, Man proposes and God

disposes, the uncertainty of outcome of any future event adds to the severity of risk

in any situation.

OBJECTIVES OF THE STUDY

To study the methodology of risk analysis adopted by the company

To understand the various risks involved in setting up an industrial project

To study various measures for controlling the risk

METHODOLOGY

The format of the study was fixed after referring various books and reports

from libraries and internet.

It helped in identifying the approach needed for project work, research

methods and report making.

Sources of these literatures are mentioned in references.

Data collection

For the preparation of any project report the collection of relevant data is

very much essential. There are basically two broad methods for collecting data,

which are followed in any report. These methods are:



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Primary data collection.

Secondary data collection.

The sources of secondary data are: Printed or published financial

statements of the corporation, Annual reports of the company.

Limitations of the study

The study is conducted for the purpose of fulfillment of the conditions

stipulated by the University for Completion of course, so the study may notfulfill all the requirements of a detailed investigation.

As I am learner, I may not be able to provide a proper findings and

suggestions.

Time was a major constraint for knowing the entire process in depth..



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CHAPTER II



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PROFILE OF THE COMPANY

Dr. Reddys Laboratories Ltd. Founded in 1984 by Dr. K. Anji Reddy,

has become Indias third biggest pharmaceutical company. Reddy had worked in the

publicly-owned Indian Drugs and Pharmaceuticals Ltd. Reddy's manufactures and

markets a wide range of pharmaceuticals in India and overseas. The company more

than 190 medications ready for patients to take, 60 active pharmaceutical ingredients,

for drug manufacture, diagnostic kits, critical care and biotechnology products.

Reddys began as a supplier to Indian drug manufacturers, but it soon started

exporting to other less-regulated markets that had the advantage of not spend time

and money on a manufacturing plant that that would gain approval from a drug

licensing body such as the USs Food and Drug Administration. Much of Reddys

early success came in those unregulated markets, where process patents not product

patents are recognized. With that money in the bank, the company could reverse-

engineer patented drugs from more developed countries and sells them royalty-free in

India and Russia. By the early 1990s, the expanded scale and profitability from these

unregulated markets enabled the company to begin focusing on getting approval from

drug regulators for their formulations and bulk drug manufacturing plants in more-

developed economies. This allowed their movement into regulated markets such as

the US andEurope.

By 2009, Reddys had six FDA-plants producing active pharmaceutical

ingredients in India and seven FDA-inspected and ISO 9001 (quality) and ISO 14001

(environmental management) certified plants making patient-ready medications five

of them in India and two in the UK.

By 2010 Dr. Reddys Q3 FY09 Revenue at Rs. 18,401 million,EBITDA at Rs. 3,453

million, PAT at Rs. 1,924 million

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By 2010 Dr. Reddys Q3 FY10 Financial Results: Revenues at Rs. 17,296 million;

EBITDA at Rs. 3,666 million, Profits after Tax adjusted for impairment at Rs. 2,307

million.

ABOUT DR.REDDYS

Established in 1984, Dr. Reddy's Laboratories (NYSE: RDY) is an emerging

global pharmaceutical company with proven research capabilities. The Company is

vertically integrated with a presence across the pharmaceutical value chain. It

produces finished dosage forms, active pharmaceutical ingredients and biotechnology

products and markets them globally, with focus on India, US, Europe and Russia. The

Company conducts research in the areas of diabetes, cardiovascular, anti-infectives,

inflammation and cancer.

KEY MILESTONES

1984

Dr Anji Reddy establishes Dr. Reddy's Laboratories with an initial capital outlay ofRs.25 lakhs

1986

Dr. Reddys goes public Dr. Reddys listed on Bombay Stock Exchange (BSE) Dr. Reddys enters international markets with exports of Methyldopa

1987

Obtains its first USFDA approval for Ibuprofen API Starts its formulations operations

1988

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Acquires Benzex Laboratories Pvt. Limited to expand its Bulk Activesbusiness.

1990

Dr. Reddys, for the first time in India, exports Norfloxacin and Ciprofloxacin toEurope and Far East.

1991

First formulation exports to Russia commence.

1993

Dr. Reddy's Research Foundation established. The company drug discoveryprogramme starts.

1994

Makes a GDR issue of USD 48 million Foundation stone laid for a finished dosages facility to cater to the highly

regulated markets such as the US.

1995

Sets up of a Joint Venture in Russia.

1997

Licenses anti-diabetic molecule, DRF 2593 (Balaglitazone), to Novo Nordisk.Becomes the first Indian pharmaceutical company to out-license an originalmolecule.

First ANDA filed with the United States Food and Drug Administration forRanitidine

1998

Licenses anti-diabetic molecule, DRF 2725 (Ragaglitazar), to Novo Nordisk



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1999

Acquisition of American Remedies Limited, a pharmaceutical company basedin India.

2000

Dr. Reddy's Laboratories becomes India's third largest pharmaceuticalcompany with the merger of Cheminor Drugs Limited, a group company

Reddy US Therapeutics, a wholly-owned subsidiary, is established at Atlanta,US to conduct target based drug discovery

2001

Becomes the first Asia Pacific pharmaceutical company, outside Japan, to liston the New York Stock Exchange. Listed with the symbol RDY on April 11,2001.

Out-licenses DRF 4158 to Novartis for up to US $55 million upfront payment Launches its first generic product, Ranitidine, in the US market Becomes the first Indian pharmaceutical company to obtain an 180-day

exclusive marketing rights for a generic drug in the US market with the launchof Fluoxetine 40 mg capsules on August 3, 2001

2002

Conducts its first overseas acquisition BMS Laboratories Limited and MeridianHealthcare in UK3

2003

Announces a 15-year exclusive product development and marketingagreement for OTC drugs with Leiner Health Products in the US

Launches Ibuprofen, first generic product to be marketed under the Dr.Reddys label in the US

2004

Acquires Trigenesis gives access to drug delivery technology platforms



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2006

Acquires Roche's API Business at the state-of-the-art manufacturing site in Mexico with a total investment of USD 59 million.

announces the formation of Perlecan Pharma: Indias First Integrated Drug

Development Company.Announces India's first major co-development and commercialization deal

for its molecule Balaglitazone (DRF 2593), with Rheoscience.announces a unique partnership for the commercialization of ANDAs with

ICICI Venture.

2009

Revenues touch USD 1 Billion in December 2009.Dr. Reddy's obtains its second 180-day marketing exclusivity for a generic

drug in the US market with the launch of Ondenesetron Hydrochloride

Tablets.becomes an Authorized Generic Partner for Mercks Proscar & Zocor

in the US market during 180 day exclusivity period.Acquires betapharm- the fourth-largest generics company in Germany for a

total enterprise value of 480 million.

