Risk Management
Risk management in Paper 14 covers identification, measurement and treatment of enterprise and financial risks, and the economics of hedging - whether the hedge genuinely reduces cash-flow volatility net of cost.
Taxonomy and framework
Risks are strategic, operational, financial (market - interest rate, FX, commodity; credit; liquidity) and compliance-related. An ERM framework runs risk appetite, identification, assessment, response (avoid, reduce, transfer, accept) and monitoring, with board-level ownership. Risk management is not risk elimination; it is the deliberate choice of which risks to retain because they are compensated.
Measurement
VaR at confidence c = position × σ × z, with z = 1.645 for 95% and 2.33 for 99% (one-tailed). Scale by √t only under i.i.d. returns. Expected shortfall averages losses beyond VaR and is sub-additive, unlike VaR. Interest rate risk: duration gap = D_A − (L/A)D_L, and ΔE = −gap × A × Δi/(1+i).
Worked example
A ₹50 crore portfolio has daily σ = 1.2%. One-day 99% VaR = 50 × 0.012 × 2.33 = ₹1.398 crore. Ten-day VaR = 1.398 × √10 = ₹4.42 crore. If the desk limit is ₹4 crore, position size must fall to 4/4.42 ≈ 90%, i.e. about ₹45 crore.
Traps
Quoting VaR as the maximum possible loss; scaling by √t while ignoring volatility clustering; mixing 95% and 99% z-values; hedging a risk you do not have (forward-covering a receivable creates a firm obligation); ignoring basis risk, margin calls and hedge cost when judging whether the hedge added value.