2010

Becomes No.1 pharmaceutical company in India in turnover and profitability.

2010

Announces strategic alliance with GlaxoSmithKline plc to develop and marketselect products across emerging markets outside India.



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CORPORATE GOVERNANCE

Dr. Reddy's long-standing commitment to high standards of corporate

governance and ethical business practices is a fundamental shared value of its

Board of Directors, management and employees. The Company's philosophy

of corporate governance stems from its belief that timely disclosures,

transparent accounting policies, and a strong and independent Board go a long

way in preserving shareholder trust while maximizing long-term shareholder

value.

The company has identified and articulated its core purpose, mission and

values in keeping with its desire for achieving corporate excellence. Dr.

Reddy's believes in creating an environment where the parameters of conduct

and behavior of the company and its management is constantly aligned with

the business environment.

The mainstays of Dr. Reddy's Corporate Governance systems are an

independent Board of Directors following international practices, a committed

management team, rigorous internal control systems and the transparent

dissemination of information to stakeholders.

Committees of the Board

Committees appointed by the Board focus on specific areas and take informeddecisions within the framework of delegated authority, and make specificrecommendations to the board on matters in their areas or purview. All decisions andrecommendations of the committees are placed before the Board for information orfor approval.



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Dr. Reddy's has seven Board-level Committees, namely

The Audit Committee The Compensation Committee The Governance Committee The Shareholders' Grievance Committee The Investment Committee The Management Committee

The members of the Committees of Board are as under:

Audit Committee Management CommitteeDr. Omkar Goswami (Chairman)Kalpana Morparia

Ravi Bhoothalingam

Satish Reddy (Chairman)G V Prasad

P N Devarajan

Compensation Committee Investment CommitteeRavi Bhoothalingam (Chairman)Kalpana MorpariaP N DevarajanDr. JP Moreau

G V Prasad (Chairman)Satish ReddyP N Devarajan

Governance Committee Shareholders' Grievance CommitteeAnupam Puri (Chairman)

Prof. Krishna G PalepuDr. Omkar Goswami

P N Devarajan (Chairman)

G V PrasadSatish Reddy



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AWARDS AND ACCOLADE

The Appreciation Certificate of the District Collector for being the Best Clean

Production Industry for the year 2010 was awarded to API Unit V.

The CII Southern Region Leadership Excellence Award was awarded to

Dr. Reddy's for the year 2009.

The CII National Award for Excellence in Water Management for the year

2005 was awarded to both API Units II and VI.

The FTO III Unit of Dr. Reddy's achieved the ISO 14001:2004 standard on

June 9, 2005.

The Genentech Environmental Excellence Silver Award for the year

2004-05 was awarded to the API Global Business Unit.

KEY PERSONS

1. Mr.Dr.K.ANJI REDDY CHAIRMAN

2. Mr.G.V.PRASAD VICE CHAIRMAN & C.E.O

3. Mr.SATISH REDDY M.D & C.O.O

4. Mr.Dr.OMKAR GOUSWAMI

5. Mr.RAVI BHOOTHALINGAM

6. Mr Dr.KRISHNA PALEPU

7. Ms.KALPANA MORPARIA



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8. Mr.J.P.MORE

OTHER OBJECTS:

1. To carry on the business of Distributors, Dealers, Wholesalers, Retailers,

Commission Agents,

Manufacturers, Representatives for all types of products.

2. To carry on the business of professionals for all types of services.

3. To carry on the business of design, engineering and execution and

implementation of various

Types of projects on contract or turnkey basis and to acquire the designing or

technical know how.

4. To cultivate, grow, produce or deal in any vegetable products and to carry

on the business of

Farmers, dairy man, milk contractors, dairy farmers, millers, surveyors and

vendors of milk cream,

Cheese, butter and poultry and provision of all kinds, growers of and dealers

in corn, lay and

Straw, seeds men and nursery men and to buy, sell and trade in any goods

usually traded and of

The above business or other business associated with the farming interest

which may be

Advantageously carried on by the company.

5. To carry on the business of manufacturers, fabricators, erectors, dealers of

in all types of

Chemical equipment, pumps, valves, storage tanks etc. required by the

chemical and Pharmaceutical industry.



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6. To purchase plant, machinery, tools and implements from time to time and

he selling or disposing of the same.

7. To transact or carry on all kinds of agency business and in particular, in

relation to the investment of money, the sale of property and collection and

receipt of money, or otherwise of any assets, funds and business under any

agreement.

8. To carry on and undertake the business of investing its funds in equity and

preference shares, stocks, bonds, debentures (convertible and non-

convertible) of new projects and securities of all kinds and every description

of well established and sound companies, to subscribe to capital issues of

joint stock companies, ventures, industries, units, trading concerns whether

old or new as the company my think fit and to assist them by granting

financial accommodation by way of loans/advances to industrial concerns and

to assist industrial enterprises in creation , expansion and modernization upon

terms whatsoever and to act as finance brokers, merchants and commission

agents and to deal in Govt. Securities including Govt. bonds, loans, Nationalsavings

Certificates, post office saving schemes, units of investments etc., include

units of Unit Trust of India.

9. To promote industrial finance, deposit or lend money, securities and

properties to or with any company, body corporate, firm person or association

whether falling under the same management otherwise, in accordance with

and to the extent permissible under the provisionscontained in Section

370&372 of the, Companies Act, 1956, with or without security and on such

Terms as may be determined from time to time. However, the company shall

not carry on the business of Banking as defined under the Banking



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Regulation Act. 1949; and to carry on and undertake the business of finance,

investment and trading, hire purchase, leasing and to finance lease

operations of all kinds, purchasing, selling, hiring or letting on hire of all kinds

of plant and machinery and equipment that the Company may think fit and to

assist in financing operations of all and every kind of description of hire

purchase or deferred payment or similar transactions and to subsidies finance

or assist in subsidizing or financing the sale and maintenance of any goods,

articles or commodities of all and every kind of description upon any terms

whatsoever and to purchase or otherwise deal in all forms of immovable and

movable property, including lands and buildings, plant and machinery,

equipment, ships, aircraft, automobiles computers and all consumer,

commercial and industrial items and to lease or otherwise deal with them in

any manner whatsoever including release there of regardless of whether the

property purchased and leased be now and /or used.

10. To provide a package of investment/merchant banking services by acting

as manages to public issue securities, by underwriting securities, act as IssueHouse and to carry on the business of registrars to investment schemes,

Money managers to secure and extend market support by conducting

surveys, collecting data, information and reports and to act as general traders

and

Agents, to carry on the agency business and warehousing indenting and

dealership of business.

IV. The liability of the members of the company is limited.

V. a. The authorized share capital of the company is Rs.50,00,00,000/- (Rs.

Fifty Crores Only)divided into 10,00,00,000 equity shares of Rs.5/- (Rs. Five

only) each.



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b. The company has power from time to issue shares, Hybrids, Derivatives,

Options, Quasiequity Instruments, with differential rights, or to increase,

consolidate, sub-divide, exchange,reduce and also to purchase any of its

shares whether or not redeemable and to make payments out of its capital in

respect of such purchase or otherwise alter its share capital as equity or non

voting equity shares or preference shares and to attach to any classes of

such shares preferences, rights, privileges or priorities in payment of

dividends or distribution of assets or otherwise, over any other shares and to

subject the same to any restriction, limitation or condition and to vary the

regulation of the company, as for apportioning the right to participate in profits

in any manner subject to the provision of the Act and consent of the

appropriate authorities if required, being obtained before doing so. We the

several persons whose names, addresses and description are subscribed

hereto are desirous of being formed into a company in pursuance of the

Memorandum of Association and we respectively agree to take the number of

shares in the Capital of the Company set opposite to our respective names.



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CHAPTER III



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RISK MANAGEMENT:

Risk management is a scientific approach applied to the

problem of risk. Although the term risk management is a recent

phenomenon, the actual practice of risk management is as old as

civilization itself. Risk management allows financial institutions to

bring their risk leels to manageable proportions while not severely

reducing their income. Factors like increasing competition,

innovative products, technological revolution, and changing

external operating environment makes it necessary that proper risk

management systems b implemented, Risk management is thus a

functional necessity and adds to the strength and efficiency of an

organization on an ongoing basis.



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Risk Management Techniques:

Risk management is a structured approach to managing uncertainty through,

risk assessment, developing strategies to manage it, and mitigation of risk using

managerial resources.

The strategies include transferring the risk to another party, avoiding the

risk, reducing the negative effect of the risk, and accepting some or all of the

consequences of a particular risk.

Some traditional risk managements are focused on risks stemming from

physical or legal causes (e.g. natural disasters or fires, accidents, death and lawsuits).

Financial risk management, on the other hand, focuses on risks that can be managed

using traded financial instruments. Objective of risk management is to reduce

different risks related to a preselected domain to the level accepted by society. On the

other hand it involves all means available for humans, or in particular, for a risk

management entity (person, staff)

Steps in the risk management process

Establish the context

Establishing the context involves

1. Identification of risk in a selected domain of interest

2. Planning the remainder of the process.

3. Mapping out the following:

o the social scope of risk management

o the identity and objectives of stakeholders

o The basis upon which risks will be evaluated, constraints.

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4. Defining a frameworkfor the activity and an agenda for identification.

5. Developing an analysis of risks involved in the process.

6. Mitigation of risks using available technological, human and organizational

resources.

Identification

After establishing the context, the next step in the process of managing riskis

to identify potential risks. Risks are about events that, when triggered, cause

problems. Hence, risk identification can start with the source of problems, or with the

problem itself.

Source analysis Risk sources may be internal or external to the system that

is the target of risk management. Examples of risk sources are: stakeholders of

a project, employees of a company or the weather over an airport.

Problem analysis Risks are related to identify threats. For example: the

threat of losing money, the threat of abuse of privacy information or the threat

of accidents and casualties. The threats may exist with various entities, most

important with shareholders, customers and legislative bodies such as the

government.

Resources and consider the threats they are exposed to and the consequences

of each. Alternatively one can start with the threats and examine which

resources they would affect, or one can begin with the consequences and

determine which combination of threats and resources would be involved to

bring them about.

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Assessment

Once risks have been identified, they must then be assessed as to their

potential severity of loss and to the probability of occurrence. These quantities

can be either simple to measure, in the case of the value of a lost building, or

impossible to know for sure in the case of the probability of an unlikely event

occurring. Therefore, in the assessment process it is critical to make the best

educated guesses possible in order to properly prioritize the implementation of the

risk management plan.

The fundamental difficulty in risk assessmentis determining the rate of

occurrence since statistical information is not available on all kinds of past

incidents. Furthermore, evaluating the severity of the consequences (impact) is

often quite difficult for immaterial assets. Asset valuation is another question that

needs to be addressed. Thus, best educated opinions and available statistics are the

primary sources of information. Nevertheless, risk assessment should produce

such information for the management of the organization.

That the primary risks are easy to understand and that the risk managementdecisions may be prioritized. Thus, there have been several theories and attempts to

quantify risks.

Numerous different risk formulae exist, but perhaps the most widely

accepted formula forriskquantification is:

Rate of occurrence multiplied by the impact of the event equals risk

Later research has shown that the financial benefits of risk management are

less dependent on the formula used but are more dependent on the frequency and how

risk assessmentis performed.

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In business it is imperative to be able to present the findings of risk

assessments in financial terms. Robert Courtney Jr. (IBM, 1970) proposed a formula

for presenting risks in financial terms. The Courtney formula was accepted as the

official risk analysismethod for the US governmental agencies. The formula proposes

calculation of ALE (annualized loss expectancy) and compares the expected loss

value to the security control implementation costs (cost-benefit analysis).

The Effect of Risk

As mentioned earlier risk results in gains or losses. If we invest in an equality

share we may gain or lose when we sell it at a later date. If a fire accident occurs in a

warehouse it will result in losses only. We are very much concerned with negative

impact of risk when we attempt to manage it. Loss is a state wherein someone is

deprived of something he/she had. When we attempt to assess the risk, it is important

to know from whose point of view the risk is being assessed. It can be perceived from

the point of view of the insurer or the insured from the point of view of an insurance

agency risk may be perceived fro thepurpose of assessing the degree of vulnerability

of a particular object to a particular event.

Potential risk treatments

Once risks have been identified and assessed, all techniques to manage the

risk fall into one or more of these four major categories: (Dorfman, 1997)

Avoidance (elimination)

Reduction (mitigation)

Retention

Transfer ( buying insurance)

Risk avoidance:

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Includes not performing an activity that could carry risk. An example would

be not buying apropertyor business in order to not take on the liabilitythat comes

with it. Another would be not flying in order to not take the risk that the airplane were

to be hijacked. Avoidance may seem the answer to all risks, but avoiding risks also

means losing out on the potential gain that accepting (retaining) the risk may have

allowed. Not entering a business to avoid the risk of loss also avoids the possibility of

earning profits. Risk Reduction.

Involves methods that reduce the severity of the loss or the risk of the loss

from occurring. Examples include sprinklers designed to put out a fireto reduce the

risk of loss by fire. This method may cause a greater loss by water damage and

therefore may not be suitable. Halon fire suppression systems may mitigate that risk,

but the cost may be prohibitive as a strategy.

Modern software development methodologies reduce risk by developing and

delivering software incrementally. Early methodologies suffered from the fact that

they only delivered software in the final phase of development; any problems

encountered in earlier phases meant costly rework and often jeopardized the whole

project. By developing in iterations, software projects can limit effort wasted to asingle iteration.

Outsourcing could be an example of risk reduction if the outsource can

demonstrate higher capability at managing or reducing risks. In this case companies

outsource only some of their departmental needs. For example, a company may

outsource only its software development, the manufacturing of hard goods, or

customer support needs to another company, while handling the business

management itself. This way, the company can concentrate more on business

development without having to worry as much about the manufacturing process,

managing the development team, or finding a physical location for a call center.

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Risk retention:

Involves accepting the loss when it occurs. True self insurance falls in this

category. Risk retention is a viable strategy for small risks where the cost of insuring

against the risk would be greater over time than the total losses sustained. All risks

that are not avoided or transferred are retained by default. This includes risks that are

so large or catastrophic that they either cannot be insured against or the premiums

would be infeasible. Waris an example since most property and risks are not insured

against war, so the loss attributed by war is retained by the insured. Also any amounts

of potential loss (risk) over the amount insured are retained risk. This may also be

acceptable if the chance of a very large loss is small or if the cost to insure for greatercoverage amounts is so great it would hinder the goals of the organization too much.

Risk transfer:

Means causing another party to accept the risk, typically by contract or by

hedging. Insurance is one type of risk transfer that uses contracts. Other times it may

involve contract language that transfers a risk to another party without the payment of

aninsurance premium. Liability among construction or other contractors is very often

transferred this way. On the other hand, taking offsetting positions in derivatives is

typically how firms use hedging to financially manage risk.

Some ways of managing risk fall into multiple categories. Risk retention

pools are technically retaining the risk for the group, but spreading it over the whole

group involves transfer among individual members of the group.

This is different from traditional insurance, in that no premium is exchangedbetween members of the group up front, but instead losses are assessed to all

members of the group.

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RISK MANAGEMENT ESSENTIALS

After reading this chapter, you will be conversant with

The nature of risk management

The evolution of risk management

Risk in personal life

Corporate/organizational risks

The process of risk management

Nature of Risk Management

Risk management aims to at controlling the risk exposure of a firm. It is a

rational approach towards controlling the risk to which an organization or an

individual is exposed to; risk management function can be grouped with other

management functions such as financial management, human resources management,

etc. An over view of different risks will help us to understand the nature of risk

management organizations and individuals are exposed to a wide arrays of risk in

their day-to-day operations, such as

1 Fire risk

2 Risk of theft

3 Loss of customers

4 Delay in delivery of raw materials

5 Break down of machinery

6 Accidents

7 Bad debts

8 Changes in industrial policy whenever the government changes

9 Changes in financial markets

10 Changes in taxation etc.



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The perspective of risks management varies from one individual.

Organizations have their own views on risk. Many scholars and practitioners

Agree that risk management is an evolving science while a distinct minority

feels that it is going to disappear in the years to come. In between there are many

views on the nature of risk management.

The traditional view of risk management, believes that risk management is

an interdisciplinary science that manages that pure risk of an organization. According

to this view risk management is not changing radically but moving in increments,

there fore it is an evolving science. This view recommends insurance purchase as a

risk management solution.

1 Hardware

2 Software failure

3 Organization failure

4 Human failure

Development of Risk Management

Risk management as discussed earlier is Avery old method through which the

organization aims to cover the perils to which the organization is exposed. The most

popular method advocated by traditional view was buying insurance. In 1929, the

corporate insurance buyers met and started discussing various problems of mutual

interest. Though the meeting was not a formal one, it was a precursor to orient

corporate thinking and deal with risk in a more systematic way. In 1931, the

American management association established an insurance division. The primary

objective of the division was to provide a platform for discussing about risk

management and publish news and views of the members. This helped in creating

awareness among the various risk managers about the existence of a systematic wing



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for managing the risk. National insurance buyers association was started in America,

which was later renamed as risk insurance management society (RIMS).

Though risk management penetrated deep in the world business as a form of

insurance, it had yet to carve a niche in the world of personal insurance, as the

individual risk management awareness arrived at a later stage of the growth of the

risk management. It is difficult to say whether the growth in risk management can be

attributed to the growth in business practices. But it can be said that the development

of present day risk management activities stem from the development which took

place during early 1950s. Risk management practices were in vogue prior to this

period, but they were not universally popular. In other ways the different countries

were having different sets of underlying principles, philosophy and strategies to

manage the risk management.

1 Maturity of the risk management.

2 Ability and knowledge of risk manager.

3 Types of organization.

During the earlier period, management was developed as an independent

function of management, as most of the organization perceived it as an offshoot of

financial management. This may be because of the conversion and measurement of

risk, which in turn resulted in underwriting of insurance policies in financial terms, as

was the case of the hierarchy of the risk manager in the organization. Previously, risk

managers were either working under the finance department of purchase department.

1 Reliability movement of the 1950s

2 System safety movement of the 1960s and the 1970s



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He illustrated how the concepts of safety management were well adopted in

risk management. He implied this way of risk management to be more inclined

towards the financial side of risk management.

The practice of risk management in Indians public sector is ever three decades

old. The reasons for late recognition of the importance of risk management are many.

In India government organization are immune to different types of legal liability and

the effect of any other exposures can be passed on to the government. Thus, the risk

management principles were not much popular in government organizations. But as

the completive forces of the market forced the government to shed the primitive

practices and rules, they have become more conscious and started to imbibe risk

management practice. There are various constraints in the implementation of risk

management function. Some of them are.

A. Size of the organization

B. Decentralization of authority

C. Democratization of decision making

D. Multiple objectives

E. Administration complexities, etc.

Corporate Risk Management

Private corporate sector adopted active risk management for a variety of

reasons. The risk management program of a corporate entity aims at logical way to

solve problems it perceives. These problems if not managed properly, can result in

heavy losses. The loss may be in term of money, material, opportunities or human

life.

1. The risk manager of a company develops plans for protecting against any

unfavorable events. He undertakes the risk management process, whish starts

from information, supervising the initiation and progress plans of loss control

measures, which are critical for the organization. He also undertakes



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negotiation for the terms and conditions to cover the losses and takes adequate

steps for amicably setting them against the insurers. There are few activities

involving risks, which still remain with in the organization even when no

insurance has been undertaken. What are the various activities or

circumstances, which can cause loss to the organization?

2. What are the alternatives available to the organization to protect it self against

these activities and circumstances?

TYPES OF RISK

BUSINESS RISKS

By definition, business risks includes all risk factors, whether it affects a

business directly (loss affecting capital etc.) or indirectly (continued loss affecting

business strategy). Business risk can be divided into following:

i. Capital risk:



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The size of the owners stake (like capital) in the organization

determines the strength of its operation. The composition of its capital- Tier-I (paid-

up capital + reserves) and Tier-II (bonds, hybrid instruments etc.)-depends on its

resource mobilization capacity. If an organization can access capital from only

limited sources like directors (their friends and relatives) rather than from the public,

then this may act as a constraint on capital. In contemporary financial management,

capital has a number of components. These include:

Accounting capital: funds belonging to the promoters/owners.

Regulatory capital: the minimum amount of capital necessary to take care of

asset value as per regulatory requirements

Economic capital: the amount of amounts of funds set aside to absorb any

violent unexpected loss.

According to the Basel committee, capital base is one of the three pillars of

risk assessment (the other two being supervisory role and market discipline).

ii. Credit risk:

While we will discuss comprehensively on this category of risk in subsequent

chapters, it may be sufficient at this stage to indicate its components:

Credit growth in the organization and composition of the credit folio in terms

of sectors, centers and size of borrowing activities

So as to assess the extent of credit concentration.

Credit quality in terms of standard, sub-standards, doubtful and loss-making

assets.

Extent of the provisions made towards poor quality credits.



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Volume of off-balance-sheet exposures having a bearing on the credit

portfolio.

iii. Market risk:

The components of this risk type are:

Composition of the investment portfolio.

Quality of the investment portfolio (i.e., investment in rated and unrated

instruments).

Interest rate volatility and sensibility.

Where in a business the foreign exchange aspect is also vital (i.e.,

banking/export oriented units).

Equity/commodity risk (i.e., hedged/unhedged component).

iv. Earnings risk:

This covers a host of items such as:

Budget and profit planning function in the organization.

Analysis of income/expenses (with a focus on interest and non-interest income

in case of banks/financial institutions).

Earnings quality and stability.



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v. Liquidity risk:

Covers areas such as:

Composition (wholesale/retail deposits in the case of banks with geographical

and classification of depositors etc.).

Liquidity profile (mismatch between term and non-term liabilities, behavioral

maturity profile, diversification of funding sources etc.)

vi. Business strategy and environment risk:

Covers the following areas:

External environment and macro-economic factors.

Strategy with regards to market share, geographical spread, compatibility ofstrategy with in-house experience and expertise.

Business profile analysis using SWOT (strength, weaknesses, Opportunities

and threats), strength of competitors, scope and diversification, extent of

customer loyalty etc.

Strategy business initiatives on the institution and streamlining of business

development and proactive measures taken.

Experience and skills of key personnel in the organization and success in

planning.

Adequacy and compatibility of IT system and business needs.



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vii. Operational risk:

This really is an omnibus type of risk as it covers the entire gamut of activities in an

organization. The main components of operational risk are:

People risk: the capabilities, competence and motives of the people in the

organization.

Technology risk: system failure, system security, back-up and disaster

recovery plans, IT- related frauds etc.

Legal risk: documentation for transactions, security, compliance with

customer confidentiality etc.

Reputation risk: perception of customers and stakeholders of the

organization, regulatory perception process, strength for transaction delivery

etc.

Operating environment: abrupt non-macro economic changes in the

organization.

viii. Group risk factors:

These include

Capital concentration of the parent/group, gearing of capital, return on capital,

investment, relationship with subsidiaries, commonality of interest.

Operating and financial performance of the subsidiaries, shares of business

and competition faced by subsidiaries.

Contagious problems overlooked by the parent organization.



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Risks arising from connected lending and intra-group exposures, risks from

joint ventures, etc.

Compliance by subsidiaries with regulatory guidelines in the area of

operation.

CONTROL RISKS

In the entire risk measurement process, control of activities finds a

prominent place. A control mechanism is a must for any organizations well-being.

Control risks can be divided into:

I. internal control risk:

Lack of a clear line of responsibility and authority. In-house lack of control

may lead to housekeeping and other problems, which may affect the

organizations well-being.

Poor system for monitoring and reporting suspicious transactions that have a

noticeable impact on the organization.

No regular surveillance of the control mechanism by the top management.

ii. Organizational risk:

Vague and overlapping organizational structure with unclear legal

implications.

Absence of a structured assessment mechanism to leverage external and

internal relationship.

Absence of a cordial industrial relationship.

Lack of an adequate support system to evaluate major customer relationships.



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iii. Management (including corporate governance) risk:

Composition, cohesiveness, competence and leadership attributes of the board

of directors. The match between the board and the organizations risk

philosophy and risk appetite.

Non-assessment of the effectiveness of control functions of senior

management.

Absence of a clear succession planning mechanism.

Undefined responsibility and accountability.

Whether it follow contemporary corporate governance practices, especially

with regards to strategy formulation and problem-solving.

iv. Risk from the compliance angle:

Necessary emphasis not accorded to compliance with guidelines laid down by

the regulatory authorities.

Deviations not reported to the competent authorities when they arise.

Non-adherence to a monitorable action plan (MAP), if any, prescribed by a

competent authority.



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avoidance of risk is a method of dealing with risk, which is a negative rather than a

positive technique. Personal advancement of the individual and progress in the

economy both require risk taking. If risk avoidance were utilized extensively, both the

individual and society would suffer. For this reason, avoidance is an unsatisfactory

approach to dealing with risks.

Retention:

Riskretention is perhaps themost common method of dealing with risk. An

individual faces an almost unlimited array of risks; in most cases nothing is done

about them. When an individual does not take positive action to avoid, reduce, and

transfer the risk, the possibility of loss involved in that risk is retained. As a general

rule, risks that should be retained are those that lead to relatively small losses.

Transfer:

Risk may be transferred from one individual to another who is more willing to

bear the risk. An example is the process of hedging, where an individual guards

against the risk of price changes in one asset by buying or selling another asset whose

price changes in an offsetting direction. For example, futures markets have been

created to allow farmers to protect themselves against changes in the price of their

crop between planting and harvesting. A farmer sells a futures contract, which is

actually a promise to deliver at a fixed price in the future. If the value of the farmers

crop declines, the value of the farmers future position goes up to offset the loss.

Insurance is also a means of shifting or transferring risk. In consideration of a

specific payment (the premium) by one party, the second party contracts to indemnifythe first party unto a certain limit for the specified loss that may or may not occur.

Sharing:



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Risk is shared when there is some type of arrangement to share losses. Risks

are shared in a number of ways in our society. Under the corporation form of

business, the investments of a large number of persons are pooled. A large number of

investors may pool their capital, each bearing only a portion of the risk that the

enterprise may fail. Insurance is another device designed to deal with risk through

sharing, (Sharing is a form of transfer, in which the risk of the individual is

transferred to a group. In addition, it may be viewed as a form of retention. In which

the risks of a number of individuals are retained collectively).

Reduction:

Risk may be reduced in two ways i.e., through loss prevention and control.

There is almost no source of loss where some efforts are not made to avert the loss.

Safety programs and loss prevention measures, such as Medicare, fire departments,

security guards, burglar alarms are examples of attempts to deal with risk by

preventing the loss or reducing the chance that it will occur.

RISK MANAGEMENT PROCESS

Risk management activities occur before, during, and after losses. Most

planning is done before losses occur. Losses involving natural disasters and other

emergencies also require action while losses are happening. After the loss, the risk

manager must file insurance claims and analyze loss patterns.

Establishing risk management objectives, tolerances and limits for all of

the enterprise's significant risks



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Assessing risks within the context of established tolerances

Developing cost-effective risk management strategies and processes

consistent with the overall goals and objectives

Implementin g risk management processes

Monitoring and reporting upon the performance of risk management

processes

Improving risk management processes continuously

Ensuring adequate communication and information for decision making



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SOURCES OF RISK

Source of risk can b classified in several ways. Source of risk that arises from

the ownership of property: physical (e.g., fire), social (riot), and economic (inflation).



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Changing morals and values, human behavior, social structures, and

institutions are a second source of risk. Many American business executives become

frustrated when thy move into the international domain. For example, differing social

values and norms in Japan have proven to be a particular source of uncertainly for

American and European business managers. Within the underscores the important of

this source of risk. Changing culture values also create opportunities, as when new

attitudes regarding women in the workforce open a door to a significant talent pool.

POLITICAL ENVIRONMENT:

Within a single country, the political environment cans b an important source

of risk. A new president can move the nation into a policy direction that might have

dramatic effects on particular organizations (cuts in aid to local governments, new

stringent regulation on toxic waste disposal). In the international realm, the political

environment is even more complex. Not all nations are democratic in their form of

government, and politics towards business. Foreign assts might b confiscated by a

host government o tax policies might change dramatically. The political environment

also can promote positive opportunities though fiscal and monetary policy,

enforcement of laws.

LEGAL ENVIRONMENT:

Within the United States today, a gat deal of uncertainty and risk arises from

the legal system. Not only are standards of conduct upheld and punishments enforced,

but as the system itself evolves new standards arise may that not b fully anticipated.

In the international domain, complexity increases because legal standards can vary

from country to country. The legal environment also produces positive outcomes in



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the sense that rights are protected and that the legal system provides a stabilizing

influences on society.

OPRATIONAL ENVIRONEMNT:

Processes and procedures of an organization generate risk and uncertainty. A

formal procedure for promoting, hiring, or firing employees may generate a legal

liability. The manufacturing process may put employees at risk of physical harm.

Activities of an organization may result in ham to the environment. International

business may suffer from risk or uncertainty due to unreliable transportation systems.

The operational environment also provides gains, as it is the ultimate source of the

goods and service by which an organization succeeds or fails.

ECONOMIC ENVIRONMENT:

Although the economic environment often flows directly from the political

realm, the dramatic expansion of the global market place has created an environmentthat is greater than any single government. Although a markets is beyond the reach

of a single nation. Inflation, recession and depression are now elements of

interdependent economic systems. On a local level, interest rates and credit policies

can impose significant risk on an organization.

COGNITIVE ENVIRONMENT:

An important source of risk for organization is the difference between perception andreality. The cognitive environment is a challenging source of risk to identify and

analyze. The analyst must contemplate such questions as How do we understand the

effect of uncertainty on the organization? and How do we know whether perceived



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risk is real? An evaluation of the cognitive environment partly addresses the

distinction between risk and uncertainty.

CHAPTER IV



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WHAT IS VAR?

Value-at-risk (VaR) is a quintile based method of risk assessment of a

portfolio. Value-at risk is widely used by banks, securities firms, commodity

merchants, energy merchants, and other trading organizations. Such firms could track

their portfolios' market risk by using historical volatility as a risk metric. They might

do so by calculating the historical volatility of their portfolio's market value over a

rolling 100 trading days. However, the problem with doing this is that it would

provide a retrospective indication of risk. The historical volatility would illustrate

how risky the portfolio had been over the previous 100 days. It would say nothingabout how much market risk the portfolio was taking today. For institutions to

manage risk, they must know about risks while they are being taken. If a trader

mishedges a portfolio, his employer needs to find out before a loss is incurred. Value

at-risk gives institutions the ability to do so. Unlike retrospective risk metrics, such as

historical volatility, value-at-risk is prospective. It quantifies market risk while it is

being taken. Another reason for popularity of VaR estimates is that it summarizes in a

single, easy to understand number the downside risk of an institution due to financial

market variables.

VaR can be intuitively defined as the worst loss over a target horizon with a

given confidence level. It can be defined either as an absolute number or as a



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percentage of the portfolio value .Crucial for the determination of the extreme future

market value, and hence for the VaR, is the distribution function of the return on

market value. The portfolio value as of today is a known parameter. However, its

future value in a given time horizon is unknown and is a random variable. It will have

a probability distribution based on historical data or expected value of different

market variables like interest rate, Forex, etc. One such distribution is as shown in

Exhibit 3, where the present portfolio value is shown to be P0. With VaR, we

summarize the portfolios market risk by reporting some parameter of this

distribution. For Ex, if the above distribution is for daily portfolio value, then the VaR

value in the above figure depicts the 95% quintile of the portfolios daily loss. By this

we mean that, the maximum loss in a single period cant exceed this value with a

confidence level of 95% i.e. the expected loss would not be more than this value in 19

out of 20 days. Or in other words, the portfolio is expected to lose more than this

value in 1 out of 20 days.

Exhibit 3:The distribution function of the return on market value usually a

normal or lognormal distribution is assumed for the market return. However, a normal

distribution is claimed to underestimate the probability in the tail and hence the VaR,

as VaR deals with extreme market situations. Popular alternatives include GARCH-

type of models to allow for time-varying volatility and the Student-t distribution,

since it allows for more probability mass in the tail than the normal distribution.

Equally important for VaR estimation is uncertainty in parameter values. Parameter

uncertainty leads to uncertainty in the VaR estimates. And this uncertainty increases

with models that try to incorporate complex tail behaviors. Hence there is a trade off

between more complex tail behavior and uncertainty in the VaR estimate.

There are different methods for VaR calculation. One thing to keep in mind is

that the choice of methodology used to estimate VaR gives rise to very different



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results of the VaR and hence it is more important to identify which method is best

suited for a given portfolio and the intended use. The different methods are:

1. Variance-Covariance method

2. Historical simulation

3. Constant maturity model

4. Monte Carlo simulation

VaR

Variance-Covariance Method

In this method, the portfolio return is assumed to have normal probability

distribution. The advantage of this assumption is that the model can be defined in its

entirety in terms of only 2 parameters Mean and Standard deviation of the portfolio

return. In this way, this method is parametric in nature. The expected value of the

portfolio is calculated as: Where 0E (1P) is the expected portfolio value in period 1

based on information in period 0.B is a column vector giving the weightage ofdifferent variables in the portfolio.is the mean vector of the variables in the portfolio.

Similarly, standard deviation of the portfolio is defined as: Where: is the standard

deviation for the portfolio. Is the covariance matrix of the portfolio, 1|0 indicating that

the parameter is for period 1, and conditional on information available in period 0? B`

is the transpose of vectorb. One advantage of normal assumption is that quintiles of a

normal distribution occur a fixed number (z) of standard deviations from the

distributions mean which can be determined from standard normal distribution table.

Since the computations are so modest, implementation of Variance-Covariance

method runs in real time.



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However, it has the disadvantages associated with the normal distribution

function. It ignores the distribution with fat tails and since VaR is more of a measure

of tail distribution, normal assumption can lead to problem of overestimation or

underestimation of VaR, thereby defeating the purpose of VaR estimation

Historical Simulation

This method is the simplest and most transparent method of calculation. This

involves evaluating the current portfolio across a set of historical changes in the

underlying variables to yield a distribution of changes in portfolio value, and

computing VaR. The benefits of the method are its simplicity to implement, and the

fact that it does not assume a normal distribution of asset returns. However, it requires

a large database of historical values to be effective. Moreover, it assumes that the

historical values are a good estimate for future values, which may not be always true.

Constant Maturity Model

In the Variance-Covariance method, the interaction between different

variables underlying the portfolio has to be taken into account. This leads to

multivariate models that include many parameters that are all estimated with

uncertainty. This suggests that VaR-estimates for portfolios of securities are more

uncertain. To avoid multivariate models, constant maturity value of the portfolio is

determined at all times in history. The resulting time series of constant maturity

values may be modeled in a univariate time series framework, which can be used to



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determine the VaR estimate for the constant maturity value of the portfolio. There is

difference in the actual value and constant maturity value of a portfolio, however,

over short forecasting horizons, this difference is negligible. An advantage of this

approach is that it focuses on the portfolio return directly and not on

Individual variable. Moreover, we can restrict ourselves to univariate models, which

have the advantage of less parameter uncertainty than multivariate models, as the

number of parameters to be estimated is less.

Monte Carlo Simulation

It is conceptually simple, but is generally computationally more intensive

than the methods described above. In this method, some market model is used to

generate random scenario of market variables for the pre-decided number of

iterations. For each set, portfolio is revaluated and profit (loss) is calculated under the

simulated scenario. These profits/losses are sorted in an order to give the simulated

distribution and then this distribution is used to determine VaR at a particular

confidence level. It is possible to compute an error term associated with the VaR

estimate thus obtained and this error will reduce as the number of simulationsincreases. Monte Carlo Simulation is generally used to compute VaR for portfolios

containing securities with non-linear returns. However, for a portfolio without these

complex instruments, variance-covariance method is perfectly suitable and should be

used. One thing should be kept in mind that Monte Carlo method is subjected to

model risk if the model used is not very suitable.

To determine which method is best suited for a given portfolio, the validity of the

VaR

Estimate should be carried out. This is generally done by back-testing. This is done

through comparison of predicted and actual loss levels. This testing can also help in

checking the assumptions, parameters and accuracy of the model. Another important



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aspect of VaR estimation is determination of time horizon and confidence level the

popular values for time horizon are 1 day and 10 days. And for confidence level are

95% and 99%. We recommend the use of 1 day VaR with a confidence level of 99%.

Time horizon of 1 day will help in monitoring daily mark-to-market changes in

portfolio value and 99% confidence level would reduce the frequency of loss

exceeding the VaR estimate.

ILLUSTRATION

In this section, the actual portfolio for the company taken as on 17 th of May, 2010 is

taken and then this portfolio is evaluated using market data since Apr 99 to

determine VaR estimates with time horizon ranging from 1 day to 1 month and a

confidence level of 95% and 99%. Valuation of Assets and Liabilities

Below shows the exposure of the Company to various risk elements because of its

Operation as well as treasury activities.

Particulars Amount Exposure to Forex Exposure to Interest Rate

Receivables USD 100 Millions

Payables USD 10 Millions

Loan EUR 400 Millions

PCFC USD 154.5 Millions

Adv (Falcon) USD 39 Millions

Adv (Betapharma) EUR 26 Millions

Exhibit 4:



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Risk elements because of the company operation and treasury activities. Net

Receivables Because of the predominantly export oriented business of the company,

its Receivables in USD is greater than its Payables in USD and hence the difference is

net receivables2. As explained earlier, because of a possible adverse forex market

movement, the Company stands the risk of incurring a loss. Loan On 16th of

February, 2009, the Company made the historic acquisition of Betapharma, 4th

largest generic pharma company of Germany, for a huge sum of EUR 480,000,000.

This acquisition has strategic importance because this will help the Company to get a

strong 2 For the sake of simplicity; it is assumed that all the receivables and payables

are only in USD. Although there are sales and purchases in other currencies as well,

these are minor compared to USD transaction and hence this assumption is justified.

14 footholds in European market. However, for the acquisition, the Company had the

take a massive long term loan ofEUR 400,000,000 that is linked to the volatile 6 M

EUR Libor rate. This loan is to be repaid within 5 years such that the average

duration does not exceed 4 years. Because of this linkage and since the repayment of

loan is to be made in EUR, the company is subjected to both interest rate and Forex

risk. The terms of the loan are stated in Exhibit 5below:

Bank Amount (EUR) Resettlement Freq Interest Rate Duration

Citibank 400,000,000 3 months 6 M EUR Libor rate + 150 basis points 5 Years

Exhibit 5:

Terms of the loan of EUR 400,000,000 for Betapharma acquisition since the

interest rate is reset every 3 months, the market value of the loan amount is same as

the book value on the date of reset. Hence, the valuation of the loan on any date is

done as follows:

Where:



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P = Book value of the loan

CP = Interest rate (Reset every 3 months, 6 M EUR Libor rate + 150 basis points)

DR = Discount rate (6 M EUR spot Libor rate + 150 basis points)

D = Number of days from valuation date to next resettlement

Z = Number of days between resettlements

B = Interest basis (Taken 365 days)

The Market value obtained is in EUR and to convert it to INR, it has to be multiplied

with the EUR/INR exchange rate on the valuation date.

PCFC

Packing Credit Foreign Currency (PCFC) are short term loans taken by the Company

for

Meeting its working capital requirement. Exhibit 6below shows the terms and details

of the various PCFC loans taken by the Company.

P*(1+CP/4) (ZD)*CP

(1+DR/4) D/Z B Market Value =15

Bank Amount (USD) Start Date End Date Basis points Resettlement Freq

StanC 5,000,000 5/6/2009 5/31/2010173.60 1 Month

StanC 10,000,000 12/29/2009 6/27/2010 60.00 1 Month

StanC 20,000,000 2/16/2009 8/15/2010 50.00 1 Month

StanC 10,000,000 3/17/2009 9/13/2010 51.00 1 Month

HSBC 10,000,000 2/16/2009 8/17/2010 68.00 1 Month

HSBC 4,500,000 3/21/2009 6/19/2010 60.00 1 Month

Bank Am 15,000,000 3/3/2009 6/2/2010 59.00 1 MonthSBI 25,000,000 4/28/2009 5/28/2010 51.00 1 Month

CITI 20,000,000 4/3/2009 9/3/2010 -10.30 1 Month

CITI 10,000,000 3/17/2009 9/13/2010 75.00 1 Month



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CITI 20,000,000 2/16/2009 8/15/2010 82.00 1 Month

CITI 5,000,000 3/17/2009 9/13/2010 40.00 1 Month

Exhibit 6:

Terms and details of the PCFC loan taken by the Company Interest rate is

reset every 1 month and it is linked to the 6 M USD Libor rate plus the basis point as

indicated against each of the PCFC. The valuation of a PCFC loan is done as follows:

Where all the symbols have the same meaning as described above the market value

obtained is in USD and to obtain the corresponding INR value, the USD value is to be

multiplied with the spot USD/INR exchange rate. Because of the dependence of INR

value on interest rate and exchange rate, the value of a PCFC is subjected to both

interest rate and forex risk.

Advances

The Company has given advances to its subsidiaries for their operation. The

details of the advances are shown in Exhibit 7below3.

3 Advances have been given to subsidiaries other than Falcon and Betapharma as

well. However, they are not considered here for 2 reasons:

1. They are insignificant compared to advances to Falcon and Betapharma2. The notional currency for them is INR; hence there is no forex risk for those

subsidiaries

P*(1+CP/12) (ZD)*CP


Subsidiary Amount Start Date Basis points Resettlement Freq

Falcon USD 39,000,000 1/1/2010 150.00 3 Months. Betapharma EUR 26,000,000

2/16/2010 175.00 3 Months.

Exhibit 7:



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Details of the advances to Falcon and Betapharma the market value of the advances is

calculated in the same way as that for the loan above. It is copied below for

convenience. The symbols have same meaning described earlier. The value obtained

will be in respective currencies and hence need to be multiplied with appropriate spot

exchange rate to determine the value in INR. Because of the dependence on both

interest rate and exchange rate, advances are subjected to both interest rate and Forex

risk.

Calculation

The calculations shown below are the snapshot of VaR estimate for the

portfolio of Dr.Reddys as on a particular day. Hence the estimates shown below

should not be taken to be conclusive. It would change with the changes in the

portfolio. Moreover, these calculations are done for determining the method that

gives a better estimate of VaR. Variance-Covariance method is not taken for the

calculation purpose because of the complexity involved in assigning weightage to

each of the market variable manually.

Parameters Method Overall Risk Interest Rate Forex Risk

Historical Simulation Rs. 20.7 Crores Rs. 0.11 Crores Rs. 20.6 Crores

Constant Maturity Rs. 24.2 Crores Rs. 0.14 Crores Rs. 24.0 Crores TH 1 day

and CL 95%

Monte Carlo Simulation Rs. 16.0 Crores NA NA

Historical Simulation Rs. 38.6 Crores Rs. 0.23 Crores Rs. 38.4 Crores

Constant Maturity Rs. 34.1 Crores Rs. 0.197 Crores Rs. 33.9 Crores TH 1 dayAnd CL 99%

Monte Carlo Simulation Rs. 24.7 Crores NA NA



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Historical Simulation Rs. 98.5 Crores Rs. 0.68 Crores Rs. 97.8 Crores TH 1

Month

And CL 95% Constant Maturity Rs. 91.5 Crores Rs. 0.73 Crores Rs. 90.7 Crores

Historical Simulation Rs. 111.3 Crores Rs. 1.16 Crores Rs. 110.1 Crores TH 1

Month and CL 99% Constant Maturity Rs. 127.2 Crores Rs. 1.03 Crores Rs.

126.2 Crores

P*(1+CP/4) (ZD)*CP


Back-testing of various models has not been considered in the absence of more

sophisticated techniques. Hence, another criterion for comparison can be the

conservative nature of the estimate. We can see thatHistorical Simulation Method

gives the most conservative estimate for a time horizon of 1 day and 99% confidence

level. Hence it can be used for the VaR estimation in case a conservative estimate is

desired. However, Variance-Covariance method can also be looked at before making

any decision.

The calculations are shown in the attached files:

E:\Summers\FinalPresentation\VaREstimation\HistoricalReturnDaily.xls

E:\Summers\FinalPresentation\VaREstimation\HistoricalReturnMonthly.xls

H OW TO U SE V A R?

Because of the variability in the market condition, businesses run the risk of

losing because of possible adverse market movement. However, with the advent of

derivative products and various other hedging mechanisms, it is possible for treasury

department to hedge the cash flows such that irrespective of the market movement,

the company has a risk-free cash flow. But it has a downside to it. While the

Company stands to lose from adverse market movement, at the same time it can gain

substantially if the market moves favorably for the Companys portfolio. So, if

treasury hedges the entire portfolio, the Company will miss out the opportunity to



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LIMITATIONS OF VAR

Although VaR is the most used method of risk assessment, it is not panacea

of risk measurement methodologies. According to theory of coherent risk measur

risk management apr[1]

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